U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
FORM 10-KSB
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1998
Commission File No.: 000-24933
HERITAGE BANCORP, INC.
(Name of Small Business Issuer in its charter)
Virginia 54-1914902
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
1313 Dolley Madison Blvd., McLean, Virginia 22101
(Address of principal executive offices)
(703) 356-6060
(Issuer's Telephone Number, Including Area Code)
Securities registered pursuant to section 12(g) of the Exchange Act:
Common Stock, no par value
(Title of Class)
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such
shorter period that the registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days. Yes X No __
Check if there is no disclosure of delinquent filers in response to
Item 405 of Regulation S-B is not contained in this form, and no disclosure will
be contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-KSB
or any amendment to this Form 10-KSB. [ X ]
The revenues for the issuer's fiscal year ended December 31, 1998 are
$3,902,000.
State the aggregate market value of the voting and non-voting common
equity held by non-affiliates computed by reference to the price at which the
common equity was sold, as of a specified date within the last 60 days. On
February 19, 1999: $9,752,122.
State the number of shares outstanding of each of the issuer's classes
of common equity, as of the latest practicable date. The Company had 2,294,617
shares outstanding as of March 10, 1999.
DOCUMENTS INCORPORATED BY REFERENCE
None.
Transitional Small Business Disclosure Format (check one):
Yes No X
<PAGE>
<TABLE>
TABLE OF CONTENTS
Page
<S> <C> <C> <C>
PART
ITEM 1. BUSINESS...............................................................................1
ITEM 2. PROPERTIES............................................................................14
ITEM 3. LEGAL PROCEEDINGS.....................................................................14
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...................................14
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND
RELATED STOCKHOLDER MATTERS...........................................................15
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS..................................................16
ITEM 7. FINANCIAL STATEMENTS..................................................................34
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE...................................................34
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND
CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a)
OF THE EXCHANGE ACT AND PRINCIPAL OFFICERS
OF THE COMPANY........................................................................34
ITEM 10. EXECUTIVE COMPENSATION................................................................34
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
AND MANAGEMENT........................................................................40
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS........................................40
PART III
ITEM 13. EXHIBITS, LIST AND REPORTS ON FORM 8-K..................................................
AUDITED FINANCIAL STATEMENTS...........................................................................F-1
</TABLE>
i
<PAGE>
PART I
ITEM 1. BUSINESS
General
Heritage Bancorp, Inc. (the "Company"), a Virginia corporation, is the
holding company for The Heritage Bank (the "Bank"), a Virginia chartered
commercial bank. On October 1, 1998, the Company acquired all of the capital
stock of the Bank and the shareholders of the Bank became shareholders of the
Company in a share for share exchange under a plan of reorganization approved by
the Bank's shareholders on August 26, 1998, whereby the Bank became the
wholly-owned subsidiary of the Company (the "Reorganization"). The Company's
sole business activity is ownership of the Bank. The Company's common stock
trades on the Nasdaq SmallCap Market under the symbol "HBVA." At December 31,
1998, the Company had total assets of $64.8 million, total deposits of $53.4
million and total stockholders' equity of $8.9 million. Net income for the year
ended December 31, 1998 was $133,000, a decrease of 76.67% from net income of
$570,000 for the comparable period in 1997. Basic earnings per share for the
year ended December 31, 1998 were $0.07 ($0.07 per share, assuming dilution), up
from $0.45 per share ($0.44 per share, assuming dilution) for the year ended
December 31, 1997. Unless otherwise disclosed, the information presented in this
Report on Form 10-KSB represents the activity of the Bank for the period prior
to October 1, 1998 and the activity of the Company consolidated thereafter.
Unless the context otherwise requires, all references to the Bank or the Company
include the Company and the Bank on a consolidated basis.
The Bank is the only independent financial institution headquartered in
McLean, Virginia. Established in 1987, the Bank operated as a wholly-owned
subsidiary of Heritage Bankshares, Inc. (formerly Independent Banks of Virginia,
Inc.), until 1992 when it became an independent bank. The Bank is a well-
capitalized, profitable community bank dedicated to financing small business and
consumer needs in its market area and providing personalized "hometown" quality
service to its customers by tailoring its products and services to appeal to a
local market. The Bank currently operates one full-service office and engages in
a broad range of lending and deposit services aimed at individual and commercial
customers in the McLean area of Fairfax County, Virginia. The Bank closed its
secondary offering of common stock (the "Offering") in which it sold 805,000
share of common stock to the public at a per share price of $5.50, resulting the
raising of net proceeds to the Bank of approximately $4.1 million.
The business of the Bank consists of attracting deposits from the
general public and using these funds to originate various types of individual
and commercial loans primarily in the McLean area. The Bank's commercial
activities include providing checking accounts, money market accounts and
certificates of deposit to small and medium sized businesses. The Bank also
provides credit services, such as lines of credit, term loans, construction
loans, and letters of credit, as well as real estate loans and other forms of
collateralized financing. The Bank's personal services include checking
accounts, NOW accounts, savings accounts, certificates of deposit, installment
accounts, construction and other personal loans, home improvement loans,
automobile and other consumer financing.
The Bank's profitability depends primarily on its net interest income,
the difference between the interest income it earns on its loans and investment
portfolio and its cost of funds, which consists mainly of interest paid on
deposits. Net interest income is affected by the relative amounts of
interest-earning assets and interest-bearing liabilities and the interest rates
earned or paid on these balances. When interest-earning assets approximate or
exceed interest-bearing liabilities, any positive interest rate spread will
generate net interest income.
The Bank's profitability is also affected by the level of other
(noninterest) income and operating expenses. Other income consists primarily of
service fees, loan servicing and other loan fees and gains on
1
<PAGE>
sales of investment securities. Operating expenses consist of salaries and
benefits, occupancy-related expenses, and other general operating expenses.
The operations of the Bank, and banking institutions in general, are
significantly influenced by general economic conditions and related monetary and
fiscal policies of financial institutions' regulatory agencies. Deposit flows
and the cost of funds are influenced by interest rates on competing investments
and general market rates of interest. Lending activities are affected by the
demand for financing real estate and other types of loans, which in turn are
affected by the interest rates at which such financing may be offered and other
factors affecting loan demand and the availability of funds.
Asset/Liability Management
A principal operating objective of the Bank is to produce stable
earnings by achieving a favorable interest rate spread that can be sustained
during fluctuations in prevailing interest rates. Since the Bank's principal
interest-earning assets have longer terms to maturity than its primary source of
funds, i.e., deposit liabilities, increases in general interest rates will
generally result in an increase in the Bank's cost of funds before the yield on
its asset portfolio adjusts upward. The Bank has sought to reduce its exposure
to adverse changes in interest rates by attempting to achieve a closer match
between the periods in which its interest-bearing liabilities and
interest-earning assets can be expected to reprice through the origination of
adjustable-rate mortgages and loans with shorter terms and the purchase of other
shorter term interest-earning assets.
The term "interest rate sensitivity" refers to those assets and
liabilities which mature and reprice periodically in response to fluctuations in
market rates and yields. As noted above, one of the principal goals of the
Bank's asset/liability program is to maintain and match the interest rate
sensitivity characteristics of the asset and liability portfolios.
In order to properly manage interest rate risk, the Bank's Board of
Directors has established an Asset/Liability Management Committee ("ALCO") made
up of members of management to monitor the difference between the Bank's
maturing and repricing assets and liabilities and to develop and implement
strategies to decrease the "negative gap" between the two. The primary
responsibilities of the committee are to assess the Bank's asset/liability mix,
recommend strategies to the Board that will enhance income while managing the
Bank's vulnerability to changes in interest rates and report to the Board the
results of the strategies used.
Credit Policies
The Bank utilizes written policies and procedures to enhance management
of credit risk. The loan portfolio is managed under a specifically-defined
credit process. This process includes formulation of portfolio management
strategy, guidelines for underwriting standards and risk assessment, procedures
for ongoing identification and management of credit deterioration, and regular
portfolio reviews to estimate loss exposure and ascertain compliance with the
Bank's policies. Lending authority is granted to individual lending officers
with the current highest limit being $150,000 for secured and $25,000 for
unsecured loans. Any two officers acting together may approve a loan up to the
amount of the lower lending authority of the two officers. An Officers' Loan
Committee comprised of six officers is authorized to approve credit of up to
$400,000 for secured loans and $200,000 for unsecured loans. Approval of such
credits requires a majority vote of the Officers' Loan Committee. The Directors'
Loan Committee is authorized to approve loans up to the legal lending limit of
the Bank.
The Bank's management generally requires that secured loans have a
loan-to-value ratio of 80% or less. Management believes that when a borrower has
significant equity in the assets securing the loan, the borrower is less likely
to default on the outstanding loan balance.
2
<PAGE>
A major element of credit risk management is diversification. The
Bank's objective is to maintain a diverse loan portfolio to minimize the impact
of any single event or set of circumstances. Concentration parameters are based
on factors of individual risk, policy constraints, economic conditions,
collateral and product type.
Lending activities include a variety of consumer, real estate and
commercial loans with a strong emphasis on serving the needs of customers within
the Bank's market territory. Consumer loans are made primarily on a secured
basis in the form of installment obligations or personal lines of credit. The
focus of real estate lending is commercial mortgages, but also includes home
improvement loans, construction lending and home equity lines of credit.
Commercial lending is provided to businesses seeking credit for working capital
and the purchase of equipment and facilities. The principal lending activity of
the Bank is concentrated in mortgage loans secured by commercial real estate,
usually consisting of commercial and warehouse facilities in the Bank's market
area.
Market Area
The Bank currently has one office serving the McLean area of Fairfax
County, Virginia. From this office, the Bank serves its customers, the majority
of whom own businesses or reside in the McLean/Great Falls area of Northern
Virginia, which is located eight miles west of Washington, DC. The remainder of
the Bank's customers reside primarily in other communities in Fairfax County,
and, to a lesser extent, Arlington and Loudoun counties. A second branch is
scheduled to open in Loudoun County, Virginia (the "CountrySide Branch") in late
March or April, 1999.
McLean lies in the northernmost part of Fairfax County, Virginia, by
most measures, the wealthiest county in Virginia. The median household income in
Fairfax County in 1996 was $78,000 - the highest in the country. The 1997
population of Fairfax County is estimated to have been 913,012. Fairfax County
is also home to many information technology firms including UUNet and PSINet. It
is estimated that nearly one-half of all international Internet traffic flows
through one of the Fairfax-based access providers.
McLean is home to the Central Intelligence Agency, McLean's largest
employer, and the Federal Home Loan Mortgage Corporation. The Bank provides
financial services to the many professional service firms, including lawyers,
accountants, consultants and engineers that have offices in McLean. McLean's
population is estimated to be approximately 63,000. The median household income
in McLean was estimated to be $70,000 in 1996. McLean also includes the Tysons
Corner area, an office and commercial district that is home to a significant
number of high-technology employers. Major employers in Tysons Corner include
INOVA Health Systems, EDS, SAIC and AT&T. Tysons Corner is also home to two
major shopping centers and several major hotels.
With the opening of the CountrySide branch, the Bank expects to expand
its market area to include a significant portion of Loudoun County, one of the
fastest growing counties in the United States. According to census figures, the
1997 population of Loudoun County has increased to approximately 133,000
persons, representing an increase of 55% since 1990 compared to population
growth of 9% in the Washington, D.C. region as a whole during the same period.
Among counties with more than 10,000 residents, Loudoun County's 7.7% growth
rate for 1996-97 ranked eighth in the nation. This area is experiencing
significant economic growth as a result of the expansion of the Dulles
International Airport technology corridor and the influx of "high-tech"
companies from Fairfax County. The Loudoun County market is predominately
residential with a healthy mix of retail, service activities and light industry.
Eastern Loudoun County, with a population of approximately 50,000, is
the fastest growing area of Loudoun County and Northern Virginia. It contains
several mature residential neighborhoods and the newer developments of
CountrySide, Cascades, and Ashburn Village. Several large high-tech companies
such as America Online and Alcatel Data Networks have recently moved their
headquarters to eastern Loudoun County, giving rise to accelerated residential
building and retail development in the area. More than 4,000 housing sites are
in various stages of future development in the area. In addition, the 300-acre
regional mall,
3
<PAGE>
Dulles Town Center, is being constructed within one mile of the site. The new
branch will be located in the CountrySide Shopping and Professional Center, a
350,000 square foot retail/professional/medical campus near the entrance to the
2,500 unit CountrySide residential community that is home to over 12,000
persons. The site also borders on Cascades, a new 6,000-unit planned residential
development and associated shopping center, Cascades Market Place. Over 100,000
persons with an average family income of $71,000 are estimated to live within
five miles of the branch's location. The Bank believes that development now
taking place along the Route 7 and Route 28 corridors, coupled with the rapid
population growth in eastern Loudoun County, will provide the Bank with the
opportunity to expand its consumer and small business services.
Competition
The Bank operates in the highly competitive environment of the McLean
area of Fairfax County. It competes for deposits and loans with commercial
banks, savings and loans, credit unions and other financial institutions,
including non-bank competitors such as loan companies, insurance companies and
large securities firms. Many of these organizations possess substantially
greater financial and technical resources than the Bank.
In Fairfax County, the Bank commands 0.42% of the market, according to
the most recent survey of deposits by the Federal Deposit Insurance Corporation
("FDIC"). In McLean, the Bank commands 3.27% of the market. Seventeen banks with
31 branches operate in the greater McLean area and 17 of these branches are
located in proximity to the Bank in the McLean Central Business District. The
Heritage Bank is the only community bank headquartered in McLean.
The market is mature and the growth of deposits and loan demand has
slowed in recent years. While it can produce stable earnings from its operations
in the McLean office, the Bank believes the future growth of the Bank will be in
expansion to other parts of Northern Virginia, including Loudoun County.
There are 12 commercial banks with 37 branches located in Loudoun
County with deposits totaling approximating $900 million. A number of mortgage
companies along with several non-bank financial institutions also compete in the
area. Nine bank branches are located in eastern Loudoun County. All are
full-service banks and provide a wide array of bank products and services,
although none of these banks is considered to be a community bank, like The
Heritage Bank. The Bank believes that it will enjoy a competitive advantage due
to its local community bank orientation and reputation for providing
personalized service to its customers.
With the opening of the CountrySide Branch, the Bank expects to
increase its deposit base, which in turn will increase the funds available for
loans and other profitable opportunities for the Bank. While the Bank will
continue to experience a competitive environment in Fairfax and Loudoun
counties, there still exist opportunities to establish new branches in those
areas where significant population increases and economic growth are occurring.
Year 2000 Issues
Background. The "Year 2000 Problem" centers on the inability of
computer systems to precisely recognize the year 2000. Many existing computer
programs and systems were originally programmed with six digit dates that
provided only two digits to identify the calendar year in the date field,
without considering the upcoming change in the century. With the impending
millennium, these programs and computers will recognize "00" as the year 1900
rather than the year 2000. If computer systems are not adequately changed to
identify the year 2000, many computer applications could fail or create
erroneous results. As a result, many calculations which rely on the date/field
information, such as interest, payment or due dates and other operating
functions, will generate results which could be significantly misstated, and the
Bank could experience a temporary inability to process transactions, send
invoices or engage in similar normal business
4
<PAGE>
activities. In addition, under certain circumstances, failure to adequately
address the Year 2000 Problem could adversely affect the viability of the Bank's
suppliers and creditors and the creditworthiness of its borrowers. Thus, if not
adequately addressed, the Year 2000 Problem could result in a significant
adverse impact on the Bank's products, services and competitive condition.
In addition, noninformation technology systems, such as telephones,
copies and elevators may contain embedded technology which controls its
operations and which may be affected by the Year 2000 Problem. Thus, even
noninformation technology systems may affect the normal operations of the
Company upon the arrival of the Year 2000.
Financial institution regulators have recently increased their focus
upon year 2000 issues, issuing guidance concerning the responsibilities of
senior management and directors. The FDIC and the other federal banking
regulators have issued safety and soundness guidelines to be followed by insured
depository institutions, such as the Bank, to assure resolution of any year 2000
problems. The federal banking agencies have asserted that year 2000 testing and
certification is a key safety and soundness issue in conjunction with regulatory
exams, and thus an institution's failure to address appropriately the Year 2000
Problem could result in supervisory action, including such enforcement actions
as the reduction of the institution's supervisory ratings, the denial of
applications for approval of a merger or acquisition, or the imposition of civil
money penalties.
Federal banking regulators have also issued safety and soundness
guidelines to be used in conjunction with routine regulatory examinations.
Failure by federally regulated institutions to adequately address the Year 2000
Problem may result in supervisory action, including the reduction to the
institution's supervisory rating, the denial of applications for approval of
mergers and acquisitions, the denial of applications for new branch openings or
the imposition of civil money penalties.
Risk. Similar to other financial institutions and companies that
utilize computer technology, the Company's operations may be significantly
affected by the Year 2000 Problem because of its reliance on electronic data
processing technology and date-sensitive information. The Year 2000 issue also
impacts other aspects of our non-technical business processes. If the Year 2000
Problem is not adequately addressed, and systems are not modified to properly
identify the Year 2000, computer systems and software applications may fail or
create erroneous information.
If the Bank and the Company are affected by the Year 2000 Problem, the
worst case scenario may be that information that relies on dates, such as
interest calculations, loan payment schedules and other operating functions,
could be significantly incorrect. The Bank may not be able to process
withdrawals or deposits, prepare account statements, or engage in any of the
many transactions that constitute its normal operations. The Bank's inability to
adequately address the Year 2000 Problem could also have a significant adverse
affect on the Bank's suppliers and service providers. Should the Bank experience
a Year 2000 failure that can not readily be fixed, it may result in a
significant adverse impact on our financial condition and results of operations.
State of Readiness. The Company believes that technology plays a
critical role in its overall business strategy. It has consistently attempted to
stay current with technological advances in the industry. In this regard, the
board of managers and senior management have consistently supported investment
in established and proven technologies. Because of this philosophy, the board of
managers and senior management have been actively engaged in managing the Year
2000 project. Management has consistently allocated both human and financial
resources to this project to achieve the objectives and time frames mandated by
the FFIEC.
To address the Year 2000 Problem, the Bank hired an outside consultant
to assess the impact of the Year 2000 Problem on the Bank. Because the Bank
outsources its data processing operations, a significant
5
<PAGE>
component of the Year 2000 plan is working with external vendors to test and
certify their systems as Year 2000 compliant. The Bank's eternal vendors have
surveyed their programs to inventory the necessary changes and have begun
correcting the applicable computer programs and replacing equipment so that the
Bank's information systems will be Year 2000 compliant by the end of 1998. This
will enable the Bank to devote substantial time to the testing of the upgraded
systems prior to the arrival of the millennium in order to comply with all
applicable regulations.
The Company's timetable for working on the Year 2000 Problem, in order
to achieve a successful transition to the Year 2000, is divided into the
following five phases:
<TABLE>
<CAPTION>
PHASE DESCRIPTION STATUS
- --------------------- ----------------------------------------------- ----------------------
<S> <C> <C> <C>
1. Awareness Define the problem. Completed - 11/1/97
2. Assessment Identify all systems and criticality of systems. Completed - 6/1/98
3. Renovation Program enhancements, hardware and software 99% Complete -
upgrades, system replacements, and vendor 11/30/98
certifications.
4. Validation Test and verify system changes. 99% Complete -
11/30/98
5. Implementation Components certified as Year 2000 compliant 99% Complete -
and moved to production. 11/30/98
</TABLE>
Contingency Planning. The Bank has a contingency plan to keep the Bank
in operation in the event that some Year 2000 problems have been overlooked and
system malfunctions occur at the turn of the century. This plan was developed by
the Bank's outside consultant with the help of Bank management. The Company has
developed contingency or alternate plans for its mission critical systems on a
department-by- department basis in anticipation of potential unplanned system
difficulties or third-party failures at January 1, 2000 or dates beyond.
However, the Bank understands that certain events beyond its control, such as
extended power outages and loss of telecommunications, may diminish its ability
to provide minimum levels of service. Failure of these services will affect
companies, individuals and the government, and can not be remedied by anyone
other than the responsible party. For some systems, contingency plans consist of
using or reverting to manual systems until the problems can be corrected.
While the Company expects to complete its Year 2000 project in a timely
manner, it can not guarantee that the systems of companies with whom it conducts
business, will also be completed in a timely manner. The failure of these
entities to adequately address the Year 2000 Problem could adversely affect the
Company's and Bank's ability to conduct business.
Costs. The Company currently estimates its total direct and indirect
cost will be $35,000. To date, the Company has spent $31,000 on Year 2000
issues. The costs of the project and the date on which the Bank plans to
complete the Year 2000 modifications are based on management's best estimates,
which were derived utilizing numerous assumptions of future events including the
continued availability of certain resources, third party modification plans and
other factors. However, there can be no guarantee that these estimates will be
achieved, and actual results could differ materially from those plans. In
addition, there can be no guarantee that the systems of other companies on which
the Bank's systems rely will be timely converted, or that a failure to convert
by another company, or a conversion that is incompatible with the Bank's
systems, would not have a material adverse effect on the Bank.
