10-K 1 mfc10k.txt SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2002 Commission file number 0-24159 MIDDLEBURG FINANCIAL CORPORATION (Exact Name of Registrant as Specified in its Charter) Virginia 54-1696103 (State or Other Jurisdiction (I.R.S. Employer of Incorporation or Organization) Identification No.) 111 West Washington Street Middleburg, Virginia 20117 (Address of Principal Executive Offices) (Zip Code) (703) 777-6327 (Registrant's Telephone Number, Including Area Code) Securities registered pursuant to Section 12(b) of the Act: Name of Each Exchange Title of Each Class on Which Registered ------------------- ------------------- None n/a Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $5.00 per share (Title of Class) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for past 90 days. Yes _X_ No ___ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not 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-K or any amendment to this Form 10-K. [ X ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes ___ No _X__ 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 last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant's most recently completed second fiscal quarter. $61,170,310 Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date. 1,852,682 shares of Common Stock DOCUMENTS INCORPORATED BY REFERENCE Proxy Statement for the 2003 Annual Meeting of Shareholders - Part III TABLE OF CONTENTS PART I ------ Page ---- ITEM 1. BUSINESS.............................................................3 ITEM 2. PROPERTIES...........................................................7 ITEM 3. LEGAL PROCEEDINGS....................................................8 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...............................................9 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.......................................9 ITEM 6. SELECTED FINANCIAL DATA.............................................10 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS..............................11 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK......................................................36 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.........................38 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE...........................38 PART III -------- ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS....................................38 ITEM 11. EXECUTIVE COMPENSATION..............................................38 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS..............................................38 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS......................39 ITEM 14. CONTROLS AND PROCEDURES.............................................39 PART IV ------- ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K..............................................40 -2- PART I ------ ITEM 1. BUSINESS General Middleburg Financial Corporation ("MFC" or the "Company") is a bank holding company that was incorporated under Virginia law in 1993. The Company changed its name in May 2002 from Independent Community Bankshares, Inc. to Middleburg Financial Corporation. The Company conducts its primary operations through three wholly owned subsidiaries, Middleburg Bank (the "Bank"), Tredegar Trust Company ("Tredegar") both of which are chartered under Virginia law, and Gilkison Patterson Investment Advisors, Inc. ("GPIA"), which is an investment advisor registered with the Securities and Exchange Commission. The Bank has five full service branches and one limited service facility. The Bank has its main office at 111 West Washington Street, Middleburg, Virginia 20117, and has offices in Purcellville, Leesburg and Ashburn, Virginia. The Bank opened for business on July 1, 1924. Tredegar has its main office at 821 East Main Street, Richmond, Virginia 23219, and a branch office in Middleburg, Virginia. Tredegar opened for business in January 1994. GPIA has its main office at 1901 North Beauregard Street, Alexandria, Virginia 22311. The Bank serves western Loudoun County. Loudoun County is in northwestern Virginia and included in the Washington-Baltimore Metropolitan statistical area. Loudoun County's population is approximately 170,000 with over one-third of the population located in the Company's markets. The local economy is driven by service industries requiring a high skill level, self-employed individuals, the equine industry and the independently wealthy. Tredegar serves primarily the greater Richmond area including the counties of Henrico, Chesterfield, Hanover, Goochland and Powhatan, as well as Loudoun County. However, Tredegar does have clients outside of its primary market. Richmond is the state capital of Virginia, and the greater Richmond area has a population in excess of 800,000 people. GPIA primarily serves the District of Columbia metropolitan area including contingent markets in Virginia and Maryland but also has clients in 25 other states. The Company, through its subsidiaries, offers a wide range of banking, fiduciary and investment management services available to both individuals and small businesses. The banking services include various types of checking and savings deposit accounts, and the making of business, real estate, development, mortgage, home equity, automobile and other installment, demand and term loans. Also, the Bank offers ATMs at all locations, internet banking, travelers' checks, money orders, safe deposit rentals, collections, notary public, wire services and other traditional bank services to its customers. Tredegar provides a variety of investment management and fiduciary services including trust and estate settlement. Tredegar can also serve as escrow agent, attorney-in-fact, guardian of property or trustee of an IRA. GPIA provides fee based investment management services for its clients. The Bank has one wholly owned subsidiary, Middleburg Bank Service Corporation. Middleburg Bank Service Corporation is a partner in a limited liability company, Bankers Title Shenandoah, LLC, which sells title insurance to its members. Middleburg Bank Service Corporation has also invested in another limited liability company, Virginia Bankers Insurance Center, LLC, which acts as a broker for insurance sales for its member banks. The Company has a fourth wholly owned subsidiary, ICBI Capital Trust I, which is a Delaware Business Trust that the Company formed in connection with the issuance of $10 million in trust preferred debt in November 2001. -3- As of December 31, 2002, the Company had a total of 152 full time equivalent employees. The Company considers relations with its employees to be excellent. The Company's employees are not represented by a collective bargaining unit. Competition The Company faces significant competition for both loans and deposits. Competition for loans comes from commercial banks, savings and loan associations and savings banks, mortgage banking subsidiaries of regional commercial banks, subsidiaries of national mortgage bankers, insurance companies, and other institutional lenders. Its most direct competition for deposits has historically come from savings and loan associations and savings banks, commercial banks, credit unions and other financial institutions. Based upon total deposits at June 30, 2002 as reported to the FDIC, MFC has the largest share of deposits among the banking organizations operating in Loudoun County, Virginia. MFC also faces competition for deposits from short-term money market mutual funds and other corporate and government securities funds. Tredegar competes for clients and accounts with banks, other financial institutions and money managers. Even though many of these institutions have been engaged in the trust or investment management business for a considerably longer period of time than Tredegar and have significantly greater resources, Tredegar has grown through its commitment to quality trust services and a local community approach to business. GPIA competes for its clients and accounts with other money managers and investment brokerage firms. Like the rest of the Company, GPIA is dedicated to quality service and high investment performance for its clients. GPIA has successfully operated in its markets for 21 years. For 19 years, GPIA operated under the name of Kahn Brothers Investment Management Company ("KBIMC"). Upon entering into a purchase option with MFC, KBIMC changed its name to "Gilkison Patterson Investment Advisors, Inc." Supervision and Regulation General. As a bank holding company, the Company is subject to regulation under the Bank Holding Company Act of 1956, as amended, (the "BHCA") and the examination and reporting requirements of the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"). Under the BHCA, a bank holding company may not directly or indirectly acquire ownership or control of more than 5% of the voting shares or substantially all of the assets of any bank or merge or consolidate with another bank holding company without the prior approval of the Federal Reserve Board. The BHCA also generally limits the activities of a bank holding company to that of banking, managing or controlling banks, or any other activity that is determined to be so closely related to banking or to managing or controlling banks that an exception is allowed for those activities. As a state-chartered commercial bank, the Bank is subject to regulation, supervision and examination by the Virginia State Corporation Commission's Bureau of Financial Institutions. It is also subject to regulation, supervision and examination by the Federal Reserve Board. State and federal law also governs the activities in which the Bank engages, the investments that it makes and the aggregate amount of loans that may be granted to one borrower. Various consumer and compliance laws and regulations also affect the Bank's operations. The earnings of the Company's subsidiaries, and therefore the earnings of the Company, are affected by general economic conditions, management policies, changes in state and federal legislation and actions of various regulatory authorities, including those referred to above. The following description -4- summarizes the significant federal and state laws to which the Company, the Bank and Tredegar are subject. To the extent statutory or regulatory provisions or proposals are described, the description is qualified in its entirety by reference to the particular statutory or regulatory provisions or proposals. Payment of Dividends. The Company is a legal entity separate and distinct from its banking and other subsidiaries. The majority of the Company's revenues are from dividends paid to the Company by the Bank. The Bank is subject to laws and regulations that limit the amount of dividends it can pay. In addition, both the Company and the Bank are subject to various regulatory restrictions relating to the payment of dividends, including requirements to maintain capital at or above regulatory minimums. Banking regulators have indicated that banking organizations should generally pay dividends only if the organization's net income available to common shareholders over the past year has been sufficient to fully fund the dividends and the prospective rate of earnings retention appears consistent with the organization's capital needs, asset quality and overall financial condition. The Company does not expect that any of these laws, regulations or policies will materially affect the ability of the Bank to pay dividends. During the year ended December 31, 2002, the Bank declared $2.1 million in dividends payable to the Company. Capital. The Federal Reserve Board has issued risk-based and leverage capital guidelines applicable to banking organizations that it supervises. Under the risk-based capital requirements, the Company and the Bank are each generally required to maintain a minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) of 8%. At least half of the total capital must be composed of common equity, retained earnings and qualifying perpetual preferred stock, less certain intangibles ("Tier 1 capital"). The remainder may consist of certain subordinated debt, certain hybrid capital instruments, qualifying preferred stock and a limited amount of the loan loss allowance ("Tier 2 capital," which, together with Tier 1 capital, composes "total capital"). In addition, each of the federal banking regulatory agencies has established minimum leverage capital requirements for banking organizations. Pursuant to these requirements, banking organizations must maintain a minimum ratio of Tier 1 capital to adjusted average quarterly assets equal to 3% to 5% subject to federal banking regulatory evaluation of an organization's overall safety and soundness. The risk-based capital or standards of the Federal Reserve Board explicitly identify concentrations of credit risk and the risk arising from non-traditional activities, as well as an institution's ability to manage these risks, as important factors to be taken into account by the agency in assessing an institution's overall capital adequacy. The capital guidelines also provide that an institution's exposure to a decline in the economic value of its capital due to changes in interest rates be considered by the agency as a factor in evaluating a banking organization's capital adequacy. Other Safety and Soundness Regulations. There are a number of obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by federal law and regulatory policy that are designed to reduce potential loss exposure to the depositors of such depository institutions and to the Federal Deposit Insurance Corporation ("FDIC") insurance funds in the event that the depository institution is insolvent or is in danger of becoming insolvent. For example, under requirements of the Federal Reserve Board with respect to bank holding company operations, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit resources to support such institutions in circumstances where it might not do so otherwise. In addition, the "cross-guarantee" provisions of federal law require insured depository institutions under common control to reimburse the FDIC for any loss suffered or reasonably anticipated by the FDIC as a result of the insolvency of commonly controlled insured depository institutions or for any assistance provided by the FDIC to commonly controlled insured depository institutions in danger of failure. The FDIC may decline to enforce the cross-guarantee provision if it determines that a waiver is in -5- the best interests of the deposit insurance funds. The FDIC's claim for reimbursement under the cross guarantee provisions is superior to claims of shareholders of the insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and nonaffiliated holders of subordinated debt of the commonly controlled insured depository institutions. The federal banking agencies also have broad powers under current federal law to take prompt corrective action to resolve problems of insured depository institutions. The extent of these powers depends upon whether the institution in question is well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized or critically undercapitalized, as defined by the law. As of December 31, 2002, the Company and the Bank were classified as well capitalized. State banking regulators also have broad enforcement powers over the Bank, including the power to impose fines and other civil and criminal penalties, and to appoint a conservator. Interstate Banking and Branching. Current federal law authorizes interstate acquisitions of banks and bank holding companies without geographic limitation. Effective June 1, 1997, a bank headquartered in one state was authorized to merge with a bank headquartered in another state, as long as neither of the states had opted out of such interstate merger authority prior to such date. After a bank has established branches in a state through an interstate merger transaction, the bank may establish and acquire additional branches at any location in the state where a bank headquartered in that state could have established or acquired branches under applicable federal or state law. Gramm-Leach-Bliley Act of 1999. The Gramm-Leach-Bliley Act of 1999 (the "Act") was signed into law on November 12, 1999. The Act covers a broad range of issues, including a repeal of most of the restrictions on affiliations among depository institutions, securities firms and insurance companies. Most of the Act's provisions require the federal banking regulatory agencies and other regulatory bodies to adopt regulations to implement the Act, and for that reason an assessment of the full impact on the Company of the Act must await completion of that regulatory process. The Act repeals sections 20 and 32 of the Glass-Stegall Act, thus permitting unrestricted affiliations between banks and securities firms. The Act also permits bank holding companies to elect to become financial holding companies. A financial holding company may engage in or acquire companies that engage in a broad range of financial services, including securities activities such as underwriting, dealing, brokerage, investment and merchant banking, insurance underwriting, sales and brokerage activities. In order to become a financial holding company, the bank holding company and all of its affiliated depository institutions must be well-capitalized, well-managed, and have at least a satisfactory Community Reinvestment Act rating. The Act provides that the states continue to have the authority to regulate insurance activities but prohibits the states in most instances from preventing or significantly interfering with the ability of a bank, directly or through an affiliate, to engage in insurance sales, solicitations or cross-marketing activities. Although the states generally must regulate bank insurance activities in a nondiscriminatory manner, the states may continue to adopt and enforce rules that specifically regulate bank insurance activities in certain areas identified in the Act. The Act directs the federal banking regulatory agencies to adopt insurance consumer protection regulations that apply to sales practices, solicitations, advertising and disclosures. The Act adopts a system of functional regulation under which the Federal Reserve Board is confirmed as the umbrella regulator for financial holding companies, but financial holding company affiliates are to be principally regulated by functional regulators such as the FDIC for state nonmember bank affiliates, the Securities and Exchange Commission for securities affiliates and state insurance -6- regulators for insurance affiliates. The Act repeals the broad exemption of banks from the definitions of "broker" and "dealer" for purposes of the Securities Exchange Act of 1934, as amended, but identifies a set of specific activities, including traditional bank trust and fiduciary activities, in which a bank may engage without being deemed a "broker", and a set of activities in which a bank may engage without being deemed a "dealer". The Act also makes conforming changes in the definitions of "broker" and "dealer" for purposes of the Investment Company Act of 1940, as amended, and the Investment Advisers Act of 1940, as amended. The Act contains extensive customer privacy protection provisions. Under these provisions, a financial institution must provide to its customers, at the inception of the customer relationship and annually thereafter, the institution's policies and procedures regarding the handling of customers' nonpublic personal financial information. The Act provides that, except for certain limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure. An institution may not disclose to a non-affiliated third party, other than to a consumer reporting agency, customer account numbers or other similar account identifiers for marketing purposes. The Act also provides that the states may adopt customer privacy protections that are more strict than those contained in the Act. The Act also makes a criminal offense, except in limited circumstances, obtaining or attempting to obtain customer information of a financial nature by fraudulent or deceptive means. Tredegar. Tredegar operates as a trust subsidiary of the Company. It is subject to supervision and regulation by the Virginia State Corporation Commission's Bureau of Financial Institutions and the Federal Reserve Board. State and federal regulators have substantial discretion and latitude in the exercise of their supervisory and regulatory authority over Tredegar, including the statutory authority to promulgate regulations affecting the conduct of business and the operations of Tredegar. They also have the ability to exercise substantial remedial powers with respect to Tredegar in the event that it determines that Tredegar is not in compliance with applicable laws, orders or regulations governing its operations, is operating in an unsafe or unsound manner, or is engaging in any irregular practices. GPIA. GPIA operates as a non-banking subsidiary of the Company. It is subject to supervision and regulation by the Securities and Exchange Commission under the Investment Advisors Act of 1940, as amended. ITEM 2. PROPERTIES The headquarters building of the Company and the Bank, which also serves as a branch office for Tredegar, was completed in 1981 and is a two-story building of brick construction, with approximately 18,000 square feet of floor space, located at 111 West Washington Street, Middleburg, Virginia 20117. The office operates nine teller windows, including three drive-up facilities and one stand-alone automatic teller machine. The Bank owns the headquarters building. The Purcellville bank branch was purchased in 1994 and is a one-story building with a basement of brick construction, with approximately 3,000 square feet of floor space, located at 431 East Main Street, Purcellville, Virginia 20132. The office operates four teller windows, including three drive-up facilities and one drive-up automatic teller machine. The Bank owns this branch building. -7- The Catoctin Circle, Leesburg bank branch was completed in 1997 and is a two-story building of brick construction, with approximately 6,000 square feet of floor space, located at 102 Catoctin Circle, SE, Leesburg, Virginia 20175. The office operates five teller windows, including three drive-up facilities and one drive-up automatic teller machine. The Bank owns this branch building. The Fort Evans Road, Leesburg bank branch was completed in July 2002 and is a one-story building of brick construction, with approximately 3,500 square feet of floor space, located at 211 Fort Evans Road, NE, Leesburg, Virginia 20176. The office operates five teller windows, including three drive-up facilities and one drive-up automatic teller machine. The Bank owns this branch building. The Leesburg limited service facility, located at 200 North King Street, was leased beginning April 1999. The leased space consists of 200 square feet with one teller window and a stand-alone automated teller machine. Transactions in this branch are limited to paying and receiving teller functions. The initial term of this lease is five years with two additional renewal periods of five years each. The annual lease expense associated with this location is $5,400. The Ashburn bank branch, which is leased, opened in June 1999 and consists of 3,400 rentable square feet at 20955 Professional Plaza, Suite 100, Ashburn, Virginia 20147. The office is a full service branch with five teller windows, three drive-up facilities and a drive-up automated teller machine. The initial term of the lease is 15 years with two five-year renewal options. The annual lease expense associated with this location is $68,000. The Leesburg operations building was completed in June 2002. The building is Class A office space and is home to the deposit and loan operations, data processing, information technology, human resources, training and mortgage banking departments. This building is a two story building with 18,000 square feet of floor space, located at 106 Catoctin Circle, SE, Leesburg, Virginia 20175. The Bank owns this building. Tredegar leases its main office at 821 East Main Street in Richmond, Virginia. The lease, which was entered into in August 2001 when Tredegar moved from its former location, is for a term of 15 years, with no renewal options. The annual lease expense for the new location will be $165,000. Total lease expense for 2001, including the new and previous office space, was $76,000. Tredegar closed its branch office in Williamsburg, Virginia in April 2001. The space included approximately 500 square feet used primarily for business development and sales. The annual lease expense associated with this location was $7,500. GPIA leases its main office at 1901 North Beauregard Avenue, Alexandria, Virginia, 22311. The lease, which was entered into in May 1999, is for a term of five years, with no renewal options. The space includes approximately 3,500 square feet of office space and 900 square feet of storage. The annual lease expense associated with this location is $79,000. The lease is currently in negotiations with no anticipated increase in expense. All of the Company's properties are in good operating condition and are adequate for the Company's present and anticipated future needs. ITEM 3. LEGAL PROCEEDINGS There are no material pending legal proceedings to which the company is a party or of which the property of the Company is subject. -8- ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted during the fourth quarter of the fiscal year covered by this report to a vote of security holders of the Company. PART II ------- ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Since May 15, 2002, the Company's Common Stock has traded on the Nasdaq SmallCap Market under the symbol "MBRG". From September 15, 2000 until May 14, 2002, the Company's Common Stock had traded on the Nasdaq SmallCap Market under the symbol "ICBX". Market Price and Dividends Sales Price ($) Dividends ($) --------------- ------------- High Low ---- --- 2001: 1st quarter............................ 33.00 21.00 .25 2nd quarter............................ 31.25 27.00 .25 3rd quarter............................ 36.00 29.00 .25 4th quarter............................ 35.90 32.50 .25 2002: 1st quarter............................ 45.58 35.11 .30 2nd quarter............................ 50.00 44.10 .30 3rd quarter............................ 48.75 44.00 .30 4th quarter............................ 48.25 45.25 .30 MFC historically has paid cash dividends on a quarterly basis. The final determination of the timing, amount and payment of dividends on the Common Stock is at the discretion of MFC's Board of Directors and will depend upon the earnings of MFC and its subsidiaries, principally its subsidiary bank, the financial condition of MFC and other factors, including general economic conditions and applicable governmental regulations and policies. MFC or the Bank has paid regular cash dividends for over 200 consecutive quarters. As of March 4, 2003, MFC had approximately 1,350 shareholders of record. -9- ITEM 6. SELECTED FINANCIAL DATA The information set forth in the following table should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements and Notes thereto.
