Farmers and Merchants Bancshares, Inc.

Table of Contents

 

 

PART I
ITEM 1.	Business	4
ITEM 1A.	Risk Factors	13
ITEM 1B.	Unresolved Staff Comments	22
ITEM 2	Properties	23
ITEM 3.	Legal Proceedings	24
ITEM 4.	Mine Safety Disclosures	24
PART II
ITEM 5.	Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	24
ITEM 6.	Selected Financial Data	25
ITEM 7.	Management’s Discussion and Analysis of Financial Condition & Results of Operations	26
ITEM 7A.	Quantitative and Qualitative Disclosures About Market Risk	48
ITEM 8.	Financial Statements and Supplementary Data	48
ITEM 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	87
ITEM 9A.	Controls and Procedures	87
ITEM 9B.	Other Information	89
PART III
ITEM 10.	Directors, Executive Officers and Corporate Governance	89
ITEM 11.	Executive Compensation	89
ITEM 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	89
ITEM 13.	Certain Relationships and Related Transactions, and Director Independence	89
ITEM 14.	Principal Accountant Fees and Services	89
PART IV
ITEM 15.	Exhibits and Financial Statement Schedules	89
SIGNATURES		91

 

 

Forward-Looking Statements

 

As used in this Annual Report on Form 10-K, the terms the “Company”, “we”, “us”, and “our” refer to Farmers and Merchants Bancshares, Inc. and, unless the context clearly requires otherwise, its consolidated subsidiaries.

 

Some of the statements contained in this annual report may include projections, predictions, expectations or statements as to beliefs or future events or results or refer to other matters that are not historical facts. Such statements constitute forward-looking statements and are subject to known and unknown risks, uncertainties and other factors that could cause the actual results to differ materially from those contemplated by the statements. The forward-looking statements are based on various factors and were derived using numerous assumptions. In some cases, you can identify forward-looking statements by words like “may”, “will”, “should”, “expect”, “plan”, “anticipate”, “intend”, “believe”, “estimate”, “predict”, “potential”, or “continue” or the negative of those words and other comparable words. You should be aware that those statements reflect only our predictions. If known or unknown risks or uncertainties should materialize, or if underlying assumptions should prove inaccurate, actual results could differ materially from past results and those anticipated, estimated or projected. You should bear this in mind when reading this annual report and not place undue reliance on these forward-looking statements. Factors or events that could cause our actual results to differ from our forward-looking statements may emerge from time to time, and it is not possible for us to predict all of them.

 

The following factors are among those that may cause actual results to differ materially from our forward-looking statements in this annual report:

 

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unexpected changes in the housing market, business markets, and/or general economic conditions in our market area, or a slower-than-anticipated economic recovery, which might lead to increased or decreased demand for loans, deposits and other products and services and/or increase loan delinquencies or defaults;

 

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changes in market rates and prices may adversely impact the value of securities, loans, deposits and other financial instruments and the interest rate sensitivity of our balance sheet;

 

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our liquidity requirements could be adversely affected by changes in our assets and liabilities;

 

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the effects of legislative or regulatory developments, including changes in laws concerning taxes, banking, securities, insurance and other aspects of the financial services industry;

 

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competitive factors among financial services organizations, including product and pricing pressures and our ability to attract, develop and retain qualified banking professionals;

 

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the effects of changes in accounting policies and practices, as may be adopted by the Financial Accounting Standards Board, the Securities and Exchange Commission (the “SEC”), the Public Company Accounting Oversight Board and other regulatory agencies;

 

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the impact of acquisitions and other strategic transactions;

 

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the effects of fiscal and governmental policies of the United States federal government; and

 

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the impact of the COVID-19 pandemic on economic, market and/or business conditions.

 

You should also consider carefully the risk factors discussed in Item 1A of Part I of this annual report, which address additional factors that could cause our actual results to differ from those set forth in the forward-looking statements and could materially and adversely affect our business, operating results and financial condition. The risks discussed in this annual report are factors that, individually or in the aggregate, management believes could cause our actual results to differ materially from expected and historical results. You should understand that it is not possible to predict or identify all such factors. Consequently, you should not consider such disclosures to be a complete discussion of all potential risks or uncertainties.

 

The forward-looking statements speak only as of the date on which they are made, and, except to the extent required by federal securities laws, we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.

 

 

ITEM 1.

BUSINESS

 

Recent Developments

 

Effective on October 1, 2020, the Company consummated its previously-announced acquisition of Carroll Bancorp, Inc. (“Carroll”) and its wholly-owned subsidiary, Carroll Community Bank. Each share of common stock of Carroll (“Carroll Common Stock”) that was outstanding immediately prior to the effective time of the Merger (the “Effective Time”) was converted into the right to receive cash in the amount $21.63 (the “Per Share Consideration”). Immediately prior to the Effective Time, there were 1,146,913 outstanding shares of Carroll Common Stock, all of which were converted into the Per Share Consideration. The Company funded the payment of the merger consideration with $7.8 million in cash and the proceeds of a $17 million term loan obtained from a third-party.

 

General

 

Farmers and Merchants Bancshares, Inc. is a Maryland corporation chartered on August 8, 2016 that is registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve”) as a bank holding company under the Bank Holding Company Act of 1956, as amended (the “BHC Act”). At the time it registered as a bank holding company, the Company also elected to become a financial holding company, which allows it to engage in certain activities, and own shares or control of certain entities, that are in addition to those permissible for an entity that is a bank holding company only. Effective November 1, 2016, the Company consummated a bank holding company reorganization involving the Bank pursuant to which the Bank became a wholly-owned subsidiary of the Company and all of the Bank’s stockholders became stockholders of the Company (the “Reorganization”).

 

The Company’s primary business activities are serving as the parent company of the Bank and holding a series investment in First Community Bankers Insurance Co., LLC, a Tennessee “series” limited liability company and licensed protected cell captive insurance company (“FCBI”). The Company owns 100% of one series of membership interests issued by FCBI, which series is deemed a “protected cell” under Tennessee law and has been designated “Series Protected Cell FCB-4” (such series investment is hereinafter referred to as the “Insurance Subsidiary”).

 

The Bank is a Maryland commercial bank chartered on October 24, 1919 that is engaged in a general commercial and retail banking business. The Bank has had one inactive subsidiary, Reliable Community Financial Services, Inc., a Maryland corporation that was incorporated in April 1992 to facilitate the sale of fixed rate annuity products and later positioned to sell a full array of investment and insurance products.

 

The Insurance Subsidiary represents one protected cell of a protected cell captive insurance company (FCBI) that was formed on November 9, 2016 to better manage our risk programs, provide insurance efficiencies, and add operating income by both keeping our insurance premiums within our affiliated group of entities and realizing certain tax benefits that are unique to captive insurance companies. The Company’s investment in the Insurance Subsidiary represents one series of membership interests in FCBI. As a “series” limited liability company, FCBI is authorized by state law and its governing instruments to issue one or more series of membership interests, each of which, for all purposes under state law, is deemed to be a legal entity separate and apart from FCBI and its other series.

 

At December 31, 2020, our consolidated assets totaled approximately $677 million and stockholders’ equity was approximately $51.7 million.

 

Banking Activities

 

The Bank has been doing business in Maryland since 1919 and is engaged in both the commercial and consumer banking business. At December 31, 2020, the Bank had approximately 19,585 deposit accounts, representing $573 million in deposits. At December 31, 2020, the Bank had $522 million in loans, representing 77% of its total assets of $677 million.

 

The Bank’s general market area runs along the Route 30, Route 795, Route 140, and Route 26 corridors south from Owings Mills and north to the Pennsylvania line including the areas of Reisterstown, Upperco, Hampstead, Manchester, Eldersburg, and Westminster. The Bank’s western area includes the communities of Woodbine and New Windsor, while the eastern side includes Sparks, Hereford and Parkton. All of these communities are located in Carroll County or Baltimore County, Maryland.

 

This market area serves as a bedroom community to large employment areas such as Owings Mills, Hunt Valley, Towson, White Marsh, Columbia and Baltimore City. The market area is primarily residential with retail, commercial and light-manufacturing activity. The opening of Interstate 795 in the 1980’s made it convenient to enjoy a rural lifestyle while still being able to commute to work in a reasonable time.

 

 

The Bank’s main office is located in Upperco, Maryland, and it has six additional full service branches located in the Maryland communities of Hampstead, Greenmount, Reisterstown, Owings Mills, Eldersburg, and Westminster. In addition, the Bank has a satellite branch located at the senior living community of Carroll Lutheran Village in Westminster, Maryland.

 

As a convenience to its customers, the Bank offers drive through automated teller machines (“ATMs”) at the Upperco, Owings Mills, Hampstead, Reisterstown, and Westminster locations and walk-up ATMs at the Greenmount and Eldersburg offices. The Greenmount In-Store location is open 7-days a week while the other six full service offices offer convenient banking hours which include Saturday mornings. The satellite branch is opened five days a week with limited business hours. Drive-thru windows are available at the Upperco, Owings Mills, Hampstead, Reisterstown, Eldersburg, and Westminster branches. The Bank offers 24-hour on-line, internet banking for account balance inquiries, bill paying, or transferring funds between accounts. The Bank provides mobile banking functionality to its internet services. In addition, the 24-hour Dial-A-Bank automated telephone service is available. Debit cards are another service the Bank provides to its customers. The Bank joined Allpoint, America’s largest surcharge-free ATM network, to enable Bank customers to have access to over 55,000 ATMs, surcharge-free.

 

The Bank provides a wide range of personal banking services designed to meet the needs of local consumers. Among the deposit services provided are checking accounts, savings accounts, money market accounts, certificates of deposit and individual retirement accounts. The Bank also offers repurchase agreements and remote check deposits.

 

The Bank grants available credit for residential mortgages (including Federal Housing Administration and Veterans Affairs loans), construction loans, home equity lines, personal installment loans and other consumer financing.

 

The Bank also is engaged in financing commerce and industry by providing credit and deposit services for small to medium size businesses and the agricultural community in the Bank’s market area. The Bank offers many forms of commercial lending, including commercial mortgages, land acquisition and development loans, lines of credit, accounts receivable financing, term loans for fixed asset purchases, as well as loans guaranteed by the Small Business Administration (the “SBA”) and the United States Department of Agriculture (the “USDA”).

 

In addition, commercial depositors may take advantage of many different services including checking accounts, remote deposit banking services, sweep accounts, money market accounts, savings accounts and certificates of deposit.

 

The Bank also has strategic alliances that allow for the issuance of credit cards to retail customers and to provide merchant services so commercial customers can accept credit cards and debit cards as payment for their goods and services.

 

The Bank has adopted policies and procedures designed to mitigate credit risk and maintain the quality of the loan portfolio. These policies include underwriting standards for new credits as well as the continuous monitoring and reporting of asset quality and the adequacy of the allowance for loan losses. These policies, coupled with continuous training efforts, have provided effective checks and balances for the risk associated with the lending process. Lending authority is based on the level of risk, size of the loan, and the experience of the lending officer. The Bank’s policy is to make the majority of its loan commitments in the market area it serves. This tends to reduce risk because Management is familiar with the credit histories of loan applicants and has in-depth knowledge of the risk to which a given credit is subject. No material portion of the Bank’s loans is concentrated within a single industry or group of related industries. Most of the Bank’s loans are, however, made to Maryland customers and many are secured by real estate located in or around Maryland. Although Management believes that the loan portfolio is diversified, its performance will be influenced by the economy of the region.

 

Investment Activities

 

The Bank maintains a portfolio of investment securities to provide liquidity and income. The current portfolio of $78 million equals approximately 12% of the total assets at December 31, 2020 and is invested primarily in mortgage-backed securities and municipal bonds.

 

A key objective of the investment portfolio is to provide a balance in the Bank’s asset mix of investments and loans consistent with its liability structure, and to assist in management of interest rate risk. The investments augment the Bank’s capital position, providing the necessary liquidity to meet fluctuations in credit demand of the community and fluctuations in deposit levels. In addition, the portfolio provides collateral for pledging against public funds and repurchase agreements and an opportunity to minimize income tax liability. Finally, the investment portfolio is designed to provide income for the Bank. In view of the above objectives, only securities that meet conservative investment criteria are purchased.

 

 

Insurance Activities

 

As noted above, the Insurance Subsidiary is one protected cell of a protected cell captive insurance company. It reinsures certain risks of the Company and the Bank as well as other groups of related entities that are not affiliated with the Bank for which it receives premiums. The insurance policies that are the subject of this reinsurance obligation are issued each year. Once the claim deadline passes for a particular policy year, the premium earned by the Insurance Subsidiary may be retained as earnings (subject to any regulatory capital and surplus requirements imposed by applicable law). As the sole owner of the Insurance Subsidiary, the Company may choose to terminate the Insurance Subsidiary’s participation in this reinsurance arrangement with respect to a future year at any time.

 

Competition

 

The banking business, in all of its phases, is highly competitive. Within our market areas, we compete with commercial banks, (including local banks and branches or affiliates of other larger banks), savings and loan associations and credit unions for loans and deposits, with consumer finance companies for loans, and with other financial institutions for various types of products and services. There is also competition for commercial and retail banking business from banks and financial institutions located outside our market areas and on the internet.

 

The primary factors in competing for deposits are interest rates, personalized services, the quality and range of financial services, convenience of office locations and office hours. The primary factors in competing for loans are interest rates, loan origination fees, the quality and range of lending services and personalized services.

 

To compete with other financial services providers, we rely principally upon local promotional activities, personal relationships established by officers, directors and employees with customers, and specialized services tailored to meet customers’ needs. In those instances in which we are unable to accommodate a customer’s needs, we attempt to arrange for those services to be provided by other financial services providers with which we have a relationship.

 

Supervision and Regulation

 

The following is a summary of the material regulations and policies applicable to the Company and its subsidiaries and is not intended to be a comprehensive discussion. Changes in applicable laws and regulations may have a material effect on our business.

 

General

 

The Company is subject to the supervision, examination and reporting requirements of the BHC Act and the regulations of the Federal Reserve that apply to financial holding companies. As a holding company of a Maryland-chartered bank, the Company is also subject to supervision by the Office of the Maryland Commissioner of Financial Regulation (the “Maryland Commissioner”). Because the Company’s common stock is registered under Section 12(g) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), the Company is also subject to regulation and supervision by the SEC.

 

The Bank is a Maryland commercial bank subject to the banking laws of Maryland and to regulation by the Maryland Commissioner, who is required by statute to make at least one examination in each calendar year (or at 18-month intervals if the Maryland Commissioner determines that an examination is unnecessary in a particular calendar year). As a member of the Federal Deposit Insurance Corporation (the “FDIC”), the Bank is also subject to certain provisions of federal laws and regulations regarding deposit insurance and activities of insured state-chartered banks, including those that require examination by the FDIC. In addition to the foregoing, there are a myriad of other federal and state laws and regulations that affect, or govern the business of banking, including consumer lending and deposit-taking.

 

All non-bank subsidiaries of the Company are subject to examination by the Federal Reserve, and, as affiliates of the Bank, are subject to examination by the FDIC and the Maryland Commissioner. In addition, the Insurance Subsidiary is subject to licensing and regulation by the Tennessee Insurance Department, and, as a captive insurance company, is subject to certain restrictions and requirements imposed under the Internal Revenue Code of 1986, as amended (the “IRC”).

 

Regulatory Reforms

 

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which was enacted in July 2010, significantly restructured the financial regulatory regime in the United States. The Dodd-Frank Act established the Consumer Financial Protection Bureau (the “CFPB”), and contains a wide variety of provisions affecting the regulation of depository institutions, including fair lending, fair debt collection practices, mortgage loan origination and servicing obligations, bankruptcy, military service member protections, use of credit reports, privacy matters, and disclosure of credit terms and correction of billing errors.  In addition, the Dodd-Frank Act permits states to adopt stricter consumer protection laws and each state attorney general may enforce consumer protection rules issued by the CFPB.  Since the enactment of the Dodd-Frank Act, the CFPB, and to some extent, some state attorney generals, have used provisions of the Dodd-Frank Act to bring enforcement actions seeking to curb “unfair, deceptive or abusive acts or practices” (“UDAAP”) in the financial services sector.  With a change of leadership at the CFPB, and continued enforcement and regulatory actions at the state level, enforcement and regulatory priorities could change, resulting in increased regulatory compliance burdens and costs and restrictions on the financial products and services that we offer to our customers in the future.

 

 

Regulation of Bank Holding Companies and Financial Holding Companies

 

The Company and its affiliates are subject to the provisions of Section 23A and Section 23B of the Federal Reserve Act. Section 23A limits the amount of loans or extensions of credit to, and investments in, the Company and its non-bank affiliates by the Bank. Section 23B requires that transactions between the Bank and the Company and its non-bank affiliates be on terms and under circumstances that are substantially the same as with non-affiliates.

 

Under Federal Reserve policy, the Company is expected to act as a source of strength to the Bank, and the Federal Reserve may charge the Company with engaging in unsafe and unsound practices for failure to commit resources to a subsidiary bank when required. This support may be required at times when the bank holding company may not have the resources to provide the support. Under the prompt corrective action provisions, if a controlled bank is undercapitalized, then the regulators could require the bank holding company to guarantee the bank’s capital restoration plan. In addition, if the Federal Reserve believes that a bank holding company’s activities, assets or affiliates represent a significant risk to the financial safety, soundness or stability of a controlled bank, then the Federal Reserve could require the bank holding company to terminate the activities, liquidate the assets or divest the affiliates. The regulators may require these and other actions in support of controlled banks even if such actions are not in the best interests of the bank holding company or its stockholders. Because the Company is a bank holding company, it is viewed as a source of financial and managerial strength for any controlled depository institutions, like the Bank.

 

In addition, under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), depository institutions insured by the FDIC can be held liable for any losses incurred by, or reasonably anticipated to be incurred by, the FDIC in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution in danger of default. Accordingly, in the event that any insured subsidiary of the Company causes a loss to the FDIC, other insured subsidiaries of the Company could be required to compensate the FDIC by reimbursing it for the estimated amount of such loss. Such cross guaranty liabilities generally are superior in priority to obligations of a financial institution to its shareholders and obligations to other affiliates. The Bank is the Company’s only FDIC-insured depository institution.

 

The provisions of the BHC Act relating to financial holding companies and the regulations promulgated thereunder require the Bank to remain “well capitalized” and “well managed”. The capital requirement is discussed below under the heading, “Prompt Corrective Act”. The Bank will be considered to be well managed so long as it achieves a CAMEL composite rating of at least “2” as a result of its most recent examination and at least a “satisfactory” management rating (if such rating is given). If the Bank were to fail to meet either of these requirements, then the Company would be required to enter into an agreement with the Federal Reserve that would address the remediation of the condition that led to the failure. During the term of that agreement, which is typically 180 days but which can be extended at the discretion of the Federal Reserve, the Company would be prohibited from commencing any additional activity or acquiring control or shares of any company that would otherwise be permissible for a financial holding company under Section 4(k) of the BHC Act. If the Company were to fail to correct that condition by the expiration of the agreement’s term, then the Federal Reserve could order the Company to divest its ownership of the Bank or, alternatively, terminate all financial holding company activities. For so long as the Company remains a financial holding company, the Bank must also maintain a Satisfactory or better rating under the Community Reinvestment Act (the “CRA”). During any period that the Bank fails to satisfy this requirement, the Company is prohibited from commencing any additional activity or acquiring control or shares of any company that would otherwise be permissible for a financial holding company under Section 4(k) of the BHC Act. The Bank currently satisfies all of the foregoing conditions.

 

Federal Banking Regulation

 

Federal banking regulators, such as the Federal Reserve and the FDIC, may prohibit the institutions over which they have supervisory authority from engaging in activities or investments that the agencies believe are unsafe or unsound banking practices. Federal banking regulators have extensive enforcement authority over the institutions they regulate to prohibit or correct activities that violate law, regulation or a regulatory agreement or which are deemed to be unsafe or unsound practices. Enforcement actions may include the appointment of a conservator or receiver, the issuance of a cease and desist order, the termination of deposit insurance, the imposition of civil money penalties on the institution, its directors, officers, employees and institution-affiliated parties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the removal of or restrictions on directors, officers, employees and institution-affiliated parties, and the enforcement of any such mechanisms through restraining orders or other court actions.

 

The Bank is subject to certain restrictions on extensions of credit to executive officers, directors, and principal shareholders or any related interest of such persons, which generally require that such credit extensions be made on substantially the same terms as those available to persons who are not related to the Bank and not involve more than the normal risk of repayment. Other laws tie the maximum amount that may be loaned to any one customer and its related interests to capital levels.

