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EX-32.2 - CERTIFICATE PURSUANT TO SECTION 18 U.S.C. PURSUANT TO SECTION 906 OF THE SARBANE - Paragon Commercial CORPpbnc_ex322.htm
EX-32.1 - CERTIFICATE PURSUANT TO SECTION 18 U.S.C. PURSUANT TO SECTION 906 OF THE SARBANE - Paragon Commercial CORPpbnc_ex321.htm
EX-31.2 - CERTIFICATION PURSUANT TO RULE 13A-14(A)/15D-14(A) CERTIFICATIONS SECTION 302 OF - Paragon Commercial CORPpbnc_ex312.htm
EX-31 - CERTIFICATION PURSUANT TO RULE 13A-14(A)/15D-14(A) CERTIFICATIONS SECTION 302 OF - Paragon Commercial CORPpbnc_ex311.htm
 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 
For the quarterly period ended June 30, 2017
 
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: 001-37802
 
PARAGON COMMERCIAL CORPORATION
(Exact name of registrant as specified in its charter)
 
North Carolina
56-2278662
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
 
 
3535 Glenwood Avenue
Raleigh, North Carolina
27612
(Address of principal executive offices)
(Zip Code)
 
(919) 788-7770
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  ☒    NO  ☐
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    YES  ☒    NO  ☐
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See definitions of “large accelerated filer”, “accelerated filer”, “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer
Accelerated filer
Non-accelerated filer
(Do not check if a smaller reporting company)
Smaller reporting company
 
 
Emerging growth company
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act 
 
Indicate by check mark whether registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    YES  ☐    NO  ☒
 
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
 
As of August 8, 2017, there were approximately 5,459,982 shares of the registrant’s common stock outstanding.
 

 
 
 
PARAGON COMMERCIAL CORPORATION
FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2017
 
TABLE OF CONTENTS
 
 
 
 Page No.
Part I.
FINANCIAL INFORMATION
 
Item 1.
Financial Statements
 
 
 
 
 
Consolidated Balance Sheets (Unaudited) as of June 30, 2017 and December 31, 2016
1
 
 
 
 
Consolidated Statements of Income (Unaudited) for the Three and Six Months Ended June 30, 2017 and 2016
2
 
 
 
 
Consolidated Statements of Comprehensive Income (Unaudited) for the Three and Six Months Ended June 30, 2017 and 2016
3
 
 
 
 
Consolidated Statement of Changes in Stockholders' Equity (Unaudited) for the Six Months Ended June 30, 2017 and 2016
4
 
 
 
 
Consolidated Statements of Cash Flows (Unaudited) for the Six Months Ended June 30, 2017 and 2016
5
 
 
 
 
Notes to Consolidated Financial Statements (Unaudited)
6
 
 
 
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
32
 
 
 
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
59
 
 
 
Item 4.
Controls and Procedures
60
 
 
 
PART 2.
OTHER INFORMATION
 
 
 
 
Item 1.
Legal Proceedings
60
 
 
 
Item 1A.
Risk Factors
60
 
 
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
63
 
 
 
Item 3.
Defaults Upon Senior Securities
63
 
 
 
Item 4.
Mine Safety Disclosures
63
 
 
 
Item 5.
Other Information
63
 
 
 
Item 6.
Exhibits
64
 
 
 
 
SIGNATURES
65
 
 
 
 
 
 
 
Part I.  
Financial Information
Item 1. 
Financial Statements
 
PARAGON COMMERCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS (Unaudited)
June 30, 2017 and December 31, 2016
(Balance Sheet as of December 31, 2016 is derived from Audited Financial Statements)

 
(In thousands, except share data)
 
2017
 
 
2016
 
 
Assets
 
 
 
 
 
 
 
Cash and due from banks:
 
 
 
 
Interest-earning
 $13,380 
 $38,384 
Noninterest-earning
  4,184 
  4,621 
Investment securities - available-for-sale, at fair value
  203,544 
  197,441 
Federal Home Loan Bank stock, at cost
  12,828 
  8,400 
Loans - net of unearned income and deferred fees
  1,339,860 
  1,191,280 
Allowance for loan losses
  (8,921)
  (7,909)
Net loans
  1,330,939 
  1,183,371 
Accrued interest receivable
  4,690 
  4,368 
Bank premises and equipment, net
  15,233 
  15,642 
Bank owned life insurance
  34,703 
  34,190 
Other real estate owned
  4,690 
  4,740 
Deferred tax assets
  3,882 
  4,841 
Other assets
  7,494 
  7,769 
Total assets
 $1,635,567 
 $1,503,767 
 
   
   
Liabilities and stockholders' equity
 
    
    
Deposits:
    
    
Noninterest-bearing demand
 $200,944 
 $211,202 
Interest-bearing checking and money market
  794,255 
  742,046 
Time deposits
  179,531 
  219,007 
Total deposits
  1,174,730 
  1,172,255 
Repurchase agreements and federal funds purchased
  21,256 
  20,174 
Federal Home Loan Bank advances
  270,000 
  150,000 
Other liabilities
  5,730 
  6,679 
Total liabilities
  1,490,274 
  1,367,666 
Stockholders' equity:
    
    
Common stock, $0.008 par value; 20,000,000 shares
  44 
  44 
authorized; 5,458,528 and 5,450,713 issued and
    
    
outstanding as of June 30, 2017 and December 31, 2016
    
    
Additional paid-in-capital
  80,721 
  80,147 
Accumulated other comprehensive loss
  (859)
  (2,840)
Retained earnings
  65,387 
  58,750 
Total stockholders' equity
  145,293 
  136,101 
Total liabilities and stockholders' equity
 $1,635,567 
 $1,503,767 
 
See accompanying notes to these unaudited consolidated financial statements.
 
-1-
 
 
PARAGON COMMERCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
For the Three and Six Months Ended June 30, 2017 and 2016

 
 
 
Three months
 
 
Six months
 
 
 
ended June 30,
 
 
ended June 30,
 
(In thousands, except per share data)
 
2017
 
 
2016
 
 
2017
 
 
2016
 
Interest income
 
 
 
 
 
 
 
 
 
 
 
 
Loans and fees on loans
 $14,014 
 $11,840 
 $27,084 
 $23,030 
Investment securities and FHLB stock
  1,465 
  1,369 
  2,868 
  2,588 
Federal funds and other
  71 
  63 
  230 
  121 
Total Interest income
  15,550 
  13,272 
  30,182 
  25,739 
Interest expense
    
    
    
    
Interest-bearing checking and money market
  1,127 
  836 
  2,201 
  1,693 
Time deposits
  458 
  556 
  969 
  1,123 
Borrowings and repurchase agreements
  947 
  579 
  1,675 
  1,071 
Total interest expense
  2,532 
  1,971 
  4,845 
  3,887 
Net interest income
  13,018 
  11,301 
  25,337 
  21,852 
Provision for loan losses
  650 
  - 
  809 
  - 
Net interest income after provision for loan losses
  12,368 
  11,301 
  24,528 
  21,852 
Non-interest income
    
    
    
    
Increase in cash surrender value of bank owned life insurance
  255 
  226 
  513 
  449 
Net gain on sale of securities
  - 
  - 
  - 
  85 
Service charges and fees
  68 
  56 
  130 
  114 
Mortgage origination fees and gains on sale of loans
  26 
  33 
  77 
  65 
Net loss on sale or impairment of foreclosed assets
  (22)
  (45)
  (22)
  (257)
Other fees and income
  167 
  111 
  299 
  191 
Total non-interest income
  494 
  381 
  997 
  647 
Non-interest expense
    
    
    
    
Salaries and employee benefits
  4,310 
  3,742 
  8,772 
  7,609 
Furniture, equipment and software costs
  451 
  390 
  953 
  882 
Occupancy
  373 
  342 
  732 
  686 
Data processing
  580 
  524 
  1,110 
  820 
Director related fees and expenses
  253 
  219 
  477 
  471 
Professional fees
  244 
  182 
  447 
  419 
FDIC and other supervisory assessments
  201 
  217 
  367 
  412 
Advertising and public relations
  297 
  234 
  518 
  422 
Unreimbursed loan costs and foreclosure related expenses
  104 
  142 
  278 
  211 
Merger related costs
  368 
  - 
  368 
  - 
Other
  676 
  496 
  1,447 
  1,156 
Total non-interest expense
  7,857 
  6,488 
  15,469 
  13,088 
Income before income taxes
  5,005 
  5,194 
  10,056 
  9,411 
Income tax expense
  1,722 
  1,719 
  3,419 
  3,098 
Net income
 $3,283 
 $3,475 
 $6,637 
 $6,313 
 
    
    
    
    
Net income per common share
    
    
    
    
Basic
 $0.61 
 $0.76 
 $1.23 
 $1.38 
 
 $- 
 $- 
 $- 
 $- 
Diluted
 $0.61 
 $0.75 
 $1.23 
 $1.37 
 
See accompanying notes to these unaudited consolidated financial statements.
 
-2-
 
 
PARAGON COMMERCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF COMPREHENSIVEINCOME (Unaudited)
Three and Six Months Ended June 30, 2017 and 2016

 
 
 
Three months
 
 
Six months
 
 
 
ended June 30,
 
 
ended June 30,
 
(In thousands)
 
2017
 
 
2016
 
 
2017
 
 
2016
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income
 $3,283 
 $3,475 
 $6,637 
 $6,313 
 
     
     
     
     
Other comprehensive income items:
     
     
     
     
Securities available for sale:
     
     
     
     
Unrealized gains
  2,436 
  2,920 
  2,889 
  3,914 
Reclassification of gains recognized in net income
  - 
  - 
  - 
  (85)
Other comprehensive income
  2,436 
  2,920 
  2,889 
  3,829 
Deferred tax expense
  940 
  1,116 
  1,112 
  1,462 
Other comprehensive income, net of tax
  1,496 
  1,804 
  1,777 
  2,367 
 
    
    
    
    
Cash flow hedges:
     
     
     
     
Unrealized gains (losses)
  (21)
  (575)
  351 
  (2,136)
Other comprehensive income (loss)
  (21)
  (575)
  351 
  (2,136)
Deferred tax (benefit) expense
  8 
  (217)
  147 
  (803)
Other comprehensive income (loss), net of tax
  (29)
  (358)
  204 
  (1,333)
 
    
    
    
    
Total other comprehensive income, net of tax
  1,467 
  1,446 
  1,981 
  1,034 
 
    
    
    
    
Comprehensive income
 $4,750 
 $4,921 
 $8,618 
 $7,347 
 
See accompanying notes to these unaudited consolidated financial statements.
 
-3-
 
 
PARAGON COMMERCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)
Six Months Ended June 30, 2017 and 2016

 
 
 
 
 
 
 
 
 
 
 
 
Accumulated
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Additional
 
 
Other
 
 
 
 
 
Total
 
 
 
Common Stock
 
 
Paid-in
 
 
Comprehensive
 
 
Retained
 
 
Stockholders'
 
(In thousands, except share data)
 
Shares
 
 
Amount
 
 
Capital
 
 
Income (Loss)
 
 
Earnings
 
 
Equity
 
Balance at December 31, 2016
  5,450,713 
 $44 
 $80,147 
 $(2,840)
 $58,750 
 $136,101 
 
    
    
    
    
    
    
Net income
  - 
  - 
  - 
  - 
  6,637 
  6,637 
Unrealized gain on securities, net of
    
    
    
    
    
    
tax expense of $1,112
  - 
  - 
  - 
  1,777 
  - 
  1,777 
Unrealized gain on cash flow hedges,
    
    
    
    
    
    
net of tax expense of $147
  - 
  - 
  - 
  204 
  - 
  204 
Restricted stock expense recognized
  - 
  - 
  240 
  - 
  - 
  240 
Stock options exercised
  6,313
 
  -
 
  270
 
  -
 
  -
 
  270
 
Issuance of stock for employee stock
    
    
    
    
    
    
purchase plan
  1,502 
  - 
  64 
  - 
  - 
  64 
Balance at June 30, 2017
  5,458,528 
 $44 
 $80,721 
 $(859)
 $65,387 
 $145,293 
 
 
 
 
 
 
 
 
 
 
 
 
Accumulated
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Additional
 
 
Other
 
 
 
 
 
Total
 
 
 
Common Stock
 
 
Paid-in
 
 
Comprehensive
 
 
Retained
 
 
Stockholders'
 
(In thousands, except share data)
 
Shares
 
 
Amount
 
 
Capital
 
 
Income (Loss)
 
 
Earnings
 
 
Equity
 
Balance at December 31, 2015
  4,581,334 
 $37 
 $53,147 
 $(886)
 $45,360 
 $97,658 
 
    
    
    
    
    
    
Net income
  - 
  - 
  - 
  - 
  6,313 
  6,313 
 
Unrealized gain on securities, net of
 
    
    
    
    
    
tax expense of $1,462
  - 
  - 
  - 
  2,367 
  - 
  2,367 
 
Unrealized loss on cash flow hedges,
 
    
    
    
    
    
net of tax benefit of $803
  - 
  - 
  - 
  (1,333)
  - 
  (1,333)
Restricted stock expense recognized
  - 
  - 
  205 
  - 
  - 
  205 
Issuance of stock for public offering
  845,588 
  6 
  26,388 
  - 
  - 
  26,394 
Issuance of restricted stock awards
  19,145 
  - 
  - 
  - 
  - 
  - 
 
Issuance of stock for employee stock
 
    
    
    
    
    
purchase plan
  3,799 
  - 
  105 
  - 
  - 
  105 
Balance at June 30, 2016
  5,449,866 
 $43 
 $79,845 
 $148 
 $51,673 
 $131,709 
 
See accompanying notes to these unaudited consolidated financial statements.
 
-4-
 
 
PARAGON COMMERCIAL CORPORATION AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Six Months Ended June 30, 2017 and 2016

 
(In thousands)
 
2017
 
 
2016
 
Cash flows from operating activities:
 
 
 
 
 
 
Net income
 $6,637 
 $6,313 
Adjustments to reconcile net income to net cash provided by
    
    
operating activities:
    
    
Depreciation and amortization
  704 
  711 
Provision for loan losses
  809 
  - 
Net loss on sale or impairment of foreclosed assets
  22 
  257 
Increase in cash surrender value of life insurance
  (513)
  (449)
Accretion of premiums/discounts on securities, net
  569 
  567 
Net gain on sale of securities
  - 
  (85)
Loss on disposal of property and equipment
  1 
  - 
Deferred tax expense (benefit)
  (289)
  196 
Restricted stock expense
  240 
  205 
Changes in assets and liabilities:
    
    
Accrued interest receivable and other assets
  304 
  (135)
Accrued interest payable and other liabilities
  (949)
  (293)
Net cash provided by operating activities
  7,535 
  7,287 
Cash flows from investing activities:
    
    
Net decrease in Federal Home Loan Bank stock
  (4,428)
  (552)
Purchase of securities available for sale
  (13,526)
  (39,434)
Proceeds from maturities and paydowns of securities available for sale
  9,732 
  9,639 
Proceeds from sales of securities available for sale
  - 
  15,714 
Net increase in loans
  (148,377)
  (88,843)
Proceeds from sale of foreclosed real estate
  28 
  13 
Additions to bank premises and equipment
  (296)
  (402)
Net cash used in investing activities
  (156,867)
  (103,865)
Cash flows from financing activities:
    
    
Net increase in demand and money market deposit accounts
  41,951 
  170,958 
Net decrease in time deposits
  (39,476)
  (53,604)
Net increase (decrease) in repurchase agreements
  1,082 
  (7,890)
Net increase in FHLB and other borrowings
  120,000 
  5,200 
Net proceeds from sale of common stock
  - 
  26,394 
Issuance of common stock for employee stock purchase
    
    
plan and stock options
  334 
  105 
Net cash provided by financing activities
  123,891 
  141,163 
Net change in cash and cash equivalents
  (25,441)
  44,585 
Cash and cash equivalents at beginning of year
  43,005 
  55,530 
 
    
    
Cash and cash equivalents at end of year
 $17,564 
 $100,115 
 
See accompanying notes to these unaudited consolidated financial statements.
 
-5-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
NOTE 1 - ORGANIZATION AND OPERATIONS
 
On April 2, 2001, Paragon Commercial Corporation (the “Company”) was incorporated for the purpose of serving as a holding company for Paragon Commercial Bank (the “Bank”). The Company currently has no operations and conducts no business on its own other than owning the Bank and two statutory business trusts, Paragon Commercial Capital Trust I and II.
 
The Bank was incorporated on May 4, 1999 and began banking operations on May 10, 1999. The Bank is engaged in general commercial banking in Wake and Mecklenburg Counties, North Carolina, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation and the North Carolina Commissioner of Banks. The Bank undergoes periodic examinations by those regulatory authorities. In addition, the Company undergoes periodic examinations by the Federal Reserve.
 
The Company formed Paragon Commercial Capital Trust I (“Trust I”) during 2004 in order to facilitate the issuance of trust preferred securities. Trust I is a statutory business trust formed under the laws of the state of Delaware, of which all common securities are owned by the Company. The Company formed Paragon Commercial Capital Trust II (“Trust II”) during 2006 to serve the same purpose. The junior subordinated debentures issued by the Company to the trusts are classified as debt and the Company’s equity interest in the trusts are included in other assets.
 
The trust preferred securities presently qualify as Tier 1 regulatory capital and are reported in Federal Reserve regulatory reports as minority interests in unconsolidated subsidiaries. The junior subordinated debentures do not qualify as Tier 1 regulatory capital.
 
In June 2016, the Company completed its initial public offering in which it issued and sold 845,588 shares of common stock at a public offering price of $34.00 per share. The Company received net proceeds of $26.4 million after deducting underwriting discounts and commissions of approximately $1.7 million and other offering expenses of approximately $615,000.
 
In addition to its headquarters and operations center in Raleigh, North Carolina, the Bank has locations in Charlotte and Cary, North Carolina.
 
NOTE 2 – BASIS OF PRESENTATION
 
The accompanying unaudited consolidated financial statements include the accounts and transactions of Paragon Commercial Corporation and Paragon Commercial Bank. All significant intercompany transactions and balances are eliminated in consolidation. Paragon Commercial Capital Trusts I and II are not consolidated subsidiaries of the Company.
 
The consolidated financial information included herein as of and for the three and six month periods ended June 30, 2017 and 2016 is unaudited. Accordingly, it does not include all of the information and footnotes required by U.S. GAAP for complete financial statements. However, such information reflects all adjustments which are, in the opinion of management, necessary for a fair statement of the financial condition and results of operations for the interim periods. The December 31, 2016 consolidated balance sheet was derived from the Company’s December 31, 2016 audited consolidated financial statements as of and for the periods ended December 31, 2016. These unaudited interim consolidated financial statements as of and for the three and six month periods ended June 30, 2017 and 2016 should be read in conjunction with the audited consolidated financial statements as of and for the periods ended December 31, 2016 included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2016 filed with the Securities and Exchange Commission on March 21, 2017, as amended on April 28, 2017. The results of operations for the three and six months ended June 30, 2017 are not necessarily indicative of the results to be expected for the full year ending December 31, 2017 or any other future period.
 
 
-6-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
The accounting policies followed by the Company and other relevant information is contained in the notes to the audited consolidated financial statements as of and for the periods ended December 31, 2016, which are included within the Company’s Annual Report on Form 10-K as of and for the year ended December 31, 2016.
 
Earnings Per Common Share
 
Basic and diluted net income per common share have been computed by dividing net income for each period by the weighted average number of shares of common stock outstanding during each period. Diluted net income per common share reflects the potential dilution that could occur if outstanding stock options were exercised.
 
Basic and diluted net income per common share have been computed based upon net income as presented in the accompanying unaudited consolidated statements of income divided by the weighted average number of common shares outstanding or assumed to be outstanding as summarized below:
 
 
 
Three months
 
 
Six months
 
 
 
ended June 30,
 
 
ended June 30,
 
 
 
2017
 
 
2016
 
 
2017
 
 
2016
 
Shares used in the computation of earnings per share:
 
 
 
 
 
 
 
 
 
 
 
 
Weighted average number of shares outstanding - basic
  5,398,530 
  4,581,193 
  5,394,870 
  4,563,349 
Dilutive effect of restricted shares
  14,740 
  43,133 
  14,176 
  44,184 
Weighted average number of shares outstanding - diluted
  5,413,270 
  4,624,326 
  5,409,046 
  4,607,533 
 
Weighted average anti-dilutive stock options and unvested restricted shares excluded from the computation of diluted earnings per share are as follows:
 
 
 
Three months
 
 
Six months
 
 
 
ended June 30,
 
 
ended June 30,
 
 
 
2017
 
 
2016
 
 
2017
 
 
2016
 
Anti-dilutive stock options
  - 
  80,500 
  - 
  80,500 
Unvested restricted shares
  56,733 
  45,338 
  56,733 
  45,338 
 
Comprehensive Income
 
The Company reports as comprehensive income all changes in stockholders' equity during the year from sources other than stockholders. Other comprehensive income refers to all components (revenues, expenses, gains, and losses) of comprehensive income that are excluded from net income.
 
