ITEM 1A. RISK FACTORS
The significant risks and uncertainties related to us, our business and our securities of which we are aware are discussed below. Investors and shareholders should carefully consider these risks and uncertainties before making investment decisions with respect to the Corporation’s securities. Any of these factors could materially and adversely affect our business, financial condition, operating results and prospects and could negatively impact the market price of the Corporation’s securities. If any of these risks materialize, the holders of the Corporation’s securities could lose all or part of their investments in the Corporation. Additional risks and uncertainties that we do not yet know of, or that we currently think are immaterial, may also impair our business operations. Investors and shareholders should also consider the other information contained in this annual report, including our financial statements and the related notes, before making investment decisions with respect to the Corporation’s securities.
Risks Relating to the COVID-19 Global Pandemic
The COVID-19 pandemic has adversely impacted our business and financial results and that of many of our customers, and the ultimate impact will depend on future developments, which are highly uncertain, cannot be predicted, and are largely outside of our control, including the scope and duration of the pandemic and actions taken by governmental authorities in response to the pandemic.
The COVID-19 pandemic has adversely impacted our business and financial results and that of many of our customers, and the ultimate impact will depend on future developments, which are highly uncertain, cannot be predicted, and are largely outside of our control, including the scope and duration of the pandemic and actions taken by governmental authorities in response to the pandemic. The COVID-19 pandemic has created extensive disruptions to the global and U.S. economies and to the lives of individuals throughout the world. Governments, businesses, and the public are taking unprecedented actions to contain the spread of COVID-19 and to mitigate its effects, including quarantines, travel bans, shelter-in-place orders, closures of businesses and schools, fiscal and monetary stimulus, and legislation designed to deliver financial aid and other relief. While the scope, duration, and full effects of COVID-19 are rapidly evolving and not fully known, the pandemic and the efforts to contain it have disrupted global economic activity, adversely affected the functioning of financial markets, impacted market interest rates, increased economic and market uncertainty, and disrupted trade and supply chains. If these effects continue for a prolonged period or result in sustained economic stress or recession, many of the risk factors identified in this Annual Report on Form 10-K could be exacerbated and the effects of COVID-19 could have a material adverse impact on us in a number of ways as described in more detail below.
Credit Risk - Our risks of timely loan repayment and the value of collateral supporting the loans are affected by the strength of our borrowers’ businesses. Concern about the spread of COVID-19 has caused and is likely to continue to cause business shutdowns, limitations on commercial activity and financial transactions, labor shortages, supply chain interruptions, increased unemployment and commercial property vacancy rates, reduced profitability and ability for property owners to make mortgage payments, and overall economic and financial market instability, all of which may cause our customers to be unable to make scheduled loan payments.
Hotel and restaurant operators and others in the leisure, hospitality and travel industries, among other industries, have been particularly harmed by COVID-19. See the discussion contained in Item 7 of Part II of this Annual Report for information about the Company’s outstanding loans to borrowers in the hotel and restaurant industries. If the effects of COVID-19 result in widespread and sustained repayment shortfalls on loans in our portfolio, then we could incur significant delinquencies, foreclosures and credit losses, particularly if the available collateral is insufficient to cover our credit exposure. The future effects of COVID-19 on economic activity could negatively affect the collateral values associated with our existing loans, the ability to liquidate the real estate collateral securing our residential and commercial real estate loans, our ability to maintain loan origination volume and to obtain additional financing, the future demand for or profitability of our lending and services, and the financial condition and credit risk of our customers. Further, in the event of delinquencies, regulatory changes and policies designed to protect borrowers may slow or prevent us from making our business decisions or may result in a delay in our taking certain remediation actions, such as foreclosure. In addition, we have unfunded commitments to extend credit to customers. During a challenging economic environment, our customers depend more on our credit commitments and increased borrowings under these commitments could adversely impact our liquidity. Furthermore, in an effort to support our communities during the pandemic, we are participating in the Paycheck Protection Program (“PPP”) under the CARES Act whereby loans to small businesses are made and those loans are subject to the regulatory requirements that would require forbearance of loan payments for a specified time or that would limit our ability to pursue all available remedies in the event of a loan default. If the borrower under the PPP loan fails to qualify for loan forgiveness, we are at the heightened risk of holding these loans at unfavorable interest rates as compared to the loans to customers that we would have otherwise extended credit.
Strategic Risk - Our success may be affected by a variety of external factors that may affect the price or marketability of our products and services, changes in interest rates that may increase our funding costs, reduced demand for our financial products due to economic conditions and the various response of governmental and nongovernmental authorities. The COVID-19 pandemic has significantly increased economic and demand uncertainty and has led to disruption and volatility in the global capital markets. Furthermore, many of the governmental actions have been directed toward curtailing household and business activity to contain COVID-19. These actions have been rapidly expanding in scope and intensity. For example, in many of our markets, local governments have
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acted to temporarily close or restrict the operations of most businesses. The future effects of COVID-19 on economic activity could negatively affect the future banking products we provide, including a decline in originating loans.
Operational Risk - Current and future restrictions on our workforce’s access to our facilities could limit our ability to meet customer servicing expectations and have a material adverse effect on our operations. We rely on business processes and branch activity that largely depend on people and technology, including access to information technology systems as well as information, applications, payment systems and other services provided by third parties. In response to COVID-19, we have modified our business practices with a portion of our employees working remotely from their homes to have our operations uninterrupted as much as possible. Further, technology in employees’ homes may not be as robust as in our offices and could cause the networks, information systems, applications, and other tools available to employees to be more limited or less reliable than in our offices. The continuation of these work-from-home measures also introduces additional operational risk, including increased cybersecurity risk from phishing, malware, and other cybersecurity attacks, all of which could expose us to risks of data or financial loss and could seriously disrupt our operations and the operations of any impacted customers.
Moreover, we rely on many third parties in our business operations, including the appraiser of the real property collateral, vendors that supply essential services such as loan servicers, providers of financial information, systems and analytical tools and providers of electronic payment and settlement systems, and local and federal government agencies, offices, and courthouses. In light of the developing measures responding to the pandemic, many of these entities may limit the availability and access of their services. If the third-party service providers continue to have limited capacities for a prolonged period or if additional limitations or potential disruptions in these services materialize, it may negatively affect our operations.
Interest Rate Risk/Market Value Risk - Our net interest income, lending and investment activities, deposits and profitability could be negatively affected by volatility in interest rates caused by uncertainties stemming from COVID-19. In March 2020, the Federal Reserve lowered the target range for the federal funds rate to a range from 0% to 0.25%, citing concerns about the impact of COVID-19 on financial markets and market stress in the energy sector. A prolonged period of extremely volatile and unstable market conditions could increase our funding costs and negatively affect market risk mitigation strategies. Higher income volatility from changes in interest rates and spreads to benchmark indices could cause a loss of future net interest income and a decrease in prevailing fair market values of our investment securities and other assets, including mortgage servicing rights and SBA loan servicing rights. Fluctuations in interest rates will impact both the level of income and expense recorded on many of our assets and liabilities and the market value of all interest-earning assets and interest-bearing liabilities, which in turn could have a material adverse effect on our net income, operating results, or financial condition.
Because there have been no comparable recent global pandemics that resulted in similar global impact, we do not yet know the full extent of COVID-19’s effects on our business, operations, or the global economy as a whole. Any future development will be highly uncertain and cannot be predicted, including the scope and duration of the pandemic, the effectiveness of our work-from-home arrangements, third party providers’ ability to support our operations, and any actions taken by governmental authorities and other third parties in response to the pandemic. The uncertain future development of this crisis could materially and adversely affect our business, operations, operating results, financial condition, liquidity or capital levels.
The outbreak of other pandemics in the future could have similar or worse impacts on our financial condition and/ or results of operations.
Risks Relating to First United Corporation and its Affiliates
First United Corporation’s future success depends on the successful growth of its subsidiaries.
The Corporation’s primary business activity for the foreseeable future will be to act as the holding company of the Bank and its other direct and indirect subsidiaries. Therefore, the Corporation’s future profitability will depend on the success and growth of these subsidiaries.
The Bank’s funding sources may prove insufficient to replace deposits and support our future growth.
The Bank relies on customer deposits, advances from the FHLB, lines of credit at other financial institutions and brokered funds to fund our operations. Although the Bank has historically been able to replace maturing deposits and advances if desired, no assurance can be given that the Bank would be able to replace such funds in the future if our financial condition or the financial condition of the FHLB or market conditions were to change. Our financial flexibility will be severely constrained and/or our cost of funds will increase if we are unable to maintain our access to funding or if financing necessary to accommodate future growth is not available at favorable interest rates. Finally, if we are required to rely more heavily on more expensive funding sources to support future growth, our revenues may not increase proportionately to cover our costs. In that case, our profitability would be adversely affected.
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Interest rates and other economic conditions will impact our results of operations.
Our net income depends primarily upon our net interest income. Net interest income is the difference between interest income earned on loans, investments and other interest-earning assets and the interest expense incurred on deposits and borrowed funds. The level of net interest income is primarily a function of the average balance of our interest-earning assets, the average balance of our interest-bearing liabilities, and the spread between the yield on such assets and the cost of such liabilities. These factors are influenced by both the pricing and mix of our interest-earning assets and our interest-bearing liabilities which, in turn, are impacted by such external factors as the local economy, competition for loans and deposits, the monetary policy of the Federal Open Market Committee of the Federal Reserve Board of Governors, and market interest rates.
Different types of assets and liabilities may react differently, and at different times, to changes in market interest rates. We expect that we will periodically experience gaps in the interest rate sensitivities of our assets and liabilities. That means either our interest-bearing liabilities will be more sensitive to changes in market interest rates than our interest-earning assets, or vice versa. When interest-bearing liabilities mature or re-price more quickly than interest-earning assets, an increase in market rates of interest could reduce our net interest income. Likewise, when interest-earning assets mature or re-price more quickly than interest-bearing liabilities, falling interest rates could reduce our net interest income. We are unable to predict changes in market interest rates, which are affected by many factors beyond our control, including inflation, deflation, recession, unemployment, money supply, domestic and international events and changes in the United States and other financial markets.
We also attempt to manage risk from changes in market interest rates, in part, by controlling the mix of interest rate sensitive assets and interest rate sensitive liabilities. However, interest rate risk management techniques are not exact. A rapid increase or decrease in interest rates could adversely affect our results of operations and financial performance.
Changes to LIBOR may adversely impact the value of, and the return on, our loans, investment securities and derivatives which are indexed to LIBOR.
We have certain FHLB advances, brokered deposits, loans and investment securities indexed to LIBOR to calculate the loan interest rate. On July 27, 2017, the United Kingdom Financial Conduct Authority, which regulates LIBOR, announced that it will no longer persuade or compel banks to submit rates for the calculation of LIBOR to the LIBOR administrator after 2021. The announcement also indicates that the continuation of LIBOR on the current basis cannot and will not be guaranteed after 2021. Consequently, at this time, it is not possible to predict whether and to what extent banks will continue to provide LIBOR submissions to the LIBOR administrator or whether any additional reforms to LIBOR may be enacted in the United Kingdom or elsewhere. Similarly, it is not possible to predict whether LIBOR will continue to be viewed as an acceptable benchmark for certain loans and liabilities including our subordinated notes, what rate or rates may become accepted alternatives to LIBOR or the effect of any such changes in views or alternatives on the values of the loans and liabilities, whose interest rates are tied to LIBOR. Uncertainty as to the nature of such potential changes, alternative reference rates, the elimination or replacement of LIBOR, or other reforms may adversely affect the value of, and the return on our loans, and our investment securities.
The majority of our business is concentrated in Maryland and West Virginia, much of which involves real estate lending, so a decline in the real estate and credit markets could materially and adversely impact our financial condition and results of operations.
Most of the Bank’s loans are made to borrowers located in Western Maryland and Northeastern West Virginia, and many of these loans, including construction and land development loans, are secured by real estate. At December 31, 2020, approximately 10%, or $117.0 million, of our total loans were real estate acquisition, construction and development loans that were secured by real estate. Accordingly, a decline in local economic conditions would likely have an adverse impact on our financial condition and results of operations, and the impact on us would likely be greater than the impact felt by larger financial institutions whose loan portfolios are geographically diverse. We cannot guarantee that any risk management practices we implement to address our geographic and loan concentrations will be effective to prevent losses relating to our loan portfolio.
The Bank’s concentrations of commercial real estate loans could subject it to increased regulatory scrutiny and directives, which could force us to preserve or raise capital and/or limit future commercial lending activities.
The federal banking regulators believe that institutions that have particularly high concentrations of Commercial Real Estate (“CRE”) loans within their lending portfolios face a heightened risk of financial difficulties in the event of adverse changes in the economy and CRE markets. Accordingly, through published guidance, these regulators have directed institutions whose concentrations exceed certain percentages of capital to implement heightened risk management practices appropriate to their concentration risk. The guidance provides that banking regulators may require such institutions to reduce their concentrations and/or maintain higher capital ratios than institutions with lower concentrations in CRE. At December 31, 2020, our CRE concentrations were below the heightened risk management thresholds set forth in this guidance.
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The Bank may experience loan losses in excess of its allowance for loan losses, which would reduce our earnings.