 

 

As part of the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), each federal banking regulator adopted non-capital safety and soundness standards for institutions under its authority. These standards include internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, and compensation, fees and benefits. An institution that fails to meet those standards may be required by the agency to develop a plan acceptable to meet the standards. Failure to submit or implement such a plan may subject the institution to regulatory sanctions. We believe that the Bank meets substantially all standards that have been adopted. FDICIA also imposes capital standards on insured depository institutions.

 

The CRA requires the FDIC, in connection with its examination of financial institutions within its jurisdiction, to evaluate the record of those financial institutions in meeting the credit needs of their communities, including low and moderate income neighborhoods, consistent with principles of safe and sound banking practices. These factors are also considered by all regulatory agencies in evaluating mergers, acquisitions and applications to open a branch or facility. As of the date of its most recent examination report, the Bank had a CRA rating of “Satisfactory”.

 

The Bank is also subject to a variety of other laws and regulations with respect to the operation of its business, including, but not limited to, the Truth in Lending Act, the Truth in Savings Act, the Equal Credit Opportunity Act, the Electronic Funds Transfer Act, the Fair Housing Act, the Home Mortgage Disclosure Act, the Fair Debt Collection Practices Act, the Fair Credit Reporting Act, Expedited Funds Availability (Regulation CC), Reserve Requirements (Regulation D), Privacy of Consumer Information (Regulation P), Margin Stock Loans (Regulation U), the Right To Financial Privacy Act, the Flood Disaster Protection Act, the Homeowners Protection Act, the Servicemembers Civil Relief Act, the Real Estate Settlement Procedures Act, the Telephone Consumer Protection Act, the CAN-SPAM Act, the Children’s Online Privacy Protection Act, and the John Warner National Defense Authorization Act.

 

Capital Requirements

 

In addition to operational requirements, the Bank and the Company are subject to risk-based capital regulations, which were adopted and are monitored by federal banking regulators. These regulations are used to evaluate capital adequacy and require an analysis of an institution’s asset risk profile and off-balance sheet exposures, such as unused loan commitments and stand-by letters of credit.

 

On July 2, 2013, the Federal Reserve approved final rules that substantially amended the regulatory risk-based capital rules applicable to the Company. The FDIC subsequently approved the same rules, which are applicable to the Bank. The final rules implement the ”Basel III” regulatory capital reforms and changes required by the Dodd-Frank Act and were implemented as of March 31, 2015. 

 

The Basel III capital rules include new risk-based capital and leverage ratios, which were phased in from 2015 to 2019, and which refine the definition of what constitutes “capital” for purposes of calculating those ratios. The minimum capital level requirements applicable to the Company under the final rules are: (i) a common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 capital ratio of 6% (increased from 4%); (iii) a total capital ratio of 8% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 4% for all institutions. The final rules also establish a “capital conservation buffer” of 2.5% above the new regulatory minimum capital requirements, which must consist entirely of common equity Tier 1 capital. The following minimum ratios were in effect at the beginning of 2019: (a) a common equity Tier 1 capital ratio of 7.0%, (b) a Tier 1 capital ratio of 8.5% and (c) a total capital ratio of 10.5%. Under the final rules, institutions are subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions.

 

The Basel III capital final rules also implement revisions and clarifications consistent with Basel III regarding the various components of Tier 1 capital, including common equity, unrealized gains and losses, as well as certain instruments that no longer qualify as Tier 1 capital, some of which will be phased out over time. Under the final rules, the effects of certain accumulated other comprehensive items are not excluded; however, banking organizations like the Company and the Bank that are not considered “advanced approaches” banking organizations may make a one-time permanent election to continue to exclude these items. The Company and the Bank made this election in their first quarter 2015 regulatory filings in order to avoid significant variations in the level of capital depending upon the impact of interest rate fluctuations on the fair value of the Company’s available-for-sale securities portfolio.

 

The Basel III capital rules also contain revisions to the prompt corrective action framework, which is designed to place restrictions on insured depository institutions if their capital levels begin to show signs of weakness. These revisions were effective January 1, 2015. Under the prompt corrective action requirements, which are designed to complement the capital conservation buffer, insured depository institutions are required to meet the following capital level requirements in order to qualify as “well capitalized”: (i) a new common equity Tier 1 capital ratio of 6.5%; (ii) a Tier 1 capital ratio of 8% (increased from 6%); (iii) a total capital ratio of 10% (unchanged from current rules); and (iv) a Tier 1 leverage ratio of 5% (increased from 4%).

 

 

The Basel III capital rules set forth certain changes for the calculation of risk-weighted assets. These changes include (i) an increased number of credit risk exposure categories and risk weights; (ii) an alternative standard of creditworthiness consistent with Section 939A of the Dodd-Frank Act; (iii) revisions to recognition of credit risk mitigation; (iv) rules for risk weighting of equity exposures and past due loans, and (v) revised capital treatment for derivatives and repo-style transactions.

 

Regulators may require higher capital ratios when warranted by the particular circumstances or risk profile of a given banking organization. In the current regulatory environment, banking organizations must stay well-capitalized in order to receive favorable regulatory treatment on acquisition and other expansion activities and favorable risk-based deposit insurance assessments. Our capital policy establishes guidelines meeting these regulatory requirements and takes into consideration current or anticipated risks as well as potential future growth opportunities.

 

As of December 31, 2020, we were in compliance with the applicable requirements of the Basel III rules.

 

Additional information about our capital ratios and requirements is contained in Item 7 of this Annual Report under the heading, “Capital Resources”.

 

Prompt Corrective Action

 

The Federal Deposit Insurance Act (the “FDI Act”) requires, among other things, the federal banking agencies to take “prompt corrective action” in respect of depository institutions that do not meet minimum capital requirements. The FDI Act includes the following five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” A depository institution’s capital tier will depend upon how its capital levels compare with various relevant capital measures and certain other factors, as established by regulation. The relevant capital measures are the total capital ratio, the Tier 1 capital ratio and the leverage ratio.

 

A bank will be (i) “well capitalized” if the institution has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and a leverage ratio of 5.0% or greater, and is not subject to any order or written directive by any such regulatory authority to meet and maintain a specific capital level for any capital measure, (ii) “adequately capitalized” if the institution has a total risk-based capital ratio of 8.0% or greater, a Tier 1 risk-based capital ratio of 4.0% or greater, and a leverage ratio of 4.0% or greater and is not “well capitalized”, (iii) “undercapitalized” if the institution has a total risk-based capital ratio that is less than 8.0%, a Tier 1 risk-based capital ratio of less than 4.0% or a leverage ratio of less than 4.0%, (iv) “significantly undercapitalized” if the institution has a total risk-based capital ratio of less than 6.0%, a Tier 1 risk-based capital ratio of less than 3.0% or a leverage ratio of less than 3.0%, and (v) “critically undercapitalized” if the institution’s tangible equity is equal to or less than 2.0% of average quarterly tangible assets. An institution may be downgraded to, or deemed to be in, a capital category that is lower than indicated by its capital ratios if it is determined to be in an unsafe or unsound condition or if it receives an unsatisfactory examination rating with respect to certain matters. A bank’s capital category is determined solely for the purpose of applying prompt corrective action regulations, and the capital category may not constitute an accurate representation of the bank’s overall financial condition or prospects for other purposes.

 

Effective January 1, 2015, the Basel III capital rules revised the prompt corrective action requirements by (i) introducing the CET1 ratio requirement at each level (other than critically undercapitalized), with the required CET1 ratio being 6.5% for well-capitalized status; (ii) increasing the minimum Tier 1 capital ratio requirement for each category (other than critically undercapitalized), with the minimum Tier 1 capital ratio for well-capitalized status being 8%; and (iii) eliminating the provision that permitted a bank with a composite supervisory rating of 1 but a leverage ratio of at least 3% to be deemed adequately capitalized. The Basel III Capital Rules did not change the total risk-based capital requirement for any prompt corrective action category.

 

The FDI Act generally prohibits a depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be “undercapitalized.” “Undercapitalized” institutions are subject to growth limitations and are required to submit a capital restoration plan. The agencies may not accept such a plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. In addition, for a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee that the institution will comply with such capital restoration plan. The bank holding company must also provide appropriate assurances of performance. The aggregate liability of the parent holding company is limited to the lesser of (i) an amount equal to 5.0% of the depository institution’s total assets at the time it became undercapitalized and (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it is “significantly undercapitalized.” Significantly undercapitalized” depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become “adequately capitalized,” requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. “Critically undercapitalized” institutions are subject to the appointment of a receiver or conservator.

 

 

The appropriate federal banking agency may, under certain circumstances, reclassify a well-capitalized insured depository institution as adequately capitalized. The FDI Act provides that an institution may be reclassified if the appropriate federal banking agency determines (after notice and opportunity for hearing) that the institution is in an unsafe or unsound condition or deems the institution to be engaging in an unsafe or unsound practice.

 

The appropriate agency is also permitted to require an adequately capitalized or undercapitalized institution to comply with the supervisory provisions as if the institution were in the next lower category (but not treat a significantly undercapitalized institution as critically undercapitalized) based on supervisory information other than the capital levels of the institution.

 

As of December 31, 2020, the Bank was “well capitalized” based on the aforementioned ratios.

 

Liquidity Requirements

 

We require cash to fund loans, satisfy our obligations under the Bank’s letters of credit, meet the deposit withdrawal demands of the Bank’s customers, and satisfy our other monetary obligations. To the extent that deposits are not adequate to fund these requirements, we can rely on the funding sources identified in Item 2 of this Annual Report under the heading, “Liquidity Management”. At December 31, 2020, the Bank had $23.5 million available through unsecured and secured lines of credit with correspondent banks, $33.2 million available through a secured line of credit with the Fed Discount Window and approximately $89.3million available through the Federal Home Loan Bank (“FHLB”). Management is not aware of any demands, commitments, events or uncertainties that are likely to materially affect our ability to meet our future liquidity requirements.          

 

Historically, the regulation and monitoring of bank liquidity has been addressed as a supervisory matter, without required formulaic measures. The Basel III liquidity framework requires banks to measure their liquidity against specific liquidity tests that, although similar in some respects to liquidity measures historically applied by banks and regulators for management and supervisory purposes, going forward would be required by regulation. One test, referred to as the liquidity coverage ratio (“LCR”), is designed to ensure that the banking entity maintains an adequate level of unencumbered high-quality liquid assets equal to the entity’s expected net cash outflow for a 30-day time horizon (or, if greater, 25% of its expected total cash outflow) under an acute liquidity stress scenario. The other test, referred to as the net stable funding ratio (“NSFR”), is designed to promote more medium- and long-term funding of the assets and activities of banking entities over a one-year time horizon. These requirements will incent banking entities to increase their holdings of U.S. Treasury securities and other sovereign debt as a component of assets and increase the use of long-term debt as a funding source. In October 2013, the federal banking agencies proposed rules implementing the LCR for advanced approaches banking organizations and a modified version of the LCR for bank holding companies with at least $50 billion in total consolidated assets that are not advanced approach banking organizations, neither of which would apply to us. In the second quarter of 2016, the federal banking regulators issued a proposed rule that would implement the NSFR for certain U.S. banking organizations to ensure that they have access to table funding over a one-year time horizon. The proposed rule would not apply to a U.S. banking organization with less than $50 billion in total consolidated assets, such as the Bank

 

Deposit Insurance

 

The Bank is a member of the FDIC and pays an insurance premium to the FDIC based upon its assessable deposits on a quarterly basis. Deposits are insured up to applicable limits by the FDIC and such insurance is backed by the full faith and credit of the United States Government. Deposits are insured by the FDIC through the Deposit Insurance Fund (the “DIF”) and such insurance is backed by the full faith and credit of the United States Government. Under the Dodd-Frank Act, a permanent increase in deposit insurance to $250,000 was authorized. The coverage limit is per depositor, per insured depository institution for each account ownership category.

 

The Federal Deposit Insurance Reform Act of 2005, which created the DIF, gave the FDIC greater latitude in setting the assessment rates for insured depository institutions which could be used to impose minimum assessments. The FDIC has the flexibility to adopt actual rates that are higher or lower than the total base assessment rates adopted without notice and comment, if certain conditions are met.

 

The Dodd-Frank Act also set a new minimum DIF reserve ratio at 1.35% of estimated insured deposits. The FDIC was required to attain this ratio by September 30, 2020. The Dodd-Frank Act required the FDIC to redefine the deposit insurance assessment base for an insured depository institution. As redefined pursuant to the Dodd-Frank Act, an institution’s assessment base is now an amount equal to the institution’s average consolidated total assets during the assessment period minus average tangible equity. Institutions with less than $1.0 billion in assets at the end of a fiscal quarter, like the Bank, are permitted to report their average consolidated total assets on a weekly basis (rather than on a daily basis) and to report their average tangible equity on an end-of-quarter balance (rather than on an end-of-month balance).

 

 

DIF-insured institutions pay a Financing Corporation (“FICO”) assessment in order to fund the interest on bonds issued in the 1980s in connection with the failures in the thrift industry. These assessments ended in 2019. In addition, when the DIF reserve ratio exceeded 1.35%, smaller institutions were eligible to receive a credit. The Bank’s credit was $98,970 with most of it realized in 2019. The Bank expensed $201,714 and $30,571 in FDIC insurance premiums, including FICO assessments and net of the credit, in 2020 and 2019, respectively.

 

The FDIC is authorized to conduct examinations of and require reporting by FDIC-insured institutions. It is also authorized to terminate a depository bank’s deposit insurance upon a finding by the FDIC that the bank’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the bank’s regulatory agency. The termination of deposit insurance would have a material adverse effect on our earnings, operations and financial condition.

 

The FDIC is authorized to conduct examinations of and require reporting by FDIC-insured institutions. It is also authorized to terminate a depository bank’s deposit insurance upon a finding by the FDIC that the bank’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the bank’s regulatory agency. The termination of deposit insurance for our bank subsidiary would have a material adverse effect on our earnings, operations and financial condition.

 

Bank Secrecy Act/Anti-Money Laundering

 

The Bank Secrecy Act (“BSA”), which is intended to require financial institutions to develop policies, procedures, and practices to prevent and deter money laundering, mandates that every insured depository institution have a written, board-approved program that is reasonably designed to assure and monitor compliance with the BSA.

 

The program must, at a minimum: (i) provide for a system of internal controls to assure ongoing compliance; (ii) provide for independent testing for compliance; (iii) designate an individual responsible for coordinating and monitoring day-to-day compliance; and (iv) provide training for appropriate personnel. In addition, state-chartered banks are required to adopt a customer identification program as part of its BSA compliance program. State-chartered banks are also required to file Suspicious Activity Reports when they detect certain known or suspected violations of federal law or suspicious transactions related to a money laundering activity or a violation of the BSA.

 

In addition to complying with the BSA, the Bank is subject to the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA Patriot Act”). The USA Patriot Act is designed to deny terrorists and criminals the ability to obtain access to the United States’ financial system and has significant implications for depository institutions, brokers, dealers, and other businesses involved in the transfer of money. The USA Patriot Act mandates that financial service companies implement additional policies and procedures and take heightened measures designed to address any or all of the following matters: customer identification programs, money laundering, terrorist financing, identifying and reporting suspicious activities and currency transactions, currency crimes, and cooperation between financial institutions and law enforcement authorities.

 

Mortgage Lending and Servicing

 

The Bank’s mortgage lending and servicing activities are subject to various laws and regulations that are enforced by the federal banking regulators and the CFPB, such as the Truth in Lending Act, the Real Estate Settlement Procedures Act, and various rules adopted thereunder, including those relating to consumer disclosures, appraisal requirements, mortgage originator compensation, prohibitions on mandatory arbitration provisions under certain circumstances, and the obligation to credit payments and provide payoff statements within certain time periods and provide certain notices prior to interest rate and payment adjustments.

 

The Bank is required to make a reasonable and good faith determination based on verified and documented information that a consumer applying for a mortgage loan has a reasonable ability to repay the loan according to its terms. Qualified mortgages that that are not “higher-priced” are afforded a safe harbor presumption of compliance with the ability to repay rules, while qualified mortgages that are “higher-priced” garner a rebuttable presumption of compliance with the ability to repay rules. In general, a “qualified mortgage” is a mortgage loan without negative amortization, interest-only payments, balloon payments, or a term exceeding 30 years, where the lender determines that the borrower has the ability to repay, and where the borrower’s points and fees do not exceed 3% of the total loan amount. “Higher-priced” mortgages must have escrow accounts for taxes and insurance and similar recurring expenses.

 

 

Consumer Lending – Military Lending Act

 

The Military Lending Act (the “MLA”), which was initially implemented in 2007, was amended and its coverage significantly expanded in 2015. The Department of Defense (the “DOD”) issued a final rule under the MLA that took effect on October 15, 2015, but financial institutions were not required to take action until October 3, 2016. The types of credit covered under the MLA were expanded to include virtually all consumer loan and credit card products (except for loans secured by residential real property and certain purchase-money motor vehicle/personal property secured transactions). Lenders must now provide specific written and oral disclosures concerning the protections of the MLA to active duty members of the military and dependents of active duty members of the military (“covered borrowers”). The rule imposes a 36% “Military Annual Percentage Rate” cap that includes costs associated with credit insurance premiums, fees for ancillary products, finance charges associated with the transactions, and application and participation charges. In addition, loan terms cannot include (i) a mandatory arbitration provision, (ii) a waiver of consumer protection laws, (iii) mandatory allotments from military benefits, or (iv) a prepayment penalty. The revised rule also prohibits “roll-over” or refinances of the same loan unless the new loan provides more favorable terms for the covered borrower. Lenders may verify covered borrower status using a DOD database or information provided by credit bureaus. We believe that we are in compliance with the revised rule.

 

Cybersecurity

 

We rely on electronic communications and information systems to conduct our operations and store sensitive data. We employ an in-depth approach that leverages people, processes, and technology to manage and maintain cybersecurity controls. In addition, we employ a variety of preventative and detective tools to monitor, block, and provide alerts regarding suspicious activity, as well as to report on any suspected advanced persistent threats. Notwithstanding the strength of our defensive measures, the threat from cyber-attacks is severe, attacks are sophisticated and increasing in volume, and attackers respond rapidly to changes in defensive measures.

 

The federal banking regulators have adopted guidelines for establishing information security standards and cybersecurity programs for implementing safeguards under the supervision of a financial institution’s board of directors. These guidelines, along with related regulatory materials, increasingly focus on risk management and processes related to information technology and the use of third parties in the provision of financial products and services. The federal banking regulators expect financial institutions to establish lines of defense and to ensure that their risk management processes address the risk posed by compromised customer credentials, and also expect financial institutions to maintain sufficient business continuity planning processes to ensure rapid recovery, resumption and maintenance of the institution’s operations after a cyberattack. If we fail to meet the expectations set forth in this regulatory guidance, then we could be subject to various regulatory actions and we may be required to devote significant resources to any required remediation efforts.

 

Laws Related to the Insurance Subsidiary

 

The Insurance Subsidiary is treated as a separate legal entity for state law purposes and is licensed and supervised by the Tennessee Department of Commerce and Insurance as a series protected cell of a protected cell captive insurance company. Tennessee insurance law requires a protected cell to possess and maintain unimpaired paid-in capital and surplus of at least $25,000, and the Tennessee Department of Commerce and Insurance has the authority to prescribe additional requirements based on the type, volume and nature of insurance business to be conducted. No captive insurance company may pay a dividend out of, or other distribution with respect to, capital or surplus without the prior approval of the Tennessee Department of Commerce and Insurance.

 

The Insurance Subsidiary was formed with the intention that it be treated as a “captive insurance company” by the Internal Revenue Service (the “IRS”) so that, among other things, some or all of the premiums that we pay to the Insurance Subsidiary will be deductible as trade or business expenses. Because of the significant tax benefits that can be realized through the operation of a captive insurance company, the IRS has recently focused significant attention on these arrangements to ensure that they are not simply a disguise for self-insurance. Amounts paid to the Insurance Subsidiary will be deductible only if they constitute “insurance premiums” under the IRC. The federal courts and the IRS have concluded that amounts paid to an insurance company will be deemed insurance premiums only if the arrangement under which those amounts were paid evidences an appropriate level of both “risk shifting” and “risk distribution”.