The Company’s only two components of other comprehensive income are unrealized gains and losses on investment securities available-for-sale, net of income taxes and unrealized gains and losses on cash flow hedges, net of income taxes. Information concerning the Company’s accumulated other comprehensive income for the six-month period ended June 30, 2017 and for the year ended December 31, 2016, respectively is as follows:
 
 
-7-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
 
 
June 30,
 
 
December 31,
 
(In thousands)
 
2017
 
 
2016
 
Unrealized gains (losses) on securities available-for-sale
 $1,113 
 $(1,775)
Deferred tax (benefit) expense
  (433)
  678 
Other comprehensive income (loss), net of tax
  680 
  (1,097)
Unrealized losses on cash flow hedges
  (2,441)
  (2,792)
Deferred tax benefit
  902 
  1,049 
Other comprehensive loss, net of tax
  (1,539)
  (1,743)
Total other comprehensive loss
 $(859)
 $(2,840)
 
The accumulated balances related to each component of other comprehensive income (loss) are as follows:
 
 
 
 
 
 
Unpaid
 
 
 
 
 
 
Unrealized
 
 
Unrealized
 
 
 
 
 
 
Gains and
 
 
Gains and
 
 
 
 
 
 
Losses on
 
 
Losses on
 
 
 
 
 
 
Available-for
 
 
Cash Flow
 
 
 
 
(in thousands)
 
Sale Securities
 
 
Hedges
 
 
Total
 
Balance as of December 31, 2016
 $(1,097)
 $(1,743)
 $(2,840)
Other comprehensive income before reclassification
  1,777 
  204 
  1,981 
Net current-period other comprehensive income
  1,777 
  204 
  1,981 
Balance as of June 30, 2017
 $680 
 $(1,539)
 $(859)
 
    
    
    
Balance as of December 31, 2015
 $848 
 $(1,734)
 $(886)
Other comprehensive income (loss) before reclassification
  2,452 
  (1,333)
  1,119 
Amounts reclassified from accumulated other
    
    
    
comprehensive income
  (85)
  - 
  (85)
Net current-period other comprehensive income (loss)
  2,367 
  (1,333)
  1,034 
Balance as of June 30, 2016
 $3,215 
 $(3,067)
 $148 
 
Recent Accounting Pronouncements
 
In May 2014, the Financial Accounting Standards Board (the “FASB”) issued guidance to change the recognition of revenue from contracts with customers. The core principle of the new guidance is that an entity should recognize revenue to reflect the transfer of goods and services to customers in an amount equal to the consideration the entity receives or expects to receive. The guidance will be effective for the Company for reporting periods beginning after December 15, 2017. The Company will apply the guidance using a full retrospective approach. The Company does not expect these amendments to have a material effect on its financial statements.
 
In August 2015, the FASB deferred the effective date of ASU 2014-09, Revenue from Contracts with Customers. As a result of the deferral, the guidance in ASU 2014-09 will be effective for the Company for reporting periods beginning after December 15, 2017. The Company will apply the guidance using a full retrospective approach. The Company does not expect these amendments to have a material effect on its financial statements.
 
 
-8-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
In January 2016, the FASB amended the Financial Instruments topic of the ASC to address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. The amendments will be effective for fiscal years beginning after December 15,
2017, including interim periods within those fiscal years. The Company will apply the guidance by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. The amendments related to equity securities without readily determinable fair values will be applied prospectively to equity investments that exist as of the date of adoption of the amendments. The Company does not expect these amendments to have a material effect on its financial statements.
 
In February 2016, the FASB amended the Leases topic of the Accounting Standards Codification to revise certain aspects of recognition, measurement, presentation, and disclosure of leasing transactions. The amendments will be effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. The Company is currently evaluating the effect that implementation of the new standard will have on its financial statements.
 
In March 2016, the FASB amended the Derivatives and Hedging topic of the Accounting Standards Codification to 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 designation of that hedging relationship provided that all other hedge accounting criteria continue to be met. The amendments became effective January 1, 2017. The amendments did not have a material effect on the Company's financial statements.
 
In March 2016, the FASB amended the Revenue from Contracts with Customers topic of the Accounting Standards Codification to clarify the implementation guidance on principal versus agent considerations and address how an entity should assess whether it is the principal or the agent in contracts that include three or more parties. The amendments will be effective for the Company for reporting periods beginning after December 15, 2017. The Company does not expect these amendments to have a material effect on its financial statements.
 
In March 2016, the FASB issued guidance to simplify several aspects of the accounting for share-based payment award transactions including the income tax consequences, the classification of awards as either equity or liabilities, and the classification on the statement of cash flows. Additionally, the guidance simplifies two areas specific to entities other than public business entities allowing them apply a practical expedient to estimate the expected term for all awards with performance or service conditions that have certain characteristics and also allowing them to make a one-time election to switch from measuring all liability-classified awards at fair value to measuring them at intrinsic value. The amendments became effective as of January 1, 2017. The amendments did not have a material effect on the Company's financial statements.
 
In June 2016, the FASB issued guidance to change the accounting for credit losses and modify the impairment model for certain debt securities. The amendments will be effective for the Company for reporting periods beginning after December 15, 2019. The Company is currently evaluating the effect that implementation of the new standard will have on its financial position, results of operations, and cash flows.
 
 
-9-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
In August 2016, the FASB amended the Statement of Cash Flows topic of the Accounting Standards Codification to clarify how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The amendments will be effective for the Company for fiscal years beginning after December 15, 2017 including interim periods within those fiscal years. Early adoption is permitted. The Company does not expect these amendments to have a material effect on its financial statements.
 
In December 2016, the FASB issued technical corrections and improvements to the Revenue from Contracts with Customers Topic. These corrections make a limited number of revisions to several pieces of the revenue recognition standard issued in 2014. The effective date and transition requirements for the technical corrections will be effective for the Company for reporting periods beginning after December 15, 2017. The Company will apply the guidance using a modified retrospective approach. The Company does not expect these amendments to have a material effect on its financial statements.
 
In March 2017, the FASB amended the requirements in the Receivables—Nonrefundable Fees and Other Costs Topic of the Accounting Standards Codification related to the amortization period for certain purchased callable debt securities held at a premium. The amendments shorten the amortization period for the premium to the earliest call date. The amendments will be effective for the Company for interim and annual periods beginning after December 15, 2018. Early adoption is permitted. The Company does not expect these amendments to have a material effect on its financial statements.
 
In May 2017, the FASB amended the requirements in the Compensation—Stock Compensation Topic of the Accounting Standards Codification related to changes to the terms or conditions of a share-based payment award. The amendments provide guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting. The amendments will be effective for the Company for annual periods, and interim periods within those annual periods, beginning after December 15, 2017. The Company does not expect these amendments to have a material effect on its financial statements.
 
Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.
 
Reclassifications
 
Certain amounts in the 2016 financial statements have been reclassified to conform to the 2017 presentation. The reclassifications had no effect on total assets, net income or stockholders' equity as previously reported.
 
NOTE 3 – MERGERS AND ACQUISITIONS
 
Proposed Merger with TowneBank
 
On April 26, 2017, the Company entered into an Agreement and Plan of Reorganization (the “Merger Agreement”) with TowneBank and TB Acquisition, LLC (“TB Acquisition”). Pursuant to the terms of the Merger Agreement, the Company will merge with and into TB Acquisition (the “Merger”) and the Bank will subsequently merge with and into TowneBank (the “Bank Merger” and, together with the Merger, the “Transaction”). TB Acquisition will be the surviving entity in the Merger and TowneBank will be the surviving entity in the Bank Merger.
 
 
-10-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
Under the terms of the Merger Agreement, the Company’s stockholders will be entitled to receive 1.7250 shares (the “Exchange Ratio”) of TowneBank common stock for each share of the Company’s common stock. Based on TowneBank’s closing price of $34.35 as of April 26, 2017, the day the Transaction was announced, the estimated aggregate purchase price was $323.4 million. The Transaction is expected to close in the first quarter of 2018, subject to stockholder and regulatory approval and other customary closing conditions.
 
NOTE 4 - INVESTMENT SECURITIES
 
The following is a summary of the securities portfolio by major classification at June 30, 2017 and December 31, 2016.
 
 
 
 
 
 
Gross
 
 
Gross
 
 
Estimated
 
 
 
Amortized
 
 
Unrealized
 
 
Unrealized
 
 
Fair
 
(In thousands)
 
Cost
 
 
Gains
 
 
Losses
 
 
Value
 
June 30, 2017
 
 
 
 
 
 
 
 
 
 
 
 
Available-for-sale:
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Agency obligations
 $15,715 
 $192 
 $52 
 $15,855 
Collateralized mortgage obligations
  40,833 
  322 
  128 
  41,027 
Mortgage-backed securities
  75,777 
  360 
  768 
  75,369 
Municipal bonds
  66,429 
  1,424 
  56 
  67,797 
Other
  3,677 
  62 
  243 
  3,496 
 
 $202,431 
 $2,360 
 $1,247 
 $203,544 
 
    
    
    
    
December 31, 2016
    
    
    
    
Available-for-sale:
    
    
    
    
U.S. Agency obligations
 $17,062 
 $44 
 $163 
 $16,943 
Collateralized mortgage obligations
  42,439 
  300 
  242 
  42,497 
Mortgage-backed securities
  75,138 
  213 
  1,478 
  73,873 
Municipal bonds
  60,901 
  474 
  698 
  60,677 
Other
  3,676 
  29 
  254 
  3,451 
 
 $199,216 
 $1,060 
 $2,835 
 $197,441 
 
The fair values of securities available-for-sale at June 30, 2017 by contractual maturity are shown below. Actual expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations.
 
 
 
 
 
 
After One
 
 
After Five
 
 
 
 
 
No Stated
 
 
 
 
 
 
Within
 
 
Within
 
 
Within
 
 
After
 
 
Maturity
 
 
 
 
(In thousands)
 
1 Year
 
 
Five Years
 
 
Ten Years
 
 
Ten Years
 
 
Date
 
 
Total
 
  U.S. Agency obligations
 $- 
 $- 
 $- 
 $15,855 
 $- 
 $15,855 
  Collateralized mortgage obligations
  - 
  - 
  - 
  41,027 
  - 
  41,027 
  Mortgage-backed securities
  - 
  7,545 
  7,619 
  60,205 
  - 
  75,369 
  Municipal bonds
  - 
  2,249 
  8,898 
  56,650 
  - 
  67,797 
  Other
  - 
  - 
  1,527 
  - 
  1,969 
  3,496 
 
 $- 
 $9,794 
 $18,044 
 $173,737 
 $1,969 
 $203,544 
 
 
-11-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
The following tables show gross unrealized losses and fair values of investment securities, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position at June 30, 2017 and December 31, 2016. 
 
 
 
Less Than 12 Months
 
 
12 Months or Greater
 
 
Total
 
(In thousands)
 
 
 
 
Unrealized
 
 
 
 
 
Unrealized
 
 
 
 
 
Unrealized
 
June 30, 2017
 
Fair Value
 
 
Losses
 
 
Fair Value
 
 
Losses
 
 
Fair Value
 
 
Losses
 
 Securities available-for-sale:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  U.S. Agency obligations
 $2,623 
 $52 
 $- 
 $- 
 $2,623 
 $52 
  Collateralized mortgage obligations
  17,381 
  128 
  - 
  - 
  17,381 
  128 
  Mortgage-backed securities
  46,180 
  768 
  - 
  - 
  46,180 
  768 
  Municipal bonds
  7,116 
  56 
  - 
  - 
  7,116 
  56 
  Other
  - 
  - 
  1,909 
  242 
  1,909 
  242 
Total temporarily impaired
    
    
    
    
    
    
securities
 $73,300 
 $1,004 
 $1,909 
 $242 
 $75,209 
 $1,246 
 
 
 
Less Than 12 Months
 
 
12 Months or Greater
 
 
Total
 
 
 
 
(In thousands)
 
 
 
 
Unrealized
 
 
 
 
 
Unrealized
 
 
 
 
 
Unrealized
 
December 31, 2016
 
Fair Value
 
 
Losses
 
 
Fair Value
 
 
Losses
 
 
Fair Value
 
 
Losses
 
 Securities available-for-sale:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  U.S. Agency obligations
 $10,334 
 $163 
 $- 
 $- 
 $10,334 
 $163 
  Collateralized mortgage obligations
  18,124 
  242 
  - 
  - 
  18,124 
  242 
  Mortgage-backed securities
  58,825 
  1,478 
  - 
  - 
  58,825 
  1,478 
  Municipal bonds
  33,110 
  698 
  - 
  - 
  33,110 
  698 
  Other
  1,897 
  254 
  - 
  - 
  1,897 
  254 
Total temporarily impaired
    
    
    
    
    
    
securities
 $122,290 
 $2,835 
 $- 
 $- 
 $122,290 
 $2,835 
 
The table below summarizes the number of investment securities in an unrealized loss position:
 
 
 
June 30,
 
 
December 31,
 
Available-for-sale:
 
2017
 
 
2016
 
U.S. Agency obligations
  2 
  5 
Collateralized mortgage obligations
  6 
  6 
Mortgage-backed securities
  12 
  13 
Municipal bonds
  12 
  53 
Other
  1 
  1 
 
  33 
  78 
 
The unrealized losses primarily relate to debt securities that have incurred fair value reductions due to higher market interest rates since the securities were purchased.  The unrealized losses are not likely to reverse unless and until market interest rates decline to the levels that existed when the securities were purchased. Since none of the unrealized losses on the debt securities in 2017 or 2016 relate to the marketability of the securities or the issuer’s ability to honor redemption obligations and since management has the intent to hold these securities until maturity and believes it is more likely than not that the Company will not have to sell any such securities before a recovery of cost given the current liquidity position, none of those debt securities are deemed to be other than temporarily impaired.
 
 
-12-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
The following table summarizes securities gains for the periods presented:
 
 
 
Three months
 
 
Six months
 
 
 
ended June 30,
 
 
ended June 30,
 
 
 
2017
 
 
2016
 
 
2017
 
 
2016
 
Gross gains on sales of securities available for sale
 $- 
 $- 
 $- 
 $136 
Gross losses on sales of securities available for sale
  - 
  - 
  - 
  (51)
Total securities gains
 $- 
 $- 
 $- 
 $85 
 
Securities with a fair value of $71.0 million and $75.8 million were pledged as of June 30, 2017 and December 31, 2016, respectively, to secure repurchase agreements, lines of credit and other borrowings.
 
NOTE 5 - LOANS AND ALLOWANCE FOR LOAN LOSSES
 
Following is a summary of loans at June 30, 2017 and December 31, 2016:
 
 
 
June 30,
 
 
December 31,
 
(In thousands)
 
2017
 
 
2016
 
Construction and land development
 $70,661 
 $79,738 
Commercial real estate:
    
    
Non-farm, non-residential
  433,486 
  365,569 
Owner occupied
  202,982 
  186,892 
Multifamily, nonresidential and junior liens
  106,106 
  89,191 
Total commercial real estate
  742,574 
  641,652 
Consumer real estate:
    
    
Home equity lines
  87,229 
  87,489 
Secured by 1-4 family residential, secured by first deeds of trust
  231,903 
  195,343 
Secured by 1-4 family residential, secured by second deeds of trust
  4,712 
  4,289 
Total consumer real estate
  323,844 
  287,121 
Commercial and industrial loans (except those secured by real estate)
  181,643 
  170,709 
Consumer and other
  20,840 
  11,542 
Total loans
  1,339,562 
  1,190,762 
Deferred loan costs
  298 
  518 
Allowance for loan losses
  (8,921)
  (7,909)
Net loans
 $1,330,939 
 $1,183,371 
 
 
-13-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
A further breakdown of the make-up of the construction and land development and commercial real estate portfolio at June 30, 2017 and December 31, 2016 is as follows:
 
 
 
June 30,
 
 
December 31,
 
(in thousands)
 
2017
 
 
2016
 
Construction and land development:
   
   
Land
 $12,115 
 $12,595 
Residential
  29,684 
  36,253 
Commercial
  28,862 
  30,890 
Total construction and land development
 $70,661 
 $79,738 
 
 
   
Commercial real estate:
    
    
Non-farm, non-residential:
    
    
Office
 $137,771 
 $108,228 
Industrial
  33,240 
  36,264 
Hotel/motel
  32,054 
  28,453 
Retail
  193,781 
  165,434 
Special purpose/Other
  36,640 
  27,190 
  Total commercial real estate
  433,486 
  365,569 
Owner occupied :
    
    
Office
  66,448 
  60,500 
Industrial
  52,698 
  46,876 
Retail
  30,965 
  31,085 
Special purpose/Other
  52,871 
  48,431 
  Total owner occupied
  202,982 
  186,892 
 
    
    
Multifamily, nonresidential and junior liens
  106,106 
  89,191 
Total commercial real estate
 $742,574 
 $641,652 
 
Loans are primarily made in the Research Triangle and Charlotte areas of North Carolina. Real estate loans can be affected by the condition of the local real estate market. Commercial and installment loans can be affected by the local economic conditions.
 
 
-14-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
Changes in the allowance for loan losses for the three and six months ended June 30, 2017 and 2016 were as follows:
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
& Industrial
 
 
 
 
 
 
 
 
 
Construction
 
 
 
 
 
Consumer
 
 
Loans Not
 
 
 
 
 
 
 
 
 
and Land
 
 
Commercial
 
 
Real
 
 
Secured By
 
 
Consumer
 
 
Total
 
(In thousands)
 
Development
 
 
Real Estate
 
 
Estate
 
 
Real Estate
 
 
& Other
 
 
Loans
 
Three months ended June 30, 2017
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Beginning balance
 $490 
 $3,968 
 $1,939 
 $1,646 
 $82 
 $8,125 
Provision for loan losses
  (225)
  273 
  87 
  481 
  34 
  650 
Loans charged off
  - 
  - 
  - 
  - 
  - 
  - 
Recoveries
  138 
  - 
  - 
  8 
  - 
  146 
Net (chargeoffs) recoveries
  138 
  - 
  - 
  8 
  - 
  146 
Ending balance
 $403 
 $4,241 
 $2,026 
 $2,135 
 $116 
 $8,921 
 
    
    
    
    
    
    
Six months ended June 30, 2017
    
    
    
    
    
    
Beginning balance
 $486 
 $3,719 
 $1,900 
 $1,728 
 $76 
 $7,909 
Provision for loan losses
  (230)
  494 
  126 
  366 
  53 
  809 
Loans charged off
  - 
  - 
  - 
  (10)
  (13)
  (23)
Recoveries
  147 
  28 
  - 
  51 
  - 
  226 
Net (chargeoffs) recoveries
  147 
  28 
  - 
  41 
  (13)
  203 
Ending balance
 $403 
 $4,241 
 $2,026 
 $2,135 
 $116 
 $8,921 
 
    
    
    
    
    
    
 
    
    
    
    
    
    
Three months ended June 30, 2016
    
    
    
    
    
    
Beginning balance
 $523 
 $3,072 
 $1,972 
 $1,790 
 $574 
 $7,931 
Provision for loan losses
  (125)
  187 
  (88)
  492 
  (466)
  - 
Loans charged off
  - 
  - 
  - 
  - 
  (1)
  (1)
Recoveries
  8 
  19 
  3 
  25 
  1 
  56 
Net recoveries
  8 
  19 
  3 
  25 
  - 
  55 
Ending balance
 $406 
 $3,278 
 $1,887 
 $2,307 
 $108 
 $7,986 
 
    
    
    
    
    
    
Six months ended June 30, 2016
    
    
    
    
    
    
Beginning balance
 $509 
 $3,156 
 $2,046 
 $1,786 
 $144 
 $7,641 
Provision for loan losses
  (340)
  66 
  (165)
  485 
  (46)
  - 
Loans charged off
  - 
  - 
  - 
  - 
  (1)
  (1)
Recoveries
  237 
  56 
  6 
  36 
  11 
  346 
Net recoveries
  237 
  56 
  6 
  36 
  10 
  345 
Ending balance
 $406 
 $3,278 
 $1,887 
 $2,307 
 $108 
 $7,986 
 
 
-15-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
The balance in the allowance for loan losses and the recorded investment in loans by portfolio segment are based on the impairment method as of June 30, 2017 and December 31, 2016 and were as follows:
 
 
 
 
 
 
 
 
 
 
 
 
Commercial
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
& Industrial
 
 
 
 
 
 
 
 
 
Construction
 
 
 
 
 
Consumer
 
 
Loans Not
 
 
 
 
 
 
 
 
 
and Land
 
 
Commercial
 
 
Real
 
 
Secured By
 
 
Consumer
 
 
Total
 
(in thousands)
 
Development
 
 
Real Estate
 
 
Estate
 
 
Real Estate
 
 
& Other
 
 
Loans
 
June 30, 2017
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Allowance for Loan Losses:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Individually evaluated for impairment
 $- 
 $- 
 $45 
 $781 
 $- 
 $826 
Collectively evaluated for impairment
  403 
  4,241 
  1,981 
  1,354 
  116 
  8,095 
Total ending allowance
 $403 
 $4,241 
 $2,026 
 $2,135 
 $116 
 $8,921 
 
    
    
    
    
    
    
Loans:
    
    
    
    
    
    
Individually evaluated for impairment
 $118 
 $307 
 $374 
 $2,077 
 $- 
 $2,876 
Collectively evaluated for impairment
  70,543 
  742,267 
  323,470 
  179,566 
  20,840 
  1,336,686 
Total ending loans
 $70,661 
 $742,574 
 $323,844 
 $181,643 
 $20,840 
 $1,339,562 
 
    
    
    
    
    
    
(in thousands)
    
    
    
    
    
    
December 31, 2016
    
    
    
    
    
    
Allowance for Loan Losses:
    
    
    
    
    
    
Individually evaluated for impairment
 $- 
 $- 
 $223 
 $286 
 $- 
 $509 
Collectively evaluated for impairment
  486 
  3,719 
  1,677 
  1,442 
  76 
  7,400 
Total ending allowance
 $486 
 $3,719 
 $1,900 
 $1,728 
 $76 
 $7,909 
 
    
    
    
    
    
    
Loans:
    
    
    
    
    
    
Individually evaluated for impairment
 $125 
 $836 
 $1,121 
 $1,139 
 $- 
 $3,221 
Collectively evaluated for impairment
  79,613 
  640,816 
  286,000 
  169,570 
  11,542 
  1,187,541 
Total ending loans
 $79,738 
 $641,652 
 $287,121 
 $170,709 
 $11,542 
 $1,190,762 
 
Loans are charged down or off as soon as the Company determines that the full principal balance due under any loan becomes uncollectible. The amount of the charge is determined as follows:
●            
If unsecured, the loan must be charged off in full.
● 
If secured, the outstanding principal balance of the loan should be charged down to the net realizable value of the collateral.
 