The risk of credit losses on loans varies with, among other things, general economic conditions, the type of loans being made, the creditworthiness of the borrowers over the term of the loans and, in the case of collateralized loans, the value and marketability of the collateral for the loans. Management of the Bank maintains an ALL based upon, among other things, historical experience, an evaluation of economic conditions and regular reviews of delinquencies and loan portfolio quality. Based upon such factors, management makes various assumptions and judgments about the ultimate collectability of the loan portfolio and provides the ALL based upon a percentage of the outstanding balances and for specific loans when their ultimate collectability is considered questionable. If management’s assumptions and judgments prove to be incorrect and the ALL is inadequate to absorb future losses, or if the bank regulatory authorities require us to increase the ALL as a part of its examination process, our earnings and capital could be significantly and adversely affected. Although management continually monitors our loan portfolio and makes determinations with respect to the ALL, future adjustments may be necessary if economic conditions differ substantially from the assumptions used or adverse developments arise with respect to our non-performing or performing loans. Material additions to the ALL could result in a material decrease in our net income and capital; and could have a material adverse effect on our financial condition.
A new accounting standard will likely require us to increase our allowance for loan losses and may have a material adverse effect on our financial condition and results of operations.
The Financial Accounting Standards Board (“FASB”) has adopted a new accounting standard that was originally effective for the Corporation and the Bank beginning with our first full fiscal year after December 15, 2019. In November 2019, the FASB approved a delay of the required implementation date of ASU No. 2016-13 for smaller reporting companies, as defined by the SEC, and other non-SEC reporting entities, including the Corporation, resulting in a required implementation date for the Corporation of January 1, 2023. This standard, referred to as Current Expected Credit Loss, or CECL, will require financial institutions to determine periodic estimates of lifetime expected credit losses on loans, and recognize the expected credit losses as allowances for loan losses. This standard will change the current method of providing allowances for loan losses that are probable, which would likely require us to increase our ALL, and to greatly increase the types of data we would need to collect and review to determine the appropriate level of the ALL. Any increase in our ALL or expenses incurred to determine the appropriate level of the ALL may have a material adverse effect on our financial condition and results of operations.
The Bank’s lending activities subject the Bank to the risk of environmental liabilities.
A significant portion of the Bank’s loan portfolio is secured by real property. During the ordinary course of business, the Bank may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, the Bank may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require the Bank to incur substantial expenses and may materially reduce the affected property’s value or limit the Bank’s ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase the Bank’s exposure to environmental liability. Although the Bank has policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our financial condition and results of operations.
The market value of our investments could decline.
At December 31, 2020, investment securities in our investment portfolio having a cost basis of $230.5 million and a market value of $226.9 million were classified as available-for-sale pursuant to FASB Accounting Standards Codification (“ASC”) Topic 320, Investments – Debt and Equity Securities,relating to accounting for investments. Topic 320 requires that unrealized gains and losses in the estimated value of the available-for-sale portfolio be “marked to market” and reflected as a separate item in shareholders’ equity (net of tax) as accumulated other comprehensive loss. There can be no assurance that future market performance of our investment portfolio will enable us to realize income from sales of securities. Shareholders’ equity will continue to reflect the unrealized gains and losses (net of tax) of these investments. Moreover, there can be no assurance that the market value of our investment portfolio will not decline, causing a corresponding decline in shareholders’ equity.
Management believes that several factors could affect the market value of our investment portfolio. These include, but are not limited to, changes in interest rates or expectations of changes, the degree of volatility in the securities markets, inflation rates or expectations of inflation and the slope of the interest rate yield curve (the yield curve refers to the differences between shorter-term and longer-term interest rates; a positively sloped yield curve means shorter-term rates are lower than longer-term rates). Also, the passage of time will affect the market values of our investment securities, in that the closer they are to maturing, the closer the market price should be to par value. These and other factors may impact specific categories of the portfolio differently, and management cannot predict the effect these factors may have on any specific category.
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Impairment of investment securities, goodwill, or deferred tax assets could require charges to earnings, which could result in a negative impact on our results of operations.
In assessing whether the impairment of investment securities is other-than-temporary, management considers the length of time and extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability to retain our investment in the security for a period of time sufficient to allow for any anticipated recovery in fair value in the near term. See the discussion under the heading “Estimates and Critical Accounting Policies – Other-Than-Temporary Impairment of Investment Securities” in Item 7 of Part II of this annual report for further information.
Under current accounting standards, goodwill is not amortized but, instead, is subject to impairment tests on at least an annual basis or more frequently if an event occurs or circumstances change that reduce the fair value of a reporting unit below its carrying amount. A decline in the price of the shares of Common Stock or occurrence of a triggering event following any of our quarterly earnings releases and prior to the filing of the periodic report for that period could, under certain circumstances, cause us to perform a goodwill impairment test and result in an impairment charge being recorded for that period which was not reflected in such earnings release. In the event that we conclude that all or a portion of our goodwill may be impaired, a non-cash charge for the amount of such impairment would be recorded to earnings. Such a charge would have no impact on tangible capital. At December 31, 2020, we had recorded goodwill of $11.0 million, representing approximately 8.4% of shareholders’ equity. See the discussion under the heading “Estimates and Critical Accounting Policies – Goodwill” in Item 7 of Part II of this annual report for further information.
At December 31, 2020, our net deferred tax assets were valued at $8.0 million. Included in that total is $2.7 million of state net operating loss carryforwards (“NOLs”) associated with separate company tax filings of the Corporation, which we do not expect to use and, thus, we have established a $2.7 million valuation allowance. A deferred tax asset is reduced by a valuation allowance if, based on the weight of the evidence available, both negative and positive, including the recent trend of quarterly earnings, management believes that it is more likely than not that some portion or all of the total deferred tax asset will not be realized. Moreover, our ability to utilize our net operating loss carryforwards to offset future taxable income may be significantly limited if we experience an “ownership change,” as determined under Section 382 of the Code. If an ownership change were to occur, the limitations imposed by Section 382 of the Code could result in a portion of our net operating loss carryforwards expiring unused, thereby impairing their value. Section 382’s provisions are complex, and we cannot predict any circumstances surrounding the future ownership of the Common Stock. Accordingly, we cannot provide any assurance that we will not experience an ownership change in the future.
The impact of each of these impairment matters could have a material adverse effect on our business, results of operations, and financial condition.
We operate in a competitive environment, and our inability to effectively compete could adversely and materially impact our financial condition and results of operations.
We operate in a competitive environment, competing for loans, deposits, and customers with commercial banks, savings associations and other financial entities. Competition for deposits comes primarily from other commercial banks, savings associations, credit unions, money market and mutual funds and other investment alternatives. Competition for loans comes primarily from other commercial banks, savings associations, mortgage banking firms, credit unions and other financial intermediaries. Competition for other products, such as securities products, comes from other banks, securities and brokerage companies, and other non-bank financial service providers in our market area. Many of these competitors are much larger in terms of total assets and capitalization, have greater access to capital markets, and/or offer a broader range of financial services than those that we offer. In addition, banks with a larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the needs of larger customers.
In addition, changes to the banking laws over the last several years have facilitated interstate branching, merger and expanded activities by banks and holding companies. For example, the federal Gramm-Leach-Bliley Act (the “GLB Act”) revised the BHC Act and repealed the affiliation provisions of the Glass-Steagall Act of 1933, which, taken together, limited the securities and other non-banking activities of any company that controls an FDIC insured financial institution. As a result, the ability of financial institutions to branch across state lines and the ability of these institutions to engage in previously-prohibited activities are now accepted elements of competition in the banking industry. These changes may bring us into competition with more and a wider array of institutions, which may reduce our ability to attract or retain customers. Management cannot predict the extent to which we will face such additional competition or the degree to which such competition will impact our financial conditions or results of operations.
The banking industry is heavily regulated; significant regulatory changes could adversely affect our operations.
Our operations will be impacted by current and future legislation and by the policies established from time to time by various federal and state regulatory authorities. The Corporation is subject to supervision by the Federal Reserve. The Bank is subject to supervision and periodic examination by the Maryland Commissioner of Financial Regulation, the West Virginia Division of Banking, and the FDIC. Banking regulations, designed primarily for the safety of depositors, may limit a financial institution’s growth and the
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return to its investors by restricting such activities as the payment of dividends, mergers with or acquisitions by other institutions, investments, loans and interest rates, interest rates paid on deposits, expansion of branch offices, and the offering of securities or trust services. The Corporation and the Bank are also subject to capitalization guidelines established by federal law and could be subject to enforcement actions to the extent that either is found by regulatory examiners to be undercapitalized. It is not possible to predict what changes, if any, will be made to existing federal and state legislation and regulations or the effect that such changes may have on our future business and earnings prospects. Management also cannot predict the nature or the extent of the effect on our business and earnings of future fiscal or monetary policies, economic controls, or new federal or state legislation. Further, the cost of compliance with regulatory requirements may adversely affect our ability to operate profitably.
The Consumer Financial Protection Bureau may continue to reshape the consumer financial laws through rulemaking and enforcement of the prohibitions against unfair, deceptive and abusive business practices. Compliance with any such change may impact our business operations.
The CFPB has broad rulemaking authority to administer and carry out the provisions of the Dodd-Frank Act with respect to financial institutions that offer covered financial products and services to consumers. The CFPB has also been directed to adopt rules identifying practices or acts that are unfair, deceptive or abusive in connection with any transaction with a consumer for a consumer financial product or service, or the offering of a consumer financial product or service. The concept of what may be considered to be an “abusive” practice is new under the law. We have been required to dedicate significant personnel resources to address the compliance burdens imposed by the CFBP’s adoption of various rules, and the adoption of additional rules in the future would likely require us to dedicate even more resources.
Bank regulators and other regulations, including the Basel III Capital Rules, may require higher capital levels, impacting our ability to pay dividends or repurchase our stock.
The capital standards to which we are subject, including the standards created by the Basel III Capital Rules, may materially limit our ability to use our capital resources and/or could require us to raise additional capital by issuing additional shares of Common Stock or other equity securities. The issuance of additional equity securities could dilute existing stockholders.
A material weakness or significant deficiency in our disclosure or internal controls could have an adverse effect on us.
The Corporation is required by the Sarbanes-Oxley Act of 2002 to establish and maintain disclosure controls and procedures and internal control over financial reporting. These control systems are intended to provide reasonable assurance that material information relating to the Corporation is made known to our management and reported as required by the Exchange Act, to provide reasonable assurance regarding the reliability and preparation of our financial statements, and to provide reasonable assurance that fraud and other unauthorized uses of our assets are detected and prevented. We may not be able to maintain controls and procedures that are effective at the reasonable assurance level. If that were to happen, our ability to provide timely and accurate information about the Corporation, including financial information, to investors could be compromised and our results of operations could be harmed. Moreover, if the Corporation or its independent registered public accounting firm were to identify a material weakness or significant deficiency in any of those control systems, our reputation could be harmed and investors could lose confidence in us, which could cause the market price of the Corporation’s stock to decline and/or limit the trading market for the shares of the Common Stock.
We may not be able to keep pace with developments in technology.
We use various technologies in conducting our businesses, including telecommunication, data processing, computers, automation, internet-based banking, and debit cards. Technology changes rapidly. Our ability to compete successfully with other financial institutions may depend on whether we can exploit technological changes. We may not be able to exploit technological changes, and any investment we do make may not make us more profitable.
Our operational or communications systems or infrastructure may fail or may be the subject of a breach or cyber-attack that, if successful, could adversely affect our business or disrupt business continuity.
Our business depends heavily on the use of computer systems, the Internet and other means of electronic communication and recordkeeping to process, record, and monitor client transactions and to communicate with clients and other institutions on a continuous basis. As client, industry, public, and regulatory expectations regarding operational and information security have increased, our operational systems and infrastructure continue to be safeguarded and monitored for potential failures, disruptions, and breakdowns, whether as a result of events beyond our control or otherwise.
Our business, financial, accounting, data processing, or other operating systems and facilities may stop operating properly or become disabled or damaged as a result of a number of factors, including events that are wholly or partially beyond our control. For example, there could be sudden increases in client transaction volume; electrical or telecommunications outages; natural disasters such as earthquakes, tornadoes, floods, and hurricanes; disease pandemics; events arising from local or larger scale political or social matters,
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including terrorist acts; occurrences of employee error, fraud, theft, or malfeasance; disruptions caused by technology implementation, including hardware deployment and software updates; and, as described below, cyber-attacks.
Although we have business continuity plans and other safeguards in place, our operations and communications may be adversely affected by significant and widespread disruption to our systems and infrastructure that support our businesses, clients, and teammates. While we continue to evolve and modify our business continuity plans, there can be no assurance in an escalating threat environment that they will be effective in avoiding disruption and business impacts. Our insurance may not be adequate to compensate us for all resulting losses, and the cost to obtain adequate coverage may increase for us or the industry.
Security risks for financial institutions such as ours have dramatically increased in recent years in part because of the proliferation of new technologies, the use of the internet and telecommunications technologies to conduct financial transactions, and the increased sophistication, resources, and activities of hackers, terrorists, activists, industrial spies, insider bad actors, organized crime, and other external parties, including nation state actors. In addition, to access our products and services, clients may use devices and/or software that are beyond our control environment, which may provide additional avenues for attackers to gain access to confidential information. Although we have information security procedures and controls in place, our technologies, systems, networks, and clients' devices and software may become the target of cyber-attacks, information security breaches, business email compromise, or information theft that could result in the unauthorized release, gathering, monitoring, misuse, loss, change, or destruction of our or our clients' or teammates' confidential, proprietary, or other information (including personal identifying information of individuals), or otherwise disrupt our or our clients' or our third parties' business operations. U.S. financial institutions and financial service companies have reported breaches in the security of their websites or other systems, including attempts to shut down access to their networks and/or systems in an attempt to extract compensation from them to regain control. Financial institutions, including the Bank, have experienced distributed denial-of-service attacks, a sophisticated and targeted attack intended to disable or degrade internet service or to sabotage systems.