6
<PAGE>
Employees
At December 31, 1998, the Bank had twenty-seven full-time equivalent
employees. None of its employees is represented by any collective bargaining
unit. The Bank considers relations with its employees to be good.
Federal Taxation
General. The following is intended only as a discussion of material
federal income tax matters and does not purport to be a comprehensive
description of the federal income tax rules applicable to the Bank or the
Company. For federal income tax purposes, the Company and the Bank, as members
of the same affiliated group, file consolidated income tax returns on a December
31 fiscal year basis using the accrual method of accounting and are subject to
federal income taxation in the same manner as other corporations with some
exceptions, including particularly the Bank's tax reserve for bad debts,
discussed below.
Bad Debt Reserves. The Bank, as a "small bank" (one with assets having
an adjusted tax basis of $500 million or less) is permitted to maintain a
reserve for bad debts with respect to "qualifying loans," which, in general, are
loans secured by certain interests in real property, and to make, within
specified formula limits, annual additions to the reserve which are deductible
for purposes of computing the Bank's taxable income. Pursuant to the Small
Business Job Protection Act of 1996, the Bank is now recapturing (taking into
income) over a multi-year period a portion of the balance of its bad debt
reserve as of December 31, 1995. See Note 8 to the consolidated financial
statements.
Distributions. To that the extent that the Bank makes "non-dividend
distributions" to the Company, such distributions will be considered to have
been made from the Bank's "base year reserve", and then from the Bank's
supplemental reserve for losses on loans, to the extent thereof, and an amount
based on the amount distributed (but not in excess of the amount of such
reserves) will be included in the Bank's income. Non-dividend distributions
include distributions in excess of the Bank's current and accumulated earnings
and profits, as calculated for federal income tax purposes, distributions in
redemption of stock, and distributions in partial or complete liquidation.
Dividends paid out of the Bank's current or accumulated earnings and profits
will not be so included in the Bank's income.
The amount of additional taxable income created from a non-dividend
distribution is an amount that, when reduced by the tax attributable to the
income, is equal to the amount of the distribution. Thus, if the Bank makes a
non-dividend distribution to the Company, approximately one and one-half times
the amount of such distribution (but not in excess of the amount of such
reserves) would be includible in income, assuming a 34% federal corporate income
tax rate. The Bank does not intend to pay dividends that would result in a
recapture of any portion of its bad debt reserves.
Corporate Alternative Minimum Tax. The Code imposes a tax ("AMT") on
alternative minimum taxable income ("AMTI") at a rate of 20%. Only 90% of AMTI
can be offset by net operating loss carryovers of which the Bank currently has
none. AMTI is also adjusted by determining the tax treatment of certain items in
a manner that negates the deferral of income resulting from the regular tax
treatment of those items. Thus, the Bank's AMTI is increased by an amount equal
to 75% of the amount by which the Bank's adjusted current earnings exceeds its
AMTI (determined without regard to this adjustment and prior to reduction for
net operating losses). The Bank does not expect to be subject to the AMT.
Elimination of Dividends; Dividends Received Deduction. The Company may
exclude from its income 100% of dividends received from the Bank as a member of
the same affiliated group of corporations.
7
<PAGE>
State Taxation
The Bank is exempt from paying state income tax to the Commonwealth of
Virginia. Under Virginia law, however, banks must pay a franchise tax at the
rate of $1 on each $100 of net capital as defined under Virginia law. For
additional information regarding taxation, see Note 8 of the Notes to Financial
Statements.
REGULATION AND SUPERVISION
The Bank is extensively regulated under both federal and state law. The
following is a brief summary of certain statutes, rules and regulations
affecting the Company and the Bank. This summary is qualified in its entirety by
reference to the particular statutory and regulatory provisions referred to
below and is not intended to be an exhaustive description of the statutes or
regulations applicable to the Bank's business.
Regulation of the Bank
The Bank is organized as a Virginia-chartered banking corporation and
is regulated and supervised by the Virginia State Corporation Commission
("SCC"). In addition, the Bank is regulated and supervised by the FRB, which
serves as its primary federal regulator, and is subject to certain regulations
promulgated by the FDIC. The SCC and the FRB conduct regular examinations of the
Bank, reviewing the adequacy of its loan loss reserves, the quality of its loans
and investments, the propriety of management practices, compliance with laws and
regulations, and other aspects of the Bank's operations. In addition to these
regular examinations, the Bank must furnish to the FRB quarterly reports
containing detailed financial statements and schedules.
Federal and Virginia banking laws and regulations govern all areas of
the operations of the Bank, including reserves, loans, mortgages, capital,
issuance of securities, payment of dividends and establishment of branches.
Federal and state bank regulatory agencies also have the general authority to
limit the dividends paid by insured banks. See "--Limits on Dividends and Other
Payments." As its primary federal regulator, the FRB has authority to impose
penalties, initiate civil and administrative actions and take other steps
intended to prevent the Bank from engaging in unsafe or unsound practices. In
this regard, the Federal Reserve has adopted capital adequacy requirements
applicable to state member banks such as the Bank. See "--Capital Requirements."
Transactions with Affiliates and Insiders of the Bank. Transactions
between an insured bank, such as the Bank, and any of its affiliates are
governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a
bank is any company or entity which controls, is controlled by or is under
common control with the bank. Generally, Sections 23A and 23B (i) limit the
extent to which the bank or its subsidiaries may engage in "covered
transactions" with any one affiliate to an amount equal to 10% of such
institution's capital stock and surplus, and limit all such transactions with
all affiliates to an amount equal to 20% of such capital stock and surplus and
(ii) require that all such transactions be on terms that are consistent with
safe and sound banking practices. In addition, any purchase of assets or
services by a bank from an affiliate must be on terms that are substantially the
same, or at least as favorable, to the institution as those that would be
provided to a non-affiliate. The term "covered transaction" includes the making
of loans, purchase of assets, issuance of guarantees and similar other types of
transactions. Further, most loans by a bank to its affiliate must be supported
by collateral in amounts ranging from 100 to 130 percent of the loan amounts.
Banks are also subject to the restrictions contained in Section 22(h)
of the Federal Reserve Act and the Federal Reserve Board's Regulation O
thereunder on loans to executive officers, directors and principal stockholders.
Under Section 22(h), loans to a director, an executive officer or a greater than
10% stockholder of a bank as well as certain affiliated interests of any of the
foregoing, may not exceed, together with all other outstanding loans to such
person and affiliated interests, the loans-to-one-borrower limit applicable to
national banks (generally 15% of the institution's unimpaired capital and
surplus), and all loans to all such persons in the aggregate may not exceed the
institution's unimpaired capital and unimpaired surplus. Regulation O also
prohibits the making of loans in an amount greater than $25,000 or 5% of capital
and surplus but in any event over $500,000, to directors, executive officers and
greater than 10% stockholders of a bank, and their respective affiliate, unless
such loans are approved in advance by a majority of the Board of Directors of
the bank with any "interested" director not participating in the voting.
Further, Regulation O requires that loans to directors, executive officers and
principal stockholders be made on terms substantially the same as those that are
offered in comparable transactions to other persons. Regulation O
8
<PAGE>
also prohibits a depository institution from paying the overdrafts over $1,000
of any of its executive officers or directors unless they are paid pursuant to
written pre-authorized extension of credit or transfer of funds plans.
Community Reinvestment. Under the Community Reinvestment Act ("CRA"),
as implemented by FRB regulations, a bank has a continuing and affirmative
obligation consistent with its safe and sound operation to help meet the credit
needs of its entire community, including low and moderate income neighborhoods.
The CRA does not establish specific lending requirements or programs for
financial institutions nor does it limit an institution's discretion to develop
the types of products and services that it believes are best suited to its
particular community, consistent with the CRA. The CRA requires the FRB, in
connection with its examination of a bank, to assess the bank's record of
meeting the credit needs of its community and to take such record into account
in its evaluation of certain applications by such bank. The CRA also requires
all institutions to make public disclosure of their CRA ratings. The Bank
received a "satisfactory" CRA rating in its most recent examination.
In April 1995, the federal banking agencies adopted amendments revising
their CRA regulations. Among other things, the amended CRA regulations
substitute for the prior process-based assessment factors a new evaluation
system that would rate an institution based on its actual performance in meeting
community needs. In particular, the proposed system would focus on three tests:
(a) a lending test, to evaluate the institution's record of making loans in its
service areas; (b) an investment test, to evaluate the institution's record of
investing in community development projects, affordable housing, and programs
benefitting low or moderate income individuals and businesses; and (c) a service
test, to evaluate the institution's delivery of services through its branches,
ATMs, and other offices. Small banks would be assessed pursuant to a streamlined
approach focusing on a lesser range of information and performance standards.
The term "small bank" is defined as including banks with less than $250 million
in assets or an affiliate of a holding company with banking and thrift assets of
less than $1 billion, which would include the Bank.
The regulatory agency's assessment of the bank's record is made
available to the public. Further, such assessment is required by any bank which
has applied to, among other things, establish a new branch office that will
accept deposits, relocate an existing office, or merge, consolidate with or
acquire the assets or assume the liabilities of a federally-regulated financial
institution.
Safety and Soundness Standards. Pursuant to the requirements of Section
39 of the FDICIA, as amended by the Riegle Community Development and Regulatory
Improvement Act of 1994, each federal banking agency, including the FRB, has
adopted guidelines establishing general standards relating to internal controls,
information and internal audit systems, loan documentation, credit underwriting,
interest rate exposure, asset growth, asset quality, earnings and compensation,
fees and benefits. In general, the guidelines require, among other things,
appropriate systems and practices to identify and manage the risks and exposures
specified in the guidelines. The guidelines prohibit excessive compensation as
an unsafe and unsound practice and describe compensation as excessive when the
amounts paid are unreasonable or disproportionate to the services performed by
an executive officer, employee, director, or principal shareholder.
Capital Requirements
The Federal Deposit Insurance Corporation Act of 1991 ("FDICIA")
requires the Federal Reserve to take "prompt corrective action" with respect to
any insured depository institution which does not meet specified minimum capital
requirements. The applicable regulations establish five capital levels, ranging
from "well-capitalized" to "critically undercapitalized," and require or permit
the Federal Reserve to take supervisory action in certain circumstances. Under
these regulations, an insured depository institution is considered
well-capitalized if it 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 it is not subject to an order, written agreement, capital
directive or prompt corrective action directive to meet and maintain a specific
9
<PAGE>
capital level for any capital measure. An insured depository institution is
considered adequately capitalized if it has a Total Risk-based Capital ratio of
8.0% or greater, a Tier I Risk-based Capital ratio and Leverage ratio of 4.0% or
greater (or a Leverage ratio of 3.0% or greater if the institution is rated
composite 1 in its most recent report of examination, subject to appropriate
federal banking agency guidelines), and the institution does not meet the
definition of an undercapitalized institution. An insured depository institution
is considered undercapitalized if it has a Total Risk-based Capital ratio that
is less than 8.0%, a Tier 1 Risk-based Capital ratio that is less than 4.0%, or
a Leverage ratio that is less than 4.0%. A significantly undercapitalized
institution is one which has a Total Risk-based Capital ratio that is less than
6.0%, a Tier 1 Risk-based Capital ratio that is less than 3.0%, or a Leverage
ratio that is less than 3.0%. A critically undercapitalized institution is one
which has a ratio of tangible equity to total assets that is equal to or less
than 2.0%. As of December 31, the Bank was classified as well-capitalized. The
Bank's Tier 1 and Total Risk-based Capital ratios as of December 31, 1997 were
17.4% and 18.6%, respectively.
The severity of action authorized or required to be taken under prompt
corrective action regulations increases as a bank's capital deteriorates within
the three undercapitalized categories. All banks are prohibited from paying
dividends or other capital distributions or paying management fees to any
controlling person, if, following such distribution, the bank will be
undercapitalized. The Federal Reserve is authorized by this legislation and
under Regulation H (which regulates state member banks) to take various
enforcement actions against any undercapitalized insured depository institution
and any insured depository institution that fails to submit an acceptable
capital restoration plan or fails to implement a plan accepted by the Federal
Reserve. These powers include, among other things, requiring the institution to
be recapitalized, prohibiting asset growth, restricting interest rates paid,
requiring prior approval of capital distributions by any bank holding company
which controls the institution, requiring divestiture by the institution of its
subsidiaries or by the holding company of the institution itself, requiring new
election of directors, and requiring the dismissal of directors and officers.
With certain exceptions, insured depository institutions will be
prohibited from making capital distributions or paying management fees if the
payment of such distributions or fees will cause them to become
undercapitalized. Furthermore, undercapitalized insured depository institutions
will be required to file capital restoration plans with the Federal Reserve.
Undercapitalized insured depository institutions also will be subject to
restrictions on growth, acquisitions, branching and engaging in new lines of
business unless they have an approved capital plan that permits otherwise. The
Federal Reserve also may, among other things, require an undercapitalized
insured depository institution to issue shares or obligations, which could be
voting stock, to recapitalize the institution or, under certain circumstances,
to divest itself of any subsidiary.
Significantly and critically undercapitalized insured depository
institutions may be subject to more extensive control and supervision. The
Federal Reserve may prohibit any such institutions from, among other things,
entering into any material transaction not in the ordinary course of business,
amending their Articles of Incorporation or bylaws, or engaging in certain
transactions with affiliates. In addition, critically undercapitalized
institutions generally will be prohibited from making payments of principal or
interest on outstanding subordinated debt. Within 90 days of an insured
depository institution becoming critically undercapitalized, the Federal Reserve
must appoint a receiver or conservator unless certain findings are made with
respect to the prospect for the institution's continued viability. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Analysis of Financial Condition -- Capital Requirements" for more
information about the Bank's capital ratios and applicable minimum ratios.
Branching
Under the Riegle-Neal Interstate Banking and Branching Efficiency Act
of 1994 (the "Riegle Act"), the Federal Reserve may approve bank holding company
acquisitions of banks in other states, subject to certain aging and deposit
concentration limits. As of June 1, 1997, banks in one state may merge with
banks
10
<PAGE>
in another state, unless the other state has chosen not to implement this
section of the Riegle Act. These mergers are also subject to similar aging and
deposit concentration limits.
Virginia "opted-in" to the provisions of the Riegle Act. Since July 1,
1995, an out-of-state bank that did not already maintain a branch in Virginia
was permitted to establish and maintain a de novo branch in Virginia, or acquire
a branch in Virginia, if the laws of the home state of the out-of-state bank
permit Virginia banks to engage in the same activities in that state under
substantially the same terms as permitted by Virginia. Also, Virginia banks may
merge with out-of-state banks, and an out-of-state bank resulting from such an
interstate merger transaction may maintain and operate the branches in Virginia
of a merged Virginia bank, if the laws of the home state of the out-of-state
bank involved in the interstate merger transaction permit interstate merger.
Legislative Developments
On September 30, 1996, President Clinton signed the Economic Growth and
Regulatory Paperwork Reduction Act of 1996 (the "Growth Act"), which contained a
comprehensive approach to recapitalize the FDIC's Savings Association Insurance
Fund (the "SAIF") and to assure payment of the Financing Corporation (the
"FICO") obligations. Most of the Bank's deposits are insured by the FDIC's Bank
Insurance Fund (the "BIF"). Under the Growth Act, banks with deposits that are
insured under the BIF are required to pay a portion of the interest due on bonds
that were issued by FICO to help shore up the ailing Federal Savings and Loan
Insurance Corporation in 1987. The Growth Act stipulates that the BIF assessment
rate to contribute toward the FICO obligations must be equal to one-fifth the
SAIF assessment rate through year-end 1999, or until the insurance funds are
merged, whichever occurs first. The amount of FICO debt service to be paid by
all BIF-insured institutions is approximately $0.0126 per $100 of BIF-insured
deposits for each year from 1997 through 1999 when the obligation of BIF-insured
institutions increases to approximately $0.0240 per $100 of BIF-insured deposits
per year through the year 2019, subject in all cases to adjustments by the FDIC
on a quarterly basis. The Growth Act also contained provisions protecting banks
from liability for environmental clean-up costs; prohibiting credit unions
sponsored by Farm Credit System banks; easing application requirements for most
bank holding companies when they acquire a thrift or a permissible non-bank
operation; easing Fair Credit Reporting Act restrictions between bank holding
company affiliates; and reducing regulatory burden under the Real Estate
Settlement Procedures Act, the Truth-in-Savings Act, the Truth-in-Lending Act
and the Home Mortgage Disclosure Act.
Federal Reserve System
Pursuant to regulations of the FRB, a bank must maintain average daily
reserves equal to 3% on the first $52 million of net transaction accounts, plus
10% on the remainder. This percentage is subject to adjustment by the FRB.
Because required reserves must be maintained in the form of vault cash or in a
non-interest bearing account at a Federal Reserve Bank, the effect of the
reserve requirement is to reduce the amount of the institution's
interest-earning assets. As of December 31, 1998, the Bank met its reserve
requirements.
Effect of Economic Environment
The policies of regulatory authorities, including the monetary policy
of the Federal Reserve, have a significant effect on the operating results of
banks and their subsidiaries. Among the means available to the Federal Reserve
to affect the money supply are open market operations in U.S. government
securities, changes in the discount rate on member bank borrowings, and changes
in reserve requirements against member bank deposits. These means are used in
varying combinations to influence overall growth and distribution of bank loans,
investments and deposits, and their use may affect interest rates charged on
loans or paid for deposits.
11
<PAGE>
Federal Reserve monetary policies have materially affected the
operating results of commercial banks in the past and are expected to continue
to do so in the future. The nature of future monetary policies and the effect of
such policies on the business and income of the Bank cannot be predicted.
Limits on Dividends and Other Payments
As a state member bank subject to the regulations of the Federal
Reserve, the Bank must obtain the approval of the Federal Reserve for any
dividend if the total of all dividends declared in any calendar year would
exceed the total of its net profits, as defined by the Federal Reserve, for that
year, combined with its retained net profits for the preceding two years. In
addition, the Bank may not pay a dividend in an amount greater than its
undivided profits then on hand after deducting its losses and bad debts. For
this purpose, bad debts are generally defined to include the principal amount of
loans which are in arrears with respect to interest by six months or more,
unless such loans are fully-secured and in the process of collection. Moreover,
for purposes of this limitation, the Bank is not permitted to add the balance in
its allowance for loan losses account to its undivided profits then on hand;
however, it may net the sum of its bad debts, as so defined, against the balance
in its allowance for loan losses account and deduct from undivided profits only
bad debts, as so defined, in excess of that account. At December 31, 1998, the
Bank could not declare or pay any dividends and had made no requests to do so.
The Bank expects that it will qualify to pay dividends in 1999.
In addition, the Federal Reserve is authorized to determine under
certain circumstances relating to the financial condition of a state member
bank, that the payment of dividends would be an unsafe or unsound practice and
to prohibit payment thereof. The payment of dividends that would deplete a
bank's capital base could be deemed to constitute such an unsafe or unsound
practice. The Federal Reserve has indicated that banking organizations should
generally pay dividends only out of current operating earnings.
FDICIA provides that no insured depository institution may make any
capital distribution, including a cash dividend if, after making the
distribution, the institution would not satisfy one or more of its minimum
capital requirements.
In addition, Virginia law imposes restrictions on the ability of all
banks chartered under Virginia law to pay dividends. Under Virginia law, no
dividend may be declared or paid that would impair a Virginia-chartered bank's
paid-in capital. The SCC also has authority to limit the payment of dividends by
a Virginia bank if it determines the limitation is in the public interest and is
necessary to ensure the bank's financial soundness.
Regulation of Holding Company
Federal Regulation. The Company is subject to examination, regulation
and periodic reporting under the BHCA, as administered by the FRB. The FRB has
adopted capital adequacy guidelines for bank holding companies on a consolidated
basis substantially similar to those of the FRB for the Bank.
The Company is required to obtain the prior approval of the FRB to
acquire all, or substantially all, of the assets or any bank of bank holding
company. Prior FRB approval will be required for the Company to acquire direct
or indirect ownership or control of any voting securities of any bank or bank
holding company if, after giving effect to such acquisition, it would, directly
or indirectly, own or control more than 5% of any class of voting shares of such
bank or bank holding company.
The Company is required to give the FRB prior written notice of any
purchase or redemption of its outstanding equity securities if the gross
consideration for the purchase or redemption, when combined with the net
consideration paid for all such purchases or redemptions during the preceding 12
months, is equal to 10% or more of the Company's consolidated net worth. The FRB
may disapprove such a purchase or redemption if it determines that the proposal
would constitute an unsafe and unsound practice, or would
12
<PAGE>
violate any law, regulation, FRB order or directive, or any condition imposed
by, or written agreement with, the FRB. Such notice and approval is not required
for a bank holding company that would be treated as "well capitalized" under
applicable regulations of the FRB, that has received a composite "1" or "2"
rating at its most recent bank holding company inspection by the FRB, and that
is not the subject of any unresolved supervisory issues.
The status of the Company as a registered bank holding company under
the BHCA does not exempt it from certain federal and state laws and regulations
applicable to corporations generally, including, without limitation, certain
provisions of the federal securities laws.
In addition, a bank holding company is prohibited generally from
engaging in, or acquiring 5% or more of any class of voting securities of any
company engaged in, non-banking activities. One of the principal exceptions to
this prohibition is for activities found by the FRB to be so closely related to
banking or managing or controlling banks as to be a proper incident thereto.
