U. S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

FORM 10-K

x	ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2012

¨	TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number 0-11255

HERITAGE BANKSHARES, INC.

(Exact name of registrant as specified in its charter)

Virginia

54-1234322

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

150 Granby Street

Norfolk, Virginia

23510

(Address of Principal Executive Offices)

(Zip Code)

Registrant’s telephone number (757) 648-1700

Securities registered pursuant to Section 12(b) of the Exchange Act: None

Securities registered pursuant to Section 12(g) of the Exchange Act: Common Stock, $5.00 par value

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Section 405 of the Securities Act. Yes ¨ No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act. Yes ¨ No x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

The aggregate market value of the registrant’s Common Stock held by non-affiliates of the registrant as of June 30, 2012 was approximately $20,212,000. Aggregate market value was computed by reference to the sales price of the Common Stock of the registrant on June 30, 2012 of $12.20 per share and 1,656,714 shares of voting stock held by non-affiliates of the registrant on that date.

As of February 28, 2013, 2,276,617 shares of Common Stock of the registrant, par value $5.00 per share were issued and outstanding.

TABLE OF CONTENTS


			Page No.

PART I

	Item 1.	Business		3

	Item 1A.	Risk Factors		16

	Item 1B.	Unresolved Staff Comments		19

	Item 2.	Properties		20

	Item 3.	Legal Proceedings		20

	Item 4.	Mine Safety Disclosures		20

PART II

	Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities		21

	Item 6.	Selected Financial Data		22

	Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		22

	Item 7A.	Quantitative and Qualitative Disclosures About Market Risk		41

	Item 8.	Financial Statements and Supplementary Data		42

	Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure		81

	Item 9A.	Controls and Procedures		81

	Item 9B.	Other Information		82

PART III

	Item 10.	Directors, Executive Officers and Corporate Governance		82

	Item 11.	Executive Compensation		87

	Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters		94

	Item 13.	Certain Relationships and Related Transactions, and Director Independence		96

	Item 14.	Principal Accounting Fees and Services		101

PART IV

	Item 15.	Exhibits, Financial Statement Schedules		102

PART I

As used in this annual report on Form 10-K, the “Company,” “we,” “our” and “us” refer to Heritage Bankshares, Inc. and its subsidiaries, collectively, unless the context requires otherwise.

Forward-Looking Statements

Statements contained in this annual report on Form 10-K that are not historical facts are forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. Such forward-looking statements may be identified by the use of such words as “may,” “will,” “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated” and “potential”, among others, though these words are not the exclusive means of identifying such forward-looking statements. These forward-looking statements relate to, among other things, expectations regarding the business environment in which we operate, projections of future performance and perceived opportunities in the market, and they are based on management’s current beliefs, assumptions and expectations. Such forward-looking statements are subject to risks and uncertainties which could cause actual results to differ materially from the expectations of future results, performance or financial condition we express or imply in any forward-looking statements. For a detailed discussion of the factors that might cause such a difference, see Item 1A, “Risk Factors.”

Factors that might affect forward-looking statements include, among other things:

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the demand for our products and services;

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actions taken by our competitors;

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changes in prevailing interest rates;

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changes in delinquencies and defaults by our borrowers;

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changes in loan quality and performance;

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changes in FDIC insurance assessments;

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legislative or regulatory changes or actions that affect our business, including new regulations imposed by the Dodd-Frank Act;

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our ability to achieve financial goals and strategic plans;

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our participation in the Small Business Lending Fund Program;

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litigation; and

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credit and other risks of lending activities.

As a result, we cannot assure you that our future results of operations, financial condition or other matters will be consistent with those expressed or implied in any forward-looking statements. You should not place undue reliance on these forward-looking statements, as they all are based only on information available at this time, and we assume no obligation to update any of these statements.

ITEM 1.

BUSINESS

General

Heritage Bankshares, Inc. (the “Company”) is a bank holding company incorporated under the laws of the Commonwealth of Virginia in 1983, and serves as the holding company for its wholly-owned subsidiary, Heritage Bank. Since 1992, the Company has operated as a one bank holding company. The principal executive office of the Company is located at 150 Granby Street, Norfolk, Virginia. Currently, the Company does not transact any material business other than through Heritage Bank. Information concerning the Company and Heritage Bank may be found on our website located at www.heritagebankva.com.

Heritage Bank (the “Bank”) is a wholly-owned subsidiary of the Company and is a state banking corporation engaged in the general commercial and retail banking business. The Bank was incorporated in Virginia on September 19, 1975 and commenced business in Norfolk, Virginia on February 7, 1977. On December 31, 2012, the Bank had assets of $334.6 million, with total loans held for investment, net, of $221.0 million and deposits of $295.3 million.

The Bank has one wholly-owned subsidiary, Sentinel Financial Group, Inc. (“Sentinel Financial”). At December 31, 2012, Sentinel Financial owned an interest in Bankers Insurance, LLC, which offers various insurance services. Our ownership interest in this company, through Sentinel Financial, allows the Bank to provide various insurance services to our customers; however, the Bank does not at this time market insurance services to our customers.

Principal Products or Services

The Company, through the Bank, engages in a general community and commercial banking business, targeting the banking needs of small to medium sized businesses in its primary service area, which includes Chesapeake, Norfolk and Virginia Beach, Virginia. The principal business of the Bank is to attract deposits and to lend or invest those deposits on profitable terms. These deposits are in varied forms of both demand and time accounts including checking accounts, interest checking, money market accounts, savings accounts and certificates of deposit.

The Company actively extends commercial credit and is involved in the construction and real estate lending market. Loans consist of varying terms and may be secured or unsecured. Loans to individuals are limited to owners or senior managers of existing or prospective business clients and are for personal, household and family purposes. Loans to businesses are made for purposes such as working capital, financing of facilities, and equipment purchases. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” for a breakdown of loans by classification.

The Bank’s lending policies, deposit products and related services are intended to meet the needs of individuals and businesses in its market area. The Bank’s plan of operation for future periods is to continue to operate as a community bank and to focus its lending and deposit activities in its primary service area. Consistent with its focus on providing community based financial services, the Bank currently does not plan to diversify its loan portfolio geographically by making significant loans outside of its primary service area. While the Bank and its borrowers will be directly affected by the economic conditions and the prevailing real estate market in the area, the Bank is better able to monitor the financial condition of its borrowers by concentrating its lending activities in its primary service area. The Bank may evaluate the feasibility of entering into other markets as opportunities to do so become available.

Market Area

The Company is located in the Virginia Beach-Norfolk-Newport News Metropolitan Statistical Area (“MSA”), which extends approximately 65 miles from Williamsburg, Virginia, to Virginia Beach, Virginia, and Currituck County, North Carolina. This MSA is the 36^th largest Metropolitan Statistical Area in the United States with a population of approximately 1.7 million persons. The Company’s principal market within this MSA is the Hampton Roads area, which comprises the cities of Norfolk, Portsmouth, Virginia Beach, Chesapeake, Suffolk, Hampton, and Newport News. The Company maintains its corporate headquarters in Norfolk, Virginia, and as of December 31, 2012 the Bank has a total of seven retail offices located in the cities of Chesapeake, Norfolk and Virginia Beach, Virginia.

Although the Hampton Roads area supports a wide range of industrial and commercial activities, the area’s principal employer is the United States Navy and other branches of the Armed Forces of the United States. Significant cutbacks in defense spending and consolidations of domestic military installations could affect the general economy of the market area in which the Company operates. Depending on whether the Hampton Roads area experiences an overall increase or decrease in military and federal wages and salaries, the potential future impact of any such cutbacks or consolidations could be either favorable or unfavorable.

Competition

The banking business in the MSA, and the Company’s principal market area of Hampton Roads, is highly competitive, and the Company faces significant competition both in making loans and in attracting deposits. At June 30, 2012, the Company’s deposit market share as a percentage of FDIC-insured institutions’ deposits in the MSA was 1.28%. The Company’s competition for loans comes from commercial banks, savings banks, mortgage banking subsidiaries of regional commercial banks, national mortgage bankers, insurance companies, and other institutional lenders. The Company’s most direct competition for deposits has historically come from savings banks, commercial banks, credit unions and other financial institutions. The Company may face an increase in competition as a result of the continuing reduction in the restrictions on the interstate operations of financial institutions. The Company also faces competition for deposits from short-term money market mutual funds and other corporate and government securities funds. (For additional discussion regarding competition facing the Company, see Item 1A, “Risk Factors,” below.)

Employees

At December 31, 2012, we employed 49 full-time equivalent employees. None of our employees are represented by any collective bargaining agreements, and employee relations are considered excellent.

Participation in Small Business Lending Fund

On August 11, 2011, we entered into and consummated the transactions contemplated by a Securities Purchase Agreement (the “Securities Purchase Agreement”) with the Secretary of the Treasury (the “Secretary”) under the Small Business Lending Fund program (the “SBLF Program”), a $30 billion fund established under the Small Business Jobs Act of 2010 designed to encourage lending to small businesses by providing capital to qualified community banks with assets of less than $10 billion. Under the Securities Purchase Agreement, we issued to the Secretary a total of 7,800 shares of the Company’s Senior Non-Cumulative Perpetual Preferred Stock, Series C (the “SBLF Preferred Stock”), having a liquidation value of $1,000 per share, for total proceeds of $7,800,000.

The SBLF Preferred Stock qualifies as Tier 1 capital. Non-cumulative dividends are payable quarterly on the SBLF Preferred Stock, and the dividend rate is calculated as a percentage of the aggregate liquidation value of the outstanding SBLF Preferred Stock and is based on changes in the Bank’s level of “Qualified Small Business Lending” or “QSBL” (as defined in the Securities Purchase Agreement), as compared to the Bank’s baseline QSBL level of approximately $70 million.

For the initial 2.5 years of the SBLF Program, our dividend rate will fluctuate between 1% and 5% to reflect changes in the Bank’s level of QSBL compared to the initial baseline. More specifically, if the Bank’s QSBL at the end of a quarter has increased as compared to the baseline, then the dividend rate payable on the SBLF Preferred Stock would change as follows:


Relative Increase in QSBL to Baseline	Dividend Rate

less than 2.5%		5	%
between 2.5% and 5.0%		4	%
between 5.0% and 7.5%		3	%
between 7.5% and 10.0%		2	%
10% or more		1	%

During the year ended December 31, 2012, the Company declared $137,000 in SBLF Preferred Stock dividends, a dividend rate of 1.75%. Based on the Bank’s latest measured levels of QSBL, the dividend rate on the SBLF Preferred Stock increased to 2.36% for the first quarter of 2013 and decreased to 1% for the second quarter of 2013, and we expect to pay corresponding dividends of $46,000 on or about April 1, 2013 and $19,500 on or about July 1, 2013.

After the initial 2.5 years of the SBLF Program and continuing through 4.5 years after the SBLF Program transaction closing, the dividend rate on the SBLF Preferred Stock will be fixed at between 1% and 7% based on the level of QSBL at that time, as compared to the baseline; however, the dividend rate will increase to 7% only if the Bank’s rate of small business lending has stayed the same or decreased relative to the baseline. If any SBLF Preferred Stock remains outstanding after 4.5 years, the dividend rate will increase to 9%.

The potential dividend rate reduction is limited, such that the reduction will not apply to any SBLF Program investment proceeds that exceed the increase in Qualified Small Business Lending. In other words, to take full advantage of available dividend rate reductions on the SBLF Preferred Stock, the Bank must maintain increased levels of QSBL of at least $7.8 million, or about $76.8 million in total qualified lending (the dividend rate for “non-qualifying” SBLF funds is 5%).

The SBLF Preferred Stock is generally non-voting, except in limited circumstances that could impact the SBLF investment, such as (i) authorization of senior stock, (ii) charter amendments adversely affecting the SBLF Preferred Stock and (iii) extraordinary transactions such as mergers, asset sales, share exchanges and the like (unless the SBLF Preferred Stock remains outstanding and the rights and preferences are not impaired by the transaction).

If we miss five dividend payments, whether or not consecutive, the holder of the SBLF Preferred Stock will have the right to appoint an “observer” on the Company’s Board of Directors.

The SBLF Preferred Stock is not convertible to common stock or any other securities. Distributions upon any liquidation of the Company must be paid on the SBLF Preferred Stock up to the aggregate liquidation value, plus accrued dividends, before any other shareholder distributions can be made.

The SBLF Preferred Stock may be redeemed (repurchased) by the Company at any time, at a redemption price of $1,000 per share plus accrued but unpaid dividends to the date of redemption, subject to the approval of our federal banking regulator. The SBLF Preferred Stock may be redeemed in whole or in part, subject to a minimum redemption of at least 25% of the original SBLF investment (i.e., a minimum redemption of about $1.95 million).

The SBLF Preferred Stock was issued in a private placement transaction exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended. We have agreed to register the SBLF Preferred Stock under applicable securities laws upon the request of the Secretary, as further described in the Securities Purchase Agreement. The SBLF Preferred Stock is not subject to any contractual restrictions on transfer and thus the Secretary may sell, transfer, exchange or enter into other transactions with respect to the SBLF Preferred Stock without our consent.

Simultaneously with the closing of the SBLF Program transaction on August 11, 2011, we entered into and consummated the transactions contemplated by a letter agreement (the “Repurchase Document”) with the U.S. Treasury. Under the Repurchase Document, we redeemed (repurchased) from the Treasury, largely using proceeds received from the issuance of the SBLF Preferred Stock, all 7,497 remaining outstanding shares of our Fixed Rate Cumulative Perpetual Preferred Stock, Series A, liquidation amount $1,000 per share, and all 303 outstanding shares of our Fixed Rate Cumulative Perpetual Preferred Stock, Series B, liquidation amount $1,000 per share (collectively, the “TARP Preferred Stock”), for a redemption price of approximately $7.896 million, including accrued but unpaid dividends to the date of redemption. We had previously repurchased 2,606 shares of TARP Preferred Stock in March 2011.

As a result of our redemption of the TARP Preferred Stock, we are no longer subject to the limits on executive compensation and other restrictions stipulated under the TARP Program (which the Treasury has likewise confirmed in writing). We will, of course, be subject to all terms, conditions and other requirements for participation in the SBLF Program for as long as any SBLF Preferred Stock remains outstanding, as described above and also under Item 1A, “Risk Factors”, below.

Deregistration of the Company’s common stock

Pursuant to the Jumpstart Our Business Startups Act enacted in 2012, which amended the Securities Exchange Act of 1934 (the “Exchange Act”) to, among other things, permit bank holding companies like us with fewer than 1,200 record shareholders to deregister securities previously registered with the SEC, we filed Form 15s with the SEC to deregister our common stock. The deregistration was effective on or about February 28, 2013; as a result, we are no longer subject to the periodic reporting requirements of the Exchange Act, and following the filing of this Form 10-K we will no longer make any filings with the SEC. Both the Company and the Bank will continue to comply with the financial reporting requirements of the Federal Reserve and other applicable regulatory agencies, and those financial statements are and will continue to be available for review by our shareholders through the applicable agency(ies). In light of these regulatory financial reporting requirements, and notwithstanding the deregistration of our common stock, we anticipate that our stock will continue to be quoted on over-the-counter markets such as the OTC Markets Group and the OTC Bulletin Board so long as market makers continue to make a market in our stock.

Supervision and Regulation

Bank holding companies and banks are extensively regulated under both federal and state law. The following summary briefly describes certain significant provisions of applicable federal and state laws and applicable regulations and the potential impact of such provisions on the Company and the Bank. This summary is not complete, and we refer you to the particular statutory or regulatory provisions or proposals for more information. Because federal regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot forecast how federal regulation of financial institutions may change in the future and impact the operations of the Company and the Bank.

Dodd-Frank Act

Generally, the regulatory capital framework under which the Company and the Bank operate is in a period of change with likely legislation or regulation that will continue to modify the current standards and perhaps increase capital requirements for the entire banking industry. In particular, the Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted on July 21, 2010 (the “Dodd-Frank Act”), has already resulted, and will continue to result, in sweeping changes in the regulation of financial institutions designed to strengthen the operation of the financial services sector. Many of the Dodd-Frank Act’s provisions generally apply to and/or are or more likely to affect larger institutions. However, the Dodd-Frank Act contains numerous other provisions that will affect all banks and bank holding companies, including, among other things, (i) enhanced resolution authority of troubled and failing banks and their holding companies; (ii) increased regulatory examination fees; and (iii) numerous other provisions designed to improve supervision and oversight of, and strengthening soundness for, the financial services sector. Additionally, the Dodd-Frank Act establishes a new framework for systemic risk oversight within the financial system to be distributed among new and existing federal regulatory agencies, including the Financial Stability Oversight Council, the Federal Reserve Board, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation. A summary of certain provisions of the Dodd-Frank Act is set forth below.

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Minimum Capital Requirements and Enhanced Supervision. Federal banking agencies established minimum leverage and risk-based capital requirements for banks and bank holding companies consistent with the requirements of Section 171 of the Dodd-Frank Act. The Dodd-Frank Act also increased regulatory oversight, supervision and examination of banks, bank holding companies and their respective subsidiaries by the appropriate regulatory agency.

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The Consumer Financial Protection Bureau (“CFPB”). The Dodd-Frank Act created the CFPB within the Federal Reserve. The CFPB is tasked with establishing and implementing rules and regulations under certain federal consumer protection laws with respect to the conduct of providers of certain consumer financial products and services. The CFPB has rulemaking authority over many of the statutes governing products and services offered to bank consumers. In addition, the Dodd-Frank Act permits states to adopt consumer protection laws and regulations that are more stringent than those regulations promulgated by the CFPB and state attorneys general are permitted to enforce consumer protection rules adopted by the CFPB against state-chartered institutions.

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Deposit Insurance. The Dodd-Frank Act makes permanent the $250,000 deposit insurance limit for insured deposits. The Dodd-Frank Act also required amendments to the Federal Deposit Insurance Act that revised the assessment base against which an insured depository institution’s deposit insurance premiums paid to the Deposit Insurance Fund (“DIF”) will be calculated. Under the amendments, the assessment base will no longer be the institution’s deposit base, but rather its average consolidated total assets less its average tangible equity during the assessment period. Additionally, the Dodd-Frank Act made changes to the minimum designated reserve ratio of the DIF, increasing the minimum from 1.15 percent to 1.35 percent of the estimated amount of total insured deposits and eliminating the requirement that the FDIC pay dividends to depository institutions when the reserve ratio exceeds certain thresholds.