Loans are considered uncollectible when:
● 
No regularly scheduled payment has been made within four months unless fully secured and in the process of collection.
● 
The collateral value is insufficient to cover the outstanding indebtedness and it is unlikely the borrower will have the ability to pay the debt in a timely manner.
● 
The loan is unsecured, the borrower files for bankruptcy protection and there is no other (guarantor, etc.) support from an entity outside of the bankruptcy proceedings.
 
Impaired loans totaled $2.9 million and $3.2 million at June 30, 2017 and December 31, 2016, respectively. Included in the $2.9 million at June 30, 2017 is $600,000 of loans classified as troubled debt restructurings (“TDRs”). Included in the $3.2 million at December 31, 2016 is $1.3 million of loans classified as TDRs. A modification of a loan’s terms constitutes a TDR if the creditor grants a concession to the borrower for economic or legal reasons related to the borrower’s financial difficulties that it would not otherwise consider. All TDRs are considered impaired.
 
 
-16-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
The following table provides information on performing and nonperforming TDRs as of June 30, 2017 and December 31, 2016:
 
 
 
June 30,
 
 
December 31,
 
(In thousands)
 
2017
 
 
2016
 
Performing TDRs:
 
 
 
 
 
 
Commercial real estate
 $296 
 $520 
Consumer real estate
  - 
  338 
Commercial and industrial loans
  - 
  297 
Total performing TDRs
  296 
  1,155 
 
    
    
Nonperforming TDRs:
    
    
Construction and land development
  118 
  125 
Consumer real estate
  186 
  58 
Total nonperformingTDRs
  304 
  183 
Total TDRs
 $600 
 $1,338 
 
During the first six months of 2017, two of the six loans that were designated TDRs as of December 31, 2016 totaling $389,000 were paid off.  The largest of these for $388,000 was a residential real estate loan.  Another commercial real estate loan totaling $125,000 was refinanced and is no longer considered a TDR as the loan was refinanced at market terms.  The remaining three loans are all performing as agreed.
 
The Bank added one new TDR loan in February, a $130,000 business loan secured by residential property due to a restructure of the loan payment terms in response to borrower’s financial difficulties.  That loan continues to perform as agreed since restructure.      
 
In order to quantify the value of any impairment, the Company evaluates loans individually. At June 30, 2017, the Company had $2.9 million of impaired loans. The detail of loans evaluated for impairment as of June 30, 2017 is presented below:
 
 
 
 
 
 
 
Unpaid
 
 
 
 
 
 
 
 
 
 
Contractual
 
 
 
 
(in thousands)
 
 
Recorded
 
 
Principal
 
 
Allocated
 
June 30, 2017
 
 
Investment
 
 
Balance
 
 
Allowance
 
Loans without a specific valuation allowance:
 
 
 
 
 
 
 
 
 
Construction and land development
 $118 
 $165 
 $  
Commercial real estate
  307 
  307 
  - 
Loans with a specific valuation allowance:
    
    
    
Consumer real estate
  374 
  432 
  45 
Commercial and industrial loans
  2,077 
  2,108 
  781 
Total
 $2,876 
 $3,012 
 $826 
 
 
-17-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
At December 31, 2016, the Company had $3.2 million of impaired loans. The detail of loans evaluated for impairment as of December 31, 2016 is presented below:
 
 
 
 
 
 
 
Unpaid
 
 
 
 
 
 
 
 
 
 
Contractual
 
 
 
 
(in thousands)
 
 
Recorded
 
 
Principal
 
 
Allocated
 
December 31, 2016
 
 
Investment
 
 
Balance
 
 
Allowance
 
Loans without a specific valuation allowance:
 
 
 
 
 
 
 
 
 
Construction and land development
 $125 
 $195 
 $  
Commercial real estate
  836 
  836 
  - 
Loans with a specific valuation allowance:
    
    
    
Consumer real estate
  1,121 
  1,152 
  223 
Commercial and industrial loans (except
    
    
    
those secured by real estate)
  1,139 
  1,382 
  286 
Total
 $3,221 
 $3,565 
 $509 
 
The average recorded investment balance of impaired loans for the three- and six-month periods ending June 30, 2017 and 2016 are as follows:
 
 
 
Three months ended June 30,
 
 
 
2017
 
 
2016
 
 
 
Average
 
 
Interest
 
 
Average
 
 
Interest
 
 
 
Balance
 
 
Income
 
 
Balance
 
 
Income
 
Construction and land development
 $119 
 $- 
 $133 
 $- 
Commercial real estate
  307 
  3 
  1,113 
  13 
Consumer real estate
  491 
  3 
  404 
  4 
Commercial and industrial loans
  1,929 
  22 
  2,671 
  17 
Consumer and other
  - 
  - 
  13 
  - 
Total securities gains
 $2,846 
 $28 
 $4,334 
 $34 
 
 
 
  Six months ended June 30,
 
 
 
  2017
 
 
  2016
 
 
 
Average
 
 
Interest
 
 
Average
 
 
Interest
 
 
 
Balance
 
 
Income
 
 
Balance
 
 
Income
 
Construction and land development
 $121 
 $- 
 $182 
 $- 
Commercial real estate
  570 
  13 
  1,633 
  37 
Consumer real estate
  611 
  9 
  406 
  9 
Commercial and industrial loans
  1,504 
  32 
  1,618 
  47 
Consumer and other
  - 
  - 
  17 
  - 
Total securities gains
 $2,806 
 $54 
 $3,856 
 $93 
 
When the Company cannot reasonably expect full and timely repayment of principal and interest of its loan, the loan is placed on nonaccrual status. The Company will continue to track the contractual interest for purposes of customer reporting and any potential litigation or later collection of the loan but accrual of interest for the Company’s financial statement purposes is to be discontinued. Subsequent payments of interest can be recognized as income on a cash basis provided that full collection of principal is expected. Otherwise, all payments received are to be applied to principal only. At the time of nonaccrual, past due or accrued interest is reversed from income.
 
Loans over 90 days past due will be placed on nonaccrual status. Loans that are less delinquent may also be placed on nonaccrual status if full collection of principal and interest is unlikely.
 
 
-18-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
The following table presents the recorded investment in nonaccrual loans by portfolio segment as of June 30, 2017 and December 31, 2016:
 
 
 
Nonaccrual
 
 
 
June 30,
 
 
December 31,
 
  (in thousands)
 
2017
 
 
2016
 
Construction and land development
 $118 
 $125 
Commercial real state
  - 
  783 
Consumer real estate
  374 
  - 
Commercial and industrial loans
  - 
  60 
Total
 $492 
 $968 
 
There were no loans 90 days or more past due and accruing interest at June 30, 2017 or December 31, 2016.
 
The following table presents the aging of the recorded investment in past due loans as of June 30, 2017 and December 31, 2016 by portfolio segment:
 
 
 
 
 
 
 
 
 
Greater
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
30 - 59
 
 
60 - 89
 
 
than 90
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Days
 
 
Days
 
 
Days
 
 
 
 
 
Total
 
 
 
 
 
 
 
(in thousands)
 
Past
 
 
Past
 
 
Past
 
 
Non-
 
 
Past
 
 
 
 
 
Total
 
June 30, 2017
 
Due
 
 
Due
 
 
Due
 
 
Accrual
 
 
Due
 
 
Current
 
 
Loans
 
Construction and land development
 $- 
 $- 
 $- 
 $118 
 $118 
 $70,543 
 $70,661 
Commercial real estate
  - 
  - 
  - 
  - 
  - 
  742,574 
  742,574 
Consumer real estate
  - 
  - 
  - 
  374 
  374 
  323,470 
  323,844 
Commercial and industrial loans
  - 
  - 
  - 
  - 
  - 
  181,643 
  181,643 
Consumer and other
  - 
  - 
  - 
  - 
  - 
  20,840 
  20,840 
Total
 $- 
 $- 
 $- 
 $492 
 $492 
 $1,339,070 
 $1,339,562 
 
 
 
 
 
 
 
 
 
Greater
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
30 - 59
 
 
60 - 89
 
 
than 90
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Days
 
 
Days
 
 
Days
 
 
 
 
 
Total
 
 
 
 
 
 
 
(in thousands)
 
Past
 
 
Past
 
 
Past
 
 
Non-
 
 
Past
 
 
 
 
 
Total
 
December 31, 2016
 
Due
 
 
Due
 
 
Due
 
 
Accrual
 
 
Due
 
 
Current
 
 
Loans
 
Construction and land development
 $- 
 $- 
 $- 
 $125 
 $125 
 $79,613 
 $79,738 
Commercial real estate
  - 
  - 
  - 
  - 
  - 
  641,652 
  641,652 
Consumer real estate
  - 
  - 
  - 
  783 
  783 
  286,338 
  287,121 
Commercial and industrial loans
  - 
  - 
  - 
  60 
  60 
  170,649 
  170,709 
Consumer and other
  - 
  - 
  - 
  - 
  - 
  11,542 
  11,542 
Total
 $- 
 $- 
 $- 
 $968 
 $968 
 $1,189,794 
 $1,190,762 
 
Credit Quality Indicators
 
The Company utilizes a nine-point grading system in order to evaluate the level of inherent risk in the loan portfolio as part of its allowance for loan losses methodology. Loans collectively evaluated for impairment are grouped by loan type and, in the case of commercial and construction loans, by risk rating. Each loan type is assigned an allowance factor based on risk grade, historical loss experience, economic conditions, overall portfolio quality including delinquency rates and commercial real estate loan concentrations (as applicable). As risk grades increase, additional reserves are applied stated in basis points in order to account for the added inherent risk.
 
 
-19-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
The Company categorizes all business and commercial purpose loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by setting the risk grade at the inception of a loan through the approval process. A certain percentage of loan dollars is reviewed each year by a third party loan review function. The risk rating process is inherently subjective and based upon management’s evaluation of the specific facts and circumstances for individual borrowers. As such, the assigned risk ratings are subject to change based upon changes in borrower status and changes in the external environment affecting the borrower. The Company uses the following definitions for risk ratings:
 
Risk Grade 1 – Minimal - Credits in this category are virtually risk-free and are well-collateralized by cash-equivalent instruments. The repayment program is well-defined and achievable. Repayment sources are numerous.
Risk Grade 2 – Modest - Loans to borrowers of significantly better than average financial strength or loans secured by readily marketable securities. Earnings performance is consistent and primary and secondary sources of repayment are well established.  The borrower exhibits excellent asset quality and liquidity with very strong debt servicing capacity and coverage.  Company management has depth, is experienced and well regarded in the industry.
Risk Grade 3 – Average - Loans in this category are to borrowers of satisfactory financial strength. Earnings performance is consistent. Primary and secondary sources of repayment are well defined and adequate to retire the debt in a timely and orderly fashion. These borrowers would generally exhibit satisfactory asset quality and liquidity.  They have moderate leverage and experienced management in key positions.
Risk Grade 4 – Acceptable - Loans in this category are to borrowers involving more than average risk which contain certain characteristics that require some supervision and attention by the lender.  Asset quality is acceptable, but debt capacity is modest. Little excess liquidity is available. The borrower may be fully leveraged and unable to sustain major setbacks.  Covenants are structured to ensure adequate protection. Management may have limited experience and depth. This category includes loans which are highly leveraged transactions due to regulatory constraints and also includes loans involving reasonable exceptions to policy.
Risk Grade 5 - Acceptable with Care - A loan in this category is sound and collectible but contains considerable risk.  Although asset quality remains acceptable, the borrower has a smaller and/or less diverse asset base, very little liquidity and limited debt capacity. Earnings performance is inconsistent and the borrower is not strong enough to sustain major setbacks.  The borrower may be highly leveraged and below average size or a lower-tier competitor.  There might be limited management experience and depth.  These loans may be to a well-conceived start-up venture but repayment is still dependent upon a successful operation.  This category includes loans with significant documentation or policy exceptions, improper loan structure, or inadequate loan servicing procedures and may also include a loan in which strong reliance for a secondary repayment source is placed on a guarantor who exhibits the ability and willingness to repay or loans which are highly leveraged transactions due to the obligor’s financial status.
Risk Grade 6 - Special Mention or Critical - Loans in this category have potential weaknesses which may, if not checked or corrected, weaken the asset or inadequately protect the Company’s credit position at some future date. These may also include loans of marginal quality and liquidity that if not corrected may jeopardize the liquidation of the debt and the Company’s credit position. These loans require close supervision and must be monitored to ensure there is not a pattern of deterioration in the credit that may lead to further downgrade. These characteristics include but are not limited to:
 
 
 
 
-20-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
o
Repayment performance has not been demonstrated to prudent standards;
o
Repayment performance is inconsistent and highly sensitive to business and operating cycle swings;
o
Fatal documentation errors and;
o
Performing as agreed without documented capacity or collateral protection.
Risk Grade 7 – Substandard - A substandard loan is inadequately protected by the current sound net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans classified as substandard have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
Risk Grade 8 – Doubtful - Loans classified doubtful have all the weaknesses inherent in loans classified substandard, plus the added characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions, and values highly questionable and improbable. However, these loans are not yet rated as loss because certain events may occur which would salvage the debt. Among these events are:
o
Injection of capital;
o
Alternative financing;
o
Liquidation of assets or the pledging of additional collateral.
The ability of the borrower to service the debt is extremely weak, overdue status is constant, the debt has been placed on nonaccrual status and no definite repayment schedule exists. Doubtful is a temporary grade where a loss is expected but is presently not quantified with any degree of accuracy. Once the loss position is determined, the amount is charged off. There were no loans rated as doubtful as of June 30, 2017 or December 31, 2016.
Risk Grade 9 – Loss - Loans classified Loss are considered uncollectable and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value but rather that it is not practical or desirable to defer writing off the worthless loan even though partial recovery may be affected in the future. Probable loss portions of doubtful assets should be charged against the allowance for loan losses. Loans may reside in this classification for administrative purposes for a period not to exceed the earlier of thirty days or calendar quarter-end. There were no loans rated as loss as of June 30, 2017 or December 31, 2016.
 
 
 
-21-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
As of June 30, 2017 and December 31, 2016 and based on the most recent analysis performed, the risk category of loans by class of loans is as follows:
 
 
 
Risk Grade
 
 
 
 
(in thousands)
    1 
    2 
    3 
    4 
    5 
    6 
    7 
 
Total
 
June 30, 2017
    
    
    
    
    
    
    
 
 
 
Construction and land development
 $- 
 $417 
 $1,189 
 $26,200 
 $42,695 
 $42 
 $118 
 $70,661 
Commercial real estate
  - 
  210 
  270,566 
  362,522 
  92,486 
  16,790 
  - 
  742,574 
Consumer real estate
  48 
  27,908 
  149,905 
  107,810 
  36,662 
  1,137 
  374 
  323,844 
Commercial and industrial loans
  6,899 
  1,123 
  25,252 
  110,526 
  35,541 
  229 
  2,073 
  181,643 
Consumer and other
  782 
  3,466 
  2,363 
  13,061 
  1,168 
  - 
  - 
  20,840 
Total
 $7,729 
 $33,124 
 $449,275 
 $620,119 
 $208,552 
 $18,198 
 $2,565 
 $1,339,562 
 
 
 
Risk Grade
 
 
 
 
(in thousands)
    1 
    2 
    3 
    4 
    5 
    6 
    7 
 
Total
 
December 31, 2016
    
    
    
    
    
    
    
 
 
 
Construction and land development
 $- 
 $1,005 
 $911 
 $22,901 
 $54,601 
 $195 
 $125 
 $79,738 
Commercial real estate
  - 
  539 
  223,549 
  311,711 
  87,443 
  18,500 
  - 
  641,652 
Consumer real estate
  50 
  19,247 
  130,748 
  102,137 
  33,013 
  1,143 
  783 
  287,121 
Commercial and industrial loans
  2,133 
  1,525 
  32,304 
  104,019 
  29,035 
  556 
  1,137 
  170,709 
Consumer and other
  1,160 
  730 
  1,086 
  7,392 
  1,174 
  - 
  - 
  11,542 
Total
 $3,343 
 $23,046 
 $388,598 
 $548,160 
 $205,266 
 $20,394 
 $2,045 
 $1,190,762 
 
NOTE 6 - OFF-BALANCE SHEET RISK
 
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
 
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company, upon extension of credit is based on management’s credit evaluation of the borrower. Collateral obtained varies but may include real estate, stocks, bonds, and certificates of deposit.
 
 
-22-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
A summary of the contract amounts of the Company’s exposure to off-balance sheet credit risk as of June 30, 2017 and December 31, 2016 is as follows:
 
 
 
June 30,
 
 
December 31,
 
(In thousands)
 
2017
 
 
2016
 
Financial instruments whose contract amounts
 
 
 
 
 
 
represent credit risk:
 
 
 
 
 
 
Undisbursed lines of credit
 $251,049 
 $216,769 
Standby letters of credit
  5,048 
  3,904 
Total
 $256,097 
 $220,673 
 
NOTE 7 - DERIVATIVES AND FINANCIAL INSTRUMENTS
 
To mitigate exposure to variability in expected future cash flows resulting from changes in interest rates, in May 2013 the Company entered into two forward swap arrangements (the “Swaps”) whereby the Company would pay fixed rates on two short-term borrowings at some point in the future for a determined period of time. For both agreements, the Company would renew advances with the Federal Home Loan Bank (“FHLB”) for 3-month terms as a primary funding source and pay the prevailing 3-month rate. The first swap, a “2-5 Swap”, was a $20 million agreement whereby 2 years from the May 2013 execution date, the Company would begin to swap out the 3-month FHLB advance pricing at that date for a fixed rate of 1.964% for a period of 5 years. The second swap, a “3-5 Swap”, was similar in terms except that it was a $30 million agreement whereby 3 years from the May 2013 execution date, the Company would begin to swap out the 3-month FHLB advance pricing at that date for a fixed rate of 2.464% for a period of 5 years.
 
The Company designated the forward-starting interest rate swaps (the hedging instruments) as cash flow hedges of the risk of changes attributable to the benchmark 3-Month LIBOR interest rate risk for the forecasted issuances of FHLB advances arising from a rollover strategy. The Company intended to sequentially issue a series of 3-month fixed rate debt as part of a planned roll-over of short-term debt for the next seven to eight years.
 
In September 2014, as a result of continued increasing fixed rate exposure, the Company determined that an additional strategy was needed and, as a result, exited from the Swaps for a deferred gain of $372,000. In their place, the Company purchased three interest rate caps with a strike price of 3-month LIBOR at 0.50% and a five-year term. The instruments hedged were $100 million of FHLB borrowings maturing quarterly on the same reset dates. The Company executed three separate agreements between $30 million and $35 million maturing between August 2019 and October 2019.
 