Some of the principal activities that the FRB has determined by regulation to be
so closely related to banking as to be a proper incident thereto are: (i) making
or servicing loans; (ii) performing certain data processing services; (iii)
providing discount brokerage services; (iv) acting as fiduciary, investment or
financial advisor; (v) leasing personal or real property; (vi) making
investments in corporations or projects designed primarily to promote community
welfare; and (vii) acquiring a savings and loan association.
Under FIRREA, depository institutions are liable to the FDIC for losses
suffered or anticipated by the FDIC in connection with the default of a commonly
controlled depository institution or any assistance provided by the FDIC to such
an institution in danger of default. This law would have potential applicability
if Bancorp ever acquired as a separate subsidiary a depository institution in
addition to the Bank. There are no current plans for such an acquisition.
Subsidiary banks of a bank holding company are subject to certain
quantitative and qualitative restrictions imposed by the Federal Reserve Act on
any extension of credit to, or purchase of assets from, or letter of credit on
behalf of, the bank holding company or its subsidiaries, and on the investment
in or acceptance of stocks or securities of such holding company or its
subsidiaries as collateral for loans. In addition, provisions of the Federal
Reserve Act and FRB regulations limit the amounts of, and establish required
procedures and credit standards with respect to, loans and other extensions of
credit to officers, directors and principal stockholders of the Bank, the
Company, any subsidiary of the Company and related interests of such persons.
Moreover, subsidiaries of bank holding companies are prohibited from engaging in
certain tie-in arrangements (with the holding company or any of its
subsidiaries) in connection with any extension of credit, lease or sale of
property or furnishing of services.
Federal Securities Laws
The Company's Common Stock is registered with the SEC under Section
12(g) of the Securities Exchange Act of 1934 (the "Exchange Act"). The Company
is subject to the information, proxy solicitation, insider trading restrictions
and other requirements under the Exchange Act.
ITEM 2. PROPERTIES
The principal office of the Bank is located at 1313 Dolley Madison
Boulevard, McLean, Virginia where the Bank leases approximately 8,407 square
feet in an office building. All of the Bank's administrative and customer
service facilities are at this location. The lease was for an initial term of
ten years, beginning July 1988, with three 5 year renewal options. The current
monthly rent is $15,046. The Bank also owns a parcel of land in Great Falls,
Virginia valued at $245,000, which it is holding for future bank use. The Bank
has classified one parcel of real estate, acquired through foreclosure, as
"other real estate owned" totaling $263,000.
13
<PAGE>
The Bank also entered into a ten-year lease for its future branch
office. The lease is ten years and commences on June 1, 1998 or 15 days
following the issuance of an occupancy certificate, whichever occurs last. In
the first year of the lease, the minimum monthly rent will be $6,500, with
minimal increases in subsequent years. The Bank made the first lease payment on
March 1 1999.
ITEM 3. LEGAL PROCEEDINGS
In the normal course of its operations, the Bank from time to time is
party to various legal proceedings. Based upon information currently available,
and after consultation with its counsel, management believes that such legal
proceedings, in the aggregate, will not have a material adverse effect on the
Bank's business, financial position or results of operations, except for the
following.
The Heritage Bank is a defendant in a suit in Fairfax Circuit Court
styled Brault & Associates, et al. v. The Heritage Bank, Law No. 174525. In the
suit the plaintiffs allege conversion (Count I), breach of fiduciary duty (Count
II), defamation (Count III), and breach of contract (Count IV) as a result of a
dispute over a loan repayment and the collateral securing such loan. The Bank
filed an answer denying the plaintiffs' claims. The Bank's insurance carrier
contributed Thirty Thousand Dollars ($30,000.00) towards a settlement of this
matter and the Bank has settled this matter in principle as of March 2, 1999 for
a total cash payment of Fifty Thousand Dollars ($50,000.00), which involves a
Twenty Thousand Dollar ($20,000.00) payment from the Bank. The parties are now
in the process of preparing final settlement documents for execution which will
result in the dismissal of the above case with prejudice.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
14
<PAGE>
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS
Heritage Bancorp, Inc.'s common stock is traded on the Nasdaq SmallCap
Market and quoted under the symbol "HBVA." Prior to its secondary offering of
805,000 shares on May 18, 1998 (the "Offering") and commencement of trading on
the Nasdaq SmallCap Market, the common stock of The Heritage Bank traded on the
OTC Bulletin Board on a limited basis. The Bank's common stock traded as Company
common stock when Reorganization became effective in October 1998, prior to the
end of the Company's 1998 fiscal year.
At December 31, 1998, the last trading date in the Company's fiscal
year, the Company's common stock closed at $3.75. At March 10, 1999, there were
2,294,617 shares of the Company's common stock outstanding, which were held of
record by approximately 2,000 stockholders.
The Board of Directors has not paid a cash dividend since its
incorporation. The Board of Directors may consider the payment of cash dividends
dependant on the results of operations and financial condition of the Company,
tax considerations, industry standards, economic conditions, regulatory
restrictions and other factors. There are significant regulatory limitations on
the Company's ability to pay dividends depending on the dividends it receives
from its subsidiary, The Heritage Bank, which are subject to regulations and the
Bank's continued compliance with all regulatory capital requirements and the
overall health of the institution.
The table below shows the high and low sales price during the periods
indicated.
Price Range ($)
-------------------------
Quarter Ended High Low
- --------------------------------------------------------------------------------
Fiscal year ended December 31, 1998:
Second Quarter ended June 30, 1998............... 6 3/4 4 3/4
Third Quarter ended September 30, 1998........... 5 1/2 3 3/4
Fourth Quarter ended December 31, 1998 .......... 4 3/4 3 1/2
Based on information available to the Bank from a limited number of sellers
and purchasers of the Bank's common stock prior to the Offering, the Bank
believes that the selling price for the Bank common stock ranged from $2.25 to
$4.00 during 1997 and from $4.00 to $4.625 from January 1, 1998 through March
31, 1998.
15
<PAGE>
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS
SELECTED FINANCIAL DATA
The year-end income statement data, the year-end balance sheet data and the
year-end per share data regarding net income contained in the following selected
financial data for the five years ended December 31, 1998 are derived from the
financial statements of the Company and the Bank, which have been audited on an
annual basis. The selected financial information should be read in conjunction
with the financial statements and the notes thereto.
<TABLE>
<CAPTION>
Years ended December 31,
---------------------------------------------------------------------
(Dollars in thousands, except per share data)
<S> <C> <C> <C> <C> <C>
Summary of operating results:
Total interest income....................... $ 3,766 $ 3,256 $ 3,420 $ 3,048 $ 3,034
Total interest expense...................... 1,272 1,111 1,411 1,165 960
-----------------------------------------------------------------
Net interest income......................... $ 2,494 $ 2,145 2,009 1,883 2,074
Provision for (recovery of) loan losses..... 117 4 - (87) 488
-----------------------------------------------------------------
Net interest income after provision for
recovery of) loan losses................... $ 2,377 $ 2,141 2,009 1,970 1,586
Other income................................ 137 181 119 98 168
Other expenses.............................. 2,421 1,836 1,725 1,854 1,868
-----------------------------------------------------------------
Income (loss) before taxes.................. 93 486 403 214 (114)
Income tax expense (benefit)(1)............. (40) (85) - 31 -
--------- ------------- -----------------------------------------
Net income (loss)........................... $ 133 $ 571 $ 403 $ 183 $ (114)
=================================================================
Per share:
Basic earnings (loss) per share............. $ 0.07 $ 0.45 $ 0.32 $ 0.15 $ (0.09)
Diluted earnings (loss) per share........... 0.07 0.44 0.32 0.15 (0.09)
Dividend payout ratio....................... - - - - -
Book value at period end.................... 3.89 3.18 2.84 2.52 2.30
Common shares outstanding................... 2,294,617 1,489,636 1,249,634 1,249,634 1,249,634
Balance sheet data (at period end):
Loans, net of unearned interest............. $ 29,610 $ 23,390 25,202 24,346 27,426
Allowance for loan loss..................... 429 634 617 685 1,164
Total assets................................ 64,776 45,450 46,075 46,874 41,944
Total deposits.............................. 53,442 40,604 42,387 43,539 38,933
Total stockholders' equity.................. 8,928 4,730 3,543 3,149 2,878
Performance and asset quality ratios:
Return on average total assets.............. 0.26% 1.33% 0.87% 0.46% (0.26)%
Return on average stockholders' equity...... 1.79 15.24 12.05 5.89 (3.84)
Average stockholders' equity to average
total assets............................... 14.47 8.74 7.19 7.74 6.81
Non-accrual and past due loans to total loans 1.35 .98 1.85 2.93 3.11
Allowance for loan losses to total loans.... 1.45 2.71 2.45 2.81 4.24
Net yield................................... 3.87 4.29 3.69 3.96 4.26
Net interest margin(2)...................... 5.09 5.25 4.54 4.93 4.37
</TABLE>
- ------------------
(1) At December 31, 1998, the Bank had available approximately $139,000 of
an operating loss carryforward which could be offset against future
income.
(2) Net interest margin is calculated as net interest income divided by
average earning assets and represents the Bank's net yield on its
earning assets.
16
<PAGE>
Management's Discussion and Analysis of Financial Condition and
Results of Operations
The following discussion is intended to assist readers in understanding
and evaluating the financial condition and results of operations of the Company
and the Bank. This review should be read in conjunction with the audited
financial statements and accompanying notes. This analysis provides an overview
of the significant changes that occurred during the periods presented.
Results of Operations
The Bank' s operating results depend primarily upon its net interest
income, the difference between the interest earned on its interest-bearing
assets (loans and investment securities) and the interest paid on
interest-bearing liabilities (deposits). Operating results are significantly
affected by provisions for loan losses, other income and operating expenses.
Each of these factors is significantly affected not only by the Bank's policies,
to varying degrees, but general economic and competitive conditions and by
policies of state and federal regulatory authorities.
Comparison of Financial Condition at December 31, 1998 and 1997
The management team has been concentrating on a growth oriented
strategy designed to enhance the Company's franchise value and operating
profitability by increasing the size and quality of the Bank's assets. The
Company has also tried to improve long term profitability by strengthening the
quality of the Bank's loan portfolio. As a result of this strategy, total assets
increased $19.3 million, or 42.5%, from $45.4 at December 31, 1997 to $64.7
million at December 31, 1998.
Loans increased by $6.4 million during 1998 from $22.8 million at
December 31, 1997 to $29.1 million at December 31, 1998. This increase was
primarily due to increased loan demand due to the favorable interest rate
environment in 1998. The proceeds of the Offering also increased the Bank' s
legal lending limit, permitting the Bank to originate a higher volume of loans.
Securities increased by $7.8 million from $12.0 million at December
31, 1997 to $19.8 million on December 31, 1998. This increase is due in part to
the receipt by the Bank of $4.1 million in net proceeds from the Offering which
closed on May 18, 1998. In addition, Fed Funds sold increased $950,000 from $7.6
million at December 31, 1997 to $8,5 million at December 31, 1998. This shift in
assets was the result of the Bank's increase in deposits over 1997.
Stockholders' equity at December 31, 1998 was $8.9 million, as compared
to $4.7 million on December 31, 1997. The increase in stockholders' equity was
due to net income for the year of $133,000 and to the sale of 805,000 shares of
common stock at $5.50 per share in the Offering which increased capital and
surplus by $4.1 million. Book value per share increased from $3.18 per share on
December 31, 1997 to $3.89 per share on December 31, 1998.
Total deposits increased 31.6%, from $40.6 million at December 31, 1997
to $53.4 million at December 31, 1998. Of the $12.8 million increase in
deposits, $8.0 million were deposits that came into the Bank on the last two
days of 1998 into attorneys escrow account and the left the Bank within next
fifteen days.
The Company's return on average assets was 0.26% and its return on
average equity was 1.79% in fiscal year 1998. The Bank's return on average
assets was 1.33% and its return on average equity was 15.24% in fiscal year
1997.
The Bank is required to meet certain capital requirements as
established by the Federal Reserve Board. At December 31, 1998 and 1997, the
Bank met all capital adequacy requirements to which it was subject.
17
<PAGE>
Results of Operations for the Years Ended December 31, 1998 and 1997
Net Income. Net income for the year ended December 31, 1998 decreased
$437,000 to $133,000, or $0.07 basic earnings per share ($0.07 per share,
assuming dilution), from net income of $570,000, or $0.45 basic earnings per
share ($0.44 per share, assuming dilution) for the year ended December 31, 1997.
The decrease in net income was primarily due to loan loss from a bankruptcy
during the third quarter totaling $141,456, an increase in stockholder expenses
of $89,944 incurred in connection with the formation of the holding company, an
increase in legal fees of $175,000 incurred in defending lawsuits and the
$25,000 settlement of a lawsuit plus the $25,000 loss due to a robbery. The
expenses associated with the formation of the holding company, the opening of
the CountrySide branch in Sterling, Virginia, and the legal fees incurred in
connection with the settlement of a lawsuit are nonrecurring items and are not
expected to have an impact on the long-term profitability of the Bank.
Interest Income. The major component of the Bank's net earnings is net
interest income, which is the excess of interest income on interest-earning
assets over the interest expense on interest-bearing liabilities. Net interest
income is affected by changes in volume resulting from growth and alterations of
the balance sheet composition as well as fluctuations in interest rates
("interest rate spread") and maturities of sources and uses of funds. The Bank's
management seeks to maximize net interest income by managing the balance sheet
and determining the optimal product mix with respect to yields on assets and
costs of funds in light of projected economic conditions, while maintaining an
acceptable level of risk.
Interest income totaled $3.7 million for the year ended December 31,
1998, an increase of $509,000 or 15.6% from $3.2 million from the year ended
December 31, 1997. The increase in interest income was due to a $108,000
increase in interest on federal funds sold and an increase of $302,000 on
securities held for investment. Loan interest income also increased by $99,000.
The increase in interest on securities held for investment was the result of the
Bank investing the funds received from the sale of stock in the Offering in
investment bonds. The increase in Fed Funds interest was the result of the
increase in deposits. The increase in interest income on loans was the result of
an increase in the loan portfolio, due to the ability of the Bank to increase
its legal lending limit as a result of proceeds received in the Offering and
favorable interest rates in fiscal 1998.
Interest Expense. Total interest expense increased $162,000, or 14.55%,
from $1.1 million for the year ended December 31, 1997 to $1.3 million for the
year ended December 31, 1998. This increase was primarily due to the $3.1
million increase in the average balance of interest-bearing liabilities from
$30.2 million for the year ended December 31, 1997 to $33.3 million for the year
ended December 31, 1998.
Net Interest Income. Net interest income increased by $349,000 or 16.3%
from $2.1 million for the year ended December 31, 1997 to $2.5 million for the
year ended December 31, 1998.
The Bank's net interest margin (net interest income expressed as a
percentage of total average interest-earning assets) decreased to 5.09% for the
year ended December 31, 1998 compared to 5.25% for the year ended December 31,
1997. The Bank's net yield (the average yield earned on interest-earning assets
less the average rate incurred on interest-bearing liabilities) was 4.69% and
4.29% for the years ended December 31, 1998 and 1997, respectively.
Provision for Losses. The provision for loan losses for the year ended
December 31, 1998 was $117,000 as compared to $3,825 for the year ended December
31, 1997. This increase was due to loss on a loan in connection with a
bankruptcy.
Management believes that the provision for loan losses and the
allowance for loan losses are reasonable and adequate to cover any known losses
and any losses reasonably expected in the loan portfolio. While management
estimates loan losses using the best available information, no assurance can be
made that future additions to the allowance will not be necessary.
18
<PAGE>
Noninterest Income. Noninterest income consists primarily of service
charges and fees associated with the Bank's loan and savings accounts and gains
on the sale of securities. Noninterest income for the year ended December 31,
1998 was $137,000, representing a decrease of $44,000 from the noninterest
income of $181,000 for the year ended December 31, 1997. This decrease was
caused primarily by a $47,000 decrease in gains on the sale of government
securities.
Noninterest Expense. Noninterest expense consists primarily of
operating expenses for compensation and related benefits, occupancy, federal
insurance premiums and operating assessments, and equipment expenses.
Noninterest expense increased $585,000 or 31.9% from $1.8 million for
the year ended December 31, 1997 to $2.4 million for the year ended December 31,
1998. This increase was due in part to an increase in salaries and employee
benefits expense of $121,000 or 12.7% from $953,000 for the year ended December
31, 1997 to $1,074,000 for the year ended December 31, 1998. Other operating
expenses increased by $489,000 or 84.3% from $580,000 to $1,069,000 for the
years ended December 31, 1997 and 1998, respectively. This increase was due to
settlement of a lawsuit of $108,800, loss on a bankruptcy of $141,456, legal
fees of $175,732 incurred in defending a lawsuit, expenses associated with the
formation of the holding company of $89,944 and the $25,000 loss in a robbery.
Income Taxes. The Bank had an income tax benefit of $41,000 for the
year ended December 31, 1998 compared to a benefit of $85,000 in 1997. At
December 31, 1998, the Bank has operating loss carryforwards of approximately
$139,000 that may be offset against future taxable income. The Bank expects to
use its net operating loss carryforward in its entirety by the end of fiscal
year 1999.
Results of Operations for the Years Ended December 31, 1997 and 1996
Net Income. Net income for the year ended December 31, 1997 increased
$168,000 to $571,000, or $0.45 basic earnings per share ($0.44 per share,
assuming dilution), from net income of $403,000, or $0.32 basic earnings per
share ($0.32 per share, assuming dilution) for the year ended December 31, 1996.
The increase in net income is primarily due to an increase of $136,000 in net
interest income to $2.1 million for the year ended December 31, 1997 from $2.0
million for the year ended December 31, 1996.
Interest Income. The major component of the Bank's net earnings is net
interest income, which is the excess of interest income on interest-earning
assets over the interest expense on interest-bearing liabilities. Net interest
income is affected by changes in volume resulting from growth and alterations of
the balance sheet composition as well as fluctuations in interest rates
("interest rate spread") and maturities of sources and uses of funds. The Bank's
management seeks to maximize net interest income by managing the balance sheet
and determining the optimal product mix with respect to yields on assets and
costs of funds in light of projected economic conditions, while maintaining an
acceptable level of risk.
Interest income totaled $3.3 million for the year ended December 31,
1997, a decrease of $164,000 or 4.8% from $3.4 million from the year ended
December 31, 1996. This decrease in interest income was due to a $121,000
decrease in interest on federal funds sold with lower yields on loans. Interest
on federal funds sold decreased because of the decrease in deposits, resulting
in less federal funds available to sell. The decrease in interest income is also
due in part to a decrease in the loan portfolio which resulted from management's
policy to improve the overall quality of the Bank's loan portfolio. Net loans
decreased by $1.8 million or 7.4% from December 31, 1996 to December 31, 1997.
Interest Expense. Total interest expense decreased $300,000, or 21.3%,
from $1.4 million for the year ended December 31, 1996 to $1.1 million for the
year ended December 31, 1997. This decrease was primarily due to the $4.6
million decrease in the average balance of interest-bearing liabilities from
$34.8 million for the year ended December 31, 1996 to $30.2 million for the year
ended December 31, 1997. The
19
<PAGE>
decrease also resulted from a decrease in the average rate paid on
interest-bearing liabilities from 4.05% to 3.68% due to a management decision
not to renew Certificates of Deposit at higher rates previously offered.
Net Interest Income. Net interest income increased by $136,000 or 6.8%
from $2.0 million for the year ended December 31, 1996 to $2.1 million for the
year ended December 31, 1997.
The Bank's net interest margin (net interest income expressed as a
percentage of total average interest-earning assets) increased to 5.25% for the
year ended December 31, 1997 compared to 4.54% for the year ended December 31,
1996. The Bank's net yield (the average yield earned on interest-earning assets
less the average rate incurred on interest-bearing liabilities) was 4.29% and
3.69% for the years ended December 31, 1997 and December 31, 1996, respectively.
Provision for Losses. The provision for loan losses for the year ended
December 31, 1997 was $3,825 as compared to $0 for the year ended December 31,
1996.
Management believes that the provision for loan losses and the
allowance for loan losses are reasonable and adequate to cover any known losses
and any losses reasonably expected in the loan portfolio. While management
estimates loan losses using the best available information, no assurance can be
made that future additions to the allowance will not be necessary.
Noninterest Income. Noninterest income for the year ended December 31,
1997 was $181,000, representing an increase of $62,000 from the noninterest
income of $119,000 for the year ended December 31, 1996. This increase was
caused primarily by an increase in service charges on deposit accounts and
$47,000 representing gains on the sale of government securities during 1997.
Noninterest Expense. Noninterest expense consists primarily of
operating expenses for compensation and related benefits, occupancy, federal
insurance premiums and operating assessments, and equipment expenses.