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Payment of Interest on Demand Deposits. The Dodd-Frank Act resulted in the repeal of federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts.

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Transactions with Insiders. The Dodd-Frank Act expanded insider transaction limitations through the strengthening of loan restrictions to insiders and the expansion of the types of transactions subject to the various limits, including derivative transactions, repurchase agreements, reverse repurchase agreements and securities lending or borrowing transactions. Restrictions are also placed on certain asset sales to and from an insider to an institution, including requirements that such sales be on market terms and, in certain circumstances, approved by the institution’s board of directors.

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Enhanced Lending Limits. The Dodd-Frank Act strengthened the previous limits on a depository institution’s credit exposure to one borrower which limited a depository institution’s ability to extend credit to one person (or group of related persons) in an amount exceeding certain thresholds. The Dodd-Frank Act expanded the scope of these restrictions to include credit exposure arising from derivative transactions, repurchase agreements, and securities lending and borrowing transactions.

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Compensation Practices. The Dodd-Frank Act provided that the appropriate federal regulators must establish standards prohibiting as an unsafe and unsound practice any compensation plan of a bank holding company or other “covered financial institution” that provides an insider or other employee with “excessive compensation” or compensation that gives rise to excessive risk or could lead to a material financial loss to such firm.

Although certain Dodd-Frank Act rules and regulations have been finalized, many of the requirements called for will be implemented over time and most will be subject to implementing regulations over the course of several years. Given uncertainty associated with the manner in which certain provisions of the Dodd-Frank Act will be implemented by the various regulatory agencies and through regulations, the full extent of the impact such requirements will have on our operations is unclear. The changes resulting from the Dodd-Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and/or leverage ratio requirements or otherwise adversely affect our business. These changes may also require us to invest significant management attention and resources to evaluate and make necessary changes in order to comply with new statutory and regulatory requirements. In light of the relatively early stages of this new legislation, however, it is difficult to anticipate its overall financial impact on the Company, the Bank, our customers or the financial industry in general.

The Company

Bank Holding Company Act. The Company is registered with the Federal Reserve Bank (“Federal Reserve”) as a financial holding company under the Bank Holding Company Act of 1956 (the “BHCA”), as amended by the Gramm-Leach-Bliley Act of 1999 (the “GLB Act”), and is subject to ongoing regulation, supervision and examination by the Federal Reserve. The Company is required to file with the Federal Reserve periodic and annual reports and other information concerning its own business operations and those of its subsidiaries. The Federal Reserve also supervises the Company’s operations and major transactions affecting its capital structure, including mergers, acquisitions and share redemptions.

Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve Act on any extensions of credit to the bank holding company or any of its subsidiaries, or investments in the stock or other securities thereof, and on the taking of such stock or securities as collateral for loans to any borrower. Further, a bank holding company and any subsidiary bank are prohibited from engaging in certain tie-in arrangements in connection with the extension of credit to its customers. Among other limitations, a subsidiary bank may not extend credit, lease or sell property or furnish any services, or fix or vary the consideration for any of the foregoing, on the condition that: (i) the customer obtain or provide some additional credit, property or services from or to such bank, other than a loan, discount, deposit or trust service; (ii) the customer obtain or provide some additional credit, property or service from or to company or any other subsidiary of the company; or (iii) the customer not obtain some other credit, property or service from competitors, except for reasonable requirements to ensure the soundness of credit extended.

Certain other provisions of the BHCA are described below under “Change of Control”.

Capital Adequacy. The Federal Reserve has promulgated capital adequacy regulations for all bank holding companies with assets in excess of $150 million. The Federal Reserve’s capital adequacy regulations are based

upon a risk-based capital determination, whereby a bank holding company’s capital adequacy is determined in light of the risk, both on- and off-balance sheet, contained in the company’s assets. Different categories of assets are assigned risk weightings and are counted at a percentage of their book value.

The regulations divide capital between Tier 1 capital (core capital) and Tier 2 capital. For a bank holding company, Tier 1 capital consists primarily of common stock, related surplus, noncumulative perpetual preferred stock, minority interests in consolidated subsidiaries and a limited amount of qualifying cumulative preferred securities. Goodwill and certain other intangibles are excluded from Tier 1 capital. Tier 2 capital consists of an amount equal to the allowance for loan and lease losses up to a maximum of 1.25% of risk-weighted assets, limited other types of preferred stock not included in Tier 1 capital, hybrid capital instruments and term subordinated debt. Investments in and loans to unconsolidated banking and finance subsidiaries that constitute capital of those subsidiaries are excluded from capital. The sum of Tier 1 and Tier 2 capital constitutes qualifying total capital. The Tier 1 component must comprise at least 50% of qualifying total capital.

Every bank holding company has to achieve and maintain a minimum Tier 1 capital ratio (Tier 1 capital to risk-weighted assets) of at least 4.0% and a minimum total capital ratio of at least 8.0%. In addition, banks and bank holding companies are required to maintain a minimum leverage ratio of Tier 1 capital to average total consolidated assets (leverage capital ratio) of at least 3.0% for the most highly-rated, financially sound banks and bank holding companies, and a minimum leverage ratio of at least 4.0% for all other banks. The Federal Deposit Insurance Corporation (“FDIC”) and the Federal Reserve define Tier 1 capital for banks in the same manner for both the leverage ratio and the risk-based capital ratio. However, the Federal Reserve defines Tier 1 capital for bank holding companies in a slightly different manner.

The Federal Reserve guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory level, without significant reliance on intangible assets. The guidelines also indicate that the Federal Reserve will continue to consider a “Tangible Tier 1 Leverage Ratio” in evaluating proposals for expansion or new activities. The Tangible Tier 1 Leverage Ratio is the ratio of Tier 1 capital, less intangibles not deducted from Tier 1 capital, to quarterly average total assets.

Consistent with the general changing regulatory environment described above, under the Dodd-Frank Act, bank regulators are required to establish new minimum leverage and risk-based capital requirements for certain bank holding companies (and systematically important non-bank financial companies). The new minimum thresholds will not be lower than existing regulatory capital and leverage standards applicable to insured depository institutions and may, in fact, be higher once established.

Source of Strength for Subsidiary. Under Federal Reserve Board policy, the Company is expected to act as a source of financial strength for its subsidiaries and to commit resources to support them. More specifically, pursuant to the Dodd-Frank Act, the federal banking regulators are required to issue, within two years of enactment, rules that require a bank holding company to serve as a source of financial strength for any depository institution subsidiary such as the Bank. In addition, any capital loans made by the Company to its subsidiaries may be repaid only after the applicable subsidiary’s deposits and various other obligations are repaid in full and, in the unlikely event of the Company’s bankruptcy, any commitment by it to a federal bank regulatory agency to maintain the capital of the Bank will be assumed by the bankruptcy trustee and entitled to a priority of payment.

Dividends. As a bank holding company that does not, as an entity, currently engage in separate business activities of a material nature, the Company’s ability to pay cash dividends to its shareholders depends upon the cash dividends it receives from the Bank. The Company must first pay operating expenses from funds it receives from the Bank; therefore, shareholders may receive cash dividends from the Company only to the extent that funds are available after payment of operating expenses. In addition, the Federal Reserve generally prohibits bank holding companies from paying cash dividends except out of operating earnings and permits dividends only if the prospective rate of earnings retention appears consistent with the bank holding company’s capital needs, asset quality and overall financial condition. As a Virginia corporation, the Company’s payment of cash dividends is also subject to the restrictions under Virginia law on the declaration of cash dividends. Under such provisions, a corporation is prohibited from paying any cash dividends if after paying such cash dividend the corporation would not be able to pay its debts as they become due in the usual course of business or the corporation’s total assets would be less than the sum of its total liabilities plus the amount that would be needed to satisfy certain preferential liquidation rights.

Furthermore, as a result of our participation in the SBLF Program, (i) we may pay dividends on our common stock only if, after payment of such dividends, our Tier 1 capital will be at least 90% of our Tier 1 capital as of the date we consummated the SBLF Program transaction, excluding any subsequent net charge-offs and/or redemptions of SBLF Preferred Stock. (This 90% “threshold” may be reduced over time to the extent our level of Qualified Small Business Lending increases over our initial baseline level.) In addition, if we fail to pay dividends on the SBLF Preferred Stock in a given quarter, then during that quarter and the next three quarters after the missed dividend payment, we will be prohibited from paying any dividends on our common stock (or any other stock that is junior to the SBLF Preferred Stock) except in very limited circumstances. Finally, if any SBLF Preferred Stock remains outstanding on the tenth (10^th) anniversary of issuance, we will be prohibited from paying any further dividends on our common stock (or any other junior stock) until the SBLF Preferred Stock is redeemed in full. (See “The Bank – Dividends” below for discussion regarding regulatory considerations for dividends payable by the Bank and “The Company – United States Treasury Oversight (SBLF)” for more detailed discussion regarding the limitations on dividend payments under the SBLF Program.)

Change of Control. State and federal banking law restricts the amount of voting stock of a bank that a person may acquire without the prior approval of banking regulators. The BHCA requires that a bank holding company obtain the approval of the Federal Reserve before it may merge with a bank holding company, acquire a subsidiary bank or acquire substantially all of the assets of any bank, or before it may acquire ownership or control of any voting shares of any bank or bank holding company if, after such acquisition, it would own or control, directly or indirectly, more than 5% of the voting shares of that bank or bank holding company. The overall effect of such laws is to make it more difficult to acquire the Company by tender offer or similar means than it might be to acquire control of another type of corporation. Consequently, the Company’s shareholders may be less likely to benefit from rapid increases in stock prices that often result from tender offers or similar efforts to acquire control of other types of companies.

In addition, under certain amendments to the Virginia Financial Institutions Holding Company Act that became effective July 1, 1983, no corporation, partnership or other business entity may acquire, or make any public offer to acquire, more than 5% of the stock of any Virginia financial institution, or any Virginia financial institution holding company, unless it first files an application with the Virginia State Corporation Commission (the “SCC”). The SCC is directed by the statute to solicit the views of the affected financial institution, or financial institution holding company, with respect to such stock acquisition and is also empowered to conduct an investigation during the 60 days following receipt of such an application. If the SCC takes no action within the prescribed period, or if during the prescribed period it issues notice of its intent not to disapprove an application, the acquisition may be completed.

Corporate Governance. The Dodd-Frank Act will enhance corporate governance requirements to include, perhaps among other things, (i) requiring publicly traded companies (not just financial institutions) to give shareholders a non-binding vote on executive compensation on a periodic basis (and at least every three years) and on so-called “golden parachute” payments in connection with approvals of mergers and acquisitions unless previously voted on by shareholders; (ii) authorizing the Securities and Exchange Commission (the “SEC”) to promulgate rules that would allow shareholders to nominate their own candidates for election as directors using a company’s proxy materials (so called “proxy access” rules, which have been temporarily stayed pending further review by applicable regulatory agencies); (iii) directing federal banking regulators to promulgate rules prohibiting excessive compensation paid to executives of institutions and their holding companies with assets in excess of $1.0 billion, regardless of whether or not the company is publicly traded; and (iv) authorizing the SEC to prohibit broker discretionary voting on the election of directors and on executive compensation matters. Some of these provisions will not apply to the Company, in particular in light of the fact that the Company has deregistered its common stock and is no longer subject to SEC reporting requirements as described above under “Deregistration of the Company’s common stock”.

Legislation

Sarbanes-Oxley Act. The Sarbanes-Oxley Act (“SOX”) was enacted on July 30, 2002. SOX is not a banking law, but applies to all public companies, including the Company. The stated goals of SOX are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies, and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. Given the extensive role of the SEC in implementing and interpreting the rules relating to many of SOX’s requirements, and the continuing evolution of SOX’s requirements, the impact on the Company of these requirements has changed and may continue to change for some time. SOX includes additional disclosure requirements and corporate governance rules for public companies and other related rules adopted by the SEC for public companies, increases criminal penalties for violations of the securities laws, and mandates further

studies of specified issues by the SEC and other federal government agencies. SOX also provides for the federal regulation of accounting firms that provide services to public companies and mandates additional listing standards for the securities exchanges. Not all of the rules that the SEC has adopted implementing the provisions of SOX presently apply to the Company because certain of the rules have delayed effective dates and/or do not apply to companies, like us, whose securities are quoted solely on over-the counter securities markets. The SEC has also extended the effective dates of certain rules after their adoption.

Bank Secrecy Act; USA PATRIOT Act. Under the Bank Secrecy Act (“BSA”), a financial institution is required to have systems in place to detect certain transactions, based on the size and nature of the transaction. Financial institutions are generally required to report to the United States Treasury cash transactions involving more than $10,000. In addition, financial institutions are required to file suspicious activity reports for any transaction that involves more than $5,000 and which the financial institution knows, suspects or otherwise has reason to suspect involves illegal funds, is designed to evade the requirements of the BSA or has no lawful purpose. The USA PATRIOT Act of 2001 (the “Patriot Act”), enacted in response to the September 11, 2001 terrorist attacks, strengthens the anti-money laundering provisions of the BSA. Many of the provisions added by the Patriot Act apply to accounts at or held by foreign banks, or accounts of or transactions with foreign entities, and thus do not apply to the Bank because it does not have significant foreign business. However, the Patriot Act does require federal banking regulators to consider a bank’s record of compliance under the BSA in acting on any application filed with such federal regulators. The Bank’s record of compliance with the BSA will be an additional factor in any applications filed with federal regulators in the future.

United States Treasury Oversight (SBLF). As described above, contemporaneously with the consummation of our participation in the SBLF Program, we redeemed our TARP Preferred Stock and exited the TARP Program. As a result, we are no longer subject to the limits on executive compensation and other restrictions stipulated under the TARP Program in accordance with the American Recovery and Reinvestment Act of 2009. However, while generally less onerous than the TARP Program, until we repay the SBLF Program investment in full, we will continue to be subject to Treasury oversight, including pursuant to applicable provisions of the Small Business Jobs Act of 2010, which include (among other things) certain restrictions on capital repurchases and cash dividends.

For instance, the terms of the SBLF Preferred Stock impose limits on our ability to pay dividends on and repurchase shares of our common stock and other securities. More specifically, if we fail to declare and pay dividends on the SBLF Preferred Stock in a given quarter, then during such quarter and for the next three quarters following such missed dividend payment, we will be prohibited from paying any dividends on or repurchasing any common stock or any other securities that are junior to (or in parity with) the SBLF Preferred Stock, except in very limited circumstances.

Also under the terms of the SBLF Preferred Stock, we may declare and pay dividends on our common stock or any other stock junior to the SBLF Preferred Stock, or repurchase shares of any such stock, only if after payment of such dividends or repurchase of such shares our Tier 1 capital would be at least 90% of our “Signing Date Tier 1 Capital”, as set forth in the Articles of Amendment that established and govern the SBLF Preferred Stock, excluding any subsequent net charge-offs and any redemptions of the SBLF Preferred Stock (the “Tier 1 Dividend Threshold”). The Tier 1 Dividend Threshold is subject to reduction, beginning on the second (2^nd) anniversary and ending on the tenth (10^th) anniversary of issuance of the SBLF Preferred Stock, by ten percent (10%) for each one percent (1%) increase in the Bank’s Qualified Small Business Lending over the baseline level.

If any SBLF Preferred Stock remains outstanding on the tenth (10^th) anniversary of issuance, we will be prohibited from paying any further dividends on our common stock (or any other junior stock) until the SBLF Preferred Stock is redeemed in full.

The Consumer Financial Protection Bureau. The Dodd-Frank Act creates the Consumer Financial Protection Bureau (the “CFP Bureau”) within the Federal Reserve Board. The CFP Bureau is tasked with establishing and implementing rules and regulations under certain federal consumer protection laws with respect to the conduct of providers of certain consumer financial products and services. The CFP Bureau has rulemaking authority over many of the statutes governing products and services offered to bank consumers. In addition, the Dodd-Frank Act permits states to adopt consumer protection laws and regulations that are more stringent than those regulations promulgated by the CFP Bureau and state attorneys general are permitted to enforce consumer protection rules adopted by the CFP Bureau against state-chartered institutions.

The Bank

General. The Bank operates as a state bank subject to supervision and regulation by the Bureau of Financial Institutions of the SCC. The Bureau of Financial Institutions regulates all areas of a Virginia state bank’s commercial banking operations, including reserves, loans, mergers, payment of dividends, establishment of branches and other aspects of operations.

Transactions with Affiliates; Loans to Insiders. Federal laws strictly limit the ability of banks to engage in transactions with their affiliates, including their bank holding companies. Regulations promulgated by the Federal Reserve Board limit the types and amounts of these transactions that may take place and generally require those transactions to be on an arm’s-length basis. In general, these regulations require that any “covered transactions” between a subsidiary bank and its parent company (or the non-bank subsidiaries of the bank holding company) be limited to 10% of a bank subsidiary’s capital and surplus and, with respect to such parent company (and all such nonbank subsidiaries), to an aggregate of 20% of the bank subsidiary’s capital and surplus. Further, loans and extensions of credit generally are required to be secured by eligible collateral in specified amounts. The Dodd-Frank Act significantly expands the coverage and scope of the limitations on affiliate transactions within a banking organization. For example, since July 2011, the Dodd-Frank Act requires that the 10% of capital limit on these transactions begin to apply to financial subsidiaries as well. “Covered transactions” are defined by statute to include a loan or extension of credit, as well as a purchase of securities issued by an affiliate, a purchase of assets (unless otherwise exempted by the Federal Reserve Board) from the affiliate, the acceptance of securities issued by the affiliate as collateral for a loan, and the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate. Federal law also limits a bank’s authority to extend credit to its directors, executive officers and 10% shareholders, as well as to entities controlled by such persons. Among other things, extensions of credit to insiders are required to be made on terms that are substantially the same as, and follow credit underwriting procedures that are not less stringent than, those prevailing for comparable transactions with unaffiliated persons. Also, the terms of such credit may not involve more than the normal risk of repayment or present other unfavorable features and may not exceed certain limitations on the amount of credit extended to such persons, individually and in the aggregate, which limits are based, in part, on the amount of the bank’s capital. Banks are also subject to prohibitions on certain tying arrangements by which a depository institution is prohibited, subject to some exceptions, from extending credit to or offering any other service, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the institution or its affiliates or not obtain services of a competitor of the institution.