 
-23-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
The following table reflects the cash flow hedges included in the consolidated balance sheets as of June 30, 2017 and December 31, 2016:
 
 
 
June 30, 2017
 
 
December 31, 2016
 
 
 
Notational
 
 
Fair
 
 
Notational
 
 
Fair
 
(In thousands)
 
Amount
 
 
Value
 
 
Amount
 
 
Value
 
Included in other assets:
 
 
 
 
 
 
 
 
 
 
 
 
Cap 1 - maturing August 2019
 $35,000 
 $856 
 $35,000 
 $1,011 
Cap 2 - maturing September 2019
  35,000 
  872 
  35,000 
  1,045 
Cap 3 - maturing October 2019
  30,000 
  812 
  30,000 
  929 
 
 $100,000 
 $2,540 
 $100,000 
 $2,985 
 
Remaining amortization of the premium on the interest rate caps is as follows:
 
(In thousands)
 
 
 
2017
 $982 
2018
  2,247 
2019
  1,752 
 
 $4,981 
 
The Company recorded $421,000 and $198,000 for the three-month periods ended June 30, 2017 and 2016, respectively, in amortization associated with the interest rate caps. The Company recorded $791,000 and $341,000 for the six-month periods ended June 30, 2017 and 2016, respectively, in amortization associated with the interest rate caps. Those expenses are reflected in the consolidated statements of income as a component of borrowings and repurchase agreements interest expense.
 
Remaining amortization of the gain associated with the exit of the swaps is as follows:
 
(In thousands)
 
 
 
2017
 $37 
2018
  74 
Thereafter
  147 
 
 $258 
 
The Company realized $12,000 and $31,000 in gains on the Swaps during the three- and six-month periods ended June 30, 2017, respectively, shown as a reduction of borrowings and repurchase agreements interest expense. These were the first returns from the Swaps.
 
The Company anticipates little to no ineffectiveness in this hedging relationship as long as the terms are matched at each forecasted debt issuance. The Company notes that the actual interest cost incurred at each rollover will be a function of market rates at that time. However, the Company is only hedging the benchmark interest rate risk in each rollover.
 
The Company does not use derivatives for trading or speculative purposes.
 
 
-24-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
NOTE 8 - FAIR VALUE OF FINANCIAL INSTRUMENTS
 
Fair value is a market-based measurement and is defined as the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. In general, the transaction price will equal the exit price and, therefore, represent the fair value of the asset or liability at initial recognition. In determining whether a transaction price represents the fair value of the asset or liability at initial recognition, each reporting entity is required to consider factors specific to the transaction and the asset or liability, the principal or most advantageous market for the asset or liability, and market participants with whom the entity would transact in the market.
 
Outlined below is the application of the fair value hierarchy applied to the Company’s financial assets that are carried at fair value.
 
Level 1 – Inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets. An active market for the asset or liability is a market in which the transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis. As of June 30, 2017, the types of financial assets and liabilities the Company carried at fair value hierarchy Level 1 included marketable equity securities with readily available market values.
 
Level 2 – Inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument. As of June 30, 2017, the types of financial assets and liabilities the Company carried at fair value hierarchy Level 2 included agency bonds, collateralized mortgage obligations, mortgage backed securities, municipal bonds and derivatives.
 
Level 3 – Inputs to the valuation methodology are unobservable and significant to the fair value measurement. Unobservable inputs are supported by little or no market activity or by the entity’s own assumptions. As of June 30, 2017, the Company valued certain financial assets including one corporate subordinated debenture, measured on both a recurring and a non-recurring basis, at fair value hierarchy Level 3.
 
The Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs.
 
Fair Value on a Recurring Basis
 
The Company measures certain assets at fair value on a recurring basis, as described below.
 
Investment Securities Available-for-Sale
 
Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include U.S. agencies, mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.
 
 
-25-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
Derivative Assets and Liabilities
 
Derivative instruments held or issued by the Company for risk management purposes are traded in over-the-counter markets where quoted market prices are not readily available. For those derivatives, the Company measures fair value using models that use primarily market observable inputs, such as yield curves and option volatilities, and include the value associated with counterparty credit risk. The Company classifies derivative instruments held or issued for risk management purposes as Level 2. As of June 30, 2017 and December 31, 2016, the Company’s derivative instruments consist solely of interest rate caps.
 
Below is a table that presents information about assets measured at fair value on a recurring basis at June 30, 2017 and December 31, 2016:
 
 
 
 
 
 
Fair Value Measurements Using
 
 
 
 
 
 
Quoted Prices
 
 
Significant
 
 
 
 
 
 
 
 
 
in Active
 
 
Other
 
 
Significant
 
 
 
 
 
 
Markets for
 
 
Observable
 
 
Unobservable
 
(In thousands)
 
Total
 
 
Identical Assets
 
 
Inputs
 
 
Inputs
 
Description
 
Fair Value
 
 
(Level 1)
 
 
(Level 2)
 
 
(Level 3)
 
June 30, 2017
 
 
 
 
 
 
 
 
 
 
 
 
Securities available-for-sale:
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Agency obligations
 $15,855 
 $- 
 $15,855 
 $- 
Collateralized mortgage obligations
  41,027 
  - 
  41,027 
  - 
Mortgage-backed securities
  75,369 
  - 
  75,369 
  - 
Municipal bonds
  67,797 
  - 
  67,797 
  - 
Other
  3,496 
  1,969 
  - 
  1,527 
 
  203,544 
  1,969 
  200,048 
  1,527 
Interest rate caps
  2,540 
  - 
  2,540 
  - 
Total assets at fair value
 $206,084 
 $1,969 
 $202,588 
 $1,527 
 
    
    
    
    
December 31, 2016
    
    
    
    
Securities available-for-sale:
    
    
    
    
U.S. Agency obligations
 $16,943 
 $- 
 $16,943 
 $- 
Collateralized mortgage obligations
  42,497 
  - 
  42,497 
  - 
Mortgage-backed securities
  73,873 
  - 
  73,873 
  - 
Municipal bonds
  60,677 
  - 
  60,677 
  - 
Other
  3,451 
  1,951 
  - 
  1,500 
 
  197,441 
  1,951 
  193,990 
  1,500 
Interest rate caps
  2,985 
  - 
  2,985 
  - 
Total assets at fair value
 $200,426 
 $1,951 
 $196,975 
 $1,500 
 
 
-26-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
The table below summarizes the Company’s activity in investment securities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the six months ended June 30, 2017.
 
 
 
Level 3
 
 
 
Investment
 
(In thousands)
 
Securities
 
Balance at December 31, 2016
 $1,500 
Purchases
  - 
Unrealized gain
  27 
Balance at June 30, 2017
 $1,527 
 
Fair Value on a Nonrecurring Basis
 
The Company measures certain assets at fair value on a nonrecurring basis, as described below.
 
Impaired Loans
 
The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures the impairment. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. Impaired loans require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records the impaired loan as nonrecurring Level 2. When current appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company records the impaired loan as nonrecurring Level 3. Impaired loans totaled $2.9 million and $3.2 million at June 30, 2017 and December 31, 2016, respectively.   
 
Other Real Estate Owned
 
Other real estate owned, which includes foreclosed assets, is adjusted to fair value upon transfer of loans and premises to other real estate. Subsequently, other real estate owned is carried at the lower of carrying value or fair value.
 
At the date of transfer, losses are charged to the allowance for credit losses. Subsequent write-downs are charged to expense in the period they are incurred.
 
 
-27-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
Below is a table that presents information about assets measured at fair value on a nonrecurring basis at June 30, 2017 and December 31, 2016:
 
 
 
 
 
 
Fair Value Measurements Using
 
 
 
 
 
 
Quoted Prices
 
 
Significant
 
 
 
 
 
 
 
 
 
in Active
 
 
Other
 
 
Significant
 
 
 
 
 
 
Markets for
 
 
Observable
 
 
Unobservable
 
(In thousands)
 
Total
 
 
Identical Assets
 
 
Inputs
 
 
Inputs
 
June 30, 2017
 
Fair Value
 
 
(Level 1)
 
 
(Level 2)
 
 
(Level 3)
 
Impaired loans
 $2,050 
 $- 
 $- 
 $2,050 
Other real estate owned
  4,690 
  - 
  - 
  4,690 
Total
 $6,740 
 $- 
 $- 
 $6,740 
 
 
 
 
 
 
  Fair Value Measurements Using
 
 
 
 
 
 
Quoted Prices
 
 
Significant
 
 
 
 
 
 
 
 
 
in Active
 
 
Other
 
 
Significant
 
 
 
 
 
 
Markets for
 
 
Observable
 
 
Unobservable
 
(In thousands)
 
Total
 
 
Identical Assets
 
 
Inputs
 
 
Inputs
 
December 31, 2016
 
Fair Value
 
 
(Level 1)
 
 
(Level 2)
 
 
(Level 3)
 
Impaired loans
 $2,712 
 $- 
 $- 
 $2,712 
Other real estate owned
  4,740 
  - 
  - 
  4,740 
Total
 $7,452 
 $- 
 $- 
 $7,452 
 
For Level 3 assets and liabilities measured at fair value on a recurring or nonrecurring basis as of June 30, 2017 and December 31, 2016, the significant unobservable inputs used in the fair value measurements were as follows:
 
             
June 30, 2017 and December 31, 2016
             
Valuation
 
Significant
 
Significant
             
Technique
 
Observable Inputs
 
unobservable Inputs
Impaired loans            
Appraisal value
 
Appraisals and/or sales of comparable properties
 
Appraisals discounted 5% to 10% for sales commissions and other holding costs
             
 
 
 
 
 
Other real estate owned            
Appraisal value/
Comparison sale/
Other estimates
 
Appraisals and/or sales of comparable properties
 
Appraisals discounted 5% to 10% for sales commissions and other holding costs
 
The Company provides certain disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. 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.
 
In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. Accordingly, certain financial instruments and all nonfinancial instruments are excluded from disclosure. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.
 
 
-28-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:
 
Cash and Due from Banks
 
The carrying amounts for cash and due from banks approximate fair value because of the short maturities of those instruments.
 
Federal Home Loan Bank Stock
 
The carrying value of Federal Home Loan Bank stock approximates fair value based on the redemption provisions of such Federal Home Loan Bank stock.
 
Bank-owned life insurance
 
The carrying value of bank-owned life insurance approximates fair value because this investment is carried at cash surrender value, as determined by the insurer.
 
Loans
 
The fair value of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.
 
Deposits
 
The fair value of demand deposits is the amount payable on demand at the reporting date. The fair value of time deposits is estimated by discounting expected cash flows using the rates currently offered for instruments of similar remaining maturities.
 
Accrued Interest
 
The carrying amount is a reasonable estimate of fair value.
 
Short-Term Borrowings and Long-Term Debt
 
The fair values are based on discounting expected cash flows using the current interest rates for debt with the same or similar remaining maturities and collateral requirements.
 
Financial Instruments with Off-Balance Sheet Risk
 
With regard to financial instruments with off-balance sheet risk, it is not practicable to estimate the fair value of future financing commitments.
 
 
-29-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
The following table presents the estimated fair values and carrying amounts of the Company’s financial instruments, none of which are held for trading purposes, at June 30, 2017 and December 31, 2016:
 
 
 
June 30, 2017
 
 
 
Carrying
 
 
  Fair Value
 
(in thousands)
 
Amount
 
 
Total
 
 
Level 1
 
 
Level 2
 
 
Level 3
 
Financial assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash and due from banks
 $17,564 
 $17,564 
 $17,564 
 $- 
 $- 
Investment securities available-for-
    
    
    
    
    
sale
  203,544 
  203,544 
  1,969 
  200,048 
  1,527 
Loans, net
  1,330,939 
  1,331,557 
  - 
  1,329,507 
  2,050 
Accrued interest receivable
  4,690 
  4,690 
  4,690 
  - 
  - 
Federal Home Loan Bank stock
  12,828 
  12,828 
  - 
  - 
  12,828 
Bank-owned life insurance
  34,703 
  34,703 
  - 
  34,703 
  - 
Interest rate caps
  2,540 
  2,540 
  - 
  2,540 
  - 
Financial liabilities:
    
    
    
    
    
Non-maturing deposits
  995,199 
  995,199 
  - 
  995,199 
  - 
Time deposits
  179,531 
  179,731 
  - 
  179,731 
  - 
Accrued interest payable
  451 
  451 
  451 
  - 
  - 
Repurchase agreements and
    
    
    
    
    
federal funds purchased
  21,256 
  21,256 
  - 
  21,256 
  - 
FHLB Advances and other borrowings
  270,000 
  270,005 
  - 
  270,005 
  - 
Subordinated debt
  18,558 
  14,302 
  - 
  14,302 
  - 
 
    
    
    
    
    
 
 
 
December 31, 2016
 
 
 
Carrying
 
 
Fair Value
 
(in thousands)
 
Amount
 
 
Total
 
 
Level 1
 
 
Level 2
 
 
Level 3
 
Financial assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cash and due from banks
 $43,005 
 $43,005 
 $43,005 
 $- 
 $- 
Investment securities available-for-
    
    
    
    
    
sale
  197,441 
  197,441 
  1,951 
  193,990 
  1,500 
Loans, net
  1,183,371 
  1,184,621 
  - 
  1,181,909 
  2,712 
Accrued interest receivable
  4,368 
  4,368 
  4,368 
  - 
  - 
Federal Home Loan Bank stock
  8,400 
  8,400 
  - 
  - 
  8,400 
Bank-owned life insurance
  34,190 
  34,190 
  - 
  34,190 
  - 
Interest rate caps
  2,985 
  2,985 
  - 
  2,985 
  - 
Financial liabilities:
    
    
    
    
    
Non-maturing deposits
  953,248 
  953,248 
  - 
  953,248 
  - 
Time deposits
  219,007 
  219,038 
  - 
  219,038 
  - 
Accrued interest payable
  294 
  294 
  294 
  - 
  - 
Repurchase agreements and
    
    
    
    
    
federal funds purchased
  20,174 
  20,174 
  - 
  20,174 
  - 
FHLB Advances and other borrowings
  150,000 
  149,997 
  - 
  149,997 
  - 
Subordinated debt
  18,558 
  14,197 
  - 
  14,197 
  - 
 
 
-30-
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 
 
 
NOTE 9 – SUPPLEMENTAL CASH FLOW DISCLOSURE
 
 
 
For the six-months
 
 
 
ended June 30,
 
(In thousands)
 
2017
 
 
2016
 
Supplemental Disclosures of Cash Flow Information:
   
   
 
   
   
Interest paid
 $4,678 
 $3,907 
 
   
   
Income taxes paid
 $3,770 
 $2,635 
 
    
    
Supplemental Schedule of Noncash Investing and Financing Activites:
    
    
 
    
    
Change in fair value of securities available-for-sale, net of taxes
 $1,777 
 $2,367 
 
   
   
Change in fair value of cash flow hedges, net of taxes
 $204 
 $(1,333)
 
NOTE 10 – SUBSEQUENT EVENTS
 
Subsequent events are events or transactions that occur after the balance sheet date but before financial statements are issued. Recognized subsequent events are events or transactions that provide additional evidence about conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements.
 
Nonrecognized subsequent events are events that provide evidence about conditions that did not exist at the date of the balance sheet but arose after that date. Management has reviewed events occurring through the date the financial statements were available to be issued and no subsequent events occurred requiring accrual or disclosure.
 
 
-31-
 
Item 2
- Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Paragon Commercial Corporation (the “Company” or “Paragon”) is a bank holding company incorporated under the laws of North Carolina and headquartered in Raleigh, North Carolina. The Company conducts its business operations primarily through its wholly owned subsidiary, Paragon Bank (the “Bank”), a full-service, state-chartered community bank with 3 locations in Raleigh, Charlotte and Cary, North Carolina. Paragon Bank provides banking services to businesses and consumers across the Carolinas.
 
Because the Company has no material operations and conducts no business on its own other than owning its subsidiaries, the discussion contained in this management’s discussion and analysis concerns primarily the business of Paragon Bank. For ease of reading and because the financial statements are presented on a consolidated basis, Paragon Commercial Corporation and Paragon Bank are collectively referred to herein as “the Company,” “we”, “our”, or “us”, unless otherwise noted.
 
Management’s discussion and analysis is intended to assist readers in understanding and evaluating the financial condition and consolidated results of operations of the Company. This discussion and analysis includes descriptions of significant transactions, trends and other factors affecting the Company’s operating results for the three- and six-month periods ended June 30, 2017, and 2016, as well as the financial condition of the Company as of June 30, 2017 and December 31, 2016. This discussion and analysis should be read in conjunction with the unaudited consolidated financial statements included in this report and the audited consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2016 filed with the Securities and Exchange Commission on March 21, 2017, as amended on April 28, 2017. The results of operations for the three and six months ended June 30, 2017 are not necessarily indicative of the results to be expected for the full year ending December 31, 2017 or any other future period.
 
Forward-Looking Information
 
This periodic report on Form 10-Q contains certain “forward-looking statements” that represent management’s judgments concerning the future and are subject to risks and uncertainties that could cause the Company’s actual operating results and financial position to differ materially from those projected in the forward-looking statements. These statements are included throughout this report and relate to, among other things our business strategy, goals, and expectations concerning our market position, future operations, margins, profitability, liquidity, and capital resources. Additional statements regarding the proposed merger with TowneBank relate to, among other things, the timing of the proposed merger and whether the proposed merger will occur; the benefits, results and effects of the proposed merger; and the combined company's plans, objectives, expectations, costs, and the effect on earnings per share. Such forward-looking statements can be identified by the use of forward-looking terminology such as “may,” “will,” “anticipate,” “should,” “would,” “project,” “future,” “strategy,” “believe,” “contemplate,” “expect,” “estimate,” “continue,” “intend,” “seeks,” or other similar words and expressions of the future.
 
 
-32-
 
 
Risks and other factors that could cause actual results to differ materially from those expected include the following:
● costs and difficulties related to the proposed merger, including, among other things, the integration of our business with TowneBank, the inability to retain key personnel, competitive response to the proposed merger, or potential adverse reactions to changes in business or employee relationships could be more significant than we anticipate, resulting in higher costs or reduced benefits;
● failure of the merger to be completed on the proposed terms and schedule, or at all;
● business uncertainties and contractual restrictions during the pendency of the merger and management distraction;
● risks associated with any change in management, strategic direction, business plan, or operations;
● local economic conditions affecting retail and commercial real estate;
● disruptions in the credit markets;
● changes in interest rates;
● adverse developments in the real estate market affecting the value and marketability of collateral securing loans made by the Company;
● the failure of assumptions underlying loan loss and other reserves; and
● competition and the risk of new and changing regulation.
 
Additional factors that could cause actual results to differ materially are discussed in the Risk Factors section of this report and in the Company’s other filings with the SEC. The forward-looking statements in this report speak only as of the date hereof, and the Company does not assume any obligation to update such forward-looking statements, except as may otherwise be required by law.
 
GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures
 
Some of the financial measures included in this report are not measures of financial performance recognized by GAAP. These non-GAAP financial measures are “tangible stockholders’ equity,” “tangible book value per share,” “tangible average equity to tangible average assets,” and “efficiency ratio.” Our management uses these non-GAAP financial measures in its analysis of our performance and because of market expectations of use of these ratios to evaluate the Company. Management believes each of these non-GAAP financial measures provides useful information about our financial condition and results of operation. As noted below, the efficiency ratio shows the amount of revenue generated for each dollar spent and provides investors with a measure of our productivity. We also believe the presentation of tangible stockholders’ equity, tangible book value per share, tangible equity to risk-weighted assets and tangible average equity to tangible average assets would provide investors with a clear picture of our assets and equity. However, because the Company has not consummated any merger transactions and does not use any derivatives that might give rise to an intangible asset, there is no difference in tangible equity or assets and GAAP equity or assets.
 
 
“Efficiency ratio” is defined as total non-interest expense less merger related costs divided by adjusted operating revenue. Adjusted operating revenue is equal to net interest income (taxable equivalent) plus non-interest income, adjusted to exclude the impacts of gains and losses on the sale of securities and gains and losses on the sale or write-down of foreclosed real estate. We believe the efficiency ratio is important as an indicator of productivity because it shows the amount of revenue generated by our core operations for each dollar spent. While the efficiency ratio is a measure of productivity, its value reflects the attributes of the business model we employ.
 
 
-33-
 
 
 
 
Three-Month Periods
 
 
Six-Month Periods
 
 
 
Ended June 30,
 
 
Ended June 30,
 
(Dollars in thousands)
 
2017
 
 
2016
 
 
2017
 
 
2016
 
Efficiency Ratio
 
 
 
 
 
 
 
 
 
 
 
 
Non-interest expense
 $7,857 
 $6,488 
 $15,469 
 $13,088 
Merger related expenses
  368 
  - 
  368 
  - 
 
 $7,489 
 $6,488 
 $15,101 
 $13,088 
 
    
    
    
    
Net interest taxable equivalent income
 $13,351 
 $11,560 
 $25,979 
 $22,346 
Non-interest income
  494 
  381 
  997 
  647 
Less gain on investment securities
  - 
  - 
  - 
  (85)
Plus loss on sale or writedown of foreclosed real estate
  22 
  45 
  22 
  257 
  Adjusted operating revenue
 $13,867 
 $11,986 
 $26,998 
 $23,165 
 
    
    
    
    
Efficiency ratio
  54.01%
  54.13%
  57.30%
  56.50%
 
Executive Overview of Recent Financial Performance
 
Net income available to common stockholders totaled $3.3 million, or $0.61 per diluted common share, in the second quarter (“Q2”) of 2017, which was a decrease year over year from $3.5 million, or $0.75 per diluted share, in Q2 2016.
 
