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UNITED STATES

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, 2006

 

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

Commission file number: 0-20293

 


UNION BANKSHARES CORPORATION

(Exact name of registrant as specified in its charter)

 


 

VIRGINIA   54-1598552

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

212 North Main Street, P.O. Box 446, Bowling Green, Virginia 22427

(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code is (804) 633-5031

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

Securities registered pursuant to Section 12(g) of the Act: Common Stock $1.33 par value

 


Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 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 Section 15(d) of the 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) 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, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  ¨    Accelerated filer  x    Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

Yes  ¨    No  x

The aggregate market value of voting stock held by non-affiliates of the registrant as of June 30, 2006 was approximately $368,875,052.

The number of shares of common stock outstanding as of February 1, 2007 was 13,303,912.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s definitive proxy statement to be used in conjunction with the registrant’s 2007 Annual Meeting of Shareholders are incorporated into Part III of this Form 10-K.

 



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UNION BANKSHARES CORPORATION

FORM 10-K

INDEX

 

ITEM

        PAGE
   PART I   
Item 1.    Business    1
Item 1A.    Risk Factors    8
Item 1B.    Unresolved Staff Comments    11
Item 2.    Properties    11
Item 3.    Legal Proceedings    13
Item 4.    Submission of Matters to a Vote of Security Holders    13
   PART II   
Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities    14
Item 6.    Selected Financial Data    16
Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operation    17
Item 7A.    Quantitative and Qualitative Disclosures About Market Risk    35
Item 8.    Financial Statements and Supplementary Data    36
Item 9.    Changes in and Disagreements With Accountants on Accounting and Financial Disclosure    71
Item 9A.    Controls and Procedures    71
Item 9B.    Other Information    72
   PART III   
Item 10.    Directors, Executive Officers and Corporate Governance    72
Item 11.    Executive Compensation    72
Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters    72
Item 13.    Certain Relationships and Related Transactions, and Director Independence    72
Item 14.    Principal Accounting Fees and Services    72
   PART IV   
Item 15.    Exhibits, Financial Statement Schedules    73

 

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FORWARD-LOOKING STATEMENTS

Certain statements in this report may constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements that include projections, predictions, expectations or beliefs about future events or results or otherwise are not statements of historical fact. Such statements are often characterized by the use of qualified words (and their derivatives) such as “expect,” “believe,” “estimate,” “plan,” “project,” “anticipate” or other statements concerning opinions or judgment of the Company and its management about future events. Although the Company believes that its expectations with respect to forward-looking statements are based upon reasonable assumptions within the bounds of its existing knowledge of its business and operations, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. Actual future results and trends may differ materially from historical results or those anticipated depending on a variety of factors, including, but not limited to, the effects of and changes in: general economic conditions, the interest rate environment, legislative and regulatory requirements, competitive pressures, new products and delivery systems, inflation, changes in the stock and bond markets, technology, and consumer spending and savings habits. The Company does not update any forward-looking statements that may be made from time to time by or on behalf of the Company.

PART I

ITEM 1.—BUSINESS.

GENERAL

Union Bankshares Corporation (the “Company”) is a multi-bank holding company organized under Virginia law and registered under the Bank Holding Company Act of 1956. The Company is headquartered in Bowling Green, Virginia. The Company is committed to the delivery of financial services through its five community bank subsidiaries (the “Community Banks”) and three non-bank financial services affiliates. The Company’s Community Banks and non-bank financial services affiliates are:

 

Community Banks

Union Bank & Trust Company

     Bowling Green, Virginia

Northern Neck State Bank

     Warsaw, Virginia

Rappahannock National Bank

     Washington, Virginia

Bay Community Bank

     Newport News, Virginia

Prosperity Bank & Trust Company

     Fairfax County, Virginia
Financial Services Affiliates

Union Mortgage Group, Inc.

     Annandale, Virginia

Union Investment Services, Inc.