Regulation of Lending Activities. Loans made by the Bank are also subject to numerous federal and state laws and regulations, including the Truth-In-Lending Act, the Federal Consumer Credit Protection Act, the Equal Credit Opportunity Act, the Real Estate Settlement Procedures Act and adjustable rate mortgage disclosure requirements. Remedies are available to the borrower or consumer and the Bank is subject to penalties if the Bank fails to comply with these laws and regulations. The scope and requirements of these laws and regulations have expanded significantly in recent years.

Privacy Standards. The Bank is subject to the FDIC’s regulations implementing the privacy protection provisions of the GLB Act. These regulations require the Bank to disclose its privacy policy, including identifying with whom it shares “non-public personal information,” to customers at the time of establishing the customer relationship and annually thereafter. The regulations also require the Bank to provide its customers with initial and annual notices that accurately reflect its privacy policies and practices. In addition, the Bank is required to provide its customers with the ability to “opt-out” of having the Bank share their non-public personal information with unaffiliated third parties before they can disclose such information, subject to certain exceptions. The Bank is subject to regulatory guidelines establishing standards for safeguarding customer information. These regulations implement certain provisions of the GLB Act. The guidelines describe the agencies’ expectations for the creation, implementation and maintenance of an information security program, which would include administrative, technical and physical safeguards appropriate to the size and complexity of the institution and the nature and scope of its activities. The standards set forth in the guidelines are intended to ensure the security and confidentiality of customer records and information, protect against any anticipated threats or hazards to the security or integrity of such records and protect against unauthorized access to or use of such records or information that could result in substantial harm or inconvenience to any customer.

Branch Banking. All banks located in Virginia are authorized to branch statewide. Accordingly, a bank located anywhere in Virginia has the ability, subject to regulatory approval, to establish branch facilities near any of our facilities and within the Bank’s market area. Applicable Virginia statutes permit regulatory authorities to approve de novo branching in Virginia by institutions located in states that would permit Virginia institutions to branch on a de novo basis into those states. Prior to the enactment of the Dodd-Frank Act, national and

state-chartered banks were generally permitted to branch across state lines by merging with banks in other states if allowed by the applicable states’ laws. However, interstate branching is now permitted for all national and state-chartered banks as a result of the Dodd-Frank Act, provided that a state bank chartered by the state in which the branch is to be located would also be permitted to establish a branch.

Reserve Requirements. Pursuant to regulations of the Federal Reserve, the Bank must maintain average daily reserves against its transaction accounts. During 2012, no reserves were required to be maintained on the first $11.5 million of net transaction accounts, but reserves equal to 3.0% were required on the aggregate balances of those accounts between $11.5 million and $71.0 million, and additional reserves were required on aggregate balances in excess of $71.0 million in an amount equal to 10.0% of the excess. These percentages are subject to annual adjustment by the Federal Reserve, which has advised that for 2013 no reserves will be required to be maintained on the first $12.4 million of net transaction accounts, but reserves equal to 3.0% will be required on the aggregate balances of those accounts between $12.4 million and $79.5 million, and additional reserves are required on aggregate balances in excess of $79.5 million in an amount equal to 10.0% of the excess. Required reserves must be maintained in the form of vault cash or in an interest-bearing account at a Federal Reserve Bank. As of December 31, 2012, the Bank met its reserve requirements.

Community Reinvestment. Under the Community Reinvestment Act (“CRA”), as implemented by regulations of the federal bank regulatory agencies, an insured bank has a continuing and affirmative obligation, consistent with its safe and sound operation, to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for banks, nor does it limit a bank’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA does however require the federal bank regulatory agencies, in connection with their examination of insured banks, to assess the banks’ records of meeting the credit needs of their communities, using the ratings of “outstanding,” “satisfactory,” “needs to improve” or “substantial noncompliance,” and to take that record into account in its evaluation of certain applications by those banks. All banks are required to make public disclosure of their CRA performance ratings. The Bank’s current CRA performance rating is “satisfactory.”

Governmental Monetary Policies. The commercial banking business is affected not only by general economic conditions but also by the monetary policies of the Federal Reserve. The monetary policies available to the Federal Reserve include, among other things, changes in the discount rate on member bank borrowings, control of borrowings, open market transactions in United States government securities, the imposition of and changes in reserve requirements against member banks and deposits and assets of foreign bank branches, and the imposition of and changes in reserve requirements against certain borrowings by banks and their affiliates. Those monetary policies influence to a significant extent the overall growth of all bank loans, investments and deposits and the interest rates charged on loans or paid on time and savings deposits in order to mitigate recessionary and inflationary pressures. These techniques are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may also affect interest rates charged on loans or paid for deposits. The monetary policies of the Federal Reserve have had a significant impact on the operating results of commercial banks in the past and are expected to continue to do so in the future. In view of changing conditions in the national economy and money markets, as well as the effect of actions by monetary and fiscal authorities, we cannot make any prediction as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of the Bank.

Dividends. All dividends paid by the Bank are paid to the Company, the sole shareholder of the Bank. The general dividend policy of the Bank is to pay dividends at levels consistent with maintaining liquidity and preserving applicable capital ratios and servicing obligations. The dividend policy of the Bank is subject to the discretion of the board of directors of the Bank and will depend upon such factors as future earnings, financial condition, cash needs, capital adequacy, compliance with applicable statutory and regulatory requirements and general business conditions. The ability of the Bank to pay dividends is also restricted under applicable law and regulations. Under Virginia banking law, dividends must be paid out of retained earnings and no cash dividends may be paid if the Bank’s surplus is less than 50% of its paid-in capital. In addition, under federal banking law, no cash dividend may be paid if the Bank is undercapitalized or insolvent or if payment of the cash dividend would render the Bank undercapitalized or insolvent, and no cash dividend may be paid by the Bank if it is in default of any deposit insurance assessment due to the FDIC.

Capital Adequacy. The capital adequacy regulations that apply to state banks, such as the Bank, are similar to the Federal Reserve requirements promulgated with respect to bank holding companies discussed above.

Enforcement Authority. The federal banking laws contain civil and criminal penalties available for use by the appropriate regulatory agency against certain “institution-affiliated parties,” primarily including management, employees and agents of a financial institution, as well as independent contractors such as attorneys and accountants and others who participate in the conduct of the financial institution’s affairs and who caused or are likely to cause more than minimum financial loss to or a significant adverse effect on the institution, in each case who knowingly or recklessly violate a law or regulation, breach a fiduciary duty or engage in unsafe or unsound practices. These practices can include the failure of an institution to timely file required reports or the submission of inaccurate reports. These laws authorize the appropriate banking agency to issue cease and desist orders that may, among other things, require affirmative action to correct any harm resulting from a violation or practice, including restitution, reimbursement, indemnification or guarantees against loss. A financial institution may also be ordered to restrict its growth, dispose of certain assets or take other action as determined by the primary federal banking agency to be appropriate. The Bank is current in all required filings with the Federal Reserve.

Prompt Corrective Action. Banks are subject to restrictions on their activities depending on their level of capital. Federal “prompt corrective action” regulations divide banks into five different categories, depending on their level of capital:

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A bank is considered “well-capitalized” if it has a total risk-based capital ratio of 10% or more, a core capital ratio of 6% or more and a leverage ratio of 5% or more, and if the bank is not subject to an order or capital directive to meet and maintain a certain capital level.

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A bank is considered “adequately capitalized” if it has a total risk-based capital ratio of 8% or more, a core capital ratio of 4% or more and a leverage ratio of 4% or more (unless it receives the highest composite rating at its most recent examination and is not experiencing or anticipating significant growth, in which instance it must maintain a leverage ratio of 3% or more).

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A bank is considered “undercapitalized” if it has a total risk-based capital ratio of less than 8%, a core capital ratio of less than 4% or a leverage ratio of less than 3%.

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A bank is considered “significantly undercapitalized” if it has a risk-based capital ratio of less than 6%, a core capital ratio of less than 3% and a leverage ratio of less than 3%.

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A bank is considered “critically undercapitalized” if it has a leverage ratio of less than or equal to 2%.

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In addition, the applicable federal banking agency has the ability to downgrade a bank’s classification (though not to “critically undercapitalized”) based on other considerations even if the bank meets the otherwise applicable capital guidelines.

If a state member bank, such as the Bank, is classified as “undercapitalized,” the bank is required to submit a capital restoration plan to the Federal Reserve. An undercapitalized bank is prohibited from increasing its assets, engaging in a new line of business, acquiring any interest in any company or insured depository institution or opening or acquiring a new branch office, except under certain circumstances, including the acceptance by the Federal Reserve of a capital restoration plan for that bank. The Federal Reserve may also take other actions to correct the capital position of a state member bank that is classified as “undercapitalized”.

If a state member bank is classified as “significantly undercapitalized,” the Federal Reserve is required to take one or more prompt corrective actions. These actions include, among other things, requiring sales of new securities to bolster capital, changes in management, limits on interest rates paid, prohibitions on transactions with affiliates, termination of certain risky activities and restrictions on compensation paid to executive officers.

If a bank is classified as “critically undercapitalized,” the bank must be placed into conservatorship or receivership within 90 days, unless the FDIC determines otherwise.

The capital classification of a bank affects the frequency of examinations of the bank and impacts the ability of the bank to engage in certain activities; capital classification also affects the deposit insurance assessments paid by the bank. Furthermore, banks may be restricted in their ability to accept brokered deposits depending on their capital classification. “Well-capitalized” banks are permitted to accept brokered deposits, but banks that are not well-capitalized may not accept such deposits. (The Federal Reserve may, on a case-by-case basis, permit member banks that are “adequately capitalized” to accept brokered deposits if the Federal Reserve determines that acceptance of such deposits would not constitute an unsafe or unsound banking practice with respect to the bank.) At December 31, 2012, the Bank was classified as “well-capitalized.”

FDIC Insurance Assessments. The FDIC insures deposits, up to prescribed statutory limits, of federally insured banks and savings institutions and safeguards the safety and soundness of the banking and savings industries. The FDIC insures our customer deposits through the Deposit Insurance Fund (the “DIF”) up to prescribed limits for each depositor. Under the Dodd-Frank Act, (i) the maximum deposit insurance amount has been permanently increased from $100,000 to $250,000 per depositor, and (ii) certain non-interest bearing deposit accounts are accorded unlimited insurance until December 31, 2012. The amount of FDIC assessments paid by each DIF member institution is based on its relative risk of default as measured by regulatory capital ratios and other supervisory factors.

All FDIC-insured institutions are required to pay assessments to the FDIC to fund interest payments on bonds issued by the Financing Corporation (“FICO”), an agency of the Federal government established to recapitalize the predecessor to the DIF. The FICO assessment rates, which are determined quarterly, averaged 0.66% of insured deposits in fiscal 2012. These assessments will continue until the FICO bonds mature in 2017.

On November 17, 2009, the FDIC imposed a prepayment requirement on most insured depository organizations, requiring that the organizations prepay estimated quarterly risk-based assessments for the fourth quarter of 2009 and for each calendar quarter for calendar years 2010, 2011 and 2012. The prepaid assessments were based on the institutions’ estimated deposit levels over the period. The amount of our prepaid assessment, which as noted covered the fourth quarter of 2009 through the end of 2012, was approximately $1.1 million and was paid in December 2009. Subsequent to December 31, 2009, we have and will continue to expense our regular FDIC assessment and record an offsetting credit to the prepaid assessment asset until the asset is exhausted. If the prepaid assessment is not exhausted by June 30, 2013, any remaining amount will be returned to the Bank. The FDIC has stated that the prepayment requirement was imposed in response to a negative balance in the DIF, and has further indicated that prepayment of DIF assessments was in lieu of additional special assessments; however, there can be no guarantee that continued pressures on the DIF will not result in additional special assessments being imposed in the future.

Under the Dodd-Frank Act, the FDIC is also required to change its method of assessment of insurance premiums to an assessment based on the average total consolidated assets of the insured depository institution less the institutions average tangible equity for the assessment period.

The FDIC is also required to set its designated reserve ratio for each year at 1.35% of estimated insured deposits and take actions necessary to reach a reserve ratio of 1.35% of total estimated insured deposits by September 30, 2020. The FDIC may be required to increase deposit insurance premium assessments to meet the reserve ratio requirements. However, under the Dodd-Frank Act, the effects of any increases in deposit insurance premium assessments are to be offset for the benefit of depository institutions, like the Bank, with total consolidated assets of less than $10 billion.

The FDIC has the authority to further increase insurance assessments. In addition, insurance of deposits may be terminated by the FDIC upon a finding that an insured institution has engaged in unsafe or unsound practices, is in unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC.

Available Information

We maintain an Internet website at www.heritagebankva.com. Among other Company-related information, this website contains a link to our current and prior-period filings with the SEC on Form 10-K, Form 10-Q, and Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. The foregoing information is free of charge and may be reviewed, downloaded and printed from our website at any time. You may also read and copy any material we file with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. You may obtain information on the operation of the SEC’s Public Reference Room by calling the SEC at (202) 942-8090. Copies of these materials may be obtained at prescribed rates from the SEC at such address. These materials can also be inspected on the SEC’s web site at www.sec.gov.

As noted above, we have deregistered our common stock and are no longer subject to reporting requirements of the Exchange Act, therefore, following the filing of this Form 10-K, we will no longer make any filings with the SEC.

ITEM 1A.

Risk Factors

Our business, operations and financial condition are subject to various risks. In addition to the other information contained in this Form 10-K, before making an investment in our common stock, you should carefully consider the risks, uncertainties and other factors described below because they could materially and adversely affect our business, financial condition, operating results, cash flow and prospects and/or the market price of our common stock. This section does not describe all risks that may be applicable to us, our business or our industry, and the information is included solely as a summary of certain material risk factors.

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U.S. credit markets and economic conditions could adversely affect our liquidity, financial condition and profitability. U.S. and local market and economic conditions have been in recent periods, and to some extent continue to be, disruptive and volatile and the disruption has had a particularly negative impact on the financial sector. The possible duration and severity of this adverse economic cycle is unknown. Although we remain well capitalized and have not suffered any liquidity issues as a result of these recent events, the cost and availability of funds may be adversely affected by illiquid credit markets. Continued turbulence in U.S. and local markets and economies could also adversely affect our financial condition and profitability. Furthermore, as a result of previous disruptions in the financial markets, significant new federal laws and regulations relating to financial institutions were adopted, and the potential exists for additional federal or state laws and regulations regarding, among other matters, lending and funding practices and liquidity standards. While we believe we are well-positioned to respond to additional regulatory requirements, any such new legislation could negatively impact our operations by restricting our business operations, including our ability to originate loans, and adversely impact our financial performance.

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Our need to comply with extensive and complex government regulation could have an adverse effect on our business. The banking industry is subject to extensive regulation by state and federal authorities to protect depositors, the public and/or the insurance funds maintained by the FDIC. In particular, the Dodd-Frank Act, enacted in July 2010 (and described above under Item 1, “Business-Supervision and Regulation”), implemented major changes to the regulatory regimes for banks and other financial institutions, which have resulted in some immediate effects on the Company and the Bank and will likely continue to impact us for the foreseeable future. Banking regulations affect our lending practices, capital structure, investment practices, dividend policy and many other aspects of our business. These requirements may constrain our rate of growth, and changes in regulations could adversely affect us. The burden imposed by these federal and state regulations may place banks, including the Bank, at a competitive disadvantage compared to less regulated competitors. In addition, the cost of compliance with regulatory requirements could adversely affect our ability to operate profitably. (See Item 1, “Business – Supervision and Regulation” above, for more information about applicable banking laws and regulations.) Further, because federal regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot forecast how federal regulation of financial institutions may change in the future nor the impact those changes may have on our operations. We fully expect that the financial institution industry will remain heavily regulated in the near future and that additional laws and regulations will be adopted further regulating specific banking practices.

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We rely heavily on our management team and on our ability to attract and retain key personnel. We are a customer-focused and relationship-driven organization. We expect our future growth to be driven in large part by the relationships maintained with our customers by our Chief Executive Officer and our other executive and senior lending officers. We also rely heavily on our management team to maintain and evolve our internal controls, accounting and reporting systems. We have entered into employment agreements with our Chief Executive Officer, Chief Financial Officer and certain other key executives. The existence of such agreements, however, does not necessarily ensure that we will be able to continue to retain their services. The loss of our Chief Executive Officer, Chief Financial Officer or other key employees for any reason could have a material adverse effect on our business and possibly result in reduced revenues and earnings.

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We depend on the profitability of the Bank. We are a single bank holding company and our business is owning all of the outstanding stock of the Bank. As a result, our operating results and financial position depend on the operating results and financial position of the Bank. Many factors could adversely affect our short- and long-term operating performance, including those described below.

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We may incur losses if we are unable to successfully manage interest rate risk. Our profitability will depend in substantial part upon the spread between the interest rates we earn on loans and investments and the interest rates we pay on deposits and other interest-bearing liabilities. We occasionally engage in marketing and promotions that offer above-market rates to attract deposits; however, we have not in the past and currently do not expect to solicit or accept brokered deposits. Changes in interest rates will affect our operating performance and financial condition in diverse ways, including the pricing of loans and deposits. We attempt to minimize our exposure to interest rate risk, but we will be unable to eliminate it. Our net interest spread will depend on many factors that are partly or entirely outside our control, including competition, federal economic, monetary and fiscal policies, and economic conditions generally.

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We may be adversely affected by economic conditions in our market area. We are headquartered in Norfolk, Virginia, and our market includes the Hampton Roads metropolitan area. Because our lending is concentrated in this market, we will be affected by the general economic conditions in the Hampton Roads and neighboring areas. Changes in the economy may influence the growth rate of our loans and deposits and the quality of our loan portfolio and loan and deposit pricing. A significant decline in general economic conditions caused by inflation, continued or new recessionary environments, unemployment or other factors beyond our control would impact local economic conditions and the demand for banking products and services generally, which could negatively affect our financial condition and performance. In addition, given the significance of the Navy and military generally to the local economy, significant cutbacks in defense spending and/or decreases in military and federal wages locally could adversely impact the local economy and, in turn, our financial performance.

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Our loans secured by real estate may increase our credit losses, which would adversely affect our financial results. We offer a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Many of our loans are secured by real estate (both residential and commercial) in our market area. Continued or worsening decline in the real estate market could adversely affect the value of our collateral for real estate loans and our customers’ ability to pay these loans, which in turn could impact us. Risk of loan defaults and foreclosures are unavoidable in the banking industry, and we try to limit our exposure to this risk by monitoring our extensions of credit carefully. We cannot fully eliminate credit risk, however, and as a result loan losses may occur in the future.