We and others in our industry are regularly the subject of attempts by attackers to gain unauthorized access to our networks, systems, and data, or to obtain, change, or destroy confidential data (including personal identifying information of individuals) through a variety of means, including computer viruses, malware, business email compromise, and phishing. These attacks may result in unauthorized individuals obtaining access to our confidential information or that of our clients or teammates, or otherwise accessing, compromising, damaging, or disrupting our systems or infrastructure.
We are continuously developing and enhancing our controls, processes, and practices designed to protect our systems, computers, software, data, and networks from attack, damage, or unauthorized access. This continued development and enhancement will require us to expend additional resources, including resources to investigate and remediate any information security vulnerabilities that may be detected. Despite our ongoing investments in security resources, talent, and business practices, we are unable to assure that any security measures will be effective.
If our systems and infrastructure were to be breached, compromised, damaged, or disrupted, or if we were to experience a loss of our confidential information or that of our clients or teammates, we could be subject to serious negative consequences, including disruption of our operations, damage to our reputation, a loss of trust in us on the part of our clients, vendors or other counterparties, client or teammate attrition, reimbursement or other costs, increased compliance costs, significant litigation exposure and legal liability, or regulatory fines, penalties or intervention. Any of these could materially and adversely affect our results of operations, our financial condition, and/or our share price.
A disruption, breach, or failure in the operational systems or infrastructure of our third party vendors or other service providers, including as a result of cyber-attacks, could adversely affect our business.
Third parties perform significant operational services on our behalf. These third parties with whom we do business or that facilitate our business activities, including exchanges, clearing houses, central clearing counterparties, financial intermediaries, or vendors that provide services or security solutions for our operations, could also be sources of operational and information security risk to us, including from breakdowns or failures of their own systems or capacity constraints. In particular, operating our business requires us to provide access to client, teammate, and other sensitive Company information to our contractors, consultants, and other third parties and authorized entities. Controls and oversight mechanisms are in place that are designed to limit access to this information and protect it from unauthorized disclosure, theft, and disruption. However, control systems and policies pertaining to system access are subject to errors in design, oversight failure, software failure, human error, intentional subversion, or other compromise resulting in theft, error, loss, or inappropriate use of information or systems to commit fraud, cause embarrassment to us or our executives or to gain competitive advantage. In addition, regulators expect financial institutions to be responsible for all aspects of their performance, including aspects which they delegate to third parties. If a disruption, breach, or failure in the system or infrastructure of any third party with whom we do business occurred, then our business may be materially and adversely affected in a manner similar to if our own systems or infrastructure had been compromised. As has been the case in other major system events in the U.S., our systems and infrastructure may also be attacked, compromised, or damaged as a result of, or as the intended target of, any disruption, breach, or failure in the systems or infrastructure of any third party with whom we do business.
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First United Corporation will likely incur significant expenses and faces the possibility of damages in connection with recent litigation.
As discussed below in Item 3 of Part I of this report, the Corporation, its directors, and two former directors have been sued by Driver Opportunity Fund I LP (the “Driver Shareholder”). This litigation has, and will likely continue to be, time consuming and has involved, and will likely continue to involve, significant defense and other costs. We cannot predict what expenses that we might incur in connection with this litigation. This litigation, if decided adversely to us, could result in significant monetary damages and reputational harm and require us to incur significant expenses related to holding a new meeting of shareholders, if the court were to order such a meeting as part of the relief granted. Subject to certain conditions imposed by Maryland law, our bylaws require us to indemnify and advance expenses to each of the current and former directors who are parties to this litigation. Further, our insurance policies might not cover all expenses and/or claims that have been or might be brought against us and the individual defendants, and insurance coverage might not continue to be available to us at a reasonable cost. As a result, we are exposed to the possibility of substantial uninsured liabilities in connection with this litigation, including pursuant to our indemnification obligations, which could materially and adversely affect our business, prospects, results of operations and financial condition.
We may be subject to claims and the costs of defensive actions, and such claims and costs could materially and adversely impact our financial condition and results of operations.
Our customers may sue us for losses due to alleged breaches of fiduciary duties, errors and omissions of employees, officers and agents, incomplete documentation, our failure to comply with applicable laws and regulations, or many other reasons. Also, our employees may knowingly or unknowingly violate laws and regulations. Management may not be aware of any violations until after their occurrence. This lack of knowledge may not insulate us from liability. Claims and legal actions will result in legal expenses and could subject us to liabilities that may reduce our profitability and hurt our financial condition.
The loss of key personnel could disrupt our operations and result in reduced earnings.
Our growth and profitability will depend upon our ability to attract and retain skilled managerial, marketing and technical personnel. Competition for qualified personnel in the financial services industry is intense, and there can be no assurance that we will be successful in attracting and retaining such personnel. Our current executive officers provide valuable services based on their many years of experience and in-depth knowledge of the banking industry and the market areas we serve. Due to the intense competition for financial professionals, these key personnel would be difficult to replace and an unexpected loss of their services could result in a disruption to the continuity of operations and a possible reduction in earnings.
We are a community banking organization and our ability to maintain our reputation is critical to the success of our business.
We are a community banking organization, and our reputation is one of the most valuable components of our business. A key component of our business strategy is to rely on our reputation for customer service and knowledge of local markets to expand our presence by capturing new business opportunities from existing and prospective customers in our current market and contiguous areas. As such, we strive to conduct our business in a manner that enhances our reputation. This is done, in part, by recruiting, hiring and retaining employees who share our core values of being an integral part of the communities we serve, delivering superior service to our customers and caring about our customers and associates. If our reputation is negatively affected by the actions of our employees, by our inability to conduct our operations in a manner that is appealing to current or prospective customers, or otherwise, our business and, therefore, our operating results may be materially adversely affected.
We could be adversely affected by risks associated with future acquisitions and expansions.
Although our core growth strategy is focused around organic growth, we may from time to time consider acquisition and expansion opportunities involving a bank or other entity operating in the financial services industry. We cannot predict if or when we will engage in such a strategic transaction, or the nature or terms of any such transaction. To the extent that we grow through an acquisition, we cannot assure investors that we will be able to adequately and profitably manage that growth or that an acquired business will be integrated into our existing businesses as efficiently or as timely as we may anticipate. Acquiring another business would generally involve risks commonly associated with acquisitions, including:
increased capital needs;
increased and new regulatory and compliance requirements;
implementation or remediation of controls, procedures and policies with respect to the acquired business;
diversion of management time and focus from operation of our then-existing business to acquisition-integration challenges;
coordination of product, sales, marketing and program and systems management functions;
transition of the acquired business’s users and customers onto our systems;
retention of employees from the acquired business;
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integration of employees from the acquired business into our organization;
integration of the acquired business’s accounting, information management, human resources and other administrative systems and operations with ours;
potential liability for activities of the acquired business prior to the acquisition, including violations of law, commercial disputes and tax and other known and unknown liabilities;
potential increased litigation or other claims in connection with the acquired business, including claims brought by regulators, terminated employees, customers, former stockholders, vendors, or other third parties; and
potential goodwill impairment.
Our failure to execute our acquisition strategy could adversely affect our business, results of operations, financial condition and future prospects risks of unknown or contingent liabilities.
Risks Relating to First United Corporation’s Securities
The shares of Common Stock are not insured.
The shares of Common Stock are not deposits and are not insured against loss by the FDIC or any other governmental or private agency.
The shares of Common Stock are not heavily traded.
Shares of the Common Stock are listed on the NASDAQ Global Select Market, but are not heavily traded. Securities that are not heavily traded can be more volatile than stock trading in an active public market. Factors such as our financial results, the introduction of new products and services by us or our competitors, various factors affecting the banking industry generally, and investor speculation as to our future plans and strategies could have a significant impact on the market price and trading volume of the shares of Common Stock. Likewise, events that are unrelated to the Corporation but that affect the equity markets generally, such as international health crises, wars, political instability and similar factors, could also have a significant impact on the market price and trading volume of the shares of Common Stock. Management cannot predict the extent to which an active public market for shares of Common Stock will develop or be sustained in the future. Accordingly, shareholders may not be able to sell their shares at the volumes, prices, or times that they desire.
Significant sales of shares of Common Stock, or the perception that significant sales may occur in the future, could adversely affect the market price of shares of Common Stock.
The Common Stock is currently included in the Russell 3,000 Index maintained by Financial Times Stock Exchange Group Russell, which tracks the performance of the 3,000 largest U.S.-traded equity securities. As of the date of this annual report, the Corporation believes it likely that the Common Stock will be eliminated from the Russell 3,000 Index when it is reconstituted in or about June 2021 and that, as a result, investors that invest in Russell 3,000 Index stocks could sell approximately 632,000 shares of Common Stock following such reconstitution.
The sale of a substantial number of shares of the Common Stock could adversely affect the market price of such shares. The availability of shares for future sale could adversely affect the prevailing market price of shares of Common Stock and could cause the market price of such shares to remain low for a substantial amount of time. In addition, the Corporation may grant equity awards under its equity compensation plans from time to time in effect, including fully-vested shares of Common Stock. It is possible that if a significant percentage of such available shares were attempted to be sold within a short period of time, the market for the shares would be adversely affected. Management cannot predict whether the market for shares of Common Stock could absorb a large number of attempted sales in a short period of time, regardless of the price at which they might be offered. Even if a substantial number of sales do not occur within a short period of time, the mere existence of this “market overhang” could have a negative impact on the market for the common stock and our ability to raise capital in the future.
The Corporation’s ability to pay dividends on the common stock is subject to the terms of the outstanding TPS Debentures, which prohibit the Corporation from paying dividends during an interest deferral period.
In March 2004, the Corporation issued approximately $30.9 million, in the aggregate, of junior subordinated debentures (“TPS Debentures”) to the Trusts in connection with the Trusts’ sales to third party investors of $30.0 million, in the aggregate, in mandatorily redeemable preferred capital securities. The terms of the TPS Debentures require the Corporation to make quarterly payments of interest to the Trusts, as the holders of the TPS Debentures, although the Corporation has the right to defer payments of interest for up to 20 consecutive quarterly periods. An election to defer interest payments does not constitute an event of default under the terms of the TPS Debentures. The terms of the TPS Debentures prohibit the Corporation from declaring or paying any dividends or making other distributions on, or from repurchasing, redeeming or otherwise acquiring, any shares of its capital securities, including the common
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stock, if the Corporation elects to defer quarterly interest payments under the TPS Debentures. In addition, a deferral election will require the Trusts to likewise defer the payment of quarterly dividends on their related trust preferred securities.
Applicable banking and Maryland laws impose additional restrictions on the ability of the Corporation and the Bank to pay dividends and make other distributions on their capital securities, and, in any event, the payment of dividends is at the discretion of the boards of directors of the Corporation and the Bank.
In the past, the Corporation has funded dividends on its capital securities using cash received from the Bank, and this will likely be the case for the foreseeable future. No assurance can be given that the Bank will be able to pay dividends to the Corporation for these purposes at times and/or in amounts requested by the Corporation. Both federal and state laws impose restrictions on the ability of the Bank to pay dividends. Under Maryland law, a state-chartered commercial bank may pay dividends only out of undivided profits or, with the prior approval of the Maryland Commissioner, from surplus in excess of 100% of required capital stock. If, however, the surplus of a Maryland bank is less than 100% of its required capital stock, cash dividends may not be paid in excess of 90% of net earnings. In addition to these specific restrictions, bank regulatory agencies have the ability to prohibit proposed dividends by a financial institution which would otherwise be permitted under applicable regulations if the regulatory body determines that such distribution would constitute an unsafe or unsound practice. Banks that are considered “troubled institution” are prohibited by federal law from paying dividends altogether. Notwithstanding the foregoing, shareholders must understand that the declaration and payment of dividends and the amounts thereof are at the discretion of the Corporation’s Board of Directors. Thus, even at times when the Corporation is not prohibited from paying cash dividends on its capital securities, neither the payment of such dividends nor the amounts thereof can be guaranteed.
The Corporation’s Articles of Incorporation and Bylaws and Maryland law may discourage a corporate takeover.
The Corporation’s Amended and Restated Articles of Incorporation (the “Charter”) and its Amended and Restated Bylaws, as amended (the “Bylaws”), contain certain provisions designed to enhance the ability of the Corporation’s Board of Directors to deal with attempts to acquire control of the Corporation. First, the Board of Directors is classified into three classes. Directors of each class serve for staggered three-year periods, and no director may be removed except for cause, and then only by the affirmative vote of either a majority of the entire Board of Directors or a majority of the outstanding voting stock. Second, the board has the authority to classify and reclassify unissued shares of stock of any class or series of stock by setting, fixing, eliminating, or altering in any one or more respects the preferences, rights, voting powers, restrictions and qualifications of, dividends on, and redemption, conversion, exchange, and other rights of, such securities. The board could use this authority, along with its authority to authorize the issuance of securities of any class or series, to issue shares having terms favorable to management or to a person or persons affiliated with or otherwise friendly to management. In addition, the Bylaws require any shareholder who desires to nominate a director to abide by strict notice requirements.