     Ashland, Virginia

Union Insurance Group, LLC

     Bowling Green, Virginia

History

The Company was formed in connection with the July 1993 merger of Northern Neck Bankshares Corporation and Union Bancorp, Inc. In connection with the merger, Union Bank and Trust Company (“Union Bank”) and Northern Neck State Bank became wholly owned bank subsidiaries of the Company. Although the Company was formed in 1993, the Community Banks are among the oldest in Virginia. Union Bank and Rappahannock National Bank began business in 1902 and Northern Neck State Bank dates back to 1907. On September 1, 1996, King George State Bank and on July 1, 1998, Rappahannock National Bank became wholly-owned subsidiaries of the Company. On February 22, 1999, Bay Community Bank (formerly Bank of Williamsburg) began business as a newly organized bank. In June 1999, King George State Bank was merged into Union Bank and ceased to be a subsidiary bank. The

 

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Company acquired Guaranty Financial Corporation and its wholly owned subsidiary, Guaranty Bank (“Guaranty”), on May 1, 2004, and operated Guaranty as a separate subsidiary until September 13, 2004, which is when the operations of Guaranty were merged with Union Bank, the Company’s largest subsidiary. The Company acquired Prosperity Bank & Trust Company (“Prosperity”) on April 1, 2006 and operates it as an independent bank subsidiary.

Product Offerings and Market Distribution

The Company is one of the largest community banking organizations based in Virginia, providing full service banking to the Northern, Central, Rappahannock, Tidewater and Northern Neck regions of Virginia through 51 locations of its bank subsidiaries. Union Bank currently has 33 locations in the counties of Albemarle, Caroline, Chesterfield, Fluvanna, Hanover, Henrico, King George, King William, Nelson, Spotsylvania, Stafford, Westmoreland and the Cities of Charlottesville and Fredericksburg; Northern Neck State Bank has nine locations in the counties of Essex, Lancaster, Northumberland, Richmond and Westmoreland; Rappahannock National Bank has two locations in Washington and Front Royal, Virginia; Bay Community Bank has four locations in Williamsburg, Newport News and Grafton, Virginia; and Prosperity has three locations in Springfield and Burke, Virginia. Additionally, Union Bank operates a loan production office in Manassas, Virginia.

Each of the Community Banks are full service retail commercial banks offering consumers and businesses a wide range of banking and related financial services, including checking, savings, certificates of deposit and other depository services, as well as loans for commercial, industrial, residential mortgage and consumer purposes. Also, the Community Banks issue credit cards and deliver automated teller machine services through the use of reciprocally shared ATMs in the major ATM networks as well as remote ATMs for the convenience of their customers and other consumers. Furthermore, each of the Community Banks offers internet banking services and online bill payment for all of its customers, whether consumer or commercial.

The Company provides other financial services through its non-bank affiliates, Union Investment Services, Inc., Union Mortgage Group, Inc. (“Union Mortgage”), and formerly Mortgage Capital Investors, Inc. and Union Insurance Group, LLC. Bay Community Bank owns a non-controlling interest in Johnson Mortgage Company, LLC.

Union Investment Services, Inc. has provided securities, brokerage and investment advisory services since its formation in February 1993. It has five offices within the Community Banks’ trade areas and is a full service investment company handling all aspects of wealth management including stocks, bonds, annuities, mutual funds and financial planning.

On February 11, 1999, the Company acquired CMK Corporation t/a Union Mortgage, a mortgage loan brokerage company headquartered in Springfield, Virginia, by merger of CMK Corporation into Union Mortgage, later to become a wholly owned subsidiary of Union Bank. Union Mortgage has eleven offices in the following locations: Virginia (seven), Maryland (three) and South Carolina (one). Union Mortgage is also licensed to do business in selected states throughout the Mid-Atlantic and Southeast, as well as Washington, D.C. It provides a variety of mortgage products to customers in those areas. The mortgage loans originated by Union Mortgage are generally sold in the secondary market through purchase agreements with institutional investors.