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If our allowance for loan losses becomes inadequate, our results of operations may be adversely affected. We maintain an allowance for loan losses that we believe is a reasonable estimate of known and inherent losses in our loan portfolio. Through a periodic review and consideration of our loan portfolio, management determines the amount of the allowance for loan losses by considering general market conditions, credit quality of the loan portfolio, the collateral supporting the loans and performance of our customers relative to their financial obligations with us. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates, that may be beyond our control, and these losses may exceed our current estimates. Although as noted we believe our allowance for loan losses represents a reasonable estimate of known and inherent losses in our loan portfolio, we cannot fully predict such losses or guarantee that our loan loss allowance will be adequate in the future. Excessive loan losses could have a material impact on our financial performance. Federal and state regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs, based on judgments different than those of our management. Any increase in the amount of our loan loss provision or loans charged-off as required by these regulatory agencies could have a negative effect on our operating results.

•

We may suffer losses in the Bank’s loan portfolio despite our underwriting practices; we could be adversely impacted by declines in credit quality. We seek to mitigate the risks inherent in our loan portfolio by adhering to specific underwriting practices. These practices include analysis of a borrower’s prior credit history, financial statements, tax returns and cash flow projections, valuation of collateral based on reports of independent appraisers, and verification of liquid assets. Although we believe that our underwriting criteria are appropriate for our loans, we may incur losses on loans that meet these criteria. Furthermore, we could be adversely affected in spite of sound underwriting practices if borrowers, guarantors or related parties fail to perform in accordance with the terms of their loans or if we fail to detect or respond to deterioration in asset quality in a timely manner; moreover, problems with credit quality or asset quality could cause our interest income and net interest margin to decrease and our provisions for loan losses to increase, which could adversely affect our business, financial condition and results of operations. These risks have been exacerbated by the recent developments in financial markets, and we are unable to accurately predict what effect these uncertain market conditions will continue to have on these risks.

•

Our future success is dependent on our ability to compete effectively in the highly competitive banking industry. We face vigorous competition from other banks and other financial institutions, including savings and loan associations, savings banks, finance companies and credit unions, for deposits, loans and other financial services in our market area. Most of these banks and other financial institutions are significantly larger than we are and have substantially greater access to capital and other resources, as well as larger lending limits and branch systems, and offer a wider array of banking services. We also compete with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies, insurance companies and governmental organizations, which may be able to offer financing on more favorable terms than we can. Many of our non-bank competitors are not subject to the same extensive regulations that govern us; as a result, these non-bank competitors have advantages over us in providing certain services. This competition may reduce or limit our margins and our market share and may adversely affect our results of operations and financial condition.

•

The costs of being a public bank holding company are proportionately higher for small companies like us. The U.S. PATRIOT Act, the BSA, SOX and related regulations of the Securities and Exchange Commission have increased the scope, complexity and cost of corporate governance, reporting and disclosure practices. As a result, we have experienced and may continue to incur increased compliance costs, including costs related to implementing, maintaining and periodically assessing and evaluating our compliance with all applicable regulations. These necessary compliance costs are proportionately higher for a company of our size and will affect our profitability more than that of some of our larger competitors. Deregistration of our common stock should result in a decrease in some of these compliance costs, but there is no guarantee that our overall regulatory cost-burden will decrease or that our financial results will improve as a consequence of deregistration.

•

Our ability to operate profitably may be affected by our ability to implement technologies into our operations. The market for financial services, including banking services and consumer finance services, is increasingly affected by advances in technology, including developments in telecommunications, data processing, computers, automation, Internet-based banking and telebanking. Our ability to compete successfully in our market may be affected by the extent to which we are able to utilize technological changes. If we are not able to implement new technologies at a cost that is reasonable and appropriate for a bank of our size, properly or timely anticipate such new technologies, or properly train our staff to use them, our business, financial condition or operating results could be adversely affected.

•

Our common stock has been deregistered; there is a limited trading market for our common stock; it may be difficult to sell our shares after you have purchased them. Pursuant to the Jumpstart Our Business Startups Act enacted in 2012, which amended the Securities Exchange Act of 1934 (the “Exchange Act”) to, among other things, permit bank holding companies like us with fewer than 1,200 record shareholders to deregister securities previously registered with the SEC, we filed Form 15s with the SEC to deregister our common stock. The deregistration was effective on or about February 28, 2013; as a result, we are no longer subject to the periodic

reporting requirements of the Exchange Act, and following the filing of this Form 10-K we will no longer make any filings with the SEC. Both the Company and the Bank will continue to comply with the financial reporting requirements of the Federal Reserve and other applicable regulatory agencies, and those financial statements are and will continue to be available for review by our shareholders through the applicable agency(ies). In light of these regulatory financial reporting requirements, and notwithstanding the deregistration of our common stock, we anticipate that our stock will continue to be quoted on over-the-counter markets such as the OTC Markets Group and the OTC Bulletin Board so long as market makers continue to make a market in our stock. Trading on these over-the-counter markets is more limited than on the national exchanges such as the New York Stock Exchange or NASDAQ, and no guarantee can be made that a trading market in our common stock through any over-the-counter market will be maintained. In any event, trading in the shares of our common stock has historically been limited, and the deregistration of our stock may further adversely impact the liquidity of our shares. Accordingly, there is – and likely will continue to be – a limited trading market for our stock, and there can be no assurance that it will continue or that you will be able to sell your shares at the desired price.

•

Our participation in the SBLF Program may adversely affect the value of our common stock and the rights of our common stockholders. The rights of the holders of our common stock may be adversely affected by the Company’s participation in the SBLF Program. For example:

•

The terms of the SBLF Preferred Stock impose limits on our ability to pay dividends on and repurchase shares of our common stock and other securities. More specifically, if we fail to declare and pay dividends on the SBLF Preferred Stock in a given quarter, then during such quarter and for the next three quarters following such missed dividend payment, we will be prohibited from paying any dividends on or repurchasing any common stock or any other securities that are junior to (or in parity with) the SBLF Preferred Stock, except in very limited circumstances.

•

The SBLF Preferred Stock will receive preferential treatment in the event of liquidation, dissolution or winding up of the Company.

•

Finally, the terms of the SBLF Preferred Stock require quarterly dividends to be paid on such stock at a fluctuating rate between 1% and 5% per year for the first 2.5 years and at a rate to be fixed at between 1% and 7% per year for the following 2 years thereafter; the dividend rate increases to 9% on any SBLF Preferred Stock that remains outstanding after 4.5 years, until the stock is redeemed by the Company. The payments of these preferred dividends will reduce the excess cash we would otherwise have available to pay dividends on our common stock and to use for general corporate purposes, including working capital, which could adversely impact our common stockholders and the Company in general.

ITEM 1B.

Unresolved Staff Comments

Not applicable.

ITEM 2.

Properties

At December 31, 2012, the Bank operated from eight locations:


Office Location	Type of Facility	Owned/ Leased	Approximate Square Footage

150 Granby Street, Suite 175, Norfolk, Virginia	Retail Banking Office	Leased	3,739 sq. ft

150 Granby Street, Suite 150, Norfolk, Virginia	Corporate Headquarters (Executive, Commercial Loans and Loan Administration)	Leased	8,403 sq. ft.

841 North Military Highway, Norfolk, Virginia	Retail Banking Office and Deposit Operations	Owned	6,250 sq. ft.

815 Colley Avenue, Norfolk, Virginia	Retail Banking Office	Owned	3,000 sq. ft.

735 East Ocean View Avenue, Norfolk, Virginia	Retail Banking Office	Owned	3,000 sq. ft.

601 Lynnhaven Parkway, Virginia Beach, Virginia	Retail Banking Office	Owned	3,165 sq. ft.

1756 Laskin Road, Virginia Beach, Virginia	Retail Banking Office and Commercial Loans	Owned	5,640 sq. ft.

1403 Greenbrier Parkway, Chesapeake, Virginia	Retail Banking Office and Commercial Loans	Leased	3,766 sq. ft.

We believe that all of our properties are adequately covered by insurance, are in good operating condition (ordinary wear and tear excepted) and are adequate and suitable for the ordinary and regular conduct of our business.

ITEM 3.

Legal Proceedings

There are no legal proceedings to which the Company or any of its subsidiaries is a party or of which any of their property is the subject, other than ordinary routine litigation incidental to the business of the Company and its subsidiaries.

ITEM 4.

Mine Safety Disclosures

Not applicable.

PART II

ITEM 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market Information

The Company’s common stock is currently quoted on the OTC Markets Group under the symbol “HBKS.” The following table sets forth the high and low closing sales price for our common stock, as reported by the OTC Bulletin Board, by calendar quarter for 2011 through the second quarter 2012, and by OTC Markets Group for the third and fourth quarters of 2012. These quotations represent inter-dealer prices, without retail mark-up, mark-down or commission, and may not represent actual transactions.


	HIGH		LOW
2012
Fourth Quarter	$	12.10	$	11.61
Third Quarter		12.45		11.81
Second Quarter		13.00		11.95
First Quarter		12.96		11.20


	HIGH		LOW
2011
Fourth Quarter	$	12.25	$	11.11
Third Quarter		13.00		11.75
Second Quarter		12.80		11.80
First Quarter		13.05		11.80

Holders

At December 31, 2012, there were approximately 825 holders of record of the 2,275,891 outstanding shares of the Company’s common stock.

Dividends

The Company has historically paid cash dividends on a quarterly basis, though the final determination regarding whether to declare and pay dividends on our common stock, and the amount of such dividends, is made at the sole discretion of the Company’s Board of Directors. Determinations by the Board of Directors with respect to dividend payments take into account the financial condition, results of operations and capital requirements of the Company and its subsidiaries, principally the Bank, as well as other relevant factors including applicable law and general business conditions, and depending on such factors the Company’s dividend policy may change from time to time at the discretion of the Board of Directors. Our ability to declare and pay dividends on our common stock is also affected by regulatory restrictions on the payment of dividends by both the Bank to the Company and the Company to its stockholders, as discussed above in Item 1, “Business – Supervision and Regulation”, including restrictions resulting from the Company’s participation in the SBLF Program. The Company declared and paid regular cash dividends of $0.24 per common share, in aggregate ($0.06 per common share in quarterly dividends), in each of 2012 and 2011. In addition the Company declared and paid a special dividend of $0.36 in December 2012, of which $0.24 is an acceleration of – and payment in lieu of – total aggregate dividends of $0.24 per share that the Company would have otherwise expected to announce and pay in quarterly installments during the 2013 calendar year, plus an additional amount of $0.12 per share.

Recent Sales of Unregistered Securities

No securities were sold by the Company within the past three years that were not registered under the Securities Act that were not previously reported in a Quarterly Report on Form 10-Q or in a Current Report on Form 8-K.

Equity Compensation Plan Information

The Company makes grants of restricted stock and options to purchase common stock of the Company pursuant to its equity compensation plans. Information regarding the Company’s outstanding equity compensation plans as of December 31, 2012 is set forth in the following table:


Plan Category	Number of Securities to be Issued Upon Exercise of Outstanding Options, Warrants and Rights (a)		Weighted-Average Exercise Price of Outstanding Options, Warrants and Rights (b)		Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (Excluding Securities Reflected in Column(a)) (c)
Equity Compensation Plans Approved by Security Holders (1)		232,000	$	12.68		4,400
Equity Compensation Plans Not Approved by Security Holders		—		—		—

Total		232,000	$	12.68		4,400

(1)

The Heritage 2006 Equity Incentive Plan previously approved by our shareholders, as amended and restated by our Board of Directors effective January 28, 2009, as subsequently amended in 2012 (“2006 Incentive Plan”), authorizes the grant of stock options, stock appreciation rights, restricted stock and certain other equity awards with respect to not more than 250,000 shares of the Company’s common stock. The Company’s ability to issue new awards under its pre-existing 1987 Stock Option Plan and 1999 Stock Option Plan was terminated concurrently with approval of the 2006 Incentive Plan.

ITEM 6.

Selected Financial Data

The Company is a smaller reporting company and thus is not required to provide the information required by this Item 6.

ITEM 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s discussion and analysis is intended to assist readers in the understanding and evaluation of our financial condition and results of operations. The discussion and analysis should be read in conjunction with the audited consolidated financial statements and accompanying notes included in this annual report on Form 10-K and the supplemental financial data appearing throughout this discussion and analysis.

Overview

Critical Accounting Policies

The preparation of our consolidated financial statements and accompanying notes are governed by accounting principles generally accepted in the United States of America. The preparation of these consolidated

financial statements requires management to use judgments, estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingent assets and liabilities. While we believe our judgments, estimates and assumptions are reasonable under the circumstances, actual results may differ materially under different conditions or using different assumptions.

We believe our critical accounting policies are those that are particularly sensitive in terms of judgments and the extent to which estimates are used, and include (a) the valuation of the allowance for loan losses and the impairment of loans, (b) the impairment of financial investments and other accounts, (c) the deferral of loan fees and direct loan origination costs, and (d) accounting for income taxes.

The Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (the “Codification” or “ASC”). In June 2009, the FASB issued an accounting standard which established the Codification to become the single source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities, with the exception of guidance issued by the U.S. Securities and Exchange Commission and its staff. All guidance contained in the Codification carries an equal level of authority. The Codification is not intended to change GAAP, but rather is expected to simplify accounting research by reorganizing current GAAP into approximately 90 accounting topics. We adopted this accounting standard in preparing our consolidated financial statements for the period ended December 31, 2009. The adoption of this accounting standard, which was subsequently codified into ASC Topic 105, “Generally Accepted Accounting Principles,” had no impact on retained earnings and will have no impact on our statements of income and condition.

Allowance for Loan Losses; Impairment of Loans. The allowance for loan losses is maintained at a level which, in management’s judgment, is adequate to absorb estimated credit losses on existing loans. If judgments and assumptions were to differ significantly from those used by management to estimate the allowance, the allowance for loan losses and the provision for loan losses on our income statement could be impacted materially. In addition, the allowance for loan losses is subject to review by various regulators who conduct examinations of the allowance for loan losses and may require adjustments to the allowance based upon the regulators’ assessment regarding our adequacy and the methodology used. (For further discussion of the Company’s allowance for loan losses, see “Lending Activities – Allowance for Loan Losses” located below in this Management’s Discussion and Analysis of Financial Condition and Results of Operations.)

A loan is considered impaired when it is probable that we will be unable to collect all interest and principal payments due according to the contractual terms of the loan agreement. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral if the loan is collateral dependent. A valuation allowance is maintained to the extent that the measure of the impaired loan is less than the recorded investment.

Impairment of Financial Investments and Other Accounts. Impairment of investment securities, other equity investments and other asset accounts results in a write-down that must be included in net income when fair value of the asset declines below cost and is other-than-temporary. The fair values of these investments and other assets are subject to change, as they are influenced by market conditions and management decisions.

Deferral of Loan Fees and Direct Loan Origination Costs. Generally accepted accounting policies relating to accounts receivable require that loan fees and direct loan origination costs be deferred and recognized as an adjustment to the loan’s yield. While the amount of fees to be deferred is generally apparent in the origination of a loan, we utilize estimates to determine the amount of deferred direct origination costs, especially payroll costs, that are attributable to the loan origination process. Management’s estimates of the amount of costs associated with successful loan origination activities are reviewed and updated annually.

Accounting for Income Taxes. The determination of the Company’s effective tax rate requires judgment. In the ordinary course of business, there are transactions and calculations for which the ultimate tax outcomes are uncertain. In addition, our tax returns are subject to audit by various tax authorities. Although we believe our estimates are reasonable, there can be no assurance that the final tax outcome will not be materially different than that which is reflected in the income tax provision and accrual.

Selected Financial Ratios

The information presented below is derived in part from our audited consolidated financial statements and notes thereto, which appear elsewhere in this annual report on Form 10-K (see Item 8, “Financial Statements and Supplementary Data,” below). This information should be read in conjunction with our consolidated financial statements.


	For the Years Ended December 31,
	2012			2011			2010
Return on average assets (1)		0.74	%		0.83	%		0.74	%
Return on average equity (2)		7.96	%		8.46	%		5.60	%
Average equity to average assets (3)		11.76	%		12.63	%		13.29	%
Dividend payout ratio (4)		62.50	%		30.77	%		36.92	%

(1)	Net income after tax, before preferred stock dividends and accretion of discount, divided by average total assets.

(2)	Net income after tax, before preferred stock dividends and accretion of discount, divided by average common equity.

(3)	Average equity divided by average total assets.

(4)	Represents common dividends declared per share divided by basic net income per share.

Financial Condition of the Company

Total Assets. The Company’s total assets increased by $42.0 million, or 14.2%, from $294.6 million at December 31, 2011 to $336.6 million at December 31, 2012. The increase in assets resulted primarily from a $36.2 million increase in our aggregate cash, securities available for sale, interest-bearing deposits in other banks and federal funds sold, together with a $7.8 million increase in loans held for investment, net.

Investments. Securities available for sale decreased by $24.1 million, from $45.3 million at December 31, 2011 to $21.2 million at December 31, 2012. Overnight funds increased by $24.6 million and certificates of deposit, interest-bearing deposits in other banks (excluding overnight funds), and federal funds sold increased by a total of $35.3 million, with a resulting aggregate increase in such investment balances from $8.7 million at December 31, 2011 to $68.6 million at December 31, 2012.

Loans. Loans held for investment, net, were $221.0 million at December 31, 2012, an increase of $7.8 million from our loan balance of $213.2 million at December 31, 2011.

Asset Quality. Nonperforming assets were $699,000, or 0.21% of total assets, at December 31, 2012, compared to $1,719,000 in nonperforming assets, or 0.58% of total assets, at December 31, 2011. Accruing loans past due 90 days or more consisted of one residential 1-4 loan and other real estate owned consisted of a bank branch site that we no longer plan to utilize.

Deposits. Total deposits at December 31, 2012 were $295.2 million compared to $250.0 million at December 31, 2011, an increase of $45.2 million, or 18.1%. Core deposits, which are comprised of noninterest-bearing, money market, NOW and savings deposits, increased by $65.9 million, or 32.0%, from $205.6 million at December 31, 2011 to $271.5 million at December 31, 2012. Noninterest-bearing deposits increased by $18.7 million to $111.5 million at December 31, 2012 and, as a percentage of total deposits, noninterest-bearing deposits increased from 37.1% at December 31, 2011 to 37.8% at December 31, 2012.