Noninterest expense increased $111,000 or 6.5% from $1.7 million for
the year ended December 31, 1996 to $1.8 million for the year ended December 31,
1997. This increase was due in part to an increase in salaries and employee
benefits expense of $54,000 or 6.1% from $899,000 for the year ended December
31, 1996 to $953,000 for the year ended December 31, 1997. Other operating
expenses increased by $60,000 or 11.5% from $520,000 to $580,000 for the years
ended December 31, 1996 and 1997, respectively. This increase was due to a
normal increase in data processing service contract charges of $8,000 from 1996
to 1997; increases in stationery and supply expense of $17,000 primarily due to
additional printing expenses for brochures for the loan department and other
printing costs; and increases due to advertising expense increasing $8,000, the
payment of directors' fees of $19,000 in 1997, and an increase of $5,000 in
charitable contributions by the Bank.
Income Taxes. The Bank had an income tax benefit of $85,000 for the
year ended December 31, 1997 and had no income tax liability for the year ended
December 31, 1996. At December 31, 1997, the Bank has operating loss
carryforwards of approximately $387,000 that may be offset against future
taxable income. The Bank expects to use its net operating loss carryforward in
its entirety by the end of fiscal year 1998.
Year 2000 Issues
For a discussion of the Year 2000 problem see "Year 2000 Issues"
discussion in Item 1 - Business to this Report on Form 10-KSB.
20
<PAGE>
Average Balances, Interest and Average Yields
The following table sets forth information relating to the Bank's
average balance sheet and reflects the average yield on assets and average cost
of liabilities for the periods indicated and the average yields earned and rates
paid for the periods indicated. Such yields and costs are derived by dividing
income or expense by the average daily balances of assets and liabilities,
respectively, for the periods presented.
AVERAGE BALANCES, INTEREST INCOME AND EXPENSES AND AVERAGE YIELDS AND RATES
(Dollars in thousands)
<TABLE>
<CAPTION>
Years ended December 31,
-------------------------------------------------------------------------------------------------
1998 1997 1996
------------------------------ ----------------------------- -------------------------------
Interest Average Interest Average Interest Average
Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/
Balance Expense Rate Balance Expense Rate Balance Expense Rate
--------- -------- ------- -------- ------- ------- -------- -------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
EARNING ASSETS:
Loans receivable(1).............. $ 25,978 $ 2,386 9.18% $ 24,533 $ 2,286 9.32% $ 24,458 $ 2,322 9.49%
Investment securities, taxable... 18,208 1,118 6.14 13,432 816 6.08 14,597 823 5.64
Federal funds sold............... 4,830 262 5.42 2,867 154 5.37 5,148 275 5.34
-------- -------- -------- ------- -------- -------
Total earning assets.......... 49,016 3,766 7.68 40,832 3,256 7.97 44,203 3,420 7.74
-------- -------- -------- ------- -------- -------
NON-EARNING ASSETS:
Cash and due from banks.......... 1,691 1,649 1,891
Other assets 802 414 444
-------- -------- ------
Total non-earning assets......... 2,493 2,063 2,335
-------- -------- --------
Total assets.................. $ 51,509 $ 42,895 $ 46,538
======== ======== =========
INTEREST-BEARING LIABILITIES:
Deposits:
Interest-bearing demand (NOW)
deposits..................... 5,696 133 2.33 $ 5,073 113 2.23 $ 5,495 119 2.17
Money market deposits......... 10,875 363 3.34 10,377 330 3.19 10,535 335 3.18
Savings deposits.............. 3,298 97 2.94 3,369 99 2.94 3,259 97 2.98
Time deposits................. 12,424 640 5.15 11,196 561 5.01 15,511 860 5.54
Repurchase agreements ....... 1,069 39 3.65 159 7 4.40 - - -
-------- -------- ------- --------- ------- ----- --------- ------- ------
Total interest-bearing
liabilities .............. 33,362 1,272 3.81 30,174 1,111 3.68 34,800 1,411 4.05
-------- -------- ------- -------- ------- ----- --------- ------- ------
NON-INTEREST-BEARING
LIABILITIES:
Demand deposits.................. 10,546 8,829 8,222
Other liabilities................ 149 145 172
-------- -------- ---------
Total non-interest-bearing
liabilities ................. 10,695 8,974 8,394
-------- -------- ---------
Stockholders' equity............. 7,452 3,747 3,344
-------- -------- ---------
Total liabilities and
stockholders' equity....... $ 51,509 $ 42,895 $ 46,538
======== ======== =========
Interest spread.................. 3.87 4.29 3.69
Net interest margin.............. $ 2,494 5.09% $ 2,145 5.25% $ 2,009 4.54%
======== ====== ========
</TABLE>
- ------------------
(1) Non-accrual loan balances are included in the calculation of average
balances.
21
<PAGE>
Rate/Volume Analysis
The following table sets forth certain information regarding changes in
interest income and interest expense of the Bank for the periods indicated. For
each category of interest-earning asset and interest-bearing liability,
information is provided on changes attributable to: (i) changes in volume
(changes in volume multiplied by old rate); and (ii) changes in rates (change in
rate multiplied by old volume). Changes in rate-volume (changes in rate
multiplied by the changes in volume) are allocated between changes in rate and
changes in volume.
RATE AND VOLUME ANALYSIS
(Dollars in thousands)
<TABLE>
<CAPTION>
Year Ended Year Ended
December 31, 1998 December 31, 1997
Compared To Compared To
December 31, 1997 December 31, 1996
Increase (Decrease) Due to Increase (Decrease) Due to
------------------------------------------------------------------------------
Rate Volume Total Rate Volume Total
------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
INTEREST EARNED ON:
Loans receivable, net...................... $(34) $ 134 $ 100 $ (43) $ 7 $ (36)
Investment securities, taxable............. 8 294 302 304 (311) (7)
Federal funds sold......................... 1 107 108 2 (123) (121)
----- ------ ------ ----- ----- ------
Total interest income (25) 535 510 263 (427) (164)
----- ------ ------ ----- ----- ------
INTEREST PAID ON:
Interest-bearing (NOW) deposits............ 5 15 20 3 (9) (6)
Money market deposits...................... 16 17 33 1 (5) (4)
Savings deposits........................... - (2) (2) (1) 3 2
Time deposits.............................. 15 63 78 (77) (222) (299)
Federal funds purchased................... - 32 32 - 7 7
----- ----- ----- ----- ----- ------
Total interest expense................ 36 125 161 (74) (226) (300)
----- ------ ------ ----- ----- ------
Net interest income................ $(61) $ 410 $ 349 $ 337 $(201) $ 136
===== ====== ====== ===== ===== ======
</TABLE>
Interest Rate Sensitivity
An important element of both earnings performance and liquidity is
management of interest rate sensitivity. Interest rate sensitivity reflects the
potential effect on net interest income of a movement in interest rates. The
difference between the Bank's interest-sensitive assets and interest-sensitive
liabilities for a specified time frame is referred to as "gap." A financial
institution is considered to be asset-sensitive, or having a positive gap, when
the amount of its earning assets maturing or repricing within a given time
period exceeds the amount of its interest-bearing liabilities also maturing or
repricing within that time period. Conversely, a financial institution is
considered to be liability-sensitive, or have a negative gap, when the amount of
its interest-bearing liabilities maturing or repricing within a given period
exceeds the amount of earning assets also maturing or repricing within that time
period. During a period of rising interest rates, a positive gap would tend to
increase net interest income, while a negative gap would tend to have an adverse
effect on net interest income. During a period of falling interest rates, a
positive gap would tend to have an adverse effect on net interest income, while
a negative gap would tend to increase net interest income.
The Bank evaluates interest sensitivity risk and then formulates
guidelines regarding asset generation and pricing, funding sources and pricing,
and off-balance sheet commitments in order to decrease sensitivity risk. These
guidelines are based upon management's outlook regarding future interest rate
movements, the state of the regional and national economy and other financial
and business risk factors. The Bank uses a static gap model and a computer
simulation to measure the effect on net interest income of various interest rate
scenarios over selected time periods. The gap can be managed by repricing assets
or liabilities, selling investments held for sale, replacing an asset or
liability prior to maturity or adjusting the interest rate during
22
<PAGE>
the life of an asset or liability. Matching the amount of assets and liabilities
repricing during the same time interval helps to reduce the risk and minimize
the impact on net interest income in periods of rising or falling interest
rates.
As of December 31, 1998, the Bank's static one-year cumulative gap to
total interest-sensitive assets position was a positive 7.4% and the Bank was,
therefore, in a asset-sensitive position. It is the Bank's policy to control the
mix and rate sensitivity of assets and liabilities such that the revolving gap
(the gap is less than one year) will never exceed 10% (positive or negative) of
assets.
The following table illustrates the interest sensitivity gap position
of the Bank as of December 31, 1998 (focusing only on repricing schedules, not
fixed versus variable rates). This table presents a position as of a particular
day, which position changes continually and is not necessarily indicative of the
Bank's position at any other time.
INTEREST SENSITIVITY ANALYSIS
December 31, 1998
(Dollars in thousands)
<TABLE>
<CAPTION>
Maturing or Repricing In:
-------------------------------------------------
3 Months 4-12 1 to 5 More than
or Less Months Years 5 Years Total
------------ ---------- -------- ----------- ---------
<S> <C> <C> <C> <C> <C>
Interest-sensitive Assets:
Loans (1)..................................... $ 12,525 $ 6,509 $ 8,663 $ 1,518 $ 29,215
Securities.................................... 500 3,200 15,359 500 19,824
Federal funds sold............................ 8,550 - - - 8,550
--------- --------- -------- -------- --------
Total interest-sensitive assets........... 21,575 9,709 24,022 2,018 57,324
========= ========= ======== ======== ========
Interest-sensitive Liabilities:
Certificates of deposit > $100,000............ 1,393 2,099 2,847 - 6,339
Certificates of deposit (greater than) $100,000 1,320 3,945 3,719 - 8,984
Super NOW accounts/Money Market deposit
accounts(2)............................... 17,761 - - - 17,761
--------- --------- -------- -------- --------
Total interest-sensitive liabilities...... 20,474 6,044 6,566 - 33,084
========= ========= ======== ======== ========
Period gap......................................... $ 1,101 $ 3,665 $ 17,456 $ 2,018 $ 24,240
Cumulative gap..................................... $ 1,101 $ 4,766 $ 22,222 $24,240 -
Ratio of cumulative interest-
sensitive liabilities to interest-sensitive asset 94.9% 84.8% 59.8% 37.7% -
======== ========= ========= =======
</TABLE>
- ------------------
(1) Excludes non-accrual loans.
(2) Non-certificate deposit accounts are shown as repricing within the 3 month
or less timeframe, although the Bank believes, based on historical
experience, that such deposits are less interest sensitive.
ANALYSIS OF FINANCIAL CONDITION
Loan Portfolio
The loan portfolio is the largest category of the Bank's earning assets
and is comprised of commercial real estate loans, commercial loans, home equity
loans, construction loans, consumer loans and participation loans with other
financial institutions. The primary markets in which the Bank makes loans
include the town of McLean, Virginia and Fairfax County, Virginia. The mix of
the loan portfolio is weighted toward loans secured by real estate and
commercial loans. In management's opinion, there are no significant
concentrations of credit with particular borrowers engaged in similar
activities.
23
<PAGE>
Net loans consist of total loans minus the allowance for loan losses,
unearned discounts . The Bank's net loans were $29.2 million at December 31,
1998, representing a 28.3% increase over net loans of $22.8 million at December
31, 1997. Loan volume increased in 1998 due to the Banks ability to make larger
loans because of the increase in Bank's legal lending limit as a result of the
Offering. Net loans decreased 7.4% in 1997, from a balance of $24.6 million at
December 31, 1996. The average balance of total loans as a percentage of average
earning assets was 53.0% for December 31, 1998, down from 60.1% for 1997. The
average balance of total loans as a percentage of average earnings assets was
55.3% for 1996.
In the normal course of business, the Bank makes various commitments to
meet the financing needs of its customers and incurs certain contingent
liabilities , including standby letters of credit and commitments to extend
credit. At December 31, 1998, commitments for standby letters of credit totaled
$181,000 and commitments to extend credit totaled $8.7 million. Commitments for
standby letters of credit totaled $191,000 and $274,000 for the years ended
December 31, 1997 and 1996, respectively. Commitments to extend credit totaled
$6.7 million and $5.2 million for the years ended December 31, 1997 and 1996,
respectively.
The following table summarizes the composition of the Bank's loan
portfolio at the periods indicated:
LOAN PORTFOLIO
(Dollars in thousands)
<TABLE>
<CAPTION>
December 31,
------------------------------------------------------------------------------------------------
1998 1997 1996 1995 1994
------------------- ------------------ ----------------- ------------------ -----------------
Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Real estate:
Mortgage....... $ 24,077 77.5% $17,532 75.0% $19,524 77.5% $18,735 76.9% $21,219 77.4%
Construction... 441 1.5 448 1.9 633 2.5 147 0.6 305 1.1
Commercial......... 3,786 14.5 4,191 17.9 4,210 16.7 4,526 18.6 4,851 17.7
Consumer........... 1,306 6.5 1,219 5.2 835 3.3 938 3.9 1,051 3.8
---------- ---- --------- ------- --------- ------ ---------- -------- ---------- ------
Loans, gross....... 29,610 100% 23,390 100% 25,202 100.% 24,346 100.% 27,426 100%
---------- ---- --------- ------- --------- ------ ---------- -------- ---------- ------
Less: allowance for
loan losses.... (429) (634) (617) (685) (1,164)
-------- ------- ------- ------- -------
Loans, net......... $ 29,181 $22,756 $24,585 $23,661 $26,262
======== ======= ======= ======= =======
</TABLE>
The following table sets forth certain information with respect to the
Bank's non-accrual, restructured and past due loans, as well as foreclosed
assets, for the periods indicated.
NON-PERFORMING ASSETS
(Dollars in thousands)
<TABLE>
<CAPTION>
Years Ended December 31,
----------------------------------------------------
1998 1997 1996 1995 1994
----------------------------------------------------
<S> <C> <C> <C> <C> <C>
Non-accrual loans......................................... $ 395 222 465 445 594
Real estate owned......................................... 263 263 263 300 500
----------------------------------------------------
Total non-performing loans............................ 658 485 728 745 1,094
----------------------------------------------------
Loans past due 90 or more days accruing interest.......... - 7 - 268 260
Non-performing loans to total loans, at period end........ 1.3% 0.9% 1.8% 1.8% 2.2%
Non-performing assets to period end assets................ 1.0% 1.1% 1.6% 1.6% 2.6%
Non-performing assets: total loans
and other real estate owned........................... 2.2% 2.1% 2.9% 3.0% 3.9%
</TABLE>
24
<PAGE>
The amount of interest on non-accrual loans which would have been
recorded as income under the original terms of such loans was approximately
$32.800, $34,300, and $10,800 for the years ended December 31, 1998, 1997 and
1996, respectively. Loans are placed on non-accrual when a loan is specifically
determined to be impaired or when principal or interest is delinquent for 90
days or more.
In addition to the nonaccrual loans, past due loans, and other real
estate owned listed above, loans totaling $2.5 million or 8.4% of total loans at
December 31, 1998 were either internally classified or specially mentioned,
require more than normal attention, and are potential problem loans. These
potential problem loans represent an decrease from $3.6 million of potential
problem loans, or 15.4% of total loans, at December 31, 1997. The decrease is
related primarily to the Bank's efforts to improve loan quality.
The Real Estate Owned of $263,000 in 1998 consists of a single piece of
industrial property located in Loudoun County, Virginia which the Bank currently
has for sale.
Loan Maturity
The following table shows the contractual maturity at December 31, 1998. The
table reflects the entire unpaid principal balance in the maturity period that
includes the final loan payment date and, accordingly, does not give effect to
periodic principal repayments or possible prepayments.
<TABLE>
<CAPTION>
MATURITY AND RATE SENSITIVITY OF LOANS
(Dollars in thousands)
At December 31, 1998
-----------------------------------------------------------------------------------
One Year Over One Year
or Less Through Five Years Over Five Years
------- --------------------------------- -------------------------------
<S> <C> <C> <C> <C> <C>
Fixed Rate Floating Rate Fixed Rate Floating Rate
---------- ------------- ---------- --------------
Commercial $2,108 $793 $ 753 $132 $ -
Real estate-construction 441 - - - -
------ ---- ------ ---- ----
$2,549 $793 $ 753 $132 $ -
====== ==== ======= ==== ====
</TABLE>
Allowance for Loan Losses
In originating loans, the Bank recognizes that credit losses will be
experienced and the risk of loss will vary with, among other things, general
economic conditions, the type of loan being made, the creditworthiness of the
borrower over the term of the loan and, in the case of a collateralized loan,
the quality of the collateral for such loan. The Bank maintains an allowance for
loan losses based upon, among other things, such factors as changes in the
character and size of the loan portfolio and related loan loss experience, a
review and examination of overall loan quality which includes the assessment of
problem loans, the amount of non-performing assets, regulatory policies,
generally accepted accounting principles, general economic conditions, and other
factors related to the collectability of loans in the Bank's portfolios. In
addition to unallocated allowances, specific allowances are provided for
individual loans when ultimate collection is considered questionable by
management after reviewing the current status of loans which are contractually
past due and after considering the net realizable value of any collateral for
the loan.
Management actively monitors the Bank's asset quality in a continuing
effort to charge-off loans against the allowance for loan losses and to provide
specific loss allowances when necessary. Although management believes it uses
the best information available to make determinations with respect to the
allowance for loan losses, future adjustments may be necessary if economic
conditions differ from the assumptions used in making the initial
determinations. The Bank's allowance for loan losses was $429,000, or 1.45% of
total loans, as of December 31, 1998, $634,000, or 2.71% of total loans, as of
December 31, 1997 and $617,000, or 2.45% of total loans, as of December 31,
1996.
25
<PAGE>
Management believes the allowance is adequate to absorb losses inherent
in the loan portfolio. The Bank expects that its allowance for loan losses is
adequate and that with the expected increases in the Bank's loan portfolio, the
allowance for loan losses remains adequate. The Bank expects to grow its loan
portfolio and believes it has adequate reserves in the allowance for loan losses
to mirror the growth in the loan portfolio.
In view of the Bank's plans for expansion and possible loan growth,
management will continue to closely monitor the performance of its portfolio and
make additional provisions as necessary. The Bank does not presently anticipate
that such provisions will have a material adverse impact on the Bank's results
of operations in future periods.
An analysis of the allowance for loan losses, including charge-off
activity, is presented below:
ALLOWANCE FOR LOAN LOSSES
(Dollars in thousands)
<TABLE>
<CAPTION>
Years Ended December 31,
------------------------------------------------------------------
1998 1997 1996 1995 1994
---------- ---------- ---------- ----------- -----------
<S> <C> <C> <C> <C> <C>
Allowance for loan losses:
Balance at beginning of year.................. $ 634 $ 617 $ 685 $ 1,164 $ 959
Charge-offs:
Commercial................................ 332 8 70 360 85
Real estate............................... - 50 34 158 234
Consumer.................................. 7 3 5 2 5
------- ------- ------- --------- -------
Total loans charged off............... 339 61 109 520 324
------- ------- ------- --------- -------
Recoveries:
Commercial................................ 13 60 15 32 35
Real estate............................... - 14 26 96 -
Consumer.................................. 4 - - - 6
------- ------- ------- --------- -------
Total recoveries...................... 17 74 41 128 41
------- ------- ------- --------- -------
Net charge-offs (recoveries)................... 322 (13) 68 392 283
Provision for (recovery of) loan losses....... 117 4 - (87) 488
------- ------- ------- -------- -------
Balance at end of year......................... $ 429 $ 634 $ 617 $ 685 $ 1,164
======= ======= ======= ======== =======
Ratio of net charge-offs (recoveries) to
average loans outstanding................ 1.24% (.05)% .28% 1.49% 0.95%
Ratio of allowance for loan
losses to loans at year-end............... 1.45% 2.71% 2.45% 2.81% 4.24%
</TABLE>
26
<PAGE>
A breakdown of the allowance for loan losses is provided in the
following table. However, the Bank's management does not believe that the
allowance for loan losses can be allocated by category with a degree of
precision that would be useful to investors. Because all of these factors are
subject to change, the allocation of loan losses in the following table is not
necessarily predictive of future loan losses in the indicated categories. See
Note 1 of the notes to the financial statements for further information
regarding the classification of loan losses.
ALLOCATION OF ALLOWANCE FOR LOAN LOSSES
(Dollars in thousands)
<TABLE>
<CAPTION>
December 31,
---------------------------------------------------------------------------------------------------------
1997 1996 1995 1994 1993
------------------- ------------------- ------------------- ------------------- -------------------
Amount Percent(1) Amount Percent(1) Amount Percent(1) Amount Percent(1) Amount Percent(1)
------ ---------- ------ ---------- ------ ---------- ------ ---------- ------ ----------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Commercial............ $ 82 14.5% $109 17.9% $105 16.7% $ 88 18.6% $ 456 17.7%
Real Estate
Mortgage and
Construction...... 334 79.0 502 76.9 492 80.0 560 77.5 656 78.5
Consumer.............. 13 6.5 23 5.2 20 3.3 37 3.9 52 3.8
---- ---- ---- ---- ------
Total allowance for
loan losses........... $429 $634 $617 $ 85 $1,164
==== ==== ==== ==== ======
</TABLE>
- ------------------
(1) Represents percentage of loans in each category to total loans.