On August 31, 2003, the Company formed Union Insurance Group, LLC (“UIG”), an insurance agency, in which each of the subsidiary banks owns a proportionate stake based on asset size. This agency operates in a joint venture with Bankers Insurance, LLC, a large insurance agency owned by community banks across Virginia and managed by the Virginia Bankers Association. UIG generates revenue through sales of various insurance products, including long term care insurance and business owner policies.

 

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SEGMENTS

The Company has two reportable segments: its traditional full service community banking business and its mortgage loan origination business, each as described above. For more financial data and other information about each of the Company’s operating segments, refer to the “Management’s Discussion and Analysis of Financial Condition and Result of Operations” section, “Community Bank Segment” and to Note 18 “Segment Reporting” in the “Notes to Consolidated Financial Statements”.

EXPANSION AND STRATEGIC ACQUISITIONS

The Company expands its market area and increases its market share through internal growth, de novo expansion and strategic acquisitions. Strategic acquisitions by the Company to date have included whole bank acquisitions and financial affiliations, as well as branch and deposit acquisitions and purchases of former bank branch facilities. The Company generally considers acquisitions of companies in strong growth markets or with unique products or services that will benefit the entire organization. Targeted acquisitions are priced to be economically feasible with minimal short-term drag to achieve positive long-term benefits. These acquisitions may be paid for in the form of cash, stock, debt or a combination thereof. The amount and type of consideration and deal charges paid could have a dilutive short-term effect on the Company’s earnings per share or book value. However, cost savings and revenue enhancements in such transactions are anticipated to provide long-term economic benefit to the Company.

On April 3, 2006, the Company announced it had completed the acquisition of Prosperity, effective April 1, 2006, in a transaction valued at approximately $36 million. Prosperity, with nearly $130 million in assets, operates three branches in Springfield and Burke, Virginia, located in Fairfax County, a suburb in the Washington, D.C area.

In addition to the Prosperity acquisition, the Company grew through de novo expansion, opening five new branches throughout Virginia in the last two years:

 

   

Twin Hickory, Union Bank branch, located in Richmond (December 2006)

 

   

Front Royal, Rappahannock National Bank branch located in Front Royal (December 2006)

 

   

Grafton, Bay Community Bank branch located in Grafton (March 2006)

 

   

Sycamore Square, Union Bank branch located in Midlothian (May 2005)

 

   

Monticello, Bay Community Bank branch, located in Williamsburg (January 2005)

During 2006, the Company completed the relocation of Union Bank’s Ladysmith branch in Caroline County to a new facility directly behind the former location. Additionally, Union Bank’s Arlington Boulevard leased branch in the City of Charlottesville completed its relocation to an owned branch space on Barracks Road.

The Company is also in the process of constructing a new 70,000 square foot operations center in Caroline County, Virginia at a cost of approximately $13 million. The facility is located near the intersection of Interstate 95 and Route 1 approximately twelve miles west of the current facility in Bowling Green, Virginia. The new facility will accommodate the Company’s anticipated growth and provide improved access to the Greater Richmond and Fredericksburg workforce. Management anticipates that the existing operations center in Bowling Green will be either sold or leased.

EMPLOYEES

As of December 31, 2006, the Company had approximately 646 full-time equivalent employees, including executive officers, loan and other banking officers, branch personnel, operations personnel and other support personnel. None of the Company’s employees is represented by a union or covered under a collective bargaining agreement. Management of the Company considers its employee relations to be excellent.

 

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COMPETITION

The financial services industry remains highly competitive and is constantly evolving. The Company experiences strong competition in all aspects of its business. In its market areas, the Company competes with large national and regional financial institutions, credit unions and other independent community banks, as well as credit unions, consumer finance companies, mortgage companies, loan production offices, mutual funds and life insurance companies. Competition has increasingly come from out-of-state banks through their acquisitions of Virginia-based banks. Competition for deposits and loans is affected by various factors including interest rates offered, the number and location of branches and types of products offered, as well as the reputation of the institution. In addition, credit unions have been allowed to increasingly expand their membership definitions and to offer more attractive loan and deposit pricing due to their favorable tax status. The Company’s non-bank financial services affiliates also operate in highly competitive environments.