Return on average assets equaled 0.83% in Q2 2017 compared to 1.00% in Q2 2016 while return on average equity equaled 9.19% in Q2 2017 compared to 13.41% for the same period in 2016.
 
The efficiency ratio, which represents operating expenses to total operating revenues, improved to 54.01% in Q2 2017 from 54.13% in Q2 2016.
 
The Company had net recoveries of charged-off loans of $146,000 in Q2 2017, compared to $55,000 in Q2 2016.
 
Annualized net loan growth was 36% in Q2 2017, resulting from net loan originations during the quarter of $108.9 million.
 
Proposed Merger with TowneBank
 
On April 26, 2017, the Company entered into an Agreement and Plan of Reorganization (the “Merger Agreement”) with TowneBank and TB Acquisition, LLC (“TB Acquisition”). Pursuant to the terms of the Merger Agreement, the Company will merge with and into TB Acquisition (the “Merger”) and the Bank will subsequently merge with and into TowneBank (the “Bank Merger” and, together with the Merger, the “Transaction”). TB Acquisition will be the surviving entity in the Merger and TowneBank will be the surviving entity in the Bank Merger.
 
 
-34-
 
 
Under the terms of the Merger Agreement, the Company’s stockholders will be entitled to receive 1.7250 shares (the “Exchange Ratio”) of TowneBank common stock for each share of the Company’s common stock. Based on TowneBank’s closing price of $34.35 as of April 26, 2017, the day the Transaction was announced, the estimated aggregate purchase price was $323.4 million. The Transaction is expected to close in the first quarter of 2018, subject to stockholder and regulatory approval and other customary closing conditions.
 
Analysis of Results of Operations
 
Second Quarter 2017 compared to Second Quarter 2016
 
During the three-month period ended June 30, 2017, the Company had net income of $3.3 million compared to net income of $3.5 million for the same period in 2016. Basic and diluted net income per share for the quarter ended June 30, 2017 were $0.61 and $0.61, respectively, compared with basic and diluted net income per share of $0.76 and $0.75 for the same period in 2016. Income during the second quarter of 2017 was negatively impacted by merger related costs of $368,000 as well as $650,000 in additional loan loss provisions related to strong loan growth. The second quarter of 2016 had no merger related costs or loan loss provisions.
 
Year-to-Date 2017 compared to Year-to-Date 2016
 
During the six-month period ended June 30, 2017, the Company had net income of $6.6 million compared to net income of $6.3 million for the same period in 2016. Basic and diluted net income per share for the six-months ended June 30, 2017 were $1.23 and $1.23, respectively, compared with basic and diluted net income per share of $1.38 and $1.37 for the same period in 2016. Income during the six-month period ended 2017 was also negatively impacted by merger related costs of $368,000 as well as $809,000 in additional loan loss provisions related to strong loan growth. The same period in 2016 had no merger related costs or loan loss provisions.
 
As discussed in greater detail below, the improvements in the results of operations in the second quarter and first six months of 2017, compared to the respective periods of 2016, reflect the benefit of balance sheet growth period over period as well as continued credit improvement.
 
Net Interest Income
 
Second Quarter 2017 compared to Second Quarter 2016
 
Like most financial institutions, the primary component of earnings for the Company is net interest income. Net interest income is the difference between interest income, principally from loans and investment securities portfolios, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume, spread and margin. For this purpose, volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities, spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and margin refers to net interest income divided by average interest-earning assets. Margin is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities, as well as by the levels on non-interest bearing liabilities and capital.
 
Net interest income increased by $1.7 million to $13.0 million for the three months ended June 30, 2017. The Company’s total interest income was impacted by an increase in interest earning assets. Average total interest-earning assets were $1.53 billion in the second quarter of 2017 compared with $1.31 billion in the same period in 2016. The yield on those assets was 4.17% in the second quarter of 2017 compared to 4.15% for the same period in 2016. The improvement in yield was primarily the result of a shift in asset composition from lower yielding short-term investments and cash into loans. Meanwhile, average interest-bearing liabilities increased by $139 million from $1.08 billion for the three months ended June 30, 2016 to $1.22 billion for the same period ended June 30, 2017. The Company’s cost of these funds increased by 10 basis points year over year to 0.83% from 0.73% in the second quarter of 2016 primarily as a result of the Federal Reserve’s increase in rates impacting the cost of the Company’s borrowings at the FHLB. During the three-month period ended June 30, 2017, the Company’s net interest margin was 3.51% and net interest spread was 3.34%. In the second quarter of 2016, net interest margin was 3.55% and net interest spread was 3.42%.
 
 
-35-
 
 
The following table summarizes the major components of net interest income and the related yields and costs for the quarterly periods presented.
 
 
 
For the Three Months Ended June 30,
 
 
 
2017
 
  2016
 
 
Average
 
 
 
 
 
Average
 
 
Average
 
 
 
 
 
Average
 
(Dollars in thousands)
 
Amount
 
 
Interest
 
 
Rate
 
 
Amount
 
 
Interest
 
 
Rate
 
Loans, net of allowance (1)
 $1,272,604 
 $14,014 
  4.42%
 $1,071,325 
 $11,840 
  4.44%
Investment securities (2)
  213,205 
  1,798 
  3.38%
  193,231 
  1,628 
  3.39%
Other interest-earning assets
  41,666 
  71 
  0.68%
  45,954 
  63 
  0.55%
Total interest-earning assets
  1,527,475 
  15,883 
  4.17%
  1,310,510 
  13,531 
  4.15%
Other assets
  59,091 
    
    
  83,212 
    
    
Total assets
 $1,586,566 
    
    
 $1,393,722 
    
    
 
    
    
    
    
    
    
Deposits:
    
    
    
    
    
    
Interest-bearing checking accounts
 $244,569 
  238 
  0.39%
 $170,209 
  170 
  0.40%
Money markets
  537,884 
  889 
  0.66%
  402,851 
  666 
  0.66%
Time deposits less than $100,000
  11,303 
  30 
  1.08%
  11,635 
  30 
  1.05%
Time deposits greater than or
    
    
    
    
    
    
equal to $100,000
  177,991 
  428 
  0.96%
  242,444 
  526 
  0.87%
Borrowings
  249,010 
  947 
  1.53%
  254,540 
  579 
  0.91%
Total interest-bearing liabilities
  1,220,757 
  2,532 
  0.83%
  1,081,679 
  1,971 
  0.73%
Noninterest-bearing deposits
  225,725 
    
    
  191,994 
    
    
Other liabilities
  (2,748)
    
    
  16,367 
    
    
Stockholders' equity
  142,832 
    
    
  103,682 
    
    
Total liabilities and stockholders'
    
    
    
    
    
    
equity
 $1,586,566 
    
    
 $1,393,722 
    
    
 
    
    
    
    
    
    
Net interest income/interest rate
    
    
    
    
    
    
spread (taxable-equivalent basis) (3)
    
 $13,351 
  3.34%
    
 $11,560 
  3.42%
 
    
    
    
    
    
    
Net interest margin (taxable-
    
    
    
    
    
    
equivalent basis) (4)
    
    
  3.51%
    
    
  3.55%
 
    
    
    
    
    
    
Ratio of interest-bearing assets to
    
    
    
    
    
    
interest-bearing liabilities
  125.13%
    
    
  121.16%
    
    
 
    
    
    
    
    
    
Reported net interest income
    
    
    
    
    
    
Net interest income (taxable-equivalent
    
    
    
    
    
    
basis)
    
 $13,351 
    
    
 $11,560 
    
Less:
    
    
    
    
    
    
Taxable-equivalent adjustment
    
  333 
    
    
  259 
    
Net interest income
    
 $13,018 
    
    
 $11,301 
    
 
(1) Loans include nonaccrual loans.
 
(2) Yields related to investment securities exempt from income taxes are stated on a taxable-equivalent basis assuming a federal income tax rate of 30.0 percent. The taxable-equivalent adjustment was $333,000 and $259,000 for the 2017 and 2016 periods, respectively.
 
(3) Net interest spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.
 
(4) Net interest margin represents annualized net interest income divided by average interest-earning assets.
 
 
-36-
 
 
Changes in interest income and interest expense can result from variances in both volume and rates. The following table presents the relative impact on tax-equivalent net interest income to changes in the average outstanding balances of interest-earning assets and interest-bearing liabilities and the rates earned and paid on such assets and liabilities.
 
 
 
Three Months Ended
 
 
 
June 30, 2017 vs. 2016
 
 
 
Increase (Decrease) Due to
 
(Dollars in thousands)
 
Volume
 
 
Rate
 
 
Total
 
Interest income
 
 
 
 
 
 
 
 
 
Loans, net of allowance
 $2,231 
 $(57)
 $2,174 
Investment securities
  169 
  1 
  170 
Other interest-earnings assets
  (6)
  14 
  8 
Total interest income (taxable-
    
    
    
equivalent basis)
  2,394 
  (42)
  2,352 
 
    
    
    
Interest expense
    
    
    
Deposits:
    
    
    
Interest-bearing checking accounts
  74 
  (6)
  68 
Money markets
  224 
  (1)
  223 
Time deposits less than $100,000
  (1)
  1 
  - 
Time deposits greater than or
    
    
    
equal to $100,000
  (140)
  42 
  (98)
Borrowings
  (13)
  381 
  368 
Total interest expense
  144 
  417 
  561 
 
    
    
    
Net interest income increase/
    
    
    
(decrease)(taxable equivalent basis)
 $2,250 
 $(459)
  1,791 
 
    
    
    
Less:
    
    
    
Taxable-equivalent adjustment
    
    
  74 
Net interest income increase
    
    
 $1,717 
 
Year-to-Date 2017 compared to Year-to-Date 2016
 
Net interest income increased by $3.5 million to $25.3 million for the six months ended June 30, 2017. The Company’s total interest income was impacted by an increase in interest earning assets. Average total interest-earning assets were $1.51 billion for the six-month period ended June 30, 2017 compared with $1.27 billion in the same period in 2016. The yield on those assets was 4.12% in 2017 compared to 4.14% for the same period in 2016. The slight decline in yield was primarily the result of a 3 basis point decrease in average loan yield as a result of competitive pricing pressure. Meanwhile, average interest-bearing liabilities increased by $140.5 million from $1.07 billion for the year-to-date period ended June 30, 2016 to $1.21 billion for the same period ended June 30, 2017. The Company’s cost of these funds increased from 0.73% for the year-to-date period ended June 30, 2016 to 0.81% for the same period ended June 30, 2017. The increase was primarily as a result of the Federal Reserve’s increase in rates impacting the cost of the Company’s borrowings at the FHLB. During the six-month period ended June 30, 2017, the Company’s net interest margin was 3.47% and net interest spread was 3.31%. For the same period in 2016, net interest margin was 3.53% and net interest spread was 3.41%.
 
 
-37-
 
 
The following table summarizes the major components of net interest income and the related yields and costs for the quarterly periods presented.
 
 
 
For the Six Months Ended June 30,
 
 
 
2017
 
  2016
 
 
Average
 
 
 
 
 
Average
 
 
Average
 
 
 
 
 
Average
 
(Dollars in thousands)
 
Amount
 
 
Interest
 
 
Rate
 
 
Amount
 
 
Interest
 
 
Rate
 
Loans, net of allowance (1)
 $1,240,959 
 $27,084 
  4.40%
 $1,045,361 
 $23,020 
  4.43%
Investment securities (2)
  210,180 
  3,510 
  3.37%
  185,556 
  3,082 
  3.34%
Other interest-earnings assets
  58,689 
  230 
  0.79%
  41,958 
  121 
  0.58%
Total interest-earning assets
  1,509,828 
  30,824 
  4.12%
  1,272,875 
  26,233 
  4.14%
Other assets
  56,356 
    
    
  85,685 
    
    
Total assets
 $1,566,184 
    
    
 $1,358,560 
    
    
 
    
    
    
    
    
    
Deposits:
    
    
    
    
    
    
Interest-bearing checking accounts
 $224,528 
  425 
  0.38%
 $155,299 
  348 
  0.45%
Money markets
  533,715 
  1,776 
  0.67%
  402,641 
  1,345 
  0.67%
Time deposits less than $100,000
  11,374 
  60 
  1.07%
  11,639 
  60 
  1.03%
Time deposits greater than or
    
    
    
    
    
    
equal to $100,000
  189,055 
  909 
  0.97%
  261,536 
  1,063 
  0.82%
Borrowings
  249,655 
  1,675 
  1.35%
  236,674 
  1,071 
  0.91%
Total interest-bearing liabilities
  1,208,327 
  4,845 
  0.81%
  1,067,789 
  3,887 
  0.73%
Noninterest-bearing deposits
  219,242 
    
    
  175,562 
    
    
Other liabilities
  (1,784)
    
    
  13,823 
    
    
Stockholders' equity
  140,399 
    
    
  101,386 
    
    
Total liabilities and stockholders'
    
    
    
    
    
    
equity
 $1,566,184 
    
    
 $1,358,560 
    
    
 
    
    
    
    
    
    
Net interest income/interest rate
    
    
    
    
    
    
spread (taxable-equivalent basis) (3)
    
 $25,979 
  3.31%
    
 $22,346 
  3.41%
 
    
    
    
    
    
    
Net interest margin (taxable-
    
    
    
    
    
    
equivalent basis) (4)
    
    
  3.47%
    
    
  3.53%   
 
    
    
    
    
    
    
Ratio of interest-bearing assets to
    
    
    
    
    
    
interest-bearing liabilities
  124.95%
    
    
  119.21%
    
    
 
    
    
    
    
    
    
Reported net interest income
    
    
    
    
    
    
Net interest income (taxable-equivalent
    
    
    
    
    
    
basis)
    
 $25,979 
    
    
 $22,346 
    
Less:
    
    
    
    
    
    
Taxable-equivalent adjustment
    
  642 
    
    
  494 
    
Net interest income
    
 $25,337 
    
    
 $21,852 
    
 
(1) Loans include nonaccrual loans.
 
(2) Yields related to investment securities exempt from income taxes are stated on a taxable-equivalent basis assuming a federal income tax rate of 30.0 percent. The taxable-equivalent adjustment was $642,000 and $494,000 for the 2017 and 2016 periods, respectively.
 
(3) Net interest spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.
 
(4) Net interest margin represents annualized net interest income divided by average interest-earning assets.
 
 
-38-
 
 
Changes in interest income and interest expense can result from variances in both volume and rates. The following table presents the relative impact on tax-equivalent net interest income to changes in the average outstanding balances of interest-earning assets and interest-bearing liabilities and the rates earned and paid on such assets and liabilities.
 
 
 
Six Months Ended
 
 
 
June 30, 2017 vs. 2016
 
 
 
Increase (Decrease) Due to
 
(Dollars in thousands)
 
Volume
 
 
Rate
 
 
Total
 
Interest income
 
 
 
 
 
 
 
 
 
Loans, net of allowance
 $4,297 
 $(243)
 $4,054 
Investment securities
  408 
  20 
  428 
Other interest-earning assets
  48 
  61 
  109 
Total interest income (taxable-
    
    
    
equivalent basis)
  4,753 
  (162)
  4,591 
 
    
    
    
Interest expense
    
    
    
Deposits:
    
    
    
Interest-bearing checking accounts
  155 
  (78)
  77 
Money markets
  437 
  (6)
  431 
Time deposits less than $100,000
  (1)
  1 
  - 
Time deposits greater than or
    
    
    
equal to $100,000
  (294)
  140 
  (154)
Borrowings
  59 
  545 
  604 
Total interest expense
  356 
  602 
  958 
 
    
    
    
Net interest income increase/
    
    
    
(decrease)(taxable equivalent basis)
 $4,397 
 $(764)
  3,633 
 
    
    
    
Less:
    
    
    
Taxable-equivalent adjustment
    
    
  148 
Net interest income increase/
    
    
    
(decrease)
    
    
 $3,485 
 
Provision for Loan Losses
 
Second Quarter 2017 compared to Second Quarter 2016
 
Provisions for loan losses are charged to income to bring the allowance for loan losses to a level deemed appropriate by management. In evaluating the allowance for loan losses, management considers factors that include growth, composition and industry diversification of the portfolio, historical loan loss experience, current delinquency levels, adverse situations that may affect a borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions and other relevant factors.
 
In determining the loss history to be applied to its ASC 450 loan pools within the allowance for loan losses, the Company uses net charge-off history for the most recent five consecutive years. Since each of the five past years contain a declining amount of charge-offs coupled with a large number of recoveries, the impact of the Company’s improvement in historical credit quality has resulted in a continually declining balance of reserves as a percentage of the loan portfolio.
 
 
-39-
 
 
The following table summarizes the changes in the allowance for loan losses for the three months ended June 30, 2017 and 2016:
 
(In thousands)
 
 
 
Three months ended June 30, 2017
 
 
 
Beginning balance
 $8,125 
Provision for loan losses
  650 
Loans charged off
  - 
Recoveries
  146 
Net recoveries
  146 
Ending balance
 $8,921 
 
    
Three months ended June 30, 2016
    
Beginning balance
 $7,931 
Provision for loan losses
  - 
Loans charged off
  (1)
Recoveries
  56 
Net chargeoffs
  55 
Ending balance
 $7,986 
 
 
The Company recorded $650,000 in provision for loan losses in the second quarter of 2017 but did not record a provision for loan losses during the same period in 2016. The increase in the provision for 2017 was the result of rapid loan growth along with additions to impaired loans during the quarter.
 
Year-to-Date 2017 compared to Year-to-Date 2016
 
The following table summarizes the changes in the allowance for loan losses for the six months ended June 30, 2017 and 2016:
 
(In thousands)
 
 
 
Six months ended June 30, 2017
 
 
 
Beginning balance
 $7,909 
Provision for loan losses
  809 
Loans charged off
  (23)
Recoveries
  226 
Net recoveries
  203 
Ending balance
 $8,921 
 
    
Six months ended June 30, 2016
    
Beginning balance
 $7,641 
Provision for loan losses
  - 
Loans charged off
  (1)
Recoveries
  346 
Net chargeoffs
  345 
Ending balance
 $7,986 
 
 
-40-
 
 
The Company recorded $809,000 in provision for loan losses in the first six months of 2017 but did not record a provision for loan losses during the same period in 2016. The increase in the provision for 2017 was primarily the result of rapid loan growth in 2017.
 
Non-Interest Income
 
The following table provides a summary of non-interest income for the periods presented.
 
 
 
Three months
 
 
Six months
 
 
 
ended June 30,
 
 
ended June 30,
 
(In thousands, except per share data)
 
2017
 
 
2016
 
 
2017
 
 
2016
 
Non-interest income
 
 
 
 
 
 
 
 
 
 
 
 
Increase in cash surrender value of bank owned
 
 
 
 
 
 
 
 
 
 
 
 
life insurance
 $255 
 $226 
 $513 
 $449 
Net gain on sale of securities
  - 
  - 
  - 
  85 
Service charges and fees
  68 
  56 
  130 
  114 
Mortgage origination fees and gains on sale of loans
  26 
  33 
  77 
  65 
Net loss on sale or impairment of foreclosed assets
  (22)
  (45)
  (22)
  (257)
Other fees and income
  167 
  111 
  299 
  191 
Total non-interest income
 $494 
 $381 
 $997 
 $647 
 
Second Quarter 2017 compared to Second Quarter 2016
 
Non-interest income for the quarter ended June 30, 2017 was $494,000, an increase of $113,000 from $381,000 for the same period in 2016. The primary reason for the increase was an increase of $83,000 in income distributions from a minority partnership investment.
 
 
-41-
 
 
Year-to-Date 2017 compared to Year-to-Date 2016
 
Non-interest income for the six months ended June 30, 2017 was $997,000, an increase of $350,000 from $647,000 for the same period in 2016. The primary reason for the increase was a decrease of $257,000 in the amount of losses on sale or write-down of other real estate. This was partially offset by a decrease of $85,000 on gains of sales of securities taken during 2016.
 
Non-Interest Expenses
 
The following table provides a summary of non-interest expenses for the periods presented.
 