Years Ended December 31, 2002 2001 2000 1999 1998 (In thousands, except ratios and per share amounts) Income Statement Data: Interest income $23,758 $21,822 $19,209 $15,522 $13,785 Interest expense 6,524 7,814 7,041 5,345 5,313 Net interest income $17,234 $14,008 $12,168 $10,177 $8,472 Provision for loan losses 300 300 400 420 135 Net interest income after provision for loan losses $16,934 $13,708 $11,768 $9,757 $8,337 Noninterest income 7,312 4,827 3,669 2,959 2,187 Securities gains (losses) (73) 384 (204) (13) (18) Noninterest expense 15,526 11,947 9,555 8,040 6,674 Income before income taxes $8,647 $6,972 $5,678 $4,663 $3,832 Income taxes 2,335 1,755 1,450 1,097 857 Net income $6,312 $5,217 $4,228 $3,566 $2,975 Per Share Data: Net Income, Basic $3.47 $2.99 $2.43 $2.00 $1.65 Net Income, Diluted 3.39 2.93 2.41 1.99 1.63 Cash Dividends 1.20 1.00 0.84 0.68 0.75 Book value at period end 22.35 17.31 15.68 12.97 12.85 Balance Sheet Data: Assets $424,974 $354,101 $289,461 $243,925 $205,403 Loans, net of unearned income 212,107 196,400 177,598 143,235 121,323 Securities 163,673 124,351 81,577 67,739 57,786 Deposits 328,903 271,731 224,640 203,837 172,680 Shareholders' equity 41,410 30,338 27,271 23,075 22,863 Average shares outstanding, 1,821 1,746 1,741 1,779 1,803 Basic Average shares outstanding, 1,863 1,783 1,752 1,795 1,821 Diluted Performance Ratios: Return on Average Assets 1.62% 1.67% 1.62% 1.60% 1.54% Return on Average Equity 17.24% 17.55% 17.46% 15.48% 13.24% Capital to Assets 9.74% 8.57% 9.42% 9.49% 11.13% Dividend payout 35.04% 33.53% 34.57% 34.00% 45.45% Efficiency (1) 60.93% 60.4% 57.4% 57.9% 58.5% Capital and Liquidity Ratios: Risk-based capital ratios: Tier 1 capital 14.8% 16.4% 12.7% 14.0% 17.1% Total capital 15.6% 17.3% 13.6% 14.8% 17.9% Leverage 10.6% 12.5% 9.7% 10.8% 11.2%
-------- (1) Computed by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income, net of securities gains or losses. -10- ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion provides information about the major components of the results of operations and financial condition, liquidity, and capital resources of MFC. This discussion and analysis should be read in conjunction with the Company's Consolidated Financial Statements and Notes to Consolidated Financial Statements. Critical Accounting Policies The financial condition and results of operations presented in the Consolidated Financial Statements, accompanying Notes to the Consolidated Financial Statements and management's discussion and analysis are, to a large degree, dependent upon the accounting policies of the Company. The selection and application of these accounting policies involve judgments, estimates, and uncertainties that are susceptible to change. Presented below is discussion of those accounting policies that management believes are the most important ("Critical Accounting Policies") to the portrayal and understanding of the Company's financial condition and results of operations. These Critical Accounting Policies require management's most difficult, subjective and complex judgments about matters that are inherently uncertain. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood. Allowance for Loan Losses The Company monitors and maintains an allowance for loan losses to absorb an estimate of probable losses inherent in the loan and lease portfolio. The Company maintains policies and procedures that address the systems of controls over the following areas of maintenance of the allowance: the systematic methodology used to determine the appropriate level of the allowance to provide assurance they are maintained in accordance with accounting principles generally accepted in the United States of America; the accounting policies for loan charge-offs and recoveries; the assessment and measurement of impairment in the loan and lease portfolio; and the loan grading system. The Company evaluates various loans individually for impairment as required by Statement of Financial Accounting Standard ("SFAS") No. 114, Accounting by Creditors for Impairment of a Loan, and SFAS No. 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures. Loans evaluated individually for impairment include non-performing loans, such as loans on non-accrual, loans past due by 90 days or more, restructured loans and other loans selected by management. The evaluations are based upon discounted expected cash flows or collateral valuations. If the evaluation shows that a loan is individually impaired, then a specific reserve is established for the amount of impairment. If a loan evaluated individually is not impaired, then the loan is assessed for impairment under SFAS No. 5, Accounting for Contingencies ("SFAS 5"), with a group of loans that have similar characteristics. For loans without individual measures of impairment, the Company makes estimates of losses for groups of loans as required by SFAS 5. Loans are grouped by similar characteristics, including the type of loan, the assigned loan grade and the general collateral type. A loss rate reflecting the expected loss inherent in a group of loans is derived based upon estimates of default rates for a given loan grade, the predominant collateral type for the group and the terms of the loan. The resulting estimate of losses for groups of loans are adjusted for relevant environmental factors and other conditions of the portfolio of loans and leases, including: borrower and industry concentrations; levels and trends in delinquencies, -11- charge-offs and recoveries; changes in underwriting standards and risk selection; level of experience, ability and depth of lending management; and national and local economic conditions. The amount of estimated impairment for individually evaluated loans and groups of loans is added together for a total estimate of loans and lease losses. This estimate of losses is compared to the allowance for loan and lease losses of the Company as of the evaluation date and, if the estimate of losses is greater than the allowance, an additional provision to the allowance would be made. If the estimate of losses is less than the allowance, the degree to which the allowance exceeds the estimate is evaluated to determine whether the allowance falls outside a range of estimates. If the estimate of losses is below the range of reasonable estimates, the allowance would be reduced by way of a credit to the provision for loan losses. The Company recognizes the inherent imprecision in estimates of losses due to various uncertainties and variability related to the factors used, and therefore a reasonable range around the estimate of losses is derived and used to ascertain whether the allowance is too high. If different assumptions or conditions were to prevail and it is determined that the allowance is not adequate to absorb the new estimate of probable losses, an additional provision for loan losses would be made, which amount may be material to the Consolidated Financial Statements. Valuation of Derivatives The Company maintains an overall interest rate risk management strategy that incorporates the use of derivative financial instruments. The Company has used derivative financial instruments only for asset/liability management through the hedging of a specific transaction or position, and not for trading or speculative purposes. Management believes that the risk associated with using derivative financial instruments to mitigate interest rate risk sensitivity is minimal and should not have any material unintended impact on the Company's financial condition or results of operations. Intangibles and Goodwill The Company has approximately $6.9 million in intangible assets and goodwill at December 31, 2002, an increase of $5.9 million since December 31, 2001. The increase is associated with the April 1, 2002 acquisition of Gilkison Patterson Investment Advisors, Inc. ("GPIA"), a registered investment advisor. In connection with this investment, a purchase price valuation (using FAS 141 and 142 as a guideline) was completed to determine the appropriate allocation to identified intangibles. The valuation concluded that approximately 42% of the purchase price was related to the acquisition of customer relationships with an amortizable life of 15 years. Another 19% of the purchase price was allocated to a non-compete agreement with an amortizable life of 7 years. The remainder of the purchase price has been allocated to goodwill. The purchase price allocation process requires management estimates and judgment as to expectations for the life span of various customer relationships as well as the value that key members of management add to the success of the Company. For example, customer attrition rates were determined based upon assumptions that the past five years may predict the future. If the actual attrition rates, among other assumptions, differed from the estimates and judgments used in the purchase price allocation, the amounts recorded in the financial statements could result in a possible impairment of the intangible assets and goodwill or require an acceleration in the amortization expense. In addition, FAS 142 requires that goodwill be tested annually using a two-step process. The first step is to identify a potential impairment. The second step measures the amount of the impairment loss, if any. Processes and procedures have been identified for the two-step process. -12- When the Company completes its ongoing review of the recoverability of intangible assets and goodwill, factors that are considered important to determining whether an impairment might exist include loss of customers acquired or significant withdrawals of the assets currently under management and/or early retirement or termination of key members of management. Any changes in the key management estimates or judgments could result in an impairment charge, and such a charge could have an adverse effect on the Company's financial condition and results of operations. Overview MFC is headquartered in Middleburg, Virginia and conducts its primary operations through three wholly owned subsidiaries, the Bank, Tredegar and GPIA. The Bank is a community bank serving western Loudoun County, Virginia with five full service branches and one limited service facility. Tredegar is a trust company headquartered in Richmond, Virginia with a branch office in Middleburg, Virginia. GPIA is a registered investment advisor headquartered in Alexandria, Virginia serving clients in 26 states. MFC exercised its option to buy GPIA in April 2002. The terms of the transaction include a total purchase price of $6 million with 59,874 common shares of MFC issued to the shareholders of GPIA. At the time of acquisition GPIA had approximately $630 million of assets under management with clients in 30 states. Clients who are located in Washington, DC, Maryland and Virginia account for approximately 68% of the assets under management. With the addition of GPIA, assets under management by both Tredegar and GPIA exceeded $1 billion at December 31, 2002. In 2002, MFC continued to realize the benefit of high growth rates in both assets and net earnings. Results for 2002 were also favorably affected by the growth in revenues from the Bank's mortgage banking and investment sales operations. By December 31, 2002, total assets were $425.0 million, an increase of 20.0%. Total assets at December 31, 2001 were $354.1 million. Loans, net of unearned income, grew 8.0% from $196.4 million at December 31, 2001 to $212.1 million at December 31, 2002. Total deposits increased $57.2 million from $271.7 million at December 31, 2001 to $328.9 million at December 31, 2002. MFC remains well capitalized with risk-adjusted core capital and total capital ratios well above the regulatory minimums. Asset quality measures also remained consistently strong throughout the year. MFC is not aware of any current recommendations by any regulatory authorities that, if they were implemented, would have a material effect on the registrant's liquidity, capital resources or results of operations. -13- Results of Operations Net Income Net income for 2002 was $6.3 million, an increase of 21.0% over 2001's net income of $5.2 million. Net income for 2001increased 23.4% over 2000's net income of $4.2 million. For 2002, earnings per diluted share were $3.39 compared to $2.93 and $2.41 for 2001 and 2000, respectively. Return on average assets ("ROA") measures how effectively MFC employs its assets to produce net income. The ROA for MFC decreased slightly to 1.62% for the year ended December 31, 2002 from 1.67% for the same period in 2001. The decrease in the net interest margin and additional investments in fixed assets during 2002 contributed to the five basis point decrease in the ROA. The ROA for 2000 was 1.62%. Return on average equity (ROE), another measure of earnings performance, indicates the amount of net income earned in relation to the total equity capital invested. ROE decreased to 17.24% for the year ended December 31, 2002. The additional capital issued in the acquisition of GPIA contributed the decrease in ROE during 2002. ROE was 17.6% and 17.5% for the years ended December 31, 2001 and 2000, respectively. -14-
Average Balances, Income and Expenses, Yields and Rates Years Ended December 31, ------------------------------------------------------------------------------------------------- 2002 2001 2000 ------------------------------------------------------------------------------------------------- Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/ Balance Expense Rate Balance Expense Rate Balance Expense Rate ------------------------------------------------------------------------------------------------- (Dollars in thousands) Assets : Securities: Taxable $ 101,725 $ 5,629 5.53% $ 52,040 $ 3,364 6.46% $ 46,838 $ 3,334 7.12% Tax-exempt (1) (2) 36,471 2,757 7.56% 38,748 2,933 7.57% 30,963 2,392 7.73% --------- --------- ---------- --------- ---------- --------- Total securities $ 138,197 $ 8,386 6.07% $ 90,788 $ 6,297 6.94% $ 77,801 $ 5,726 Loans Taxable $ 213,844 $ 16,137 7.55% $ 194,835 $ 16,297 8.36% $ 160,658 $ 14,049 8.74% Tax-exempt 758 63 8.32% 520 46 8.85% 437 41 9.38% --------- --------- ---------- --------- ---------- --------- Total loans $ 214,602 $ 16,200 7.55% $ 195,355 $ 16,343 8.37% $ 161,095 $ 14,090 8.75% Federal funds sold 5,396 82 1.52% 3,046 117 3.84% 2,800 170 6.07% Interest on money market investments 2,194 39 1.77% 1,742 63 3.62% 512 40 7.81% Interest bearing deposits in other financial institutions 349 5 1.30% 250 9 3.60% 104 4 3.85% --------- --------- ---------- --------- ---------- --------- Total earning assets $ 360,738 $ 24,712 6.85% $ 291,181 $ 22,829 7.84% $ 242,312 $ 20,030 8.27% Less: allowances for credit losses (2,187) (1,948) (1,595 Total nonearning assets 31,071 23,508 20,875 --------- --------- ---------- Total assets $ 389,621 $ 312,741 $ 261,592 ========= ========= ========== Liabilities: Interest-bearing deposits: Checking $ 39,430 $ 93 0.24% $ 33,978 $ 223 0.66% $ 32,461 $ 295 0.91% Regular savings 19,813 183 0.92% 15,183 278 1.83% 13,148 263 2.00% Money market savings 66,102 905 1.37% 46,616 1,166 2.50% 42,852 1,162 2.71% Time deposits: $100,000 and over 51,723 1,648 3.19% 39,154 2,086 5.33% 25,997 1,453 5.59% Under $100,000 44,367 1,392 3.14% 46,409 2,088 4.50% 44,389 2,151 4.85% --------- --------- ---------- --------- ---------- --------- Total interest-bearing deposits $ 221,435 $ 4,221 1.91% $ 181,340 $ 5,841 3.22% $ 158,847 $ 5,324 3.35% Federal Home Loan Bank Advances 3,126 115 3.68% 7,543 482 6.39% 9,186 584 6.36% Securities sold under agreements to repurchase 13,434 177 1.31% 13,292 399 3.00% 12,279 616 5.02% Long-term debt 38,156 2,007 5.26% 19,332 1,076 5.57% 8,090 500 6.18% Federal Funds Purchased 221 4 1.78% 371 16 4.31% 286 17 5.94% --------- --------- ---------- --------- ---------- --------- Total interest-bearing liabilities $ 276,373 $ 6,524 2.36% $ 221,878 $ 7,814 3.52% $ 188,688 $ 7,041 3.73% Non-interest bearing liabilities Demand Deposits 74,787 59,289 47,355 Other liabilities 1,860 1,854 1,329 --------- --------- ---------- Total liabilities $ 353,019 $ 283,021 $ 237,372 Shareholders' equity 36,602 29,720 24,220 --------- --------- ---------- Total liabilities and shareholders' Equity $ 389,621 $ 312,741 $ 261,59 ========= ========= ========== --------- --------- --------- Net interest income $ 18,188 $ 15,015 $ 12,989 ========= ========= ========= Interest rate spread 4.49% 4.32% 4.54% Interest expense as a percent of average earning assets 1.81% 2.68% 2.91% Net interest margin 5.04% 5.16% 5.36%
---------- (1) Income and yields are reported on tax equivalent basis assuming a federal tax rate of 34%. (2) Income and yields include dividends on preferred bonds that are 70% excludable for tax purposes. -15- Net Interest Income Net interest income represents the principal source of earnings of MFC. Net interest income is the amount by which interest generated from earning assets exceeds the expense of funding those assets. Changes in volume and mix of interest earning assets and interest bearing liabilities, as well as their respective yields and rates, have a significant impact on the level of net interest income. Net interest income on a fully tax-equivalent basis was $18.2 million for the year ended December 31, 2002. This is an increase of 21.1% over the $15.0 million reported for the same period in 2001. Net interest income for 2001 increased 15.6% over the $13.0 million reported for 2000. The increase in net interest income in 2002 resulted from the 23.9% growth in average earning assets. The 99 basis point decrease in earning assets yield was offset by a 116 basis point decrease in the cost of funding, which allowed the net interest margin to remain above 5% throughout 2002. The average balance in the securities portfolio increased by $47.4 million while the tax-equivalent yield decreased 87 basis points to 6.07%. Nevertheless, the increase in the average balance of the securities portfolio was able to provide $2.1 million in additional interest income on a tax-equivalent basis. The average loan portfolio volume increased 9.9% during 2002. Conversely, the average yield on the loan portfolio decreased 82 basis points. Loan demand was strong throughout 2002; however, the loan portfolio experienced significant run off due to borrower refinancings of residential real estate loans. In 2002, MFC experienced significant growth in its interest bearing checking, savings and money market accounts. Despite a 30.9% increase in the average balances of these accounts, the decline in deposit rates during 2002 allowed MFC to experience a decrease in the respective interest expenses of $486,000. The average balances in certificates of deposit increased 12.3%, while the interest expense associated with these deposits decreased 27.2% or $1.1 million. MFC's reliance on other funding sources, such as the Federal Home Loan Bank overnight advances, decreased on average by $4.4 million with a related decrease in interest expense of $367,000. During 2002, however, MFC increased on average its long term borrowings from the Federal Home Loan Bank by $10.8 million. Total interest expense for 2002 was $6.5 million, a decrease of $1.3 million compared to the total interest expense for 2001. The increase in net interest income in 2001 resulted from largely from the continued growth in the average earning assets. Both the assets yields and the cost of funding decreased at ratable amounts resulting in a decrease of 20 basis points in the net interest margin. The average balance in the securities portfolio increased $13.0 million, while the tax-equivalent yield decreased 42 basis points to 6.94%, providing $571,000 in additional interest income on a tax-equivalent basis. The asset/liability strategies employed by management influenced the increase in the investment portfolio yield. The average loan portfolio volume increased 21.3% during 2001, providing $2.8 million in interest income, while the average yield on the loan portfolio decreased 38 basis points, causing the interest income provided by the loan portfolio to decrease by $579,000. In 2001, MFC experienced respectable growth in its interest bearing checking, savings and money market accounts. In spite of the 8.3% increase in the average balances, the decline in deposit rates during 2001 allowed MFC to experience a decrease in the respective interest expenses of $53,000. The average balances in certificates of deposit increased 21.6%, while the interest expense associated with these deposits increased 15.8% or $570,000. The decline in the average rate paid on certificates of deposit produced a decrease in interest expense of approximately $235,000, while the increased volume of certificates of deposit increased interest expense by approximately $805,000. -16- MFC's reliance on other funding sources, such as the Federal Home Loan Bank overnight advances, decreased on average by $1.6 million with a related decrease in interest expense of $102,000. However, during 2001, MFC increased on average its long term borrowings from the Federal Home Loan Bank by $9.5 million. During the fourth quarter of 2001, MFC issued $10 million in trust preferred securities adding $1.7 million in average long term debt to the balance sheet. The interest expense related to the trust preferred securities is also included in long term debt interest expense and amounted to approximately $59,000. Total interest expense for 2001 was $7.8 million, an increase of $773,000 compared to 2000. -17- The following table analyzes changes in net interest income attributable to changes in the volume of interest-bearing assets and liabilities compared to changes in interest rates. The change in interest due to both volume and rate has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each. Nonaccruing loans are included in the average outstanding loans. Volume and Rate Analysis (Tax Equivalent Basis) Years Ended December 31,