 

Moreover, our tax planning assumes that the Insurance Company will have made an effective election under Section 831(b) of the IRC for each taxable year so that it will be taxed only on its investment income (and not also on its premium income) generated in that year. A Section 831(b) election for a taxable year is available only if (i) the insurance company’s net written premiums (or, if greater, direct written premiums) for the year do not exceed $2.2 million and (ii) either (a) no more than 20% of the written premiums (net or direct, as applicable) for the year is attributable to any single insured or (b) the insurance company satisfies certain ownership diversification requirements specified in Section 831(b)(2)(B)(i)(II) of the IRC.

 

 

The laws governing these arrangements are complicated and the positions taken by the IRS with respect to these laws and arrangements evolve and are subject to change. For additional information, see the risk factors entitled “We may not achieve the expected benefits from the Insurance Subsidiary” and “Our fiscal year 2016, 2017, and 2018 U.S. consolidated federal income tax returns are currently being audited” in Item 1A of this annual report under the heading “Risks Relating to the Company and its Affiliates”.

 

SEC Regulation

 

The shares of the Company’s common stock are registered with the SEC under Section 12(g) of the Exchange Act and the Company is subject to the information reporting requirements, proxy solicitation requirements, insider trading restrictions and other requirements of the Exchange Act, including the requirements imposed under the federal Sarbanes-Oxley Act of 2002. Among other things, loans to and other transactions with insiders are subject to restrictions and heightened disclosure.

 

Governmental Monetary and Credit Policies and Economic Controls

 

The earnings and growth of the banking industry and ultimately of the Bank are affected by the monetary and credit policies of governmental authorities, including the Federal Reserve. An important function of the Federal Reserve is to regulate the national supply of bank credit in order to control recessionary and inflationary pressures. Among the instruments of monetary policy used by the Federal Reserve to implement these objectives are open market operations in U.S. Government securities, changes in the federal funds rate, changes in the discount rate of member bank borrowings, and changes in reserve requirements against member bank deposits. These means are used in varying combinations to influence overall growth of bank loans, investments and deposits and may also affect interest rates charged on loans or paid on deposits. The monetary policies of the Federal Reserve authorities have had a significant effect on the operating results of commercial banks in the past and are expected to continue to have such an effect in the future. In view of changing conditions in the national economy and in the money markets, as well as the effect of actions by monetary and fiscal authorities, including the Federal Reserve, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or their effect on our businesses and earnings.

 

Employees

 

As of December 31, 2020, we employed 102 individuals, of whom 86 were full-time employees.

 

ITEM 1A.

RISK FACTORS.

 

The significant risks and uncertainties related to us, our business and our securities of which we are aware are discussed below. You should carefully consider these risks and uncertainties before making investment decisions in respect of our securities. Any of these factors could materially and adversely affect our business, financial condition, operating results and prospects and could negatively impact the market price of our securities. If any of these risks materialize, you could lose all or part of your investment in the Company. Additional risks and uncertainties that we do not yet know of, or that we currently think are immaterial, may also impair our business operations. You should also consider the other information contained in this annual report, including our financial statements and the related notes, before making investment decisions in respect of our securities.

 

Risks Relating to the COVID-19 Global Pandemic

 

The COVID-19 pandemic has adversely impacted our business and financial results and that of many of our customers, and the ultimate impact will depend on future developments, which are highly uncertain, cannot be predicted, and are largely outside of our control, including the scope and duration of the pandemic and actions taken by governmental authorities in response to the pandemic.

 

The COVID-19 pandemic has adversely impacted our business and financial results and that of many of our customers, and the ultimate impact will depend on future developments, which are highly uncertain, cannot be predicted, and are largely outside of our control, including the scope and duration of the pandemic and actions taken by governmental authorities in response to the pandemic. The COVID-19 pandemic has created extensive disruptions to the global and U.S. economies and to the lives of individuals throughout the world. Governments, businesses, and the public are taking unprecedented actions to contain the spread of COVID-19 and to mitigate its effects, including quarantines, travel bans, shelter-in-place orders, closures of businesses and schools, fiscal and monetary stimulus, and legislation designed to deliver financial aid and other relief. While the scope, duration, and full effects of COVID-19 are rapidly evolving and not fully known, the pandemic and the efforts to contain it have disrupted global economic activity, adversely affected the functioning of financial markets, impacted market interest rates, increased economic and market uncertainty, and disrupted trade and supply chains. If these effects continue for a prolonged period or result in sustained economic stress or recession, many of the risk factors identified in this annual report 10-K could be exacerbated and the effects of COVID-19 could have a material adverse impact on us in a number of ways as described in more detail below.

 

 

Credit Risk - Our risks of timely loan repayment and the value of collateral supporting the loans are affected by the strength of our borrowers’ businesses. Concern about the spread of COVID-19 has caused and is likely to continue to cause business shutdowns, limitations on commercial activity and financial transactions, labor shortages, supply chain interruptions, increased unemployment and commercial property vacancy rates, reduced profitability and ability for property owners to make mortgage payments, and overall economic and financial market instability, all of which may cause our customers to be unable to make scheduled loan payments.

 

If the effects of COVID-19 result in widespread and sustained repayment shortfalls on loans in our portfolio, then we could incur significant delinquencies, foreclosures and credit losses, particularly if the available collateral is insufficient to cover our credit exposure. The future effects of COVID-19 on economic activity could negatively affect the collateral values associated with our existing loans, the ability to liquidate the real estate collateral securing our residential and commercial real estate loans, our ability to maintain loan origination volume and to obtain additional financing, the future demand for or profitability of our lending and services, and the financial condition and credit risk of our customers. Further, in the event of delinquencies, regulatory changes and policies designed to protect borrowers may slow or prevent us from making our business decisions or may result in a delay in our taking certain remediation actions, such as foreclosure. In addition, we have unfunded commitments to extend credit to customers. During a challenging economic environment, our customers depend more on our credit commitments and increased borrowings under these commitments could adversely impact our liquidity. Furthermore, in an effort to support our communities during the pandemic, we are participating in the PPP, whereby loans to small businesses are made and those loans are subject to the regulatory requirements that would require forbearance of loan payments for a specified time or that would limit our ability to pursue all available remedies in the event of a loan default. If the borrower under the PPP loan fails to qualify for loan forgiveness, we are at the heightened risk of holding these loans at unfavorable interest rates as compared to the loans to customers that we would have otherwise extended credit.

 

Strategic Risk - Our success may be affected by a variety of external factors that may affect the price or marketability of our products and services, changes in interest rates that may increase our funding costs, reduced demand for our financial products due to economic conditions and the various response of governmental and nongovernmental authorities. The COVID-19 pandemic has significantly increased economic and demand uncertainty and has led to disruption and volatility in the global capital markets. Furthermore, many of the governmental actions have been directed toward curtailing household and business activity to contain COVID-19. These actions have been rapidly expanding in scope and intensity. For example, in many of our markets, local governments have acted to temporarily close or restrict the operations of most businesses. The future effects of COVID-19 on economic activity could negatively affect the future banking products we provide, including a decline in originating loans.

 

Operational Risk - Current and future restrictions on our workforce’s access to our facilities could limit our ability to meet customer servicing expectations and have a material adverse effect on our operations. We rely on business processes and branch activity that largely depend on people and technology, including access to information technology systems as well as information, applications, payment systems and other services provided by third parties. In response to COVID-19, we have modified our business practices with a portion of our employees working remotely from their homes to have our operations uninterrupted as much as possible. Further, technology in employees’ homes may not be as robust as in our offices and could cause the networks, information systems, applications, and other tools available to employees to be more limited or less reliable than in our offices. The continuation of these work-from-home measures also introduces additional operational risk, including increased cybersecurity risk from phishing, malware, and other cybersecurity attacks, all of which could expose us to risks of data or financial loss and could seriously disrupt our operations and the operations of any impacted customers.

 

Moreover, we rely on many third parties in our business operations, including the appraiser of the real property collateral, vendors that supply essential services such as loan servicers, providers of financial information, systems and analytical tools and providers of electronic payment and settlement systems, and local and federal government agencies, offices, and courthouses. In light of the developing measures responding to the pandemic, many of these entities may limit the availability and access of their services. If the third-party service providers continue to have limited capacities for a prolonged period or if additional limitations or potential disruptions in these services materialize, it may negatively affect our operations.

 

Interest Rate Risk/Market Value Risk - Our net interest income, lending and investment activities, deposits and profitability could be negatively affected by volatility in interest rates caused by uncertainties stemming from COVID-19. In March 2020, the Federal Reserve lowered the target range for the federal funds rate to a range from 0% to 0.25%, citing concerns about the impact of COVID-19 on financial markets and market stress in the energy sector. A prolonged period of extremely volatile and unstable market conditions could increase our funding costs and negatively affect market risk mitigation strategies. Higher income volatility from changes in interest rates and spreads to benchmark indices could cause a loss of future net interest income and a decrease in prevailing fair market values of our investment securities and other assets, including mortgage servicing rights and SBA loan servicing rights. Fluctuations in interest rates will impact both the level of income and expense recorded on many of our assets and liabilities and the market value of all interest-earning assets and interest-bearing liabilities, which in turn could have a material adverse effect on our net income, operating results, or financial condition.

 

 

Because there have been no comparable recent global pandemics that resulted in similar global impact, we do not yet know the full extent of COVID-19’s effects on our business, operations, or the global economy as a whole. Any future development will be highly uncertain and cannot be predicted, including the scope and duration of the pandemic, the effectiveness of our work-from-home arrangements, third party providers’ ability to support our operations, and any actions taken by governmental authorities and other third parties in response to the pandemic. The uncertain future development of this crisis could materially and adversely affect our business, operations, operating results, financial condition, liquidity or capital levels.

 

Risks Related to Our Merger with Carroll Bancorp, Inc.

 

We may fail to realize all of the anticipated benefits of the Merger.

 

Realization of the anticipated benefits in the Merger for our stockholders will depend, in part, on the combined company’s ability to successfully integrate the businesses and operations of the Company and Carroll. The combined company will be required to devote significant management attention and resources to integrating its business practices, operations and support functions.

 

The success of the Merger will depend, in part, on our ability to realize the anticipated benefits and cost savings from combining the businesses of Carroll and the Company. To realize these anticipated benefits and cost savings, however, we must successfully combine the businesses of Carroll and the Company. If we are unable to achieve these objectives, then the anticipated benefits and cost savings of the Merger may not be realized fully or at all or may take longer to realize than expected.

 

Risks Relating to the Company and its Affiliates

 

The Company’s future success depends on the successful growth of its subsidiaries.

 

The Company’s primary business activity for the foreseeable future will be to act as the holding company of the Bank and the Insurance Subsidiary. Therefore, the Company’s future profitability will depend on the success and growth of these subsidiaries.

 

We could be adversely affected by risks associated with future acquisitions and expansions.

 

Although our core growth strategy has historically focused around organic growth, we may from time to time consider acquisition and expansion opportunities involving a bank or other entity operating in the financial services industry, such as the Merger. We cannot predict if or when we will engage in strategic transactions, or the nature or terms of any such transactions. To the extent that we grow through an acquisition, we cannot assure investors that we will be able to adequately and profitably manage that growth or that an acquired business will be integrated into our existing businesses as efficiently or as timely as we may anticipate. Acquiring another business would generally involve risks commonly associated with acquisitions, including:

 

•

increased capital needs;

•

increased and new regulatory and compliance requirements;

•

implementation or remediation of controls, procedures and policies with respect to the acquired business;

•

diversion of management time and focus from operation of our then-existing business to acquisition-integration challenges;

•

coordination of product, sales, marketing and program and systems management functions;

•

transition of the acquired business’s users and customers onto our systems;

•

retention of employees from the acquired business;

•

integration of employees from the acquired business into our organization;

•

integration of the acquired business’s accounting, information management, human resources and other administrative systems and operations with ours;

•

potential liability for activities of the acquired business prior to the acquisition, including violations of law, commercial disputes and tax and other known and unknown liabilities;

•

potential increased litigation or other claims in connection with the acquired business, including claims brought by regulators, terminated employees, customers, former stockholders, vendors, or other third parties; and

•

potential goodwill impairment.

 

Our failure to execute on our acquisition strategy could adversely affect our business, results of operations, financial condition and future prospects risks of unknown or contingent liabilities.

 

 

The majority of our business is concentrated in Maryland, much of which involves real estate lending, so a decline in the real estate and credit markets could materially and adversely impact our financial condition and results of operations.

 

Most of the Bank’s loans are made to borrowers located in Maryland, and many of these loans, including construction and land development loans, are secured by real estate. At December 31, 2020, approximately 6%, or $34 million, of our total loans were real estate acquisition, construction and development loans that were secured by real estate. Accordingly, a decline in local economic conditions would likely have an adverse impact on our financial condition and results of operations, and the impact on us would likely be greater than the impact felt by larger financial institutions whose loan portfolios are geographically diverse. We cannot guarantee that any risk management practices we implement to address our geographic and loan concentrations will be effective to prevent losses relating to our loan portfolio.

 

The Bank’s concentrations of commercial real estate loans could subject it to increased regulatory scrutiny and directives, which could force us to preserve or raise capital and/or limit future commercial lending activities.

 

The federal banking regulators believe that institutions with particularly high concentrations of CRE loans in their lending portfolios face a heightened risk of financial difficulties in the event of adverse changes in the economy and CRE markets. Accordingly, through published guidance, these regulators have directed institutions whose concentrations exceed certain percentages of capital to implement heightened risk management practices appropriate to their concentration risk. The guidance provides that banking regulators may require such institutions to reduce their concentrations and/or maintain higher capital ratios than institutions with lower concentrations in CRE. At December 31, 2020, our CRE concentrations were above the heightened risk management thresholds set forth in this guidance. No assurance can be given that the Company’s enhanced risk management practices and monitoring controls will be effective.

 

The Bank may experience loan losses in excess of its allowance, which would reduce our earnings.

 

The risk of credit losses on loans varies with, among other things, general economic conditions, the type of loans being made, the creditworthiness of the borrowers over the term of the loans and, in the case of collateralized loans, the value and marketability of the collateral for the loans. Management of the Bank maintains an allowance for loan losses based upon, among other things, historical experience, an evaluation of economic conditions and regular reviews of delinquencies and loan portfolio quality. Based upon such factors, management makes various assumptions and judgments about the ultimate collectability of the loan portfolio and provides an allowance for loan losses based upon a percentage of the outstanding balances and for specific loans when their ultimate collectability is considered questionable. If management’s assumptions and judgments prove to be incorrect and the allowance for loan losses is inadequate to absorb future losses, or if the bank regulatory authorities require us to increase the allowance for loan losses as a part of its examination process, our earnings and capital could be significantly and adversely affected. Although management continually monitors our loan portfolio and makes determinations with respect to the allowance for loan losses, future adjustments may be necessary if economic conditions differ substantially from the assumptions used or adverse developments arise with respect to our non-performing or performing loans. Material additions to the allowance for loan losses could result in a material decrease in our net income and capital, and could have a material adverse effect on our financial condition.

 

Interest rates and other economic conditions will impact our results of operations.

 

Our net income depends primarily upon our net interest income. Net interest income is the difference between interest income earned on loans, investments and other interest-earning assets and the interest expense incurred on deposits and borrowed funds. The level of net interest income is primarily a function of the average balance of our interest-earning assets, the average balance of our interest-bearing liabilities, and the spread between the yield on such assets and the cost of such liabilities. These factors are influenced by both the pricing and mix of our interest-earning assets and our interest-bearing liabilities which, in turn, are impacted by such external factors as the local economy, competition for loans and deposits, the monetary policy of the Federal Open Market Committee of the Federal Reserve Board of Governors, and market interest rates.

 

Different types of assets and liabilities may react differently, and at different times, to changes in market interest rates. We expect that we will periodically experience gaps in the interest rate sensitivities of our assets and liabilities. That means either our interest-bearing liabilities will be more sensitive to changes in market interest rates than our interest-earning assets, or vice versa. When interest-bearing liabilities mature or re-price more quickly than interest-earning assets, an increase in market rates of interest could reduce our net interest income. Likewise, when interest-earning assets mature or re-price more quickly than interest-bearing liabilities, falling interest rates could reduce our net interest income. We are unable to predict changes in market interest rates, which are affected by many factors beyond our control, including inflation, deflation, recession, unemployment, money supply, domestic and international events and changes in the United States and other financial markets.

 

We also attempt to manage risk from changes in market interest rates, in part, by controlling the mix of interest rate sensitive assets and interest rate sensitive liabilities. However, interest rate risk management techniques are not exact. A rapid increase or decrease in interest rates could adversely affect our results of operations and financial performance.

 

 

Changes to LIBOR may adversely impact the value of, and the return on, our loans, investment securities and derivatives which are indexed to LIBOR.

 

We have certain loans indexed to LIBOR to calculate the loan interest rate. On July 27, 2017, the United Kingdom Financial Conduct Authority, which regulates LIBOR, announced that it will no longer persuade or compel banks to submit rates for the calculation of LIBOR to the LIBOR administrator after 2021. The announcement also indicates that the continuation of LIBOR on the current basis cannot and will not be guaranteed after 2021. Consequently, at this time, it is not possible to predict whether and to what extent banks will continue to provide LIBOR submissions to the LIBOR administrator or whether any additional reforms to LIBOR may be enacted in the United Kingdom or elsewhere. Similarly, it is not possible to predict whether LIBOR will continue to be viewed as an acceptable benchmark for certain loans and liabilities including our subordinated notes, what rate or rates may become accepted alternatives to LIBOR or the effect of any such changes in views or alternatives on the values of the loans and liabilities, whose interest rates are tied to LIBOR. Uncertainty as to the nature of such potential changes, alternative reference rates, the elimination or replacement of LIBOR, or other reforms may adversely affect the value of, and the return on our loans, and our investment securities.

 

A new accounting standard will likely require us to increase our allowance for loan losses and may have a material adverse effect on our financial condition and results of operations.

 

The Financial Accounting Standards Board (the “FASB”) has adopted a new accounting standard that will be effective for the Company beginning with our first full fiscal year after December 15, 2022. This standard, referred to as Current Expected Credit Loss, or CECL, will require financial institutions to determine periodic estimates of lifetime expected credit losses on loans, and recognize the expected credit losses as allowances for loan losses. This standard will change the current method of providing allowances for loan losses that are probable, which would likely require us to increase our allowance for loan losses, and to greatly increase the types of data we would need to collect and review to determine the appropriate level of the allowance for loan losses. Any increase in our allowance for loan losses or expenses incurred to determine the appropriate level of the allowance for loan losses may have a material adverse effect on our financial condition and results of operations.

 

The market value of our investments could decline.

 

As of December 31, 2020, investment securities in our investment portfolio having a cost basis of $53.5 million and a market value of $54.5 million were classified as available-for-sale pursuant to FASB Accounting Standards Codification (“ASC”) Topic 320, Investments – Debt and Equity Securities, relating to accounting for investments. Topic 320 requires that unrealized gains and losses in the estimated value of the available-for-sale portfolio be “marked to market” and reflected as a separate item in stockholders’ equity (net of tax) as accumulated other comprehensive gain or loss. There can be no assurance that future market performance of our investment portfolio will enable us to realize income from sales of securities. Stockholders’ equity will continue to reflect the unrealized gains and losses (net of tax) of these investments. Moreover, there can be no assurance that the market value of our investment portfolio will not decline, causing a corresponding decline in stockholders’ equity.

 

Management believes that several factors could affect the market value of our investment portfolio. These include, but are not limited to, changes in interest rates or expectations of changes, the degree of volatility in the securities markets, inflation rates or expectations of inflation and the slope of the interest rate yield curve (the yield curve refers to the differences between shorter-term and longer-term interest rates; a positively sloped yield curve means shorter-term rates are lower than longer-term rates). Also, the passage of time will affect the market values of our investment securities, in that the closer they are to maturing, the closer the market price should be to par value. These and other factors may impact specific categories of the portfolio differently, and management cannot predict the effect these factors may have on any specific category.

 

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

 

In assessing whether the impairment of investment securities is other-than-temporary, management considers the length of time and extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability to retain our investment in the security for a period of time sufficient to allow for any anticipated recovery in fair value in the near term. See the discussion under the heading “Application of Critical Accounting Policies” in Item 7 of Part II of this annual report for further information.

 

In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. Assessing the need for, or the sufficiency of, a valuation allowance requires management to evaluate all available evidence, both negative and positive, including the recent trend of quarterly earnings. Positive evidence necessary to overcome the negative evidence includes whether future taxable income in sufficient amounts and character within the carryback and carry forward periods is available under the tax law, including the use of tax planning strategies. When negative evidence (e.g., cumulative losses in recent years, history of operating loss or tax credit carry forwards expiring unused) exists, more positive evidence than negative evidence will be necessary. At December 31, 2020, our net deferred tax assets were valued at $1.2 million.