 
 
Three months
 
 
Six months
 
 
 
ended June 30,
 
 
ended June 30,
 
(In thousands, except per share data)
 
2017
 
 
2016
 
 
2017
 
 
2016
 
Non-interest expense
 
 
 
 
 
 
 
 
 
 
 
 
Salaries and employee benefits
 $4,310 
 $3,742 
 $8,772 
 $7,609 
Furniture, equipment and software costs
  451 
  390 
  953 
  882 
Occupancy
  373 
  342 
  732 
  686 
Data processing
  580 
  524 
  1,110 
  820 
Director related fees and expenses
  253 
  219 
  477 
  471 
Professional fees
  244 
  182 
  447 
  419 
FDIC and other supervisory assessments
  201 
  217 
  367 
  412 
Advertising and public relations
  297 
  234 
  518 
  422 
Unreimbursed loan costs and foreclosure related expenses
  104 
  142 
  278 
  211 
Merger related expenses
  368 
  - 
  368 
  - 
Other
  676 
  496 
  1,447 
  1,156 
Total non-interest expense
 $7,857 
 $6,488 
 $15,469 
 $13,088 
 
Second Quarter 2017 compared to Second Quarter 2016
 
Non-interest expenses increased period over period by $1.4 million, or 21.1%, to $7.9 million for the three-month period ended June 30, 2017, from $6.5 million for the same period in 2016. The following are highlights of the significant changes in non-interest expenses in the second quarter of 2017 compared to the second quarter of 2016.
 
Personnel expenses increased $568,000 to $4.3 million due primarily to the addition of more personnel to handle the growth of the Company.
 
The Company had merger related expenses of $368,000 in the second quarter of 2017 as a result of the April 26th announcement of the proposed merger with TowneBank.
 
Advertising fees increased $63,000 to $297,000 from $234,000 in the second quarter of 2017 due largely to costs associated with advertisement placements within more magazine related content in 2017 that were not incurred in the second quarter of 2016.
 
Year-to-Date 2017 compared to Year-to-Date 2016
 
Non-interest expenses increased period over period by $2.4 million, or 18.2%, to $15.5 million for the six-month period ended June 30, 2017, from $13.1 million for the same period in 2016. The following are highlights of the significant changes in non-interest expenses in the first six months of 2017 compared to the same period in 2016.
 
Personnel expenses increased $1.2 million to $8.8 million due primarily to the addition of more personnel to handle the rapid growth of the Company.
 
 
-42-
 
 
The Company had merger related expenses of $368,000 in the second quarter of 2017 as a result of the April 26th announcement of the proposed merger with TowneBank.
 
Data Processing charges increased by $290,000 primarily due to an increase in core processing related expenses associated with the growth of the Company.
 
Provision for Income Taxes
 
Income tax expense was $1.7 million in the second quarter of 2017 and 2016. The Company’s effective tax rate for the second quarter of 2017 was 34.4%, compared to 33.10% for the same period in 2016. The increase in effective tax rate was primarily due to a larger portion of the quarter over quarter growth coming from taxable instruments such as loans compared to nontaxable instruments and to nondeductible merger related costs incurred in the second quarter of 2017.
 
For the six-month period ended June 30, 2017, income tax expense was $3.4 million compared to $3.1 million for the same period in 2016. The Company’s effective tax rate for the six-month period ended June 30, 2017 was 34.00%, compared to 32.92% for the same period in 2016. The increase in effective tax rate was primarily due to a larger portion of the year over year growth coming from taxable instruments such as loans compared to nontaxable instruments and to nondeductible merger related costs incurred in the second quarter of 2017.
 
In 2017, the North Carolina state corporate income tax rate decreased from 4% to 3%.
 
Analysis of Financial Condition
 
Overview
 
Total assets at June 30, 2017 were $1.64 billion, an increase of $131.8 million or 8.8% over the balance as of December 31, 2016 of $1.50 billion. Interest earning assets at June 30, 2017 totaled $1.56 billion and consisted of $1.33 billion in net loans, $203.5 million in investment securities, $12.8 million in Federal Home Loan Bank of Atlanta stock, and $13.4 million in overnight investments and interest-bearing deposits in other banks. Interest earning assets at December 31, 2016 totaled $1.43 billion and consisted of $1.18 billion in net loans, $168.9 million in investment securities, $8.1 million in Federal Home Loan Bank of Atlanta stock, and $31.0 million in overnight investments and interest-bearing deposits in other banks. Total deposits and stockholders’ equity at June 30, 2017 were $1.17 billion and $145.3 million, respectively. Total deposits and stockholders’ equity at December 31, 2016 were $1.17 billion and $136.1 million, respectively.
 
Investment Securities
 
The Company's investment portfolio plays a major role in the management of liquidity and interest rate sensitivity and, therefore, is managed in the context of the overall balance sheet. In general, the primary goals of the investment portfolio are: (i) to provide a sufficient margin of liquid assets to meet unanticipated deposit and loan fluctuations and overall funds management objectives; (ii) to provide eligible securities to secure public funds as prescribed by law and other borrowings; (iii) to provide structures and terms to enable proper interest rate risk management; and (iv) to earn the maximum return on funds invested that is commensurate with meeting the requirements of (i), (ii) and (iii). The Company invests in securities as allowable under bank regulations and its investment policy. These securities include U.S. Agency obligations, U.S. government-sponsored entities, including collateralized mortgage obligations and mortgage-backed securities, bank eligible obligations of state or political subdivisions, and limited types of permissible corporate debt and equity securities.
 
 
-43-
 
 
Investment securities as of June 30, 2017 and December 31, 2016 were $203.5 million and $197.4 million, respectively. The Company’s investment portfolio at June 30, 2017 and December 31, 2016, consisted of U.S. government agency obligations, collateralized mortgage obligations, mortgage-backed securities, municipal bonds and other equity investments, and had a weighted average taxable equivalent yield of 2.92% and 2.83% at June 30, 2017 and December 31, 2016, respectively. The Company also held an investment of $12.8 million and $8.4 million in Federal Home Loan Bank Stock as of June 30, 2017 and December 31, 2016 with a weighted average yield of 4.87% and 4.64% for those periods. The FHLB stock is recorded at cost and is classified separately from investment securities on the consolidated balance sheets.
 
The investment portfolio increased $6.1 million during the first six months of 2017, the net result of $13.5 million in purchases, $9.7 million of maturities and prepayments and an increase of $2.9 million in the market value of securities held available for sale.
 
The securities in an unrealized loss position as of June 30, 2017 continue to perform and are expected to perform through maturity, and the issuers have not experienced significant adverse events that would call into question their ability to repay these debt obligations according to contractual terms.
 
The following is a summary of the securities portfolio by major classification at June 30, 2017 and December 31, 2016.
 
 
 
June 30, 2017
 
 
December 31, 2016
 
 
 
Amortized
 
 
Fair
 
 
Amortized
 
 
Fair
 
(In thousands)
 
Cost
 
 
Value
 
 
Cost
 
 
Value
 
Available-for-sale:
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Agency obligations
 $15,715 
 $15,855 
 $17,062 
 $16,943 
Collateralized mortgage obligations
  40,833 
  41,027 
  42,439 
  42,497 
Mortgage-backed securities
  75,777 
  75,369 
  75,138 
  73,873 
Municipal bonds
  66,429 
  67,797 
  60,901 
  60,677 
Other
  3,676 
  3,496 
  3,676 
  3,451 
 
 $202,430 
 $203,544 
 $199,216 
 $197,441 
 
 
-44-
 
 
The following table summarizes the securities portfolio by major classification as of June 30, 2017 and December 31, 2016:
 
 
 
June 30, 2017
 
  December 31, 2016
 
 
 
 
 
 
 
 
Weighted
 
 
 
 
 
 
 
 
Weighted
 
 
 
 
 
 
 
 
 
Average Tax
 
 
 
 
 
 
 
 
Average Tax
 
 
 
Amortized
 
 
Fair
 
 
Equivalent
 
 
Amortized
 
 
Fair
 
 
Equivalent
 
(Dollars in thousands)
 
Cost
 
 
Value
 
 
Yield (1)
 
 
Cost
 
 
Value
 
 
Yield (1)
 
U.S. government agency obligations
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Due within one year
 $- 
 $- 
  - 
 $- 
 $- 
  - 
Due after one but within five years
  - 
  - 
  - 
  - 
  - 
  - 
Due after five but within ten years
  - 
  - 
  - 
  - 
  - 
  - 
Due after ten years
  15,715 
  15,855 
  2.62%
  17,062 
  16,943 
  2.61%
 
  15,715 
  15,855 
  2.62%
  17,062 
  16,943 
  2.61%
Collateralized mortgage obligations
    
    
    
    
    
    
Due within one year
  - 
  - 
  - 
  - 
  - 
  - 
Due after one but within five years
  - 
  - 
  - 
  - 
  - 
  - 
Due after five but within ten years
  - 
  - 
  - 
  - 
  - 
  - 
Due after ten years
  40,833 
  41,027 
  2.36%
  42,439 
  42,497 
  2.43%
 
  40,833 
  41,027 
  2.36%
  42,439 
  42,497 
  2.43%
Mortgage-backed securities
    
    
    
    
    
    
Due within one year
  - 
  - 
  - 
  - 
  - 
  - 
Due after one but within five years
  7,393 
  7,545 
  2.54%
  7,492 
  7,581 
  2.54%
Due after five but within ten years
  7,480 
  7,619 
  2.75%
  5,237 
  5,341 
  3.07%
Due after ten years
  60,904 
  60,205 
  2.34%
  62,409 
  60,951 
  2.13%
 
  75,777 
  75,369 
  2.40%
  75,138 
  73,873 
  2.24%
Municipal bonds
    
    
    
    
    
    
Due within one year
  - 
  - 
  - 
  - 
  - 
  - 
Due after one but within five years
  2,187 
  2,249 
  3.09%
  1,734 
  1,771 
  3.23%
Due after five but within ten years
  8,685 
  8,897 
  3.52%
  6,078 
  6,087 
  3.22%
Due after ten years
  55,557 
  56,651 
  4.04%
  53,089 
  52,819 
  4.02%
 
  66,429 
  67,797 
  3.94%
  60,901 
  60,677 
  3.92%
Other investments
    
    
    
    
    
    
Due within one year
  - 
  - 
  - 
  - 
  - 
  - 
Due after one but within five years
  - 
  - 
  - 
  - 
  - 
  - 
Due after five but within ten years
  1,500 
  1,527 
  6.64%
  1,500 
  1,500 
  6.77%
Due after ten years (2)
  2,176 
  1,969 
  0.00%
  2,176 
  1,951 
  0.00%
 
  3,676 
  3,496 
  2.76%
  3,676 
  3,451 
  2.76%
Total securities available for sale
    
    
    
    
    
    
Due within one year
  - 
  - 
  - 
  - 
  - 
  - 
Due after one but within five years
  9,580 
  9,794 
  2.66%
  9,226 
  9,352 
  2.67%
Due after five but within ten years
  17,665 
  18,043 
  3.47%
  12,815 
  12,928 
  2.82%
Due after ten years (2)
  175,185 
  175,707 
  2.88%
  177,175 
  175,161 
  2.91%
 
 $202,430 
 $203,544 
  2.92%
 $199,216 
 $197,441 
  2.85%
 
(1)
The marginal tax rate used to calculate tax equivalent yield was 30.0%.
(2)
Includes investments with no stated maturity date
 
As of June 30, 2017, the weighted average life of the Company's debt securities was 5.0 years, and the weighted average effective duration was 3.7 years.
 
 
-45-
 
 
Loans Receivable
 
The Company serves the credit needs of commercial and private banking clients in its markets through a range of commercial and consumer loan products. The goal of the Company's lending function is to help clients reach their goals. This is accomplished through loan products that best fit the needs of each client and are profitable to the Company. The lending process combines a thorough knowledge of each client and the local market with the high standards of the Company’s credit culture. Underwriting criteria governing the level of assumed risk and a sharp focus on maintaining a well-balanced loan portfolio play a critical role in the process.
 
Strict attention is placed on balancing loan quality and profitability with loan growth. The Company has established concentration limits by borrower, product type, loan structure, and industry. Commercial loans are generally secured by business assets and real estate, supported by personal guarantees as needed. Loans to private banking clients are primarily secured with personal assets and real estate.
 
The loan portfolio at June 30, 2017 totaled $1.34 billion and was composed of $70.7 million in construction and land development loans, $742.6 million in commercial real estate loans, $323.8 million in consumer real estate loans, $181.6 million in commercial and industrial loans, and $20.8 million in consumer and other loans. Also included in loans outstanding is $298,000 in net deferred loan costs.
 
The loan portfolio at December 31, 2016 totaled $1.19 billion and was composed of $79.7 million in construction and land development loans, $641.7 million in commercial real estate loans, $287.1 million in consumer real estate loans, $170.7 million in commercial and industrial loans, and $11.5 million in consumer and other loans. Also included in loans outstanding is $518,000 in net deferred loan costs.
 
 
-46-
 
 
The following table describes the Company’s loan portfolio composition by category:
 
 
 
At June 30,
 
 
At December 31,
 
 
 
2017
 
 
2016
 
 
 
 
 
 
% of
 
 
 
 
 
% of
 
 
 
 
 
 
Total
 
 
 
 
 
Total
 
(Dollars in thousands)
 
Amount
 
 
Loans
 
 
Amount
 
 
Loans
 
Construction and land development
 $70,661 
  5.3%
 $79,738 
  6.7%
Commercial real estate:
    
    
    
    
Non-farm, non-residential
  433,486 
  32.4%
  365,569 
  30.7%
Owner occupied
  202,982 
  15.1%
  186,892 
  15.7%
Multifamily, nonresidential and junior liens
  106,106 
  7.9%
  89,191 
  7.5%
Total commercial real estate
  742,574 
  55.4%
  641,652 
  53.9%
Consumer real estate:
    
    
    
    
Home equity lines
  87,229 
  6.5%
  87,489 
  7.3%
Secured by 1-4 family residential, secured by
    
    
    
    
first deeds of trust
  231,903 
  17.3%
  195,343 
  16.4%
Secured by 1-4 family residential, secured by
    
    
    
    
second deeds of trust
  4,712 
  0.4%
  4,289 
  0.4%
Total consumer real estate
  323,844 
  24.2%
  287,121 
  24.1%
Commercial and industrial loans (except those
    
    
    
    
secured by real estate)
  181,643 
  13.6%
  170,709 
  14.3%
Consumer and other
  20,840 
  1.6%
  11,542 
  1.0%
Less:
    
    
    
    
Deferred loan origination (fees) costs
  298 
  0.0%
  518 
  0.0%
Total loans
  1,339,860 
  100%
  1,191,280 
  100%
Allowance for loan losses
  (8,921)
    
  (7,909)
    
Total net loans
 $1,330,939 
    
 $1,183,371 
    
 
During the six months ended June 30, 2017, loans receivable increased by $148.6 million, or 12.5%, to $1.34 billion as of period end. The increase in loans during the quarter is primarily attributable to new loan origination driven by the demand in the Company’s market areas.
 
During 2016, loans receivable increased by $175.1 million, or 17.2%, to $1.19 billion as of December 31, 2016. The increase in loans during the year is also primarily attributable to new loan origination driven by the demand in the Company’s market areas.
 
 
-47-
 
 
Maturities and Sensitivities of Loans to Interest Rates
 
The following table presents the maturity distribution of the Company’s loans at June 30, 2017. The table also presents the portion of loans that have fixed interest rates or variable interest rates that fluctuate over the life of the loans in accordance with changes in an interest rate index such as the prime rate:
 
 
 
At June 30, 2017
 
 
 
 
 
 
Due after one
 
 
 
 
 
 
 
 
 
Due within
 
 
year but within
 
 
Due after
 
 
 
 
(in thousands)
 
one year
 
 
five years
 
 
five years
 
 
Total
 
Fixed rate loans (1):
 
 
 
 
 
 
 
 
 
 
 
 
Construction and land development
 $15,341 
 $17,056 
 $4,065 
 $36,462 
Commercial real estate
  28,281 
  218,910 
  85,151 
  332,342 
Commercial real estate owner occupied
  11,529 
  102,259 
  75,705 
  189,493 
Multifamily, nonresidential and junior liens
  3,497 
  39,802 
  21,808 
  65,107 
Home equity lines
  - 
  625 
  - 
  625 
Secured by 1-4 family residential, secured by first
    
    
    
    
deeds of trust
  7,719 
  76,395 
  141,664 
  225,778 
Secured by 1-4 family residential, secured by
    
    
    
    
second deeds of trust
  139 
  2,597 
  716 
  3,452 
Commercial and industrial loans (except those
    
    
    
    
secured by real estate)
  12,236 
  68,397 
  20,126 
  100,759 
Consumer and other
  1,223 
  8,526 
  59 
  9,808 
Total at fixed rates
  79,965 
  534,567 
  349,294 
  963,826 
Variable rate loans (1):
    
    
    
    
Construction and land development
  15,453 
  13,591 
  5,037 
  34,081 
Commercial real estate
  19,340 
  42,974 
  38,830 
  101,144 
Commercial real estate owner occupied
  2,430 
  3,395 
  7,664 
  13,489 
Multifamily, nonresidential and junior liens
  866 
  22,527 
  17,606 
  40,999 
Home equity lines
  4,070 
  13,325 
  69,021 
  86,416 
Secured by 1-4 family residential, secured by first
    
    
    
    
deeds of trust
  2,912 
  2,211 
  872 
  5,995 
Secured by 1-4 family residential, secured by
    
    
    
    
second deeds of trust
  420 
  465 
  319 
  1,204 
Commercial and industrial loans (except those
    
    
    
    
secured by real estate)
  55,987 
  21,616 
  3,281 
  80,884 
Consumer and other
  4,523 
  6,371 
  138 
  11,032 
Total at variable rates
  106,001 
  126,475 
  142,768 
  375,244 
Subtotal
  185,966 
  661,042 
  492,062 
  1,339,070 
Non-accrual loans (2)
  56 
  248 
  188 
  492 
Gross Loans
 $186,022 
 $661,290 
 $492,250 
  1,339,562 
Deferred origination costs
    
    
    
  298 
Total loans
    
    
    
 $1,339,860 
 
(1)
Loan maturities are presented based on the final contractual maturity of each loan and do not reflect contractual principal payments prior to maturity on amortizing loans.
(2)
Includes nonaccrual restructured loans.
 
The Company may renew loans at maturity when requested by a customer whose financial strength appears to support such renewal or when such renewal appears to be in the Company’s best interest. In such instances, the Company generally requires payment of accrued interest and may require a principal reduction or modify other terms of the loan at the time of renewal.
 
 
-48-
 
 
Past Due Loans and Nonperforming Assets
 
Loans are reported as past due when the contractual amounts due with respect to principal and interest are not received by the contractual due date. Loans are generally classified as nonaccrual if they are past due for a period of 90 days or more, unless such loans are well secured and in the process of collection. If a loan or a portion of a loan is classified as doubtful or as partially charged off, the loan is generally classified as nonaccrual. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt. Loans may be returned to accrual status when all principal and interest amounts contractually due are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment performance of interest and principal by the borrower in accordance with the contractual terms.
 
While a loan is classified as nonaccrual and the future collectability of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to the principal outstanding, except in the case of loans with scheduled amortizations where the payment is generally applied to the oldest payment due. When the future collectability of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan had been partially charged off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered.
 
Assets acquired as a result of foreclosure are recorded at estimated fair value in other real estate (or foreclosed assets). Any excess of cost over estimated fair value at the time of foreclosure is charged to the allowance for loan losses. Valuations are periodically performed on these properties, and any subsequent write-downs are charged to earnings. Routine maintenance and other holding costs are included in non-interest expense. Loans are classified as troubled debt restructurings (“TDR”) by the Company when certain modifications are made to the loan terms and concessions are granted to the borrowers due to financial difficulty experienced by those borrowers. The Company grants concessions by (1) reduction of the stated interest rate for the remaining original life of the debt or (2) extension of the maturity date at a stated interest rate lower than the current market rate for new debt with similar risk. The Company does not generally grant concessions through forgiveness of principal or accrued interest. The Company’s policy with respect to accrual of interest on loans restructured in a TDR follows relevant supervisory guidance. That is, if a borrower has demonstrated performance under the previous loan terms and shows capacity to perform under the restructured loan terms, continued accrual of interest at the restructured interest rate is likely. If a borrower was materially delinquent on payments prior to the restructuring but shows the capacity to meet the restructured loan terms, the loan will likely continue as nonaccrual until there is demonstrated performance under new terms. Lastly, if the borrower does not perform under the restructured terms, the loan is placed on nonaccrual status. The Company closely monitors these loans and ceases accruing interest on them if management believes that the borrowers may not continue performing based on the restructured note terms.
 