Average total deposits increased by $28.1 million, or 11.5%, from $244.3 million for the twelve-month period ended December 31, 2011 to $272.4 million for the twelve-month period ended December 31, 2012. Average core deposits increased by $46.1 million, or 23.6%, over the comparable twelve-month periods. Average noninterest-bearing deposits increased by $11.8 million, from $88.4 million in the twelve-month period ending December 31, 2011 to $100.2 million in the twelve-month period ending December 31, 2012. As a percentage of average total deposits, average noninterest-bearing deposits increased slightly from 36.2% at December 31, 2011 to 36.8% at December 31, 2012.

Borrowed Funds. Borrowed funds decreased by $3.2 million, from $6.3 million at December 31, 2011 to $3.1 million at December 31, 2012.

Capital. Stockholders’ equity increased by $237,000, from $36,437,000 at December 31, 2011 to $36,674,000 at December 31, 2012, primarily due to an increase in earnings, partially offset by a $333,000 decrease in accumulated other comprehensive income related to the reduction of our securities available for sale portfolio and an $819,000 special dividend declared in the fourth quarter of 2012.

Net Interest Income

Like most financial institutions, the primary component of our earnings is net interest income. Net interest income is the difference between interest income, primarily from loan and investment securities portfolios, and interest expense, primarily on customer deposits and other Company borrowings. Changes in net interest income result from changes in volume, spread and margin. For purposes of determining such changes in net interest income, (a) volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities, (b) spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and (c) margin refers to net interest income divided by average interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities, as well as levels of noninterest-bearing liabilities. During the years ended December 31, 2012 and 2011, our average interest-earning assets were $291.3 million and $269.1 million, respectively. During these same years, our net interest margins, on a tax-equivalent basis, were 3.58% and 4.12%, respectively.

Average Balances and Average Rates Earned and Paid. The following table sets forth for the Company, for the periods indicated, information with regard to average balances of assets and liabilities, as well as the total dollar amounts on a tax-equivalent basis of interest income from interest-earning assets and interest expense on interest-bearing liabilities, resultant yields or costs, net interest income, net interest spread, net interest margin and ratio of average interest-earning assets to average interest-bearing liabilities. In preparing the table, nonaccrual loans are included in the average loan balance.


	YEAR ENDED								YEAR ENDED								YEAR ENDED
	DECEMBER 31, 2012								DECEMBER 31, 2011								DECEMBER 31, 2010
	Average Balance (1)			Interest		Yield/ Cost			Average Balance (1)			Interest		Yield/ Cost			Average Balance (1)			Interest		Yield/ Cost
	(dollars in thousands)
Interest-earning assets (2)
Loans (2) (3)	$	214,956		$	10,388		4.82	%	$	214,962		$	11,423		5.31	%	$	193,394		$	10,218		5.28	%
Investment securities taxable		35,682			824		2.31	%		26,561			799		3.01	%		41,996			1,404		3.34	%
FHLB and Federal Reserve Stock		1,238			48		3.86	%		1,972			48		2.44	%		2,232			40		1.79	%
Federal funds sold		73			—		0.02	%		136			—		0.08	%		651			1		0.12	%
Other interest income		39,358			183		0.46	%		25,489			93		0.36	%		24,365			132		0.54	%

Total interest-earning assets		291,307			11,443		3.92	%		269,120			12,363		4.59	%		262,638			11,795		4.49	%

Noninterest-earning assets
Other real estate owned		1,472								522								102
Other assets		22,326								17,263								17,656

Total assets	$	315,105							$	286,905							$	280,396


Interest-bearing liabilities
Money market, NOW accounts	$	137,501		$	693		0.50	%	$	103,907		$	579		0.56	%	$	98,962		$	586		0.59	%
Savings deposits		4,230			6		0.15	%		3,488			6		0.18	%		2,957			6		0.20	%
Certificates of deposit		30,515			244		0.80	%		48,517			634		1.31	%		49,072			806		1.64	%

Total interest-bearing deposits		172,246			943		0.55	%		155,912			1,219		0.78	%		150,991			1,398		0.93	%


Other borrowings		3,449			29		0.82	%		4,304			44		1.02	%		10,982			144		1.30	%

Total interest-bearing liabilities		175,695			972		0.56	%		160,216			1,263		0.79	%		161,973			1,542		0.96	%


Noninterest-bearing liabilities
Demand deposits		100,148								88,371								79,237
Other liabilities		2,217								2,092								1,930

Total liabilities		278,060								250,679								243,140


Stockholders’ equity		37,045								36,226								37,256

Total liabilities and Stockholders’ equity	$	315,105							$	286,905							$	280,396


Net interest income and interest spread				$	10,471		3.36	%				$	11,100		3.80	%				$	10,253		3.53	%


Net interest margin							3.58	%							4.12	%							3.90	%


Ratio of average interest-earning assets to average interest-bearing liabilities		165.80	%							167.97	%							162.15	%

(1)	The calculations are based on daily average balances.

(2)	Yields are stated on a taxable-equivalent basis assuming tax rates in effect for the periods presented.

(3)	For the purposes of these computations, nonaccrual loans are included in average loan balances.

Rate/Volume Analysis

The following table analyzes the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. The table distinguishes between (i) changes attributable to volume (changes in volume multiplied by the prior period’s rate), (ii) changes attributable to

rate (changes in rate multiplied by the prior period’s volume), and (iii) net change (the sum of the previous columns). The change attributable to both rate and volume (changes in rate multiplied by changes in volume) has been allocated equally to both the changes attributable to volume and the changes attributable to rate.


	YEAR ENDED									YEAR ENDED
	December 31, 2012 vs. 2011									December 31, 2011 vs. 2010
	Increase(Decrease) Due to									Increase(Decrease) Due to
	Volume			Rate			Total			Volume			Rate			Total
	(in thousands)
Interest income
Loans	$	—		$	(1,035	)	$	(1,035	)	$	1,146		$	59		$	1,205
Investment securities taxable		237			(212	)		25			(477	)		(128	)		(605	)
FHLB & FRB stock		(22	)		22			—			(5	)		13			8
Federal funds sold		—			—			—			(1	)		—			(1	)
Other interest income		59			31			90			6			(45	)		(39	)

Total interest income		274			(1,194	)		(920	)		669			(101	)		568


Interest expense
Deposits
Money Market/NOW accounts		179			(65	)		114			26			(33	)		(7	)
Savings deposits		1			(1	)		—			1			(1	)		—
Certificates of deposit		(190	)		(200	)		(390	)		(9	)		(163	)		(172	)
Borrowings		(7	)		(8	)		(15	)		(74	)		(26	)		(100	)

Total interest expense		(17	)		(274	)		(291	)		(56	)		(223	)		(279	)

Net interest income
Increase(decrease)	$	291		$	(920	)	$	(629	)	$	725		$	122		$	847

Comparison of Operating Results for the Twelve Months Ended December 31, 2012 and 2011

Overview. The Company’s pretax income was $3,249,000 for the year ended December 31, 2012, compared to pretax income of $3,502,000 for the year ended December 31, 2011, a decrease of $253,000. This decrease resulted primarily from a $694,000 decrease in net interest income partially offset by a $317,000 increase in noninterest income and a $174,000 decrease in noninterest expense between the two years. The Company’s effective tax rate for 2012 was 28.3% compared to an effective tax rate of 32.4% for 2011.

Net Interest Income. The Company’s net interest income before provision for loan losses decreased by $694,000, comparing the years 2012 and 2011. Our average loan portfolio remained unchanged at $215.0 million for the respective twelve-month periods ending December 31, 2012 and 2011. Our average investment in overnight funds increased by $13.7 million and our average investment in securities available for sale and other interest-earning assets (excluding loans and overnight funds) increased by $8.5 million, for a net increase in average interest-earning assets of $22.2 million comparing the two twelve-month periods. Average interest-bearing liabilities increased by $15.5 million from $160.2 million in 2011 to $175.7 million in 2012, resulting primarily from a $16.3 million increase in average interest-bearing deposits. The average yield on our interest-earning assets was adversely impacted by lower yields on loans and an increase in the average balance of investment securities and other interest-earning assets, which was only partially offset by a decrease in the average cost of interest-bearing liabilities. As a result, our interest rate spread decreased by 44 basis points from 3.80% in 2011 to 3.36% in 2012, and our net interest margin decreased by 54 basis points from 4.12% in 2011 to 3.58% in 2012.

Provision for Loan Losses. Provision for loan losses was $35,000 for 2012 compared to a $15,000 reduction in provision for loan losses for 2011.

Noninterest Income. Total noninterest income increased by $317,000, from $868,000 in 2011 to $1,185,000 in 2012. The primary factors contributing to this increase were a $197,000 increase in gains on the sale of investment securities and a $184,000 increase in income from bank-owned life insurance in 2012.

Noninterest Expense. Total noninterest expense decreased by $174,000, from $8,324,000 in 2011 to $8,150,000 in 2012, primarily attributable to decreased compensation expense of $232,000.

Income Taxes. The Company’s income tax expense for 2012 was $921,000, reflecting an effective tax rate of 28.3%, compared to income tax expense of $1,134,000 and an effective tax rate of 32.4% for 2011. This reduction in effective tax rate was primarily attributable to an increase in tax-exempt interest income and other non-taxable income.

Net Income Available to Common Stockholders. After the impact of dividends on our preferred stock, net income available to common shareholders was $2,191,000 for 2012, or earnings per diluted common share of $0.94, compared to net income available to common stockholders of $1,787,000 for 2011, or earnings per diluted common share of $0.77, an increase of $404,000, or $0.17 per diluted common share. This increase in earnings available to common stockholders is primarily attributable to qualified loan growth which resulted in a 1.75% average dividend rate on our SBLF preferred stock in 2012, compared to accelerated accretion of the discount on outstanding TARP preferred stock and the associated average dividend rate of 7.07% in 2011.

The following tables set forth, for the periods indicated, components of noninterest income and noninterest expense:


	Years Ended December 31,
	2012		2011
	(in thousands)
Noninterest income
Service charges on deposit accounts	$	252	$	334
Gain on sale of investment securities		284		87
Income from bank-owned life insurance		203		19
Late charges and other fees on loans		98		129
Other		348		299

Total noninterest income	$	1,185	$	868


	Years Ended December 31,
	2012		2011
	(in thousands)
Noninterest expense
Compensation	$	4,151	$	4,383
Data processing		630		580
Occupancy		887		838
Furniture and equipment		579		583
Taxes and licenses		318		338
Professional fees		332		366
FDIC assessment		155		170
Loss on sale or impairment of other real estate owned		70		54
Other miscellaneous		1,028		1,012

Total noninterest expense	$	8,150	$	8,324

Lending Activities

Loans held for investment, net of allowance for loan losses and unearned fees and costs, at December 31, 2012 were $221.0 million compared with $213.2 million at December 31, 2011, an increase of $7.8 million. As a percentage of average earning assets, average loans were 73.8% for the year ended 2012 and 79.9% for the year ended 2011.

General. We engage in a wide range of lending activities, which include the origination, primarily in our market area, of (1) commercial business loans, (2) commercial real estate loans, (3) construction loans, (4) land acquisition and development loans, and (5) home equity, consumer and residential mortgage loans.

Commencing in early 2005, we have taken a number of steps, such as the recruitment of highly knowledgeable and experienced lending officers, the introduction of centralized loan processing, the implementation of new underwriting and documentation requirements and the regular utilization of the loan committee process, to improve the underwriting, documentation and administration of the Bank’s loan portfolio. The discussion in this section relates to the lending practices we have utilized since early 2005 and continue to use today.

Loan Policy. Our Loan Policy provides general guidance on underwriting of loans, risk management, credit approval, loan administration and problem asset management. The Loan Policy is designed to help ensure that loan growth is accompanied by acceptable asset quality with uniform and consistently applied approval, administration and documentation practices and standards.

Commercial Business Lending. We actively solicit commercial business loans of all types. Commercial business loans include revolving lines of credit to provide working capital, term loans to finance the purchase of vehicles and equipment, letters of credit to guarantee payment and performance, and other loans to assist businesses in cash management or growth opportunities.

Revolving lines of credit are typically secured by various assets of the borrower, provide for the acceleration of repayment upon any event of default, are monitored monthly or quarterly to ensure compliance with loan covenants, when appropriate, and are re-underwritten annually before renewal. Interest rates on revolving lines of credit are generally variable. Term loans are generally advanced for the purchase of, and are secured by, vehicles and equipment and are normally fully amortized over a term of two to five years, on either a fixed or variable rate basis. In general, these credit facilities carry the unconditional guarantees of the owners and/or stockholders of the borrower.

Commercial Real Estate Lending. Our commercial real estate loans are primarily secured by real property and the income arising from such property. The proceeds of commercial real estate loans are generally used by the borrower to finance or refinance the cost of acquiring and/or improving a commercial property. The properties that typically secure these loans are office and warehouse facilities, retail facilities and other commercial properties. In addition, we will on a more limited basis make loans secured by special purpose facilities such as hotels, mini-storage warehouses and manufacturing facilities. We actively seek to make commercial real estate loans to borrowers who will occupy or use the financed property in connection with their normal business operations. We also make commercial real estate loans for other purposes if the borrower is in strong financial condition and presents a substantial business opportunity for the Bank, taking into account (when circumstances warrant) the extent to which the property is leased or pre-leased.

Our commercial real estate loans are usually amortized over a period of time ranging from 15 years to 25 years and usually have a term to maturity ranging from five years to 15 years. These loans normally include provisions for interest rate adjustments after the loan is three to five years old. We may extend longer interest rate adjustment periods to particularly credit-worthy borrowers. The Bank’s maximum loan-to-value ratio for a commercial real estate loan is 85%; however, this maximum can be waived for particularly strong borrowers on an exception basis. Most commercial real estate loans are further secured by one or more unconditional personal guarantees.

We structure some of our commercial real estate loans as mini-permanent loans. The amortization period, term and interest rates for these loans vary based on borrower preferences and our assessment of the loan and the degree of risk involved. If the borrower prefers a fixed rate of interest, we usually offer a loan with a fixed rate of interest for a term of three to five years with an amortization period of up to 25 years and the remaining balance of the loan due and payable in a single balloon payment at the end of the initial term. If the borrower prefers a variable or floating rate of interest, we usually offer a loan with a variable interest rate tied to a readily recognizable index, such as the Wall Street Journal’s prime rate, for a term of three to five years with an amortization period of up to 25 years and the remaining balance of the loan due and payable in a single balloon payment at the end of the initial term.

Loans secured by commercial real estate are generally larger and involve a greater degree of risk than residential mortgage loans. Because payments on loans secured by commercial real estate are usually dependent on successful operation or management of the properties securing such loans, repayment of such loans is subject to changes in both general and local economic conditions and the borrower’s business and income. As a result, events beyond our control, such as a continued or worsening downturn in the local economy, could adversely affect the performance of our commercial real estate loan portfolio. We seek to minimize these risks by lending to established customers or experienced real estate developers and generally restricting our commercial real estate loans to our primary market area. Emphasis is placed on the income producing characteristics and repayment capacity of the collateral.

Construction Lending. We have a limited construction lending program consisting of loans for the construction of one-to-four family residences, multi-family dwellings, office and warehouse facilities and other nonresidential projects, generally limited to borrowers who are owner-occupants or who present other business opportunities for the Bank.

The amounts, interest rates and terms for construction loans vary, depending upon market conditions, the size and complexity of the project, and the financial strength of the borrower and any guarantors of the loan. The term for our typical construction loan ranges from nine months to 18 months for the construction of an individual residence and from 12 months to a maximum of two years for larger residential or commercial projects. We typically do not amortize construction loans, and the borrower pays interest monthly on the outstanding principal balance of the loan. Our construction loans generally have a floating or variable rate of interest but occasionally have a fixed interest rate. We generally do not finance the construction of commercial real estate projects built on a purely speculative basis. For residential builder loans, we limit the number of models and/or speculative units allowed depending on market conditions, the builder’s financial strength and track record and other factors. Generally, the maximum loan-to-value ratio for one-to-four family residential construction loans is 80% of the property’s fair market value. The fair market value of a project is determined on the basis of an appraisal of the project usually conducted by an independent, outside appraiser acceptable to us or on the basis of an internal evaluation when permitted under our policies and applicable regulatory guidelines. For larger projects, where unit absorption or leasing is a concern, we may also obtain a feasibility study or other acceptable information from the borrower or other sources about the likely disposition of the property following the completion of construction.

Construction loans for nonresidential projects and multi-unit residential projects are generally larger and involve a greater degree of risk than residential mortgage loans. We attempt to minimize such risks by (1) making construction loans in accordance with the Bank’s underwriting standards to established customers of the Bank or experienced real estate developers in our primary market area and (2) monitoring the quality, progress and cost of construction. We have established a maximum loan-to-value ratio of 80% of the appraised value for non-residential construction projects and multi-unit residential construction projects; however, this maximum can be waived for particularly strong borrowers on an exception basis.

Land Acquisition and Development Lending. Land acquisition and development loans are made to builders and developers for the purpose of acquiring unimproved land to be developed for residential building sites, residential housing subdivisions, multi-family dwellings and a variety of commercial uses. We generally do not make land acquisition and development loans for commercial developments but will make such loans for borrowers seeking to build owner-occupied facilities on the subject land.

We underwrite and process land acquisition and development loans in much the same manner as commercial construction loans and commercial real estate loans. For residential land acquisition and development loans, we use a lower loan-to-value ratio, which is a maximum of 65% for unimproved land and 75% of the appraised value of the developed lots as determined in accordance with our appraisal policies for developed lots for single-family or townhouse construction and discounted, when appropriate, to reflect absorption periods in excess of one year. We can waive the maximum loan-to-value ratio for particularly strong borrowers on an exception basis. The term of land acquisition and development loans ranges from a maximum of two years for loans relating to the acquisition of unimproved land to, generally, a maximum of three years for other types of projects. All land acquisition and development loans generally are further secured by one or more unconditional personal guarantees. Because these loans are usually larger in amount and involve more risk than individual lot loans, we carefully evaluate the borrower’s assumptions and projections about market conditions and absorption rates in the community in which the property is located and the borrower’s ability to carry the loan if their assumptions and/or projections prove inaccurate.

Home Equity and Consumer Lending and Residential Mortgage Lending. The Bank offers consumer loans only to the owners or senior managers of existing or prospective business clients, which includes the business owners and their immediate family members (spouse, children, and grandchildren). The following products are available: secured and unsecured lines of credit and time notes with a minimum of $10,000, home equity lines and loans with a minimum of $25,000, and fixed or adjustable rate mortgages with a minimum of $50,000.