Maryland laws include provisions that could discourage a sale or takeover of the Corporation. The Maryland Business Combination Act generally prohibits, subject to certain limited exceptions, corporations from being involved in any “business combination” (defined as a variety of transactions, including a merger, consolidation, share exchange, asset transfer or issuance or reclassification of equity securities) with any “interested shareholder” for a period of five years following the most recent date on which the interested shareholder became an interested shareholder. An interested shareholder is defined generally as a person who is the beneficial owner of 10% or more of the voting power of the outstanding voting stock of the corporation after the date on which the corporation had 100 or more beneficial owners of its stock or who is an affiliate or associate of the corporation and was the beneficial owner, directly or indirectly, of 10% percent or more of the voting power of the then outstanding stock of the corporation at any time within the two-year period immediately prior to the date in question and after the date on which the corporation had 100 or more beneficial owners of its stock. The Maryland Control Share Acquisition Act applies to acquisitions of “control shares”, which, subject to certain exceptions, are shares the acquisition of which entitle the holder, directly or indirectly, to exercise or direct the exercise of the voting power of shares of stock of the corporation in the election of directors within any of the following ranges of voting power: one-tenth or more, but less than one-third of all voting power; one-third or more, but less than a majority of all voting power or a majority or more of all voting power. Control shares have limited voting rights. Maryland banking laws provide that the Maryland Commissioner must approve certain acquisitions of the common stock of the Corporation and/or the Bank, and these laws impose penalties on persons who effect such acquisitions without approval, including a five year voting prohibition.
Although these provisions do not preclude a sale or takeover, they may have the effect of discouraging, delaying or deferring a sale, tender offer, or takeover attempt that a shareholder might consider in his or her best interest, including those attempts that might result in a premium over the market price for the common stock. Such provisions will also render the removal of the Board of Directors and of management more difficult and, therefore, may serve to perpetuate current management. These provisions could potentially adversely affect the market prices of the Corporation’s securities.
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Risks Relating to Proxy Contests
We are subject to risks associated with proxy contests and other actions of activist shareholders.
In connection with the 2020 Annual Meeting of Shareholders (the “2020 Meeting”), the Driver Shareholder nominated (conditionally accepted by the Corporation) three candidates for election to the Corporation’s Board of Directors at the 2020 Meeting and engaged in a proxy contest with the Corporation’s Board of Directors. The Corporation incurred costs of approximately $3.3 million in connection with this proxy contest. On January 8, 2021, the Driver Shareholder notified the Corporation that it intends to nominate one director for election at the 2021 Annual Meeting of Shareholders (the “2021 Meeting”) and to present seven proposals for shareholder approval at the 2021 Meeting. The Driver Shareholder and the Corporation filed preliminary proxy statements with the SEC in respect of the 2021 Meeting on February 2, 2021 and March 2, 2021, respectively.
A proxy contest or related activities on the part of the Driver Shareholder or another shareholder could adversely affect our business for a number of reasons, including, without limitation, the following:
Responding to proxy contests and other actions by activist stockholders can be costly and time-consuming, disrupting our operations and diverting the attention of management and our employees;
Perceived uncertainties as to our future direction may result in the loss of potential business opportunities and may make it more difficult to attract and retain qualified personnel, business partners, customers and others important to our success, any of which could negatively affect our business and our results of operations and financial condition; and
If nominees advanced by activist shareholders are elected or appointed to our Board of Directors with a specific agenda, it may adversely affect our ability to effectively and timely implement our strategic plans or to realize long-term value from our assets, and this could in turn have an adverse effect on our business and on our results of operations and financial condition.
Proxy contests may cause our stock price to experience periods of volatility. Further, if a proxy contest results in a change in control of our Board of Directors, such an event could subject us to risks relating to certain third parties’ rights under our existing contractual obligations, which could adversely affect our business.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2. PROPERTIES
The headquarters of the Corporation and the Bank occupies approximately 29,000 square feet at 19 South Second Street, Oakland, Maryland, and a 30,000 square feet operations center located at 12892 Garrett Highway, Oakland Maryland. These premises are owned by the Corporation. The Bank owns 19 of its banking offices and leases six. Total rent expense on the leased offices and properties was $0.4 million in 2020.
ITEM 3. LEGAL PROCEEDINGS
On September 4, 2020, the Driver Shareholder filed a lawsuit against the Corporation, all of its then-current directors, and former directors Robert W. Kurtz and Elaine L. McDonald (the individuals being collectively referred to as the “Director Defendants”) in the United States District Court for the District of Maryland (the “District Court”) and styled Driver Opportunity Partners I LP v. First United Corp., et al., No. 1:20-cv-2575 RDB (the “Driver Litigation”). The Driver Shareholder’s complaint follows a lawsuit filed by the Corporation in May 2020 against the Driver Shareholder and affiliated persons seeking a declaration that the Driver Shareholder’s acquisition of approximately 5.1% of the Corporation’s outstanding common stock during 2019 violated Section 3-314 of the Financial Institutions Article of the Annotated Code of Maryland (“FI 3-314”), rendering those shares ineligible to be voted for five years, including at the 2020 Meeting. In connection with the 2020 Meeting, Driver ran a proxy contest seeking to replace three of the Corporation’s directors with nominees of its own. The declaratory relief action, now pending in the same court, is captioned First United Corp. v. Driver Opportunity Partners I LP, et al., No. 1:20-cv-2592-RDB, although, on January 6, 2021, the District Court certified to the Maryland Court of Appeals the question of whether the Corporation has standing to seek declaratory relief under FI 3-314 and stayed the proceedings in that case pending a decision by the Maryland Court of Appeals.
For its complaint, the Driver Shareholder alleges that certain acts and omissions of the Corporation and/or the Director Defendants in connection with the 2020 Meeting and/or in response to Driver’s proxy contest constituted a wide range of torts, including breaches of fiduciary duty, abuses of process, malicious prosecution, defamation, tortious interference, unfair competition, and unjust enrichment. The Driver Shareholder seeks unspecified compensatory and punitive damages and asks the District Court to vacate the results of director election at the 2020 Meeting and order a new meeting of shareholders for the purpose of electing directors.
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On January 11, 2021, the District Court issued an order dismissing six of the Driver Shareholder’s nine asserted claims: (i) breach of fiduciary duty; (ii) abuse of process (litigation); (iii) abuse of process (regulatory); (iv) malicious prosecution; (v) unfair competition; and (vi) unjust enrichment. Subsequently, on January 25, 2021, the Driver Shareholder filed a motion asking the District Court to reconsider its dismissal of the breach of duty claim, and filed a separate motion for leave to amend the Driver Shareholder’s complaint to assert claims for breach of fiduciary duty and for violation of Section 14(a) of the Exchange Act and SEC Rule 14a-9 focused on proxy materials related to the 2020 Meeting. On February 8, 2021, the Corporation and the Director Defendants filed papers opposing these motions. The Driver Shareholder filed reply papers on the motions on February 22, 2021, and briefing is now closed. The District Court has not yet decided either motion.
The Corporation and the Director Defendants believe that the Driver Shareholder’s claims lack merit and are vigorously defending the Driver Litigation. The Corporation maintains insurance coverages that it believes will cover portions of the legal expenses associated with the Driver Litigation and any damages that might be awarded to the Driver Shareholder. The Corporation has certain obligations both to indemnify and to advance defense expenses to each of the Director Defendants to the fullest extent permissible under Maryland law, and the Corporation intends to honor those obligations. It is not possible at this time for the Corporation to assess the likelihood of success of any of its and the Defendant Directors’ defenses or, thus, the outcome of the Driver Shareholder, or the amount of legal fees that it and the Director Defendants will incur in defending the Driver Litigation.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
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PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Shares of the Corporation’s common stock are listed on the NASDAQ Global Select Market under the symbol “FUNC”. As of February 28, 2021, the issued and outstanding shares of Common Stock were held by 1,240 shareholders of record.
The ability of the Corporation to declare dividends is limited by federal banking laws and Maryland corporation laws. Subject to these and the terms of its other securities, including the TPS Debentures, the payment of dividends on the shares of common stock and the amounts thereof are at the discretion of the Corporation’s board of directors. In November 2010, the Corporation’s board of directors suspended the declaration and payment of cash dividends. This suspension was lifted in 2018. Cash dividends are typically declared on a quarterly basis. When paid, dividends to shareholders are dependent on the ability of the Corporation’s subsidiaries, especially the Bank, to declare dividends to the Corporation. Like the Corporation, the Bank’s ability to declare and pay dividends is subject to limitations imposed by federal and Maryland banking and Maryland corporation laws. A complete discussion of these and other dividend restrictions is contained in Item 1A of Part I of this annual report under the heading “Risks Relating to First United Corporation’s Securities” and in Note 23 to the Consolidated Financial Statements, both of which are incorporated herein by reference. Accordingly, there can be no assurance that dividends will be declared on the shares of common stock in any future fiscal quarter.
The Corporation’s Board of Directors periodically evaluates the Corporation’s dividend policy, both internally and in consultation with the Federal Reserve.
Issuer Repurchases
The following table provides information about shares of common stock purchased by or on behalf of First United Corporation and its affiliated purchases (as defined in Rule 10b-18 promulgated under the Exchange Act) during the three-month period ended December 31, 2020:
Plan Category (a) (b) (c)
Equity compensation plans approved by security holders — N/A 248,059 (1)
Equity compensation plans not approved by security holders — N/A N/A
Equity Compensation Plan Information
Pursuant to the SEC’s Regulation S-K Compliance and Disclosure Interpretation 106.01, the information required by this Item pursuant to Item 201(d) of Regulation S-K relating to securities authorized for issuance under the Corporation’s equity compensation plans is located in Item 12 of Part III of this annual report and is incorporated herein by reference.
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ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth certain selected financial data for each of the last five calendar years and is qualified in its entirety by the detailed information and financial statements, including notes thereto, included elsewhere or incorporated by reference in this annual report.
Balance Sheet Data
Operating Data
Per Share Data
Significant Ratios
(1)2017 includes $3,226 from tax reform impact
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and notes thereto for the years ended December 31, 2020 and 2019, which are included in Item 8 of Part II of this annual report.
Overview
First United Corporation is a bank holding company that, through the Bank and its non-bank subsidiaries, provides an array of financial products and services primarily to customers in four Western Maryland counties and four Northeastern West Virginia counties. Its principal operating subsidiary is the Bank, which consists of a community banking network of 25 branch offices located throughout its market areas. Our primary sources of revenue are interest income earned from our loan and investment securities portfolios and fees earned from financial services provided to customers.
Consolidated net income was $13.8 million for the year ended December 31, 2020 compared to $13.1 million for the year ended December 31, 2019. Basic and diluted net income per share for the year of 2020 were $1.98 and $1.97, respectively, compared to basic and diluted net income per share of $1.85 for the same period of 2019, a 7.0% increase. Subsequent to the issuance of a press release on February 19, 2021 that described the Corporation’s financial results for the 12 and three month periods ended December 31, 2020, management determined that approximately $0.6 million of previously deferred costs associated with consulting for automated services should be expensed during the fourth quarter of 2020. This determination negatively impacted net income for 2020 by approximately $0.4 million. The increase in earnings when comparing 2020 to 2019 was primarily due to an increase in net interest income of $2.2 million, an increase in other operating income, including gains, of $1.8 million, and a decrease in other operating expenses of $1.5 million partially offset by an increase in the provision for loan losses of $4.1 million. The increase in provision expense for 2020 was driven by an increase in the qualitative factors reflecting the uncertainty of the economic environment related to the COVID-19 pandemic and its impact on our borrowers. Of the $5.4 million net provision expense for the year, $5.9 million was related to COVID-19 qualitative factor adjustments and $0.8 million was related to loan growth and the change in loan mix. Provision expense was partially offset by the release of a specific allocation of $1.3 million based on a new appraisal, as a non-accrual loan moved to the OREO portfolio. Other operating income, including net gains, increased $1.8 million for the year ended December 31, 2020 when compared to the year ended December 31, 2019. This increase was due primarily to gains on the sale of mortgages to the secondary market as well as gains on sales of investment securities. Trust and brokerage income were strong despite market volatility early in 2020. These increases were partially offset by reduced service charge income, primarily NSF income, due to reduced consumer and business overdraft activity. Bank owned life insurance (“BOLI”) income decreased due to the receipt of death claim benefits in 2019. The net interest margin, on a fully-taxable equivalent (“FTE”) basis, declined for the year ended December 31, 2020 to 3.34% compared to 3.68% for the same period of 2019.
The provision for loan losses was $5.4 million for the year ended December 31, 2020, compared to $1.3 million for the year ended December 31, 2019. The increase in provision expense for 2020 was driven by an increase in the qualitative factors reflecting the uncertainty of the economic environment related to the COVID-19 pandemic and its impact on our borrowers. Of the $5.4 million net provision expense for the year, $5.9 million was related to COVID-19 qualitative factor adjustments and $0.8 million was related to loan growth and the change in loan mix. Provision expense was partially offset by the release of a specific allocation of $1.3 million based on a new appraisal, as a non-accrual loan moved to the other real estate owned (“OREO”) portfolio.
Other operating income, including gains, increased $1.8 million for the year ended December 31, 2020 when compared with the same period in 2019. The increase was primarily attributable to the $2.5 million increase in net gains, due primarily to the increase in mortgage origination in 2020 and the sale of those loans to the secondary market. Additionally, as prepayment speeds on investments held for sale were elevated due to the low-rate environment and the investments were prepaying at par, we made the decision to capture gains through the sale of these investments. The increased gains were offset by a $1.0 million decline in BOLI income due to the receipt of $1.1 million in death benefits in the third quarter of 2019. Service charge income, primarily NSF income, decreased as the consumer and business overdraft activity decreased in the year of 2020 due to reduced consumer spending and increased cash balances resulting from borrowers’ receipt of government stimulus payments and loans under the Small Business Administration (“SBA”) Paycheck Protection Program (“PPP”). Trust and brokerage income increased $0.4 million year-over-year although it was negatively affected by market volatility early in the year as trustee fees are directly related to the value of assets under management. Debit card income increased $0.2 million for the year ended December 31, 2020 when compared with the same period of 2019 despite reduced consumer spending. Debit card income continued to increase as we grew our deposit relationships and our customers increased use of our electronic services.