--------------------------------------------------------------- 2002 vs 2001 2001 vs 2000 Increase (Decrease) Due Increase (Decrease) Due to Changes in: to Changes in: --------------------------------------------------------------- (In Thousands) Volume Rate Total Volume Rate Total ------ ---- ----- ------ ---- ----- Earning Assets: Securities: Taxable $ 2,667 $ (402) $ 2,265 $ 181 $ (151) $ 30 Tax-exempt (172) (4) (176) 590 (49) 541 Loans: Taxable 1,495 (1,655) (160) 2,825 (577) 2,248 Tax-exempt 20 (3) 17 7 (2) 5 Federal funds sold 126 (161) (35) 17 (70) (53) Interest on money market investments 25 (49) (24) 30 (7) 23 Interest bearing deposits in other financial institutions 7 (11) (4) 5 -- 5 ------- ------- ------- ------- ------- ------- Total earning assets $ 4,168 $(2,285) $ 1,883 $ 3,655 $ (856) $ 2,799 ------- ------- ------- ------- ------- ------- Interest-Bearing Liabilities: Interest checking $ 44 $ (174) (130) $ 15 $ (87) (72) Regular savings deposits 151 (246) (95) 33 (18) 15 Money market deposits 381 (642) (261) 34 (30) 4 Time deposits $100,000 and over 550 (988 (438) 697 (64) 633 Under $100,000 (88) (608) (696) 108 (171) (63) ------- ------- ------- ------- ------- ------- Total interest bearing deposits $ 1,038 $(2,658) $(1,620) $ 887 $ (370) $ 517 ------- ------- ------- ------- ------- ------- Federal Home Loan Bank Advances $ (213) $ (154) $ (367) $ (105) $ 3 $ (102) Securities sold under agree- ment to repurchase 4 (226) (222) 56 (273) (217) Long-term debt 987 (56) 931 620 (44) 576 Federal Funds Purchased (5) (7) (12) (13) 12 (1) ------- ------- ------- ------- ------- ------- Total interest bearing liabilities $ 1,811 $(3,101) $(1,290) $ 1,445 $ (672) $ 773 ------- ------- ------- ------- ------- ------- Change in net interest income $ 2,357 $ 816 $ 3,173 $ 2,210 $ (184) $ 2,026 ======= ======= ======= ======= ======= =======
--------- (1) The change in interest, due to both rate and volume, has been allocated to change due to volume and change due to rate in proportion to the relationship of the absolute dollar amounts of the change in each. -18- Provision for Loan Losses MFC's loan loss provision during 2002 and 2001 was $300,000. MFC is committed to making loan loss provisions that maintain an allowance that adequately reflects the risk inherent in the loan portfolio. This commitment is more fully discussed in the "Asset Quality" section below. Noninterest Income Noninterest income has been and will continue to be an important factor for increasing profitability. Management recognizes this and continues to review and consider areas where non-interest income can be increased. Noninterest income includes fees generated by the mortgage banking and investment sales departments of the Bank as well as by Tredegar and GPIA. Trust fee income decreased 7.7% during 2002 to $1.2 million. A significant portion of trust fees are based upon a percentage of the market value of the assets under management, so any decreases in market value of the assets under management result in a similar decrease in fees. Tredegar's accounts are typically invested in equities with a smaller allocation to fixed income securities. The continued decline in equity market values have more than offset all of the growth in the fees as result of new business. GPIA's investment advisory fees added $1.5 million to noninterest income for the eight months that they have been a subsidiary of MFC. Like Tredegar, their fees are based upon a percentage of the market value of the assets under management; however, GPIA's clients have substantially more invested in fixed income securities. The fixed income market typically has an opposite reaction to the equity markets. Thus, about 5% of their fee increase over 2001 is related to relative increases in market values of the portfolios managed while the remaining 3% is related to new business growth. Due to historic low mortgage rates and increased refinancings, the mortgage banking department contributed an additional $452,000 of fees on loans held for sale during 2002. During 2002, the Bank increased its transaction oriented deposit accounts by 30.5% resulting in growth in service charges and fee income. The service charges and fees associated with deposit accounts increased 35.0% during 2002. During 2002, MFC realized $73,000 in net losses as a result of restructuring the investment portfolio in response to the change in the interest rate environment in 2002. Total noninterest income for 2002 was $7.2 million, compared to $5.2 million for 2001. -19- Noninterest income for 2001 increased 50.4% to $5.2 million from $3.5 million in 2000. The increase is due primarily to the increase on fees on loans held for sale, investment sales fees and service charges on deposit accounts. The mortgage banking department contributed an additional $840,000 of fees on loans held for sale during 2001. The service charges and fees associated with deposit accounts increased 23.1% during 2001. The increase in these fees was due primarily to a 31.2% increase in transaction oriented deposit account growth. Noninterest Income Year Ended December 31, ---------------------------- 2002 2001 2000 ------- ------- ------- (In thousands) Service charges, commissions and fees $ 1,960 $ 1,452 $ 1,180 Trust fee income 1,181 1,279 1,594 Investment advisory fee income 1,544 -- -- Fees on loans held for sale 1,935 1,483 643 Commission on investment sales 611 485 116 Other operating income 81 128 136 ------- ------- ------- Noninterest income $ 7,312 $ 4,827 $ 3,669 Gains (losses) on securities available for sale, net (73) 384 (204) ------- ------- ------- Total noninterest income $ 7,239 $ 5,211 $ 3,465 ======= ======= ======= Noninterest Expenses Improving operating efficiency is as important to management as enhancing noninterest income. Total noninterest expenses increased 30.0% or $3.6 million to $15.5 million in 2002. The acquisition of GPIA on April 1, 2002 accounts for 32.3% or $1.1 million of the total increase in noninterest expenses. Salaries and employee benefits increased $2.2 million or 30.7% due to increased commission expense for fee-related business and enhancing the internal infrastructure to support a growing organization. Approximately $673,000 of the $2.2 million increase in salaries expense is related to the acquisition of GPIA. Occupancy and equipment expense increased $605,000 or 48.6% to $1.9 million. The costs to move the existing operations departments from the Company's main office to the operations facility as well as readying the buildings for occupancy have caused the increase in occupancy and equipment expense. Advertising expense increased 29.4% in 2002. Two additional bank mergers within the market areas presented opportunities for additional image advertising that resulted in increased business. Computer operations expense increased 32.1% to $539,000 during 2002. The Company placed in service additional equipment to enhance the security infrastructure of the internal network as well as upgraded the core bank processing software. An increase in the usage of internet banking services by accountholders also contributed to the increase in computer operations expense. Other operating expenses increased $546,000 to $3.3 million for 2002 compared to $2.8 million for 2001. Expenses associated with servicing an increased volume of accounts and transactions such as postage and printing have also impacted other operating expenses in 2002. -20- Noninterest expenses increased 25.0% or $2.4 million to $11.9 million in 2001. This increase resulted from both pressures to provide competitive salary and benefit programs and occupancy and equipment investments to position the Bank for future growth and productivity. Noninterest Expenses Years Ended December 31, -------------------------------------- 2002 2001 2000 -------- --------- --------- (In thousands) Salaries and employee benefits $ 9,383 $ 7,180 $ 5,600 Net occupancy and equipment expense 1,851 1,246 1,172 Advertising 414 320 347 Computer operations 539 408 298 Other operating expenses 3,339 2,793 2,138 -------- --------- --------- Total $ 15,526 $ 11,947 $ 9,555 ======== ========= ========= Income Taxes Reported income tax expense was $2.3 million for 2002, an increase of $580,000 compared to $1.8 million for 2001. The effective tax rate for 2002 was 27.0% compared to 25.2% in 2001 and 25.5% in 2000. The increase in the effective tax rate for 2002 was influenced by the change in the mix of the investment securities portfolio as well as the increase in non-interest income. Note 10 of the Company's Consolidated Financial Statements provides a reconciliation between the amount of income tax expense computed using the federal statutory rate and MFC's actual income tax expense. Also included in Note 10 to the Consolidated Financial Statements is information regarding the principal items giving rise to deferred taxes for the two years ended December 31, 2002. -21- Summary of Financial Results by Quarter
2002 Quarter Ended ---------------------------------------------------------- (Dollars in thousands except per share) March 31 June 30 September 30 December 31 ------------- ------------ ---------------- -------------- Net interest income $ 4,156 $ 4,290 $ 4,391 $ 4,397 Net interst income after provision for loan losses 4,081 4,215 4,316 4,322 Non interest income 1,184 1,815 2,061 2,253 Net securities gains (losses) (80) 33 (31) 5 Non interest expense 3,128 3,711 4,058 4,630 Income before income taxes 2,057 2,352 2,288 1,950 Net income 1,514 1,686 1,642 1,470 Earnings per common share - assuming dilution $ 0.84 $ 0.90 $ 0.87 $ 0.78 Dividends per common share 0.30 0.30 0.30 0.30
2001 Quarter Ended ---------------------------------------------------------- (Dollars in thousands except per share) March 31 June 30 September 30 December 31 ------------- ------------ ---------------- -------------- Net interest income $ 3,120 $ 3,422 $ 3,555 $ 3,911 Net interst income after provision for loan losses 3,045 3,347 3,480 3,836 Non interest income 1,168 1,096 1,254 1,309 Net securities gains (losses) 252 (6) 66 72 Non interest expense 2,741 2,829 2,930 3,447 Income before income taxes 1,724 1,608 1,870 1,770 Net income 1,292 1,199 1,389 1,337 Earnings per common share - assuming dilution $ 0.73 $ 0.67 $ 0.77 $ 0.75 Dividends per common share 0.25 0.25 0.25 0.25
Financial Condition MFC's total assets were $424.9 million as of December 31, 2002, up $70.9 million or 20.0% from the $354.1 million level at December 31, 2001. Securities increased $39.3 million or 31.6% from 2001 to 2002. Loans increased by $15.7 million or 8.0% from 2001 to 2002, while deposits increased $57.2 million or 21.0% during the same period. Borrowings from the Federal Home Loan Bank increased $4.0 million during 2002. It is anticipated that the borrowings from the Federal Home Loan Bank will continue to rise should deposit growth not match asset growth. Total shareholders' equity at year end 2002 and 2001 was $41.4 million and $30.3 million, respectively. Loans MFC's loan portfolio is its largest and most profitable component of earning assets, totaling 59.5% of average earning assets in 2002. MFC continues to emphasize loan portfolio growth and diversification as a means of increasing earnings while minimizing credit risk. Loans, net of unearned -22- income, were $212.1 million at December 31, 2002, an increase of 8.0% from December 31, 2001's total of $196.4 million. Proactive sales efforts, competitive pricing and the branch network supported the increase in loans during 2002. Loans increased 10.6% from $177.6 million at December 31, 2000 to $196.4 million at December 31, 2001. The loan to deposit ratio decreased to 64.5% at December 31, 2002 compared to 72.3% at December 31, 2001 and 79.1% at December 31, 2000. Loan Portfolio
December 31, --------------------------------------------------------- 2002 2001 2000 1999 1998 -------- -------- -------- -------- -------- (In thousands) Commercial, financial and agricultural $ 20,323 $ 22,993 $ 22,555 $ 19,055 $ 18,880 Real estate construction 22,008 24,174 17,693 12,151 5,436 Real estate mortgage: Residential (1-4 family) 74,298 80,824 81,545 61,062 55,595 Home equity lines 10,091 8,271 5,973 4,382 3,617 Non-farm, non-residential (1) 73,164 48,074 38,812 36,361 28,643 Agricultural 482 163 346 379 1,057 Consumer installment 11,741 11,901 10,674 9,845 8,095 -------- -------- -------- -------- --------- Total loans $212,107 $196,400 $177,598 $143,235 $121,323 ======== ======== ======== ======== ========
--------- (1) This category generally consists of commercial and industrial loans where real estate constitutes a source of collateral. At December 31, 2002, residential real estate (1-4 family) portfolio loans constituted 35.0% of the total portfolio and decreased $6.5 million during the year. The current historic low mortgage interest rates have caused many of the Bank's clients to refinance to a long term fixed rate product. Real estate construction loans consist primarily of pre-sold 1-4 family residential loans along with a marginal amount of commercial construction loans. Real estate construction loans increased to $22.0 million at December 31, 2002 and represent 10.4% of the total loan portfolio. MFC's one time closing construction/permanent loan product competes successfully in a high growth market like Loudoun County because MFC is local and can respond quickly to inspections and construction draw requests. Non-farm, non-residential real estate loans are typically owner-occupied commercial buildings. Non-farm, non-residential loans were 34.5% of the total loan portfolio at December 31, 2002. The increase in the non-farm non-residential real estate loans is the result of an increased focus on diversifying the loan portfolio. The Bank has hired commercial business development officers who have been successful in attracting new business to the Bank. The branch network has also helped to support the loan portfolio diversification, such as increased commercial real estate loans. Home equity lines and agricultural real estate loans were 4.8% and 0.23% of total loans, respectively, at December 31, 2002. MFC's commercial, financial and agricultural loan portfolio consists of secured and unsecured loans to small businesses. At December 31, 2002, these loans comprised 9.6% of the loan portfolio. This portfolio decreased 11.6% in 2002 to $20.3 million. Generally business debt has declined nationwide as well as locally thus causing a decrease in loan demand. Consumer installment loans primarily consist of unsecured installment credit and account for 5.5% of the loan portfolio. Consistent with its focus on providing community-based financial services, MFC generally does not extend loans outside its principal market area. MFC's market area for its lending services encompasses Fauquier and Loudoun Counties, where it operates full service branches. -23- MFC's unfunded loan commitments totaled $31.6 million at December 31, 2002 and $34.2 million at December 31, 2001. The decrease in the amount of unfunded commitments is attributed in part to the increase in real estate construction financing as well as customer demand for credit line products, primarily home equity lines. At December 31, 2002, MFC had no concentration of loans in any one industry in excess of 10% of its total loan portfolio. However, because of the nature of MFC's market, loan collateral is predominantly real estate. The following table reflects the maturity distribution of selected loan categories: Remaining Maturities of Selected Loan Categories December 31, 2002 Commercial, Real Financial and Estate Agricultural Construction --------------- -------------- (Dollars in thousands) Within 1 year $ 16,340 $ 10,762 --------------- -------------- Variable Rate: 1 to 5 years $ 1,600 $ 896 After 5 years - 631 --------------- -------------- Total $ 1,600 $ 1,527 --------------- -------------- Fixed Rate: 1 to 5 years $ 2,383 $ 8,790 After 5 years - 929 --------------- -------------- Total $ 2,383 $ 9,719 --------------- -------------- Total Maturities $ 20,323 $ 22,008 =============== ============== Asset Quality MFC has policies and procedures designed to control credit risk and to maintain the quality of its loan portfolio. These include underwriting standards for new originations and ongoing monitoring and reporting of asset quality and adequacy of the allowance for loan losses. Total nonperforming assets, which consist of nonaccrual loans, restructured loans and foreclosed property, were $1.1 million at December 31, 2002. This is an increase of $984,000 from the December 31, 2001 balance of $79,000. The increase is largely two residential real estate loans both of which are well secured. Nonperforming assets at December 31, 2001 decreased $26,000 from $105,000 at December 31, 2000. Nonperforming Assets Loans are placed on nonaccrual status when collection of principal and interest is doubtful, generally when a loan becomes 90 days past due. There are three negative implications for earnings when a loan is placed on nonaccrual status. First, all interest accrued but unpaid at the date that the loan is placed on nonaccrual status is either deducted from interest income or written off as a loss. Second, accruals of interest are discontinued until it becomes certain that both principal and interest can be repaid. -24- Finally, there may be actual losses that require additional provisions for loan losses be charged against earnings. For real estate loans, upon foreclosure, the balance of the loan is transferred to "Other Real Estate Owned" ("OREO") and carried at the lower of the outstanding loan balance or the fair market value of the property based on current appraisals and other current market trends. If a write down of the OREO property is necessary at the time of foreclosure, the amount is charged-off against the allowance for loan losses. A review of the recorded property value is performed in conjunction with normal loan reviews, and if market conditions indicate that the recorded value exceeds the fair market value, additional write downs of the property value are charged directly to operations. Nonperforming Assets December 31,