Investment Activities
The Bank is required to maintain an amount of liquid assets appropriate
to its level of net savings withdrawals and current borrowings. It has generally
been the Bank's policy to maintain a liquidity portfolio in excess of regulatory
requirements. At December 31, 1998, the Bank's liquidity ratio was 53.09%.
Liquidity levels may be increased or decreased depending upon the yields on
investment alternatives, management's judgment as to the attractiveness of the
yields then available in relation to other opportunities, management's
expectations of the level of yield that will be available in the future and
management's projections as to the short-term demand for funds to be used in the
Bank's loan origination and other activities.
Interest income from investments in various types of liquid assets
provides a significant source of revenue for the Bank. The Bank invests in U.S.
Treasury and Federal Agency securities, bank certificates of deposits, equity
securities, corporate debt securities, taxable municipals and overnight federal
funds. The balance of investment securities maintained by the Bank in excess of
regulatory requirements reflects management's historical objective of
maintaining liquidity at a level that assures the availability of adequate
funds, taking into account anticipated cash flows and available sources of
credit, for meeting withdrawal requests and loan commitments and making other
investments. See "Liquidity and Capital Resources."
The Bank purchases securities through a primary dealer of U.S.
Government obligations or such other securities dealers authorized by the Board
of Directors and requires that the securities be delivered to a safekeeping
agent before the funds are transferred to the broker or dealer. The Bank
purchases investment securities pursuant to an investment policy established by
the Board of Directors.
Investment securities are recorded on the books of the Bank in
accordance with GAAP. The Bank does not purchase investment securities for
trading. Effective January 1, 1994, the Bank implemented SFAS No. 115.
Available-for-sale securities are reported at fair value with unrealized gains
or losses reported as a separate component of net worth, net of tax effects.
Held-to-maturity securities are carried at amortized cost. Substantially all
purchases of investment securities conform to the Bank's interest rate risk
policy.
27
<PAGE>
The following table summarizes the carrying value of securities for the
dates indicated:
SECURITIES PORTFOLIO
(Dollars in thousands)
<TABLE>
<CAPTION>
December 31,
-----------------------------------------------
1998 1997 1996
-----------------------------------------------
<S> <C> <C> <C>
AVAILABLE FOR SALE:
U.S. treasury and other government agencies................... $ 17,333 $ 9,828 $ 12,854
State, county and municipal................................... 1,685 1,854 340
Other......................................................... 806 112 88
---------- --------- ----------
Total available for sale.................................. 19,824 11,794 13,282
---------- --------- ----------
HELD TO MATURITY:
U.S. treasury and other government agencies................... - 250 500
---------- --------- ----------
Total held to maturity.................................... - 250 500
---------- -------- ----------
Total securities.............................................. $ 19,824 $ 12,044 $ 13,782
========== ========= ==========
</TABLE>
28
<PAGE>
The following table sets forth the maturity distribution and weighted
average yields of the investment portfolio at December 31, 1997. The weighted
average yields are calculated on the basis of the book value of' the investment
portfolio and on the interest income of investments adjusted for amortization of
premium and accretion of discount.
INVESTMENT PORTFOLIO - MATURITY AND YIELDS
(Dollars in thousands)
<TABLE>
<CAPTION>
1 Year 1 Year 5 Years After
or Less to 5 Years to 10 Years 10 Years
--------------------------------------------------------------------
<S> <C> <C> <C> <C>
MATURITY DISTRIBUTION:
U.S. treasury issues............................ $ 3,051 $ - $ - $ -
U.S. agency issues.............................. 500 12,827 995 -
Municipal issues................................ 147 1,535 - -
Federal Reserve Bank Stock...................... - - - 265
------- ---------- -------- -------
Total maturity distribution................ $ 3,698 $ 14,362 $ 995 $ 265
======= ========== ======== =======
WEIGHTED AVERAGE YIELD:
U.S. treasury issues............................ 6.15% - - -
U.S. agency issues.............................. 5.34% 6.21% 6.21% -
Municipal issues................................ 6.50% 6.28% - -
Federal Reserve Bank Stock...................... - - - 6.00%
------- ---------- -------- -------
Total...................................... 6.00% 6.25% 6.21% 6.00%
======= ========== ======== =======
Total portfolio weighted average yield.......... 6.18%
=======
</TABLE>
Deposits
The Bank primarily uses deposits to fund its loans and investment
portfolio. The Bank offers a variety of deposit accounts to individuals and
small- to medium-sized businesses. Deposit accounts include checking, savings,
escrow accounts, money market and certificates of deposit. Average certificates
of deposit in amounts of $100,000 or more totaled $6.3 million at December 31,
1998 and $4.0 million at December 31, 1997. Many of these deposits are from
long-standing customers and, therefore, are believed by the Bank's management to
be as stable as, and for all practical purposes, no more rate sensitive than,
core deposits.
The following table details the average amount of, and the average rate
paid on, the following primary deposit categories for the periods indicated:
AVERAGE DEPOSITS AND AVERAGE RATES PAID
(Dollars in thousands)
<TABLE>
<CAPTION>
Years Ended December 31,
----------------------------------------------------------------------
1998 1997 1996
----------------------------------------------------------------------
Average Average Average Average Average Average
Balance Rate Balance Rate Balance Rate
--------- ------- ------- ------- -------- --------
<S> <C> <C> <C> <C> <C> <C>
Interest-bearing deposits:
NOW accounts............................ $ 5,696 2.33% $ 5,073 2.23% $ 5,495 2.17%
Money market savings.................... 10,875 3.34 10,377 3.19 10,535 3.18
Regular savings......................... 3,298 2.94 3,369 2.94 3,259 2.98
Certificates of deposit................. 12,424 5.14 11,196 5.01 15,511 5.54
-------- -------- --------
Total interest-bearing deposits......... $ 32,293 30,015 3.68 34,800 4.05
Non-interest-bearing deposits............... 10,546 8,829 8,222
-------- -------- --------
Total deposits.............................. $ 42,839 $ 38,843 $ 43,022
======== ======== ========
</TABLE>
The following is a summary of the maturity distribution of certificates
of deposit in amounts of $100,000 or more as of December 31, 1998:
MATURITIES OF CERTIFICATES OF DEPOSIT OF $100,000 OR MORE
(Dollars in thousands)
Maturity Period Amount Percent
--------------- ------ -------
3 months or less.............................. $1,393 21.98%
Over 3 months to 6 months..................... 475 7.49
Over 6 months to 12 months.................... 1,624 25.62
Over 12 months................................ 2,847 44.91
------ ------
Total.................................... $6,339 100.00%
====== ======
Short-Term Borrowings
The Bank occasionally finds it necessary to purchase funds on a
short-term basis due to fluctuations in loan and deposit levels. The Bank has
several arrangements under which it may purchase funds. A Repurchase Agreement
is maintained with First Union Bank for up to the market value of bonds in
safekeeping, which as of December 31, 1998 was $6.5 million. For the periods
ended December 31, 1998, 1997 and 1996, the expense for federal funds purchased
totaled approximately $0, $7,000, and $0, respectively.
Capital Requirements
The determination of capital adequacy depends upon a number of factors,
such as asset quality, liquidity, earnings, growth trends and economic
conditions. The Bank seeks to maintain a strong capital base to support its
growth and expansion plans, provide stability to current operations and promote
public confidence in the Bank.
Management believes that the Bank's capital position, as of December
31, 1998, exceeds all regulatory minimums. The federal banking regulators have
defined three tests for assessing the capital strength and adequacy of banks,
based on two definitions of capital. "Tier 1 Capital" is defined as a
combination of common and qualifying preferred stockholders' equity less
goodwill. "Tier 2 Capital" is defined as qualifying subordinated debt and a
portion of the allowance for loan losses. "Total Capital" is defined as Tier 1
Capital plus Tier 2 Capital. Three risk-based capital ratios are computed using
the above capital definitions, total assets and risk-weighted assets and are
measured against regulatory minimums to ascertain adequacy. All assets and
off-balance sheet risk items are grouped into categories according to degree of
risk and assigned a risk weighing and the resulting total is risk-weighted
assets. "Tier 1 Risk-based Capital" is Tier 1 Capital divided by risk-weighted
assets. "Total Risk-based Capital" is Total Capital divided by risk-weighted
assets. The Leverage Ratio is Tier 1 Capital divided by total average assets.
See "Supervision and Regulation--Capital Requirements."
29
<PAGE>
The following table shows the Bank's capital ratios and the minimum
ratios currently required by the Federal Reserve to be well-capitalized:
CAPITAL RATIOS
<TABLE>
<CAPTION>
December 31,
---------------------------------------- Regulatory
1998 1997 1996 Minimum
---------------------------------------- --------
<S> <C> <C> <C> <C>
Tier 1 Risk-based Capital............... 24.5% 17.4% 12.6% 4.0%
Total Risk-based Capital................ 25.8 18.6 13.9 8.0
Leverage ratio.......................... 13.8 11.0 7.8 4.0
</TABLE>
Liquidity and Capital Resources
Liquidity is a measure of the Bank's ability to generate sufficient
cash to meet present and future financial obligations in a timely manner through
either the sale or maturity of existing assets or the acquisition of additional
funds through liability management. These obligations include the credit needs
of customers, funding deposit withdrawals, and the day-to-day operations of the
Bank. Liquid assets include cash, interest-bearing deposits with banks, federal
funds sold, and certain investment securities. As a result of the Bank's
management of liquid assets and the ability to generate liquidity through
liability funding, management believes that the Bank maintains overall liquidity
sufficient to satisfy its depositors' requirements and meet its customers'
credit needs.
As of December 31, 1998, cash, federal funds sold, held-to-maturity
investment securities maturing within one year and available-for-sale securities
represented 61.23% of deposits and other liabilities, compared to 52.51% at
December 31, 1997 and 46.93% at December 31, 1996. See "-- Interest
Sensitivity." At December 31, 1998, based upon the Bank's investment policy,
approximately 100% of total investment securities were available for sale, and
were primarily invested in U.S. Treasury and agency securities, with a market
value of approximately $114,000 greater than their book value. See "--Investment
Activities." Asset liquidity is also provided by managing loan maturities. At
December 31, 1998, approximately 64% or $19.0 million of loans would mature or
reprice within a one-year period.
The following table summarizes the Bank's liquid assets for the periods
indicated:
SUMMARY OF LIQUID ASSETS
(Dollars in thousands)
<TABLE>
<CAPTION>
December 31,
------------------------------------------------
1998 1997 1996
------------------------------------------------
<S> <C> <C> <C>
Cash and due from banks................................... $ 5,824 $ 1,987 $ 2,879
Federal funds sold........................................ 8,550 7,600 3,800
Investment securities(1)............................... - - -
Available-for-sale securities, at fair value.............. 19,824 11,794 13,282
------ ------ ------
Total liquid assets....................................... $34,198 $21,381 $19,961
======= ======= =======
Deposits and other liabilities............................ $55,848 $40,719 $42,532
Ratio of liquid assets to deposits and other liabilities.. 61.23% 52.51% 46.93%
</TABLE>
- ------------------
(1) Only held-to-maturity investment securities at amortized cost with a
maturity of one year or less are considered liquid assets for this table.
30
<PAGE>
Impact of Inflation, Changing Prices and Monetary Policies
The financial statements and related financial data concerning the Bank
presented herein have been prepared in accordance with generally accepted
accounting principles, which require the measurement of financial position and
operating results in terms of historical dollars without considering changes in
the relative purchasing power of money over time due to inflation. The primary
effect of inflation on the operations of the Bank is reflected in increased
operating costs. Unlike industrial companies, virtually all of the assets and
liabilities of a financial institution are monetary in nature. As a result,
changes in interest rates have a more significant effect on the performance of a
financial institution than do the effects of changes in the general rate of
inflation and changes in prices. Interest rates do not necessarily move in the
same direction or in the same magnitude as the prices of goods and services.
Interest rates are highly sensitive to many factors which are beyond the control
of the Bank, including the influence of domestic and foreign economic conditions
and the monetary and fiscal policies of the U.S. government and federal
agencies, particularly the Federal Reserve.
The Federal Reserve implements national monetary policies such as
seeking to curb inflation and combat recession by its open market operations in
U.S. government securities, control of the discount rate applicable to borrowing
by banks, and establishment of reserve requirements against bank deposits. The
actions of the Federal Reserve in these areas influence the growth of bank
loans, investments and deposits, and affect the interest rates charged on loans
and paid on deposits. The nature, timing and impact of any future changes in
federal monetary and fiscal policies on the Bank and its results of operations
are not predictable.
Accounting Matters
In October 1998, the FASB issued Statement No. 134,
"Accounting for Mortgage-Backed Securities Retained after the Securitization of
Mortgage Loans Held for sale by a Mortgage Banking Enterprise, an amendment of
FSAB statement No. 65." FSAB Statement No. 65, as amended, requires that after
securitization of a mortgage loan held for sale, an entity engaged in mortgage
banking activities classify the resulting mortage-backed security as a trading
security. This Statement futher amends Statement No, 65 to require that after
the securitization of the mortgage loans held for sale, an enity engaged in
mortgage banking activities classify the resulting morgage-backed securities or
other retained interests based on its ability and intent to sell or hold those
investments. This Statement conforms the subsequent accounting for securities
retained after the securitization of mortgage loans by a mortgage banking
enterprise with the subsequent accounting for securitits retained after the
securitization of other types of assets by a non-mortgage banking enterprise.
this Statement is effective beginning in 1999
In June 1998, the FASB issued SFAS No. 133 "Accounting for Derivative
Instruments and Hedging Activities." Statement No. 133 establishes accounting
and reporting standards for derivative instruments, including derivative
instruments embedded in other contracts and for hedging activities. The
Statement is effective for all fiscal quarters of fiscal years beginning after
June 15, 1999.
ITEM 7. FINANCIAL STATEMENTS
Financial Statements are included as pages F-1 through F-26 to this
Form 10-KSB.
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE
None.
31
<PAGE>
PART III
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL
PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT
AND PRINCIPAL OFFICERS OF THE COMPANY
Directors
The following lists the Board of Directors of the Company:
<TABLE>
<CAPTION>
Term Position(s) Held Director
Age(1) Expires with the Company Since(2)
------ ------- ----------------- --------
<S> <C> <C> <C> <C>
Nominees
- --------
Harold E. Lieding 62 2001 Chairman 1990
Philip F. Herrick, Jr. 58 2001 Director 1987
George K. Degnon 58 2000 Director 1993
Kevin P. Tighe 54 2000 Director 1994
Stanley I. Richards 62 2001 Director 1996
Ronald W. Kosh 53 1999 Director 1998
George P. Shafran 72 1999 Vice Chairman 1997
</TABLE>
- -------------------
(1) As of December 31, 1998.
(2) Includes terms as a director of The Heritage Bank.
Biographical Information
Set forth below is certain information regarding the directors and
executive officers of the Company. Unless otherwise indicated, each director and
executive officer has held his current position for the last five years.
George K. Degnon has been a director of the Company since 1998 and a
director of the Bank since January, 1993. He is the present Secretary of the
Board of Directors of The Heritage Bank. Mr. Degnon is president of Degnon
Associates, Inc. (a company that provides organizational management services to
national and international health and medical associations) in McLean, Virginia.
Philip F. Herrick, Jr. has been a director of the Company since 1998
and a director of the Bank since 1987. He is the owner of Herrick Holdings
(investments and manages real estate) in Northern Virginia.
Harold E. Lieding has been a director of the Company since 1998 and a
director of the Bank since 1990. He serves as chairman of the Company and has
served as chairman of the Board of Directors of The Heritage Bank since June,
1993. He is a senior partner in the law firm of Lieding and Anderson, P.C., in
McLean, Virginia, and has practiced law in McLean since 1970. Mr. Lieding is a
member of the Fairfax Bar Association, the McLean Bar Association and the McLean
Planning & Zoning Committee.
Stanley I. Richards has been a director of the Company since 1998 and a
director of The Heritage Bank since June, 1996. Mr. Richards is the Chairman and
President of the Richards Corporation (a company engaged in the manufacture and
sale of imagery interpretation equipment) in Sterling, Virginia. He is also
Chairman and CEO of the TIA Electric Corporation (a company engaged in the
manufacture and sale of gallery insert equipment for aircraft) in Sterling,
Virginia.
32
<PAGE>
Kevin P. Tighe has been a director of the Company since 1998 and a
director of the Bank since September, 1994. He is senior partner in the law firm
of Tighe, Patton, Tabackman and Babbin in Washington, D.C. Mr. Tighe is also the
owner and Chairman of the Board of the McLean Racquet and Health Club in McLean,
Virginia.
George P. Shafran has been a director of the Company since 1998 and a
director of The Heritage Bank since June, 1997. He is the present Vice Chairman
of the Board of Directors of The Heritage Bank. Mr. Shafran is a business
consultant to a number of varied clients. He is also involved in several
partnerships and is the chairman of the AAA Mid-Atlantic Advisory Board. He is
president of Geo. P. Shafran & Associates, Inc., a consulting firm in McLean,
Virginia.
Ronald W. Kosh has been a director of the Company since 1998 and a
director of The Heritage Bank since February, 1998. He is Vice President and
Division manager of AAA MidAtlantic, Inc., Fairfax, Virginia. Mr. Kosh was
General Manager of the American Automobile Association, Inc., Fairfax, Virginia,
from 1985 to 1997.
Executive Officers
The following individual is an executive officer of the Company and The
Heritage Bank and holds the offices set forth below opposite his name.
Name Position(s) Held With the company and the Bank
William B. Sutphin Secretary, Heritage Bancorp, Inc.
Senior Vice President/Chief Financial Officer,
The Heritage Bank
William B. Sutphin, 64, has been the Senior Vice President of The
Heritage Bank in charge of operations since 1987. Mr. Sutphin also serves as the
principal accounting officer. Mr. Sutphin was Vice President in charge of
operations and accounting of the McLean Bank from 1981 to 1987 and has 43 years
banking experience. Mr. Sutphin is the present Secretary of the Board of
Directors of Heritage Bancorp, Inc.
The executive officers of the Company and the Bank are elected annually
and hold office until their respective successors have been elected and
qualified or until death, resignation, retirement or removal by the board of
directors.
33
<PAGE>
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Exchange Act requires the Company's directors,
executive officers, and any person holding more than ten percent of the
Company's Common Stock to file with the Securities and Exchange Commission
reports of ownership changes. Officers, directors and greater than ten percent
stockholders are required to furnish the Company with copies of all Section
16(a) forms they file. Based solely on its review of the copies of such forms
received by it, or written representations from certain reporting persons, the
Company believes that all filing requirements applicable to its executive
officers, directors and greater than ten percent beneficial owners were complied
with.
ITEM 10. EXECUTIVE COMPENSATION
Management Compensation
Directors' Compensation. The Company's outside directors are paid $250
per month. Each director also receives $100 for each committee meeting attended
with an annual payment cap of $600 applicable to the committee meeting
compensation only. On March 26, 1997, each outside director was granted options
to purchase 2,000 shares of Common Stock at the higher of book value or fair
market value on that date. The exercise price of all such options was deemed to
be $2.86 under these terms. Stock options must be exercised within 10 years from
date of award or within 60 days after the date which the director leaves. Each
director was also granted options under the 1998 Outside Directors Stock Option
Plan approved by the Company's shareholders at the 1998 Annual Meeting. For a
description of the plan see "--Directors Stock Option Plan." The Board of
Directors of the Company do not receive separate compensation for their service
on the Board.
Summary Compensation Table
The following table sets forth cash and noncash compensation for the
fiscal years ended December 31, 1998, 1997 and 1996 awarded to or earned by the
Bank's Chief Executive Officer and by each other executive officer whose
compensation exceeded $100,000 for services rendered in all capacities to the
bank during such years ("Named Executive Officers"). No other officers received
total compensation in excess of $100,000 in such years.
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
Long Term Compensation
----------------------------------------------
Annual Compensation(1) Awards Payouts
--------------------------------------- --------------------------------- ------------
Other Restricted
Annual Stock LTIP All Other
Name and Principal Compensation Awards Options Payouts Compensation
Positions Year Salary($) Bonus($) ($) ($)(2) (#)(2) ($)(2) ($)(3)
- -------------------------------- ---- --------- -------- ------------- ----------- ---------- ---------- ------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
John T. Rohrback, 1998 100,000 -- -- -- 2,581 -- 24,250
President and Chief 1997 100,000 -- -- -- -- -- 3,829
Executive Officer 1996 100,000(1) 10,000 -- -- -- -- 3,751
Sidney E. Bostian, 1996 76,663 -- -- -- 5,000 -- --(5)
President and Chief
Executive Officer (4)
</TABLE>
- ----------------
(1) Under Annual Compensation, the column titled "Salary" includes base
salary, amounts deferred under the Bank's 401(k) plan (but not matching
contributions from the Bank) and payroll deductions for health
insurance under the Bank's health insurance plan. Mr. Rohrback was
elected as President and Chief Executive Officer (CEO) of the Bank by
the Board of Directors effective July, 1996. Mr. Rohrback earned
$47,916 during 1996.
(2) Mr. Rohrback left the employment of the Bank as of January 26, 1999.