Other operating expenses decreased $1.5 million for the year ended December 31, 2020 when compared with the same period of 2019. Salaries and benefits decreased $3.6 million, primarily due to the $2.5 million salary expense offset related to loan originations, primarily PPP loans, as well as the reduced headcount resulting from the voluntary separation program implemented in the fourth quarter of 2019 and reduced life and health insurance costs. These reductions offset the annual merit increases awarded to our associates in April 2020, Financial First Responder bonuses paid and increased incentives for mortgage production. FDIC premiums increased
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slightly due to credits received on quarterly assessments in 2019. Equipment, occupancy and technology expenses remained stable when compared to 2019, as we began to realize cost savings from our core processor related to a new contract negotiated in 2020. Professional services increased $2.7 million primarily due to increased legal and professional expenses related to the 2020 proxy contest and related litigation. Investor relations expenses increased $1.0 million, also related to the 2020 proxy contest. OREO expenses decreased $1.5 million when compared to 2019, as we experienced lower valuation allowance write-downs related to updated appraisals. Increased marketing, consulting, miscellaneous expenses, dues and licenses, fraud expenses, miscellaneous loan fees and Visa processing fees were offset by reductions in schools and seminars, contributions, personnel related expenses, printed and office supplies, travel and lodging, mileage, contract labor, business related meals and other employee benefits expenses, most of which were related to limited operations as a result of the pandemic and management’s continued focus on cost savings and efficiencies. Other operating expenses recorded for 2020 include the above-mentioned $0.6 million of expenses associated with consulting for automated services that were previously deferred but that management determined, subsequent to February 19, 2021, should be expensed during the fourth quarter of 2020.
Outstanding loans increased to $1.2 billion at December 31, 2020, compared to $1.1 billion at December 31, 2019. The $117.4 million of growth was primarily attributable to the participation in the PPP loan program and core commercial loan growth partially offset by a decline in our mortgage loan portfolio. CRE loans increased by $33.7 million due to expansion of several new customer relationships as well as an increase in small business loans. Acquisition and development (“A&D”) loans declined by $1.0 million as amortization and payoffs offset new production. Commercial and industrial (“C&I”) loans increased by $144.4 million, including $114.0 million of PPP loans which remained on the balance sheet at December 31, 2020. The growth in the commercial portfolios was offset by a decline in residential mortgage loans of $59.3 million, as refinancing activity continued during the fourth quarter of 2020. Given the current low interest rate environment, customers have preferred longer-term fixed-rate loans. Management has elected to utilize the secondary market rather than hold mortgage loans in the portfolio at the longer-term fixed rates. The consumer loan portfolio declined slightly by $0.4 million during 2020.
Net interest income, on a non-GAAP, FTE basis, increased $2.2 million (4.7%) during the year ended December 31, 2020 when compared with the year ended December 31, 2019, driven by a $0.3 million (0.6%) increase in interest income and a $1.9 million (16.3%) decrease in interest expense. The net interest margin for the year ended December 31, 2020 was 3.34%, compared to 3.68% for the year ended December 31, 2019. The impact of average balances of PPP loans of approximately $137.0 million, offset by the $3.0 million of interest and fees related to these loans, had a negative impact on the margin of approximately 13 basis points. The margin was also negatively affected by the 2.25% drop in the Fed Funds rate since August 2019, which resulted in new loan production and existing loans repricing at lower rates. These factors resulted in a decrease of approximately 14 basis points in average loan yield when compared with the year ended December 31, 2019.
Comparing the year ended December 31, 2020 with the year ended December 31, 2019, interest income remained stable. The increase in interest and fees on loans of $2.0 million was partially offset by the reduction in investment income of $1.0 million. While the average balance of the investment portfolio remained consistent, bonds, at higher yielding rates, were called and replaced with lower yielding investments resulting in a decrease in average yield on the investment portfolio of 44 basis points. Excess cash balances attributable to deposit growth were invested at the lower Fed Funds rate, which also negatively affected interest income for the year ended December 31, 2020. Due to the uncertainties related to the COVID-19 pandemic and the volatile economic environment, the Bank maintained higher levels of liquidity throughout 2020 when compared to 2019. The increase in interest and fees on loans was due primarily to an increase in average balances of $144.5 million, primarily driven by the PPP loans but partially offset by the declining yield. The rate earned on the loan portfolio decreased by 46 basis points as a result of the significant decline in the rate environment over the past year and the high volume of PPP loans booked at the low 1.00% interest rate as noted above.
Total deposits at December 31, 2020 increased by $280.3 million when compared with deposits at December 31, 2019. During 2020, non-interest-bearing deposits increased by $125.8 million. This growth was driven by our retail and commercial account growth as well as deposits from PPP loans. Traditional savings accounts increased by $37.1 million, as we continued to see significant growth in our Prime Saver product. Total demand deposits increased by $42.0 million and total money market accounts increased by $101.1 million, due primarily to growth in our variable rate Value Money Market account. Time deposits less than $100,000 decreased by $7.5 million and time deposits greater than $100,000 decreased by $18.2 million. The decline in time deposits greater than $100,000 was due to a local municipality utilizing a maturing certificate of deposit for cash needs during this unprecedented economic environment as well as our repayment of the full outstanding balance of $10.0 million in a brokered CD that matured in May 2020.
The decrease in interest expense, despite an increase in average interest bearing liabilities of $79.7 million, was a direct result of a reduction in the cost of deposits of 21 basis points, a 24 basis point decrease in our short-term borrowings and a 34 basis point decrease in long-term borrowings, primarily driven by maturity of an interest rate swap. In addition, during the fourth quarter of 2020, management restructured three long-term FHLB advances that resulted in a reduced weighted rate on the $70.0 million portfolio of 80 basis points. A portion of this interest expense savings was captured in the fourth quarter of 2020 with the full impact expected in 2021. We proactively monitored the rate environment and reduced rates on our deposit portfolio throughout 2020. The average balance on our interest-bearing money market accounts increased $60.1 million, while the rate on these accounts decreased by 43 basis points. Average growth of $101.4 million in our non-interest-bearing accounts benefited our overall cost of deposits. Deposit growth was
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attributable to PPP loan funding and organic deposit growth in low cost core deposits with existing customers as well as new relationship customers during 2020.
Estimates and Critical Accounting Policies
This discussion and analysis of our financial condition and results of operations is based upon our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. (See Note 1 to the Consolidated Financial Statements.) On an on-going basis, management evaluates estimates and bases those estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Management believes the following critical accounting policies affect our more significant judgments and estimates used in the preparation of the Consolidated Financial Statements.
Allowance for Loan Losses
One of our most important accounting policies is that related to the monitoring of the loan portfolio. A variety of estimates impact the carrying value of the loan portfolio and resulting interest income, including the calculation of the ALL, the valuation of underlying collateral, and the timing of loan charge-offs. The ALL is established and maintained at a level that management believes is adequate to cover losses resulting from the inability of borrowers to make required payments on loans. Estimates for loan losses are arrived at by analyzing risks associated with specific loans and the loan portfolio, current and historical trends in delinquencies and charge-offs, and changes in the size and composition of the loan portfolio. The analysis also requires consideration of the economic climate and direction, changes in lending rates, political conditions, legislation impacting the banking industry and economic conditions specific to Western Maryland and Northeastern West Virginia. Because the calculation of the ALL relies on management’s estimates and judgments relating to inherently uncertain events, actual results may differ from management’s estimates.
The ALL is also discussed below in Item 7 under the heading “Allowance for Loan Losses” and in Note 8 to the Consolidated Financial Statements.
Goodwill
ASC Topic 350, Intangibles – Goodwill and Other provides guidance with respect to goodwill. Under this guidance, goodwill is not amortized but shall be tested at least annually for impairment at a level of accounting referred to as a reporting unit. The Corporation is considered the sole reporting unit. Goodwill of a reporting unit shall be tested for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Impairment of goodwill is the condition that exists when the carrying amount of a reporting unit that includes goodwill exceeds its fair value. A goodwill impairment loss is recognized for the amount that the carrying amount of a reporting unit, including goodwill, exceeds its fair value, limited to the total amount of goodwill allocated to that reporting unit.
An entity may assess qualitative factors to determine whether it is more likely than not (that is, a likelihood of more than 50 percent) that the fair value of a reporting unit is less than its carrying amount, including goodwill. If, after assessing the totality of events or circumstances qualitatively, an entity determines that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then the entity shall perform a quantitative goodwill impairment test. However, if, after assessing the totality of events or circumstances qualitatively, an entity determines that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then the quantitative goodwill impairment test is unnecessary.
The emergence of COVID-19 as a global pandemic in beginning in March 2020, resulted in significant deterioration in general economic conditions and caused a deterioration in the environment in which the Corporation operates. This uncertainty resulted in a significant decrease in the market prices for the stock of institutions in the financial services industry, including the Corporation. Based on the totality of the circumstances and the impact of the economic conditions on the stock price, the events more likely than not reduce the fair value of a reporting unit below its carrying amount, including goodwill. As such, quantitative analyses of the fair value of the Corporation were performed by a third party for each of the first three quarters of 2020 and no impairment was recognized.
During the fourth quarter of 2020, the economy began to see improvements with stimulus funding, decreasing unemployment rates within our market areas, the distributions of COVID-19 vaccines and the significant improvement in our stock price since September 2020. Based on these positive circumstances, Management performed a qualitative assessment on the impairment of goodwill at December 31, 2020.
Having considered each of the qualitative factors and the negative and positive evidence of the totality of events and circumstances qualitatively, management has determined that it is not more likely than not that the fair value of our reporting unit is less
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than its carrying amount and a quantitative goodwill impairment test is unnecessary. As such, management concludes there is no goodwill impairment at December 31, 2020.
Accounting for Income Taxes
We account for income taxes in accordance with ASC Topic 740, “Income Taxes”. Under this guidance, deferred taxes are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates that will apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date.
We regularly review the carrying amount of our net deferred tax assets to determine if the establishment of a valuation allowance is necessary. If based on the available evidence, it is more likely than not that all or a portion of our net deferred tax assets will not be realized in future periods, then a deferred tax valuation allowance must be established. Consideration is given to various positive and negative factors that could affect the realization of the deferred tax assets. In evaluating this available evidence, management considers, among other things, historical performance, expectations of future earnings, the ability to carry back losses to recoup taxes previously paid, length of statutory carry forward periods, experience with utilization of operating loss and tax credit carry forwards not expiring, tax planning strategies and timing of reversals of temporary differences. Significant judgment is required in assessing future earnings trends and the timing of reversals of temporary differences. Our evaluation is based on current tax laws as well as management’s expectations of future performance.
Management expects that the Corporation’s adherence to the required accounting guidance may result in increased volatility in quarterly and annual effective income tax rates because of changes in judgment or measurement including changes in actual and forecasted income before taxes, tax laws and regulations, and tax planning strategies.
Additional information about income taxes is set forth below under the heading, “CONSOLIDATED STATEMENT OF INCOME REVIEW – Applicable Income Taxes” and in Note 18 to Consolidated Financial Statements presented in Item 8 of Part II of this annual report.
Other-Than-Temporary Impairment of Investment Securities
Management systematically evaluates the securities in our investment portfolio for impairment on a quarterly basis. Based upon the application of accounting guidance for subsequent measurement in ASC Topic 320 (Section 320-10-35), management assesses whether (i) we have the intent to sell a security being evaluated and (ii) it is more likely than not that we will be required to sell the security prior to its anticipated recovery. If neither applies, then declines in the fair values of securities below their cost that are considered other-than-temporary declines are split into two components. The first is the loss attributable to declining credit quality. Credit losses are recognized in earnings as realized losses in the period in which the impairment determination is made. The second component consists of all other losses, which are recognized in other comprehensive loss. In estimating other-than-temporary impairment (“OTTI”) losses, management considers (a) the length of time and the extent to which the fair value has been less than cost, (b) adverse conditions specifically related to the security, an industry, or a geographic area, (c) the historic and implied volatility of the fair value of the security, (d) changes in the rating of the security by a rating agency, (e) recoveries or additional declines in fair value subsequent to the balance sheet date, (f) failure of the issuer of the security to make scheduled interest or principal payments, and (g) the payment structure of the debt security and the likelihood of the issuer being able to make payments that increase in the future. Management also monitors cash flow projections for securities that are considered beneficial interests under the guidance of ASC Subtopic 325-40, Investments – Other – Beneficial Interests in Securitized Financial Assets, (ASC Section 325-40-35). This process is described more fully in the section of the Consolidated Balance Sheet Review entitled “Investment Securities”.
Fair Value of Investments
We have determined the fair value of our investment securities in accordance with the requirements of ASC Topic 820, Fair Value Measurements and Disclosures, which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements required under other accounting pronouncements. We measure the fair market values of our investments based on the fair value hierarchy established in Topic 820. The determination of fair value of investments and other assets is discussed further in Note 25 to the Consolidated Financial Statements.
Pension Plan Assumptions
Our pension plan costs are calculated using actuarial concepts, as discussed within the requirements of ASC Topic 715, Compensation – Retirement Benefits. Pension expense and the determination of our projected pension liability are based upon two critical assumptions: the discount rate and the expected return on plan assets. We evaluate each of these critical assumptions annually. Other assumptions impact the determination of pension expense and the projected liability including the primary employee
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demographics, such as retirement patterns, employee turnover, mortality rates, and estimated employer compensation increases. These factors, along with the critical assumptions, are carefully reviewed by management each year in consultation with our pension plan consultants and actuaries. Further information about our pension plan assumptions, the plan’s funded status, and other plan information is included in Note 20 to the Consolidated Financial Statements.