------------------------------------------------------------------- 2002 2001 2000 1999 1998 ----------- -------------- ------------ ------------- ------------- (In thousands) Nonaccrual loans $ 1,063 $ 79 $ 105 $ 530 $ 409 Restructured loans - - - - - Foreclosed property - - - - 200 -------- -------- -------- -------- -------- Total nonperforming assets $ 1,063 $ 79 $ 105 $ 530 $ 609 ======== ======== ======== ======== ======== Allowance for loan losses to nonperforming assets 217% 2608% 1718% 274% 175% Nonperforming assets to period end loans 0.50% 0.04% 0.06% 0.37% 0.50%
During 2002 and 2001, approximately $41,000 and $700, respectively, in additional interest income would have been recorded if MFC's nonaccrual loans had been current and in accordance with their original terms. At December 31, 2002, the Company had no potential problem loans. The allowance for loan losses was 217% of nonperforming loans at December 31, 2002. At December 31, 2001 and 2000 the allowance for loan losses was 2,608% and 1,718% of nonperforming loans. Management evaluates nonperforming loans relative to their collateral value and makes appropriate reductions in the carrying value of those loans based on that review. Allowance For Loan Losses The Company monitors and maintains an allowance for loan losses to absorb an estimate of probable losses inherent in the loan and lease portfolio. The Company maintains policies and procedures that address the systems of controls over the following areas of maintenance of the allowance: the systematic methodology used to determine the appropriate level of the allowance to provide assurance they are maintained in accordance with accounting principles generally accepted in the United States of America; the accounting policies for loan charge-offs and recoveries; the assessment and measurement of impairment in the loan and lease portfolio; and the loan grading system. -25- The Company evaluates various loans individually for impairment as required by SFAS No. 114, Accounting by Creditors for Impairment of a Loan, and SFAS No. 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures. Loans evaluated individually for impairment include non-performing loans, such as loans on non-accrual, loans past due by 90 days or more, restructured loans and other loans selected by management. The evaluations are based upon discounted expected cash flows or collateral valuations. If the evaluation shows that a loan is individually impaired, then a specific reserve is established for the amount of impairment. If a loan evaluated individually is not impaired, then the loan is assessed for impairment under SFAS 5 with a group of loans that have similar characteristics. For loans without individual measures of impairment, the Company makes estimates of losses for groups of loans as required by SFAS 5. Loans are grouped by similar characteristics, including the type of loan, the assigned loan grade and the general collateral type. A loss rate reflecting the expected loss inherent in a group of loans is derived based upon estimates of default rates for a given loan grade, the predominant collateral type for the group and the terms of the loan. The resulting estimate of losses for groups of loans are adjusted for relevant environmental factors and other conditions of the portfolio of loans and leases, including: borrower and industry concentrations; levels and trends in delinquencies, charge-offs and recoveries; changes in underwriting standards and risk selection; level of experience, ability and depth of lending management; and national and local economic conditions. The amount of estimated impairment for individually evaluated loans and groups of loans is added together for a total estimate of loans and lease losses. This estimate of losses is compared to the allowance for loan and lease losses of the Company as of the evaluation date and, if the estimate of losses is greater than the allowance, an additional provision to the allowance would be made. If the estimate of losses is less than the allowance, the degree to which the allowance exceeds the estimate is evaluated to determine whether the allowance falls outside a range of estimates. If the estimate of losses is below the range of reasonable estimates, the allowance would be reduced by way of a credit to the provision for loan losses. The Company recognizes the inherent imprecision in estimates of losses due to various uncertainties and variability related to the factors used, and therefore a reasonable range around the estimate of losses is derived and used to ascertain whether the allowance is too high. If different assumptions or conditions were to prevail and it is determined that the allowance is not adequate to absorb the new estimate of probable losses, an additional provision for loan losses would be made, which amount may be material to the Consolidated Financial Statements. -26- The following table depicts the transactions, in summary form, that occurred to the allowance for loan losses in each year presented: Allowance for Loan Losses
December 31, -------------------------------------------------- 2002 2001 2000 1999 1998 ------ ------ ------ ------ ------ (In thousands) Balance, beginning of period $2,060 $1,804 $1,453 $1,064 $ 974 Loans charged off: Commercial, financial, and agricultural - - 61 26 8 Real estate construction - - - - - Real estate mortgage - 48 - 29 - Consumer installment 74 35 35 96 77 ------ ------ ------ ------ ------ Total loans charged off $ 74 $ 83 $ 96 $ 151 $ 85 ------ ------ ------ ------ ------ Recoveries: Commercial, financial, and agricultural $ 2 $- $ 6 $ 7 $ 1 Real estate construction - - - - - Real estate mortgage - - - 79 6 Consumer installment 19 39 41 34 33 ------ ------ ------ ------ ------ Total recoveries $ 21 $ 39 $ 47 $ 120 $ 40 ------ ------ ------ ------ ------ Net charge offs (recoveries) 53 44 49 31 45 Provision for loan losses 300 300 400 420 135 ------ ------ ------ ------ ------ Balance, end of period $2,307 $2,060 $1,804 $1,453 $1,064 ====== ====== ====== ====== ====== Ratio of allowance for loan losses to loans outstanding at end of period 1.09% 1.05% 1.02% 1.01% 0.88% Ratio of net charge offs to average loans outstanding during period 0.03% 0.02% 0.03% 0.02% 0.04%
The allowance for loan losses was $2.3 million at December 31, 2002, an increase of $247,000 from $2.1 million at December 31, 2001. The allowance was $1.8 million at December 31, 2000. In 2002, MFC's net charge-offs increased $9,000 from the previous year's net charge-offs of $44,000. Net charge-offs as a percentage of average loans were 0.03% and 0.02% for 2002 and 2001 respectively. The provision for loan losses was $300,000 for 2002 and 2001. -27- The following table shows the balance and percentage of the MFC's allowance for loan losses allocated to each major category of loan: Allocation of Allowance for Loan Losses
Commercial, Financial, Real Estate Real Estate Agricultural Construction Mortgage Consumer --------------------------- ----------------------- ------------------------ ----------------------- Allowance Percent of Allowance Percent of Allowance Percent of Allowance Percent of for Loan in for Loan in for Loan in for Loan in Loan Category to Loan Category to Loan Category to Loan Category to Losses Total Loans Losses Total Loans Losses Total Loans Losses Total Loans --------------------------- ----------------------- ------------------------ ----------------------- (In thousands) December 31, 2002 $ 487 9.58% $ 624 10.38% $ 924 74.51% $ 272 5.54% 2001 $ 634 11.71% $ 750 12.31% $ 374 69.92% $ 302 6.06% 2000 $ 645 12.70% $ 500 9.96% $ 310 71.33% $ 349 6.01% 1999 $ 580 13.30% $ 350 8.48% $ 178 71.34% $ 345 6.82% 1998 $ 442 15.56% $ 100 4.48% $ 144 73.28% $ 378 6.43%
MFC has allocated the allowance according to the amount deemed reasonably necessary to provide for the possibility of losses being incurred within each of the above categories of loans. The allocation of the allowance as shown in the table above should not be interpreted as an indication that loan losses in future years will occur in the same proportions that they may have in prior years or that the allocation indicates future loan loss trends. Additionally, the proportion allocated to each loan category is not the total amount that may be available for the future losses that could occur within such categories since the total allowance is a general allowance applicable to the total portfolio. Securities MFC manages its investment securities portfolio consistent with established policies that include guidelines for earnings, rate sensitivity, liquidity and pledging needs. MFC holds bonds issued from the Commonwealth of Virginia and its political subdivisions with an aggregate book value and market value of $2.7 million at December 31, 2002. The aggregate holdings of these bonds approximate 6.6% of MFC's shareholders' equity. MFC accounts for securities under Financial Accounting Standards Board ("FASB") Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities." This standard requires classification of investments into three categories, "held to maturity" ("HTM"), "available for sale" ("AFS"), or "trading," as further defined in Note 1 to the Company's Consolidated Financial Statements. MFC's does not maintain a trading account and has classified no securities in this category. HTM securities are required to be carried on the financial statements at amortized cost. AFS securities are carried on the financial statements at fair value. The unrealized gains or losses, net of deferred income taxes, are reflected in shareholders' equity. The HTM classification places restrictions on MFC's ability to sell securities or to transfer securities into the AFS classification. Since MFC desires the flexibility to respond to changing balance sheet needs through investment portfolio management, it has chosen to classify only a small portion of its portfolio in this category. At December 31, 2002, 2.8% of the portfolio was classified as HTM. -28- MFC holds in its loan and securities portfolios investments that adjust or float according to changes in "prime" lending rate. These holdings are not considered speculative but instead necessary for good asset/liability management. The carrying value of the securities portfolio was $163.7 million at December 31, 2002, an increase of $39.3 million or 31.6% from the carrying value of $124.4 million at December 31, 2001. The market value of the AFS securities at December 31, 2002 was $159.0 million. The unrealized loss on the AFS securities was $409,000 that was more than offset by an unrealized gain of $5.4 million at December 31, 2002. The net market value gain at December 31, 2002 is reflective of the recent decrease in market interest rates. The net unrealized loss on the AFS securities was $376,000 at December 31, 2001. Investment Securities Portfolio The carrying value of securities held to maturity at the dates indicated were as follows:
December 31, ------------------------------------------------------------ 2002 2001 2000 ------------------ --------------- -------------- (In thousands) U.S. Government securities $ - $ - $ 250 State and political subdivision obligations 4,590 5,484 6,657 Mortgage-backed securities 53 61 93 ------------------ --------------- -------------- $ 4,643 $ 5,545 $ 7,000 ================== =============== ==============
The carrying value of securities available for sale at the dates indicated were as follows:
December 31, ------------------------------------------------------------ 2002 2001 2000 ------------------ --------------- -------------- (In thousands) U.S. Government securities $ 4,406 $ 267 $ 3,072 State and political subdivision obligations 32,639 33,220 27,961 Mortgage-backed securities 102,521 63,746 3,443 Other securities 19,464 21,573 9,501 ------------------ --------------- -------------- $ 159,030 $ 118,806 $ 43,977 ================== =============== ==============
-29- The following table indicates the increased return experienced by MFC by lengthening the maturity of the investment securities portfolio. Securities with maturities greater than five years total $83.7 million and have an average yield greater than 6.0%. The securities portfolio represents approximately 38.3% of the earning assets of MFC. For that reason, it is managed primarily to provide superior returns without sacrificing interest rate, market and credit risk. Secondarily through the asset/liability process, MFC considers the securities portfolio as a liquidity source in the event that funding is needed quickly within a 30-day period of time. Maturity Distribution and Yields of Investment Securities December 31, 2002 Taxable-Equivalent Basis
Due in 1 year Due after 1 year Due after 5 years Due after 10 years or less through 5 years through 10 years And Equities Total ------------------ ------------------ ----------------- ------------------ ----------------- Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield ------------------ ------------------ ----------------- ------------------ ----------------- (In housands) Securities held for investment: Mortgage backed securities $ 2 4.63% $ 7 4.38% $ 12 4.42% $ 32 4.53% $ 53 4.48% Tax-exempt securities (1) 376 7.39% 2,630 7.72% 1,584 7.85% - - 4,590 7.74% -------- ---- -------- ---- -------- ---- -------- ---- -------- ---- Total $ 378 7.37% $ 2,637 7.71% $ 1,596 7.83% $ 32 4.53% $ 4,643 7.70% -------- ---- -------- ---- -------- ---- -------- ---- -------- ---- Securities available for sale: U.S. Government securities $ 514 2.52% $ 3,615 3.03% $ 277 7.54% $ - - $ 4,406 3.25% Mortgage backed securities 20,662 5.77% 40,676 5.54% 22,683 5.33% 18,500 5.39% 102,521 5.51% Other 691 7.20% 6,511 4.76% 204 7.22% 7,980 3.77% 15,386 4.39% Corporate preferred - - - - - - 2,283 7.23% 2,283 7.23% -------- ---- -------- ---- -------- ---- -------- ---- -------- ---- Total taxable $ 21,867 5.74% $ 50,802 5.26% $ 23,164 5.37% $ 28,763 5.09% $124,596 5.33% Tax-exempt securities (1) 391 7.92% 1,602 7.98% 11,981 7.56% 18,136 7.71% 32,110 7.67% -------- ---- -------- ---- -------- ---- -------- ---- -------- ---- Total $ 22,258 5.78% $ 52,404 5.35% $ 35,145 6.12% $ 46,899 6.10% $156,706 5.81% -------- ---- -------- ---- -------- ---- -------- ---- -------- ---- Total securities $ 22,636 5.81% $ 55,041 5.46% $ 36,741 6.19% $ 46,931 6.10% $161,349 5.86% ======== ==== ======== ==== ======== ==== ======== ==== ======== ====
--------- (1) Yields on tax-exempt securities have been computed on a tax-equivalent basis. (2) Amounts exclude Federal Reserve Stock of $374,400 and Federal Home Loan Bank Stock of $1,950,000. Other Earning Assets MFC's average investments in federal funds sold and money market investments in 2002 were $5.4 million and $2.2 million, increases of $2.4 million and $452,000, respectively, over the 2001 amounts. Average investments in federal funds sold and money market investments in 2001 were $3.0 million and $1.7 million, respectively. Fluctuations in federal funds sold and money market investments reflect excess deposit growth over loan growth as well as management's goal to maximize asset yields while maintaining proper asset/liability structure. -30- Deposits Deposits continue to be an important funding source and primary supply of MFC's growth. MFC's strategy has been to increase its core deposits at the same time that it is controlling its cost of funds. The maturation of the branch network, as well as increased advertising campaigns and bank mergers, have contributed to the significant growth in deposits over the last several years. By monitoring interest rates within the local market and that of alternative funding sources, MFC is able to price the deposits effectively to develop a core base of deposits in each branch. The following table is a summary of average deposits and average rates paid on those deposits: Average Deposits and Rates Paid
December 31, ----------------------------------------------------------------------------------- 2002 2001 2000 --------------------------- --------------------------- -------------------------- Amount Rate Amount Rate Amount Rate --------------------------- --------------------------- -------------------------- (Dollars in Thousands) Noninterest-bearing deposits $ 74,787 - $ 59,289 - $ 47,355 - Interest-bearing accounts: Interest checking 39,430 0.24% 33,978 0.66% 32,461 0.91% Regular savings 19,813 0.92% 15,183 1.83% 13,148 2.00% Money market accounts 66,102 1.37% 46,616 2.50% 42,852 2.71% Time deposits: $ 100,000 and over 51,723 3.19% 39,154 5.33% 25,997 5.59% Under $ 100,000 44,367 3.14% 46,409 4.50% 44,389 4.85% ----------- ----------- ----------- Total interest-bearing deposits $ 221,435 1.91% $ 181,340 3.22% $ 158,847 3.35% ---------- ----------- ----------- Total $ 296,222 $ 240,629 $ 206,202 ========== =========== ===========
Average total deposits increased 23.1% during 2002, 16.7% during 2001 and 10.3% during 2000. During 2002, the average balance of non-interest bearing deposits grew 26.1%. The average balance in interest checking and money market accounts grew 16.0% and 41.8%, respectively, during 2002. Management believes that some of the growth in the average balances of money market accounts is associated with the movement of money from the equity markets to bank accounts, a significant portion of the growth is also core growth. The total number of net new deposit transactional (excluding time deposits) accounts have increased 30% per year for the past two years. MFC will continue to fund assets primarily with deposits and will focus on core deposit growth as the primary source of liquidity and stability. MFC offers individuals and small to medium-sized businesses a variety of deposit accounts, including demand and interest checking, money market, savings and time deposit accounts. MFC neither purchases brokered deposits nor solicits deposits from sources outside its primary market area. -31- The following table is a summary of the maturity distribution of certificates of deposit equal to or greater than $100,000 as of December 31, 2002: Maturities of Certificates of Deposit of $100,000 and Greater
Within Three to Six to Over Percent Three Six Twelve One of Total Months Months Months Year Total Deposits ------------- ------------ ------------- ------------ ------------- ------------ (In thousands) At December 31, 2002 $9,784 $12,653 $9,470 $24,729 $56,636 17.2%