 
-49-
 
 
The following tables present an age analysis of past due loans, segregated by class of loans as of June 30, 2017 and December 31, 2016:
 
 
 
  30+
 
 
 Non-
 
 
 Total
 
 
 
 
 
 
 
 
 
 Days
 
 
 Accrual
 
 
 Past
 
 
 
 
 
Total
 
(in thousands)
 
 Past Due
 
 
 Loans
 
 
 Due
 
 
 Current
 
 
Loans
 
At June 30, 2017
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Construction and land development
 $- 
 $118 
 $118 
 $70,543 
 $70,661 
Non-farm, non-residential
  - 
  - 
  - 
  433,486 
  433,486 
Owner occupied
  - 
  - 
  - 
  202,982 
  202,982 
Multifamily, nonresidential and junior liens
  - 
  - 
  - 
  106,106 
  106,106 
Home equity lines
  - 
  188 
  188 
  87,041 
  87,229 
Secured by 1-4 family residential, secured
    
    
    
    
    
by first deeds of trust
  - 
  130 
  130 
  231,773 
  231,903 
Secured by 1-4 family residential,
    
    
    
    
    
secured by second deeds of trust
  - 
  56 
  56 
  4,656 
  4,712 
Commercial and industrial loans (except
    
    
    
    
    
those secured by real estate)
  - 
  - 
  - 
  181,643 
  181,643 
Consumer and other
  - 
  - 
  - 
  20,840 
  20,840 
 
 $- 
 $492 
 $492 
 $1,339,070 
 $1,339,562 
 
    
    
    
    
    
At December 31, 2016
    
    
    
    
    
Construction and land development
 $- 
 $125 
 $125 
 $79,613 
 $79,738 
Non-farm, non-residential
  - 
  - 
  - 
  365,569 
  365,569 
Owner occupied
  - 
  - 
  - 
  186,892 
  186,892 
Multifamily, nonresidential and junior liens
  - 
  - 
  - 
  89,191 
  89,191 
Home equity lines
  - 
  194 
  194 
  87,295 
  87,489 
Secured by 1-4 family residential, secured
    
    
    
    
    
by first deeds of trust
  - 
  531 
  531 
  194,812 
  195,343 
Secured by 1-4 family residential,
    
    
    
    
    
secured by second deeds of trust
  - 
  58 
  58 
  4,231 
  4,289 
Commercial and industrial loans (except
    
    
    
    
    
those secured by real estate)
  - 
  60 
  60 
  170,649 
  170,709 
Consumer and other
  - 
  - 
  - 
  11,542 
  11,542 
 
 $- 
 $968 
 $968 
 $1,189,794 
 $1,190,762 
 
 
-50-
 
 
The table below sets forth, for the periods indicated, information about the Company’s nonaccrual loans, loans past due 90 days or more and still accruing interest, total non-performing loans (nonaccrual loans plus nonaccrual restructured loans), and total non-performing assets.
 
 
 
At
June 30,
 
 
At
December 31,
 
(Dollars in thousands)
 
2017
 
 
2016
 
Non-accrual loans
 $188 
 $785 
Restructured loans (1)
  304 
  183 
Total nonperforming loans
  492 
  968 
Foreclosed real estate
  4,690 
  4,740 
Total nonperforming assets
 $5,182 
 $5,708 
 
    
    
Accruing loans past due 90 days or more
 $- 
 $- 
Allowance for loan losses
  8,921 
  7,909 
 
    
    
Nonperforming loans to period end loans
  0.04%
  0.08%
Allowance for loan losses to period end
    
    
loans
  0.67%
  0.66%
Allowance for loan losses to
    
    
nonperforming loans
  1813.21%
  817.05%
Allowance for loan losses to
    
    
nonperforming assets
  172.15%
  138.56%
Nonperforming assets to total assets
  0.32%
  0.38%
 
(1)
    Restructured loans are also on nonaccrual status.
 
In addition to the above, as of June 30, 2017 the Company had $2.6 million in loans that were considered to be impaired for reasons other than their past due, accrual or restructured status. In total, there were $2.9 million in loans that were considered to be impaired as of June 30, 2017. As of December 31, 2016, the Company had $2.7 million in loans that were considered to be impaired for reasons other than their past due, accrual or restructured status. In total, there were $3.2 million in loans that were considered to be impaired at December 31, 2016.
 
Allowance for Loan Losses
 
The allowance for loan losses is a reserve established through provisions for loan losses charged to expense and represents management’s best estimate of probable loans losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated losses and risk inherent in the loan portfolio. The Company’s allowance for loan loss methodology is based on historical loss experience by type of credit and internal risk grade, specific homogeneous risk pools and specific loss allocations, with adjustments for current events and conditions. The Company’s process for determining the appropriate level of reserves is designed to account for changes in credit quality as they occur. The provision for loan losses reflects loan quality trends, including the levels of and trends related to past due loans and economic conditions at the local and national levels. It also considers the quality and risk characteristics of the Company’s loan origination and servicing policies and practices. Included in the allowance are specific reserves on loans that are considered to be impaired, which are identified and measured in accordance with ASC 310.
 
 
-51-
 
 
The following table presents the Company’s allowance for loan losses allocated to each category of the Company’s loan portfolio and each category of the loan portfolio as a percentage of total loans, at June 30, 2017 and at December 31, 2016.
 
 
 
At June 30,
 
 
At December 31,
 
 
 
2017
 
 
2016
 
 
 
 
 
 
% of
 
 
 
 
 
% of
 
 
 
 
 
 
Total
 
 
 
 
 
Total
 
(Dollars in thousands)
 
Amount
 
 
Loans
 
 
Amount
 
 
Loans
 
Construction and land development
 $403 
  5.3%
 $486 
  6.7%
Commercial real estate
  4,241 
  55.3%
  3,719 
  53.9%
Consumer real estate
  2,026 
  24.2%
  1,900 
  24.1%
Commercial and industrial loans (except those
    
    
    
    
secured by real estate)
  2,135 
  13.6%
  1,728 
  14.3%
Consumer and other
  116 
  1.6%
  76 
  1.0%
Total
 $8,921 
  100.0%
 $7,909 
  100.0%
 
The allowance for loan losses as a percentage of gross loans outstanding was 0.67% for June 30, 2017 and 0.66% for December 31, 2016. The change in the allowance during the period resulted from net recoveries of $203,000 and loan loss provisions of $809,000 commensurate with $148.6 million of loan growth. General reserves totaled $8.1 million or 0.60% of gross loans outstanding as of June 30, 2017, a 0.02% decrease from December 31, 2016 when they totaled $7.9 million or 0.62% of loans outstanding. At June 30, 2017, specific reserves on impaired loans constituted $826,000 or 0.06% of gross loans outstanding compared to $509,000 or 0.04% of loans outstanding as of December 31, 2016.
 
The following table presents information regarding changes in the allowance for loan losses in detail for the years indicated:
 
 
 
Three months ended June 30,
 
 
Six months ended June 30,
 
(in thousands)
 
2017
 
 
2016
 
 
2017
 
 
2016
 
Allowance for loan losses at beginning of the period
 $8,125 
 $7,931 
 $7,909 
 $7,641 
Provision for loan losses
  650 
  - 
  809 
  - 
 
    
    
    
    
Loans charged off:
    
    
    
    
Commercial and industrial loans (except those
    
    
    
    
secured by real estate)
  - 
  - 
  (10)
  - 
Consumer and other
  - 
  (1)
  (13)
  (1)
Total charge-offs
  - 
  (1)
  (23)
  (1)
Recoveries of loans previously charged off:
    
    
    
    
Construction and land development
  138 
  8 
  147 
  237 
Commercial real estate
  - 
  19 
  28 
  56 
Consumer real estate
  - 
  3 
  - 
  6 
Commercial and industrial loans (except those
    
    
    
    
secured by real estate)
  8 
  25 
  51 
  36 
Consumer and other
  - 
  1 
  - 
  11 
Total recoveries
  146 
  56 
  226 
  346 
Net recoveries
  146 
  55 
  203 
  345 
Allowance for loan losses at end of the period
 $8,921 
 $7,986 
 $8,921 
 $7,986 
 
    
    
    
    
Ratio of net recoveries during the period
    
    
    
    
to average loans outstanding during
    
    
    
    
the period
  0.01%
  0.01%
  0.02%
  0.03%
 
 
-52-
 
 
While the Company believes that it uses the best information available to establish the allowance for loan losses, future adjustments to the allowance may be necessary and results of operations could be adversely affected if circumstances differ substantially from the assumptions used in making determinations regarding the allowance.
 
Management believes the level of the allowance for loan losses as of June 30, 2017 and December 31, 2016 is appropriate in light of the risk inherent within the Company’s loan portfolio.
 
Other Assets
 
At June 30, 2017, non-earning assets totaled $74.8 million, a decrease of $1.3 million from $76.1 million at December 31, 2016. Non-earning assets at June 30, 2017 consisted of: cash and due from banks of $4.2 million, premises and equipment totaling $15.2 million, foreclosed real estate totaling $4.7 million, accrued interest receivable of $4.7 million, bank owned life insurance, or BOLI, of $34.7 million and other assets totaling $7.5 million, with net deferred taxes of $3.9 million.
 
At December 31, 2016, non-earning assets totaled $76.1 million. Non-earning assets at December 31, 2016 consisted of: cash and due from banks of $4.6 million, premises and equipment totaling $15.6 million, foreclosed real estate totaling $4.7 million, accrued interest receivable of $4.4 million, bank owned life insurance of $34.2 million and other assets totaling $7.8 million, with net deferred taxes of $4.8 million.
 
As of June 30, 2017, the Company had an investment in bank owned life insurance of $34.7 million, which increased $513,000 from December 31, 2016. The increase in BOLI was due to an increase in cash surrender value. Since the income on this investment is included in non-interest income, the asset is not included in the Company’s calculation of earning assets.
 
Deposits
 
Deposits gathered from clients represent the primary source of funding for the Company’s lending activities. Commercial and private banking deposit services include non-interest and interest bearing checking accounts, money market accounts, and to a limited extent, IRAs and CDs. Interest rates for each account type are set by the Company within the context of marketplace factors, current deposit needs, and a keen awareness of maintaining a strong margin.
 
Total deposits at June 30, 2017 were $1.17 billion and consisted of $200.9 million in non-interest-bearing demand deposits, $794.3 million in interest-bearing checking and money market accounts, and $179.5 million in time deposits. Total deposits increased by $2.48 million from $1.17 billion as of December 31, 2016. Non-interest-bearing demand deposits decreased by $10.3 million from $211.2 million as of December 31, 2016. Interest-bearing and money market accounts increased by $52.2 million from $742.0 million as of December 31, 2016. Time deposits decreased by $39.5 million during the six-month period ended June 30, 2017 from $219.0 million as of December 31, 2016. The increase in deposits was primarily due to a focus on growing core customer deposits and demand in the markets in which the Bank operates.
 
 
-53-
 
 
The table below provides a summary of the Company’s deposit portfolio by deposit type.
 
 
 
As of
 
 
 
June 30,
 
 
December 31,
 
Composition of Deposit Portfolio
 
2017
 
 
2016
 
Non-interest bearing
  17.1%
  18.0%
Interest-bearing checking accounts
  23.7%
  19.7%
Money markets
  43.9%
  43.7%
Time deposits
  15.3%
  18.6%
Total
  100.0%
  100.0%
 
The following table shows historical information regarding the average balances outstanding and average interest rates for each major category of deposits:
 
 
 
For the Three Month Period Ended June 30,
 
 
 
2017
 
 
2016
 
 
 
Average
 
 
% of
 
 
Average
 
 
Average
 
 
% of
 
 
Average
 
(Dollars in thousands)
 
Amount
 
 
Total
 
 
Rate
 
 
Amount
 
 
Total
 
 
Rate
 
Interest-bearing checking accounts
 $244,569 
  20.4%
  0.39%
 $170,209 
  16.7%
  0.40%
Money markets
  537,884 
  44.9%
  0.66%
  402,851 
  39.5%
  0.66%
Time deposits
  189,294 
  15.8%
  0.97%
  254,079 
  24.9%
  0.88%
Total interest-bearing deposits
  971,747 
  81.1%
  0.65%
  827,139 
  81.2%
  0.67%
Noninterest-bearing deposits
  225,725 
  18.9%
  - 
  191,994 
  18.8%
  - 
Total deposits
 $1,197,472 
  100.0%
  0.53%
 $1,019,133 
  100.0%
  0.55%
 
 
 
For the Six Month Period Ended June 30,
 
 
 
2017
 
 
2016
 
 
 
Average
 
 
% of
 
 
Average
 
 
Average
 
 
% of
 
 
Average
 
(Dollars in thousands)
 
Amount
 
 
Total
 
 
Rate
 
 
Amount
 
 
Total
 
 
Rate
 
Interest-bearing checking accounts
 $224,528 
  19.1%
  0.38%
 $155,299 
  15.4%
  0.45%
Money markets
  533,715 
  45.3%
  0.67%
  402,641 
  40.0%
  0.67%
Time deposits
  200,429 
  17.0%
  0.98%
  273,175 
  27.1%
  0.83%
Total interest-bearing deposits
  958,672 
  81.4%
  0.67%
  831,115 
  82.6%
  0.68%
Noninterest-bearing deposits
  219,242 
  18.6%
  - 
  175,562 
  17.4%
  - 
Total deposits
 $1,177,914 
  100.0%
  0.54%
 $1,006,677 
  100.0%
  0.56%
 
The overall mix of deposits has shifted to a higher percentage of non-interest demand deposits and interest-bearing demand with reductions in the percentage of deposits held in time deposit accounts. The Company believes its deposit product offerings are properly structured to attract and retain core low-cost deposit relationships. The average cost of deposits was 0.53% in the second quarter of 2017 compared to 0.55% in the second quarter of 2016 due to changes in deposit mix. The average cost of deposits was 0.53% for the six-month period ended June 30, 2017 compared to 0.56% in the second quarter of 2016 due to changes in deposit mix.
 
 
-54-
 
 
Short-Term and Long-Term Debt
 
The Company uses short-term borrowings and long-term debt to provide both funding and, to a lesser extent, regulatory capital. As of June 30, 2017, the Company had $270.0 million in short-term debt, which consisted solely of FHLB advances compared to an outstanding balance of $150.0 million at year-end 2016. The increase in short-term debt was due to the Company’s rapid loan growth during the first six months of 2017.
 
The Company had outstanding $18.6 million in junior subordinated debentures as of June 30, 2017 and December 31, 2016. These junior subordinated debentures were issued to Paragon Commercial Trust I and Paragon Commercial Trust II in connection with the issuance of trust preferred securities on May 18, 2004 and May 30, 2006, respectively. Additional information regarding the junior subordinated debentures can be found in Note 7 of the Company’s 2016 audited consolidated financial statements, which are included within the Company’s Annual Report on Form 10-K as of and for the year ended December 31, 2016.
 
Stockholders’ Equity
 
Total stockholders’ equity at June 30, 2017 was $145.3 million, an increase of $9.2 million from $136.1 million as of December 31, 2016. The change in stockholders’ equity principally represents net income to common stockholders for the six months ended June 30, 2016 of $6.6 million and other comprehensive income of $2.0 million related to net increasing values in the Company’s available for sale investment securities portfolio and its cash flow hedges.
 
Liquidity
 
Market and public confidence in the Company’s financial strength and in the strength of financial institutions in general will largely determine the Company’s access to appropriate levels of liquidity. This confidence depends significantly on the Company’s ability to maintain sound asset quality and appropriate levels of capital resources. The term “liquidity” refers to the Company’s ability to generate adequate amounts of cash to meet current needs for funding loan originations, deposit withdrawals, maturities of borrowings and operating expenses. Investment portfolio principal payments and maturities, loan principal payments, deposit growth, brokered deposit sources, available borrowings from the FHLB, and various federal funds lines from correspondent banks are the primary sources of liquidity for the Bank. Management measures the Bank’s liquidity position by giving consideration to both on- and off-balance sheet sources of, and demands for, funds on a daily and weekly basis.
 
Liquid assets (consisting of cash and due from banks, interest-earning deposits with other banks, federal funds sold and investment securities classified as available for sale) represented 10.5% and 12.1% of total assets at June 30, 2017 and December 31, 2016, respectively.
 
The Bank has seen a net reduction in wholesale funding, maintaining liquidity sufficient to fund new loan demand and to reduce part of its wholesale funding. When the need arises, the Bank has the ability to sell securities classified as available for sale, sell loan participations to other banks, or to borrow funds as necessary. The Bank has established credit lines with other financial institutions to purchase up to $102.5 million in federal funds and had no borrowings as of June 30, 2017 or December 31, 2016. Also, as a member of the Federal Home Loan Bank of Atlanta, the Bank may obtain advances of up to 30% of assets, subject to our available collateral. The Bank had an available borrowing line at June 30, 2017 of $465.0 million at the FHLB, secured by qualifying loans. As of that date, the Bank had $270.0 million outstanding on the line and available borrowing capacity of $195.0 million. In addition, the Bank may borrow up to $151.0 million at the Federal Reserve discount window and has pledged loans for that purpose. As another source of short-term borrowings, the Bank also utilizes securities sold under agreements to repurchase. At June 30, 2017, borrowings of securities sold under agreements to repurchase were $21.3 million.
 
 
-55-
 
 
At June 30, 2017, the Bank had undisbursed lines of credit of $251.0 million, and letters of credit of $5.0 million. The Bank believes that its combined aggregate liquidity position from all sources is sufficient to meet the funding requirements of loan demand and deposit maturities and withdrawals in the near term.
 
Total deposits were $1.17 billion as of June 30, 2017 and December 31, 2016. Time deposits, which are the only deposit accounts that have stated maturity dates, are generally considered to be rate sensitive. Time deposits represented 15.3% and 18.6% of total deposits at June 30, 2017 and December 31, 2016, respectively. Other than brokered time deposits, management believes most other time deposits are relationship-oriented. While competitive rates will need to be paid to retain these deposits at their maturities, there are other subjective factors that will determine their continued retention.
 
Management believes that current sources of funds provide adequate liquidity for the Company’s current cash flow needs. The Bank’s parent company maintains minimal cash balances. Management believes that the current cash balances plus taxes receivable will provide adequate liquidity for the Company’s current cash flow needs.
 
Contractual Obligations
 
During the second quarter of 2017, the Company amended its original lease on its Cary location. The new lease added another 2,600 square feet of additional space on the second floor of the building at 5000 Valleystone Drive, Cary, NC. The lease term is 66 months.
 
The following table presents the Company's significant fixed and determinable contractual obligations by payment date. The payment amounts represent those amounts contractually due to the recipient. The table excludes liabilities recorded where management cannot reasonably estimate the timing of any payments that may be required in connection with these liabilities.
 
 
 
June 30, 2017
 
 
 
1 Year
 
 
Over 1 to
 
 
Over 3 to
 
 
More Than
 
 
 
 
(In thousands)
 
or Less
 
 
3 Years
 
 
5 Years
 
 
5 Years
 
 
Total
 
Time deposits
 $123,639 
 $51,499 
 $4,393 
 $- 
 $179,531 
Short term borrowings
  270 
  - 
  - 
  - 
  270 
Subordinated debentures
  - 
  - 
  - 
  18,558 
  18,558 
Operating leases
  781 
  1,060 
  548 
  4,017 
  6,406 
Total contractual obligations
 $124,690 
 $52,559 
 $4,941 
 $22,575 
 $204,765 
 
Capital
 
Our management seeks to maintain adequate capital to support anticipated asset growth, operating needs and unexpected risks, and to ensure that the Company and the Bank are in compliance with all current and anticipated regulatory capital guidelines. Our primary sources of new capital include retained earnings and proceeds from the sale and issuance of capital stock or other securities.
 
On July 2, 2013, the Federal Reserve, and on July 9, 2013, the FDIC, adopted a final rule that implemented the Basel III changes to the international regulatory capital framework, referred to as the “Basel III Rules.” The Basel III Rules apply to both depository institutions and their holding companies. The Basel III Rules, which became effective for both the Company and the Bank on January 1, 2015, include new risk-based and leverage capital ratio requirements which refined the definition of what constitutes “capital” for purposes of calculating those ratios. The minimum capital level requirements applicable to the Company and the Bank under the Basel III Rules are: (i) a common equity Tier 1 risk-based capital ratio of 4.5 percent; (ii) a Tier 1 risk-based capital ratio of 6 percent; (iii) a total risk-based capital ratio of 8 percent; and (iv) a Tier 1 leverage ratio of 4 percent for all institutions. Common equity Tier 1 capital consists of retained earnings and common stock instruments, subject to certain adjustments.
 
 
-56-
 
 
The Basel III Rules also establish a “capital conservation buffer” of 2.5 percent above the new regulatory minimum risk-based capital requirements. The conservation buffer, when added to the capital requirements, result in the following minimum ratios: (i) a common equity Tier 1 risk-based capital ratio of 7.0 percent, (ii) a Tier 1 risk-based capital ratio of 8.5 percent, and (iii) a total risk-based capital ratio of 10.5 percent. The new capital conservation buffer requirement is to be phased in beginning in January 2016 at 0.625 percent of risk-weighted assets and will increase by that amount each year until fully implemented in January 2019. An institution will be subject to limitations on certain activities including payment of dividends, share repurchases and discretionary bonuses to executive officers if its capital level is below the buffer amount.
 