Other than as discussed above, management does not believe that any material changes in our critical accounting policies have occurred since December 31, 2020.
Response to COVID-19
Early in 2020, we established a set of COVID-19 protocols, focused on protecting the health, safety, and financial well-being of our associates and customers. We sustained frequent ongoing communication with associates and customers, enhanced the use of electronic and digital banking services and upheld consistently high standards for fraud and internal controls all while delivering our full array of financial services to our customers. In addition, we made significant efforts to relieve pandemic related financial pressures for customers:
oWaived certificate of deposit early withdrawal penalties and NSF overdraft fees
oTemporarily waived positive pay/Treasury Management fees for new customer signup, aiding in fraud prevention efforts
oModified and deferred loans for eligible consumer and commercial loan customers experiencing hardships; total of 562 modifications for 2020 totaling $230.6 million; 40 active loan modifications totaling approximately $18.2 million, or 1.7% of the loan portfolio remaining as of February 28, 2021
oSuspended repossession and foreclosure activity
oCommunicated frequently with associates and borrowers, keeping them apprised of changing regulations regarding PPP loan application processes and forgiveness procedures
oProcessed approximately 1,174 PPP loan applications totaling $148.9 million
oProcessed approximately 348, or $34.5 million, in PPP loan forgiveness requests
oAdjusted community office lobby access based upon COVID-19 related spikes within each of our market areas.
oProvided remote work and flexible work hours for 90% of associates to protect their health and allow for care of children or other family members
oWeekly Be Informed! virtual calls and COVID-19 update email for our First United team
oPaid Financial First Responder bonuses to associates
Paycheck Protection Program
The CARES Act established the PPP, which provided small businesses with resources to maintain payroll, hire back employees who may have been laid off, and to cover applicable overhead expenses. We acted expeditiously to prepare our associates so they could guide our customers on the proper procedures necessary to enable them to take advantage of this program. We developed a PPP specific information site within our website that provided detailed information, links and materials for eligible customers to access. Internally, we reallocated resources to review, process and data enter customer applications, working tirelessly over extended hours to provide access to as many local business owners as possible. These loans are 100% guaranteed by the SBA, have up to a two or five year maturity, provide for the earlier of when the Bank received forgiveness payment from the SBA or 10 months after the end of the covered payroll period, and have an interest rate of 1%. These loans may be forgiven, in whole or in part, by the SBA if the borrower meets certain conditions, including by using at least 60% of the loan proceeds for payroll costs. The SBA also established processing fees from 1% to 5%, depending on the loan amount. Of the $3.7 million of deferred loan fees, we recognized approximately $2.0 million in 2020.
In April 2020, the Bank established eligibility to participate in the Paycheck Protection Program Liquidity Facility (“PPPLF”) which was established by Congress and administered by the Federal Reserve Bank. This facility uses the SBA guaranteed PPP loans as collateral, offering 100% collateral coverage with no recourse to the Bank. The Bank’s board of directors and management team believe that it is prudent to maintain our existing liquidity facilities available for our contingency funding plan given the current economic conditions. The majority of the PPP loan disbursements have been to internal, non-interest-bearing accounts awaiting use by borrowers. As a result, we did not access the PPPLF during 2020, but are prepared to utilize the fund if and when management determines the timing is appropriate.
During the second quarter of 2020, the Bank was approved to participate in the Main Street Lending Program established by the Federal Reserve. This program supports lending to small and medium-sized businesses and non-profit organizations that were in sound financial condition before the onset of the COVID-19 pandemic.
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During the third quarter of 2020, the Bank implemented PPP loan forgiveness processes to assist our borrowers with applications. Communication with the associates and borrowers was a focus as we helped them through this process. As of December 31, 2020, we have processed loan forgiveness applications for approximately $34.5 million of PPP loans.
In January 2021, President Trump signed the Economic Aid to Hard-Hit Small Businesses, Nonprofits, and Venues Act into law. This act provides an extension of stimulus package benefits and unemployment through March 14, 2021 as well as funding for additional PPP loans. As of March 11, 2021, we have processed 561 PPP2 loan applications totaling $56.4 million.
Liquidity Sources
Management has reviewed its Liquidity Contingency Funding Plan in preparation of funding needs as it relates to the COVID-19 pandemic. As of December 31, 2020, the Corporation had approximately $130.0 million in unsecured lines of credit with its correspondent banks, $1.1 million with the Federal Reserve Discount Window, and approximately $134.4 million of secured borrowings with the FHLB. Additionally, the Corporation has access to the brokered certificates of deposit market.
As noted above, the Corporation is eligible to access the PPPLF when it is deemed appropriate.
Capital
The Corporation’s and the Bank’s capital ratios are strong, and both institutions are considered to be well-capitalized by applicable regulatory measures
Adoption of New Accounting Standards and Effects of New Accounting Pronouncements
Note 1 to the Consolidated Financial Statements discusses new accounting pronouncements that, when adopted, could affect our future consolidated financial statements.
CONSOLIDATED STATEMENT OF INCOME REVIEW
Net Interest Income
Net interest income is our largest source of operating revenue. Net interest income is the difference between the interest that we earn on our interest-earning assets and the interest expense we incur on our interest-bearing liabilities. For analytical and discussion purposes, net interest income is adjusted to a FTE basis to facilitate performance comparisons between taxable and tax-exempt assets by increasing tax-exempt income by an amount equal to the federal income taxes that would have been paid if this income were taxable at the statutorily applicable rate. This is a non-GAAP disclosure and management believes it is not materially different than the corresponding GAAP disclosure.
The table below summarizes net interest income for 2020 and 2019.
GAAP Non-GAAP - FTE
Net interest income, on a non-GAAP, FTE basis, increased $2.2 million (4.7%) during the year ended December 31, 2020 when compared with the year ended December 31, 2019, driven by a $0.3 million (0.6%) increase in interest income and a $1.9 million (16.3%) decrease in interest expense. The net interest margin for the year ended December 31, 2020 was 3.34%, compared to 3.68% for the year ended December 31, 2019. The impact of average balances of PPP loans of approximately $137.0 million, offset by the $3.0 million of interest and fees related to these loans, had a negative impact on the margin of approximately 13 basis points. The margin was also negatively affected by the 2.25% drop in the Fed Funds rate since August 2019, which resulted in new loan production and existing loans repricing at lower rates. These factors resulted in a decrease of approximately 14 basis points in average loan yield when compared with the year ended December 31, 2019.
Comparing the year ended December 31, 2020 to the year ended December 31, 2019, interest income remained stable. The increase in interest and fees on loans of $2.0 million was partially offset by the reduction in investment income of $1.0 million. While the average balance of the investment portfolio remained consistent, bonds, at higher yielding rates, were called and replaced with lower yielding investments resulting in a decrease in average yield on the investment portfolio of 44 basis points. Excess cash balances attributable to deposit growth were invested at the lower Fed Funds rate which also negatively affected interest income for the year
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ended December 31, 2020. In late December, approximately $70.0 million of excess cash was deployed into the investment portfolio at an average yield of 1% that will provide additional interest income in 2021. Due to the uncertainties related to the COVID-19 pandemic and the volatile economic environment, the Bank maintained higher levels of liquidity in 2020 than in 2019. The increase in interest and fees on loans was due primarily to an increase in average balances of $144.5 million, primarily driven by the PPP loans but partially offset by the declining yield. The rate earned on the loan portfolio decreased by 46 basis points as a result of the significant decline in the rate environment over the past year and the high volume of PPP loans booked at the low 1.00% interest rate as noted above.
The decrease in interest expense, despite an increase in average interest bearing liabilities of $79.7 million, was a direct result of a reduction in the cost of deposits of 21 basis points, a 24 basis point decrease in our short-term borrowings and a 34 basis point decrease in long-term borrowings, primarily driven by maturity of an interest rate swap. In addition, during the fourth quarter of 2020, management restructured three long-term FHLB advances that resulted in a reduced weighted rate on the $70.0 million portfolio of 80 basis points. A portion of this interest expense savings was captured in the fourth quarter of 2020 with the full impact expected in 2021. We proactively monitored the rate environment and reduced rates on our deposit portfolio throughout 2020. The average balance on our interest-bearing money market accounts increased $60.1 million, while the rate on these accounts decreased by 43 basis points. Average growth of $101.4 million in our non-interest-bearing accounts benefited our overall cost of deposits. Deposit growth was attributable to PPP loan funding and organic deposit growth in low cost core deposits with existing customers as well as new relationship customers during 2020.
As shown below, the composition of total interest income between 2020 and 2019 remained relatively stable.
% of Total Interest Income
Interest and fees on loans 90% 87%
Interest on investment securities 9% 12%
Other 1% 1%
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The following table sets forth the average balances, net interest income and expense, and average yields and rates for our interest-earning assets and interest-bearing liabilities for 2020, 2019 and 2018.
Distribution of Assets, Liabilities and Shareholders’ Equity
Interest Rates and Interest Differential – Tax Equivalent Basis
For the Years Ended December 31
Assets
Investment Securities:
Liabilities and Shareholders’ Equity
Time deposits:
Notes:
(1)The above table reflects the average rates earned or paid stated on a FTE basis assuming a tax rate of 21% for 2020 and 2019, and 35% for 2018. Non-GAAP interest income on a fully taxable equivalent basis for the years ended December 31, 2020, 2019 and 2018 were $917, $868, and $796, respectively.
(2)The average balances of non-accrual loans for the years ended December 31, 2020, 2019 and 2018, which were reported in the average loan balances for these years, were $9,945, $11,455, and $5,023, respectively.
(3)Net interest margin is calculated as net interest income divided by average earning assets.
(4)The average yields on investments are based on amortized cost.
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The following table sets forth an analysis of volume and rate changes in interest income and interest expense of our average interest-earning assets and average interest-bearing liabilities for 2020, 2019 and 2018. This table distinguishes between the changes related to average outstanding balances (changes in volume created by holding the interest rate constant) and the changes related to average interest rates (changes in interest income or expense attributed to average rates created by holding the outstanding balance constant).
Interest Variance Analysis (1)
(In thousands and tax equivalent basis) Volume Rate Net Volume Rate Net
Interest Income:
Interest-bearing deposits (7) (7) (14) (6) 12 6
Interest Expense:
Note:
(1)The change in interest income/expense 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.
Provision for Loan Losses
The provision for loan losses was $5.4 million for the year ended December 31, 2020 and $1.3 million for the year ended December 31, 2019. Net charge-offs of $1.5 million were recorded for 2020, compared to net recoveries of $0.2 million for 2019. The increase in provision expense for 2020 was driven by an increase in the qualitative factors reflecting the uncertainty of the economic environment related to the COVID-19 pandemic and its impact on our borrowers. Of the $5.4 million net provision expense for the year, $5.9 million was related to COVID-19 qualitative factor adjustments and $0.8 million was related to loan growth and the change in loan mix. Provision expense was partially offset by the release of a specific allocation of $1.3 million based on a new appraisal, as a non-accrual loan moved to the OREO portfolio. Management believes that the ALL reflects a level commensurate with the risk inherent in our loan portfolio.
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Other Operating Income
The following table shows the major components of other operating income for the past two years, exclusive of net gains, and the percentage changes during these years:
(Dollars in thousands) 2020 2019 % Change
Other operating income, exclusive of gains, decreased $0.7 million during the year ended December 31, 2020 when compared to the same period of 2019. The decrease was primarily a result of the decrease in BOLI income relating to the $1.1 million BOLI death benefit proceeds received during the third quarter 2019. Service charge income, primarily NSF income, decreased as the consumer and business overdraft activity decreased in the year of 2020 due to reduced consumer spending and increased cash balances resulting from the receipt of government stimulus payments and PPP funding. Trust and brokerage income increased $0.4 million year-over-year although it was negatively affected by market volatility early in the year as trustee fees are directly related to the value of assets under management. Debit card income increased $0.2 million for the year ended December 31, 2020 when compared with the same period of 2019 despite reduced consumer spending. Debit card income continues to increase as we grow our deposit relationships and our customers increase use of our electronic services.
Net gains of $2.8 million and $0.3 million were reported through other income for the years ended December 31, 2020 and 2019, respectively. The $2.5 million increase in gains was attributable to the increased sales of mortgage loans to Fannie Mae as well as gains on sales in the investment portfolio.
Other Operating Expense
The following table compares the major components of other operating expense for 2020 and 2019:
(Dollars in thousands) 2020 2019 % Change
Other operating expenses decreased $1.5 million for the year ended December 31, 2020 when compared to the same period of 2019. Salaries and benefits decreased $3.6 million, primarily due to the $2.5 million salary expense offset related to loan originations, primarily PPP loans, as well as the reduced headcount resulting from the voluntary separation program implemented in the fourth quarter of 2019 and reduced life and health insurance costs. These reductions offset the annual merit increases awarded to our associates in April 2020, our payment of Financial First Responder bonuses, and increased incentives for mortgage production. FDIC premiums increased slightly due to credits received on quarterly assessments in 2019. Equipment, occupancy and technology expenses remained stable when compared with 2019 as we began to realize cost savings from our core processor related to a new contract negotiated in 2020. Professional services increased $2.7 million primarily due to increased legal and professional expenses related to the 2020 proxy contest and related litigation. Investor relations expenses increased $1.0 million, also related to the 2020 proxy contest. OREO expenses decreased $1.5 million as compared with 2019 as we experienced lower valuation allowance write-downs related to updated appraisals.