 

 

The impact of each of these impairment matters could have a material adverse effect on our business, results of operations, and financial condition.

 

We operate in a competitive environment, and our inability to effectively compete could adversely and materially impact our financial condition and results of operations.

 

We operate in a competitive environment, competing for loans, deposits, and customers with commercial banks, savings associations and other financial entities. Competition for deposits comes primarily from other commercial banks, savings associations, credit unions, money market and mutual funds and other investment alternatives. Competition for loans comes primarily from other commercial banks, savings associations, mortgage banking firms, credit unions and other financial intermediaries. Competition for other products, such as securities products, comes from other banks, securities and brokerage companies, and other non-bank financial service providers in our market area. Many of these competitors are much larger in terms of total assets and capitalization, have greater access to capital markets, and/or offer a broader range of financial services than those that we offer. In addition, banks with a larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the needs of larger customers.

 

In addition, changes to the banking laws over the last several years have facilitated interstate branching, merger and expanded activities by banks and holding companies. For example, the federal Gramm-Leach-Bliley Act revised the BHC Act and repealed the affiliation provisions of the Glass-Steagall Act of 1933, which, taken together, limited the securities and other non-banking activities of any company that controls an FDIC insured financial institution. As a result, the ability of financial institutions to branch across state lines and the ability of these institutions to engage in previously-prohibited activities are now accepted elements of competition in the banking industry. These changes may bring us into competition with more and a wider array of institutions, which may reduce our ability to attract or retain customers. Management cannot predict the extent to which we will face such additional competition or the degree to which such competition will impact our financial conditions or results of operations.

 

The banking industry is heavily regulated; significant regulatory changes could adversely affect our operations.

 

Our operations will be impacted by current and future legislation and by the policies established from time to time by various federal and state regulatory authorities. The Company is subject to supervision by the Federal Reserve. The Bank is subject to supervision and periodic examination by the Maryland Commissioner and the FDIC. The Insurance Subsidiary is subject to supervision and periodic examination by the Tennessee Insurance Department. Banking regulations, designed primarily for the safety of depositors, and insurance regulations, designed primarily for the safety of insureds, may limit a financial institution’s growth and the return to its investors by restricting such activities as the payment of dividends, mergers with or acquisitions by other institutions, investments, loans and interest rates, interest rates paid on deposits, expansion of branch offices, and the offering of securities or trust services. The Company and the Bank are also subject to capitalization guidelines established by federal law and the Insurance Subsidiary is subject to capitalization guidelines established by Tennessee law, and could be subject to enforcement actions to the extent that they are found by regulatory examiners to be undercapitalized. It is not possible to predict what changes, if any, will be made to existing federal and state legislation and regulations or the effect that such changes may have on our future business and earnings prospects. Management also cannot predict the nature or the extent of the effect on our business and earnings of future fiscal or monetary policies, economic controls, or new federal or state legislation. Further, the cost of compliance with regulatory requirements may adversely affect our ability to operate profitably.

 

The Consumer Financial Protection Bureau may continue to reshape the consumer financial laws through rulemaking and enforcement of the prohibitions against unfair, deceptive and abusive business practices. Compliance with any such change may impact our business operations.

 

The CFPB has broad rulemaking authority to administer and carry out the provisions of the Dodd-Frank Act with respect to financial institutions that offer covered financial products and services to consumers. The CFPB has also been directed to adopt rules identifying practices or acts that are unfair, deceptive or abusive in connection with any transaction with a consumer for a consumer financial product or service, or the offering of a consumer financial product or service. The concept of what may be considered to be an “abusive” practice is new under the law. The full scope of the impact of this authority has not yet been determined as the CFPB has not yet released significant supervisory guidance. Any new rules adopted by the CFPB could require the Bank to dedicate significant personnel resources and could have a material adverse effect on our operations.

 

 

Bank regulators and other regulations, including the Basel III Capital Rules, may require higher capital levels, impacting our ability to pay dividends or repurchase our stock.

 

The capital standards to which we are subject, including the standards created by the Basel III Capital Rules, may materially limit our ability to use our capital resources and/or could require us to raise additional capital by issuing common stock. The issuance of additional shares of common stock could dilute existing stockholders.

 

A material weakness or significant deficiency in our disclosure or internal controls could have an adverse effect on us.

 

The Corporation is required by the Sarbanes-Oxley Act of 2002 to establish and maintain disclosure controls and procedures and internal control over financial reporting. These control systems are intended to provide reasonable assurance that material information relating to the Corporation is made known to our management and reported as required by the Exchange Act, to provide reasonable assurance regarding the reliability and preparation of our financial statements, and to provide reasonable assurance that fraud and other unauthorized uses of our assets are detected and prevented. We may not be able to maintain controls and procedures that are effective at the reasonable assurance level. If that were to happen, our ability to provide timely and accurate information about the Corporation, including financial information, to investors could be compromised and our results of operations could be harmed. Moreover, if the Corporation or its independent registered public accounting firm were to identify a material weakness or significant deficiency in any of those control systems, our reputation could be harmed and investors could lose confidence in us, which could cause the market price of the Corporation’s stock to decline and/or limit the trading market for the common stock.

 

Customer concern about deposit insurance may cause a decrease in deposits held at the Bank.

 

Due to the large number of bank failures that have occurred since the 2008 recession, banking customers across the country have become increasingly concerned about the extent to which their deposits are insured by the FDIC. This concern could cause the Bank’s customers to withdraw deposits from the Bank in an effort to ensure that the amount they have on deposit with us is fully-insured. Because the Bank relies heavily on deposits to fund loans and purchase other interest-earning assets, a decrease in deposits could have a materially adverse effect on our funding costs and net income.

 

The Bank’s funding sources may prove insufficient to replace deposits and support our future growth.

 

The Bank relies on customer deposits, advances from the FHLB, lines of credit at other financial institutions and brokered funds to fund our operations. Although the Bank has historically been able to replace maturing deposits and advances if desired, no assurance can be given that the Bank would be able to replace such funds in the future if our financial condition or the financial condition of the FHLB or market conditions were to change. Our financial flexibility will be severely constrained and/or our cost of funds will increase if we are unable to maintain our access to funding or if financing necessary to accommodate future growth is not available at favorable interest rates. Finally, if we are required to rely more heavily on more expensive funding sources to support future growth, our revenues may not increase proportionately to cover our costs. In that case, our profitability would be adversely affected.

 

We may need to raise additional capital in the future, and such capital may not be available when needed or at all.

 

The Company may need to raise additional capital in the future to provide it with sufficient capital resources and liquidity to meet our commitments and business needs including complying with new regulatory capital rules, particularly if its asset quality or earnings were to deteriorate significantly. Our ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at that time, which are outside of its control, and its financial condition. Economic conditions and the loss of confidence in financial institutions may limit access to certain customary sources of capital, and increase the Bank’s cost of raising capital. No assurance can be given that such capital will be available on acceptable terms or at all. Any occurrence that may limit our access to the capital markets, such as a decline in the confidence of depositors, investors or counterparties participating in the capital markets may adversely affect our capital costs and our ability to raise capital and, in turn, our liquidity. Moreover, if we need to raise capital in the future, we may have to do so when many other financial institutions are also seeking to raise capital and would have to compete with those institutions for investors. An inability to raise additional capital on acceptable terms as and when needed could have a materially adverse effect on our business, financial condition and results of operations.

 

The Bank’s lending activities subject the Bank to the risk of environmental liabilities.

 

A significant portion of the Bank’s loan portfolio is secured by real property. During the ordinary course of business, the Bank may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, the Bank may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require the Bank to incur substantial expenses and may materially reduce the affected property’s value or limit the Bank’s ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase the Bank’s exposure to environmental liability. Although the Bank has policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our financial condition and results of operations.

 

 

We may be subject to claims and the costs of defensive actions, and such claims and costs could materially and adversely impact our financial condition and results of operations.

 

Our customers may sue us for losses due to alleged breaches of fiduciary duties, errors and omissions of employees, officers and agents, incomplete documentation, our failure to comply with applicable laws and regulations, or many other reasons. Also, our employees may knowingly or unknowingly violate laws and regulations. Management may not be aware of any violations until after their occurrence. This lack of knowledge may not insulate us from liability. Claims and legal actions will result in legal expenses and could subject us to liabilities that may reduce our profitability and hurt our financial condition.

 

We may not be able to keep pace with developments in technology.

 

We use various technologies in conducting our businesses, including telecommunication, data processing, computers, automation, internet-based banking, mobile banking, and debit cards. Technology changes rapidly. Our ability to compete successfully with other financial institutions may depend on whether we can exploit technological changes. We may not be able to exploit technological changes, and any investment we do make may not make us more profitable.

 

Our information systems may experience an interruption or a breach in security, including due to cyber-attacks.

 

Our business depends heavily on the use of computer systems, the Internet and other means of electronic communication and recordkeeping. In the ordinary course of business, we collect and store sensitive data, including proprietary business information and personally identifiable information of our customers and employees in systems and on networks. Moreover, we use third party vendors to provide products and services necessary to conduct our day-to-day operations, which exposes us to the risk that these vendors will not perform in accordance with the service arrangements, including by failing to protect the confidential information we entrust to them. The secure processing, maintenance, and use of our and our customers’ information is critical to our operations and business strategy. Any failure, interruption, or breach in security or operational integrity of our communications or operations systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan, and other systems. Although we have invested in various technologies and continually review processes and practices that are designed to protect our networks, computers, and data from damage or unauthorized access, our computer systems and infrastructure, and those of our third-party vendors, may nevertheless be vulnerable to attacks by hackers or breached due to employee error, malfeasance, or other disruptions. Further, cyber-attacks can originate from a variety of sources and the techniques used are increasingly sophisticated. A breach of any kind could compromise our systems and those of our vendors, and the information stored there could be accessed, damaged, or disclosed. A breach in security or other failure could result in legal claims, regulatory penalties, disruptions in operations, increased expenses, loss of customers and business partners, and damage to our reputation, which could in turn adversely affect our business, financial condition and/or results of operations. Furthermore, as cyber threats continue to evolve and increase, we may be required to expend significant additional financial and operational resources to modify or enhance our protective measures, or to investigate and remediate any identified information security vulnerabilities.

 

We may not achieve the expected benefits from the Insurance Subsidiary.

 

We formed the Insurance Subsidiary as a captive insurance company in late 2016 to insure or reinsure certain risks faced by the Company and the Bank. The Insurance Subsidiary is part of our enterprise-wide, multi-year insurance strategy that is intended to better position our risk programs and provide us with increased flexibility in the management of our insurance programs as well as contribute to efficiencies relating to our insurance programs over time. We may experience unanticipated events that could reduce or eliminate the benefits, both operational and financial, that we hope to realize through this entity, including, without limitation, significant insurance claims and/or changes in tax laws. In particular, we may not realize the tax benefits of owning a captive insurance company, which are discussed in the section of Item 1 of this annual report entitled “Supervision and Regulation” under the heading “Laws Related to the Insurance Subsidiary”. Although we believe that we have structured the Insurance Subsidiary’s operations to achieve these benefits, no assurance can be given that our efforts were or will be successful. If we are unable to achieve these benefits, then we will likely suspend the operations of the Insurance Subsidiary.

 

It should be noted that the operation by financial holding companies of captive insurance companies having a structure similar to the Insurance Subsidiary and FCBI is a relatively new development. Moreover, we have very little experience operating a captive insurance company. If we are not able to successfully manage the Insurance Subsidiary, either due to our lack of experience or otherwise, then our financial condition and/or results of operations could be materially and adversely impacted.

 

 

We may be adversely affected by recent changes in tax laws.

 

The Tax Cuts and Jobs Act (the “Tax Act”), which was enacted in December 2017, is likely to have both positive and negative effects on our financial performance. Beginning in 2018, the Tax Act reduces the federal tax rate for corporations from 35% to 21%, but it also enacted limitations on certain deductions that will have an impact on the banking industry, borrowers and the market for single-family residential real estate. These limitations include (i) a lower limit on the deductibility of mortgage interest on single-family residential mortgage loans, (ii) the elimination of interest deductions for certain home equity loans, (iii) a limitation on the deductibility of business interest expense, and (iv) a limitation on the deductibility of property taxes and state and local income taxes. These limitations could have the effect of reducing consumer demand for loans secured by real estate, which could adversely impact our financial condition and results of operations. We continue to evaluate the Tax Act and its impact on us.

 

Our fiscal year 2016, 2017, and 2018 U.S. consolidated federal income tax returns are currently being audited.

 

In April 2018, we were notified by the IRS that our fiscal year 2016 U.S. consolidated federal tax return was selected for audit. As part of its audit, the IRS is reviewing the deductions related to, and the income generated by, the Insurance Subsidiary. Management cannot predict whether any of our tax positions, including those relating to the Insurance Subsidiary, will be challenged by the IRS or, if challenged, whether we will be successful in defending those tax positions. If we are not successful in defending a challenge, then we may be required to amend our tax return and pay additional taxes, interest, fines and/or penalties and our taxable earnings and/or the effective tax rate on our future earnings could increase substantially, any of which could have a material adverse effect on our business, financial condition and results of operations. See Note 14 to the consolidated financial statements presented elsewhere in this report for further information about this risk.

 

The loss of key personnel could disrupt our operations and result in reduced earnings.

 

Our growth and profitability will depend upon our ability to attract and retain skilled managerial, marketing and technical personnel. Competition for qualified personnel in the financial services industry is intense, and there can be no assurance that we will be successful in attracting and retaining such personnel. Our current executive officers provide valuable services based on their many years of experience and in-depth knowledge of the banking industry and the market areas we serve. Due to the intense competition for financial professionals, these key personnel would be difficult to replace and an unexpected loss of their services could result in a disruption to the continuity of operations and a possible reduction in earnings.

 

We are a community bank and our ability to maintain our reputation is critical to the success of our business.

 

We are a community banking institution, and our reputation is one of the most valuable components of our business. A key component of our business strategy is to rely on our reputation for customer service and knowledge of local markets to expand our presence by capturing new business opportunities from existing and prospective customers in our current market and contiguous areas. As such, we strive to conduct our business in a manner that enhances our reputation. This is done, in part, by recruiting, hiring and retaining employees who share our core values of being an integral part of the communities we serve, delivering superior service to our customers and caring about our customers and associates. If our reputation is negatively affected by the actions of our employees, by our inability to conduct our operations in a manner that is appealing to current or prospective customers, or otherwise, our business and, therefore, our operating results may be materially adversely affected.

 

Risks Relating to Ownership of Our Common Stock

 

Our ability to pay dividends on the common stock is limited by applicable law, and the payment of dividends is at the discretion of our board of directors.

 

The Bank had a history of paying dividends on its common stock prior to the Reorganization and the Company has continued paying semi-annual dividends since its incorporation in August 2016. Because the Company is not engaged in any direct business activities, the Company expects to fund dividends, if and when declared by the Company’s board of directors, using cash received from the Bank and the Insurance Subsidiary. No assurance can be given that the Bank or the Insurance Subsidiary will be able to pay dividends to the Company for these purposes at times and/or in amounts requested by the Company. Both federal and Maryland laws impose restrictions on the ability of the Bank to pay dividends, and Tennessee law imposes restrictions on the Insurance Subsidiary’s ability to pay dividends. Further information about these limitations is contained in Item 5 of Part II of this annual report under the heading, “Market Price Analysis and Dividends”.

 

Notwithstanding the foregoing, stockholders must understand that the declaration and payment of dividends and the amounts thereof are at the discretion of the Company’s board of directors. Thus, even at times when the Company could pay cash dividends on its common stock, neither the payment of such dividends nor the amounts thereof can be guaranteed.

 

 

The shares of common stock are not insured.

 

The shares of our common stock are not deposits and are not insured against loss by the FDIC or any other governmental or private agency.

 

Our common stock is not heavily traded, and the stock price may fluctuate significantly.

 

Our common stock is not traded on any exchange. Certain brokers currently make a market in the common stock by trading shares in the over-the-counter market, but such transactions are infrequent and the volume of shares traded is relatively small. Management cannot predict whether these or other brokers will continue to make a market in our common stock. Prices on stock that is not heavily traded, such as our common stock, can be more volatile than stock trading in an active public market. Factors such as our financial results, the introduction of new products and services by us or our competitors, publicity regarding the banking industry, and various other factors affecting the banking industry may have a significant impact on the market price of the shares of our common stock. Likewise, events that are unrelated to the Company but that affect the equity markets generally, such as international health crises, wars, political instability and similar factors, could also have a significant impact on the market price and trading volume of the shares of common stock. Management also cannot predict the extent to which an active public market for our common stock will develop or be sustained in the future. Accordingly, stockholders may not be able to sell their shares of our common stock at the volumes, prices, or times that they desire.

 

The Company’s Articles of Incorporation and Bylaws and Maryland law may discourage a corporate takeover.

 

The Company’s Articles of Incorporation (the “Charter”) and Bylaws contain certain provisions designed to enhance the ability of the Company’s board of directors to deal with attempts to acquire control of the Company. First, the board of directors is classified into four classes. Directors of each class serve for staggered four-year periods, and no director may be removed except for cause, and then only by the affirmative vote of a majority of the outstanding voting stock. Second, the board has the authority to classify and reclassify unissued shares of stock of any class or series of stock by setting, fixing, eliminating, or altering in any one or more respects the preferences, rights, voting powers, restrictions and qualifications of, dividends on, and redemption, conversion, exchange, and other rights of, such securities. The board could use this authority, along with its authority to authorize the issuance of securities of any class or series, to issue shares having terms favorable to management to a person or persons affiliated with or otherwise friendly to management. In addition, the Bylaws require any stockholder who desires to nominate a director to abide by strict notice requirements.

 

Maryland laws include provisions that could discourage a sale or takeover of the Company. The Maryland Business Combination Act generally prohibits, subject to certain limited exceptions, corporations from being involved in any “business combination” (defined as a variety of transactions, including a merger, consolidation, share exchange, asset transfer or issuance or reclassification of equity securities) with any “interested stockholder” for a period of five years following the most recent date on which the interested shareholder became an interested stockholder. An interested stockholder is defined generally as a person who is the beneficial owner of 10% or more of the voting power of the outstanding voting stock of the corporation after the date on which the corporation had 100 or more beneficial owners of its stock or who is an affiliate or associate of the corporation and was the beneficial owner, directly or indirectly, of 10% percent or more of the voting power of the then outstanding stock of the corporation at any time within the two-year period immediately prior to the date in question and after the date on which the corporation had 100 or more beneficial owners of its stock. The Maryland Control Share Acquisition Act applies to acquisitions of “control shares”, which, subject to certain exceptions, are shares the acquisition of which entitle the holder, directly or indirectly, to exercise or direct the exercise of the voting power of shares of stock of the corporation in the election of directors within any of the following ranges of voting power: one-tenth or more, but less than one-third of all voting power; one-third or more, but less than a majority of all voting power or a majority or more of all voting power. Control shares have limited voting rights. Maryland banking law provides that the Maryland Commissioner must approve certain acquisitions of the common stock of the Company or the Bank, and this law imposes a mandatory five-year voting prohibition on shares that are acquired without the required approval.

 

Although these provisions do not preclude a takeover, they may have the effect of discouraging, delaying or deferring a tender offer or takeover attempt that a shareholder might consider in his or her best interest, including those attempts that might result in a premium over the market price for the common stock. Such provisions will also render the removal of the Company’s board of directors and of management more difficult and, therefore, may serve to perpetuate current management. These provisions could potentially adversely affect the market prices of the Company’s securities.

 

ITEM 1B.

UNRESOLVED STAFF COMMENTS

 

This Item 1B is not applicable because the Company is a “smaller reporting company”.

 

 

ITEM 2.

PROPERTIES

 

The Bank owns properties at which it operates branches at the following locations:

 

Main Office	Owings Mills Branch	Eldersburg Branch
15226 Hanover Pike	9320 Lakeside Boulevard	1321 Liberty Road
Upperco, MD 21155	Owings Mills, MD 21117	Eldersburg, MD 21784
Reisterstown Branch	Westminster Branch
25 Westminster Pike	275 Clifton Boulevard
Reisterstown, MD 21136	Westminster, MD 21157

 

The Bank also owns the following property that was formerly a Carroll Community Bank location. The property is under contract to sell to a company co-owned by one of the Company’s directors.