Home equity lines of credit are offered with adjustable rates of interest on an open-end revolving basis. Home equity loans are offered with fixed rates for a fixed period of time, usually between five and 15 years. Home equity lines of credit and home equity loans are secured by liens on personal residences and generally do not present as much risk as other types of consumer loans.

We originate residential mortgage loans secured by properties located in our primary market area in Hampton Roads, Virginia, offering various types of residential mortgage loans in addition to traditional long-term, fixed-rate or adjustable-rate mortgage loans. We generally underwrite loans to be retained by the Bank on terms consistent with secondary mortgage market standards.

The shorter terms and generally higher interest rates on consumer loans help the Bank maintain a profitable spread between its average loan yield and its cost of funds. Consumer loans secured by collateral other than a personal residence generally involve more credit risk than residential mortgage loans because of the type and nature of the collateral or, in certain cases, the absence of collateral. However, we believe the higher yields generally earned on such loans compensate for the increased credit risk associated with such loans.

The following table sets forth, at the dates indicated, our loan portfolio composition by type of loan:


	At December 31,
	2012			2011			2010			2009			2008
	(in thousands)

Commercial	$	39,904		$	39,212		$	37,354		$	32,050		$	33,011
Real estate-commercial		131,078			110,349			101,080			68,505			57,511
Real estate-construction and land		4,832			14,075			18,389			18,308			27,899
Real estate-residential 1-4		45,418			49,894			55,694			59,069			55,368
Consumer		1,805			1,744			3,915			5,385			4,425

Total gross loans		223,037			215,274			216,432			183,317			178,214
Allowance for loan losses		(2,075	)		(2,091	)		(2,090	)		(1,773	)		(1,652	)

Loans, net	$	220,962		$	213,183		$	214,342		$	181,544		$	176,562

(1)	Unearned loan costs(fees) have been allocated to the appropriate loan types for years ending 2008 through 2012.

The following tables present, at December 31, 2012, (i) the aggregate maturities of loans in the named categories of our loan portfolio and (ii) the aggregate amounts of such loans maturing after one year by fixed and variable rates:


	Within 1 Year		After 1 Year but Within 5 Years		After 5 Years		Total		Percentage of Total Loan Portfolio
	(in thousands except percentages data)
Commercial	$	18,457	$	10,773	$	10,674	$	39,904		17.9	%
Real estate-commercial		6,458		9,344		115,276		131,078		58.8	%
Real estate-construction and land		22		3,691		1,119		4,832		2.2	%
Real estate-residential 1-4		1,625		3,351		40,442		45,418		20.3	%
Consumer		1,004		561		240		1,805		0.8	%

Total	$	27,566	$	27,720	$	167,751	$	223,037		100.0	%


	Total
	(in thousands)
Fixed rate loans	$	56,441
Variable rate loans (includes loans subject to call)		139,030

Total	$	195,471

Allowance For Loan Losses

The Bank maintains an allowance for loan losses at a level which, in management’s judgment, is adequate to absorb estimated credit losses on existing loans. The amount of the allowance is affected by: (1) loan charge-offs, which decrease the allowance, (2) recoveries on loans previously charged-off, which increase the allowance, and (3) the provision for loan losses charged to income, which increases the allowance.

We analyze our loan portfolio through ongoing credit review processes and construct a comprehensive allowance analysis for our loan portfolio at least quarterly. This analysis includes two basic elements: (1) specific allowances for individual loans, and (2) general allowances for loan portfolio segments, which factor in historical loan loss experience and delinquency rates for the Bank and the banking industry and numerous other environmental factors.

The Bank evaluates various loans individually for impairment as required by generally accepted accounting principles related to receivables. An evaluation is based upon either discounted cash flows or collateral evaluations. If the evaluation shows that a particular loan is impaired, then a specific reserve is established, or a charge-off is made, for the amount of any impairment.

For loans without an individual measure of impairment, we estimate for groups of loans as required by generally accepted accounting principles related to contingencies. As part of the loan loss reserve methodology, loans are placed into one of four major categories or segments of loans: (1) commercial and industrial loans, (2) consumer loans, (3) 1-4 family residential loans (including home equity loans and lines), and (4) multi-family and other commercial real estate loans. We then consider the impact of various bank, industry, economic and other environmental factors and documents, which are further used in the analysis.

Our allowance for loan losses is divided into four distinct portions: (1) Historical – an amount based on the Bank’s actual net charge-offs; (2) Impaired Loans – an amount for specific allocations on significant individual credits as prescribed by generally accepted accounting principles related to receivables; (3) Loan Segments – an amount to adjust the historical allocation for the four loan segments based on environmental factors as provided by guidance for contingencies; and (4) Unallocated – an amount to reflect the imprecision inherent in these calculations.

Our allowance for loan losses was $2,075,000, or 0.93% of total loans held for investment, net of unearned fees and costs, at December 31, 2012. This compares to an allowance of $2,091,000, or 0.97% of such loans, at year-end 2011. These allowance figures are reflected in the table below.

Management currently believes that our allowance for loan losses is adequate. However, the allowance is subject to regulatory examinations and determination as to adequacy, which may take into account such factors as the methodology used to calculate the allowance and the size of the allowance in comparison to peer banks identified by regulatory agencies. Such agencies may require us to recognize additions to the allowance for loan losses based on their judgments about information available at the time of their examinations.

The following table sets forth, for the periods indicated, a summary of activity in our allowance for loan losses:


	At or for the Year Ended December 31,
	2012			2011			2010			2009			2008
	(in thousands except percentage data)
Balance at beginning of year	$	2,091		$	2,090		$	1,773		$	1,652		$	1,400

Charge-offs:
Commercial		(7	)		(1	)		(13	)		(8	)		(131	)
Real estate-commercial		—			(1	)		—			—			—
Real estate-construction and land		—			(29	)		—			(27	)		(194	)
Real estate-residential 1-4		(63	)		—			(135	)		(60	)		(37	)
Consumer		(1	)		(3	)		(14	)		(1	)		(36	)

Total charge-offs		(71	)		(34	)		(162	)		(96	)		(398	)

Recoveries
Commercial		—			2			14			47			187
Real estate-commercial		—			—			—			—			—
Real estate-construction and land		20			—			—			—			—
Real estate-residential 1-4		—			48			83			—			—
Consumer		—			—			14			1			10

Total recoveries		20			50			111			48			197


Net recoveries(charge-offs)		(51	)		16			(51	)		(48	)		(201	)

Provision for(recovery of) loan losses		35			(15	)		368			169			453

Balance at end of period:	$	2,075		$	2,091		$	2,090		$	1,773		$	1,652


Ratio of net recoveries(charge-offs) to average loans outstanding		(0.02	)%		0.01	%		(0.03	)%		(0.03	)%		(0.12	)%

Ratio of allowance for loan losses to outstanding loans held for investment, net of unearned fees and costs at end of year		0.93	%		0.97	%		0.97	%		0.97	%		0.93	%

Breakdown of Allowance for Loan Losses by Category

The following table presents an allocation of our allowance for loan losses and the percentage of loans in each category to the total amount of loans at December 31, 2012, 2011, 2010, 2009 and 2008. The allocation presented for each year reflects an allocation methodology that we adopted in 2005 for the year ended December 31, 2004 and that we have continued to utilize in all subsequent years.


	At December 31,
	2012					2011					2010					2009					2008
	Amount (2)		Percent of Total Loans (1)			Amount (2)		Percent of Total Loans (1)			Amount (2)		Percent of Total Loans (1)			Amount (2)		Percent of Total Loans (1)			Amount (2)		Percent of Total Loans (1)
	(dollars in thousands)
Loan Type Allocation
Commercial	$	339		17.9	%	$	343		18.2	%	$	327		17.3	%	$	279		17.5	%	$	296		18.5	%
Real estate-commercial		1,110		58.8	%		966		51.3	%		885		46.7	%		599		37.5	%		500		32.4	%
Real estate-construction and land		39		2.2	%		123		6.5	%		162		8.5	%		161		10.0	%		244		15.7	%
Real estate-residential 1-4		404		20.3	%		455		23.2	%		508		25.7	%		533		32.1	%		491		30.9	%
Consumer		15		0.8	%		15		0.8	%		34		1.8	%		47		2.9	%		38		2.5	%


		1,907		100.0	%		1,902		100.0	%		1,916		100.0	%		1,619		100.0	%		1,569		100.0	%


Specific problem loans		—					—					—					—					—
Unallocated		168					189					174					154					83

Total Allowance	$	2,075				$	2,091				$	2,090				$	1,773				$	1,652

(1)	Represents total of all outstanding loans in each category as a percent of total loans outstanding.

(2)	As a result of loan reclassification, allocations between loan categories may have changed to maintain comparability between years.

Nonperforming Assets

Our nonperforming assets include nonperforming loans (nonaccrual and restructured loans) and other real estate owned (“REO”). We generally do not accrue interest on commercial, real estate commercial and real estate construction and land loans that are 90 days or more past due and reverse all previously accrued, but uncollected, interest on loans that are placed in nonaccrual status (with the exception of credit card loans on which the Company does not accrue interest over 120 days).

REO is recorded at the lower of cost or estimated fair value as determined generally by appraisals. If the fair value of REO is less than the book value of the loan formerly secured by such REO, the fair value becomes the new cost basis of the REO, and the difference between the book value and the fair value is charged against either the allowance for loan losses on the date of foreclosure or completion of the appraisal, or the allowance for REO at the date of change of management’s intent with regard to its own property. Subsequent valuations are periodically performed and valuation allowances are established if the carrying value of the real estate exceeds estimated fair value. Other repossessed assets are carried at the lower of cost or estimated fair value as determined by independent surveys or appraisals at the time of repossession. If the fair value of the repossessed asset is less than the book value of the loan formerly secured by such repossessed asset, the difference between the book value and the fair value is charged to the allowance for loan losses on the date of repossession.

The following table sets forth, for the dates indicated, information with respect to our nonaccrual loans, restructured loans, total nonperforming loans (nonaccrual loans and restructured loans) and total nonperforming assets:


	At December 31,
	2012			2011			2010			2009			2008
	(dollars in thousands)
Nonaccrual loans (1)
Commercial	$	—		$	—		$	—		$	1		$	7
Real estate-commercial		—			—			—			—			—
Real estate-construction and land		—			—			—			—			—
Real estate-residential 1-4		—			—			—			—			—
Consumer		—			—			—			—			24

Total nonaccrual loans		—			—			—			1			31

Accruing loans past due 90 days or more
Commercial		—			—			—			—			8
Real estate-commercial		—			—			—			—			—
Real estate-construction and land		—			—			—			—			—
Real estate-residential 1-4		489			—			—			—			—
Consumer		—			—			—			—			2

Total accruing loans past due 90 days or more		489			—			—			—			10


Total nonperforming loans		489			—			—			1			41

Real estate owned, net		210			1,719			263			313			178


Total nonperforming assets	$	699		$	1,719		$	263		$	314		$	219


Total nonperforming assets to total assets		0.21	%		0.58	%		0.10	%		0.11	%		0.08	%

(1)

There were no restructured loans at December 31, 2008. Restructured loans of $1,469,771 at December 31, 2009 were not included as nonaccrual loans because at December 31, 2009 we expected that the applicable borrowers would satisfy in full all of their payment obligations, both interest payments and repayment of principal, in accordance with the modified terms of their respective loans. There were no nonaccrual restructured loans at December 31, 2010, 2011, or 2012.

As of the end of the period ended December 31, 2012, there are no loans in respect of which any known information about possible credit problems of borrowers cause our management to have serious doubts as to the ability of such borrowers to comply with the present loan repayment terms. Any such doubts or concerns that develop subsequent to that date, if any, may later result in loans being classified as nonaccrual, accruing but past due 90 days or more, or troubled debt restructurings.

Loans Held for Sale

There were no loans held for sale at December 31, 2012 or 2011.

Investment Securities

Our investment portfolio is a source of liquidity and is our second largest category of earning assets. At December 31, 2012, our investment portfolio included U.S. Treasury notes and securities issued by U.S. government sponsored enterprises. In addition to the investment securities, we also invest in federal funds sold as well as certificates of deposits and other short term interest-bearing deposits in other banks. Securities available for sale were $21.2 million at December 31, 2012, compared with $45.3 million at December 31, 2011. There were no securities held to maturity at December 31, 2012 or 2011.

The following table summarizes the amortized cost, gross unrealized gains and losses and the estimated fair value of securities available for sale and securities held to maturity, in each case as applicable, for the years ended December 31, 2012, 2011 and 2010:


	At December 31, 2012
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	(in thousands)
Securities Available for Sale
U.S Treasury notes	$	2,002	$	23	$	—	$	2,025
U.S. government sponsored enterprises		18,996		141		—		19,137

Total securities available for sale	$	20,998	$	164	$	—	$	21,162

Total securities (1)	$	20,998	$	164	$	—	$	21,162


	At December 31, 2011
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	(in thousands)
Securities Available for Sale
U.S Treasury Notes	$	2,004	$	39	$	—	$	2,043
U.S. government sponsored enterprises		34,000		188		—		34,188
Mortgage-backed securities		8,637		442		—		9,079

Total securities available for sale	$	44,641	$	669	$	—	$	45,310

Total securities (1)	$	44,641	$	669	$	—	$	45,310


	At December 31, 2010
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	(in thousands)
Securities Available for Sale
Mortgage-backed securities	$	16,744	$	624	$	—	$	17,368

Total securities available for sale	$	16,744	$	624	$	—	$	17,368

Total securities (1)	$	16,744	$	624	$	—	$	17,368

(1)	The Company held no securities classified as held to maturity at December 31, 2012, 2011, or 2010.

The following table presents the contractual maturity distribution and estimated weighted average yields, based on amortized cost, of our investment securities portfolio at December 31, 2012. Actual maturities will differ from contractual maturities because mortgage-backed securities will amortize and may be prepaid prior to their contractual maturity.


	1 Year or Less					After 1 Year but through 5 Years					After 5 Years but through 10 Years					After 10 Years					Total
	(dollars in thousands)
	Amortized Cost		Yield			Amortized Cost		Yield			Amortized Cost		Yield			Amortized Cost		Yield			Amortized Cost		Yield
U.S. Treasury Notes	$	—		—	%	$	2,002		1.17	%	$	—		—	%	$	—		—	%	$	2,002		1.17	%
U.S. Government				—															—
sponsored enterprises		—		—	%		—		—	%		18,996		2.00	%		—		—	%		18,996		2.00	%

Total	$	—		—	%	$	2,002		1.17	%	$	18,996		2.00	%	$	—		—	%	$	20,998		1.92	%

At December 31, 2012, U.S. Government sponsored enterprise (Federal Farm Credit Bureau) securities exceeded 10% of the Company’s stockholders’ equity.

SOURCES OF FUNDS

Deposit Activities

We provide a range of deposit services, including noninterest-bearing checking accounts, interest-bearing checking and savings accounts, money market accounts and certificates of deposit. These accounts generally earn interest at rates established by management based on competitive market factors and management’s desire to increase or decrease certain types or maturities of deposits. Our strategy has been to fund asset growth through increases in core deposits rather than the use of any brokered deposits, and we strive to establish customer relationships to attract core deposits in noninterest-bearing and other transactional accounts and thus to reduce our cost of funds.

Our deposit base includes large denomination certificates of deposit of $100,000 or more. These large denomination CDs represented approximately 0.03% and 0.2% of total deposits at December 31, 2012 and 2011, respectively.

The following table sets forth, for the periods indicated, the average balance outstanding and average interest rates for each major category of deposits:


	Year Ended December 31,
	2012					2011					2010
	Average Balance		Average Rate			Average Balance		Average Rate			Average Balance		Average Rate
	(dollars in thousands)

Interest-bearing NOW, money market and savings	$	141,731		0.49	%	$	107,395		0.54	%	$	101,919		0.58	%
Time deposits		30,515		0.80	%		48,517		1.31	%		49,072		1.64	%

Total interest-bearing deposits		172,246		0.55	%		155,912		0.78	%		150,991		0.93	%
Demand and other noninterest-bearing deposits		100,148		—			88,371		—			79,237		—

Total average deposits	$	272,394		0.35	%	$	244,283		0.50	%	$	230,228		0.61	%

The following table sets forth the amounts and maturities of certificates of deposit with balances of $100,000 or more at December 31, 2012:


Remaining Maturity	Total
	(in thousands)

Less than three months	$	—
Over three months through six months		100
Over six months through twelve months		—
Over twelve months		—

Total	$	100

Borrowings

As additional sources of funding, the Company utilizes unsecured credit lines from correspondent banks, advances from the Federal Home Loan Bank of Atlanta (“FHLB”) under a secured line of credit, and securities sold under agreements to repurchase which are secured transactions with customers and generally mature the day following the day sold. At December 31, 2012, borrowings included no Federal Home Loan Bank short-term advances and $2.6 million in securities sold under agreements to repurchase. Other borrowings of $465,000 at December 31, 2012 consisted of participated loans sold by the Bank with disproportionate cash flows to the buyer. Generally accepted accounting principles consider these loans to be incomplete transfers because risk is not proportionate and require that this type of participation be classified as a borrowing. Because of this treatment, the entire loan balance is reported in loans held for investment and not reduced for the participation.

LIQUIDITY AND CAPITAL RESOURCES

Liquidity

Liquidity refers to the availability of sufficient funds to meet the needs of depositors, borrowers, creditors and investors and to fund operations. Our primary sources of funds are customer deposits, cash, investment securities available for sale, loan repayments and borrowings. These funds are used to make loans, purchase investment securities, meet depositor withdrawals and fund operations.

Liquid assets, which include cash and due from banks, certificates of deposit in other banks, federal funds sold and nonpledged securities available for sale, totaled $92.9 million at December 31, 2012. In addition, our funding sources at December 31, 2012 consisted of established borrowing capacity with the FHLB, subject to qualifying collateral availability, equal to 25.0% of the Bank’s total assets, or $83.7 million, and established federal funds lines with correspondent banks. At December 31, 2012, there was no outstanding balance with the FHLB.

Certificates of deposit that are scheduled to mature within one year totaled $21.5 million at December 31, 2012. These deposits are generally considered to be rate sensitive. While our liquidity could be impacted by a decrease in the renewals of deposits or general deposit runoff, we believe we have the ability to raise additional deposits by conducting deposit promotions. In the event we require funds beyond our ability to generate them internally, we could borrow from established lines or obtain funds through the sale of investment securities from our available for sale portfolio; however, we have not in the past and currently do not expect to solicit or accept brokered deposits. Management believes our liquidity sources are sufficient to satisfy our current operational requirements and obligations. We maintain a high level of liquidity due to a concentration in some customer deposits, which can fluctuate significantly as depositor needs change.