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Increased marketing, consulting, miscellaneous expenses, dues and licenses, fraud expenses, miscellaneous loan fees and Visa processing fees, were offset by reductions in schools and seminars, contributions, personnel related expenses, printed and office supplies, travel and lodging, mileage, contract labor, business related meals and other employee benefits expenses, most of which were related to limited operations as a result of the pandemic and management’s continued focus on cost savings and efficiencies. Other operating expenses recorded for 2020 include $0.6 million of expenses associated with consulting for automated services that were previously deferred but that management determined, subsequent to February 19, 2021, should be expensed during the fourth quarter of 2020.
Applicable Income Taxes
We recognized a tax expense of $3.9 million in 2020, compared to a tax expense of $3.3 million in 2019. See the discussion under “Income Taxes” in Note 18 to the Consolidated Financial Statements presented elsewhere in this annual report for a detailed analysis of our deferred tax assets and liabilities. Our effective tax rate was 22.2% in 2020 and 20.3% in 2019. The increase in the effective tax rate was primarily due to the reduced tax exempt income, particularly related to the $1.1 million of BOLI death benefit proceeds received in 2019.
At December 31, 2020, the Corporation had Maryland Net Operating Losses (“NOLs”) of $40.4 million for which a deferred tax asset of $2.7 million has been recorded. There has been and continues to be a full valuation allowance on these NOLs based on management’s belief that it is more likely than not that these NOLs will not be realized prior to the expiration of their carry-forward periods because the Corporation will not generate sufficient taxable income in the future to fully utilize the NOLs. The valuation allowance was $2.7 million at December 31, 2020 and $2.6 million at December 31, 2019.
We have concluded that no valuation allowance is deemed necessary for our remaining federal and state deferred tax assets at December 31, 2020, as it is more likely than not that they will be realized based on the expected reversal of deferred tax liabilities, the generation of future income sufficient to realize the deferred tax assets as they reverse, and the ability to implement tax planning strategies to prevent the expiration of any carry-forward periods.
CONSOLIDATED BALANCE SHEET REVIEW
Overview
Total assets at December 31, 2020 increased by $291.4 million to $1.7 billion from December 31, 2019. During 2020, cash and interest-bearing deposits in other banks increased by $99.5 million, the investment portfolio increased by $69.9 million and gross loans increased by $117.4 million but were offset by an increase in unearned fees of $1.0 million and an increase to the ALL of $4.0 million. The increase in cash was due to continued deposit growth, consisting of both core deposit growth and deposits related to the PPP loans, cash flow from calls on the investment portfolio, commercial loan payoffs as well as continued refinances of balances in our mortgage portfolio. The increase in the securities portfolio resulted from a strategic decision to purchase approximately $70.0 million of new investments in December 2020 as an alternative to holding low yielding cash balances. These investments will provide additional earnings in 2021 of approximately $0.7 million. OREO balances increased due to the movement of one large commercial participation loan from non-accrual loans to OREO after the foreclosure sale of the property early in the fourth quarter of 2020. This addition was partially offset by the sale of properties during the fourth quarter of 2020. Accrued interest receivable and other assets increased $3.6 million during 2020. Total liabilities increased by $286.3 million when compared with liabilities at December 31, 2019. This increase was primarily attributable to the strong deposit growth of $280.3 million, inclusive of the remaining deposit balances related to the PPP loans at December 31, 2020. Deposit growth of $182.9 million, excluding the PPP deposits, during the year of 2020 was due to increased relationship balances as we continued to grow core relationships and customers favored insured products given the volatile economic environment. Our Treasury Management overnight investment sweep remained constant. Accrued interest payable and other liabilities increased $5.8 million. This increase was primarily related to $2.1 million of assets in 2019 in reserve for taxes moving to a liability in 2020. Total shareholders’ equity increased by $5.1 million during 2020, primarily due to the increase in earnings attributable to year-to-date net income, partially offset by common stock dividends of $3.6 million and the decline in surplus of $2.8 million related to stock repurchases during the first quarter of 2020 and the increase of $2.9 million in accumulated other comprehensive loss.
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As indicated below, the total interest-earning asset mix remained constant at December 31, 2020 as compared to December 31, 2019. The mix for each year is illustrated below:
Year End Percentageof Total Assets
Cash and cash equivalents 9% 3%
The year-end total liability mix has remained consistent during the two-year period as illustrated below.
Year End Percentageof Total Liabilities
Total deposits 90% 87%
Total borrowings 9% 11%
Loan Portfolio
The Bank is actively engaged in originating loans to customers primarily in Allegany County, Frederick County, Garrett County, and Washington County in Maryland, and in Berkeley County, Mineral County, Monongalia County, and Harrison County in West Virginia; and the surrounding regions of West Virginia and Pennsylvania. We have policies and procedures designed to mitigate credit risk and to maintain the quality of our loan portfolio. These policies include underwriting standards for new credits as well as continuous monitoring and reporting policies for asset quality and the adequacy of the ALL. These policies, coupled with ongoing training efforts, have provided effective checks and balances for the risk associated with the lending process. Lending authority is based on the type of the loan, and the experience of the lending officer.
Commercial loans are collateralized primarily by real estate and, to a lesser extent, equipment and vehicles. Unsecured commercial loans represent an insignificant portion of total commercial loans. Residential mortgage loans are collateralized by the related property. Generally, a residential mortgage loan exceeding a specified internal loan-to-value ratio requires private mortgage insurance. Installment loans are typically collateralized, with loan-to-value ratios which are established based on the financial condition of the borrower. We also have made unsecured consumer loans to qualified borrowers meeting our underwriting standards. Additional information about our loans and underwriting policies can be found in Item 1 of Part I of this annual report under the heading “Banking Products and Services”.
The following table sets forth the composition of our loan portfolio. Historically, our policy has been to make the majority of our loan commitments in our market areas. We had no foreign loans in our portfolio as of December 31 for any of the years presented.
Summary of Loan Portfolio
The following table presents the composition of our loan portfolio as of December 31 for the past five years:
Outstanding loans increased to $1.2 billion at December 31, 2020, compared to $1.1 billion at December 31, 2019. The $117.4 million of growth was primarily attributable to the participation in the PPP loan program and core commercial loan growth partially offset by a decline in our mortgage loan portfolio. CRE loans increased by $33.7 million due to expansion of several new customer relationships as well as an increase in small business loans. A&D loans declined by $0.9 million as amortization and payoffs offset new production. C&I loans increased by $144.4 million, including $114.0 million of PPP loans which remained on the balance sheet at December 31, 2020. The growth in the commercial portfolios was offset by a decline in residential mortgage loans of $59.3 million, as we saw robust refinancing activity during 2020. Given the current low interest rate environment, customers preferred
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longer-term fixed-rate loans. Management elected to utilize the secondary market rather than hold mortgage loans in the portfolio at the longer-term fixed rates. The consumer loan portfolio declined slightly by $0.5 million during 2020.
Commercial loan production for 2020 was approximately $190.1 million, including PPP loan originations. Commercial construction funding continued to ramp up during the fourth quarter as projects are entering their larger draw periods, which should result in increased outstanding balances in 2021. At 2020 year-end, unfunded, committed commercial construction loans equaled $41.0 million. Commercial amortization and payoffs were approximately $85.2 million through December 31, 2020, including approximately $34.5 million of PPP loan forgiveness. Consumer mortgage loan production continued at a record pace, with the production of approximately $144.6 million for 2020. The production and pipeline mix of in-house, portfolio loans and investor loans remained robust at December 31, 2020, with those loans totaling $24.6 million, consisting of $12.0 million in portfolio loans and $12.6 million in investor loans.
The following table sets forth the maturities, based upon contractual dates, for selected loan categories as of December 31, 2020:
Maturities of Loan Portfolio at December 31, 2020
Classified by Sensitivity to Change in Interest Rates
Management monitors the performance and credit quality of the loan portfolio by analyzing the age of the portfolio as determined by the length of time a required payment is past due. A loan is considered to be past due when a scheduled payment has not been received for 30 days past its contractual due date. For all loan segments, the accrual of interest is discontinued when principal or interest is delinquent for 90 days or more unless the loan is well-secured and in the process of collection. All non-accrual loans are considered to be impaired. Interest payments received on non-accrual loans are applied as a reduction of the loan principal balance. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured. Our policy for recognizing interest income on impaired loans does not differ from our overall policy for interest recognition.
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The following sets forth the amounts of non-accrual, past-due and restructured loans for the past five years:
Risk Elements of Loan Portfolio
At December 31,
Non-accrual loans:
Commercial and industrial — 30 — 378 —
Accruing Loans Past Due 90 days or more:
Commercial and industrial — — — 6 11
Restructured Loans (TDRs):
Valuation allowance related to impaired loans $ 57 $ 2,173 $ 144 $ 362 $ 260
Non-Accrual Loans as a % of Applicable Portfolio
Acquisition and development 0.3% 6.8% 0.1% 0.2% 0.1%
We would have recognized $0.5 million in interest income for the year ended December 31, 2020 had our non-accrual loans been current and performing in accordance with their terms. During 2020, we recognized, on a cash basis, $0.1 million of interest income on non-accrual loans that paid off.
Performing loans considered to be impaired (including performing troubled debt restructurings, or TDRs), as defined and identified by management, amounted to $4.1 million at December 31, 2020 and $4.6 million at December 31, 2019. Loans are identified as impaired when, based on current information and events, management determines that we will be unable to collect all amounts due according to contractual terms. These loans consist primarily of A&D loans and CRE loans. The fair values are generally determined based upon independent third-party appraisals of the collateral or discounted cash flows based upon the expected proceeds. Specific allocations have been made where management believes there is insufficient collateral to repay the loan balance if liquidated and there is no secondary source of repayment available. The decrease in valuation allowance related to impaired loans is due to the movement of the A&D loan to OREO, as previously discussed.
The level of performing impaired loans (other than performing TDRs) increased by $0.4 million during the year ended December 31, 2020.
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A troubled debt restructuring is the restructuring of a loan in which one or more concessions are granted to a borrower who is experiencing financial difficulties. A loan will be classified as a TDR if the Bank restructures the loan’s terms (i.e., interest rate, payment amount, amortization period and/or maturity date) after determining that the borrower is experiencing financial difficulties. A modified loan is considered to be a TDR when the Bank has determined that the borrower is experiencing financial difficulties. The Bank evaluates the probability that the borrower will be in payment default on any of its debt in the foreseeable future without modification. To make this determination, the Bank performs a global financial review of the borrower and loan guarantors to assess their current ability to meet their financial obligations. The following table presents the details of TDRs by loan class at December 31, 2020 and December 31, 2019:
Performing
Commercial real estate
Acquisition and development
Commercial and industrial 0 — 0 —
Residential mortgage
Residential mortgage – home equity 0 — 0 —
Consumer 0 — 0 —
Non-accrual
Commercial real estate
Non owner-occupied 0 $ — 0 $ —
All other CRE 0 — 0 —
Acquisition and development
1-4 family residential construction 0 — 0 —
All other A&D 0 — 0 —
Commercial and industrial 0 — 0 —
Residential mortgage
Residential mortgage – home equity 0 — 0 —
Consumer 0 — 0 —
The level of TDRs decreased by $0.2 million during the year ended December 31, 2020. There were no new loans added to TDRs and nine loans already in performing TDRs were re-modified. During the year ended December 31, 2020, one loan totaling $32 thousand paid off. Net principal payments totaling $0.2 million were received during the same time period.
At December 31, 2020, there were no additional funds committed to be advanced in connection with TDRs. Interest income not recognized due to rate modifications of TDRs was $28 thousand and interest income recognized on all TDRs was $0.2 million in 2020.
Section 4013 of the CARES Act allows financial institutions to suspend application of certain current TDR accounting guidance under ASC Subtopic 310-40 for loan modifications related to the COVID-19 pandemic made between March 1, 2020 and the date that is 60 days after the end of the COVID-19 national emergency, provided that certain criteria are met. This relief can be applied to loan modifications for borrowers that were not more than 30 days past due as of December 31, 2019 and to loan modifications that defer or delay the payment of principal or interest, or that change the interest rate on the loan. In April 2020, federal and state banking regulators issued the Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus to provide further interpretation of when a borrower is experiencing financial difficulty, specifically indicating that if the modification is either short-term (i.e., six months or less) or mandated by a federal or state government in response to the COVID-19 pandemic, the borrower is not experiencing financial difficulty as determined under ASC Subtopic 310-40. In response to the COVID-19 pandemic, the Bank developed a set of guidelines to provide relief to qualified commercial, mortgage and consumer loans customers,
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including the deferment of certain loan payments on these loans of up to 180 days. Initial deferrals of 90 days were granted to qualified customers with the option to request a second deferral for an additional 90 days. During 2020, 562 loans totaling $230.6 million were granted deferrals for interest or principal and interest payments. At December 31, 2020, 40 loans totaling $18.2 million remain in modification status. See Note 2 to the Consolidated Financial Statements presented elsewhere in this annual report for additional information regarding these modified loans.
The Bank has not characterized any of these modified loans as TDRs because they met the criteria established pursuant to Section 4013 of the CARES Act and the guidance issued thereunder, nor has the Bank designated them as past due or nonaccrual. The Bank continues to prudently work with borrowers who have been negatively impacted by the COVID-19 pandemic while managing credit risks and recognizing an appropriate ALL.
Allowance for Loan Losses
The ALL is maintained to absorb losses from the loan portfolio. The ALL is based on management’s continuing evaluation of the quality of the loan portfolio, assessment of current economic conditions, diversification and size of the portfolio, adequacy of collateral, past and anticipated loss experience, and the amount of non-performing loans.