 

1010 Baltimore Boulevard

Westminster, MD 21157

 

The Bank’s book value investment in land and buildings at December 31, 2020 totaled $7.7 million or 1% of total assets. Other than for banking purposes, the Bank does not invest in real estate. For future expansion purposes, the Bank owns two properties adjacent to its main office at 15216 and 15218 Hanover Pike, Upperco, Maryland 21155. The properties presently consist of two lots, each with a single family residence. One property is rented on a month-to-month lease. The other property has not been rented since 2011. The total rental income for both properties for 2020 was $10,200.

 

There are no encumbrances on any of these properties. Management believes that all of its properties are adequately insured. In 2020, the properties owned by the Bank in Baltimore County, MD were subject to state and county real estate taxes at a combined rate of 1.24% and the property owned by the Bank in Carroll County, MD was subject to state, county and municipal real estate taxes at combined rate of 1.68%. The Bank expensed $79,039 in real estate taxes on these properties in 2020.

 

The Bank operates under leases at the following properties:

 

Location		Square Feet				Current Annual Rent			Lease Expiration
Greenmount In-Store Branch 2205 Hanover Pike Hampstead, MD 21074			709			$	54,544		1/31/2023 with option to renew for one consecutive five-year term
Hampstead Branch 735 Hanover Pike Hampstead, MD 21074 (Land lease)			22,000			$	53,200		9/30/2024 with option to renew for five consecutive five-year terms
Corporate Offices 4510 Lower Beckleysville Road Suite H Hampstead, MD 20174			4,171			$	45,356		6/17/2025, with option to renew for three consecutive five-year terms
Carroll Lutheran Village Branch 300 St. Luke Circle Westminster, MD 21158			1,024			$	12,000		5/15/2023, with option to renew for two consecutive five-year terms

 

Note 7 and Note 9 to the consolidated financial statements included elsewhere in this annual report contain additional information about the Bank’s premises and equipment.

 

 

ITEM 3.

LEGAL PROCEEDINGS

 

We are at times, in the ordinary course of business, subject to legal actions. Management, upon the advice of counsel, believes that losses, if any, resulting from current legal actions will not have a material adverse effect on our financial condition or results of operations

 

ITEM 4.

MINE SAFETY DISCLOSURES

 

Not applicable.

 

PART II

 

ITEM 5.

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

Market Price Analysis and Dividends

 

As of February 26, 2021, the shares of the Company’s common stock were held by approximately 468 stockholders of record. Although many trades occur through privately-negotiated transactions, the shares of the Company’s common stock are traded in the over-the-counter market by certain broker-dealers and price quotations are available through the OTC Markets Group’s OTC Pink Market (the “Pink Market”) under the symbol “FMFG”. Price quotations reported through the Pink Market do not include retail mark-ups, markdowns or commissions, and may not necessarily represent actual transactions.

 

The Company’s ability to declare and pay dividends is limited by applicable laws. Subject to these laws, the payment of dividends is at the discretion of the Company’s board of directors, who considers such factors as operating results, financial condition, capital adequacy, regulatory requirements, and stockholder return. Maryland corporation laws prohibit the Company from paying dividends on our capital stock, including the common stock, unless, after giving effect to a proposed dividend, (i) we will be able to pay our debts as they come due in the normal course of business and (ii) our total assets will be greater than our total liabilities plus, unless our Charter permits otherwise, the amount that would be needed, if we were to be dissolved at the time of the dividend, to satisfy the preferential rights upon dissolution of shareholders whose preferential rights on dissolution are superior to those receiving the dividend. Notwithstanding our inability to pay dividends pursuant to item (ii) above, we may nevertheless pay dividends out of (a) our net earnings for the fiscal year in which the distribution is made, (b) our net earnings for the preceding fiscal year, or (c) the sum of our net earnings for the preceding eight fiscal quarters.

 

The Company’s ability to pay dividends will be largely dependent on its receipt of dividends from the Bank and/or the Insurance Subsidiary. Like the Company, the Bank’s ability to declare and pay dividends is subject to limitations imposed by federal and Maryland banking and Maryland corporation laws, and the Insurance Subsidiary’s ability to declare and pay dividends is subject to limitations imposed by Tennessee insurance laws.

 

Federal law prohibits the payment of a dividend by an insured depository institution if the depository institution is considered “undercapitalized” or if the payment of the dividend would make the institution “undercapitalized”. Maryland state-chartered banks may pay dividends only out of undivided profits or, with the prior approval of the Maryland Commissioner, from surplus in excess of 100% of required capital stock. If, however, the surplus of a Maryland bank is less than 100% of its required capital stock, then cash dividends may not be paid in excess of 90% of net earnings. In addition to these specific restrictions, bank regulatory agencies have the ability to prohibit a proposed dividend by a financial institution that would otherwise be permitted under applicable law if the regulatory body determines that the payment of the dividend would constitute an unsafe or unsound banking practice. A bank that is considered to be a “troubled institution” is prohibited by federal law from paying dividends altogether.

 

Under Tennessee insurance law, the Insurance Subsidiary must maintain a minimum level of unimpaired paid-in capital and surplus, and it is prohibited from paying a dividend out of, or other distribution with respect to, capital or surplus without the prior approval of the Tennessee Insurance Department.

 

Equity Compensation Plan Information

 

Pursuant to the SEC’s Regulation S-K Compliance and Disclosure Interpretation 106.01, the information regarding the Corporation’s equity compensation plans required by this Item pursuant to Item 201(d) of Regulation S-K is located in Item 12 of Part III of this annual report and is incorporated herein by reference.

 

 

ITEM 6.

SELECTED FINANCIAL DATA

 

		2020				2019				2018				2017				2016
OPERATING DATA
Interest income		$	20,763,180			$	18,702,338			$	17,768,333			$	16,594,803			$	15,351,497
Interest expense			3,458,677				3,679,953				2,507,241				1,707,240				1,346,120
Net interest income			17,304,503				15,022,385				15,261,092				14,887,563				14,005,377
Provision for loan losses			625,000				40,000				475,000				410,000				-
Net interest income after provision for loan losses			16,679,503				14,982,385				14,786,092				14,477,563				14,005,377
Noninterest income			2,072,119				1,493,567				1,365,273				1,337,094				1,465,197
Acquisition costs			3,236,817				-				-				-				-
Noninterest expense			12,345,591				10,875,814				10,332,480				10,023,102				9,534,625
Income before income taxes			3,169,214				5,600,138				5,818,885				5,791,555				5,935,949
Income taxes			487,211				1,039,334				1,106,209				2,002,314				2,026,820
Net income		$	2,682,003			$	4,560,804			$	4,712,676			$	3,789,241			$	3,909,129
PER SHARE DATA
Net income (Basic)		$	0.90			$	1.54			$	1.61			$	1.30			$	1.35
Dividends		$	0.52			$	0.51			$	0.47			$	0.43			$	0.40
Book value		$	17.18			$	16.63			$	15.41			$	14.32			$	13.46
KEY RATIOS
Return on average assets			0.51	%			1.06	%			1.14	%			0.96	%			1.08	%
Return on average equity			5.22	%			9.52	%			10.77	%			9.26	%			10.26	%
Net yield on interest-earning assets			3.67	%			3.67	%			3.88	%			3.96	%			4.13	%
Efficiency ratio			80.42	%			65.85	%			62.15	%			61.78	%			61.63	%
Average equity to average assets			9.05	%			11.10	%			10.60	%			10.32	%			10.56	%
Dividend payout ratio			57.78	%			33.12	%			29.19	%			33.08	%			29.63	%
AT PERIOD END
Total assets		$	677,317,082			$	442,215,098			$	417,157,877			$	402,904,469			$	379,831,359
Gross loans			524,987,052				362,494,703				343,940,842				332,861,406				296,171,072
Cash and cash equivalents			40,975,670				9,121,352				14,618,237				7,237,385				13,312,915
Securities			77,555,805				56,041,792				44,719,058				46,637,573				52,373,567
Deposits			573,401,547				376,613,314				354,713,003				319,796,424				302,715,136
Borrowings			42,227,252				10,958,118				14,012,000				38,768,507				36,226,159
Stockholders' equity			51,729,483				49,453,516				45,394,707				41,798,932				39,012,277
SELECTED AVERAGE BALANCES
Total assets		$	526,539,417			$	431,595,287			$	412,586,954			$	396,454,271			$	361,005,005
Gross loans			421,010,433				344,793,736				343,573,784				316,724,821				281,709,043
Cash and cash equivalents			21,272,187				20,124,328				12,054,442				12,428,778				13,271,319
Securities			65,583,845				53,049,768				44,471,457				51,508,146				50,876,488
Deposits			369,504,859				367,570,825				339,624,630				315,159,559				284,921,811
Borrowings			18,638,621				11,975,017				26,524,352				38,627,588				36,175,989
Stockholders' equity			51,344,333				47,927,778				43,748,434				40,926,674				38,115,746
ASSET QUALITY
Nonperforming assets		$	6,048,577			$	-			$	1,209,468			$	2,657,702			$	1,166,889
Nonperforming assets/total assets			0.89	%			0.00	%			0.29	%			0.66	%			0.31	%
Allowance for loan losses/total loans			0.63	%			0.72	%			0.73	%			0.73	%			0.79	%

 

 

Farmers and Merchants Bancshares, Inc.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

ITEM 7:

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

 

The following discussion and analysis should be read in conjunction with the consolidated financial statements and notes thereto for the years ended December 31, 2020 and 2019, which are presented elsewhere in this annual report.

 

The Company was incorporated on August 8, 2016 for the purpose of becoming the bank holding company of the Bank in a share exchange transaction that was intended to constitute a tax-free exchange under Section 351 of the IRC. This reorganization was consummated on November 1, 2016, at which time the Bank became a wholly-owned subsidiary of the Company and all of the Bank’s stockholders became stockholders of the Company by virtue of the conversion of their shares of common stock of the Bank into an equal number of shares of common stock of the Company. Although we use the terms “Company”, “we”, “us”, and “our” in this section of the annual report, the discussion and analysis with respect to periods ending prior to November 1, 2016 relate to the operations of the Bank and its consolidated subsidiaries, and the discussion and analysis with respect to periods ending on and after November 1, 2016 relate to the operations of the Company and its consolidated subsidiaries, including the Bank.

 

APPLICATION OF CRITICAL ACCOUNTING POLICIES

 

The consolidated financial statements of the Company are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and follow general practices within the industry in which the Company operates. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the consolidated financial statements; accordingly, as this information changes, the consolidated financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported.

 

The most significant accounting policies followed by the Company are presented in Note 1 to the consolidated financial statements presented elsewhere in the annual report. These policies, along with the disclosures presented in the other financial statement notes and in this financial review, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for loan losses as the accounting area that requires the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available.

 

The allowance for loan losses represents management’s estimate of probable loan losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the balance sheet. Note 1 to the consolidated financial statements describes the methodology used to determine the allowance for loan losses.

 

 

Management applies various valuation methodologies to assets and liabilities which often involve a significant degree of judgment, particularly when liquid markets do not exist for the particular items being valued. Quoted market prices are referred to when estimating fair values for certain assets, such as most investment securities. However, for those items for which an observable liquid market does not exist, management utilizes significant estimates and assumptions to value such items. Examples of these items include loans, deposits, borrowings, goodwill, core deposit and other intangible assets, other assets and liabilities obtained or assumed in business combinations. These valuations require the use of various assumptions, including, among others, discount rates, rates of return on assets, repayment rates, cash flows, default rates, and liquidation values. The use of different assumptions could produce significantly different results, which could have material positive or negative effects on our results of operations, financial condition or disclosures of fair value information. In addition to valuation, we must assess whether there are any declines in value below the carrying value of assets that should be considered other than temporary or otherwise require an adjustment in carrying value and recognition of a loss in the consolidated statements of income. Examples include investment securities, goodwill and core deposit intangible, among others.

 

COVID-19 PANDEMIC

 

The COVID-19 pandemic has been wreaking havoc on the U.S. economy since the World Health Organization declared it a pandemic on March 11, 2020. The full impact and its effect on the banking industry, including the Company, will not be known for several quarters, but will be significant.

 

The U.S. and state governments reacted to the outbreak of the pandemic by issuing shelter-at-home orders and requiring that non-essential businesses be closed to prevent spread of the virus. The health crisis quickly turned into a financial crisis resulting in guidance and mandates regarding foreclosures and repossessions and accounting and regulatory changes designed to encourage banks to work with customers suffering detrimental financial impact.

 

Although states, including Maryland, have eased several of the COVID-19 restrictions, including stay-at-home orders and the required closure of non-essential businesses, there appears to be a resurgence of COVID-19 cases in many states, including Maryland. As a result, it is possible that states, including Maryland, will re-implement some or all of the COVID-19 related restrictions and again require some or all non-essential businesses to close or drastically alter their business operations, which could have a material adverse impact on our customers and, thus, our financial condition and results of operations.

 

PAYCHECK PROTECTION PROGRAM

 

The U.S. Government’s Coronavirus Aid, Relief, and Economic Security Act, as amended (the “CARES Act”) established the Small Business Administration (“SBA”) Paycheck Protection Program (“PPP”), which provides small businesses with resources to maintain payroll, hire back employees who may have been laid off, and to cover applicable overhead expenses. Following the enactment of the CARES Act and the establishment of the PPP, we acted expeditiously to prepare our associates so they could guide our customers on the proper procedures necessary to enable them to take advantage of this program. We developed a PPP specific information site within our website that provided detailed information, links and materials for eligible customers to access. Internally, we reallocated resources to review, process and data enter customer applications, working tirelessly over extended hours to provide access to as many local business owners as possible. We were able to fund 172 loan applications for approximately $25.3 million from the first tranche of PPP designated funds. Congress allocated additional funding to the PPP on April 23, 2020, and we were able to gain approval for an additional 101 loan applications for approximately $5.8 million through December 31, 2020. During 2020, we gained approval for over $31 million to 273 small businesses. Approximately 70% of the loans were under $100,000 in size. All PPP loans are 100% guaranteed by the SBA, have up to a five-year maturity (the majority of our PPP originations have a two-year maturity), provide for a six-month deferral period, and have an interest rate of 1%. These loans may be forgiven by the SBA if the borrower meets certain conditions, including by using at least 75% of the loan proceeds for payroll costs. The SBA also established processing fees from 1% to 5%, depending on the loan amount. During 2020, we received $1,285,719 in fees which, net of related origination costs, will be amortized into interest income over the life of the loans. On December 27, 2020, Congress allocated additional funding to the PPP. Through February 24, 2021, we have gained approval for 121 loans applications for approximately $18.4 million from the third tranche of PPP designated funds.

 

 

In April 2020, the Bank established eligibility to participate in the Paycheck Protection Program Liquidity Facility (“PPPLF”), which was established by Congress and administered by the Federal Reserve Bank. This facility uses the SBA guaranteed PPP loans as collateral, offering 100% collateral coverage with no recourse to the Bank. The majority of the PPP loan disbursements were to internal, non-interest-bearing accounts for use by borrowers. As a result, we have not yet accessed the PPPLF, but are prepared to utilize the fund when management determines the timing is appropriate.

 

FINANCIAL CONDITION

 

Effective on October 1, 2020, the Company consummated its previously-announced acquisition of Carroll Bancorp, Inc. and its wholly-owned subsidiary, Carroll Community Bank (collectively, “Carroll”) in a series of merger transactions (the “Merger”) pursuant to which the stockholders of Carroll Bancorp, Inc. received cash in the aggregate amount of $24.8 million in exchange for their shares of common stock of Carroll Bancorp, Inc. The merger consideration was paid by the Company using $7.8 million in cash and $17 million in proceeds from a third-party term loan obtained in connection with the Merger. At the Effective Time of the Merger, Carroll had total assets of $176,159,890, net loans of $145,153,100, and total liabilities of $157,992,286, of which $144,896,990 represented deposits. The Merger was accounted for as a business combination using the acquisition method of accounting, and, accordingly, assets acquired and liabilities assumed were recorded at estimated fair values at the effective time of the Merger.

 

The following table presents the book values and fair values of the assets, liabilities, and equity of Carroll at the effective time of the Merger:

 

		Book value				Fair value
Cash		$	5,441,610			$	5,441,610
Certificates of deposit in other banks			750,000				750,000
Securities available for sale			12,863,795				12,922,620
Restricted stock, at cost			926,700				926,700
Loans held for sale			1,702,950				1,743,195
Loans			145,153,100				145,080,950
Premises and equipment			2,619,413				2,684,240
Other real estate owned			1,411,605				1,411,605
Other assets			5,290,717				5,388,546
Goodwill and other intangibles			-				7,061,490
Total assets		$	176,159,890			$	183,410,956
Deposits		$	144,896,990			$	145,513,085
FHLB advances			13,000,000				13,000,000
Other liabilities			95,296				90,143
Total liabilities			157,992,286				158,603,228
Stockholders' equity			18,167,604				24,807,728
Total liabilities and stockholders' equity		$	176,159,890			$	183,410,956

 

 

Total assets were $667,317,082 at December 31, 2020, an increase of $235,101,984, or 53.2%, over the $442,215,098 recorded at December 31, 2019. The increase was due primarily to an increase of $162,307,671 in loans, and increase of $31,854,318 in cash and cash equivalents, and an increase of $21,514,013 in securities available for sale and held for maturity. A significant portion of these increases was due to the Merger and the origination of the PPP loans.

 

 

Total liabilities were $625,587,599 at December 31, 2020, an increase of $232,826.017, or 59.3%, over the $392,761,582 recorded at December 31, 2019. The increase was due primarily to an increase of $196,788,233 in deposits, an increase of $13,795,854 of securities sold under repurchase agreements, and an increase of $16,973,280 in long-term debt. The increase in deposits was comprised of a $42,496,098 increase in noninterest-bearing accounts and a $154,292,135 increase in interest-bearing accounts. A significant portion of the increases in deposits was due to the Merger and the deposits generated from the PPP loans.

 

Stockholders’ equity was $51,729,483 at December 31, 2020 compared to $49,453,516 at December 31, 2019, an increase of $2,275,967. The increase was due primarily to net income for 2020 of $2,682,003 and an increase in the after-tax unrealized gain on available for sale securities of $663,653, offset by dividends paid, net of reinvestments, of $1,069,689.

 

Loans

 

Major categories of loans at December 31, 2020, 2019, 2018, 2017, and 2016, are as follows:

 

		2020								2019								2018								2017								2016
Real estate:
Commercial		$	274,501,327				52	%		$	240,938,149				67	%		$	238,834,149				70	%		$	234,026,574				70	%		$	206,145,076				69	%
Construction/Land development			33,641,916				6	%			18,194,955				5	%			18,265,505				5	%			18,160,366				5	%			14,392,992				5	%
Residential			156,111,245				30	%			76,122,069				21	%			63,024,106				18	%			59,241,416				18	%			54,710,809				18	%
Commercial			61,368,105				12	%			26,947,503				7	%			23,323,073				7	%			23,613,543				7	%			22,152,773				8	%
Consumer			288,454				0	%			292,027				0	%			494,009				0	%			554,017				0	%			725,269				0	%
			525,911,047				100	%			362,494,703				100	%			343,940,842				100	%			335,595,916				100	%			298,126,919				100	%
Less: Allowance for loan losses			3,296,538								2,593,715								2,509,334								2,458,911								2,363,086
Deferred origination fees net of costs			923,995								518,145								530,873								603,299								477,261
		$	521,690,514							$	359,382,843							$	340,900,635							$	332,533,706							$	295,286,572

 

The Company had no foreign loans for any of the years presented.

 

Loans increased by $162,307,671, or 45.2%, to $521,690,514 at December 31, 2020 from $359,382,843 at December 31, 2019. The growth was due primarily to increases in commercial real estate loans of $33,563,178, commercial loans of $34,420,602, residential real estate loans of $79,989,176, and construction/land development loans of $15,446,961. The allowance for loan losses increased $702,823 to $3,296,538 at December 31, 2020 as compared to $2,593,715 at December 31, 2019.

 

Commercial loans in the table above include $32,071,443 of Paycheck Protection Program (“PPP”) loans at December 31, 2020, which are 100% guaranteed by the Small Business Administration (“SBA”). A substantial portion of the PPP loans in the Company’s portfolio at December 31, 2020 are expected to be forgiven by the SBA. During the year-ended December 31, 2020, the Company collected approximately $1,286,000 in fees from the SBA in connection with the originations of the PPP loans. The fees, net of related origination costs, are being recognized as interest income over the term of the loans using the straight-line method, with accelerated recognition when the loan pays off before maturity through SBA forgiveness or by other means.