Capital Resources

The Company’s capital is reflected in its stockholders’ equity, which was $36.7 million, or 10.9% of assets, at December 31, 2012, compared to $36.4 million, or 12.4% of assets, at December 31, 2011. The $237,000 increase in stockholders’ equity was primarily due to earnings, partially offset by a $333,000 decrease in accumulated other comprehensive income related to the reduction of our securities available for sale portfolio and an $819,000, or $0.36 per common share, special dividend declared and paid in the fourth quarter of 2012. The Company paid aggregate dividends of $0.60 and $0.24 per common share in 2012 and 2011, respectively. The dividend payout ratio on our common shares was 62.50% in 2012, compared to 30.77% in 2011.

The Company’s capital continues to exceed regulatory requirements for total capital to risk weighted assets, Tier 1 capital to risk weighted assets, and Tier 1 capital to tangible assets (leverage ratio). Our total capital ratio was

15.54% at December 31, 2012, compared to 15.98% at December 31, 2011; our Tier 1 capital ratio was 14.71% at December 31, 2012, compared to 15.10% at December 31, 2011; and our leverage ratio was 10.91% at December 31, 2012, compared to 11.77% at December 31, 2011. These ratios all exceed the mandated minimum regulatory capital requirements.

The following table presents information on the capital amounts and ratios for the Company and the Bank as of December 31, 2012 and 2011:


	Actual					For Capital Adequacy Purposes					Minimum To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
	(dollars in thousands)
At December 31, 2012
Total Capital (to Risk-Weighted Assets)
Consolidated Company	$	38,640		15.54	%	$	19,892		8.00	%		N/A		N/A
Bank	$	36,478		14.70	%	$	19,852		8.00	%	$	24,815		10.00	%
Tier 1 Capital (to Risk-Weighted Assets)
Consolidated Company	$	36,566		14.71	%	$	9,946		4.00	%		N/A		N/A
Bank	$	34,403		13.86	%	$	9,926		4.00	%	$	14,889		6.00	%
Tier 1 Capital (to Average Assets)
Consolidated Company	$	36,566		10.91	%	$	13,400		4.00	%		N/A		N/A
Bank	$	34,403		10.33	%	$	13,323		4.00	%	$	16,653		5.00	%

At December 31, 2011
Total Capital (to Risk-Weighted Assets)
Consolidated Company	$	38,086		15.98	%	$	19,072		8.00	%		N/A		N/A
Bank	$	36,386		15.27	%	$	19,060		8.00	%	$	23,825		10.00	%
Tier 1 Capital (to Risk-Weighted Assets)
Consolidated Company	$	35,996		15.10	%	$	9,536		4.00	%		N/A		N/A
Bank	$	34,295		14.39	%	$	9,530		4.00	%	$	14,295		6.00	%
Tier 1 Capital (to Average Assets)
Consolidated Company	$	35,996		11.77	%	$	12,236		4.00	%		N/A		N/A
Bank	$	34,295		11.24	%	$	12,208		4.00	%	$	15,260		5.00	%

Federal and state banking regulations place certain restrictions on dividends paid and loans or advances made by the Bank to the Company. The amount of dividends the Bank may pay to the Company, without prior approval, is limited to current year earnings plus retained net profits for the two preceding years. Loans or advances to the Company are limited to 10% of the Bank’s stockholders’ equity. For additional detail, see Item 1, “Business – Supervision and Regulation,” above.

Contractual Obligations and Commitments

In the normal course of business we have various outstanding contractual obligations that will require future cash outflows. In addition, we have commitments and contingent liabilities, such as commitments to extend credit, that may or may not require future cash outflows. The following table presents information regarding our outstanding contractual obligations as of December 31, 2012:


	Payments Due by Period
Contractual Obligations	Total		On Demand Or Within 1 Year		1-3 Years		3-5 Years		More than 5 Years
	(dollars in thousands)

Securities sold under agreements to repurchase	$	2,605	$	2,605	$	—	$	—	$	—
Other borrowings		465		330		135		—		—
Operating lease obligations		1,454		336		692		426		—
Deposits		295,146		292,939		1,635		572		—
Deferred compensation		1,003		55		100		170		678
Purchase obligations		4,842		1,003		1,482		1,157		1,200

Total contractual cash obligations	$	305,515	$	297,268	$	4,044	$	2,325	$	1,878

We are a party to financial instruments with off-balance sheet credit risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit in the form of loans or loans approved but not yet funded, standby letters of credit, and commitments to sell loans. These instruments involve, to varying degrees, elements of risk which have not been recognized in our consolidated balance sheets.

Loan commitments are agreements to extend credit to a customer so long as there are no violations of the applicable contract terms prior to the funding. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee by the customer. Because certain of the commitments are expected to be withdrawn or expire unused, the total commitment amount does not necessarily represent future cash requirements. Standby letters of credit are written unconditional commitments to guarantee the performance of a Bank customer to a third party.

We use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments. Unless otherwise noted, we require collateral or other security to support financial instruments with credit risk.

The following table reflects our other commitments outstanding as of December 31, 2012 (in thousands):


Commitments to extend credit	$	36,259
Standby letters of credit		228

Total Commitments	$	36,487

Asset/Liability Management

Our primary market risk exposure is interest rate risk. Fluctuations in interest rates will impact both the level of our interest income and interest expense and the market value of our interest-earning assets and interest-bearing liabilities. Our ability to manage interest rate risk generally depends on our ability to match the maturities, repricing characteristics and expected future cash flows of our assets and liabilities while taking into account the separate goals of maintaining asset quality, liquidity and achieving the desired level of net interest income.

One of the methods we use to manage interest rate risk is the management of the Bank’s net interest income at risk. This technique estimates the impact of instantaneous and parallel changes in interest rates on net interest income over the twenty-four months following a specified balance sheet date. In this analysis, a base net interest income scenario is computed assuming interest rates that existed on interest-bearing assets and liabilities at the balance sheet date. With the balance sheet held constant, instantaneous and parallel interest rate changes are then

applied to the base interest rates and net interest income is calculated for each level of increase and decrease in interest rates. The sensitivity of net interest income to each change in interest rates is measured by the change in net interest income from the base net interest income scenario.

Numerous factors may result in the net interest income estimates resulting from this methodology to differ from actual results. Changes to the shape of the yield curve are typically not consistent with an instantaneous and parallel shift in interest rates. Also, changes in interest rates do not affect all assets and liabilities equally. For example, interest rates of certain types of assets and liabilities may fluctuate in advance of changes in market rates, while interest rates on other types of assets and liabilities may lag behind changes in market rates. Certain assets may have features that restrict changes on their interest rates.

The following table illustrates the expected effect on net interest income for the twenty-four months following the end of 2012 due to immediate and parallel changes in interest rates. The tabular results below do not reflect any action management may take to make balance sheet adjustments in response to rising interest rates. Estimated changes in net interest income are dependent on assumptions including, but not limited to, those discussed above.

Effect on Bank Net Interest Income from Base Scenario


	For the Twenty-Four Months Following December 31, 2012
	Change in Net Interest Income
	(dollars in thousands)
Change in Interest Rates	Amount			%

+200 basis points	$	(1,950.0	)		(10.59	)%
+100 basis points		(904.5	)		(4.91	)%
-100 basis points		NM	⁽¹⁾		NM	⁽¹⁾
-200 basis points		NM	⁽¹⁾		NM	⁽¹⁾

(1)	NM – Due to historically low interest rates, management believes that parallel interest rate changes on interest-bearing assets and interest-bearing liabilities in these scenarios are not meaningful.

Off Balance Sheet Arrangements

In the normal course of business, we are a party to financial instruments with off-balance-sheet risk. Those financial instruments, designed to meet the financing needs of customers, include commitments to sell loans, issue standby letters of credit and otherwise extend credit. Those instruments involve both credit and interest rate risk in addition to the amount recognized on the balance sheet. The contractual amounts of these financial instruments reflect the extent of involvement in the event of nonperformance by the other party to the financial instrument. We use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments, and we obtain collateral based on our credit assessment of the customer in each instance.

Additional information related to our off-balance-sheet risk exposure is detailed in Note 14 to the accompanying consolidated financial statements under Item 8, “Financial Statements and Supplementary Data,” below.

Effects of Inflation

The effect of changing prices is typically different for financial institutions than for other companies because a financial institution’s assets and liabilities are monetary in nature. Interest rates are significantly impacted by inflation, but neither the timing nor the magnitude of the changes is directly related to price-level indices. Our consolidated financial statements under Item 8, “Financial Statements and Supplementary Data,” below reflect the impact of inflation on interest rates, loan demands and deposits.

ITEM 7A.

Quantitative and Qualitative Disclosures About Market Risk

The Company is a smaller reporting company and thus is not required to provide the information specified by this Item 7A.

ITEM 8.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Heritage Bankshares, Inc.

Norfolk, Virginia

We have audited the consolidated balance sheets of Heritage Bankshares, Inc. and subsidiaries (the “Company”) as of December 31, 2012 and 2011, and the related consolidated statements of income, stockholders’ equity, comprehensive income and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purposes of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Heritage Bankshares, Inc. and subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.

/s/ Elliott Davis LLC

Richmond, Virginia

March 29, 2013

Part I. FINANCIAL INFORMATION

Item 1

Financial Statements

HERITAGE BANKSHARES, INC.

CONSOLIDATED BALANCE SHEETS


	At December 31,
	2012		2011
	(in thousands except share data)
ASSETS

Cash and due from banks	$	5,746	$	5,335
Interest-bearing deposits in other banks		32,717		8,646
Federal funds sold		25		33

Total cash and cash equivalents		38,488		14,014
Certificates of deposit in other banks		35,892		—
Securities available for sale, at fair value		21,162		45,310
Loans, held for investment, net of allowance for loan losses of $2,075 and $2,091, respectively		220,962		213,183
Accrued interest receivable		624		694
Stock in Federal Reserve Bank, at cost		594		591
Stock in Federal Home Loan Bank of Atlanta, at cost		440		834
Premises and equipment, net		10,602		11,029
Other real estate owned		210		1,719
Bank-owned life insurance		5,690		5,616
Other assets		1,954		1,676

Total assets	$	336,618	$	294,666

LIABILITIES AND STOCKHOLDERS’ EQUITY

Liabilities
Deposits
Noninterest-bearing	$	111,518	$	92,839
Interest-bearing		183,628		157,139

Total deposits		295,146		249,978


Federal Home Loan Bank Advances		—		4,000
Securities sold under agreements to repurchase		2,605		1,502
Other borrowings		465		782
Accrued interest payable		33		83
Other liabilities		1,695		1,884

Total liabilities		299,944		258,229


Commitments and contingencies		—		—

Stockholders’ equity
Preferred stock, no par value - 1,000,000 shares authorized: Senior non-cumulative perpetual preferred stock, Series C, 7,800 shares issued and outstanding at both December 31, 2012 and 2011		7,800		7,800
Common stock, $5 par value - 6,000,000 shares authorized; 2,275,891 shares and 2,304,965 shares issued and outstanding at December 31, 2012 and December 31, 2011, respectively		11,380		11,525
Additional paid-in capital		6,761		6,704
Retained earnings		10,625		9,967
Accumulated other comprehensive income, net		108		441

Total stockholders’ equity		36,674		36,437

Total liabilities and stockholders’ equity	$	336,618	$	294,666

See accompanying notes to consolidated financial statements.

HERITAGE BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF INCOME


	Years Ended
	December 31,
	2012			2011
	(in thousands except share and per share data)

Interest income
Interest income and fees on loans	$	10,166		$	11,267
Interest on taxable investment securities		824			798
Other interest and dividend income		231			141

Total interest income		11,221			12,206

Interest expense
Deposits		943			1,219
Borrowings		29			44

Total interest expense		972			1,263

Net interest income		10,249			10,943
Provision for(recovery of) loan losses		35			(15	)

Net interest income after provision for(recovery of) loan losses		10,214			10,958


Noninterest income
Service charges on deposit accounts		252			334
Late charges and other fees on loans		98			129
Gain on sale of investment securities		284			87
Income from bank-owned life insurance		203			19
Other		348			299

Total noninterest income		1,185			868

Noninterest expense
Compensation		4,151			4,383
Data processing		630			580
Occupancy		887			838
Furniture and equipment		579			583
Taxes and licenses		318			338
Professional fees		332			366
FDIC assessment		155			170
Loss on sale or impairment of other real estate owned		70			54
Other		1,028			1,012

Total noninterest expense		8,150			8,324

Income before provision for income taxes		3,249			3,502

Provision for income taxes		921			1,134


Net income	$	2,328		$	2,368
Preferred stock dividend and accretion of discount		(137	)		(581	)

Net income available to common stockholders	$	2,191		$	1,787


Earnings per common share
Basic	$	0.96		$	0.78

Diluted	$	0.94		$	0.77

Dividends per share	$	0.60		$	0.24


Weighted average shares outstanding - basic		2,290,533			2,305,267
Effect of dilutive equity awards		50,201			10,606

Weighted average shares outstanding - diluted		2,340,734			2,315,873

See accompanying notes to consolidated financial statements.

HERITAGE BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME


	Years Ended
	December 31,
	2012			2011
	(in thousands)

Net income	$	2,328		$	2,368

Other comprehensive income(loss):
Change in unrealized holding gains on securities available for sale		(221	)		132
Change in tax effect on unrealized gains		75			(45	)
Realized gains on sales of available for sale securities		(284	)		(87	)
Tax effect on realized gains		97			29

Total other comprehensive income(loss)		(333	)		29

Total comprehensive income	$	1,995		$	2,397

See accompanying notes to consolidated financial statements.

HERITAGE BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

Years Ended December 31, 2012 and 2011


	Preferred Shares						Common Stock						Additional Paid-in			Retained			Accumulated Other Comprehensive
	Shares			Amount			Shares			Amount			Capital			Earnings			Income			Total
	(in thousands except share data)

Balance, December 31, 2010		10,406		$	10,171			2,307,502		$	11,538		$	6,658		$	8,801		$	412		$	37,580

Total comprehensive income		—			—			—			—			—			2,368			29			2,397

Exercise of stock options and related tax benefits of $3		—			—			2,000			10			8			—			—			18
Repurchase of common shares		—			—			(4,537	)		(23	)		(33	)		—			—			(56	)
Equity-based compensation expense		—			—			—			—			83			—			—			83
Issuance of Series C preferred stock		7,800			7,800			—			—			—			—			—			7,800
Costs related to issuance of perpetual preferred stock		—			—			—			—			(12	)		—			—			(12	)

Redemption of Series A preferred stock		(10,103	)		(10,103	)		—			—			—			—			—			(10,103	)
Redemption of Series B preferred stock		(303	)		(303	)		—			—			—			—			—			(303	)
Net accretion from issuance of preferred stock warrants		—			235			—			—			—			(235	)		—			—
Cash dividends on preferred stock		—			—			—			—			—			(414	)		—			(414	)
Cash dividends on common stock ($0.24 per share)		—			—			—			—			—			(553	)		—			(553	)


Balance, December 31, 2011		7,800		$	7,800			2,304,965		$	11,525		$	6,704		$	9,967		$	441		$	36,437

Total comprehensive income		—			—			—			—			—			2,328			(333	)		1,995

Exercise of stock options and related tax benefits of $1		—			—			1,000			5			4			—			—			9
Repurchase of common shares		—			—			(30,074	)		(150	)		(54	)		(164	)		—			(368	)
Equity-based compensation expense		—			—			—			—			107			—			—			107
Cash dividends on preferred stock		—			—			—			—			—			(137	)		—			(137	)
Cash dividends on common stock ($0.60 per share)		—			—			—			—			—			(1,369	)		—			(1,369	)


Balance, December 31, 2012		7,800		$	7,800			2,275,891		$	11,380		$	6,761		$	10,625		$	108		$	36,674

See accompanying notes to consolidated financial statements.

HERITAGE BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS


	For the Years Ended
	December 31,
	2012			2011
	(in thousands)
Cash flows from operating activities:
Net income	$	2,328		$	2,368
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for(recovery of) loan loss		35			(15	)
Amortization of loan yield adjustments, net		298			326
Depreciation, amortization and accretion, net		603			607
Stock based compensation		107			83
Deferred compensation		77			82
Exercise of stock options tax benefit		1			3
Net (gains)losses on:
Sale of securities		(284	)		(87	)
Sale, disposal, or impairment of premises and equipment		—			(1	)
Sale of other long lived assets		(30	)		—
Sale or impairment of other real estate owned		70			(3	)
Net income on bank owned life insurance		(203	)		(19	)
Changes in assets/liabilities, net:
Increase in interest receivable and other assets		(47	)		(19	)
Decrease in interest payable and other liabilities		(291	)		(45	)

Net cash provided by operating activities		2,664			3,280

Cash flows from investing activities:
Proceeds from maturities and principal repayments of securities available for sale		28,200			8,061
Purchases of securities available for sale		(18,996	)		(41,921	)
Proceeds from sales of securities available for sale		14,696			6,005
Proceeds from sale of other real estate owned		1,535			28
Net decrease(increase) in certificates of deposit in other banks		(35,892	)		2,260
Net increase in loans held for investment		(8,208	)		(632	)
Purchases of Federal Home Loan Bank stock and Federal Reserve Bank stock		(59	)		(4	)
Redemption of FHLB stock and Federal Reserve Bank stock		450			939
Purchases of premises and equipment		(173	)		(440	)
Proceeds from sale of premises and equipment		—			2
Proceeds from sale of other long lived assets		40			—
Purchases of and premiums paid for bank-owned life insurance		(12	)		(5,013	)
Proceeds from bank-owned life insurance		141			—

Net cash used for investing activities		(18,278	)		(30,715	)

Cash flows from financing activities:
Proceeds from exercise of stock options		8			15
Net increase in deposits		45,168			25,875
Net (decrease)increase in Federal Home Loan Bank advances		(4,000	)		4,000
Net (decrease)increase in securities sold under agreements to repurchase		1,103			(875	)
Net decrease in other borrowings		(317	)		(305	)
Proceeds from issuance of preferred stock		—			7,788
Redemption of preferred stock		—			(10,406	)
Retirement of common stock		(368	)		(56	)
Cash dividends paid		(1,506	)		(967	)

Net cash provided by financing activities		40,088			25,069

Increase(decrease) in cash and cash equivalents		24,474			(2,366	)
Cash and cash equivalents, beginning of period		14,014			16,380

Cash and cash equivalents, end of period	$	38,488		$	14,014

Supplemental disclosure:
Interest paid	$	1,022		$	1,281
Income taxes paid	$	1,099		$	1,329
Noncash financing activities:
Transfer of loans to other real estate owned	$	96		$	1,481

See accompanying notes to consolidated financial statements.