During the fiscal year ended December 31, 1998, Mr. Rohrback received
options to purchase 2,581 shares of common stock which expire six
month's from end of employment. During the fiscal year ended December
31, 1997 and 1996, no restricted stock awards, stock options or other
long-term incentive plans were awarded to Mr. Rohrback.
(3) Includes (a) the use of a vehicle provided by the Bank valued at
$23,650, $3,325 and $3,535 for the years ended December 31, 1998, 1997
and 1996, respectively; and (b) the amount of insurance
34
<PAGE>
premiums paid by the Bank on behalf of Mr. Rohrback, in the amounts of
$600, $504 and $216 for the years ended December 31, 1998, 1997 and
1996, respectively.
(4) Mr. Bostian resigned as Chief Executive Officer of the Bank effective
June 30, 1996. Mr. Bostian received the following compensation for the
1996 and 1995 fiscal year: (i) base salary of $125,000; (ii) Tower Club
dues and use of a vehicle; and (iii) options to purchase 5,000 shares
of common stock which were terminated upon Mr. Bostian's resignation.
Employee Stock Option Plan
The Company provides long-term incentives to executives, employees and
directors through the grant of options under its various stock option plans. The
Bank adopted the 1998 The Heritage Bank Employee Incentive Stock Option Plan
(the "Employee Stock Option Plan") which was approved by the Bank's shareholders
at the 1998 Annual Meeting. The Company assumed sponsorship of the Employee
Stock Option Plan upon the effective date of the Reorganization. The Employee
Stock Option Plan provides for the grant of options to purchase Common Stock of
the Company ("Options") to certain officers and employees. The Employee Stock
Option Plan is not subject to ERISA and is not a tax-qualified plan under the
Code.
The Board of Directors or a committee of not less than 3 members of
the board (the "Option Committee") administers the Employee Stock Option Plan.
Subject to certain specific limitations and restrictions set forth in the
Employee Stock Option Plan, the Option Committee has full and final authority
to: (i) determine the fair market value of the shares covered by each Option;
(ii) interpret the Employee Stock Option Plan; (iii) prescribe, amend and
rescind rules and regulations, if any, relating to the Employee Stock Option
Plan, but not to the Employee Stock Option Plan itself; (iv) determine the terms
and provisions of each Option granted under the Employee Stock Option Plan; (v)
accelerate the exercise date of any Option; (vi) authorize any person to execute
on behalf of the Company any instrument required to effectuate the grant of an
Option; and (vii) make all determinations necessary or advisable for the
administration of the Employee Stock Option Plan.
Upon stockholder approval, the Company reserved 75,000 shares of the
Company's Common Stock ("Option Shares") for issuance upon exercise of Options.
Any Option Shares subject to grants under the Employee Stock Option Plan which
expire or are terminated, forfeited or canceled without having been exercised or
vested in full, shall again be available for purposes of the Employee Stock
Option Plan. The Employee Stock Option Plan is intended to provide for the grant
of options which qualify for favorable federal income tax treatment as
"incentive stock options" ("ISOs") and stock options which do not qualify as
ISOs are non-qualified stock options ("NQSOs").
Directors Stock Option Plan
The Bank adopted the 1998 The Heritage Bank Outside Directors Stock
Option Plan (the "Outside Directors Stock Option Plan"). The Outside Directors
Stock Option Plan was approved by the Bank's shareholders on August 26, 1998 and
the Company assumed sponsorship of the plan upon the effective date of the
Reorganization. The Outside Directors Stock Option Plan provides for the grant
of options to purchase Common Stock of the Company ("Options") to certain
outside directors. The Outside Directors Stock Option Plan is not subject to
ERISA and is not a tax-qualified plan under the Code.
The Board of Directors or a committee of not less than 3 members (the
"Option Committee") administers the Outside Directors Stock Option Plan. The
members of the Committee are appointed by the Board of Directors of the Company
and serve at the pleasure of the Board of Directors of the Company. The
Committee is composed of the following: (1) one outside director; (2) an
employee who is not an outside director; and (3) a stockholder who is neither an
employee nor an outside director. Subject to certain specific limitations and
restrictions set forth in the Outside Directors Stock Option Plan, the Option
Committee has full and final authority to: (i) determine the fair market value
of the shares covered by each Option; (ii)
35
<PAGE>
interpret the Outside Directors Stock Option Plan; (iii) prescribe, amend and
rescind rules and regulations, if any, relating to the Outside Directors Stock
Option Plan, but not to the Outside Directors Stock Option Plan itself; (iv)
determine the terms and provisions of each Option granted under the Outside
Directors Stock Option Plan; (v) accelerate the exercise date of any Option;
(vi) authorize any person to execute on behalf of the Company any instrument
required to effectuate the grant of an Option; and (vii) make all determinations
necessary or advisable for the administration of the Outside Directors Stock
Option Plan.
Upon stockholder approval, the Company reserved 75,000 shares of the
Company's Common Stock ("Option Shares") for issuance upon exercise of Options.
Any members of the Board who are Outside Directors are eligible to participate
in the Outside Directors Stock Option Plan. Effective on the Outside Directors
Stock Option Plan Effective Date, each person who was an Eligible Director on
such date was granted a NQSO to purchase shares. Such Options have an Exercise
Price equal to the fair market value of a share of the Company's Common Stock on
the date of grant and an Exercise Period commencing on the date of grant and
expiring on the earliest of (i) within 60 days of the date he or she ceases to
be an Eligible Director due to resignation or a removal for cause (in accordance
with the Bylaws of the Company or other affiliate, as applicable) and (ii) the
last day of the ten-year period commencing on the date the Option was granted.
All Option Shares not previously purchased or available for purchase will become
available for purchase on the date of the option holder's death, disability,
retirement or in the event of a Change in Control. Options granted to directors
under the Outside Directors Stock Option Plan will be NQSOs.
1992 Stock Option Plan
On March 26, 1992, the Board of Directors of Heritage Bankshares,
Inc., a Virginia corporation ("Bankshares") announced its intention to
investigate a spin-off of two of its subsidiary banks, Princess Anne Bank, a
Virginia corporation ("Princess Anne"), and The Heritage Bank. On August 20,
1992, Bankshares Board of Directors declared a distribution (the "Distribution")
of all of Princess Anne's common stock and all of The Heritage Bank's common
stock to holders of Bankshares' common stock. As a result of the Distribution,
which was effected on August 31, 1992, Princess Anne and The Heritage Bank each
became independent banks.
Prior to the Distribution, certain employees of Bankshares, Princess
Anne and The Heritage Bank participated in Bankshares' employee stock option
plan (the "Bankshares Plan"). In connection with the Distribution, (I) Princess
Anne and The Heritage Bank each adopted an employee stock option plan similar to
the Bankshares Plan, (ii) option holders in the Bankshares Plan received, in
addition to their existing options to acquire common stock of Bankshares,
options to purchase an identical number of shares of common stock in both
Princess Anne and The Heritage Bank, and (iii) the exercise price of all options
was adjusted to reflect the relative appraised values of Bankshares (39% of the
value of all three entities), Princess Anne (40% of the value of all three
entities), and The Heritage Bank (21% of the value of all three entities). Thus,
for example, if a key employee of The Heritage Bank had options to acquire 1,000
shares of Bankshares' common stock at $20.00 per share before the Distribution,
such employee would, after Distribution, have options to acquire (a) 1,000
shares of Bankshares' common stock at $7.80 per share (39% of $20), (b) 1,000
shares of Princess Anne's common stock at $8.00 per share (40% of $20), and (c)
1,000 shares of The Heritage Bank's Common Stock at $4.20 per share (21% of
$20).
Under the Company's Employee Stock Option Plan (the "Stock Option
Plan"), full-time employees and part-time employees working at least 25 hours
per week are eligible to receive options to acquire Common Stock. The Company's
Board of Directors and a Committee appointed by the Board of Directors may grant
options at prices determined by the Board or the Committee. Options expire ten
years after the date of the grant. The Stock Option Plan authorizes the Board of
Directors or committee to grant options to purchase up to 50,000 shares of
Common Stock of the Company. A total of 30,625 of these 50,000 options have been
granted in connection with the Distribution as discussed in the preceding
paragraph.
36
<PAGE>
Stock Options - Named Executive Officer
The following table summarizes the option grants that were made to
John T. Rohrback under the Employee Stock Option Plan during the fiscal year
1998.
Option/SAR Grants in Fiscal Year 1998
<TABLE>
<CAPTION>
Individual Grants
Percent of
Number of Total
Securities Options/SARs
Underlying Granted to
Options/SARs Employees in Exercise or
Granted Fiscal Year Base Price Expiration
Name (#)(1) (%) ($ per Share) Date
- ---- ------------------ ------------------ -------------- -------------
<S> <C> <C> <C> <C>
John T. Rohrback
President and Chief
Executive Officer........... 2,581 28.92 3.875 9/22/08
</TABLE>
- ---------------
(1) All options are immediately exercisable upon grant, but are subject to
forfeiture within six months of January 25, 1999, that date of Mr.
Rohrback's termination of employment with the Bank.
The following table provides information with respect to Mr. Rohrback
concerning the exercise of options during the last fiscal year and the value for
"in-the-money" options held by him at year end, which represents the positive
spread between the exercise price of any such existing stock options and the
year-end price of the Common Stock. Mr. Rohrback did not hold any "in-the-money"
options at year end.
<TABLE>
<CAPTION>
Aggregated Option Exercises in 1998 Fiscal Year and 1998 Fiscal Year End Option/Values
Number of Securities Value of Unexercised
Underlying Unexercised In-the-Money
Shares Options/SARs at Fiscal Options/SARs at Fiscal
Acquired on Value Year-end Year-end
Exercise Realized (#) ($)
(#) - ($) - Exercisable/Unexercisable Exercisable/Unexercisable(1)
Name ------------------ ---------------- ------------------------------- ------------------------------------
<S> <C> <C> <C> <C>
John T. Rohrback -- -- 2,581 / 0 N/A
</TABLE>
- ----------------------
(1) Based upon a market price of $3.75 per share at December 31, 1998 minus
the exercise price.
37
<PAGE>
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT
The following table sets forth, as a group as of March 1, 1999, the
beneficial ownership of Common Stock of the Company by (i) each director of the
Company; (ii) each executive officer named in the Summary Compensation Table;
(iii) each person who owns or is known by management to own beneficially more
than five percent of the outstanding shares of the Company's Common Stock; and
(iv) all executive officers and directors as a group.
<TABLE>
<CAPTION>
Name and Address Number of Shares Percent of Class
of Beneficial Owner(1) Owned Beneficial(1)(2) (Common Stock)(3)
---------------------- ---------------------- -----------------
<S> <C> <C> <C>
George K. Degnon 25,100(4) 1.09%
Philip F. Herrick, Jr. 130,383(5) 5.68
Ronald W. Kosh 7,900(6) 0.34
Harold E. Lieding 351,393(7) 15.31
Stanley I. Richards 13,602(8) 0.59
Kevin P. Tighe 9,000(9) 0.39
George P. Shafran 48,269(10) 2.10
--------- -----
All Directors and
Executive Officers as a
Group (8 persons) 592,482 25.82%
- ----------------------- ========= =====
</TABLE>
(1) A person is deemed to be the beneficial owner of securities that can
be acquired by such person within 60 days from March 1, 1999. Each
beneficial owner's percentage ownership is determined by assuming
that options or warrants that are held by such person (but not those
held by any other person) and which are exercisable within 60 days
from March 1, 1999. Unless otherwise indicated, the Company believes
that all persons named in the table have sole voting and investment
power with respect to all shares of Common Stock beneficially owned
by them. Unless otherwise indicated, the address for the individuals
listed above is c/o The Heritage Bank, 1313 Dolley Madison Blvd.,
McLean, Virginia 22101.
(2) Includes 4,000 shares of Common Stock issuable upon the exercise of
stock options granted to each of the following outside directors: Mr.
Degnon, Mr. Herrick, Mr. Lieding, Mr. Richards and Mr. Tighe; 3,000
shares to Mr. Shafran; 1,500 shares to Mr. Kosh.
(3) Based on 2,294,617 shares of Common Stock outstanding as of March 1,
1999. Does not include (i) 30,625 shares of Common Stock reserved for
issuance upon exercise of options granted under the Company's 1992
Employee Stock Option Plan, (ii) 19,375 shares of Common Stock
available for future grant under the Company's 1992 Employee Stock
Option Plan. (iii) 8,925 shares of Common Stock reserved for issuance
upon exercise of options granted under the Company's 1998 Employee
Incentive Stock Option Plan. (iv) 66,075 shares of Common Stock
reserved for future grant under the Company's 1998 Employee Incentive
Stock Option Plan. (v) 14,500 shares of Common Stock reserved for
issuance upon exercise of options granted under the Company's 1998
Outside Directors Stock Option Plan. (vi) 60,500 shares of Common
Stock available for future grant under the Company's 1998 Outside
Directors Stock Option Plan.
(4) Includes 110 shares held jointly with his spouse.
(5) Includes 110,383 shares held jointly with his spouse.
(6) Includes 3,700 shares held jointly with his spouse.
(7) Includes 146,652 held in an individual retirement account.
(8) Includes 7,000 shares jointly held with his spouse.
(9) Includes 3,000 shares jointly held with his spouse.
(10) Includes 3,634 shares that Mr. Shafran holds as custodian for his
minor grandchildren.
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The officers, directors, their immediate families and affiliated companies
in which they are stockholders maintain normal relationships with the Company
and the Bank. Loans made by the Bank are made in the ordinary course of business
on the same terms, including interest rates and collateral, as those prevailing
at the time of comparable transactions with others and do not involve more than
normal risks of collectability or present other unfavorable features. The amount
of such loans was approximately $279,384 and $348,483 as
38
<PAGE>
of December 31, 1998 and 1997, respectively. No loan to a director or any
director's related interest exceeded ten percent of capital or exceeded $300,000
at December 31, 1998.
ITEM 13. EXHIBITS, LIST AND REPORTS ON FORM 8-K
(1) The following financial statements of Heritage Bancorp, Inc. and the
Heritage Bank are incorporated herein by reference in item 8:
Balance Sheets - December 31 1998 and 1997.
Statement of operation - Years ended December 31, 1998, 1997, and 1996.
Statement of changes in Stockholders' Equity - Years ended December 31,
1998, 1997, and 1996
Statements of Cash Flows - Years ended December 31, 1998, 1997 and 1996
Notes to Financial statements.
Report of independent accountants.
(2) Exhibits:
2.1 Agreement and Plan of Reorganization by and among The Heritage
Bank and Heritage Bancorp, Inc.*
3.1 Articles of Incorporation of Heritage Bancorp, Inc.*
3.2 Bylaws of Heritage Bancorp, Inc.*
3.3 Articles of Incorporation of The Heritage Bank*
3.4 Bylaws of The Heritage Bank*
4.1 Stock Certificate of Heritage Bancorp, Inc.*
10.1 The Heritage Bank 1998 Employee Incentive Stock Option Plan*
10.2 The Heritage Bank 1998 Outside Director Stock Option Plan*
10.3 The Heritage Bank 1992 Employee Incentive Stock Option Plan*
23.1 Consent of Yount, Hyde & Barbour, P.C.
27.1 Financial Data Schedule (only filed in EDGAR format)
*Incorporated by reference to the initial filing of the Registration Statement
on Form S-4 as filed with the U.S. Securities and Exchange Commission on July 6,
1998, as amended,
(3) Reports on Form 8-K:
None.
39
<PAGE>
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the
registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
HERITAGE BANCORP, INC.
By: /s/ William B. Sutphin
----------------------------
William B. Sutphin
Senior Vice President
In accordance with the Exchange Act, this report has been
signed below by the following persons on behalf of the registrant and in the
capacities and on the dates indicated.
<TABLE>
<CAPTION>
Name Title Date
---- ----- ----
<S> <C> <C>
/s/ Harold E. Lieding Chairman of the Board March 25, 1998
- ------------------------------------------
Harold E. Lieding
/s/ George K. Degnon Director March 25, 1998
- ------------------------------------------
George K. Degnon
/s/ Kevin P. Tighe Director March 25, 1998
- ------------------------------------------
Kevin P. Tighe
/s/ Philip F. Herrick, Jr. Director March 25, 1998
- ------------------------------------------
Philip F. Herrick, Jr.
/s/ Ronald W. Kosh Director March 25, 1998
- ------------------------------------------
Ronald W. Kosh
/s/ Stanley I. Richards Director March 25, 1998
- ------------------------------------------
Stanley I. Richards
/s/ George P. Shafran Director and Vice Chairman March 25, 1998
- ------------------------------------------
George P. Shafran
</TABLE>
40
<PAGE>
HERITAGE BANCORP, INC.
AND SUBSIDIARY
McLean, Virginia
CONSOLIDATED FINANCIAL REPORT
DECEMBER 31, 1998
<PAGE>
C O N T E N T S
Page
INDEPENDENT AUDITOR'S REPORT F-1
CONSOLIDATED FINANCIAL STATEMENTS
Consolidated statements of condition F-2
Consolidated statements of operations F-3
Consolidated statements of changes in stockholders' equity F-4
Consolidated statements of cash flows F-5 and F-6
Notes to consolidated financial statements F-7-F-26
<PAGE>
INDEPENDENT AUDITOR'S REPORT
To the Board of Directors
Heritage Bancorp, Inc. and Subsidiary
McLean, Virginia
We have audited the accompanying consolidated statements of condition
of Heritage Bancorp, Inc. and Subsidiary as of December 31, 1998 and 1997, and
the related consolidated statements of operations, changes in stockholders'
equity and cash flows for the three years then ended. These consolidated
financial statements are the responsibility of the Corporation's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to
above present fairly, in all material respects, the financial position of
Heritage Bancorp, Inc. and Subsidiary as of December 31, 1998 and 1997, and the
results of its operations and its cash flows for the three years then ended, in
conformity with generally accepted accounting principles.
/s/ Yount, Hyde & Barbour, P.C.
Winchester, Virginia
February 5, 1999
<PAGE>
HERITAGE BANCORP, INC.
AND SUBSIDIARY
Consolidated Statements of Condition
December 31, 1998 and 1997
Assets
1997 1998
Cash and due from banks $ 5 824 649 $ 1 986 523
Federal funds sold and securities purchased under
agreement to resell 8 550 000 7 600 000
------------ ---------
Total cash and cash equivalents $ 14 374 649 $ 9 586 523
Securities available for sale, at approximate
market value 19 823 754 11 793 716
Securities to be held to maturity (fair value:
1998, $-0- and 1997, $249,375) - - 250 000
Loans, net 29 181 039 22 756 260
Premises and equipment, net 376 453 378 939
Accrued interest receivable 459 340 274 591
Other real estate owned 263 199 263 199
Other assets 297 160 146 415
------------ -----------
Total assets $ 64 775 594 $45 449 643
============ ===========
Liabilities and Stockholders' Equity
Liabilities
Noninterest-bearing deposits $ 17 552 927 $11 855 769
Savings and interest-bearing demand deposits 20 565 927 17 623 691
Time deposits 15 323 125 11 124 375
------------ -----------
Total deposits $ 53 441 979 $40 603 835
Accrued interest and other liabilities 119 170 115 460
Securities sold under agreement to repurchase 2 286 781 - -
Commitments and contingent liabilities - - - -
------------ -----------
Total liabilities $ 55 847 930 $40 719 295
------------ -----------
Stockholders' Equity
Common stock, $1 par value; authorized 10,000,000
shares; issued and outstanding 2,294,617 and
1,489,636 shares, respectively $ 2 294 617 $ 1 489 636
Capital surplus 6 529 539 3 327 451
Retained earnings (deficit) 28 549 (104 856)
Accumulated other comprehensive income 74 959 18 117
------------ ----------
Total stockholders' equity $ 8 927 664 $ 4 730 348
------------ ----------
Total liabilities and stockholders' equity $ 64 775 594 $45 449 643
============ ===========
See Accompanying Notes to Consolidated Financial Statements.
<PAGE>
HERITAGE BANCORP, INC.
AND SUBSIDIARY
Consolidated Statements of Operations
Years Ended December 31, 1998, 1997 and 1996
1998 1997 1996
---------- ---------- ----------
Interest Income
Loans $2 386 091 $2 285 986 $2 321 858
Securities 1 117 858 816 256 822 760
Federal funds sold 262 053 154 066 274 892
---------- ---------- ----------
Total interest income $3 766 002 $3 256 308 $3 419 510
---------- ---------- ----------
Interest Expense
Interest checking deposits $ 495 705 $ 443 836 $ 453 352
Other time deposits 520 405 512 337 744 650
Certificates of deposit $100,000
or more 217 440 147 801 212 699
Securities sold under agreement
to repurchase 38 859 6 797 - -
---------- ---------- ----------
Total interest expense $1 272 409 $1 110 771 $1 410 701
---------- ---------- ----------
Net interest income $2 493 593 $2 145 537 $2 008 809
Provision for loan losses 117 000 3 825 - -
---------- ---------- ----------
Net interest income after
provision for loan losses $2 376 593 $2 141 712 $2 008 809
---------- ---------- ----------
Other Income
Service charges on deposit accounts $ 122 684 $ 112 039 $ 101 440
Other operating income, net 15 477 21 233 17 660
Gain (loss) on sale of securities (781) 47 261 - -
---------- ---------- ----------
Total other income $ 137 380 $ 180 533 $ 119 100
---------- ---------- ----------
Other Expenses
Salaries and employee benefits $1 074 228 $ 953 246 $ 898 649
Occupancy expense 204 669 215 204 214 171
Equipment expense 73 667 88 275 91 687
Other operating expenses 1 068 643 579 961 520 109
---------- ---------- ----------
Total other expenses $2 421 207 $1 836 686 $1 724 616
---------- ---------- ----------
Income before income taxes $ 92 766 $ 485 559 $ 403 293
Income tax expense (benefit) (40 639) (85 297) - -
---------- ---------- ----------
Net income $ 133 405 $ 570 856 $ 403 293
========== ========== ==========
Earnings Per Share, basic $ .07 $ .45 $ .32
========== ========== ==========
Earnings Per Share, assuming dilution $ .07 $ .44 $ .32
========== ========== ==========
<PAGE>
HERITAGE BANCORP, INC.