The Basel III Rules also revised the prompt corrective action framework, which is designed to place restrictions on insured depository institutions, including the Bank, if their capital levels do not meet certain thresholds. The prompt corrective action rules were modified to include a common equity Tier 1 capital component and to increase certain other capital requirements for the various thresholds. For example, under the proposed prompt corrective action rules, insured depository institutions will be required to meet the following capital levels in order to qualify as “well capitalized:” (i) a common equity Tier 1 risk-based capital ratio of 6.5 percent; (ii) a Tier 1 risk-based capital ratio of 8 percent; (iii) a total risk-based capital ratio of 10 percent; and (iv) a Tier 1 leverage ratio of 5 percent. The Basel III Rules also set forth certain changes in the methods of calculating certain risk-weighted assets, which in turn affect the calculation of risk based ratios.
 
If the Bank fails to meet the requirements for a “well capitalized” bank, it could increase the regulatory scrutiny on the Bank and the Company. In addition, the Bank would not be able to renew or accept brokered deposits without prior regulatory approval and the Bank would not be able to offer interest rates on its deposit accounts that are significantly higher than the average rates in the Bank’s market area. As a result, it would be more difficult to attract new deposits and retain or increase existing, non-brokered deposits. If the Bank is prohibited from renewing or accepting brokered deposits and is unable to attract new deposits, our liquidity and our ability to fund our loan portfolio may be adversely affected. In addition, we would be required to pay higher insurance premiums to the FDIC, which would reduce our earnings.
 
On May 18, 2004, the Company privately issued trust preferred securities having an aggregate liquidation amount of $10.0 million through Paragon Commercial Capital Trust I. On May 30, 2006, we privately issued additional floating rate trust preferred securities having an aggregate liquidation amount of $8.0 million through Paragon Commercial Capital Trust II. The proceeds provided additional capital for the expansion of the Bank. Under the current applicable regulatory guidelines, all of the trust preferred securities qualify as Tier 1 capital.
 
 
On June 21, 2016 the Company issued 845,588 shares of its common stock in an initial public offering. Of the $26.4 million in net proceeds, $3.8 million were used to pay down existing debt at the holding company, $20.5 million were contributed to the Bank as additional capital and the remaining $2.1 million was retained at the holding company level to service existing debt at the holding company level.
 
 
-57-
 
 
Regulatory capital ratios for the Bank exceeded minimum federal regulatory guidelines for a well-capitalized depository institution as of June 30, 2017 and December 31, 2016. Management expects that the Company and the Bank will continue to be in compliance with applicable regulatory capital requirements, although there can be no assurance that additional capital will not be required in the future. The Company’s and the Bank’s capital ratios as of June 30, 2017 are presented in the table below.
 
 
 
 
 
 
 
 
 
  Minimum Requirements To Be:
 
 
 
 
 
 
 
 
 
"Adequately Capitalized"
 
 
"Well Capitalized" (2)
 
 
 
 
 
 
 
 
 
for Capital Adequacy
 
 
Under Prompt Corrective
 
 
 
Actual
 
 
 
 
 
Purposes
 
 
 
 
 
Actions Provisions
 
(Dollars in thousands)
 
Amount
 
 
Ratio (1)
 
 
Amount
 
 
Ratio (1)
 
 
Amount
 
 
Ratio (1)
 
June 30, 2017
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
The Company
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total risk-based capital ratio
 $172,973 
  12.36%
 $111,969 
  8.000%
  N/A 
  N/A 
Tier 1 risk-based capital ratio
  164,052 
  11.72%
  83,977 
  6.000%
  N/A 
  N/A 
Common equity Tier 1
  146,052 
  10.44%
  62,983 
  4.500%
  N/A 
  N/A 
Tier 1 leverage ratio
  164,052 
  10.34%
  63,476 
  4.000%
  N/A 
  N/A 
Tangible equity to tangible assets ratio
  146,052 
  9.21%
  N/A 
  N/A 
  N/A 
  N/A 
Tangible equity to risk-weighted assets ratio
  146,052 
  10.44%
  N/A 
  N/A 
  N/A 
  N/A 
 
    
    
    
    
    
    
The Bank
    
    
    
    
    
    
Total risk-based capital ratio
 $170,424 
  12.18%
 $111,908 
  8.000%
 $139,884 
  10.000%
Tier 1 risk-based capital ratio
  161,503 
  11.55%
  83,931 
  6.000%
  111,908 
  8.000%
Common equity Tier 1
  161,503 
  11.55%
  62,948 
  4.500%
  90,925 
  6.500%
Tier 1 leverage ratio
  161,503 
  10.14%
  63,716 
  4.000%
  79,645 
  5.000%
 
    
    
    
    
    
    
December 31, 2016
    
    
    
    
    
    
The Company
    
    
    
    
    
    
Total risk-based capital ratio
 $164,740 
  13.21%
 $99,778 
  8.00%
  N/A 
  N/A 
Tier 1 risk-based capital ratio
  156,831 
  12.57%
  74,833 
  6.00%
  N/A 
  N/A 
Common equity Tier 1
  138,831 
  11.13%
  56,125 
  4.50%
  N/A 
  N/A 
Tier 1 leverage ratio
  156,831 
  10.05%
  62,434 
  4.00%
  N/A 
  N/A 
Tangible equity to tangible assets ratio
  138,831 
  9.23%
  N/A 
  N/A 
  N/A 
  N/A 
Tangible equity to risk-weighted assets ratio
  138,831 
  11.31%
  N/A 
  N/A 
  N/A 
  N/A 
 
    
    
    
    
    
    
The Bank
    
    
    
    
    
    
Total risk-based capital ratio
 $161,925 
  12.99%
 $99,713 
  8.00%
 $124,641 
  10.00%
Tier 1 risk-based capital ratio
  154,016 
  12.36%
  74,785 
  6.00%
  99,713 
  8.00%
Common equity Tier 1
  154,016 
  12.36%
  56,089 
  4.50%
  81,017 
  6.50%
Tier 1 leverage ratio
  154,016 
  10.37%
  59,405 
  4.00%
  74,256 
  5.00%
 
1)
Total capital ratio is defined as Tier 1 capital plus Tier 2 capital divided by total risk-weighted assets. The Tier 1 Capital ratio is defined as Tier 1 capital divided by total risk-weighted assets. Common equity Tier 1 is defined as Tier 1 capital excluding qualifying trust preferred securities divided by total risk weighted assets. The leverage ratio is defined as Tier 1 capital divided by the most recent quarter’s average total assets.
 
2)
Prompt corrective action provisions are not applicable at the bank holding company level.
 
 
-58-
 
 
Item 3. Quantitative and Qualitative Disclosures about Market Risk
 
Management and the board of directors are responsible for managing interest rate risk and employing risk management policies that monitor and limit this exposure. Interest rate risk is measured using net interest income simulations and market value of portfolio equity analyses. These analyses use various assumptions, including the nature and timing of interest rate changes, yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, and reinvestment/replacement of asset and liability cash flows.
 
The principal objective of the Company's asset and liability management function is to evaluate the interest rate risk within the balance sheet and pursue a controlled assumption of interest rate risk while maximizing earnings and preserving adequate levels of liquidity and capital. The asset and liability management function is under the guidance of the Management Asset Liability Committee (“Management ALCO”) with direction of the Board of Directors Asset/Liability Committee (“Board ALCO”). Management ALCO meets monthly to review, among other things, funding uses and sources, the sensitivity of the Company's assets and liabilities to interest rate changes, local and national market conditions and rates. Board ALCO meets quarterly and also reviews the liquidity, capital, deposit mix, loan mix and investment positions of the Company. In addition, Board ALCO reviews modeling performed by a third party of the impact on net interest income and economic value of equity of rate changes in various scenarios as well as the impact of strategies put into place to mitigate interest rate risk. Instantaneous parallel rate shift scenarios are modeled and utilized to evaluate risk and establish exposure limits for acceptable changes in net interest margin. These scenarios, known as rate shocks, simulate an instantaneous change in interest rates and use various assumptions, including, but not limited to, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment and replacement of asset and liability cash flows.
 
We also analyze the economic value of equity as a secondary measure of interest rate risk. This is a complementary measure to net interest income where the calculated value is the result of the market value of assets less the market value of liabilities. The economic value of equity is a longer term view of interest rate risk because it measures the present value of the future cash flows. The impact of changes in interest rates on this calculation is analyzed for the risk to our future earnings and is used in conjunction with the analyses on net interest income.
 
Our interest rate risk model indicated that the Company was liability sensitive in terms of interest rate sensitivity at May 31, 2017. Since December 31, 2016, we have slightly decreased our liability sensitivity as a result of shortening the duration of the fixed rate loan and investment portfolios. The table below illustrates the impact in year one of an immediate and sustained 200 basis point increase and a 100 basis point decrease in interest rates on net interest income based on the interest rate risk model at May 31, 2017, November 30, 2016, and August 31, 2016:
 
 
Hypothetical
 
 
Estimated Resulting Theoretical Net Interest Income      
 
 
shift in interest
 
 
May 31, 2017  
 
 
February 28, 2017  
 
 
November 30, 2016  
 
 
rates (in bps)
 
 
Amount
 
 
% Change
 
 
Amount
 
 
% Change
 
 
Amount
 
 
% Change
 
 
(dollars in thousands)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
    200 
 $51,743 
  -3.16%
 $48,570 
  -3.31%
 $46,525 
  -4.26%
    0 
  53,429 
  0.00%
  50,231 
  0.00%
  48,597 
  0.00%
    (100)
  52,907 
  -0.98%
  49,881 
  -0.70%
  48,693 
  0.20%
 
Many assumptions are used to calculate the impact of interest rate fluctuations. Actual results may be significantly different than our projections due to several factors, including the timing and frequency of rate changes, market conditions and the shape of the yield curve. The computations of interest rate risk shown above do not include actions that management may undertake to manage the risks in response to anticipated changes in interest rates and actual results may also differ due to any actions taken in response to the changing rates.
 
 
-59-
 
 
Item 4. Controls and Procedures
 
Evaluation of Disclosure Controls and Procedures
 
The Company’s management, with the participation of the Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures as defined in Rules 13a-15(b) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), as of June 30, 2017. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by the Company in the reports filed or submitted by it under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and to provide reasonable assurance that information required to be disclosed by the Company in such reports is accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.
 
Changes in Internal Control Over Financial Reporting
 
There were no changes in the Company’s internal controls over financial reporting during the period covered by this Quarterly Report that have materially affected, or are reasonably likely to materially affect, the Company's internal controls over financial reporting.
 
Part II. Other Information
 
Item 1. Legal Proceedings
 
In the ordinary course of operations, the Company is party to various legal proceedings. The Company is not involved in, nor has it terminated during the three or six months ended June 30, 2017, any pending legal proceedings other than routine, nonmaterial proceedings occurring in the ordinary course of business.
 
Item 1A. Risk Factors
 
In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2016, which could materially affect our business, financial condition or future results.
 
The risks described in our Annual Report on Form 10-K are not the only risks facing the Company. Additional risks and uncertainties unknown to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results. Additionally, there are or will be important factors related to the proposed merger with TowneBank that could cause actual results to differ materially from anticipated results. We believe that these factors include, but are not limited to, those listed below. Capitalized terms used but not otherwise defined in this “Risk Factors” section have the meanings ascribed to them in other sections of this report.
 
Regulatory approvals may not be received, may take longer than expected, or may impose conditions that are not presently anticipated or that could have an adverse effect on the combined company following the Transaction.
 
 
-60-
 
 
Before the Transaction may be completed, the Company, the Bank, and TowneBank must obtain approvals from the FDIC, the Bureau of Financial Institutions of the Virginia State Corporation Commission and the North Carolina Commissioner of Banks. Other approvals, waivers or consents from regulators may also be required. In determining whether to grant these approvals the regulators consider a variety of factors, including the regulatory standing of each party. An adverse development in any party’s regulatory standing or other factors could result in an inability to obtain or a delay in receiving their approval. These regulators may impose conditions on the completion of the Transaction or require changes to the terms of the Transaction. Such conditions or changes could delay or prevent completion of the Transaction or impose additional costs on or limit the revenues of the combined company following the Transaction, any of which might have an adverse effect on the combined company following the Transaction.
 
Combining the companies may be more difficult, costly, or time-consuming than expected.
 
The Company and TowneBank have operated and, until the completion of the Transaction, will continue to operate independently. The success of the Transaction, including anticipated benefits and cost savings, will depend, in part, on TowneBank’s ability to successfully combine and integrate the businesses of TowneBank and the Company in a manner that permits growth opportunities and does not materially disrupt the existing customer relations nor result in decreased revenues due to loss of customers. It is possible that the integration process could result in the loss of key employees, the disruption of either company’s ongoing businesses or inconsistencies in standards, controls, procedures and policies that could adversely affect the combined company’s ability to maintain relationships with clients, customers, depositors and employees or to achieve the anticipated benefits and cost savings of the Transaction. The loss of key employees could adversely affect the Company’s ability to successfully conduct its business, which could have an adverse effect on the Company’s financial results and the value of the Company’s common stock. If TowneBank experiences difficulties with the integration process, the anticipated benefits of the Transaction 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 business disruptions that cause TowneBank and/or the Company to lose customers or cause customers to remove their accounts from TowneBank and/or the Company and move their business to competing financial institutions. Integration efforts will also divert management attention and resources. In addition, the actual cost savings of the Transaction could be less than anticipated.
 
The Transaction is subject to certain closing conditions that, if not satisfied or waived, will result in the Transaction not being completed. Termination of the Merger Agreement could negatively impact the Company.
 
The Transaction is subject to customary conditions to closing, including the receipt of required regulatory approvals and adoption of the Merger Agreement by the Company’s stockholders. If any condition to the Transaction is not satisfied or waived, to the extent permitted by law, including the absence of any unduly burdensome condition in the regulatory approvals, the Transaction will not be completed. In addition, either TowneBank or the Company may terminate the Merger Agreement under certain circumstances even if the Merger Agreement is adopted by the Company’s stockholders, including but not limited to, if the Transaction has not been completed on or before March 31, 2018.
 
 
-61-
 
 
If the Merger Agreement is terminated, there may be various consequences. For example, the Company’s businesses may have been impacted adversely by the failure to pursue other beneficial opportunities due to the focus of management on the Transaction, without realizing any of the anticipated benefits of completing the Transaction. 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 Transaction will be completed.
 
The Company will be subject to business uncertainties and contractual restrictions while the Transaction is pending.
 
The Merger Agreement restricts the Company from operating its business other than in the ordinary course and prohibits the Company from taking specified actions without TowneBank’s consent until the Transaction occurs. These restrictions may prevent the Company from pursuing attractive business opportunities that may arise prior to the completion of the Transaction. In addition, uncertainty about the effect of the Transaction 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 Transaction 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 Transaction is pending, as certain employees may experience uncertainty about their future roles with the Company. If key employees depart because of issues relating to the uncertainty and difficulty of integration or a desire not to remain with the Company, the Company’s business could be harmed.
 
The uncertainty caused by the pending Transaction could cause the Company’s clients and business associates to seek to change their existing business relationships with the Company. These uncertainties may impair the Company’s ability to attract, retain and grow its client base until the Transaction is complete.
 
The market value of the merger consideration that the Company’s stockholders will receive as a result of the Transaction may fluctuate.
 
If the Transaction is completed, each share of the Company’s common stock will be converted into the right to receive 1.7250 shares of TowneBank common stock, and cash in lieu of any fractional shares. The market value of the merger consideration may vary from the closing price of TowneBank common stock on the date the Transaction was announced, on the date that the proxy statement/prospectus is mailed to the Company’s stockholders, on the date of the meeting of the Company’s stockholders, on the date the Transaction is consummated, and thereafter. Stock price changes may result from a variety of factors, including general market and economic conditions, changes in the respective businesses, operations and prospects, and the regulatory situation of TowneBank and the Company. Many of these factors are beyond the control of the Company. Any change in the market price of TowneBank common stock prior to completion of the Transaction will affect the amount of and the market value of the merger consideration that the Company’s stockholders will receive upon completion of the Transaction. Accordingly, at the time of the stockholders meeting, the Company’s stockholders will not know or be able to calculate the amount or the market value of the merger consideration they would receive upon completion of the Transaction.
 
Further, the results of operations of the combined company following the Transaction and the market price of the combined company’s shares of common stock may be affected by factors different from those currently affecting the independent results of operations of TowneBank and the Company.
 
 
-62-
 
 
If the Transaction is not completed, the Company will have incurred substantial expenses without realizing the expected benefits of the Transaction.
 
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 Transaction is not completed, the Company would have to recognize these expenses without realizing the expected benefits of the Transaction.
 
The Merger Agreement limits the Company’s ability to pursue an alternative acquisition proposal and could require the Company to pay a termination fee of $12 million under certain circumstances relating to alternative acquisition proposals.
 
The Merger Agreement prohibits the Company from soliciting, initiating or knowingly encouraging certain alternative acquisition proposals with any third party, subject to exceptions set forth in the Merger Agreement. The Merger Agreement also provides for the payment by the Company to TowneBank of a termination fee in the amount of $12 million in the event that the Company or TowneBank terminates the Merger Agreement for certain specified reasons. These provisions might discourage a potential competing acquirer that might have an interest in acquiring all or a significant part of the Company from considering or proposing such an acquisition.
 
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
 
None
 
Item 3. Defaults Upon Senior Securities
 
None.
 
Item 4. Mine Safety Disclosures
 
Not applicable.
 
Item 5. Other Information
 
None
 
 
-63-
 
 
Item 6. Exhibits
 
Exhibit
No.
 
Description
 
 
 
2.1
 
Agreement and Plan of Reorganization, dated April 26, 2017, by and among TowneBank, TB Acquisition, LLC, Paragon Commercial Corporation and Paragon Commercial Bank (incorporated by reference to Exhibit 2.1 to Paragon Commercial Corporation’s Current Report on Form 8-K filed on May 1, 2017)
 
 
 
10.1
 
Amendment to Paragon Commercial Bank Salary Continuation Agreement for Matthew C. Davis, dated as of April 26, 2017 (amending the Paragon Commercial Bank Amended and Restated Salary Continuation Agreement dated December 29, 2016 and the Paragon Commercial Salary Continuation Agreement dated December 29, 2016) (incorporated by reference to Exhibit 10.1 to Paragon Commercial Corporation’s Quarterly Report on Form 10-Q filed on May 9, 2017)
 
 
 
 
Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
 
 
 
Certification of Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
 
 
 
Certification of Principal Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
 
Certification of Principal Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
101
 
Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Consolidated Balance Sheets (Unaudited) as of June 30, 2017 and December 31, 2016; (ii) Consolidated Statements of Income (Unaudited) for the Three and Six Months Ended June 30, 2017 and 2016; (iii) Consolidated Statements of Comprehensive Income (Unaudited) for the Three and Six Months Ended June 30, 2017 and 2016; (iv) Consolidated Statements of Stockholders’ Equity (Unaudited) for the Six Months Ended June 30, 2017 and 2016; (v) Consolidated Statements of Cash Flows (Unaudited) for the Six Months Ended June 30, 2017 and 2016; and (vi) Notes to Consolidated Financial Statements (Unaudited)
 
 
 
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Signatures
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized
 
 
 
PARAGON COMMERCIAL CORPORATION
 
 
 
 
 
Date: August 8, 2017
By:  
/s/  Steven E. Crouse
 
 
 
Steven E. Crouse 
 
 
 
Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) 
 
 
 
 
 

 
 
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EXHIBIT INDEX
 
Exhibit
No.
 
Description
 
 
 
2.1
 
Agreement and Plan of Reorganization, dated April 26, 2017, by and among TowneBank, TB Acquisition, LLC, Paragon Commercial Corporation and Paragon Commercial Bank (incorporated by reference to Exhibit 2.1 to Paragon Commercial Corporation’s Current Report on Form 8-K filed on May 1, 2017)
 
 
 
10.1
 
Amendment to Paragon Commercial Bank Salary Continuation Agreement for Matthew C. Davis, dated as of April 26, 2017 (amending the Paragon Commercial Bank Amended and Restated Salary Continuation Agreement dated December 29, 2016 and the Paragon Commercial Salary Continuation Agreement dated December 29, 2016) (incorporated by reference to Exhibit 10.1 to Paragon Commercial Corporation’s Quarterly Report on Form 10-Q filed on May 9, 2017)
 
 
 
 
Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
 
 
 
Certification of Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
 
 
 
Certification of Principal Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
 
Certification of Principal Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
 
101
 
Interactive data files pursuant to Rule 405 of Regulation S-T: (i) Consolidated Balance Sheets (Unaudited) as of June 30, 2017 and December 31, 2016; (ii) Consolidated Statements of Income (Unaudited) for the Three and Six Months Ended June 30, 2017 and 2016; (iii) Consolidated Statements of Comprehensive Income (Unaudited) for the Three and Six Months Ended June 30, 2017 and 2016; (iv) Consolidated Statements of Stockholders’ Equity (Unaudited) for the Six Months Ended June 30, 2017 and 2016; (v) Consolidated Statements of Cash Flows (Unaudited) for the Six Months Ended June 30, 2017 and 2016; and (vi) Notes to Consolidated Financial Statements (Unaudited)
 
 
 
 
 
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