The ALL is also based on estimates, and actual losses will vary from current estimates. These estimates are reviewed quarterly, and as adjustments, either positive or negative, become necessary, a corresponding increase or decrease is made in the ALL. The methodology used to determine the adequacy of the ALL is consistent with prior years. An estimate for probable losses related to unfunded lending commitments, such as letters of credit and binding but unfunded loan commitments is also prepared. This estimate is computed in a manner similar to the methodology described above, adjusted for the probability of actually funding the commitment.
The ALL was $16.5 million at December 31, 2020 compared to $12.5 million at December 31, 2019, an increase of 31.5% that resulted primarily from adjustments to qualitative factors associated with the negative trend in the economic outlook and uncertainties in credit quality directly related to COVID-19. Net charge-offs of $1.5 million were recorded for 2020, compared to net recoveries of $0.2 million for 2019. The ratio of the ALL to loans outstanding, including PPP loan balances, was 1.41% at December 31, 2020 compared to 1.19% at December 31, 2019 and 1.36% at September 30, 2020. The ALL to loans outstanding, excluding PPP loan balances of $114.0 million, was 1.55% at December 31, 2020.
The ratio of net charge-offs to average loans for the year ended December 31, 2020 was an annualized 0.13%, compared to net recoveries to average loans of 0.02% for the year ended December 31, 2019. Details of the ratio, by loan type are shown below. The increase in net charge offs in the A&D portfolio is related to the $1.1 million charge off of a formerly allocated specific allowance on an adversely classified non-accrual participation loan during the third quarter of 2020. This loan was subsequently purchased by the lending group at foreclosure and moved to the OREO portfolio. The project is now being aggressively marketed. Our special assets team continues to effectively collect on charged-off loans, resulting in ongoing overall low charge-off ratios.
Accruing loans past due 30 days or more decreased to 0.20%, including PPP loans, or 0.22% excluding PPP loans, compared to 0.67% at December 31, 2019. Non-accrual loans totaled $3.3 million at December 31, 2020 compared to $10.8 million at December 31, 2019. The decrease in non-accrual balances at December 31, 2020 was primarily due to the movement of the $8.0 million A&D participation loan to OREO as described previously. In February 2021, a parcel was sold within the development which reduced the OREO balance by $2.2 million.
Management believes that the ALL at December 31, 2020 is adequate to provide for probable losses inherent in our loan portfolio. Amounts that will be recorded for the provision for loan losses in future periods will depend upon trends in the loan balances, including the composition of the loan portfolio, changes in loan quality and loss experience trends, potential recoveries on previously charged-off loans and changes in other qualitative factors. Management also applies interest rate risk, collateral value and debt service sensitivity analyses to the CRE loan portfolio and obtains new appraisals on specific loans under defined parameters to assist in the determination of the periodic provision for loan losses.
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The following table presents the activity in the ALL by major loan category for the past five years.
Analysis of Activity in the Allowance for Loan Losses
For the Years Ended December 31,
Charge-offs:
Recoveries:
Allowance for loan losses to total loans(as %) 1.41% 1.19% 1.10% 1.12% 1.11%
The following presents management’s allocation of the ALL by major loan category in comparison to that loan category’s percentage of total loans. Changes in the allocation over time reflect changes in the composition of the loan portfolio risk profile and refinements to the methodology of determining the ALL. Specific allocations in any particular category may be reallocated in the future as needed to reflect current conditions. Accordingly, the entire ALL is considered available to absorb losses in any category.
Allocation of the Allowance for Loan Losses
For the Years Ended December 31,
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Investment Securities
The following table sets forth the composition of our securities portfolio by major category as of the indicated dates:
At December 31,
Securities Available-for-Sale:
Securities Held to Maturity:
Total fair value of investment securities available-for-sale at December 31, 2020 increased by $95.6 million when compared to December 31, 2019. At December 31, 2020, the securities classified as available-for-sale included a net unrealized loss of $3.6 million, compared to a net unrealized loss of $3.7 million at December 31, 2019. These unrealized losses represent the difference between the fair value and amortized cost of securities in the portfolio. On June 1, 2014, management reclassified an amortized cost basis of $107.6 million of available-for-sale securities to held to maturity. The unrealized loss of approximately $4.0 million, at the date of transfer, will continue to be reported in a separate component of shareholders’ equity as accumulated other comprehensive income and will be amortized over the remaining life of the securities as an adjustment of yield in a manner consistent with the amortization of any premium or discount.
As discussed in Note 25 to the Consolidated Financial Statements, we measure fair market values based on the fair value hierarchy established in ASC Topic 820, Fair Value Measurements and Disclosures. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). Level 3 prices or valuation techniques require inputs that are both significant to the valuation assumptions and are not readily observable in the market (i.e. supported with little or no market activity). These Level 3 instruments are valued based on both observable and unobservable inputs derived from the best available data, some of which is internally developed, and considers risk premiums that a market participant would require.
Approximately $213.6 million of the available-for-sale portfolio was valued using Level 2 pricing and had net unrealized gains of $1.7 million at December 31, 2020. The remaining $13.3 million of the securities available-for-sale represents the entire CDO portfolio, which was valued using significant unobservable inputs, or Level 3 pricing. The $5.3 million in net unrealized losses associated with the collateralized debt obligation (“CDO”) portfolio relates to nine pooled trust preferred securities. Unrealized losses of $3.8 million represent non-credit related OTTI charges on seven of the securities, while $1.5 million of unrealized losses relates to two securities which have no credit related OTTI. The unrealized losses on these securities are primarily attributable to continued depression in the marketability and liquidity associated with CDOs.
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The following table provides a summary of the trust preferred securities in the CDO portfolio and the credit status of the securities as of December 31, 2020.
Investment Description First United Level 3 Investments Security Credit Status
The terms of the debentures underlying trust preferred securities allow the issuer of the debentures to defer interest payments for up to 20 quarters, and, in such case, the terms of the related trust preferred securities require their issuers to contemporaneously defer dividend payments. The issuers of the trust preferred securities in our investment portfolio have defaulted and/or deferred payments, ranging from 5.14% to 14.83% of the total collateral balances underlying the securities. The securities were designed to include structural features that provide investors with credit enhancement or support to provide default protection by subordinated tranches. These features include over-collateralization of the notes or subordination, excess interest or spread which will redirect funds in situations where collateral is insufficient, and a specified order of principal payments. There are securities in our portfolio that are under-collateralized, which does represent additional stress on our tranche. However, in these cases, the terms of the securities require excess interest to be redirected from subordinate tranches as credit support, which provides additional support to our investment.
Management systematically evaluates securities for impairment on a quarterly basis. Based upon application of ASC Topic 320 (Section 320-10-35), management must assess whether (i) the Corporation has the intent to sell the security and (ii) it is more likely than not that the Corporation will be required to sell the security prior to its anticipated recovery. If neither applies, then declines in the fair value of securities below their cost that are considered other-than-temporary declines are split into two components. The first is the loss attributable to declining credit quality. Credit losses are recognized in earnings as realized losses in the period in which the impairment determination is made. The second component consists of all other losses. The other losses are recognized in other comprehensive income. In estimating OTTI charges, management considers (a) the length of time and the extent to which the fair value has been less than cost, (b) adverse conditions specifically related to the security, an industry, or a geographic area, (c) the historic and implied volatility of the security, (d) changes in the rating of a security by a rating agency, (e) recoveries or additional declines in fair value subsequent to the balance sheet date, (f) failure of the issuer of the security to make scheduled interest payments, and (g) the payment structure of the debt security and the likelihood of the issuer being able to make payments that increase in the future. Due to the duration and the significant market value decline in the pooled trust preferred securities held in our portfolio, we performed more extensive testing on these securities for purposes of evaluating whether or not an OTTI has occurred.
The market for these securities as of December 31, 2020 is not active and markets for similar securities are also not active. The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which these securities trade and then by a significant decrease in the volume of trades relative to historical levels. The new issue market is also inactive, as no new CDOs have been issued since 2007. There are currently very few market participants who are willing to effect transactions in these securities. The market values for these securities are very depressed relative to historical levels. Therefore, in the current market, a low market price for a particular bond may only provide evidence of stress in the credit markets in general rather than being an indicator of credit problems with a particular issue. Given the conditions in the current debt markets and the absence of observable transactions in the secondary and new issue markets, management has determined that (i) the few observable transactions and market quotations that are available are not reliable for the purpose of obtaining fair value at December 31, 2020, (ii) an income valuation approach technique (i.e. present value) that maximizes the use of relevant unobservable inputs and minimizes the use of observable inputs will be equally or more representative of fair value than a market approach, and (c) the CDO segment is appropriately classified within Level 3 of the valuation hierarchy because management determined that significant adjustments were required to determine fair value at the measurement date.
Management relies on an independent third party to prepare both the evaluations of OTTI and the fair value determinations for the CDO portfolio. Management does not believe that there were any material differences in the OTTI evaluations and pricing between December 31, 2020 and December 31, 2019.
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The approach used by the third party to determine fair value involved several steps, which included detailed credit and structural evaluation of each piece of collateral in each bond, projection of default, recovery and prepayment/amortization probabilities for each piece of collateral in the bond, and discounted cash flow modeling. The discount rate methodology used by the third party combines a baseline current market yield for comparable corporate and structured credit products with adjustments based on evaluations of the differences found in structure and risks associated with actual and projected credit performance of each CDO being valued. Currently, the only active and liquid trading market that exists is for stand-alone trust preferred securities, with a limited market for highly-rated CDO securities that are more senior in the capital structure than the securities in the CDO portfolio. Therefore, adjustments to the baseline discount rate are also made to reflect the additional leverage found in structured instruments.
Based upon a review of credit quality and the cash flow tests performed by the independent third party, management determined that no additional credit-related OTTI was required during 2020.
The following table sets forth the contractual or estimated maturities of the components of our securities portfolio as of December 31, 2020 and the weighted average yields on a tax-equivalent basis.
Investment Security Maturities, Yields, and Fair Values at December 31, 2020
Securities Available-for-Sale:
Residential mortgage-backed agencies — — — 22,899 22,899
Collateralized debt obligations — — — 13,260 13,260
Held to Maturity:
Commercial mortgage-backed agencies — 12,303 $ — — 12,303
Collateralized mortgage obligations 1,406 — — — 1,406
Obligations of states and political subdivisions — — — 28,171 28,171
The weighted average yield was calculated using historical cost balances and does not give effect to changes in fair value. The negative weighted average yield was due to increased paydowns on mortgage-backed securities which impacted their factors and three month conditional prepayment rate. At December 31, 2020, one Tax Increment Funding bond totaling $18.4 million exceeded 10% of shareholders’ equity.
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Deposits
The following table sets forth the actual and average deposit balances by major category for 2020, 2019 and 2018:
Deposit Balances
Interest-bearing deposits:
Money Market:
Time deposits less than $100K:
Time deposits $100K or more:
Total deposits at December 31, 2020 increased by $280.3 million when compared with deposits at December 31, 2019. During 2020, non-interest-bearing deposits increased by $125.8 million. This growth was driven by our retail and commercial account growth as well as deposits from PPP loans. Traditional savings accounts increased by $37.1 million, as we continued to see significant growth in our Prime Saver product. Total demand deposits increased by $42.0 million and total money market accounts increased by $101.1 million, due primarily to growth in our variable rate Value Money Market account. Time deposits less than $100,000 decreased by $7.5 million and time deposits greater than $100,000 decreased by $18.2 million. The decline in time deposits greater than $100,000 was due to a local municipality utilizing a maturing certificate of deposit for cash needs during this unprecedented economic environment as well as our repayment of the full outstanding balance of $10.0 million in a brokered CD that matured in May 2020.
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The following table sets forth the maturities of time deposits of $100,000 or more:
Maturity of Time Deposits of $100,000 or More
(In thousands) December 31, 2020
Maturities
Borrowed Funds
The following shows the composition of our borrowings at December 31:
The following is a summary of short-term borrowings at December 31 with original maturities of less than one year:
Securities sold under agreements to repurchase:
Weighted average interest rate at year end 0.19% 0.23% 0.24%
Approximate weighted average rate during the year 0.20% 0.28% 0.20%
Total borrowings increased slightly by $0.4 million, or 0.29%, in 2020 when compared to 2019 due to increased balances in our existing accounts in our Treasury Management product.
Management will continue to closely monitor interest rates within the context of its overall asset-liability management process. See the discussion under the heading “Interest Rate Sensitivity” in this Item 7 for further information on this topic.
At December 31, 2020, we had additional borrowing capacity with the FHLB totaling $134.4 million, an additional $130.0 million of unused lines of credit with various financial institutions, $1.1 million of an unused secured line of credit with the Federal Reserve Bank and approximately $142.3 million available through wholesale money market funds. See Note 13 to the Consolidated Financial Statements presented elsewhere in this annual report for further details about our borrowings and additional borrowing capacity, which is incorporated herein by reference.
Off-Balance Sheet Arrangements
In the normal course of business, to meet the financing needs of its customers, the Bank is a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit, lines of credit, and standby letters of credit. Our exposure to credit loss in the event of nonperformance by the other party to these financial instruments is represented by the contractual amount of the instruments. The credit risks inherent in loan commitments and letters of credit are essentially the same as those involved in extending loans to customers, and these arrangements are subject to our normal credit policies. We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments. We generally require collateral or other security to support the financial instruments with credit risk. The amount of collateral or other security is determined based on management’s credit evaluation of the counterparty. We evaluate each customer’s creditworthiness on a case-by-case basis.
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