Capital Resources and Dividends MFC has an ongoing strategic objective of maintaining a capital base that supports the pursuit of profitable business opportunities, provides resources to absorb risks inherent in its activities and meets or exceeds all regulatory requirements. The Federal Reserve Board has established minimum regulatory capital standards for bank holding companies and state member banks. The regulatory capital standards categorize assets and off-balance sheet items into four categories that weigh balance sheet assets according to risk, requiring more capital for holding higher risk assets. The minimum ratio of qualifying total capital to risk-weighted assets is 8.0%, of which at least 4.0% must be Tier 1 capital, composed of common equity and retained earnings. MFC had a ratio of total capital to risk-weighted assets of 15.6% at December 31, 2002, compared to 17.3% at December 31, 2001. The ratio of Tier 1 capital to risk-weighted assets was 14.8% and 16.4% at December 31, 2002 and 2001, respectively. Both ratios exceed the minimum capital requirements adopted by the federal banking regulatory agencies. -32- Analysis of Capital December 31, 2002 2001 -------------- --------------- (Dollars in thousands) Tier 1 Capital: Common stock $ 9,263 $ 8,761 Capital surplus 3,644 741 Retained earnings 25,184 21,084 Trust preferred debt 10,000 9,770 Goodwill (6,902) (1,272) --------- --------- Total Tier 1 capital $ 41,189 $ 39,084 --------- --------- Tier 2 Capital: Disallowed trust preferred $ - $ 230 Allowance for loan losses 2,307 2,060 --------- --------- Total tier 2 capital $ 2,307 $ 2,290 --------- --------- Total risk-based capital $ 43,496 $ 41,374 ========= ========= Risk weighted assets $ 278,229 $ 238,605 CAPITAL RATIOS: Tier 1 risk-based capital ratio 14.8% 16.4% Total risk-based capital ratio 15.6% 17.3% Tier 1 capital to average total assets 10.6% 12.5% MFC's core equity to asset ratio increased to 9.7% at December 31, 2002, compared to 8.6% at December 31, 2001. The issuance of additional shares in the acquisition of GPIA as well as the exercise of 40,550 stock options have contributed to the increase in capital and the equity to asset ratio in 2002. The primary source of funds for dividends paid by MFC to its shareholders is the dividends received from its subsidiaries. Federal regulatory agencies impose certain restrictions on the payment of dividends and the transfer of assets from the banking subsidiaries to the holding company. Historically, these restrictions have not had an adverse impact on MFC's dividend policy, and it is not anticipated that they will in the future. Liquidity Liquidity represents an institution's ability to meet present and future financial obligations through either the sale or maturity of existing assets or the acquisition of additional funds through liability management. Liquid assets include cash, interest-bearing deposits with banks, federal funds sold, short-term investments, securities classified as available for sale as well as loans and securities maturing within one year. As a result of MFC's management of liquid assets and the ability to generate liquidity through liability funding, management believes MFC maintains overall liquidity sufficient to satisfy its depositors' requirements and meet its customers' credit needs. MFC also maintains additional sources of liquidity through a variety of borrowing arrangements. The Bank maintains federal funds lines with large regional and money-center banking institutions. These available lines total in excess of $5 million, of which none were outstanding at December 31, 2002. Federal funds purchased during 2002 averaged $221,000 compared to an average of $371,000 during -33- 2001. At December 31, 2002 and 2001, the Bank had $8.9 million and $12.0 million, respectively, of outstanding borrowings pursuant to securities sold under agreement to repurchase transactions (Repo Accounts), with maturities of one day. The Repo Accounts are long-term commercial checking accounts with average balances that typically exceed $100,000. The Bank has a credit line in the amount of $56.5 million at the Federal Home Loan Bank of Atlanta. This line may be utilized for short and/or long-term borrowing. The Bank has utilized the credit line for overnight funding throughout 2002 with an average balance of $3.1 million. At December 31, 2002, cash, interest-bearing deposits with financial institutions, federal funds sold, short-term investments, securities available for sale, loans and securities maturing within one year were 51.3% of total deposits and liabilities. Forward-Looking Statements Certain information contained in this discussion may include "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements are generally identified by phrases such as "the Company expects," "the Company believes" or words of similar import. Such forward-looking statements involve known and unknown risks including, but not limited to, changes in general economic and business conditions, interest rate fluctuations, competition within and from outside the banking industry, new products and services in the banking industry, risk inherent in making loans such as repayment risks and fluctuating collateral values, problems with technology utilized by the Company, changing trends in customer profiles and changes in laws and regulations applicable to the Company. Although the Company believes that its expectations with respect to the forward-looking statements are based upon reliable assumptions within the bounds of its knowledge of its business and operations, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. Recent Accounting Pronouncements In December, 2001, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position 01-6, Accounting by Certain Entities (Including Entities with Trade Receivables) That Lend to or Finance the Activities of Others, to reconcile and conform the accounting and financial reporting provisions established by various AICPA industry audit guides. This Statement is effective for annual and interim financial statements issued for fiscal years beginning after December 15, 2001, and did not have a material impact on the Company's consolidated financial statements. On March 13, 2002, the Financial Accounting Standard Board determined that commitments for the origination of mortgage loans that will be held for sale must be accounted for as derivatives instruments, effective for fiscal quarters beginning after April 10, 2002. The Bank enters into commitments to originate loans whereby the interest rate on the loan is determined prior to funding. Such rate lock commitments on mortgage loans to be sold in the secondary market are considered derivatives. Accordingly, these commitments including any fees received from the potential borrower are recorded at fair value in derivative assets or liabilities, with changes in fair value recorded in the net gain or loss on sale of mortgage loans. Fair value is based on fees currently charged to enter into similar agreements, and for fixed-rate commitments also considers the difference between current levels of interest rates and the committed rates. The cumulative effect of adopting Statement No. 133 for rate lock commitments as of December 31, 2002, was not material. The Company originally adopted Statement No. 133, Accounting for Derivative Instruments and Hedging Activities on January 1, 2001. -34- In April 2002, the Financial Accounting Standards Board issued Statement 145, Rescission of FASB No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. The amendment to Statement 13 eliminates an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The provisions of this Statement related to the rescission of Statement 4 shall be applied in fiscal years beginning after May 15, 2002. The provisions of this Statement related to Statement 13 are effective for transactions occurring after May 15, 2002, with early application encouraged. In June 2002, the Financial Accounting Standards Board issued Statement 146, Accounting for Costs Associated with Exit or Disposal Activities. This Statement requires recognition of a liability, when incurred, for costs associated with an exit or disposal activity. The liability should be measured at fair value. The provisions of the Statement are effective for exit or disposal activities initiated after December 31, 2002. Effective January 1, 2002, the Corporation adopted Financial Accounting Standards Board Statement No. 142, Goodwill and Other Intangible Assets. Accordingly, goodwill is no longer subject to amortization over its estimated useful life, but is subject to at least an annual assessment for impairment by applying a fair value based test. Additionally, Statement 142 requires that acquired intangible assets (such as core deposit intangibles) be separately recognized if the benefit of the asset can be sold, transferred, licensed, rented, or exchanged, and amortized over their estimated useful life. Branch acquisition transactions were outside the scope of the Statement and therefore any intangible asset arising from such transactions remained subject to amortization over their estimated useful life. In October 2002, the Financial Accounting Standards Board issued Statement No. 147, Acquisitions of Certain Financial Institutions. The Statement amends previous interpretive guidance on the application of the purchase method of accounting to acquisitions of financial institutions, and requires the application of Statement No. 141, Business Combinations, and Statement No. 142 to branch acquisitions if such transactions meet the definition of a business combination. The provisions of the Statement do not apply to transactions between two or more mutual enterprises. In addition, the Statement amends Statement No. 144, Accounting for the Impairment of Long-Lived Assets, to include in its scope core deposit intangibles of financial institutions. Accordingly, such intangibles are subject to a recoverability test based on undiscounted cash flows, and to the impairment recognition and measurement provisions required for other long-lived assets held and used. The adoption of Statement Nos. 142, 145, 146 and 147 did not have a material impact on the Company's consolidated financial statements. The Financial Accounting Standards Board issued Statement No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure, an amendment of Statement No. 123, in December 2002. The Statement amends Statement No. 123 to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, the Statement amends the disclosure requirements of Statement 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. Finally, this Statement amends APB Opinion No. 28, Interim Financial Reporting, to require disclosure about the effects of stock options in interim financial information. The amendments to Statement No. 123 are effective for financial statements for fiscal years ending after December 15, 2002. The amendments to APB No. 28 are effective for financial reports containing condensed financial statements for interim -35- periods beginning after December 15, 2002. Early application is encouraged for both amendments. The Company continues to record stock options under APB Opinion No. 25, Accounting for Stock Issued to Employees, and has not adopted the alternative methods allowable under Statement No. 148. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates or prices such as interest rates, foreign currency exchange rates, commodity prices and equity prices. MFC's primary market risk exposure is interest rate risk, though it should be noted that the assets under management by Tredegar are affected by equity price risk. The ongoing monitoring and management of this risk is an important component of MFC's asset/liability management process, which is governed by policies established by its Board of Directors that are reviewed and approved annually. The Board of Directors delegates responsibility for carrying out asset/liability management policies to the Asset/Liability Committee ("ALCO") of the Bank. In this capacity, ALCO develops guidelines and strategies that govern MFC's asset/liability management related activities, based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends. Interest rate risk represents the sensitivity of earnings to changes in market interest rates. As interest rates change, the interest income and expense streams associated with MFC's financial instruments also change, affecting net interest income, the primary component of MFC's earnings. ALCO uses the results of a detailed and dynamic simulation model to quantify the estimated exposure of net interest income to sustained interest rate changes. While ALCO routinely monitors simulated net interest income sensitivity over a rolling two-year horizon, it also employs additional tools to monitor potential longer-term interest rate risk. The simulation model captures the impact of changing interest rates on the interest income received and interest expense paid on all assets and liabilities reflected on MFC's balance sheet. The simulation model is prepared and updated four times during each year. This sensitivity analysis is compared to ALCO policy limits, which specify a maximum tolerance level for net interest income exposure over a one-year horizon, assuming no balance sheet growth, given both a 200 basis point ("bp") upward and downward shift in interest rates. A parallel and pro rata shift in rates over a 12-month period is assumed. Given the current historic low in interest rates for the fiscal year 2002, the model assumed only a 100 bp decrease in interest rates. The following reflects the range of MFC's net interest income sensitivity analysis during the fiscal years of 2002 and 2001 as compared to the 10% Board-approved policy limit. 2002 Rate Change Estimated Net Interest Income Sensitivity ----------- ----------------------------------------- High Low Average + 200 bp (2.51%) (1.00%) (1.75%) - 100 bp 2.62% .63% 1.33% 2001 Rate Change Estimated Net Interest Income Sensitivity ----------- ----------------------------------------- High Low Average + 200 bp (2.21%) (.32%) (1.32%) - 200 bp 3.24% 1.57% 2.44% -36- At the end of 2002, MFC's interest rate risk model indicated that in a rising rate environment of 200 basis points over a 12 month period net interest income could decrease by 1.75% on average. For the same time period the interest rate risk model indicated that in a declining rate environment of 100 basis points over a 12 month period net interest income could increase by 1.33% on average. While these numbers are subjective based upon the parameters used within the model, management believes the balance sheet is very balanced with little risk to rising rates in the future. During 2001, MFC was able to test the parameters and assumptions of its simulation model in light of the 4.75% decrease in short term rates over 11 months. The simulation model proved to be accurate in its presentation of a company that benefits from falling interest rates. As presented in the table above, MFC has had minimal interest rate risks to either falling or rising interest rates over the past two years. MFC could expect a negative impact to net interest income of $364,000 if rates rise 200 basis points over the next 12 months. If rates decline 200 basis points, MFC could expect a positive impact to net interest income of $386,000 over the next 12 months. During May 2000, MFC entered into two interest rate swap agreements to assume variable market-indexed interest payments in exchange for fixed-rate interest payments. The interest rate swap was used to offset the cost of offering a premium market rate on a promotional retail certificate of deposit. MFC raised $8.5 million in new deposits during this three-day promotion. The terms of the certificate of deposit and the fixed portion of the interest rate swap are identical. The notional principal amount of interest rate swaps outstanding was $8.5 million at December 31, 2001. The original term was 24 months and matured in May 2002. The weighted-average fixed payment rate was 7.0% throughout the term. Variable interest payments received were based on three-month LIBOR The effect of these agreements was to transform the certificates of deposit (fixed rate liabilities) to variable rate certificates of deposit (liabilities). The net income from these agreements was $170,000 for the year ended December 31, 2002. The preceding sensitivity analysis does not represent an MFC forecast and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions, including the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment or replacement of asset and liability cashflows. While assumptions are developed based upon current economic and local market conditions, MFC cannot make any assurances about the predictive nature of these assumptions, including how customer preferences or competitor influences might change. Also, as market conditions vary from those assumed in the sensitivity analysis, actual results will also differ due to factors such as prepayment and refinancing levels likely deviating from those assumed, the varying impact of interest rate change, caps or floors on adjustable rate assets, the potential effect of changing debt service levels on customers with adjustable rate loans, depositor early withdrawals and product preference changes, and other internal and external variables. Furthermore, the sensitivity analysis does not reflect actions that ALCO might take in response to or anticipation of changes in interest rates. -37- ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following financial statements are filed as a part of this report following Item 15 below: Independent Auditor's Report Consolidated Balance Sheets as of December 31, 2002 and 2001 Consolidated Statements of Income for the Years Ended December 31, 2002, 2001, and 2000 Consolidated Statements of Changes in Shareholders' Equity for the Years Ended December 31, 2002, 2001,and 2000 Consolidated Statements of Cash Flows for the Years Ended December 31, 2002, 2001, and 2000 Notes to Consolidated Financial Statements ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There were no changes in or disagreements with accountants on accounting and financial disclosure during the last two fiscal years. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings "Nominees for Election for Terms Expiring in 2004," "Executive Officers Who Are Not Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's Proxy Statement for the 2003 Annual Meeting of Shareholders is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings "Director Compensation," "Compensation Committee Interlocks and Insider Participation," "Executive Compensation," "Stock Options" and "Employment Agreements" in the Company's Proxy Statement for the 2003 Annual Meeting of Shareholders is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS Security Ownership. Pursuant to General Instruction G(3) of Form 10-K, the information contained under the headings "Security Ownership of Management" and "Security Ownership of Certain Beneficial Owners" in the Company's Proxy Statement for the 2003 Annual Meeting of Shareholders is incorporated herein by reference. -38- Equity Compensation Plan Information. The following table sets forth information as of December 31, 2002, with respect to compensation plans under which shares of the Company's Common Stock are authorized for issuance.