AND SUBSIDIARY
Consolidated Statements of Changes in Stockholders' Equity
Years Ended December 31, 1998, 1997 and 1996
<TABLE>
<CAPTION>
Accumulated
Other
Common Capital Retained Comprehensive Comprehensive
Stock Surplus Earnings Income Income Total
------------- ------------ ------------ ------------- ------------- ------------
<S> <C> <C> <C> <C> <C> <C>
Balance, December 31, 1995 $ 1 249 634 $ 2 967 448 $(1 079 005) $ 10 987 $3 149 064
Net income - - - - 403 293 - - $ 403 293 403 293
Other comprehensive income,
net of tax
Unrealized holding losses
arising during period,
net of tax of $-0- - - - - - - (9 523) (9 523) (9 523)
-------------
Comprehensive income - - - - - - - - $ 393 770 - -
------------ ------------ ----------- --------- ============= ----------
Balance, December 31, 1996 $ 1 249 634 $ 2 967 448 $ (675 712) $ 1 464 $3 542 834
Net income - - - - 570 856 - - $ 570 856 570 856
Other comprehensive income,
net of tax
Unrealized holding gains
arising during period,
net of tax of $25,401 - - - - - - - - 47 845 - -
Less reclassification
adjustment, net of tax
of $16,068 - - - - - - - - (31 192) - -
-------------
Other comprehensive income - - - - - - 16 653 $ 16 653 16 653
-------------
Comprehensive income - - - - - - - - $ 587 509 - -
=============
Warrants exercised 240 002 360 003 - - - - 600 005
------------ ------------ ----------- --------- -------------
Balance, December 31, 1997 $ 1 489 636 $ 3 327 451 $ (104 856) $ 18 117 $4 730 348
Net income - - - - 133 405 - - $ 133 405 133 405
Other comprehensive income,
net of tax
Unrealized holding gains
arising during period,
net of tax of $29,016 - - - - - - - - 56 327 - -
Add reclassification adjustment,
net of tax of $266 - - - - - - - - 515 - -
-------------
Other comprehensive income - - - - - - 56 842 $ 56 842 56 842
=============
Comprehensive income - - - - - - - - $ 190 247 - -
=============
Stock options exercised 2 700 7 120 - - - - 9 820
Repurchase of stock in odd
lot tender (2 719) (12 236) - - - - (14 955)
Issuance of common stock 805 000 3 207 204 - - - - 4 012 204
------------ ------------ ----------- --------- ----------
Balance, December 31, 1998 $ 2 294 617 $ 6 529 539 $ 28 549 $ 74 959 $8 927 664
============ ============ =========== ========= ==========
</TABLE>
See Accompanying Notes to Consolidated Financial Statements.
<PAGE>
HERITAGE BANCORP, INC.
AND SUBSIDIARY
Consolidated Statements of Cash Flows
Years Ended December 31, 1998, 1997 and 1996
1998 1997 1996
---------- ---------- ---------
Cash Flows from Operating Activities
Net income $ 133 405 $ 570 856 $ 403 293
Adjustments to reconcile net income
to net cash provided by (used in)
operating activities:
Provision for loan losses 117 000 3 825 - -
(Gain) loss on sale of securities 781 (47 261) - -
Depreciation and amortization 50 958 67 733 72 182
Deferred tax (benefit) (45 239) (85 297) - -
Amortization of investment security
premiums, net of discounts 37 438 13 845 24 245
(Increase) decrease in accrued interest
and other assets (319 486) 64 677 (109 696)
Increase (decrease) in accrued interest
and other liabilities 5 412 (30 169) (17 419)
---------- --------- ---------
Net cash provided by (used in)
operating activities $ (19 731) $ 558 209 $ 372 605
----------- -------- ---------
Cash Flows from Investing Activities
Maturities and calls of securities
available for sale $9 195 000 $1 800 000 $2 000 000
Purchase of securities available
for sale (17 676 403) (9 236 816)(12 601 919)
Maturities of securities held to maturity 250 000 250 000 1 550 000
Proceeds from sale of securities available
for sale 499 219 8 984 402 5 100
Net (increase) decrease in loans (6 543 481) 1 825 409 (1 010 908)
Purchase of premises and equipment (48 472) (90 920) (42 487)
Proceeds from sale of other real
estate owned - - - - 100 508
---------- --------- ---------
Net cash provided by (used in)
investing activities $(14 324 137) $3 532 075 $(9 999 706)
---------- ---------- ----------
Cash Flows from Financing Activities
Increase in demand deposits, NOW accounts
and savings deposits $8 639 394 $550 791 $ 986 664
Increase (decrease) in certificates
of deposit 4 198 750 (2 333 488) (2 139 345)
Proceeds from stock warrants exercised - - 600 005 - -
Proceeds from sale of common stock 4 022 024 - - - -
Repurchase of common stock (14 955) - - - -
Increase in securities sold under agreement
to repurchase 2 286 781 - - - -
---------- ------------ ----------
Net cash provided by (used in)
financing activities $19 131 994 $(1 182 692)$(1 152 681)
---------- ----------- ----------
<PAGE>
HERITAGE BANCORP, INC.
AND SUBSIDIARY
Consolidated Statements of Cash Flows
(Continued)
Years Ended December 31, 1998, 1997 and 1996
<TABLE>
<CAPTION>
1998 1997 1996
---- ----- ------
<S> <C> <C> <C>
Net change in cash and cash equivalents $ 4 788 126 $2 907 592 $ (10 779 782)
Cash and Cash Equivalents, beginning of year 9 586 523 6 678 931 17 458 713
------------- ---------- --------------
Cash and Cash Equivalents, end of year $ 14 374 649 $9 586 523 $ 6 678 931
============= ========== ==============
Supplemental Disclosures of Cash Flow Information
Cash payments for:
Interest $ 1 269 516 $1 113 620 $ 1 419 643
============= ========== ==============
Income taxes $ - - $ 9 187 $ - -
============= ========== ==============
Supplemental Schedule of Noncash Investing
Activities
Other real estate acquired in settlement
of loans $ - - $ - - $ 86 750
============= ========== ==============
Unrealized gain (loss) on securities
available for sale $ 86 124 $ 25 986 $ (9 523)
============= ========== ==============
</TABLE>
See Accompanying Notes to Consolidated Financial Statements.
<PAGE>
HERITAGE BANCORP, INC.
AND SUBSIDIARY
Notes to Consolidated Financial Statements
December 31, 1998, 1997 and 1996
Note 1. Nature of Banking Activities and Significant Accounting Policies
General
Heritage Bancorp, Inc. (Corporation) is a bank holding company
organized under Virginia law in October, 1998. During 1998, Bancorp
acquired The Heritage Bank through a share exchange in which the
stockholders of The Heritage Bank received one share of Bancorp for
each share of The Heritage Bank. The exchange was a tax-free
transaction for federal income tax purposes. The merger was accounted
for on the same basis as a pooling-of-interests. Financial statements
for the year ended December 31, 1997, have been retroactively adjusted
for the exchange as if it occurred on January 1, 1997.
The Corporation's wholly-owned subsidiary, The Heritage Bank (Bank) was
incorporated under Virginia law in 1987. It operated as a wholly-owned
subsidiary of Heritage Bankshares, Inc. until September 1, 1992, when
it became independent. The Bank is a state chartered member of the
Federal Reserve System with deposits insured by the Federal Deposit
Insurance Corporation (FDIC) and is located in McLean, Virginia.
Nature of Operations
Heritage Bancorp, Inc. is a bank holding company that provides a
variety of banking services to individuals and businesses. Its primary
deposit products are demand and savings deposits and certificates of
deposit. Its primary lending products are commercial business and real
estate mortgage loans. The loans are expected to be repaid from cash
flow or proceeds from the sale of selected assets of the borrowers.
Principles of Consolidation
The accounting and reporting policies of Heritage Bancorp, Inc. and
subsidiary (the "Corporation") conform to generally accepted accounting
principles and general practices within the banking industry. The
following is a description of the more significant of those policies:
Securities
Securities are classified in three categories and accounted for as
follows:
a. Securities Held to Maturity
Securities classified as held to maturity are those debt
securities the Corporation has both the intent and ability to
hold to maturity regardless of changes in market conditions,
liquidity needs or changes in general economic conditions. These
securities are carried at cost adjusted for amortization of
premium and accretion of discount, computed by the interest
method over their contractual lives.
<PAGE>
b. Securities Available for Sale
Securities classified as available for sale are those debt and
equity securities that the Corporation intends to hold for an
indefinite period of time, but not necessarily to maturity. Any
decision to sell a security classified as available for sale
would be based on various factors, including significant
movements in interest rates, changes in the maturity mix of the
Corporation's assets and liabilities, liquidity needs,
regulatory capital considerations, and other similar factors.
Securities available for sale are carried at fair value.
Unrealized gains or losses are reported as a separate component
of other comprehensive income. Realized gains or losses,
determined on the basis of the cost of specific securities sold,
are included in earnings.
c. Trading Securities
Trading securities, which are generally held for the short term
in anticipation of market gains, are carried at fair value.
Realized and unrealized gains and losses on trading account
assets are included in interest income on trading account
securities. The Corporation had no trading securities at
December 31, 1998 and 1997.
Loans
Loans are shown on the consolidated balance sheets net of unearned
discounts and the allowance for loan losses.
Interest on loans is computed by methods which generally result in
level rates of return on principal. Interest accrual is discontinued
when, in the opinion of management, the likelihood of collection is
doubtful. Loans are charged off when in the opinion of management
they are deemed to be uncollectible after taking into consideration
such factors as the current financial condition of the customer and
the underlying collateral and guarantees.
Impairment of loans that have been separately identified for
evaluation is to be measured based on the present value of expected
future cash flows or, alternatively, the observable market price of
the loans or the fair value of the collateral. However, for those
loans that are collateral dependent (that is, if repayment of those
loans is expected to be provided solely by the underlying collateral)
and for which management has determined foreclosure is probable, the
measure of impairment of those loans is to be based on the fair value
of the collateral.
<PAGE>
The Corporation considers all consumer installment loans and
residential mortgage loans to be homogeneous loans. These loans are
not subject to the above impairment provisions. A loan is considered
impaired when it is probable that the Corporation will be unable to
collect all principal and interest amounts according to the
contractual terms of the loan agreement. Factors involved in
determining impairment include, but are not limited to, expected
future cash flows, financial condition of the borrower, and the
current economic conditions. A performing loan may be considered
impaired, if the factors above indicate a need for impairment. A loan
on nonaccrual status may not be impaired if in the process of
collection or if there is an insignificant shortfall in payment. An
insignificant delay of less than 30 days or a shortfall of less than
5% of the required principal and interest payment generally does not
indicate an impairment situation, if in management's judgment the
loan will be paid in full. Loans that meet the regulatory definitions
of doubtful or loss generally qualifies as an impaired loan.
Charge-offs for impaired loans occur when the loan or portion of the
loan is determined to be uncollectible, as is the case for all loans.
Loans are placed on nonaccrual when a loan is specifically determined
to be impaired or when principal or interest is delinquent for 90
days or more. Any unpaid interest previously accrued on those loans
is reversed from income. Interest income generally is not recognized
on specific impaired loans unless the likelihood of further loss is
remote. Interest payments received on such loans are applied as a
reduction of the loan principal balance. Interest income on other
nonaccrual loans is recognized only to the extent of interest
payments received.
Allowance for Loan Losses
The allowance for loan losses is maintained at a level which, in
management's judgement, is adequate to absorb credit losses inherent
in the loan portfolio. The amount of the allowance is based on
management's evaluation of the collectibility of the loan portfolio,
credit concentrations, trends in historical loss experience, specific
impaired loans, and economic conditions. Allowances for impaired
loans are generally determined based on collateral values or the
present value of estimated cash flows. The allowance is increased by
a provision for loan losses, which is charged to expense and reduced
by charge-offs, net of recoveries. Changes in the allowances relating
to impaired loans are charged or credited to the provision for loan
losses. Because of uncertainties inherent in the estimation process,
management's estimate of credit losses inherent in the loan portfolio
and the related allowance may change in the near term.
Bank Premises and Equipment
Premises and equipment are stated at cost less accumulated
depreciation and amortization. Premises and equipment are depreciated
over their estimated useful lives; leasehold improvements are
amortized over the lives of the respective leases or the estimated
useful life of the leasehold improvement, whichever is less.
Depreciation and amortization are recorded on the straight-line
method.
<PAGE>
Costs of maintenance and repairs are charged to expense as incurred.
Costs of replacing structural parts of major units are considered
individually and are expensed or capitalized as the facts dictate.
Income Taxes
Deferred taxes are provided on a liability method whereby deferred
tax assets are recognized for deductible temporary differences,
operating loss carryforwards, and tax credit carryforwards. Deferred
tax liabilities are recognized for taxable temporary differences.
Temporary differences are the differences between the reported
amounts of assets and liabilities and their tax bases. Deferred tax
assets are reduced by a valuation allowance when, in the opinion of
management, it is more likely than not that some portion or all of
the deferred tax assets will not be realized. Deferred tax assets and
liabilities are adjusted for the effects of the changes in tax laws
and rates on the date of enactment.
Earnings Per Share
In 1997, the Financial Accounting Standards Board issued Statement
No. 128, "Earnings per Share." Statement 128 replaced the
calculation of primary and fully diluted earnings per share with
basic and diluted earnings per share. Basic earnings per share
excludes any dilutive effects of options, warrants and convertible
securities. Diluted earnings per share is very similar to the
previously reported fully diluted earnings per share. All earnings
per share amounts for all periods have been presented, and where
appropriate, restated to conform to the statement 128 requirements.
Nonrefundable Loan Fees and Costs
Loan origination and commitment fees are being deferred and amortized
as an adjustment of the related loan's yield.
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents
include cash on hand, amounts due from banks, federal funds sold and
securities purchased under agreement to resell. Generally, federal
funds are purchased and sold for one-day periods.
Other Real Estate
Real estate acquired through foreclosure is carried at the lower of
cost or fair market value less estimated selling costs.
<PAGE>
Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results
could differ from those estimates.
Advertising
The Corporation follows the policy of charging the costs of
advertising to expense as incurred. The amount of advertising
included in expense for December 31, 1998, 1997 and 1996 was $31,482,
$20,394 and $13,071, respectively.
Comprehensive Income
As of January 1, 1998, the Corporation adopted Statement of Financial
Accounting Standards (FASB) No. 130, "Reporting Comprehensive
Income." FASB No. 130 establishes new rules for the reporting and
display of comprehensive income and its components; however, the
adoption of this statement had no impact on the Corporation's net
income or stockholders' equity. FASB No. 130 requires other
comprehensive income to include unrealized gains and losses on
available for sale securities, which prior to adoption were reported
separately in stockholders' equity. The December 31, 1997 and 1996
financial statements have been reclassified to conform to the
requirements of FASB No. 130.
Note 2. Cash and Due From Banks
The Bank is required to maintain reserve balances with the Federal
Reserve Bank. For the final weekly reporting period in the years ended
December 31, 1998 and 1997, the aggregate amounts of daily average
required balances were approximately $391,000 and $348,000,
respectively.
<PAGE>
Note 3. Securities
The amortized cost, unrealized holding gains and losses, and the fair
value of securities are summarized as follows:
<TABLE>
<CAPTION>
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains (Losses) Value
--------- ---------- ---------- -----
<S> <C> <C> <C> <C>
Available for sale
securities:
December 31, 1998:
U.S. Treasury
securities $3 021 530 $ 29 721 $ - - $ 3 051 251
U.S. Government
agencies 14 769 231 57 082 (2 344) 14 823 969
Obligations of
states and political
subdivisions 1 654 720 29 114 - - 1 683 834
Other 264 700 - - - - 264 700
---------- --------- --------- ----------
Total $19 710 181 $ 115 917 $ (2 344) $19 823 754
=========== ========= ========= ===========
December 31, 1997:
U.S. Treasury
securities $ 4 052 641 $ 26 532 $ (3 001) $ 4 076 172
U.S. Government
agencies 5 751 783 7 279 (7 841) 5 751 221
Obligations of
states and political
subdivisions 1 849 592 5 819 (1 338) 1 854 073
Other 112 250 - - - - 112 250
---------- --------- --------- ----------
Total $11 766 266 $ 39 630 $ (12 180) $11 793 716
=========== ========= ========= ==========
Held-to-maturity
securities:
December 31, 1997:
U.S. Government
agencies $ 250 000 $ - - $ (625) $ 249 375
========== ========= ========= ==========
</TABLE>
<PAGE>
The scheduled maturities of securities at December 31, 1998 were as
follows:
Available for Sale Securities
-------------------------------
Amortized Fair
Cost Value
Due in one year or less $ 4 666 530 $ 4 698 146
Due from one year to five years 13 279 838 13 362 255
Due from five years to ten years 1 499 113 1 498 653
Federal reserve stock 264 700 264 700
------------- -----------
Total $ 19 710 181 $19 823 754
============= ===========
Proceeds from sale of securities available for sale during 1998, 1997
and 1996 were $499,219, $8,984,402 and $5,100. Gross gains on those
sales during 1998, 1997 and 1996 were $-0-, $47,261 and $-0-. Gross
losses on those sales were $781, $-0- and $-0- during 1998, 1997 and
1996, respectively.
Securities having a book value of approximately $1,505,777 and
$1,000,000 at December 31, 1998 and 1997, were pledged to secure public
deposits and letters of credit.
Note 4. Loans
Major classifications of loans were as follows at December 31:
1998 1997
---------- -----------
(In Thousands)
Real estate:
Mortgage $ 23 085 $ 17 532
Farm land 992 - -
Construction 441 448
Commercial 3 786 4 191
Consumer loans 1 306 1 219
--------- ----------
$ 29 610 $ 23 390
Less: allowance for loan losses (429) (634)
--------- ----------
Loans, net $ 29 181 $ 22 756
========== ==========
<PAGE>
Changes in the allowance for loan losses are summarized as follows for the years
ended December 31:
1998 1997 1996
--------- ------------- ------------
Balance, beginning of year $633 797 $ 617 430 $ 684 607
Provision for loan losses 117 000 3 825 - -
Loans charged-off (338 944) (61 336) (108 402)
Recoveries 17 206 73 878 41 225
-------- --------- ----------
Balance at end of year $429 059 $ 633 797 $ 617 430
======== ========= ==========
Information about impaired loans as of and for the years ended December
31, 1998 and 1997 is as follows:
1998 1997
--------- ----------
Impaired loans for which an allowance
has been provided $ 29 370 $ 185 166
Impaired loans for which no allowance
has been provided - - - -
--------- ----------
Total impaired loans $ 29 370 $ 185 166
========= ==========
Allowance provided for impaired loans,
included in the allowance for loan
losses $ 11 405 $ 27 775
========= ==========
Average balance in impaired loans $ 176 334 $ 378 901
========= ==========
Interest income recognized $ 23 605 $ 26 858
========= ==========
Nonaccrual loans excluded from impaired loan disclosure under FASB 114
amounted to $365,670 and $36,735 at December 31, 1998 and 1997,
respectively. If interest on these loans had been accrued, such income
would have approximated $26,836 and $5,852 for the years ended December
31, 1998 and 1997.
Note 5. Related Party Transactions
The Corporation has loan transactions with its officers and directors
and with companies in which the officers and directors have a financial
interest. In the opinion of management, such loans were made in the
ordinary course of business on substantially the same terms and
conditions, including interest rates and collateral, as those prevailing
at the same time for comparable transactions with other customers, and
did not represent more than normal credit risk.
The aggregate amount of loans to such related parties at December 31,
1998 and 1997 was $279,384 and $348,483, respectively. During 1998, new
loans to such related parties amounted to $209,000 and repayments
amounted to $278,099.
<PAGE>
Note 6. Premises and Equipment
Premises and equipment are summarized as follows at December 31:
1998 1997
---------- -----------
Land $ 245 000 $ 245 000
Land improvements 31 885 - -
Leasehold improvements 147 647 147 647
Equipment, furniture and fixtures 354 200 337 613
----------- ---------
$ 778 732 $ 730 260
Less: accumulated depreciation and
amortization (402 279) (351 321)
--------- ---------
$ 376 453 $ 378 939
========= =========
Depreciation and amortization charged to operations totaled $50,958,
$67,733 and $72,182 in 1998, 1997 and 1996, respectively.