 

 

The Company has adopted policies and procedures that seek to mitigate credit risk and to maintain the quality of the loan portfolio. These policies include underwriting standards for new credits as well as the continuous monitoring and reporting of asset quality and the adequacy of the allowance for loan losses. These policies, coupled with continuous training efforts, have provided effective checks and balances for the risk associated with the lending process. Lending authority is based on the level of risk, size of the loan, and the experience of the lending officer. The Company’s policy is to make the majority of its loan commitments in the market area it serves. Management believes that this tends to reduce risk because management is familiar with the credit histories of loan applicants and has in-depth knowledge of the risk to which a given credit is subject. Although the loan portfolio is diversified, its performance will be influenced by the economy of the region.

 

An age analysis of past due loans, segregated by class of loans, as of year-end, is as follows:

 

										90 Days																Past Due 90
		30 - 59 Days				60 - 89 Days				or more				Total								Total				Days or More
		Past Due				Past Due				Past Due				Past Due				Current				Loans				and Accruing
2020
Real estate:
Commercial		$	182,656			$	-			$	-			$	182,656			$	274,318,671			$	274,501,327			$	-
Construction/Land development			-				-				-				-				33,641,916				33,641,916				-
Residential			24,591				-				220,967				245,558				155,865,687				156,111,245				-
Commercial			-				-				-				-				61,368,105				61,368,105				-
Consumer			-				-				-				-				288,454				288,454				-
Total		$	207,247			$	-			$	220,967			$	428,214			$	525,482,833			$	525,911,047			$	-

 

										90 Days																Past Due 90
		30 - 59 Days				60 - 89 Days				or more				Total								Total				Days or More
		Past Due				Past Due				Past Due				Past Due				Current				Loans				and Accruing
2019
Real estate:
Commercial		$	224,794			$	-			$	-			$	224,794			$	240,713,355			$	240,938,149			$	-
Construction/Land development			-				-				-				-				18,194,955				18,194,955				-
Residential			59,892				-				-				59,892				76,062,177				76,122,069				-
Commercial			-				-				-				-				26,947,503				26,947,503				-
Consumer			-				-				-				-				292,027				292,027				-
Total		$	284,686			$	-			$	-			$	284,686			$	362,210,017			$	362,494,703			$	-

 

										90 Days																Past Due 90
		30 - 59 Days				60 - 89 Days				or more				Total								Total				Days or More
		Past Due				Past Due				Past Due				Past Due				Current				Loans				and Accruing
2018
Real estate:
Commercial		$	-			$	-			$	988,811			$	988,811			$	237,845,338			$	238,834,149			$	-
Construction/Land development			-				-				-				-				18,265,505				18,265,505				-
Residential			-				-				10,507				10,507				63,013,599				63,024,106				10,507
Commercial			-				25,000				-				25,000				23,298,073				23,323,073				-
Consumer			-				-				-				-				494,009				494,009				-
Total		$	-			$	25,000			$	999,318			$	1,024,318			$	342,916,524			$	343,940,842			$	10,507

 

 

										90 Days																Past Due 90
		30 - 59 Days				60 - 89 Days				or more				Total								Total				Days or More
		Past Due				Past Due				Past Due				Past Due				Current				Loans				and Accruing
2017
Real estate:
Commercial		$	-			$	-			$	2,245,743			$	2,245,743			$	231,780,831			$	234,026,574			$	-
Construction/Land development			-				-				-				-				18,160,366				18,160,366				-
Residential			-				-				146,459				146,459				59,094,957				59,241,416				146,459
Commercial			-				-				-				-				23,613,543				23,613,543				-
Consumer			-				-				-				-				554,017				554,017				-
Total		$	-			$	-			$	2,392,202			$	2,392,202			$	333,203,714			$	335,595,916			$	146,459

 

										90 Days																Past Due 90
		30 - 59 Days				60 - 89 Days				or more				Total								Total				Days or More
		Past Due				Past Due				Past Due				Past Due				Current				Loans				and Accruing
2016
Real estate:
Commercial		$	-			$	-			$	-			$	-			$	206,145,076			$	206,145,076			$	-
Construction/Land development			-				-				752,889				752,889				13,640,103				14,392,992				-
Residential			824,554				-				-				824,554				53,886,255				54,710,809				-
Commercial			48,719				-				-				48,719				22,104,054				22,152,773				-
Consumer			-				-				-				-				725,269				725,269				-
Total		$	873,273			$	-			$	752,889			$	1,626,162			$	296,500,757			$	298,126,919			$	-

 

It is the Company’s policy to place a loan in nonaccrual status when any portion of the principal or interest is 90 days past due unless there are mitigating factors. Management closely monitors nonaccrual loans. The Company returns a nonaccrual loan to accruing status when (i) the loan is brought current with the full payment of all principal and interest arrearages, (ii) all contractual payments are thereafter made on a timely basis for at least six months, and (iii) management determines, based on a credit review, that it is reasonable to expect that future payments will be made as and when required by the contract.

 

Year-end non-accrual loans, segregated by class of loans, were as follows:

 

		2020				2019				2018				2017				2016
Non-accrual loans
Commercial real estate		$	4,407,829			$	-			$	988,811			$	2,245,743			$	-
Construction/Land development			-				-				-				-				752,889
Residential real estate			220,967				-				-				-				-
Total non-accrual loans		$	4,628,796			$	-			$	988,811			$	2,245,743			$	752,889

 

 

At December 31, 2020, the Company had one nonaccrual commercial real estate loan totaling $4,407,829 and two nonaccrual residential real estate loans totaling $220,967. The loans were secured by real estate, business assets and a personal guaranty. Gross interest income of $13,395 would have been recorded in 2020 if these nonaccrual loans had been current and performing in accordance with the original terms. The Company allocated $0 of its allowance for loan losses to these nonaccrual loans. The balance of the nonaccrual loans was net of charge-offs and a nonaccretable discount totaling $8,176 at December 31, 2020.

 

 

At December 31, 2019, the Company had no nonaccrual loans.

 

At December 31, 2020, the Company had no loans that were delinquent 90 days or greater other than the nonaccrual loans listed above. At December 31, 2019, the Company had no loans that were delinquent 90 days or greater.

 

Year-end impaired loans are set forth in the following table:

 

		2020				2019				2018				2017				2016
Impaired loans no valuation allowance		$	6,875,374			$	2,135,045			$	3,177,381			$	2,937,439			$	2,348,275
Impaired loans with a valuation allowance			2,313,161				-				-				2,245,743				994,469
Total impaired loans		$	9,188,535			$	2,135,045			$	3,177,381			$	5,183,182			$	3,342,744
Valuation allowance related to impaired loans		$	-			$	-			$	-			$	127,213			$	24,167

 

Impaired loans include certain loans that have been modified in troubled debt restructurings (“TDRs”) where economic concessions have been granted to borrowers who have experienced or are expected to experience financial difficulties. These concessions typically result from the Company’s loss mitigation activities and could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance, or other actions. Certain TDRs are classified as nonperforming at the time of restructure and may only be returned to performing status after considering the borrower’s sustained repayment performance for a reasonable period, generally six months.

 

At December 31, 2020, the Company had two commercial real estate loans totaling $2,252,316 and one residential loan totaling $44,733 classified as TDRs. One of the commercial real estate loans with a principal balance of $182,656 was restructured as a TDR during 2020. All three loans are included in impaired loans above. Each loan is paying as agreed. There have been no charge-offs or allowances associated with these three loans.

 

At December 31, 2019, the Company had one commercial real estate loan totaling $2,084,988 and one residential loan totaling $50,057 classified as TDRs. Both are included in impaired loans above. Each loan is paying as agreed. There have been no charge-offs or allowances associated with these two loans.

 

Year-end TDRs are set forth in the following table:

 

		2020				2019				2018				2017				2016
Restructured loans (TDRs):
Performing as agreed		$	2,297,049			$	2,135,045			$	2,188,570			$	2,937,439			$	2,348,275
Not performing as agreed			-				-				-				-				241,580
Total TDRs		$	2,297,049			$	2,135,045			$	2,188,570			$	2,937,439			$	2,589,855

 

 

Section 4013 of the U.S. Government’s Coronavirus Aid, Relief, and Economic Security Act allows financial institutions to suspend application of certain current TDR accounting guidance under ASC 310-40 for loan modifications related to the COVID-19 pandemic made between March 1, 2020 and the earlier of December 31, 2020 or 60 days after the end of the COVID-19 national emergency, provided certain criteria are met. This relief can be applied to loan modifications for borrowers that were not more than 30 days past due as of December 31, 2019 and to loan modifications that defer or delay the payment of principal or interest, or change the interest rate on the loan. In April 2020, federal and state banking regulators issued the Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus to provide further interpretation of when a borrower is experiencing financial difficulty, specifically indicating that if the modification is either short-term (e.g., six months) or mandated by a federal or state government in response to the COVID-19 pandemic, the borrower is not experiencing financial difficulty under Accounting Standards Codification (“ASC”) 310-40. The Company continues to prudently work with borrowers who have been negatively impacted by the COVID-19 pandemic while managing credit risks and recognizing appropriate allowance for loan losses on its loan portfolio. During the second quarter of 2020, the Company modified loans, due to the pandemic and at the borrower’s request, with an aggregate principal balance of $109.2 million, or 30% of its loan portfolio. During the third quarter of 2020, $21.8 million of these previously-deferred loans were granted additional three-month deferrals, which amount represented 6% of the Company’s loan portfolio. At December 31, 2020, five of these previously-deferred loans along with two loans acquired in the Merger totaling $14.7 million in the aggregate, or 3% of the portfolio, had been granted additional payment deferrals. None of these loans were classified as TDRs as of December 31, 2020 because they met the criteria discussed above.

 

As part of our portfolio risk management, the Company assigns a risk grade to each loan. The factors used to determine the grade are the payment history of the loan and the borrower, the value of the collateral and net worth of any guarantor, and cash flow projections of the borrower. Special mention, Substandard, and Doubtful grades are assigned to loans with a higher frequency of delinquent payments and/or the collateral and/or cash flow are insufficient to support the loan and such loans are included on the Company’s watch list. The Special mention grade is intended to be a temporary grade.

 

Year-end loans graded special mention, substandard and doubtful are set forth in the following table:

 

		2020				2019				2018				2017				2016
Special mention		$	5,951,177			$	-			$	-			$	5,391,589			$	8,962,940
Substandard			13,732,062				11,399,425				11,448,021				4,625,568				6,399,618
Doubtful			11,265				19,192				78,467				2,274,162				29,742
Total		$	19,694,504			$	11,418,617			$	11,526,488			$	12,291,319			$	15,392,300

 

The allowance for loan losses is a reserve established through a provision for loan losses and is charged to expense.  The allowance for loan losses represents an amount which, in management’s judgment, will be adequate to absorb probable losses on existing loans and other extensions of credit that may become uncollectible. The Company's allowance for loan loss methodology includes allowance allocations calculated in accordance with ASC Topic 310, "Receivables" and allowance allocations calculated in accordance with ASC Topic 450, "Contingencies." Accordingly, the 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 the allowance for loan losses is designed to account for credit deterioration as it occurs. The provision for loan losses reflects loan quality trends, including the levels of and trends related to non-accrual loans, past due loans, potential problem loans, classified and criticized loans and net charge-offs or recoveries, among other factors.

 

Although management believes, based on currently available information, that the Company’s allowance for loan losses is sufficient to cover losses inherent in its loan portfolio at this time, no assurances can be given that the Company’s level of allowance for loan losses will be sufficient to cover future loan losses incurred by the Company or that future adjustments to the allowance for loan losses will not be necessary if economic or other conditions differ substantially from the economic and other conditions at the time management determined the current level of the allowance for loan losses.

 

 

The following tables detail activity in the allowance for loan losses by portfolio for the years ended December 31, 2020, 2019, 2018, 2017, and 2016. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories.

 

																						Allowance for loan losses								Outstanding loan
						Provision																ending balance evaluated								balances evaluated
		Beginning				for loan				Charge								Ending				for impairment:								for impairment:
December 31, 2020		balance				losses				offs				Recoveries				balance				Individually				Collectively				Individually				Collectively
Real estate:
Commercial		$	1,763,861			$	418,806			$	-			$	47,462			$	2,230,129			$	-			$	2,230,129			$	6,811,698			$	267,689,629
Construction and land development			192,828				(5,536	)			-				14,400				201,692				-				201,692				1,566,174				32,075,742
Residential			478,124				166,515				-				-				644,639				-				644,639				810,633				155,300,582
Commercial			107,782				(12,353	)			-				15,961				111,390				-				111,390				-				61,368,105
Consumer			4,133				(1,995	)			-				-				2,138				-				2,138				-				288,454
Unallocated			46,987				59,563				-				-				106,550				-				106,550				-				-
		$	2,593,715			$	625,000			$	-			$	77,823			$	3,296,538			$	-			$	3,296,538			$	9,188,505			$	516,722,512

 

																						Allowance for loan losses								Outstanding loan
						Provision																ending balance evaluated								balances evaluated
		Beginning				for loan				Charge								Ending				for impairment:								for impairment:
December 31, 2019		balance				losses				offs				Recoveries				balance				Individually				Collectively				Individually				Collectively
Real estate:
Commercial		$	1,754,372			$	(11,700	)		$	-			$	21,189			$	1,763,861			$	-			$	1,763,861			$	2,084,988			$	238,853,161
Construction and land development			196,374				(17,571	)			-				14,025				192,828				-				192,828				-				18,194,955
Residential			401,626				76,498				-				-				478,124				-				478,124				50,057				76,072,012
Commercial			102,610				(3,995	)			-				9,167				107,782				-				107,782				-				26,947,503
Consumer			10,428				(6,295	)			-				-				4,133				-				4,133				-				292,027
Unallocated			43,924				3,063				-				-				46,987				-				46,987				-				-
		$	2,509,334			$	40,000			$	-			$	44,381			$	2,593,715			$	-			$	2,593,715			$	2,135,045			$	360,359,658

 

																						Allowance for loan losses								Outstanding loan
						Provision																ending balance evaluated								balances evaluated
		Beginning				for loan				Charge								Ending				for impairment:								for impairment:
December 31, 2018		balance				losses				offs				Recoveries				balance				Individually				Collectively				Individually				Collectively
Real estate:
Commercial		$	1,867,397			$	372,315			$	(690,000	)		$	204,660			$	1,754,372			$	-			$	1,754,372			$	3,177,381			$	235,656,768
Construction and land development			223,274				(78,496	)			(12,115	)			63,711				196,374				-				196,374				-				18,265,505
Residential			247,953				153,673				-				-				401,626				-				401,626				-				63,024,106
Commercial			87,353				6,090				-				9,167				102,610				-				102,610				-				23,323,073
Consumer			7,027				3,401				-				-				10,428				-				10,428				-				494,009
Unallocated			25,907				18,017				-				-				43,924				-				43,924				-				-
		$	2,458,911			$	475,000			$	(702,115	)		$	277,538			$	2,509,334			$	-			$	2,509,334			$	3,177,381			$	340,763,461

 

 

																						Allowance for loan losses								Outstanding loan
						Provision																ending balance evaluated								balances evaluated
		Beginning				for loan				Charge								Ending				for impairment:								for impairment:
December 31, 2017		balance				losses				offs				Recoveries				balance				Individually				Collectively				Individually				Collectively
Real estate:
Commercial		$	1,717,749			$	419,868			$	(275,000	)		$	4,780			$	1,867,397			$	127,213			$	1,740,184			$	5,183,182			$	228,843,392
Construction and land development			204,860				65,850				(47,436	)			-				223,274				-				223,274				-				18,160,366
Residential			247,437				368				-				148				247,953				-				247,953				-				59,241,416
Commercial			125,260				(41,240	)			-				3,333				87,353				-				87,353				-				23,613,543
Consumer			8,826				(1,799	)			-				-				7,027				-				7,027				-				554,017
Unallocated			58,954				(33,047	)			-				-				25,907				-				25,907				-				-
		$	2,363,086			$	410,000			$	(322,436	)		$	8,261			$	2,458,911			$	127,213			$	2,331,698			$	5,183,182			$	330,412,734

 

																						Allowance for loan losses								Outstanding loan
						Provision																ending balance evaluated								balances evaluated
		Beginning				for loan				Charge								Ending				for impairment:								for impairment:
December 31, 2016		balance				losses				offs				Recoveries				balance				Individually				Collectively				Individually				Collectively
Real estate:
Commercial		$	1,718,256			$	29,493			$	(30,000	)		$	-			$	1,717,749			$	7,580			$	1,710,169			$	2,425,089			$	203,719,987
Construction and land development			306,982				97,878				(200,000	)			-				204,860				16,587				188,273				752,889				13,640,103
Residential			322,084				(184,773	)			-				110,126				247,437				-				247,437				-				54,710,809
Commercial			132,362				93,383				(100,485	)			-				125,260				-				125,260				164,766				21,988,007
Consumer			7,900				926				-				-				8,826				-				8,826				-				725,269
Unallocated			95,861				(36,907	)			-				-				58,954				-				58,954				-				-
		$	2,583,445			$	-			$	(330,485	)		$	110,126			$	2,363,086			$	24,167			$	2,338,919			$	3,342,744			$	294,784,175

 

		2020				2019				2018				2017				2016
Allowance for loan losses to total loans outstanding			0.63	%			0.72	%			0.73	%			0.73	%			0.79	%
Ratio of net charge-offs to average loans outstanding during the period			-0.02	%			-0.01	%			0.12	%			0.10	%			0.08	%

 

The Company recorded net recoveries of $77,823 and $44,381 for 2020 and 2019, respectively. The provision for loan losses was $625,000 in 2020 and $40,000 in 2019.

 

 

Other Real Estate Owned

 

Other real estate owned (“OREO”) at December 31, 2020 included two properties with an aggregate carrying value of $1,411,605. The first property is an apartment building in Baltimore, Maryland with a carrying value of $1,411,605 that was obtained in the Merger. The property is under an optional sales contract with no projected closing date. The other property is land in Cecil County, Maryland with a carrying value of $0. It was acquired through foreclosure in 2007. The latter property consists of 10.43 acres and is currently under contract for a gross sales price of $295,000 with closing expected in 2021. Due to the length of time the property has been held, Maryland banking law required a write-down of the value to $0 in 2019.

 

		2020				2019				2018				2017				2016
Other Real Estate Owned		$	1,411,605			$	-			$	210,150			$	265,500			$	414,000

 

Investment Securities

 

Investment securities increased $21,514,013, or 38.4%, to $77,555,805 at December 31, 2020 from $56,041,792 at December 31, 2019. At December 31, 2020 and 2019, the Company had classified 70% and 65%, respectively, of the investment portfolio as available for sale. The remaining balance of the portfolio was classified as held to maturity.

 

Securities classified as available for sale are held for an indefinite period of time and may be sold in response to changing market and interest rate conditions as part of the Company’s asset/liability management strategy. Available for sale securities are carried at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders’ equity, net of income taxes. Securities classified as held to maturity, which management has both the positive intent and ability to hold to maturity, are reported at amortized cost. The Company does not currently follow a strategy of making security purchases with a view to near-term sales, and, therefore, does not own trading securities. The Company manages the investment portfolio within policies that seek to achieve desired levels of liquidity, manage interest rate sensitivity, meet earnings objectives, and provide required collateral for deposit and borrowing activities.

 

The following table sets forth the carrying value of investment securities at December 31:

 

		2020				2019				2018
Available for sale
State and municipal		$	986,532			$	512,670			$	1,506,505
SBA pools			1,783,807				2,151,797				2,719,372
Corporate bonds			6,797,431				-				-
Mortgage-backed securities			44,909,516				33,867,307				22,366,114
		$	54,477,286			$	36,531,774			$	26,591,991
Held to maturity
State and municipal		$	23,078,519			$	19,510,018			$	18,127,067

 

 

The following table sets forth the scheduled maturities of investment securities at December 31, 2020:

 

		Available for Sale												Held to Maturity
		Amortized Cost				Fair Value				Yield				Amortized Cost				Fair Value				Yield
Within 1 year		$	505,372			$	502,475				3.73	%		$	487,741			$	496,463				4.24	%
Over 1 to 5 years			4,646,388				4,755,483				2.78	%			793,876				813,523				2.93	%
Over 5 to 10 years			2,300,591				2,323,451				4.62	%			2,476,827				2,687,063				3.47	%
Over 10 years			202,243				202,554				0.97	%			19,320,075				20,247,737				3.01	%
			7,654,594				7,783,963				3.35	%			23,078,519				24,244,786				3.08	%
SBA Pools			1,822,226				1,783,807				1.27	%			-				-				-
Mortgage-backed securities			44,026,055				44,909,516				1.59	%			-				-				-
		$	53,502,875			$	54,477,286				1.83	%		$	23,078,519			$	24,244,786				3.08	%

 

SBA pools and mortgage-backed securities are due in monthly installments.