Number of Securities Number of Securities to Be Weighted Average Remaining Available Issued upon Exercise of Exercise Price of for Future Issuance Outstanding Options, Outstanding Options, Under Equity Plan Category Warrants and Rights Warrants and Rights Compensation Plans (1) ------------------- ------------------- ---------------------- Equity Compensation Plans Approved by Shareholders 1997 Incentive Stock 91,375 $29.80 35,633 Option Plan Equity Compensation Plans Not Approved by Shareholders(2) -- -- -- Total 91,375 $29.80 35,633
--------- (1) Amounts exclude any securities to be issued upon exercise of outstanding options, warrants and rights. (2) The Company does not have any equity compensation plans that have not been approved by shareholders. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Pursuant to General Instruction G(3) of Form 10-K, the information contained under the heading "Transactions with Management" in the Company's Proxy Statement for the 2003 Annual Meeting of Shareholders is incorporated herein by reference. ITEM 14. CONTROLS AND PROCEDURES Within the 90 days prior to the date of this report, the Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures pursuant to Rule 13a-14 under the Securities Exchange Act of 1934, as amended. Based upon that evaluation, the Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's periodic filings with the Securities and Exchange Commission. There have been no significant changes in the Company's internal controls or in other factors that could significantly affect internal controls subsequent to the date that the Company carried out its evaluation. In September 2002, the Company completed an upgrade conversion of its core operating software that had commenced in early 2002. The core operating software primarily provides customer accounting for deposit and loan relationships. In addition, the system will serve as a record-keeping tool for general ledger and accounts payable. The new system provides enhanced capabilities for the management of the Company's customer relationships. As with any system-related change, internal processes may need to change or adapt to retain efficiency. As part of its evaluation of its disclosure controls and procedures, -39- management continues to evaluate, document and monitor any changes to internal controls as a result of the core operating software conversion. PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) and (2). The response to this portion of Item 15 is submitted as a separate section of this report. (3). Exhibits: 3.1 Articles of Incorporation of the Company (restated in electronic format). 3.2 Bylaws of the Company, attached as Exhibit 3.2 to the Registration Statement on Form S-4, Registration No. 333-24523, filed with the Commission on April 4, 1997, incorporated herein by reference. 10.1 Employment Agreement, dated as of January 1, 1998, between the Company and Joseph L. Boling, attached as Exhibit 10.1 to the Company's Annual Report on Form 10-KSB for the year ended December 31, 1998, incorporated herein by reference. 10.2 Independent Community Bankshares, Inc. 1997 Stock Option Plan, as amended, attached as Exhibit 4.3 to the Registration Statement on Form S-8, Registration No. 333-93447, filed with the Commission on December 22, 1999, incorporated herein by reference. 10.3 Agreement and Plan of Reorganization dated as of August 9, 1999, between Gilkison Patterson Investment Advisors, Inc. ("GPIA"), the Company and Tredegar, attached as Exhibit 10.1 to the Company's Quarterly Report on Form 10-QSB for the period ended September 30, 1999 (the "Form 10-QSB"), incorporated herein by reference. 10.4 Shareholder Agreement dated as of August 9, 1999, between Robert C. Gilkison, James H. Patterson, the Company and GPIA, attached as Exhibit 10.2 to the Form 10-QSB, incorporated herein by reference. 10.5 Stock Purchase Agreement dated as of August 9, 1999, between Robert C. Gilkison, James H. Patterson and the Company, attached as Exhibit 10.3 to the Form 10-QSB, incorporated herein by reference. 10.6 Employment Agreement, dated as of August 9, 1999, between GPIA and James H. Patterson. 21 Subsidiaries of the Company. 23.1 Consent of Yount, Hyde & Barbour, P.C. -40- 99.1 Statement of Chief Executive Officer Pursuant to 18 U.S.C.ss.1350. 99.2 Statement of Chief Financial Officer Pursuant to 18 U.S.C.ss.1350. (All exhibits not incorporated herein by reference are attached as exhibits to the Company's Annual Report on Form 10-K for the year ended December 31, 2002, as filed with the Securities and Exchange Commission.) (b) Reports on Form 8-K No reports on Form 8-K were filed by the Company during the last quarter of the period covered by this report. (c) Exhibits The response to this portion of Item 15 as listed in Item 15(a)(3) above is submitted as a separate section of this report. (d) Financial Statement Schedules The response to this portion of Item 15 is submitted as a separate section of this report. -41- MIDDLEBURG FINANCIAL CORPORATION Middleburg, Virginia FINANCIAL REPORT DECEMBER 31, 2002 C O N T E N T S Page INDEPENDENT AUDITOR'S REPORT ON THE CONSOLIDATED FINANCIAL STATEMENTS 1 CONSOLIDATED FINANCIAL STATEMENTS Consolidated balance sheets 2 Consolidated statements of income 3 Consolidated statements of changes in shareholders' equity 4 Consolidated statements of cash flows 5 and 6 Notes to consolidated financial statements 7-31 [LETTERHEAD OF YOUNT, HYDE & BARBOUR, P.C.] INDEPENDENT AUDITOR'S REPORT To the Board of Directors Middleburg Financial Corporation Middleburg, Virginia We have audited the accompanying consolidated balance sheets of Middleburg Financial Corporation and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income, changes in shareholders' equity and cash flows for the years ended December 31, 2002, 2001 and 2000. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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 Middleburg Financial Corporation and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for the years ended December 31, 2002, 2001 and 2000, in conformity with accounting principles generally accepted in the United States of America. /s/ Yount, Hyde & Barbour, P.C. Winchester, Virginia January 17, 2003 1 MIDDLEBURG FINANCIAL CORPORATION Consolidated Balance Sheets December 31, 2002 and 2001 (In Thousands, Except for Share Data) Assets 2002 2001 --------- --------- Cash and due from banks $ 8,338 $ 10,053 Interest-bearing deposits in banks 274 200 Temporary investments: Federal funds sold - - 925 Other money market investments 911 1,797 Securities (fair value: 2002, $163,957; 2001, $124,522) 163,673 124,351 Loans held for sale 17,489 6,652 Loans, net of allowance for loan losses of $2,307 in 2002 and $2,060 in 2001 209,800 194,340 Bank premises and equipment, net 11,814 8,069 Accrued interest receivable and other assets 12,675 7,714 --------- --------- Total assets $ 424,974 $ 354,101 ========= ========= Liabilities and Shareholders' Equity Liabilities Deposits: Noninterest-bearing demand deposits $ 90,413 $ 68,771 Savings and interest-bearing demand deposits 138,661 111,148 Time deposits 99,829 91,812 --------- --------- Total deposits $ 328,903 $ 271,731 Securities sold under agreements to repurchase 8,924 12,011 Federal Home Loan Bank advances - - 7,000 Long-term debt 31,545 20,805 Trust preferred capital notes 10,000 10,000 Accrued interest and other liabilities 4,192 2,216 Commitments and contingent liabilities - - - - --------- --------- Total liabilities $ 383,564 $ 323,763 --------- --------- Shareholders' Equity Common stock, par value $5 per share, authorized 10,000,000 shares; issued 2002, 1,852,682 shares; issued 2001, 1,752,258 shares $ 9,263 $ 8,761 Capital surplus 3,644 741 Retained earnings 25,184 21,084 Accumulated other comprehensive income (loss) 3,319 (248) --------- --------- Total shareholders' equity $ 41,410 $ 30,338 --------- --------- Total liabilities and shareholders' equity $ 424,974 $ 354,101 ========= ========= See Notes to Consolidated Financial Statements. 2 MIDDLEBURG FINANCIAL CORPORATION Consolidated Statements of Income Years Ended December 31, 2002, 2001 and 2000 (In Thousands, Except for Per Share Data)
2002 2001 2000 ---- ---- ---- Interest and Dividend Income Interest and fees on loans $ 16,178 $ 16,327 $ 14,076 Interest on investment securities: Taxable interest income 3 19 25 Interest income exempt from federal income taxes 241 297 354 Interest and dividends on securities available for sale: Taxable interest income 5,365 3,102 3,055 Interest income exempt from federal income taxes 1,568 1,607 1,167 Dividends 277 281 318 Interest on deposits in banks 5 9 4 Interest on federal funds sold 82 117 170 Interest on other money market investments 39 63 40 -------- -------- -------- Total interest and dividend income $ 23,758 $ 21,822 $ 19,209 -------- -------- -------- Interest Expense Interest on deposits $ 4,221 $ 5,841 $ 5,324 Interest on securities sold under agreements to repurchase 181 415 633 Interest on Federal Home Loan Bank borrowings 115 482 584 Interest on long-term debt 2,007 1,076 500 -------- -------- -------- Total interest expense $ 6,524 $ 7,814 $ 7,041 -------- -------- -------- Net interest income $ 17,234 $ 14,008 $ 12,168 Provision for loan losses 300 300 400 -------- -------- -------- Net interest income after provision for loan losses $ 16,934 $ 13,708 $ 11,768 -------- -------- -------- Noninterest Income Service charges, commissions and fees $ 1,960 $ 1,452 $ 1,180 Trust and investment advisory fee income 2,725 1,279 1,594 Fees on loans held for sale 1,935 1,483 643 Gains (losses) on securities available for sale, net (73) 384 (204) Commissions on investment sales 611 485 116 Other 81 128 136 -------- -------- -------- Total noninterest income $ 7,239 $ 5,211 $ 3,465 -------- -------- -------- Noninterest Expenses Salaries and employees' benefits $ 9,383 $ 7,180 $ 5,600 Net occupancy and equipment expense 1,851 1,246 1,172 Advertising 414 320 347 Computer operations 539 408 298 Other operating expenses 3,339 2,793 2,138 -------- -------- -------- Total noninterest expenses $ 15,526 $ 11,947 $ 9,555 -------- -------- -------- Income before income taxes $ 8,647 $ 6,972 $ 5,678 Income tax expense 2,335 1,755 1,450 -------- -------- -------- Net income $ 6,312 $ 5,217 $ 4,228 ======== ======== ======== Earnings per Share, basic $ 3.47 $ 2.99 $ 2.43 ======== ======== ======== Earnings per Share, diluted $ 3.39 $ 2.93 $ 2.41 ======== ======== ========
See Notes to Consolidated Financial Statements. 3 MIDDLEBURG FINANCIAL CORPORATION Consolidated Statements of Changes in Shareholders' Equity Years Ended December 31, 2002, 2001 and 2000 (In Thousands, Except Share Data)
Accumulated Other Compre- Compre- Common Capital Retained hensive hensive Stock Surplus Earnings Income (Loss) Income Total ----- ------- -------- ------------- ------ ----- Balance, December 31, 1999 $ 8,895 $ 1,293 $ 14,852 $ (1,965) $ 23,075 Comprehensive income: Net income - 2000 - - - - 4,228 - - $ 4,228 4,228 Other comprehensive income net of tax: Unrealized holding gains arising during the period (net of tax, $1,150) - - - - - - - - 2,233 - - Reclassification adjustment (net of tax, $69) - - - - - - - - 135 - - -------- Other comprehensive income (net of tax, $1,219) - - - - - - 2,368 $ 2,368 2,368 -------- Total comprehensive income - - - - - - - - $ 6,596 - - ======== Cash dividends - 2000 ($0.84 per share) - - - - (1,464) - - (1,464) Purchase of common stock (57,785 shares) (289) (1,038) - - - - (1,327) Issuance of common stock (18,038 shares) 90 301 - - - - 391 ------- -------- -------- -------- -------- -------- Balance, December 31, 2000 $ 8,696 $ 556 $ 17,616 $ 403 $ 27,271 Comprehensive income: Net income - 2001 - - - - 5,217 - - $ 5,217 5,217 Other comprehensive income net of tax: Unrealized holding losses arising during the period (net of tax, $204) - - - - - - - - (398) - - Reclassification adjustment (net of tax, $131) - - - - - - - - (253) - - -------- Other comprehensive income (net of tax, $335) - - - - - - (651) $ (651) (651) -------- Total comprehensive income - - - - - - - - $ 4,566 - - ======== Cash dividends - 2001 ($1.00 per share) - - - - (1,749) - - (1,749) Purchase of common stock (7,131 shares) (36) (178) - - - - (214) Issuance of common stock (20,142 shares) 101 363 - - - - 464 --- ---- -------- -------- -------- -------- -------- Balance, December 31, 2001 $ 8,761 $ 741 $ 21,084 $ (248) $ 30,338 Comprehensive income: Net income - 2002 - - - - 6,312 - - $ 6,312 6,312 Other comprehensive income net of tax: Unrealized holding gains arising during the period (net of tax, $1,813) - - - - - - - - 3,519 - - Reclassification adjustment (net of tax, $25) - - - - - - - - 48 - - -------- Other comprehensive income (net of tax, $1,704) - - - - - - 3,567 $ 3,567 3,567 -------- Total comprehensive income - - - - - - - - $ 9,879 - - ======== Cash dividends - 2002 ($1.20 per share) - - - - (2,212) - - (2,212) Issuance of common stock (100,424 shares) 502 2,903 - - - - 3,405 -------- -------- -------- -------- -------- Balance, December 31, 2002 $ 9,263 $ 3,644 $ 25,184 $ 3,319 $ 41,410 ======== ======== ======== ======== ======== See Notes to Consolidated Financial Statements.
4 MIDDLEBURG FINANCIAL CORPORATION Consolidated Statements of Cash Flows Years Ended December 31, 2002, 2001 and 2000 (In Thousands)
2002 2001 2000 ---------- --------- --------- Cash Flows from Operating Activities Net income $ 6,312 $ 5,217 $ 4,228 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation 953 692 645 Amortization 313 96 64 Provision for loan losses 300 300 400 Net (gain) loss on securities available for sale 73 (384) 204 Net (gain) loss on sale of assets (3) 2 (7) Net loss on the sale of other real estate - - - - - - Discount accretion and premium amortization on securities, net (57) (110) (20) Deferred income tax provision (benefit) 193 (95) (180) Origination of loans held for sale (121,862) (93,229) (34,837) Proceeds from sales of loans held for sale 111,025 88,708 33,938 Changes in assets and liabilities: (Increase) in other assets (937) (917) (1,058) Increase in other liabilities 235 211 846 ---------- --------- --------- Net cash provided by operating activities $ (3,455) $ 491 $ 4,223 ---------- --------- --------- Cash Flows from Investing Activities Proceeds from maturity, principal paydowns and calls of investment securities $ 897 $ 2,032 $ 772 Proceeds from maturity, principal paydowns and calls of securities available for sale 24,839 9,070 4,527 Proceeds from sale of securities available for sale 21,901 24,050 16,581 Purchase of securities available for sale (81,576) (78,415) (32,316) Proceeds from sale of equipment 31 34 7 Purchases of bank premises and equipment (4,726) (2,448) (709) Net (increase) in loans (16,760) (18,846) (34,412) Purchase of subsidiary (1,240) - - - - ---------- --------- --------- Net cash (used in) investing activities $ (56,634) $ (64,523) $ (45,550) ---------- ---------- ----------
See Notes to Consolidated Financial Statements. 5 MIDDLEBURG FINANCIAL CORPORATION Consolidated Statements of Cash Flows (Continued) Years Ended December 31, 2002, 2001 and 2000 (In Thousands)
2002 2001 2000 ---------- ---------- ---------- Cash Flows from Financing Activities Net increase in noninterest-bearing and interest- bearing demand deposits and savings accounts $ 49,155 $ 33,514 $ 11,147 Net increase in certificates of deposit 8,017 13,577 9,656 Increase (decrease) in securities sold under agreements to repurchase (3,087) (2,310) 3,510 Proceeds from Federal Home Loan Bank advances 95,000 87,600 35,900 Proceeds from long-term debt 11,000 - - 1,300 Proceeds from trust preferred capital notes - - 10,000 - - Payments on Federal Home Loan Bank advances (102,000) (80,600) - - Payments on long-term debt (260) (495) (20,900) Purchase of common stock - - (214) (1,327) Net proceeds from issuance of common stock 906 464 34 Cash dividends paid (2,094) (1,676) (1,402) ---------- --------- ---------- Net cash provided by financing activities $ 56,637 $ 59,860 $ 37,918 ---------- --------- ---------- (Decrease) in cash and and cash equivalents $ (3,452) $ (4,172) $ (3,409) Cash and Cash Equivalents Beginning 12,975 17,147 20,556 ---------- --------- ---------- Ending $ 9,523 $ 12,975 $ 17,147 ========== ========= ========== Supplemental Disclosures of Cash Flow Information Cash payments for: Interest paid to depositors $ 4,772 $ 6,294 $ 5,833 Interest paid on short-term obligations 118 479 445 Interest paid on long-term debt 1,978 1,073 500 ---------- --------- ---------- $ 6,868 $ 7,846 $ 6,778 ========== ========= ========== Income taxes $ 2,158 $ 2,375 $ 1,557 ========== ========= ========== Supplemental Disclosure of Noncash Transactions Issuance of common stock for contingent payment under terms of acquisition of subsidiary $ 2,500 $ - - $ 357 ========== ========= ========== Unrealized (loss) gain on securities available for sale $ 5,405 $ (986) $ 3,587 ========== ========= ========== Note receivable forgiven in connection with purchase of subsidiary $ 1,000 $ - - $ - - ========== ========= ========== Exercise of option to purchase subsidiary $ 1,200 $ - - $ - - ========== ========= ==========
See Notes to Consolidated Financial Statements. 6 MIDDLEBURG FINANCIAL CORPORATION Notes to Consolidated Financial Statements Note 1. Nature of Banking Activities and Significant Accounting Policies Middleburg Financial Corporation's banking subsidiary, The Middleburg Bank, grants commercial, financial, agricultural, residential and consumer loans to customers principally in Loudoun County and Fauquier County, Virginia. The loan portfolio is well diversified and generally is collateralized by assets of the customers. The loans are expected to be repaid from cash flow or proceeds from the sale of selected assets of the borrowers. The Tredegar Trust Company, a non-banking subsidiary, offers a comprehensive range of fiduciary and investment management services to individuals and businesses. The accounting and reporting policies of the Company conform to accounting principles generally accepted in the United States of America and to accepted practice within the banking industry. Principles of Consolidation The consolidated financial statements of Middleburg Financial Corporation (formerly Independent Community Bankshares, Inc.) and its wholly-owned subsidiaries, The Middleburg Bank, The Tredegar Trust Company, Gilkison Patterson Investment Advisors, Inc., Middleburg Bank Service Corporation and ICBI Capital Trust I, include the accounts of all companies. All material intercompany balances and transactions have been eliminated in consolidation. Securities Investments are accounted for as follows: a. Securities Held to Maturity Securities classified as held to maturity are those debt securities the Company 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. b. Securities Available for Sale Securities classified as available for sale are those debt and equity securities that the Company 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 Company'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 increases or decreases in shareholders' equity, net of the related deferred tax effect. Realized gains or losses, determined on the basis of the cost of specific securities sold, are included in earnings. 7 Notes to Consolidated Financial Statements Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the fair value of held to maturity and available for sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method. Loans Held for Sale Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated market value in the aggregate. Substantially all loans originated are held for sale to outside investors. Loans The Company's subsidiary bank grants mortgage, commercial and consumer loans to customers. A substantial portion of the loan portfolio is represented by mortgage loans throughout Loudoun County and Fauquier County, Virginia. The ability of the debtors to honor their contracts is dependent upon the real estate and general economic conditions in this area. Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances less the allowance for loan losses. Interest income is accrued on the unpaid principal balance. The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90 days delinquent unless the credit is well-secured and in the process of collection. Personal loans are typically charged off no later than 180 days past due. In all cases, loans are placed on nonaccrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. Allowance for Loan Losses The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. 