HERITAGE BANKSHARES, INC.

Notes to Consolidated Financial Statements

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of Heritage Bankshares, Inc. and its wholly-owned subsidiary, Heritage Bank. All significant intercompany balances and transactions have been eliminated in consolidation.

Nature of Operations

Heritage Bankshares, Inc. (the “Company”) is a bank holding company incorporated under the laws of the Commonwealth of Virginia in 1983, and at December 31, 2012 the Company serves as the holding company for its wholly-owned subsidiary, Heritage Bank.

Heritage Bank (the “Bank”) is a wholly-owned subsidiary of the Company and is a state banking corporation engaged in the general commercial and retail banking business. The Bank is a full-service bank conducting a general commercial and consumer banking business with its customers located throughout the Hampton Roads area of Virginia. The Bank has one wholly-owned subsidiary, Sentinel Financial Group, Inc. (“Sentinel Financial”). At December 31, 2012, Sentinel Financial owned an interest in Bankers Insurance, LLC, providers of various insurance and products. The financial activities pertaining to these interests are recorded on the cost method of accounting for investments. In addition, at December 31, 2012, Sentinel Financial owned other real estate owned. This real estate is recorded at fair value.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for losses on loans, the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans, and the valuation of deferred tax assets.

Significant Group Concentrations of Credit Risk

The Company invests in a variety of securities, principally obligations of the United States, U.S. government sponsored enterprises, mortgage-backed securities and obligations of states and political subdivisions. Note 3 presents the Company’s investment activities. Substantially all of the Company’s lending activities are with customers located in southeastern Virginia. Note 4 presents the Company’s lending activities. The Company does not have any significant concentrations of loans in any one industry or customer.

Cash and Cash Equivalents

For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, federal funds sold and overnight investments with Federal Home Loan Bank.

Certificates of Deposit in Other Banks

The Company occasionally invests in certificates of deposit at other financial institutions with original maturity dates up to ten years.

Investment Securities

Investment securities are classified in three categories and accounted for as follows:

•

Debt securities that the Company has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost.

•

Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings.

•

Debt and equity securities not classified as either held-to-maturity or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported as other comprehensive income, a separate component of stockholders’ equity.

Gains and losses on sales of securities are computed based on specific identification of the adjusted cost of each security and included in other income. Amortization of premiums and accretion of discounts are computed by the effective yield method and recognized in interest income.

Declines in the fair value of individual held-to-maturity and available-for-sale securities below their cost that are other than temporary would result in write-downs of the individual securities to fair value. These write-downs would be included in the Company’s calculation of earnings as realized losses.

Loans

Loans are reported at their principal outstanding balance, net of charge-offs, deferred loan fees and costs on originated loans, unearned income, and unamortized premiums or discounts, if any, on purchased loans. Interest income is generally recognized when income is earned using the interest method. Loan origination fees and certain direct loan origination costs are deferred and the net amounts are amortized as an adjustment to yield on the respective loans.

Loans Held For Sale

Mortgage loans originated and intended for sale in the secondary market, if any, are carried at cost. Loans held for sale are pre-committed to secondary market investors and, subsequent to being closed, are held for short holding periods pending receipt of loan documents.

Allowance For Loan Losses

The Bank analyzes its loan portfolio through ongoing credit review processes and constructs a comprehensive allowance analysis for its loan portfolio at least quarterly. This analysis includes two basic elements: (1) specific allowances for individual loans, and (2) general allowances for loan portfolio segments, which factor in historical loan loss experience and delinquency rates for the Bank and the banking industry and numerous other environmental factors.

The Bank evaluates various loans individually for impairment based on guidance for receivables. An evaluation is based upon either discounted cash flows or collateral evaluations. If the evaluation shows that a particular loan is impaired, then a specific reserve is established, or a charge-off is made, for the amount of any impairment.

For loans without an individual measure of impairment, the Bank makes estimates of losses for groups of loans as provided by guidance for contingencies. As part of the loan loss reserve methodology, loans are placed into one of four major categories or segments of loans: (1) commercial and industrial loans, (2) consumer loans, (3) 1-4 family residential loans (including home equity loans and lines), and (4) multi-family and other commercial real estate loans.

The Bank then considers the impact of various bank, industry, economic and other environmental factors and documents which factors are used in the analysis.

The Bank’s allowance for loan losses is divided into four distinct portions: (1) Historical – an amount based on the Bank’s actual net charge-offs; (2) Impaired Loans – an amount for specific allocations on significant individual credits as prescribed by generally accepted accounting principles related to receivables; (3) Loan Segments – an amount to adjust the historical allocation for the four loan segments based on environmental factors as provided by guidance on contingencies; and (4) Unallocated – an amount to reflect the imprecision inherent in these calculations.

Income Recognition on Nonaccrual Loans

Loans are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. If a loan or a portion of a loan is classified as doubtful, or is partially charged off, the loan is generally classified as nonaccrual. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt.

Loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time and there is a sustained period of repayment performance by the borrower.

While a loan is classified as nonaccrual, and the future collectibility of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to principal outstanding. When the future collectibility of the recorded loan balance is expected, interest income may be recognized on a cash basis.

Other Real Estate Owned

Other real estate owned is comprised of real estate acquired through foreclosure, acceptance of a deed in lieu of foreclosure or loans in which the Company receives physical possession of the debtor’s real estate or change of management’s intent towards its own property. Other real estate owned is carried at the lower of the recorded investment in the loan or the fair value of the real estate. Net operating income of such properties, exclusive of depreciation, is included in other income and related depreciation expense is included in other expense.

Restructured Loans

Loans are considered troubled debt restructurings if, for economic or legal reasons, a concession has been granted to the borrower related to the borrower’s financial difficulties that the Company would not have otherwise considered. The Company restructures certain loans in instances where a determination is made that greater economic value will be realized under new terms rather than through foreclosure, liquidation or other disposition. The terms of the renegotiation generally involve some or all of the following characteristics: a reduction in the interest pay rate to reflect actual operating income, an extension of the loan maturity date to allow time for stabilization of operating income, and/or partial forgiveness of principal and interest.

The carrying value of a restructured loan is reduced by the fair value of assets or equity interest received from the borrower, if any. The Company generally continues to classify restructured nonaccrual loans as nonaccrual until such time as the loans demonstrate performance. The accrual of interest resumes when such loans can demonstrate performance, generally evidenced by six months of pre- or post-restructuring payment performance in accordance with the restructured terms, or by the presence of other significant factors. In addition, at the time of restructuring, loans are classified as impaired.

Off Balance Sheet Credit Related Financial Instruments

In the ordinary course of business, the Company enters into commitments to extend credit and issue standby letters of credit. Such financial instruments are recorded when they are funded.

Sale of Loans

Transfers of loans are accounted for as sales when control over the loans has been surrendered. Control over transferred loans is deemed to be surrendered when (1) the loans have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred loans, and (3) the Company does not maintain effective control over the transferred loans through an agreement to repurchase them before their maturity. In addition, participated loans sold by the Bank with disproportionate cash flows to the buyer are considered to be incomplete transfers because risk is not proportionate. Generally accepted accounting principles require that this type of participation be classified as a borrowing with the entire loan balance reported in loans held for investment and not reduced for the participation.

Premises and Equipment

Land is carried at cost. Buildings, leasehold improvements and equipment are carried at cost, less accumulated depreciation computed on the straight-line method over the estimated useful lives of the assets, ranging from 2 years to 40 years.

Federal Reserve Bank Stock and Federal Home Loan Bank Stock

As a member of the Federal Reserve Bank, the Company is required to hold shares of FRB capital stock, $100 par value, in an amount equal to 6% of the Bank’s total common stock and capital surplus.

As a member of the Federal Home Loan Bank of Atlanta, the Company is required to hold shares of capital stock in the FHLB in an amount equal to 0.15% of total assets plus 4.50% of borrowings from the FHLB. The Bank, as a member institution, is required to own certain stock investments in the Federal Home Loan Bank of Atlanta and the Federal Reserve Bank. Additional stock at FHLB must be purchased as a percentage of borrowings and is generally pledged against these borrowings. No ready market exists for the FHLB stock and it has no quoted market value. However, redemption of this stock has historically been at par value.

Income Taxes

The Company files a consolidated tax return. Provisions for income taxes reflect tax expense incurred as a consolidated group. Tax expense is allocated among the members of the consolidated group in accordance with an intercompany agreement for tax expense. Income taxes are provided for the tax effects of the transactions reported in the financial statements and consist of taxes currently due plus deferred taxes related primarily to differences between the basis of investment securities, deferred loan fees, allowance for loan losses, allowance for losses on foreclosed real estate, premises and equipment and deferred compensation for financial and income tax reporting. The deferred tax assets and liabilities represent the future tax return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled. An allowance is provided if it is more likely than not that the Company will not realize the benefits of a deferred tax asset. Through December 31, 2012, no valuation allowance has been provided against the Company’s deferred tax asset.

The Company analyzes tax positions taken or expected to be taken on its tax returns to determine if it has any liability related to uncertain tax positions in accordance with guidance on income taxes. Liabilities, if any, resulting from this evaluation are recorded in the current period.

Deferred Compensation Plans

The Company maintains deferred compensation agreements with certain current and former directors and the beneficiary of its former chief executive officer, as well as a Supplemental Executive Retirement Plan with its current Chief Executive Officer. The Company’s policy is to accrue the present value of estimated amounts to be paid under the contracts over the required service period to the date the participant is fully eligible to receive the benefits. At December 31, 2012, the discount rate the Company utilized to determine the deferred compensation liability under such plans was determined by computing the average of the last three year-end periods’ AA corporate bond yield, whose approximate maturity corresponded to the approximate time remaining to pay out the expected benefits for each participant.

Bank-Owned Life Insurance

The Company has purchased life insurance policies on certain current and former employees and directors. Company-owned life insurance is recorded at its cash surrender value, or the amount that can be realized.

Stock Compensation Plans

At December 31, 2012, the Company has one stock-based compensation plan, the Heritage 2006 Equity Incentive Plan, as amended and restated effective January 28, 2009, and as subsequently amended in 2012 (the “2006 Incentive Plan”). The Company has adopted accounting guidance related to share-based payments, which requires that the fair value of equity instruments, such as stock options, be recognized as an expense in the issuing entity’s financial statements as services are performed.

On January 25, 2012, the Company’s Board of Directors granted, effective February 1, 2012, 43,600 shares of restricted stock to certain executives under the 2006 Equity Incentive Plan. The shares vest at a rate of 20% over a five year period beginning on February 1, 2013 and on each February 1 thereafter. Upon the death, retirement or permanent disability of the executive or a change of control of the Company, any remaining unvested shares will vest immediately.

As defined in the 2006 Incentive Plan, as amended, fair value of the shares is measured by the price of the last sale of a share of the Company’s common stock on the OTC Markets Group occurring prior to the grant of the applicable award or, if inapplicable, the fair market value as determined in good faith by the Board. In addition, to the extent the share-recipients are not entitled to dividends until the shares vest, the grant date fair value of the award is reduced by the present value of the dividends expected to be paid on the underlying shares during the service period, discounted at the appropriate risk-free interest rate.

Earnings Per Common Share

Basic earnings per common share represent income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per common share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued. Potential common shares that may be issued by the Company relate to outstanding stock options and are determined using the treasury stock method.

Comprehensive Income

Accounting principles generally require that recognized revenue and expenses, and realized gains and losses, be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available-for-sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income, are components of comprehensive income. These items are also reflected in the Statements of Comprehensive Income.

Business Segments

The Company currently reports its activities as a single business segment. In determining appropriate segment definition and reporting, the Company considers components of the business about which financial information relating to performance and resource allocation is available and regularly evaluated by management. Management determines components for which it will implement performance and resource measurement procedures based upon criteria of relative importance and materiality to the organization.

Reclassifications

Certain reclassifications have been made to prior year financial statements to conform them to the current year presentation.

Recent Accounting Pronouncements

The following is a summary of recent authoritative pronouncements:

In January 2013, the FASB amended the Balance Sheet topic of the ASC to address implementation issues about the scope of ASU No. 2011-11 related to disclosures about offsetting assets and liabilities. The amendments clarify that the ASU only applies to certain derivatives accounted for in accordance the Derivatives and Hedging topic of the ASC, including bifurcated embedded derivatives, repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions that are either offset or subject to an enforceable master netting arrangement or similar agreement. The amendments are effective for reporting periods beginning on or after January 1, 2013. The Company does not expect these amendments to have a material effect on its financial statements.

The FASB amended the Comprehensive Income topic of the ASC in February 2013. The amendments addresses reporting of amounts reclassified out of accumulated other comprehensive income. Specifically, the amendments do not change the current requirements for reporting net income or other comprehensive income in

financial statements. However, the amendments do require an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, in certain circumstances an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income. The amendments are effective for the Company on a prospective basis for reporting periods beginning after December 15, 2012. Early adoption is permitted. The Company does not expect these amendments to have a material effect on its financial statements.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

Subsequent Events

In accordance with accounting guidance, the Company evaluated events and transactions for potential recognition or disclosure in our financial statements through the date the financial statements were issued.

NOTE 2 – RESTRICTIONS ON CASH AND DUE FROM BANKS

The Bank is required to maintain average balances on hand or with the Federal Reserve Bank. At December 31, 2012 and 2011, these required reserve balances amounted to $0 and $4,018,000, respectively.

NOTE 3 – SECURITIES

The tables below present amortized cost, unrealized gains and losses, and fair value of the Company’s investments in securities available for sale at December 31, 2012 and December 31, 2011.


	At December 31, 2012
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	(in thousands)
Securities Available for Sale
U.S Treasury notes	$	2,002	$	23	$	—	$	2,025
U.S. government sponsored enterprises		18,996		141		—		19,137

Total securities available for sale	$	20,998	$	164	$	—	$	21,162

Total securities (1)	$	20,998	$	164	$	—	$	21,162


	At December 31, 2011
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	(in thousands)
Securities Available for Sale
U.S Treasury Notes	$	2,004	$	39	$	—	$	2,043
U.S. government sponsored enterprises		34,000		188		—		34,188
Mortgage-backed securities		8,637		442		—		9,079

Total securities available for sale	$	44,641	$	669	$	—	$	45,310

Total securities (1)	$	44,641	$	669	$	—	$	45,310

(1)	At December 31, 2012 and December 31, 2011, the Company held no securities classified as held to maturity.

Investment securities having an amortized cost of $10,000,000 and $9,000,000 at December 31, 2012 and 2011, respectively, were made available for retail repurchase agreements. The estimated fair values of these securities were $10,105,000 and $9,078,000 at December 31, 2012 and 2011, respectively.

There were no investment securities with unrealized losses at either December 31, 2012 or December 31, 2011. Current year unrealized losses on investment securities, if any, are a result of changes in interest rates during the periods. Unrealized losses on investment securities, if any, are considered by management to be temporary given the credit ratings on these investment securities and the short duration of any unrealized loss due to credit quality.

The amortized cost and fair value of investment securities at December 31, 2012, by contractual maturity, are reflected below. Actual maturities will differ from contractual maturities because some securities may be called or prepaid prior to their contractual maturity.


	Securities Available for Sale
	Amortized Cost		Fair Value
	(in thousands)

Due in one year or less	$	—	$	—
Due after one year through five years		2,002		2,025
Due after five years through ten years		18,996		19,137
Due after ten years		—		—

Total	$	20,998	$	21,162

Gross proceeds from sales of securities available for sale were $14,696,000 for 2012 and $6,005,000 for 2011. Gross realized gains associated with these sales were $284,000 for 2012 and $87,000 for 2011, respectively. There were no gross losses associated with the sale of securities available for sale during either 2012 or 2011. There were no unrealized losses on investment securities at December 31, 2012 or 2011. Gains and losses on the sale of investment securities are recorded as of the trade date and are determined using the specific identification method.

NOTE 4 – LOANS HELD FOR INVESTMENT, NET

Loans at the dates indicated consisted of the following:


	At December 31,
	2012			2011
	(in thousands)

Commercial	$	39,904		$	39,212
Real estate-commercial		131,078			110,349
Real estate-construction and land		4,832			14,075
Real estate-residential 1-4		45,418			49,894
Consumer		1,805			1,744

Total loans		223,037			215,274

Allowance for loan losses		(2,075	)		(2,091	)

Total loans, net	$	220,962		$	213,183

All loan amounts are presented net of unearned fees and costs for December 31, 2012 and December 31, 2011.

Nonperforming assets at the dates indicated were:


	At December 31,		At December 31,
	2012		2011
	(in thousands)

Nonperforming loans	$	489	$	—
Real estate owned		210		1,719

Total nonperforming assets	$	699	$	1,719

A summary of the activity in the allowance for loan losses account for the periods indicated is as follows:


	At December 31,
	2012			2011
	(in thousands)

Balance, beginning of year	$	2,091		$	2,090

Provision for(recovery of) loan losses		35			(15	)

Loans charged-off
Commercial		(7	)		(1	)
Real estate-commercial		—			(1	)
Real estate-construction and land		—			(29	)
Real estate-residential 1-4		(63	)		—
Consumer		(1	)		(3	)


Total loans charged-off		(71	)		(34	)


Loans recovered
Commercial		—			2
Real estate-commercial		—			—
Real estate-construction and land		20			—
Real estate-residential 1-4		—			48
Consumer		—			—


Total loans recovered		20			50


Net recoveries(charge-offs)		(51	)		16


Balance, end of period	$	2,075		$	2,091

The following table presents the aging analysis of the Company’s loan portfolio at December 31, 2012:


	30-59 days past due		60-89 days past due		90 days or more past due		Total past due		Current		Total loans outstanding		Loans 90 days past due and accruing
	(in thousands)
Commercial	$	—	$	—	$	—	$	—	$	39,904	$	39,904	$	—
Real estate-commercial		—		—		—

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HERITAGE BANKSHARES INC /VA 10-K