 

Deposits

 

Total deposits were $573,401,547 at December 31, 2020 compared to $376,613,314 at December 31, 2019, an increase of $196,788,233, or 52.3%. The increase was due to a $47,092,893 increase in certificates of deposit, a $33,318,417 increase in savings accounts, a $44,464,294 increase in interest bearing checking accounts, a $29,416,531 increase in money market accounts and a $42,496,098 increase in noninterest-bearing accounts. The following table shows the average balances and average costs of deposits for the years ended December 31:

 

		2020								2019								2018
		Average Balance				Cost				Average Balance				Cost				Average Balance				Cost
Noninterest bearing demand deposits		$	82,514,991				0.00	%		$	59,374,960				0.00	%		$	61,972,038				0.00	%
Interest bearing demand deposits			83,893,984				0.28	%			56,851,471				0.19	%			48,070,664				0.22	%
Savings and money market deposits			119,532,831				0.24	%			101,375,083				0.40	%			97,644,061				0.25	%
Certificates of deposit			166,078,044				1.57	%			149,969,311				2.01	%			131,937,867				1.42	%
		$	452,019,850				0.69	%		$	367,570,825				0.96	%		$	339,624,630				0.65	%

 

As of December 31, 2020, certificates of deposit of $100,000 or more mature as follows:

 

Period			Balance
3 months or less			$	25,139,310
Over 3 months to 6 months				16,412,064
Over 6 months to 12 months				22,724,193
Over 12 months				29,151,118
Total			$	93,426,685

 

Off-Balance Sheet Arrangements

 

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 and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit, lines of credit, including home-equity lines and commercial lines, and letters of credit. Loan commitments generally have interest rates at current market values, fixed expiration dates, and may require a fee. Lines of credit generally have variable interest rates and do not necessarily represent future cash flow requirements because it is unlikely that all customers will draw upon their lines in full at any one time. Letters of credit are commitments issued to guarantee the performance of a customer to a third party. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet.

 

 

For commitments to extend credit, lines of credit, and letters of credit, the Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument is represented by the contractual notional amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.

 

At December 31, 2020, the Company’s off-balance sheet financial instruments were as follows:

 

Loan commitments		$	26,109,020
Unused lines of credit		$	37,713,573
Letters of credit		$	1,891,428

 

Management does not believe that any of the foregoing arrangements are reasonably likely to have a materially adverse effect on the Company’s financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors.

 

Borrowings and Other Contractual Obligations

 

The Company’s contractual obligations consist primarily of borrowings and operating leases for various facilities.

 

Securities sold under agreements to repurchase represent overnight borrowings from customers. Securities owned by the Company which are used as collateral for these borrowings are primarily U.S. government agency securities.

 

On September 30, 2020, the Company borrowed $17,000,000 from First Horizon Bank (“FHN”) to be used in the Merger on October 1, 2020. Net of issuance costs of $28,126, the proceeds of the net long-term debt was $16,971,874. The loan matures on September 30, 2025. The interest rate on the loan is fixed at 4.10%. The Company is required to make quarterly interest-only payments through October 1, 2021. The Company expects that the amount of these quarterly interest-only payments will be $174,250. During the remaining term of the loan, the Company is required to make quarterly interest and principal payments of approximately $646,472, which will be based on a nine-year straight-line amortization schedule. The remaining balance of approximately $9,916,667 will be due at maturity. To secure its obligations under this loan, the Company pledged all of its shares of common stock of the Bank to the lender.

 

 

Specific information about the Company’s borrowings and contractual obligations is set forth in the following table:

 

		At December 31,
		2020				2019				2018
Amount oustanding at year-end:
Securities sold under repurchase agreements		$	24,753,972			$	10,958,118			$	11,012,000
Federal Home Loan Bank advances			5,000,000								3,000,000
Federal Home Loan Bank advances mature in:
2020		$	-			$	-			$	3,000,000
2025			5,000,000				-				-
Long-term debt (net of issuance costs) matures in 2025			16,973,280				-				-
Weighted average rate paid at December 31:
Securites sold under repurchase agreements			0.61	%			1.49	%			1.07	%
Federal Home Loan Bank advances			1.00	%			0.00	%			1.50	%
Long-term debt			4.10	%			0.00	%			0.00	%

 

		For years ended December 31,
		2020				2019				2018
Maximum amount of borrowings outstanding at any month end:
Securities sold under repurchase agreeents		$	24,753,972			$	10,958,118			$	22,173,010
Federal Home Loan Bank advances			10,000,000				6,500,000				19,000,000
Long-term debt (net of issuance costs)			16,973,280				-				-
Average amount of borrowings oustanding with respect to:
Securities sold under repurchase agreements		$	9,355,593			$	9,273,092			$	17,479,418
Federal Home Loan Bank advances			4,877,052				2,610,959				8,795,890
Borrowings from FRB and commerical banks			-				90,966				249,044
Long-term debt (net of issuance costs)			4,425,976				-				-
Average rate paid for the year:
Securities sold under repurchase agreements			1.15	%			1.24	%			0.83	%
Federal Home Loan Bank advances			0.84	%			1.62	%			1.50	%
Borrowings from FRB and commerical banks			0.00	%			2.91	%			1.93	%
Long-term debt			4.10	%			0.00	%			0.00	%

 

The terms of the Company’s operating leases, including the future minimum payments under those leases, are disclosed in Note 9 to the consolidated financial statements.

 

 

RESULTS OF OPERATIONS

 

Overview

 

The Company reported net income of $2,682,003 for the year ended December 31, 2020 compared to $4,560,804 for the year ended December 31, 2019. The decrease of $1,878,801 from 2019 was due to an increase in noninterest expense of $4,706,594 and an increase in the provision for loan losses of $585,000, offset by an increase in net interest income of $2,282,118, an increase in noninterest income of $578,552, and a decrease in income taxes of $552,123. Included in noninterest expense was $3,236,817 of one-time expenses incurred in connection with the Merger. Without these acquisition costs, net income would have been $5,113,225 for the year ended December 31, 2020. The table below provides a comparison of the Company’s results for the year ended December 31, 2020 and 2019, both with and without the acquisition costs.

 

		Year Ended December 31,
		2020								2019
						Excluding
		As Reported				Acquisition Costs				As Reported
Income before taxes		$	3,169,214			$	6,406,031			$	5,600,138
Income taxes			487,211				1,292,806				1,039,334
Net income		$	2,682,003			$	5,113,225			$	4,560,804
Earnings per share		$	0.90			$	1.71			$	1.54
Return on average assets			0.51	%			0.97	%			1.06	%
Return on average equity			5.22	%			9.96	%			9.52	%

 

Net Interest Income

 

The primary source of income for the Company is net interest income, which is the difference between interest income on interest-earning assets, such as investment securities and loans, and interest expense incurred on interest-bearing sources of funds, such as deposits and borrowings.

 

For the year ended December 31, 2020, the Company recorded net interest income of $17,304,503 compared to $15,022,385 for 2019, an increase of $2,282,118. The increase was attributable to an increase in the average balance of interest-earning assets of $85,331,237 to $500,045,945 in 2020 from $414,714,708 in 2019, offset by a decline in the net yield on interest-earning assets of 17 basis points to 3.50% in 2020 from 3.67% in 2019.

 

Total interest income for the year ended December 31, 2020 increased by $2,060,842 to $20,763,180, from $18,702,338 for 2019. The increase was due primarily to the aforementioned increase in average interest earning assets, offset by a decrease of 36 basis points in the tax equivalent yield on interest earning assets to 4.19% in 2020 from 4.55% in 2019.

 

Interest income from loans was $19,291,162 in 2020 compared to $16,894,657 in 2019, an increase of $2,396,505. This increase was attributable to a $76,216,697 increase in the average balance of loans to $421,010,433 in 2020 from $344,793,736 in 2019, offset by a 32 basis point decrease in the average yield on loans to 4.58% in 2020 from 4.90% in 2019.

 

For the year ended December 31, 2020, the Company recorded interest income on securities of $1,395,493. For the same period of 2019, interest income on securities was $1,449,841. The $54,348 decrease in 2020 was attributable to a 65 basis point decrease in the average tax equivalent yield on securities to 2.40% in 2020 from 3.05% in 2019, offset by a $12,534,077 increase in the average balance of securities to $65,583,845 in 2020 from $53,049,768 in 2019.

 

Interest income on federal funds sold and other interest-earning assets (FHLB stock and certificates of deposit) decreased $281,315 to $76,525 in 2020 compared to $357,840 in 2019. The decrease was due to a 1.62% decrease in the average tax equivalent yield to 0.59% in 2020 from 2.21% in 2019, and a $3,419,537 decrease in the average balance of federal funds sold and other interest-earning assets to $13,451,667 in 2020 from $16,871,204 in 2019.

 

 

Total interest expense decreased $221,276 to $3,458,677 in 2020 compared to $3,679,953 in 2019. The decrease was due to a 26 basis point decrease in the cost of interest-bearing liabilities to 0.89% in 2020 from 1.15% in 2019, offset by an increase of $67,972,598 in the average balance of interest-bearing liabilities to $388,143,480 in 2020 from $320,170,882 in 2019.

 

Interest paid on NOW, savings, and money market deposit accounts increased $11,633 to $519,018 in 2020 compared to $507,385 in 2019. The increase was due to a $45,200,261 increase in the average balance of these deposits to $203,426,815 in 2020 from $158,226,554 in 2019, offset by a 6 basis point decrease in the cost of funds to 0.26% in 2020 from 0.32% in 2019.

 

Interest paid on time deposits decreased $402,599 to $2,609,976 in 2020 compared to $3,012,575 in 2019. The decrease was due to a decrease of 44 basis points in the average rate paid to 1.57% in 2020 from 2.01% in 2019, offset by an increase of $16,108,733 in the average balance to $166,078,044 in 2020 from $149,969,311 in 2019.

 

Interest paid on securities sold under repurchase agreements decreased $7,323 to $107,318 in 2020 compared to $114,641 in 2019. The decrease was attributable to a decrease of 9 basis points in the average rate to 1.15% in 2020 from 1.24% in 2019, offset by a $62,501 increase in the average balance of securities sold under repurchase agreements to $9,335,593 in 2020 from $9,273,092 in 2019,

 

Interest paid on long-term debt that was $181,465 in 2020 compared to $0 in 2019. This debt relates to the $17 million term loan obtained in 2020 to finance a portion of the cash paid to the former stockholders of Carroll Bancorp, Inc. in the Merger.

 

Interest paid on FHLB advances and other borrowings decreased $4,452 to $40,900 in 2020 from $45,352 in 2019. The decrease was attributable to a decrease of 84 basis points in the average rate to 0.84% in 2020 from 1.68% in 2019, offset by a $2,175,127 increase in the average balance of FHLB advances and other borrowings to $4,877,052 in 2020 from $2,701,925 in 2019.         

 

 

The following table sets forth certain information relating to the Company’s average interest-earning assets and interest-bearing liabilities for the periods indicated. The yields are calculated by dividing interest income or expense by the average daily balance of assets or liabilities, respectively. Non-accruing loans are included in the average balance.

 

		2020												2019												2018
		Average Balance				Interest				Yield				Average Balance				Interest				Yield				Average Balance				Interest				Yield
Assets:
Loans		$	421,010,433			$	19,291,162				4.58	%		$	344,793,736			$	16,894,657				4.90	%		$	343,573,784			$	16,401,554				4.77	%
Securities, taxable			44,207,230				774,582				1.75	%			34,949,183				875,715				2.51	%			26,807,959				617,249				2.30	%
Securities, tax exempt			21,376,615				799,841				3.74	%			18,100,585				740,077				4.09	%			17,663,498				695,282				3.94	%
Federal funds sold and other interest earning assets			13,451,667				79,846				0.59	%			16,871,204				373,678				2.21	%			8,640,895				188,479				2.18	%
Total interest-earning assets			500,045,945				20,945,431				4.19	%			414,714,708				18,884,127				4.55	%			396,686,136				17,902,564				4.51	%
Noninterest-earning assets			26,493,472												16,880,579												15,900,818
Total assets		$	526,539,417											$	431,595,287											$	412,586,954
Liabilities and Stockholders' Equity:
NOW, savings, and money market		$	203,426,815				519,018				0.26	%		$	158,226,554				507,385				0.32	%		$	145,714,725				348,416				0.24	%
Certificates of deposit			166,078,044				2,609,976				1.57	%			149,969,311				3,012,575				2.01	%			131,937,867				1,877,200				1.42	%
Securities sold under repurchase agreements			9,335,593				107,318				1.15	%			9,273,092				114,641				1.24	%			17,479,418				144,881				0.83	%
Long-term debt			4,425,976				181,465				4.10	%			-				-				0.00	%			-				-				0.00	%
FHLB advances and other borrowings			4,877,052				40,900				0.84	%			2,701,925				45,352				1.68	%			9,044,934				136,744				1.51	%
Total interest-bearing deposits			388,143,480				3,458,677				0.89	%			320,170,882				3,679,953				1.15	%			304,176,944				2,507,241				0.82	%
Noninterest-bearing deposits			82,514,991												59,374,960												61,972,038
Noninterest-bearing liabilities			4,536,613												4,121,667												2,689,538
Total liabilities			475,195,084												383,667,509												368,838,520
Stockholders' equity			51,344,333												47,927,778												43,748,434
Total liabilities and stockholders' equity		$	526,539,417											$	431,595,287											$	412,586,954
Net interest income						$	17,486,754											$	15,204,174											$	15,395,323
Interest rate spread											3.30	%											3.40	%											3.69	%
Net yield on interest-earning assets											3.50	%											3.67	%											3.88	%
Ratio of average interest-earning assets to average interest-bearing liabilities											128.83	%											129.53	%											130.41	%

 

Interest on tax-exempt investments are reported on a fully taxable equivalent basis

 

 

The following table sets forth the dollar amount of changes in interest income and interest expense for the major categories of the Company's interest-earning assets and interest-bearing liabilities. The table distinguishes between (i) changes in net interest income attributed to volume (change in volume multiplied by the prior year's interest rate), and (ii) changes in net interest income attributed to rate (change in rate multiplied by the prior year's volume). The change in interest due to the combined rate and volume changes is allocated proportionally to the change in volume and rate.

 

RATE/VOLUME ANALYSIS
		Year ended December 31, 2020 compared to 2019												Year ended December 31, 2019 compared to 2018
		Change due to variance in												Change due to variance in
		Volume				Rate				Total				Volume				Rate				Total
Interest income:
Loans		$	3,547,286			$	(1,150,781	)		$	2,396,505			$	58,420			$	434,683			$	493,103
Securities, taxable			199,306				(300,439	)			(101,133	)			200,268				58,198				258,466
Securities, tax exempt			126,207				(66,443	)			59,764				17,465				27,330				44,795
Federal funds sold and other interest-earning assets			(63,716	)			(230,116	)			(293,832	)			182,248				2,951				185,199
Total interest-earning assets			3,809,083				(1,747,779	)			2,061,304				458,401				523,162				981,563
Interest expense:
NOW, savings, and money market			127,676				(116,043	)			11,633				31,969				127,000				158,969
Certificates of deposit			300,318				(702,917	)			(402,599	)			282,876				852,499				1,135,375
Securities sold under repurchase agreements			768				(8,091	)			(7,323	)			(84,353	)			54,113				(30,240	)
Long-tern debt			181,465				-				181,465				-				-				-
FHLB advances and other borrowings			25,243				(29,695	)			(4,452	)			(105,032	)			13,640				(91,392	)
Total interest-bearing liabilities			635,470				(856,746	)			(221,276	)			125,460				1,047,252				1,172,712
Change in net interest income		$	3,173,613			$	(891,033	)		$	2,282,580			$	332,941			$	(524,090	)		$	(191,149	)

 

Noninterest Income

 

Noninterest income was $2,072,119 in 2020 compared to $1,493,567 in 2019, an increase of $578,552 or 38.7%. The increase resulted primarily from a $627,227 increase in mortgage banking income and a $210,150 lower write down of OREO, offset by decreases of $176,586 in bank owned life insurance income and $88,245 in service charges on deposit accounts. Our mortgage banking division has experienced strong mortgage origination activity during 2020 as a result of historically low interest rates. Lower service charges are a result of less customer transaction activity due to the COVID-19 pandemic.

 

Noninterest Expense

 

Total noninterest expense increased by $4,706,594, or 43.3%, to $15,582,408 in 2020 from $10,875,814 in 2019. The increase was due primarily to $3,236,817 in acquisition-related costs in 2020, an increase in salary and employee benefit expenses of $970,890, or 14.2%, to $7,795,701 in 2020, an increase in furniture and equipment expenses of $226,347, or 36.8%, and an increase in other expenses of $286,100, or 10.7%. All of these increases resulted from the Merger that was effective on October 1, 2020, which added employees, locations, and related expenses. Note 13 to the consolidated financial statements provides additional information about the Company’s other expenses.

 

Income Taxes

 

Income taxes decreased $552,123 to $487,211 in 2020 from $1,039,334 in 2019. Lower income before taxes was the primary driver of the decrease.

 

The Company’s effective tax rate decreased to 15.4% in 2020, from 18.6% in 2019. The decrease was due to a higher percentage of tax-exempt revenue. Note 14 to the consolidated financial statements provides additional information about the Company’s taxes, including a reconciliation of the Company’s effective tax rate to the Federal statutory rate of 21%.

 

 

INTEREST RATE RISK

 

The Company’s principal market risk is exposure to the risk that the interest rates associated with our interest-bearing liabilities and interest-earning assets will fluctuate. This risk arises from the Company’s lending, investing and deposit-taking activities, and is affected by many factors, including economic and financial conditions, movements in interest rates and consumer preferences. Interest rate fluctuation has a direct impact on the Company’s net interest income. Net interest income is susceptible to interest rate risk when deposits and other short-term liabilities have different repricing intervals than do loans, investments and other interest-earning assets. When interest-earning assets mature or reprice faster than interest-bearing liabilities, a decline in interest rates may cause a decline in net interest income. Conversely, when interest-bearing liabilities mature or reprice faster than interest-earning assets, an increase in interest rates may cause a decline in net interest income.

 

The Company recognizes that there are many types of interest rate risk. Management believes that the three types that pose the greatest potential threat to current and long-term earnings are:

 

•

Repricing risk – the difference in the timing of the scheduled maturity and re-pricing dates of assets and liabilities within a certain time frame;

•

Option risk – interest rate related options embedded in the Company’s assets and liabilities which change the cash flow characteristics of the assets and liabilities; and

•

Yield curve / basis risk – changes in the relationship between different interest rates with the same maturity or interest rates across a maturity spectrum which create compression or expansion of our net interest margin.

 

The Company uses earnings at risk and economic value at risk measures to quantify our exposure to these types of interest rate risk. We believe that using simulations that measure all three types of risks in combination is a more efficient tool for measurement, and we therefore do not routinely process models to isolate each risk. Rather, we combine the three types of analyses, which we believe provides a better overall result than a simulation based on a single system and a more economical use of resources than targeted models. Following is a description of the analyses to be utilized:

 

Earnings at Risk

 

Earnings at Risk (“EAR”) measures exposure to net changes in net interest income (“NII”), and is considered the Company’s best source of managing short-term interest rate risk (one-year and two-year time frames). EAR is a dynamic analysis, which can capture all the different forms of interest rate risk under many different interest rate scenarios, and using various assumptions for growth, optionality, and yield curve structure.

 

Economic Value of Equity

 

Economic Value of Equity (“EVE”) is management’s primary analytical tool for measuring long-term interest rate risk, and helps to measure if the long-term safety and soundness of the Company is being compromised for the sake of short-term results. However, the Company also recognizes the inherent difficulties of calculating a definitive value for many sections of the balance sheet as well as the weakness that EVE ignores future events (e.g., growth, etc.). These difficulties, coupled with the nature of our core business, allow the Company to adopt wide limits for this measure.