8 Notes to Consolidated Financial Statements The allowance for loan losses is evaluated on a regular basis by management and is based upon management's periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available. A loan is considered impaired when, based on current information and events, it is probable that the Company's subsidiary bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's obtainable market price, or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company's subsidiary bank does not separately identify individual consumer and residential loans for impairment disclosures. Loan Fees and Costs Loan origination and commitment fees and direct loan costs are being recognized as collected and incurred. The use of this method of recognition does not produce results that are materially different from results which would have been produced if such costs and fees were deferred and amortized as an adjustment of the loan yield over the life of the related loan. Bank Premises and Equipment Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation of property and equipment is computed principally on the straight-line method over the following estimated useful lives: Years ------- Buildings and improvements 31.5-39 Furniture and equipment 3-10 9 Notes to Consolidated Financial Statements Maintenance and repairs of property and equipment are charged to operations and major improvements are capitalized. Upon retirement, sale or other disposition of property and equipment, the cost and accumulated depreciation are eliminated from the accounts and gain or loss is included in operations. Other Real Estate Real estate acquired by foreclosure is carried at the lower of cost or fair market value less an allowance for estimated selling expenses on the future disposition of the property. Goodwill The Company adopted SFAS No. 142, Goodwill and Other Identifiable Assets, effective January 1, 2002. Accordingly, goodwill is no longer subject to amortization over its estimated useful life, but is subject to at least an annual assessment for impairment by applying a fair value based test. Additionally, under SFAS 142, acquired intangible assets (such as customer relationships and non compete agreements) are separately recognized and amortized over their useful life. Income Taxes Deferred income tax assets and liabilities are determined using the balance sheet method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws. Earnings Per Share Basic earnings per share represents income available to common shareholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options, and are determined using the treasury stock method. Cash and Cash Equivalents For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, other temporary investments and federal funds sold. Generally, federal funds are purchased and sold for one-day periods. 10 Notes to Consolidated Financial Statements Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, deferred taxes, goodwill and intangibles. Advertising Costs The Company follows the policy of charging the costs of advertising to expense as incurred. Comprehensive Income Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available for sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income are components of comprehensive income. Derivative Financial Instruments As part of the Company's asset/liability management, the Company uses interest rate swaps to modify interest rate characteristics of various balance sheet accounts. Derivatives that are used as part of the asset/liability management process are linked to specific assets or liabilities and have high correlation between the contract and the underlying item being hedged, both at inception and throughout the hedge period. Swaps are accounted for on the "accrual" method. Under that method, the interest component associated with the contract is recognized over the life of the contract in net interest income. The Company enters into commitments to originate mortgage loans whereby the interest rate on the loan is determined prior to funding (rate lock commitments). Rate lock commitments on mortgage loans that are intended to be sold are considered to be derivatives. The period of time between issuance of a loan commitment and closing and sale of the loan generally ranges from 60 to 120 days. The Company protects itself from changes in interest rates through the use of best efforts forward delivery commitments, whereby the Company commits to sell a loan at the time the borrower commits to an interest rate with the intent that the buyer has assumed interest rate risk on the loan. Stock-Based Employee Compensation Plan At December 31, 2002, the Company had a stock-based employee compensation plan which is described more fully in Note 8. The Company accounts for the plan under the recognition and measurement principles of APB opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise 11 Notes to Consolidated Financial Statements price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation. In determining the pro forma amounts below, the value of each grant is estimated at the grant date using the Black-Scholes option-pricing model, with the following weighted-average assumptions for grants in 2002 and 2000;dividend rate of 0.22% and 0.20%; risk-free interest rate of 5.51% and 5.35%; expected lives of 10 years; and expected price volatility of 18.71% and 17.96%. No options were granted during 2001. Year Ended December 31, -------------------------------------- 2002 2001 2000 --------- --------- --------- Net income, as reported $ 6,312 $ 5,217 $ 4,228 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards (289) (223) (317) --------- --------- --------- Pro forma net income $ 6,023 $ 4,994 $ 3,911 ========= ========= ========= Earnings per share: Basic - as reported $ 3.47 $ 2.99 $ 2.43 Basic - pro forma 3.31 2.86 2.25 Diluted - as reported 3.39 2.93 2.41 Diluted - pro forma 3.23 2.80 2.23 Note 2. Securities Amortized costs and fair values of securities being held to maturity as of December 31, 2002 and 2001 are summarized as follows:
Gross Gross Amortized Unrealized Unrealized Fair Cost Gains (Losses) Value ---------- ---------- ---------- --------- 2002 ----------------------------------------------------------- (In Thousands) Obligations of states and political subdivisions $ 4,590 $ 28 $ - - $ 4,874 Mortgage-backed securities 53 - - - - 53 ---------- ---------- ---------- --------- $ 4,643 $ 284 $ - - $ 4,927 ========== ========== ========== ========= 2001 ----------------------------------------------------------- (In Thousands) Obligations of states and political subdivisions $ 5,484 $ 17 $ - - $ 5,655 Mortgage-backed securities 61 - - - - 61 ---------- ---------- ---------- --------- $ 5,545 $ 171 $ - - $ 5,716 ---------- ---------- ---------- ---------
12 Notes to Consolidated Financial Statements The amortized cost and fair value of securities being held to maturity as of December 31, 2002 by contractual maturity are shown below. Maturities may differ from contractual maturities in mortgage-backed securities because the mortgages underlying the securities may be called or repaid without any penalties. Therefore, these securities are not included in the maturity categories in the following maturity summary. Amortized Fair Cost Value -------- -------- (In Thousands) Due in one year or less $ 376 $ 377 Due after one year through five years 2,630 2,780 Due after five years through 10 years 1,584 1,717 Mortgage-backed securities 53 53 -------- -------- $ 4,643 $ 4,927 ======== ======== Amortized costs and fair values of securities available for sale as of December 31, 2002 and 2001, are summarized as follows:
Gross Gross Amortized Unrealized Unrealized Fair Cost Gains (Losses) Value ---------- ---------- ---------- ---------- 2002 ------------------------------------------------------- (In Thousands) U.S. Treasury securities and obligations of U.S. Government corporations and agencies $ 4,360 $ 46 $ - - $ 4,406 Obligations of states and political subdivisions 31,195 1,444 - - 32,639 Mortgage-backed securities 98,877 3,651 (7) 102,521 Corporate preferred 2,221 93 (31) 2,283 Restricted stock 2,324 - - - - 2,324 Other 15,024 204 (371) 14,857 ---------- ---------- ---------- ---------- $ 154,001 $ 5,438 $ (409) $ 159,030 ========== ========== ========== ==========
13 Notes to Consolidated Financial Statements
Gross Gross Amortized Unrealized Unrealized Fair Cost Gains (Losses) Value ---------- ---------- ---------- ---------- 2001 ---------------------------------------------------- (In Thousands) U.S. Treasury securities and obligations of U.S. Government corporations and agencies $ 249 $ 18 $ - - $ 267 Obligations of states and political subdivisions 33,338 381 (499) 33,220 Mortgage-backed securities 64,206 231 (691) 63,746 Corporate preferred 2,188 25 (28) 2,185 Restricted stock 2,134 - - - - 2,134 Other 17,067 265 (78) 17,254 ---------- ---------- ---------- ---------- $ 119,182 $ 920 $ (1,296) $ 118,806 ========== ========== ========== ==========
The amortized cost and fair value of securities available for sale as of December 31, 2002, by contractual maturity are shown below. Maturities may differ from contractual maturities in corporate and mortgage-backed securities because the securities and mortgages underlying the securities may be called or repaid without any penalties. Therefore, these securities are not included in the maturity categories in the following maturity summary. Amortized Fair Cost Value ---------- ---------- (In Thousands) Due in one year or less $ 1,378 $ 1,388 Due after one year through five years 5,416 5,568 Due after five years through 10 years 11,046 11,685 Due after 10 years 17,715 18,404 Mortgage-backed securities 98,877 102,521 Corporate preferred 2,221 2,283 Restricted stock 2,324 2,324 Other 15,024 14,857 ---------- ---------- $ 154,001 $ 159,030 ========== ========== Proceeds from sales of securities available for sale during 2002, 2001 and 2000 were $21,900,811 , $24,050,000 and $16,581,000, respectively. Gross gains of $ 80,419, $533,000 and $23,000 and gross losses of $153,887, $149,000 and $227,000 were realized on those sales, respectively. The carrying value of securities pledged to qualify for fiduciary powers, to secure public monies as required by law and for other purposes amounted to $13,559,852 and $27,701,000 at December 31, 2002 and 2001, respectively. 14 Notes to Consolidated Financial Statements Note 3. Loans, Net
December 31, -------------------------------------- 2002 2001 --------------- --------------- (In Thousands) Mortgage loans on real estate: Construction $ 22,008 $ 24,174 Secured by farmland 482 163 Secured by 1-4 family residential 84,389 89,095 Other real estate loans 73,164 48,074 Loans to farmers (except secured by real estate) 686 632 Commercial loans 19,637 22,361 Loans to individuals for personal expenditures 11,550 11,735 All other loans 191 166 --------------- --------------- Total loans $ 212,107 $ 196,400 Less: Allowance for loan losses 2,307 2,060 --------------- --------------- Net loans $ 209,800 $ 194,340 =============== ===============
Note 4. Allowance for Loan Losses
2002 2001 2000 ----------- ----------- ----------- (In Thousands) Balance, beginning $ 2,060 $ 1,804 $ 1,453 Provision charged to operating expense 300 300 400 Recoveries 21 39 47 Loan losses charged to the allowance (74) (83) (96) ----------- ----------- ----------- $ 2,307 $ 2,060 $ 1,804 =========== =========== ===========
There were no loans recognized for impairment under SFAS No. 114 as of December 31, 2002 and 2001. The average recorded investment in impaired loans during 2000 was $15,000. No interest income on impaired loans was recognized in 2002, 2001 and 2000. Nonaccrual loans excluded from impaired loan disclosure under SFAS No. 114 amounted to $1,063,000 and $79,000 at December 31, 2002 and 2001, respectively. If interest on these loans had been accrued, such income would have approximated $41,000 and $700 for 2002 and 2001, respectively. 15 Notes to Consolidated Financial Statements Note 5. Bank Premises and Equipment, Net Bank premises and equipment consists of the following:
2002 2001 ------------ ------------- (In Thousands) Land $ 2,262 $ 2,022 Banking facilities 7,621 3,907 Furniture, fixtures and equipment 7,279 5,400 Construction in progress and deposits on equipment 210 1,406 ------------ ------------- $ 17,372 $ 12,735 Less accumulated depreciation 5,558 4,666 ------------ ------------- $ 11,814 $ 8,069 ============ =============
Depreciation expense was $953,000, $692,000, and $645,000 for the years ended December 31, 2002, 2001 and 2000, respectively. Note 6. Deposits The aggregate amount of jumbo time deposits, each with a minimum denomination of $100,000, was approximately $ 56,636,000 and $45,679,000 in 2002 and 2001, respectively. At December 31, 2002, the scheduled maturities of time deposits (in thousands) are as follows: 2003 57,578 2004 23,852 2005 7,215 2006 4,575 2007 6,418 Thereafter 191 ------------ $ 99,829 ------------ At December 31, 2002 and 2001, overdraft demand deposits reclassified to loans totaled $191,000 and $166,000, respectively. Note 7. Borrowings The Company has a $82,690,000 line of credit with the Federal Home Loan Bank of Atlanta. Advances on the line are secured by all of the Company's first lien loans on one-to-four unit single-family dwellings. As of December 31, 2002, the book value of these loans totaled approximately $67,000,000. The amount of the available credit is limited to seventy-five percent of qualifying collateral. Any borrowings in excess of the qualifying collateral require pledging of additional assets. 16 Notes to Consolidated Financial Statements The Company's fixed-rate long-term debt with the Federal Home Loan Bank of $31,000,000 at December 31, 2002 matures through 2012. During 2002 and 2001, the interest rates ranged from 3.83 percent to 6.16 percent and from 4.73 percent to 6.16 percent, respectively. At December 31, 2002 and 2001, the weighted average interest rates were 5.13 percent and 5.73 percent, respectively. At December 31, 2002, the Company had floating-rate long-term debt with other institutions totaling $ 545,000 and maturing on March 31, 2003. The floating rate is based on the 30-day LIBOR plus 115 basis points. The interest rate ranged from 2.53 % to 3.03 % during 2002. The contractual maturities of the Company's long-term debt are as follows: 2002 ------------- (In Thousands) Due in 2003 $ 545 Due in 2004 11,000 Due in 2005 15,000 Due in 2012 5,000 ------------- $ 31,545 The Company has an additional $5,300,000 in lines of credit available from other institutions at December 31, 2002. Note 8. Stock Option Plan The Company sponsors a stock option plan, which provides for the granting of both incentive and nonqualified stock options. Under the plan, the Company may grant options to its officers and employees for up to 190,000 shares of common stock. The exercise price of each option equals the market price of the Company's stock on the date of grant. The options vest over the three years following the date of grant. All options expire ten years from the grant date. 17 Notes to Consolidated Financial Statements Options outstanding at December 31, 2002, 2001 and 2000 are summarized as follows:
2002 2001 2000 ------------------- -------------------- --------------------- Weighted Weighted Weighted Average Average Average Exercise Exercise Exercise Shares Price Shares Price Shares Price ------ -------- ------ --------- ------ -------- Outstanding at beginning of year 104,425 $ 20.76 154,825 $ 21.15 123,825 $ 21.13 Granted 27,500 45.50 - - - - 31,000 21.66 Exercised (40,550) 17.10 (22,442) 20.29 - - - - Forfeited - - - - (27,958) 23.28 - - - - ------- ------- ------- Outstanding at end of year 91,375 $ 29.80 104,425 $ 20.76 154,825 $ 21.15 ======= ======= ======= Options exercisable at year end 69,600 $ 25.71 94,425 $ 20.62 116,749 $ 20.69 Weighted average fair value of options granted during the year $ 12.04 $ - - $ 9.20
As of December 31, 2002, options outstanding and exercisable are summarized as follows: Weighted Remaining Exercise Options Contractual Options Prices Outstanding Life Exercisable ------------ ----------- ----------- ----------- $ 17.00 2,000 4.9 2,000 23.50 18,000 6.0 18,000 24.50 3,875 6.7 3,875 24.75 20,000 7.0 20,000 21.25 20,000 8.0 17,640 45.50 27,500 9.3 8,085 Note 9. Employee Benefit Plans The Company has a noncontributory, defined benefit pension plan covering substantially all full-time employees. The Company funds pension costs in accordance with the funding provisions of the Employee Retirement Income Security Act. Information about the plan follows: 18 Notes to Consolidated Financial Statements 2002 2001 2000 ------- ------- ------- (In Thousands) Change in Benefit Obligation Benefit obligation, beginning of year $ 2,299 $ 1,862 $ 2,002 Service cost 155 274 215 Interest cost 172 140 150 Plan amendments - - - - (350) Actuarial loss (gain) (181) 42 (33) Benefits paid (329) (19) (122) ------- ------- ------- Benefit obligation, end of year $ 2,116 $ 2,299 $ 1,862 ------- ------- ------- Change in Plan Assets Fair value of plan assets, beginning of year $ 1,736 $ 1,894 $ 1,562 Actual return on plan assets (131) (289) 269 Employer contributions 705 151 185 Benefits paid (329) (20) (122) ------- ------- ------- Fair value of plan assets, ending $ 1,981 $ 1,736 $ 1,894 ------- ------- ------- Funded status $ (135) $ (563) $ 32 Unrecognized net actuarial loss 1,034 956 463 Unrecognized net obligation at transition (24) (28) (32) Unrecognized prior service cost (199) (199) (200) ------- ------- ------- Prepaid benefit cost included in other assets $ 676 $ 166 $ 263 ======= ======= ======= Components of Net Periodic Benefit Cost Service cost $ 155 $ 274 $ 215 Interest cost 172 140 150 Expected return on plan assets (163) (174) (140) Amortization of prior service cost (1) (1) 17 Amortization of net obligation at transition (4) (4) (4) Recognized net actuarial loss 35 14 22 ------- ------- ------- Net periodic benefit cost $ 194 $ 249 $ 260 ======= ======= ======= Weighted-Average Assumptions as of December 31 Discount rate 7.25% 7.50% 7.50% Expected return on plan assets 9.00% 9.00% 9.00% Rate of compensation increase 5.00% 5.00% 5.00% 19 Notes to Consolidated Financial Statements A deferred compensation plan was adopted for the President and Chief Executive Officer. Benefits are to be paid in monthly installments for 15 years following retirement or death. The agreement provides that if employment is terminated for reasons other than death or disability prior to age 65, the amount of benefits would be reduced. The deferred compensation expense for 2002, 2001 and 2000, based on the present value of the retirement benefits, was $23,320, $21,794, and $20,368. The plan is unfunded. However, life insurance has been acquired on the life of the employees in amounts sufficient to discharge the obligations. Note 10. Income Taxes Net deferred tax assets (liabilities) consist of the following components as of December 31, 2002 and 2001: 2002 2001 ------- ------- (In Thousands) Deferred tax assets: Allowance for loan losses $ 670 $ 585 Deferred compensation 60 52 Other 25 13 Securities available for sale - - 128 ------- ------- $ 755 $ 778 ------- ------- Deferred tax liabilities: Property and equipment $ 423 $ 243 Prepaid pension costs 244 126 Securities available for sale 1,712 - - ------- ------- $ 2,379 $ 369 ------- ------- $(1,624 ) $ 409 ======= ======= The provision for income taxes charged to operations for the years ended December 31, 2002, 2001 and 2000 consists of the following: 2002 2001 2000 ---- ---- ---- (In Thousands) Current tax expense $ 2,142 $ 1,850 $ 1,630 Deferred tax provision (benefit) 193 (95) (180) ------- ------- ------- $ 2,335 $ 1,755 $ 1,450 ======= ======= ======= 20 Notes to Consolidated Financial Statements 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, 2002, 2001 and 2000, due to the following: 2002 2001 2000 ---- ---- ---- (In Thousands) Computed "expected" tax expense $ 2,940 $ 2,370 $ 1,931 (Decrease) in income taxes resulting from: Tax-exempt interest income (594) (578) (466) Other, net (11) (37) (15) ------- ------- ------- $ 2,335 $ 1,755 $ 1,450 ======= ======= ======= Note 11. Related Party Transactions The Company's subsidiary bank has had, and may be expected to have in the future, banking transactions in the ordinary course of business with directors, principal officers, their immediate families and affiliated companies in which they are principal stockholders (commonly referred to as related parties), on the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with others. These persons and firms were indebted to the subsidiary bank for loans totaling $4,211,000 and $2,550,000 at December 31, 2002 and 2001, respectively. During 2002, total principal additions were $2,854,000 and total principal payments were $1,193,000. Note 12. Contingent Liabilities and Commitments In the normal course of business, there are outstanding various commitments and contingent liabilities, which are not reflected in the accompanying financial statements. The Company does not anticipate any material loss as a result of these transactions. See Note 15 with respect to financial instruments with off-balance-sheet risk. The Company must maintain a reserve against its deposits in accordance with Regulation D of the Federal Reserve Act. For the final weekly reporting period in the years ended December 31, 2002 and 2001, the aggregate amount of daily average required reserves for each year was approximately $25,000. 21 Notes to Consolidated Financial Statements Note 13. 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.