Note 7. Repurchase Agreement
In 1994, the Corporation executed a Master Repurchase Agreement with a
major financial institution. Under this agreement, the Bank may borrow
short-term funds by selling securities under agreement to repurchase.
Generally, these securities will be limited to U.S. Government and
government agency securities and agency mortgage-backed securities. The
amount available to be borrowed under this plan is limited by the amount
of securities held in safekeeping by the correspondent financial
institution, which was $2,994,677 at year end. As of December 31, 1998
$2,286,781 was borrowed under this agreement. No funds were borrowed
under this agreement at December 31, 1997.
Note 8. Income Taxes
Net deferred tax assets consist of the following as of December 31, 1998
and 1997:
1998 1997
---------- -----------
Deferred tax assets:
Net operating loss carryforwards $ 47 105 $ 131 717
Alternative minimum tax credits 6 652 14 354
Accumulated depreciation 28 160 32 233
Allowance for loan losses 32 448 995
Organization costs 19 362 - -
Other 11 163 5 649
Less: valuation allowance - - (85 297)
--------- ----------
Gross deferred tax asset $ 144 890 $ 99 651
--------- ----------
Deferred tax liabilities, unrealized gain
on securities available for sale $ 38 615 $ 9 333
---------- ----------
Net deferred tax asset $ 106 275 $ 90 318
========== ==========
The provision for income taxes charged to operations for the years ended
December 31, 1998, 1997 and 1996, consists of the following:
1998 1997 1996
--------- ------------- -----------
Current $ 4 600 $ - - $ - -
Deferred 40 058 161 717 132 611
Change in valuation allowance (85 297) (247 014) (132 611)
-------- --------- ---------
$(40 639) $ (85 297) $ - -
======= ========= =========
The income tax provision differs from the amount of income tax
determined by applying the U.S. federal income tax rate to pretax income
for the years ended December 31, 1998, 1997 and 1996, due to the
following:
1998 1997 1996
--------- ------------- -----------
Tax expense at statutory rate $ 31 540 $ 165 090 $137 120
Benefit of operating loss
carryforwards (85 297) (247 014) (132 611)
Other, net 13 118 (3 373) (4 509)
-------- --------- --------
$(40 639) $ (85 297) $ - -
======== ========== ========
At December 31, 1998, the Corporation has operating loss carryforwards
of approximately $138,543 that may be offset against future taxable
income and which will expire over various years from 2006 to 2010.
Note 9. Deposits
The aggregate amount of jumbo time deposits, each with a minimum
denomination of $100,000 was $6,339,277 and $4,352,098 in 1998 and
1997, respectively.
At December 31, 1998, the scheduled maturities of time deposits are as
follows:
(Amounts in Thousands)
1999 $ 8 732 253
2000 5 028 193
2001 1 562 679
2002 - -
2003 - -
2004 and thereafter - -
-----------
$15 323 125
===========
<PAGE>
Note 10. Other Operating Expenses
The components of other operating expenses consisted of the following
for the years ended December 31:
1998 1997 1996
--------- ----------- ------------
Data processing $ 99 589 $ 78 702 $ 70 594
Insurance 24 626 21 498 29 192
Professional fees 374 229 115 024 128 628
Stationery and supplies 70 172 61 957 44 843
Postage 33 235 36 899 37 499
Stockholder expense 77 524 18 116 10 294
Other (includes no items in
excess of 1% of
total revenue) 389 268 247 765 199 059
--------- ----------- ------------
$1 068 643 $ 579 961 $ 520 109
========= =========== ============
Note 11. Earnings Per Share
The following shows the weighted average number of shares used in
computing earnings per share and the effect on weighted average number
of shares of diluted potential common stock. Potential dilutive common
stock had no effect on income available to common stockholders.
<TABLE>
<CAPTION>
1998 1997 1996
Per Share Per Share Per Share
Shares Amount Shares Amount Shares Amount
------- -------- --------- --------- ------- ----------
<S> <C> <C> <C> <C> <C> <C>
Basic earnings
per share 1 890 666 $ .07 1 271 176 $ .45 1 249 634 $ .32
======== ======== ========
Effect of dilutive
securities:
Stock options 5 585 1 307 - -
Warrants - - 22 726 - -
-------- -------- ---------
Diluted earnings
per share 1 896 251 $ .07 1 295 209 $ .44 1 249 634 $ .32
========= ======== ========= ======== ========= ========
</TABLE>
Warrants on 240,002 shares of common stock were not included in
computing diluted EPS in 1996 because their effects were antidilutive.
Options on 30,675 shares of common stock were not included in computing
diluted EPS in 1996 because their effects were antidilutive.
<PAGE>
Note 12. Commitments and Contingencies
The Corporation entered into a long-term lease for its main office and
operations center which expires in 2008. The lease contains three
five-year renewal periods. Total rent expense was $191,272, $194,945
and $197,096 for 1998, 1997 and 1996, respectively, and was included in
occupancy expense.
The following is a schedule by year of future minimum lease payments
required under the long-term noncancelable lease agreements.
1999 $ 237 555
2000 256 371
2001 264 063
2002 271 985
2003 280 145
Due thereafter 1 424 288
---------
$2 734 407
==========
The Corporation also entered into a long-term lease for its future
branch office on December 22, 1997. The term of the lease is ten years
commencing June 1, 1998 or fifteen days following the issuance of an
occupancy permit, whichever occurs last. If the Certificate of
Occupancy is not granted, the lease may be declared void by either
party by providing written notice to the other party.
The Corporation is conducting a comprehensive review of its computer
systems to identify the systems that could be affected by the Year 2000
Issue, and is developing a remediation plan to resolve the Issue. The
Issue is whether computer systems will properly recognize
date-sensitive information when the year changes to 2000. Systems that
do not properly recognize such information could generate erroneous
data or cause a system to fail. The Corporation is heavily dependent on
computer processing in the conduct of its business activities. Failure
of these systems could have a significant impact on the Corporation's
operations.
In the normal course of business there are outstanding various
commitments and contingent liabilities, which are not reflected in the
accompanying consolidated financial statements. Management does not
anticipate any material losses as a result of these transactions.
See Note 15 with respect to financial instruments with
off-balance-sheet risk.
<PAGE>
Note 13. Stock-Based Compensation
In 1998, the stockholders approved an employee incentive stock option
plan. The option price for shares granted under this plan shall be
determined by a Committee of the Corporation's Board of Directors, but
in no event shall the option price be less than the fair market value
of the Corporation's stock at the time of grant. The term of each
option granted under the plan is ten years, unless the optionee has
been discharged from his or her employment by the Corporation for cause
in which case the option must be exercised no later than six months
following the date of discharge. The maximum aggregate number of shares
which may be optioned and sold under the plan is 75,000 shares. As of
December 31, 1998, 8,925 options were outstanding under this plan.
In 1992, the Corporation adopted a nonqualified stock option plan which
full-time employees and part-time employees working at least 25 hours
per week were eligible to receive options to acquire Common Stock.
Options expire ten years after the date of grant. There are 20,625
options outstanding under this plan as of December 31, 1998.
Grants under the above plans are accounted for following APB Opinion
No. 25 and related interpretations. Accordingly, no compensation cost
has been recognized for grants under the stock option plans. No
employee stock options were granted during 1997 and 1996. Had
compensation cost for the employee stock-based compensation plan been
determined based on the grant date fair values of awards (the method
described in FASB Statement No. 123), reported net income and earnings
per common share would have been reduced to the pro forma amounts shown
below for 1998:
Net income:
As reported $ 133 405
Pro forma $ 116 581
Basic earnings per share:
As reported $ 0.07
Pro forma $ 0.06
Diluted earnings per share:
As reported $ 0.07
Pro forma $ 0.06
The fair value of each grant is estimated at the grant date using the
Black-Scholes option-pricing model. The following weighted average
assumptions for grants in 1998 were used: price volatility of 20.94%;
risk-free interest rate of 4.50%; dividend rate of 0% and expected life
of 10 years.
<PAGE>
The status of the Option Plans during 1998 and 1997 is as follows:
<TABLE>
<CAPTION>
1998 1997 1996
---------------------------------------------------------------------------
Weighted Weighted Weighted
Average Average Average
Number Exercise Number Exercise Number Exercise
of Shares Price of Shares Price of Shares Price
--------------------------------------------- ----------------------------
<S> <C> <C> <C> <C> <C> <C>
Outstanding at
January 1 27 375 $ 3.43 30 675 $ 3.51 40 675 $ 3.26
Granted 8 925 3.875 - - - - - - - -
Exercised (2 700) 3.64 - - - - - - - -
Canceled (4 050) 4.13 (3 300) 4.20 (10 000) 2.50
------- ------ -------
Outstanding at
December 31 29 550 $ 3.45 27 375 $ 3.43 30 675 $ 3.51
======== ======= =======
Exercisable at
end of year 29 550 27 375 30 675
========= ======== ======
Weighted-average
fair value per
option of options
granted during
the year $ 1.69 $ - - $ - -
======== ======== ========
</TABLE>
The status of the options outstanding at December 31, 1998 is as
follows:
Number Weighted
Range of Outstanding Remaining Average
Exercise and Contractual Exercise
Price Exercisable Life Price
------- ----------- ------------ ----------
$3.10 - $3.15 18 125 1.75 years $3.14
$3.875 8 925 9.75 3.875
$4.10 2 500 .75 4.10
--------
29 550 5.77 3.45
========
<PAGE>
Note 14. Director Compensation Plan
In 1998, the stockholders approved a stock option plan for outside
directors of the Corporation. The option price for shares to be issued
upon exercise of any option granted under this plan shall be
determined by a Committee of the Corporation's Board of Directors, but
in no event shall the option price be less than the fair market value
of the Corporation's stock at the time of grant. The term of each
option granted under this plan shall be ten years from the date of
grant. If a director resigns or is removed from the Board, all of the
Director's stock options must be exercised within sixty days of his or
her departure from the Board. The maximum aggregate number of shares
which may be optioned and sold under the plan is 75,000 shares. As of
December 31, 1998, 16,000 options were outstanding under this plan.
On March 26, 1997, the Board of Directors granted stock options to
those members serving on the Bank's Board of Directors, who were not
employees or officers of the Bank, to acquire common stock at an
exercise price of $2.86. The options expire ten years after the grant
date, unless the Director ceases to be a member of the Bank's Board of
Directors, in which case the options expire sixty days following such
date. As of December 31, 1998, there were 10,000 options outstanding.
The status of the Option Plan during 1998 and 1997 is as follows:
1998 1997
--------------------------------------------
Weighted Weighted
Average Average
Number Exercise Number Exercise
of Shares Price of Shares Price
--------- -------- ---------- ---------
Outstanding at January 1 10 000 $ 2.86 - - $ - -
Granted 16 000 3.875 10 000 2.86
Exercised - - - - - - - -
Forfeited - - - - - - - -
------ ------
Outstanding at December 31 26 000 3.48 10 000 $ 2.86
======= ======
The status of the options outstanding as of December 31, 1998 is as
follows:
Weighted
Average Remaining
Exercise Contractual
Price Number Life
------- --------- -----------
$ 2.86 10 000 8.25 years
3.875 16 000 9.75
-------
$ 3.48 26 000 9.17
=======
<PAGE>
Note 15. Financial Instruments With Off-Balance-Sheet Risk
The Corporation is party to financial instruments with
off-balance-sheet risk in the normal course of business to meet the
financing needs of its customers. These financial instruments include
commitments to extend credit and standby letters of credit. Those
instruments involve, to varying degrees, elements of credit and
interest rate risk in excess of the amount recognized in the balance
sheet. The contract or notional amounts of those instruments reflect
the extent of involvement the Corporation has in particular classes of
financial instruments.
The Corporation's exposure to credit loss in the event of
nonperformance by the other party to the financial instrument for
commitments to extend credit and standby letters of credit is
represented by the contractual amount of those instruments. The
Corporation uses the same credit policies in making commitments and
conditional obligations as it does for on-balance-sheet instruments.
A summary of the contract or notional amount of the Corporation's
exposure to off-balance-sheet risk as of December 31, 1998 and 1997 is
as follows:
1998 1997
----------- ------------
Financial instruments whose contract
amounts represent credit risk:
Commitments to extend credit $ 8 708 866 $ 6 654 155
Standby letters of credit $ 181 900 $ 191 257
Commitments to extend credit are agreements to lend to a customer as
long as there is no violation of any condition established in the
contract. Commitments generally have fixed expiration dates or other
termination clauses and may require payment of a fee. Since many of the
commitments are expected to expire without being drawn upon, the total
commitment amounts do not necessarily represent future cash
requirements. The Corporation evaluates each customer's credit
worthiness on a case-by-case basis. The amount of collateral obtained,
if deemed necessary by the Corporation upon extension of credit, is
based on management's credit evaluation of the counterparty. Collateral
held varies but may include accounts receivable, inventory, property
and equipment, and income-producing commercial properties.
Standby letters of credit are conditional commitments issued by the
Corporation to guarantee the performance of a customer to a third
party. Those guarantees are primarily issued to support public and
private borrowing arrangements, including commercial paper, bond
financing, and similar transactions. The credit risk involved in
issuing letters of credit is essentially the same as that involved in
extending loan facilities to customers. The Corporation holds cash and
marketable securities supporting those commitments for which collateral
is deemed necessary. The extent of collateral held for those
commitments at December 31, 1998 varies from 0 percent to 100 percent;
the average amount collateralized is 85 percent.
The Corporation maintains its cash accounts in other commercial banks.
The amount on deposit with correspondent institutions at December 31,
1998, exceeded the insurance limits of the Federal Deposit Insurance
Corporation by $55,465.
<PAGE>
Note 16. Restrictions on Transfers to Parent
Transfers of funds from banking subsidiary to the Parent Corporation in
the form of loans, advances and cash dividends, are restricted by
federal and state regulatory authorities. As of December 31, 1998, the
aggregate amount of unrestricted funds which could be transferred from
the banking subsidiary to the Parent Corporation without prior
regulatory approval totaled $1,107,554 or 12.4% of the consolidated net
assets.
Note 17. Capital Requirements
The Corporation is subject to various regulatory capital requirements
administered by the Federal banking agencies. Failure to meet minimum
capital requirements can initiate certain mandatory - possibly
additional discretionary - actions by regulators that, if undertaken,
could have a direct material effect on the Corporation's financial
statements. Under capital adequacy guidelines and the regulatory
framework for prompt corrective action, the Corporation must meet
specific capital guidelines that involve quantitative measures of the
Corporation's assets, liabilities, and certain off-balance-sheet items
as calculated under regulatory accounting practices. The Corporation's
capital amounts and classification are also subject to qualitative
judgments by the regulators about components, risk weightings, and
other factors.
Quantitative measures established by regulation to ensure capital
adequacy require the Corporation to maintain minimum amounts and ratios
(set forth in the table below) of total and Tier 1 capital to
risk-weighted assets, and of Tier 1 capital to average assets.
Management believes, as of December 31, 1998, that the Corporation
meets all capital adequacy requirements to which it is subject.
As of December 31, 1998, the most recent notification from the Federal
Reserve Bank categorized the Corporation as well capitalized under the
regulatory framework for prompt corrective action. To be categorized as
well capitalized, the Corporation must maintain minimum total
risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth
in the table. There are no conditions or events since that notification
that management believes have changed the institution's category.
The Corporation and Subsidiary's actual capital amounts and ratios are also
presented in the table. No amount was deducted from capital for interest-rate
risk.
<PAGE>
<TABLE>
<CAPTION>
To Be Well
Capitalized Under
For Capital Prompt Corrective
Actual Adequacy Purposes Action Provisions
------------------- -------------------------- ------------------------
Amount Ratio Amount Ratio Amount Ratio
(Amount in Thousands)
<S> <C> <C> <C> <C> <C> <C>
As of December 31, 1998:
Total Capital (to Risk
Weighted Assets)
Consolidated $ 9 282 25.7% >$2 886 >8.0% N/A
- -
The Heritage Bank $ 9 282 25.7% >$2 886 >8.0% >$ 3 607 >10.0%
- - - -
Tier 1 Capital (to Risk
Weighted Assets)
Consolidated $ 8 853 24.5% >$1 443 >4.0% N/A
- -
The Heritage Bank $ 8 853 24.5% >$1 443 >4.0% >$ 2 164 >6.0%
Tier 1 Capital (to - - - -
Average Assets)
Consolidated $ 8 853 17.2% >$2 060 >4.0% N/A
- -
The Heritage Bank $ 8 853 17.2% >$2 060 >4.0% >$ 2 575 >5.0%
- - - -
As of December 31, 1997:
Total Capital (to Risk
Weighted Assets)
Consolidated $ 5 051 18.6% >$2 170 >8.0% N/A
- -
The Heritage Bank $ 5 051 18.6% >$2 170 >8.0% >$ 2 712 >10.0%
Tier 1 Capital (to Risk - - - -
Weighted Assets)
Consolidated $ 4 712 17.4% >$1 085 >4.0% N/A
- -
The Heritage Bank $ 4 712 17.4% >$1 085 >4.0% >$ 1 627 >6.0%
Tier 1 Capital (to - - - -
Average Assets)
Consolidated $ 4 712 11.0% >$1 714 >4.0% N/A
- -
The Heritage Bank $ 4 712 11.0% >$1 714 >4.0% >$ 2 142 >5.0%
- - - -
</TABLE>
Note 18. Common Stock
On May 18, 1998, the Corporation completed a secondary stock offering
in which it sold 805,000 shares of common stock at a price of $5.50
per share. Net proceeds for the Corporation were $4,012,204 after
deducting underwriting commissions of $309,925 and direct offering
costs of $105,371. On June 8, 1998, the Corporation used part of the
new capital to complete an odd-lot tender offer, purchasing 2,719
shares at $5.50 per share for a total cost of $14,954.50.
<PAGE>
Note 19. Parent Corporation Only Financial Statements
HERITAGE BANCORP, INC.
(Parent Corporation Only)
Balance Sheet
December 31, 1998
Assets
Investment in subsidiary, at cost, plus
equity in undistributed net income $8 927 664
==========
Shareholders' Equity
Common stock $2 294 617
Surplus 6 529 539
Retained earnings 28 549
Accumulated other comprehensive income 74 959
----------
$8 927 664
==========
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
We consent to the incorporation by reference in the registration
statement (No. 333-67867) on Form S-8 of Heritage Bancorp, Inc. of our report
dated February 5, 1999, relating to the consolidated statements of condition of
Heritage Bancorp, Inc. and Subsidiary as of December 31, 1998 and 1997 and the
related consolidated statements of operations, changes in stockholders' equity
and cash flows for the three years then ended, which report is included in the
December 31, 1998 annual report on Form 10-KSB of Heritage Bancorp, Inc.
/s/YOUNT, HYDE & BARBOUR, P.C.
Winchester, Virginia
March 25, 1999
<TABLE> <S> <C>
<ARTICLE> 9
<LEGEND>
This schedule contains summary financial information extracted from the
consolidated balance sheets and the statements of income of Heritage Bancorp,
Inc. and is qualified in its entirety by reference to such financial statements.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> DEC-31-1998
<CASH> 5,825,000
<INT-BEARING-DEPOSITS> 17,386,000
<FED-FUNDS-SOLD> 8,550,000
<TRADING-ASSETS> 0
<INVESTMENTS-HELD-FOR-SALE> 19,824,000
<INVESTMENTS-CARRYING> 0
<INVESTMENTS-MARKET> 0
<LOANS> 29,610,000
<ALLOWANCE> 429,000
<TOTAL-ASSETS> 64,776,000
<DEPOSITS> 53,442,000
<SHORT-TERM> 2,287,000
<LIABILITIES-OTHER> 119,000
<LONG-TERM> 0
0
0
<COMMON> 2,295,000
<OTHER-SE> 6,633,000
<TOTAL-LIABILITIES-AND-EQUITY> 8,928,000
<INTEREST-LOAN> 2,385,000
<INTEREST-INVEST> 1,118,000
<INTEREST-OTHER> 262,000
<INTEREST-TOTAL> 3,765,000
<INTEREST-DEPOSIT> 1,231,000
<INTEREST-EXPENSE> 1,270,000
<INTEREST-INCOME-NET> 2,495,000
<LOAN-LOSSES> 117,000
<SECURITIES-GAINS> (1,000)
<EXPENSE-OTHER> 2,423,000
<INCOME-PRETAX> 92,000
<INCOME-PRE-EXTRAORDINARY> 92,000
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 92,000
<EPS-PRIMARY> 0.07
<EPS-DILUTED> 0.07
<YIELD-ACTUAL> 3.87
<LOANS-NON> 395,000
<LOANS-PAST> 0
<LOANS-TROUBLED> 0
<LOANS-PROBLEM> 1,283,000
<ALLOWANCE-OPEN> 634,000
<CHARGE-OFFS> 339,000
<RECOVERIES> 17,000
<ALLOWANCE-CLOSE> 429,000
<ALLOWANCE-DOMESTIC> 0
<ALLOWANCE-FOREIGN> 0
<ALLOWANCE-UNALLOCATED> 0
</TABLE>