 

In order to mitigate the impact of changing interest rates, the Board of Directors has established policies and procedures that include acceptable parameters for the relationship between rate sensitive assets to rate sensitive liabilities as measured by earnings at risk and economic value at risk. The Asset/Liability Committee reviews rate sensitivity measures on a quarterly basis. Material deviations from policy parameters are reported to the Board of Directors and corrective action is initiated and monitored.

 

 

Measures of NII at risk produced by simulation analysis are indicators of an institution’s short-term performance in alternative rate environments. These measures are typically based upon a relatively brief period, usually one year. They do not necessarily indicate the long-term prospects or economic value of the institution.

 

Based upon the simulation analysis performed at December 31, 2020 and 2019, management estimated the following changes in NII, assuming the indicated rate changes:

 

Change in Rate		2020				2019
400 basis point increase		$	(157,000	)		$	(854,000	)
300 basis point increase			17,000				(547,000	)
200 basis point increase			116,000				(310,000	)
100 basis point increase			139,000				(136,000	)
100 basis point decrease			(95,000	)			115,000
200 basis point decrease			(124,000	)			74,000
300 basis point decrease			(124,000	)			84,000

 

LIQUIDITY MANAGEMENT

 

Liquidity describes our ability to meet financial obligations that arise out of the ordinary course of business. Liquidity is primarily needed to meet depositor withdrawal requirements, to fund loans, and to fund our other debts and obligations as they come due in the normal course of business. We maintain our asset liquidity position internally through short-term investments, the maturity distribution of the investment portfolio, loan repayments, and income from earning assets. On the liability side of the balance sheet, liquidity is affected by the timing of maturing liabilities and the ability to generate new deposits or borrowings as needed. The Bank is approved to borrow 75% of eligible pledged single family residential loans and 50% of eligible pledged commercial loans as well as investment securities, or approximately $89.3 million under a secured line of credit with the FHLB. The Bank also has a facility with the Federal Reserve Bank of Richmond (the “Reserve Bank”) under which the Bank could borrow approximately $33.2 million. Finally, the Bank has $23,500,000 ($14,500,000 unsecured and $9,000,000 secured) overnight federal funds lines of credit available from commercial banks. FHLB advances of $5,000,000 and $0 were outstanding as of December 31, 2020 and 2019, respectively. There were no borrowings from the Reserve Bank or from the commercial banks’ lines of credit at December 31, 2020 and 2019. On September 30, 2020, the Company borrowed $17,000,000 from a commercial bank, which was used on October 1, 2020 to fund a portion of the cash consideration paid to the former stockholders of Carroll Bancorp, Inc. in the Merger. The outstanding balance at December 31, 2020, net of unamortized issuance costs, was $16,973,280. Management believes that we have adequate liquidity sources to meet all anticipated liquidity needs over the next 12 months. Management knows of no trend or event which is likely to have a material impact on our ability to maintain liquidity at satisfactory levels.

 

Information about the various financial obligations, including contractual obligations and commitments that may require future cash payments, to which we are subject is set forth above under the captions “Off-Balance Sheet Transactions” and “Borrowings and Other Contractual Obligations”.

 

CAPITAL RESOURCES AND ADEQUACY

 

The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possible additional, discretionary actions by the regulators that, if undertaken, could have a direct material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off‑balance sheet items as calculated under regulatory accounting practices.

 

 

The Basel III Capital Rules became effective for the Bank on January 1, 2015 (subject to a phase-in period for certain provisions). Quantitative measures established by the Basel III Capital Rules to ensure capital adequacy require the maintenance of minimum amounts and ratios (set forth in the table below) of Common Equity Tier 1 capital, Tier 1 capital, and Total capital (as defined in the regulations) to risk‑weighted assets (as defined), and of Tier 1 capital to adjusted quarterly average assets (as defined).

 

Additional information regarding the capital requirements that apply to us can be found in Note 15 of the consolidated financial statements and notes thereto included in the Annual Report.

 

The following table presents actual and required capital ratios as of December 31, 2020 and 2019, for the Bank under the Basel III Capital Rules. The minimum required capital amounts presented include the minimum required capital levels as of December 31, 2020 and 2019, based on the phase-in provisions of the Basel III Capital Rules. Capital levels required to be considered well capitalized are based upon prompt corrective action regulations, as amended to reflect the changes under the Basel III Capital Rules.

 

										Minimum								To Be Well
(Dollars in thousands)		Actual								Capital Adequacy								Capitalized
December 31, 2020		Amount				Ratio				Amount				Ratio				Amount				Ratio
Total capital (to risk-weighted assets)		$	63,400				12.62	%		$	52,732				10.50	%		$	50,221				10.00	%
Tier 1 capital (to risk-weighted assets)			60,104				11.97	%			42,688				8.50	%			40,177				8.00	%
Common equity tier 1 (to risk-weighted assets)			60,104				11.97	%			35,155				7.00	%			32,644				6.50	%
Tier 1 leverage (to average assets)			60,104				9.05	%			26,569				4.00	%			33,211				5.00	%
December 31, 2019
Total capital (to risk-weighted assets)		$	51,274				13.88	%		$	38,775				10.50	%		$	36,928				10.00	%
Tier 1 capital (to risk-weighted assets)			48,681				13.18	%			31,389				8.50	%			29,543				8.00	%
Common equity tier 1 (to risk-weighted assets)			48,681				13.18	%			25,850				7.00	%			24,003				6.50	%
Tier 1 leverage (to average assets)			48,681				10.94	%			17,798				4.00	%			22,247				5.00	%

 

The Company intends to fund future growth primarily with cash, federal funds, maturities of investment securities and deposit growth. Management knows of no other trend or event that will have a material impact on capital.

 

RECENT ACCOUNTING PRONOUNCEMENTS

 

Management has the responsibility for the selection and use of appropriate accounting policies. The significant accounting policies used by the Company are described in the notes to the consolidated financial statements.

 

The following accounting guidance has been approved by the Financial Accounting Standards Board (the “FASB”) and would apply to the Company if the Company entered into an applicable activity.

 

In June 2016, the FASB issued Accounting Standards Update (“ASU”) 2016‑13, “Financial Instruments – Credit Losses”. The ASU sets forth a “current expected credit loss” (CECL) model which requires the Company to measure all expected credit losses for financial instruments held at the reporting date based on historical experience, current conditions, and reasonable supportable forecasts. This replaces the existing incurred loss model and is applicable to the measurement of credit losses on financial assets measured at amortized cost and applies to some off-balance sheet credit exposures. ASU 2019-10 “Financial Instruments – Credit Losses (Topic 326), Derivatives and hedging (Topic 815), and Leases (Topic 842): Effective Dates” extended the implementation date to 2023 for SEC registered smaller reporting companies and private companies. The Company is considered a smaller reporting company. The Company has engaged a third-party vendor to assist in the implementation of this ASU.

 

 

In August 2018, the FASB issued ASU 2018-14, “Compensation - Retirement Benefits-Defined Benefit Plans-General (Subtopic 715-20).” ASU 2018-14 amends and modifies the disclosure requirements for employers that sponsor defined benefit pension or other post-retirement plans. The amendments in this update remove disclosures that no longer are considered cost beneficial, clarify the specific requirements of disclosures, and add disclosure requirements identified as relevant. ASU 2018-14 will be effective for us on January 1, 2021, with early adoption permitted, and is not expected to have a material impact on the Company’s financial statements.

 

In August 2018, the FASB issued ASU 2018-15, “Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40) - Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract.” ASU 2018-15 clarifies certain aspects of ASU 2015-05, “Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement,” which was issued in April 2015. Specifically, ASU 2018-15 aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal-use software license). ASU 2018-15 does not affect the accounting for the service element of a hosting arrangement that is a service contract. ASU 2018-15 became effective for us on January 1, 2020, with early adoption permitted, and is not expected to have a material impact on the Company’s financial statements.

 

In December 2019, FASB released ASU 2019-12 - Income Taxes (Topic 740), which simplifies the accounting for income taxes by removing multiple exceptions to the general principals in Topic 740. ASU 2019-12 is effective for public business entities for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2020. The Company is in the process of reviewing the impact of adopting this standard on the Company’s financial statements.

 

The accounting policies adopted by management are consistent with authoritative GAAP and are consistent with those followed by our peers.

 

 

ITEM 7A.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

The Bank is a “smaller reporting company” as defined in Exchange Act Rule 12b-2 and, accordingly, is not required to include the information required by this item.

 

ITEM 8.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

	Page
Report of Independent Registered Public Accounting Firm	49
Consolidated Balance Sheets at December 31, 2020 and 2019	51
Consolidated Statements of Income for the years ended December 31, 2020 and 2019	52
Consolidated Statement of Comprehensive Income for the years ended December 31, 2020 and 2019	53
Consolidated Statement of Changes in Stockholders’ Equity for the years ended December 31, 2020 and 2019	54
Consolidated Statement of Cash Flows for the years ended December 31, 2020 and 2019	55
Notes to Consolidated Financial Statements for the years ended December 31, 2020 and 2019	57

 

 

 

 

 

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Consolidated Balance Sheets

 

 

 The accompanying notes are an integral part of these consolidated financial statements.

 

 

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Consolidated Statements of Income

 

 

 The accompanying notes are an integral part of these consolidated financial statements.

 

 

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

 

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Consolidated Statements of Changes in Stockholders’ Equity

 

 

 The accompanying notes are an integral part of these consolidated financial statements.

 

 

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

 

 

 The accompanying notes are an integral part of these consolidated financial statements.

 

 

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

 

 

 The accompanying notes are an integral part of these consolidated financial statements.

 

 

Farmers and Merchants Bancshares, Inc. and Subsidiaries

 

Notes to Consolidated Financial Statements

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ITEM 9.

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

 

None.

 

ITEM 9A.

CONTROLS AND PROCEDURES

 

The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports filed under the Exchange Act with the SEC, such as this annual report, is recorded, processed, summarized and reported within the time periods specified in those rules and forms, and that such information is accumulated and communicated to the Company’s management, including the principal executive officer (“PEO”) and the principal financial officer (“PFO”), as appropriate, to allow for timely decisions regarding required disclosure. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, a control may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.

 

An evaluation of the effectiveness of these disclosure controls as of December 31, 2020 was carried out under the supervision and with the participation of the Company’s management, including the PEO and the PFO. Based on that evaluation, the Company’s management, including the PEO and the PFO, has concluded that the Company’s disclosure controls and procedures are, in fact, effective at the reasonable assurance level.

 

During the fourth quarter of 2020, there was no change in the Company’s internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

As required by Section 404 of the Sarbanes-Oxley Act of 2002, management has performed an evaluation and testing of the Company’s internal control over financial reporting as of December 31, 2020. Management’s report on the Company’s internal control over financial reporting is included on the following page. The Company’s is a “smaller reporting company” as defined by Rule 12b-2 under the Exchange Act and, accordingly, its independent registered public accounting firm is not required to attest to the foregoing management report.

 

 

Management’s Report on Internal Control over Financial Reporting

 

Management of Farmers and Merchants Bank (the “Bank”) is responsible for the preparation, integrity and fair presentation of the consolidated financial statements included in this annual report. The Bank’s consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and, as such, include some amounts that are based on the best estimates and judgments of management.

 

Pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act, reports on internal control over financial reporting issued by management of “smaller reporting companies”, as defined by Exchange Act Rule 12b-2, are exempt from the auditor attestation requirements imposed by Section 404(b) of the Sarbanes-Oxley Act of 2002. The Bank is a smaller reporting company. Accordingly, this annual report on Form 10-K does not include an attestation report of the Bank’s registered public accounting firm regarding internal control over financial reporting.

 

The Bank’s management is responsible for establishing and maintaining adequate internal control over financial reporting. This internal control system is designed to provide reasonable assurance to management and the Board of Directors regarding the reliability of the Bank’s financial reporting and the preparation and presentation of financial statements for external reporting purposes in conformity with accounting principles generally accepted in the United States of America, as well as to safeguard assets from unauthorized use or disposition. The system of internal control over financial reporting is evaluated for effectiveness by management and tested for reliability through a program of internal audit with actions taken to correct potential deficiencies as they are identified. Because of inherent limitations in any internal control system, no matter how well designed, misstatement due to error or fraud may occur and not be detected, including the possibility of the circumvention or overriding of controls. Accordingly, even an effective internal control system can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, internal control effectiveness may vary over time.

 

Management assessed the effectiveness of the Bank’s internal control over financial reporting as of December 31, 2020 based upon criteria set forth in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

 

Based on this assessment and on the foregoing criteria, management has concluded that, as of December 31, 2020, the Bank’s internal control over financial reporting is effective.

 

March 19, 2021

 

/s/James R. Bosley, Jr.		/s/Mark C. Krebs
James R. Bosley, Jr.		Mark C. Krebs
President & Chief Executive Officer		Executive Vice President & Chief Financial Officer
(Principal Executive Officer)		(Principal Financial Officer)

 

 

ITEM 9B.

OTHER INFORMATION

 

None.

PART III

 

ITEM 10.

DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

 

The Company has adopted a Code of Ethics applicable to its principal executive officer, principal financial officer, principal accounting officer, or controller, or persons performing similar functions. This Code of Ethics is applicable to all directors and employees. A copy of this Codes of Ethics is available on our website, www.fmb1919.com, and may be accessed by clicking on “Investor Relations”, then “Corporate Overview” and then “Code of Ethics”.

 

All other information required by this item is incorporated herein by reference to the following sections of the Company’s definitive proxy statement for the 2021 annual meeting of stockholders that will be filed by April 30, 2020 with the SEC pursuant to Regulation 14A (the “2021 Proxy Statement”):

 

	●	ELECTION OF DIRECTORS (Proposal 1);
	●	CONTINUING DIRECTORS;
	●	QUALIFICATIONS FOR DIRECTOR NOMINEES AND CURRENT DIRECTORS;
	●	EXECUTIVE OFFICERS;
	●	SECTION 16(a) BENEFICIAL OWNERSHIP AND REPORTING COMPLIANCE; and
	●	CORPORATE GOVERNANCE (under “Committees of the Board of Directors - Audit Committee”).

 

ITEM 11.

EXECUTIVE COMPENSATION

 

The information required by this item is incorporated herein by reference to the sections of the 2021 Proxy Statement entitled “DIRECTOR COMPENSATION” and “EXECUTIVE COMPENSATION”.

 

ITEM 12.

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

 

The Company has not adopted or implemented any equity compensation plans or arrangements.

 

All other information required by this item is incorporated herein by reference to the section of the 2021 Proxy Statement entitled “SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT”.

 

ITEM 13.

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

 

The information required by this item is incorporated herein by reference to the sections of the 2021 Proxy Statement entitled “CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS” and “CORPORATE GOVERNANCE MATTERS” (under “Director Independence”).

 

ITEM 14.

PRINCIPAL ACCOUNTANT FEES AND SERVICES

 

The information required by this item is incorporated herein by reference to the section of the 2021 Proxy Statement entitled “AUDIT FEES AND SERVICES”.

 

PART IV

 

ITEM 15.

EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

 

(a)(1), (2) and (c) Financial Statements.

 

Report of Independent Registered Public Accounting Firm

Consolidated Balance Sheets at December 31, 2020 and 2019

Consolidated Statements of Income for the years ended December 31, 2020 and 2019

Consolidated Statement of Comprehensive Income for the years ended December 31, 2020 and 2019

Consolidated Statement of Changes in Stockholders’ Equity for the years ended December 31, 2020 and 2019

Consolidated Statement of Cash Flows for the years ended December 31, 2020 and 2019

Notes to Consolidated Financial Statements for the years ended December 31, 2020 and 2019

 

 

(a)(3) and (b) Exhibits.

 

The exhibits filed or furnished with this annual report are listed in the following Exhibit Index:

 

Exhibit	Description
2.1	Plan of Reorganization and Share Exchange, dated as of August 15, 2016, by and between Farmers and Merchants Bancshares, Inc. and Farmers and Merchants Bank (incorporated by reference to Exhibit 2.1 to the Company’s Registration Statement on Form 10)
2.2	Agreement and Plan of Merger, dated as of September 28, 2020, between Farmers and Merchants Bancshares, Inc. and Carroll Bancorp, Inc. (incorporated by reference to Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on October 1, 2020)
2.3	Agreement and Plan of Merger, dated as of March 6, 2020, among the Company, Anthem Acquisition Corp., and Carroll Bancorp, Inc. (incorporated by reference to Exhibit 2.1 to the Current Report of Farmers and Merchants Bancshares, Inc. on Form 8-K filed on March 11, 2020)
3.1(i)	Articles of Incorporation (incorporated by reference to Exhibit 3.1(i) to the Company’s Registration Statement on Form 10)
3.1(ii)	Articles of Share Exchange, dated as of October 20, 2016, by and between Farmers and Merchants Bancshares, Inc. and Farmers and Merchants Bank (incorporated by reference to Exhibit 3.1(ii) to the Company’s Registration Statement on Form 10)
3.2	Amended and Restated Bylaws (incorporated by reference to Exhibit 3.2 to the Company’s Registration Statement on Form 10)
10.1	Supplemental Executive Retirement Agreement, dated as of December 30, 2010, between Farmers and Merchants Bank and James R. Bosley, Jr. (incorporated by reference to Exhibit 10.1 to the Company’s Registration Statement on Form 10)
10.2	First Amendment to Supplemental Executive Retirement Agreement, dated as of February 22, 2011, between Farmers and Merchants Bank and James R. Bosley, Jr. (incorporated by reference to Exhibit 10.2 to the Company’s Registration Statement on Form 10)
10.3	Supplemental Executive Retirement Agreement, dated as of December 30, 2010, between Farmers and Merchants Bank and Christopher T. Oswald (incorporated by reference to Exhibit 10.3 to the Company’s Registration Statement on Form 10)
10.4	First Amendment to Supplemental Executive Retirement Agreement, dated as of February 22, 2011, between Farmers and Merchants Bank and Christopher T. Oswald (incorporated by reference to Exhibit 10.4 to the Company’s Registration Statement on Form 10)
10.5	Performance Driven Retirement Plan Agreement, dated as of November 17, 2015, between Farmers and Merchants Bank and Mark C. Krebs (incorporated by reference to Exhibit 10.5 to the Company’s Registration Statement on Form 10)
10.6	Settlement Agreement with Russell J. Grimes, Jr. (incorporated by reference to Appendix E of Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on March 11, 2020)
10.7	Business Protection Agreement with Russell J. Grimes, Jr. (incorporated by reference to Appendix F of Exhibit 2.1 to the Company’s Current Report on Form 8-K filed on March 11, 2020)
21	Subsidiaries (filed herewith)
23.1	Consent of Independent Registered Public Accounting Firm (filed herewith)
31.1	Certifications of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act (filed herewith)

 

 

31.2	Certifications of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act (filed herewith)
32	Certifications pursuant to Section 906 of the Sarbanes-Oxley Act (furnished herewith)
101	Interactive Data Files pursuant to Rule 405 of Regulation S-T (filed herewith)

 

SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) 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.

 

	FARMERS AND MERCHANTS BANCSHARES, INC.
Dated: March 19, 2021	By:	/s/ James R. Bosley, Jr.
		James R. Bosley, Jr.
		President and Chief Executive Officer
		(Principal Executive Officer)

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated.

 

/s/ James R. Bosley, Jr.		/s/ Roger D. Cassell
James R. Bosley, Jr., Director, President		Roger D. Cassell, Director
and Chief Executive Officer		March 19, 2021
(Principal Executive Officer)
March 19, 2021
/s/ Steven W. Eline		/s/ Edward A. Halle, Jr.
Steven W. Eline, Director		Edward A. Halle, Jr., Director
March 19, 2021		March 19, 2021
/s/ Ronald W. Hux		/s/ Mark C. Krebs
Ronald W. Hux, Director		Mark C. Krebs, Treasurer and Chief Financial Officer
March 19, 2021		(Principal Financial Officer and Principal Accounting Officer)
		March 19, 2021
/s/ Bruce L. Schindler		/s/ J. Lawrence Mekulski
Bruce L. Schindler, Director		J. Lawrence Mekulski, Director
March 19, 2021		March 19, 2021
/s/ Teresa L. Smack		/s/ John J. Schuster, Jr.
Teresa L. Smack, Director		John J. Schuster, Jr., Director
March 19, 2021		March 19, 2021
/s/ Louna S. Primm		/s/ Paul F. Wooden, Jr.
Louna S. Primm, Director		Paul F. Wooden, Jr., Director
March 19, 2021		March 19, 2021