2002 2001 2000 ------------------------ ------------------------ ------------------------ Per Per Per Share Share Share Shares Amount Shares Amount Shares Amount --------- ---------- --------- ---------- --------- ---------- Basic EPS 1,821,000 $ 3.47 1,746,000 $ 2.99 1,741,000 $ 2.43 ========== ========== ========== Effect of dilutive securities: Stock options 42,000 37,000 11,000 --------- ---------- --------- Diluted EPS 1,863,000 $ 3.39 1,783,000 $ 2.93 1,752,000 $ 2.41 ========= =========== ========== ========== ========= ==========
In 2002 and 2000, stock options representing 6,875 and 69,825 shares, respectively, were not included in the calculation of earnings per share because they would have been antidilutive. No options were excluded from the computation of diluted earnings per share for the year ended December 31, 2001. Note 14. Retained Earnings Transfers of funds from the banking subsidiary to the Parent Company in the form of loans, advances and cash dividends are restricted by federal and state regulatory authorities. As of December 31, 2002, the aggregate amount of unrestricted funds which could be transferred from the Company's subsidiaries to the Parent Company, without prior regulatory approval, totaled $11,010,000 or 27.0 % of the total consolidated net assets. Note 15. Financial Instruments With Off-Balance-Sheet Risk and Credit Risk The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit, standby letters of credit and interest rate swaps. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments. The Company'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 Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. 22 Notes to Consolidated Financial Statements A summary of the contract amount of the Company's exposure to off-balance-sheet risk as of December 31, 2002 and 2001, is as follows: 2002 2001 ------------ ------------ (In Thousands) Financial instruments whose contract amounts represent credit risk: Commitments to extend credit $ 31,590 $ 34,244 Standby letters of credit 1,969 2,343 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 Company evaluates each customer's credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management's credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property and equipment, and income-producing commercial properties. Unfunded commitments under lines of credit are commitments for possible future extensions of credit to existing customers. Those lines of credit may not be drawn upon to the total extent to which the Company is committed. Standby letters of credit are conditional commitments issued by the Company 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 Company holds certificates of deposit, deposit accounts, and real estate as collateral supporting those commitments for which collateral is deemed necessary. The extent of collateral held for those commitments at December 31, 2002 averages 66.0 percent. The Company has utilized derivative instruments in the form of interest rate swaps during the years 2002 and 2001. Interest rate swaps are contracts in which a series of interest flows in a single currency are exchanged over a prescribed period. These transactions involve both credit and market risk. The notional amounts are amounts on which calculations and payments are based. The notional amounts are not exchanged and do not represent direct credit exposure. Direct credit exposure is limited to the net difference between the calculated amounts to be received and paid, if any. 23 Notes to Consolidated Financial Statements During May 2000, the Company entered into two interest rate swap agreements to assume variable market-indexed interest payments in exchange for fixed-rate interest payments (interest rate swaps). The notional principal amount of interest rate swaps outstanding was $8,525,000 at December 31, 2001 and 2000. The original term to maturity was 24 months. The weighted-average fixed payment rate was 7.00% at December 31, 2002 and 2001. Variable interest payments received are based on three-month LIBOR. At December 31, 2002 and 2001, the weighted average rate of variable market-indexed interest payment obligations to the Company was 1.56 % and 1.67%, respectively. The effect of these agreements was to transform fixed rate liabilities to variable rate liabilities. The net income from these agreements was $ 169,774 and $250,848 for the twelve-month periods ended December 31, 2002 and 2001, which was charged to income as it accrued. During 2002 and 2001, interest rate swaps used for other-than-trading purposes modify the interest rate exposure in the Company's interest-bearing deposits. The Company has approximately $4,288,237 in deposits in financial institutions in excess of amounts insured by the Federal Deposit Insurance Corporation (FDIC) at December 31, 2002. Note 16. Fair Value of Financial Instruments and Interest Rate Risk The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: Cash and Short-Term Investments For those short-term instruments, the carrying amount is a reasonable estimate of fair value. Securities For securities held for investment purposes, fair values are based on quoted market prices or dealer quotes. Loans Held for Sale Fair values of loans held for sale are based on commitments on hand from investors or prevailing market prices. Loans For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values for other loans were estimated using discounted cash flow analyses, using interest rates currently being offered. Accrued Interest The carrying amounts of accrued interest approximate fair values. 24 Notes to Consolidated Financial Statements Deposits and Borrowings The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. For all other deposits and borrowings, the fair value is determined using the discounted cash flow method. The discount rate was equal to the rate currently offered on similar products. Off-Balance-Sheet Financial Instruments The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present credit worthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date. At December 31, 2002 and 2001, the carrying amounts of loan commitments and standby letters of credit approximated fair values. Fair values for off-balance-sheet derivative financial instruments, for other-than-trading purposes, are based upon quoted market prices. The estimated fair values, and related carrying amounts, of the Company's financial instruments are as follows:
2002 2001 ---------------------- ---------------------- Carrying Fair Carrying Fair Amount Value Amount Value -------- -------- -------- -------- (In Thousands) Financial assets: Cash and short-term investments $ 9,523 $ 9,523 $ 12,975 $ 12,975 Securities 163,673 163,957 124,351 124,522 Loans held for sale 17,489 17,533 6,652 6,668 Loans 209,800 212,857 194,340 203,720 Accrued interest receivable 2,051 2,051 1,984 1,984 Financial liabilities: Deposits $328,903 $330,768 $271,731 $272,864 Securities sold under agreements to repurchase 8,924 8,924 12,011 12,011 Federal Home Loan Bank advances - - - - 7,000 7,000 Long-term debt 31,545 33,180 20,805 23,136 Trust preferred capital notes 10,000 10,000 10,000 10,000 Accrued interest payable 681 681 819 819 Off-balance-sheet derivative financial instruments: Other-than-trading assets: Interest rate swaps $ - - $ - - $ - - $ 225
25 Notes to Consolidated Financial Statements The Company assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of the Company's financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Company. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Company's overall interest rate risk. Note 17. Capital Requirements The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - possibly additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the Company's and Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company's and the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank 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, 2002 and 2001, that the Company and the Bank meet all capital adequacy requirements to which they are subject. As of December 31, 2002, the most recent notification from the Federal Reserve Bank categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution 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. 26 Notes to Consolidated Financial Statements The Company's and the Bank's actual capital amounts and ratios are also presented in the table.
Minimum To Be Well Minimum Capitalized Under Capital Prompt Corrective Actual Requirement Action Provisions -------------------------- ------------------------- ------------------------ Amount Ratio Amount Ratio Amount Ratio ------ ----- ------ ----- ------ ----- (In Thousands) As of December 31, 2002: Total Capital (to Risk Weighted Assets): Consolidated $ 43,496 15.6% $ 22,258 8.0% N/A The Middleburg Bank $ 39,804 15.6% $ 20,396 8.0% $ 25,495 10.0% Tier 1 Capital (to Risk Weighted Assets): Consolidated $ 41,189 14.8% $ 11,129 4.0% N/A The Middleburg Bank $ 37,497 14.7% $ 10,198 4.0% $ 15,297 6.0% Tier 1 Capital (to Average Assets): Consolidated $ 41,189 10.6% $ 15,597 4.0% N/A The Middleburg Bank $ 37,497 9.9% $ 15,154 4.0% $ 18,943 5.0% As of December 31, 2001: Total Capital (to Risk Weighted Assets): Consolidated $ 41,374 17.3% $ 19,088 8.0% N/A The Middleburg Bank $ 34,969 15.0% $ 18,675 8.0% $ 23,344 10.0% Tier 1 Capital (to Risk Weighted Assets): Consolidated $ 39,084 16.4% $ 9,544 4.0% N/A The Middleburg Bank $ 32,909 14.1% $ 9,338 4.0% $ 14,007 6.0% Tier 1 Capital (to Average Assets): Consolidated $ 39,084 12.5% $ 12,542 4.0% N/A The Middleburg Bank $ 32,909 10.8% $ 12,218 4.0% $ 15,273 5.0%
Note 18. Acquisition On August 9, 1999, the Company purchased one percent of the issued and outstanding capital stock of Gilkison Patterson Investment Advisors, Inc. ("GPIA"), an investment advisory firm based in Alexandria, Virginia. The Company also acquired the right to purchase all of the remaining authorized, issued and outstanding shares of GPIA's capital stock on or after July 1, 2001. This option was extended through June 30, 2002. On April 1, 2002, the Company completed the acquisition of GPIA. The terms of the transaction included a total purchase price of $6 million, which included 59,874 shares ($2.5 million value) of the Company's common stock issued to the shareholders of GPIA. Based on a purchase price valuation, the Company allocated approximately 61% of the purchase price to identified intangibles with a weighted-average life of 12.5 years. The remaining 39% of the purchase price has been treated as goodwill. 27 Notes to Consolidated Financial Statements Note 19. Trust Preferred Capital Notes On November 14, 2001, ICBI Capital Trust I, a wholly-owned subsidiary of the Company, was formed for the purpose of issuing redeemable Capital Securities. On November 28, 2001, $10 million of trust preferred securities were issued through a pooled underwriting totaling approximately $750 million. The securities have a LIBOR-indexed floating rate of interest. During 2002, the interest rates ranged from 5.17% to 5.85%. At December 31, 2002 the weighted-average interest rate was 5.79%. The securities have a mandatory redemption date of December 8, 2031, and are subject to varying call provisions beginning December 8, 2006. The principal asset of the Trust is $10 million of the Company's junior subordinated debt securities with the like maturities and like interest rates to the Capital Securities. The Trust Preferred Securities may be included in Tier 1 capital for regulatory capital adequacy determination purposes up to 25% of Tier 1 capital after its inclusion. The portion of the Trust Preferred not considered as Tier 1 capital may be included in Tier 2 capital. The obligations of the Company with respect to the issuance of the Capital Securities constitute a full and unconditional guarantee by the Company of the Trust's obligations with respect to the Capital Securities. Subject to certain exceptions and limitations, the Company may elect from time to time to defer interest payments on the junior subordinated debt securities, which would result in a deferral of distribution payments on the related Capital Securities. 28 Notes to Consolidated Financial Statements Note 20. Condensed Financial Information - Parent Corporation Only MIDDLEBURG FINANCIAL CORPORATION (Parent Corporation Only) Balance Sheets December 31, 2002 and 2001
Assets 2002 2001 -------- -------- (In Thousands) Cash on deposit with subsidiary bank $ 95 $ 35 Money market fund 556 1,409 Securities available for sale 2,292 2,273 Investment in subsidiaries, at cost, plus equity in undistributed net income 42,228 33,881 Note receivable - - 1,000 Goodwill 3,422 1,272 Intangible assets 3,481 - - Other assets 454 1,770 -------- -------- Total assets $ 52,528 $ 41,640 ======== ======== Liabilities and Shareholders' Equity Liabilities Long-term debt $ 545 $ 805 Trust preferred capital notes 10,000 10,000 Other liabilities 573 497 -------- -------- Total liabilities $ 11,118 $ 11,302 -------- -------- Shareholders' Equity Common stock $ 9,263 $ 8,761 Capital surplus 3,644 741 Retained earnings 25,184 21,084 Accumulated other comprehensive income (loss) 3,319 (248) -------- -------- Total shareholders' equity $ 41,410 $ 30,338 -------- -------- Total liabilities and shareholders' equity $ 52,528 $ 41,640 ======== ========
29 Notes to Consolidated Financial Statements MIDDLEBURG FINANCIAL CORPORATION (Parent Corporation Only) Statements of Income Years Ended December 31, 2002, 2001 and 2000
2002 2001 2000 ------- ------- ------- (In Thousands) Income Dividends from subsidiaries $ 2,555 $ 1,795 $ 1,500 Interest and dividends from investments 158 169 224 Interest on money market 14 18 6 Interest from loan to GPIA 16 74 80 Management fees from GPIA 40 78 77 Gains (losses) on securities available for sale, net (6) 119 (5) ------- ------- ------- Total income $ 2,777 $ 2,253 $ 1,882 ------- ------- ------- Expenses Salaries and employee benefits $ 2 $ 16 $ 123 Amortization 313 96 64 Legal and professional fees 73 63 65 Printing and supplies 51 1 9 Directors fees - - 50 34 Advertising 115 - - - - Interest expense on loan from subsidiary - - 37 40 Interest expense other 584 114 76 Other 145 145 156 ------- ------- ------- Total expenses $ 1,310 $ 66 $ 567 ------- ------- ------- Income before allocated tax benefits and undistributed income of subsidiaries $ 1,467 $ 1,586 $ 1,315 Income tax (benefit) (296) (49) (34) ------- ------- ------- Income before equity in undistributed income of subsidiaries $ 1,763 $ 1,635 $ 1,349 Equity in undistributed income of subsidiaries 4,549 $ 3,582 $ 2,879 ------- ------- ------- Net income $ 6,312 $ 5,217 $ 4,228 ======= ======= =======
30 Notes to Consolidated Financial Statements MIDDLEBURG FINANCIAL CORPORATION (Parent Corporation Only) Statements of Cash Flows Years Ended December 31, 2002, 2001 and 2000
2002 2001 2000 ------- ------- ------- (In Thousands) Cash Flows from Operating Activities Net income $ 6,312 $ 5,217 $ 4,228 Adjustments to reconcile net income to net cash provided by operating activities: Amortization 313 96 64 Undistributed earnings of subsidiaries (4,549) (3,582) (2,879) (Gain) loss on sale of securities available for sale 6 (119) 5 (Increase) in other assets (190) (300) (19) Increase (decrease) in other liabilities (42) (10) 92 ------- ------- ------- Net cash provided by operating activities $ 1,850 $ 1,302 $ 1,491 ------- ------- ------- Cash Flows from Investing Activities Purchase of securities available for sale $ (156) $ (162) $- - Proceeds from sale of securities available for sale 201 503 100 Investment in subsidiary bank - - (8,000) - - Purchase of subsidiary (1,240) - - - - ------- ------- ------- Net cash provided by (used in) investing activities $(1,195) $(7,659) $ 100 ------- ------- ------- Cash Flows from Financing Activities Proceeds from issuance of trust preferred capital notes $ - - $ 10,000 $ - - Proceeds from long-term debt - - - - 1,300 Payments on long-term debt (260) (495) - - Payment of note payable to subsidiary - - (500) - - Purchase of common stock - - (214) (1,327) Net proceeds from issuance of common stock 906 464 34 Cash dividends paid (2,094) (1,676) (1,402) ------- ------- ------- Net cash provided by (used in) financing activities $(1,448) $ 7,579 $(1,395) ------- ------- ------- Increase (decrease) in cash and cash equivalents $ (793) $ 1,222 $ 196 Cash and Cash Equivalents Beginning 1,444 $ 222 $ 26 ------- ------- ------- Ending $ 65 $ 1,444 $ 222 ======= ======= ======= Supplemental Disclosure of Noncash Transactions Issuance of common stock for contingent payment under terms of acquisition of subsidiary $ 2,500 $ - - $ 357 ======= ======= ======= Note receivable forgiven in connection with purchase of subsidiary $ 1,000 $ - - - - ======= ======= ======= Exercise of option to purchase subsidiary $ 1,200 $ - - - - ======= ======= =======
31 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MIDDLEBURG FINANCIAL CORPORATION Date: March 28, 2003 By: /s/ Joseph L. Boling -------------------------------------- Joseph L. Boling Chairman of the Board, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature Title Date --------- ----- ---- /s/ Joseph L. Boling Chairman of the Board, President and Chief March 28, 2003 ------------------------------------------- Executive Officer and Director Joseph L. Boling (Principal Executive Officer) /s/ Alice P. Frazier Executive Vice President and March 28, 2003 ------------------------------------------- Chief Financial Officer Alice P. Frazier (Principal Financial Officer) /s/ Kathleen J. Chappell Senior Vice President and Controller March 28, 2003 ------------------------------------------- (Principal Accounting Officer) Kathleen J. Chappell /s/ Howard M. Armfield Director March 28, 2003 ------------------------------------------- Howard M. Armfield /s/ Childs Frick Burden Director March 28, 2003 ------------------------------------------- Childs Frick Burden /s/ J. Lynn Cornwell, Jr. Director March 28, 2003 ------------------------------------------- J. Lynn Cornwell, Jr. /s/ William F. Curtis Director March 28, 2003 ------------------------------------------- William F. Curtis Director March 28, 2003 ------------------------------------------- Robert C. Gilkison Director March 28, 2003 ------------------------------------------- C. Oliver Iselin, III Director March 28, 2003 ------------------------------------------- Gary D. LeClair Director March 28, 2003 ------------------------------------------- Thomas W. Nalls /s/ John Sherman Director March 28, 2003 ------------------------------------------- John Sherman /s/ Millicent W. West Director March 28, 2003 ------------------------------------------- Millicent W. West /s/ Edward T. Wright Director March 28, 2003 ------------------------------------------- Edward T. Wright
CERTIFICATION I, Joseph L. Boling, Chairman of the Board, President and Chief Executive Officer of Middleburg Financial Corporation, certify that: 1. I have reviewed this annual report on Form 10-K of Middleburg Financial Corporation; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: (a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and (c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 28, 2003 /s/ Joseph L. Boling ----------------------------------- Joseph L. Boling Chairman of the Board, President and Chief Executive Officer CERTIFICATION I, Alice P. Frazier, Executive Vice President and Chief Financial Officer of Middleburg Financial Corporation, certify that: 1. I have reviewed this annual report on Form 10-K of Middleburg Financial Corporation; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: (a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and (c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 28, 2003 /s/ Alice P. Frazier -------------------------------------- Alice P. Frazier Executive Vice President and Chief Financial Officer EXHIBIT INDEX Exhibit No. Description ----------- ----------- 3.1 Articles of Incorporation of the Company (restated in electronic format). 3.2 Bylaws of the Company, attached as Exhibit 3.2 to the Registration Statement on Form S-4, Registration No. 333-24523, filed with the Commission on April 4, 1997, incorporated herein by reference. 10.1 Employment Agreement, dated as of January 1, 1998, between the Company and Joseph L. Boling, attached as Exhibit 10.1 to the Company's Annual Report on Form 10-KSB for the year ended December 31, 1998, incorporated herein by reference. 10.2 Independent Community Bankshares, Inc. 1997 Stock Option Plan, as amended, attached as Exhibit 4.3 to the Registration Statement on Form S-8, Registration No. 333-93447, filed with the Commission on December 22, 1999, incorporated herein by reference. 10.3 Agreement and Plan of Reorganization dated as of August 9, 1999, between Gilkison Patterson Investment Advisors, Inc. ("GPIA"), the Company and Tredegar, attached as Exhibit 10.1 to the Company's Quarterly Report on Form 10-QSB for the period ended September 30, 1999 (the "Form 10-QSB"), incorporated herein by reference. 10.4 Shareholder Agreement dated as of August 9, 1999, between Robert C. Gilkison, James H. Patterson, the Company and GPIA, attached as Exhibit 10.2 to the Form 10-QSB, incorporated herein by reference. 10.5 Stock Purchase Agreement dated as of August 9, 1999, between Robert C. Gilkison, James H. Patterson and the Company, attached as Exhibit 10.3 to the Form 10-QSB, incorporated herein by reference. 10.6 Employment Agreement, dated as of August 9, 1999, between GPIA and James H. Patterson. 21 Subsidiaries of the Company. 23.1 Consent of Yount, Hyde & Barbour, P.C. 99.1 Statement of Chief Executive Officer Pursuant to 18 U.S.C.ss.1350. 99.2 Statement of Chief Financial Officer Pursuant to 18 U.S.C.ss.1350. (All exhibits not incorporated herein by reference are attached as exhibits to the Company's Annual Report on Form 10-K for the year ended December 31, 2002, as filed with the Securities and Exchange Commission.)