The Company is headquartered in Bowling Green, Virginia and is one of the largest independent bank holding companies in Virginia. The Company believes its community bank framework and philosophy provide a competitive advantage, particularly with regard to larger national and regional institutions, allowing the Company to compete effectively in the markets it serves. The Company’s Community Banks generally have strong and growing market shares within the markets they serve. The Company’s deposit market share in Virginia was 1.27% and 1.28% as of June 30, 2006 and 2005, respectively.

SUPERVISION AND REGULATION

Bank holding companies and banks are extensively and increasingly regulated under both federal and state law. The following description briefly addresses certain provisions of federal and state laws as well as certain regulations and proposed regulations, and the potential impact of such provisions on the Company and the Community Banks. To the extent statutory or regulatory provisions or proposals are described herein, the description is qualified in its entirety by reference to the particular statutory or regulatory provisions or proposals.

Bank Holding Companies

As a bank holding company registered under the Bank Holding Company Act of 1956 (the “BHCA”), the Company is subject to regulation by the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The Federal Reserve has jurisdiction under the BHCA to approve any bank or non-bank acquisition, merger or consolidation proposed by a bank holding company. The BHCA generally limits the activities of a bank holding company and its subsidiaries to that of banking, managing or controlling banks, or any other activity that is so closely related to banking or to managing or controlling banks as to be a proper incident thereto.

Since September 1995, the BHCA has permitted bank holding companies from any state to acquire banks and bank holding companies located in any other state, subject to certain conditions, including nationwide and state imposed concentration limits. Banks are also able to branch across state lines, provided certain conditions are met, including that applicable state law must expressly permit such interstate branching. Virginia has adopted legislation that permits branching across state lines, provided there is reciprocity with the state in which the out-of-state bank is based. The Company has no plans to branch outside of the Commonwealth of Virginia.

There are a number of obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by federal law and regulatory policy. Collectively, these are designed to reduce potential loss exposure to the depositors of such depository institutions and to the Federal Deposit

 

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Insurance Corporation (the “FDIC”) insurance funds in the event the depository institution becomes in danger of default or is in default. For example, under a policy of the Federal Reserve with respect to bank holding company operations, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit resources to support such institutions in circumstances where it might not do so absent such policy. In addition, the “cross-guarantee” provisions of federal law require insured depository institutions under common control to reimburse the FDIC for any loss suffered or reasonably anticipated by the Deposit Insurance Fund (“DIF”) as a result of the default of a commonly controlled insured depository institution in danger of default. The FDIC may decline to enforce the cross-guarantee provisions if it determines that a waiver is in the best interest of the BIF. The FDIC’s claim for damages is superior to claims of stockholders of the insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and holders of subordinated debt (other than affiliates) of the commonly controlled insured depository institutions.

The Federal Deposit Insurance Act (the “FDIA”) also provides that amounts received from the liquidation or other resolution of any insured depository institution by any receiver must be distributed (after payment of secured claims) to pay the deposit liabilities of the institution prior to payment of any other general creditor or stockholder. This provision would give depositors a preference over general and subordinated creditors and stockholders in the event a receiver is appointed to distribute the assets of such depository institutions.

The Company is registered under the bank holding company laws of Virginia. Accordingly, the Company and the Community Banks (other than Rappahannock National Bank, which is regulated and supervised by the Office of the Comptroller of the Currency (“OCC”)) are subject to regulation and supervision by the State Corporation Commission of Virginia (the “SCC”) and the Federal Reserve.

Capital Requirements

The Federal Reserve, the OCC and the FDIC have issued substantially similar risk-based and leverage capital guidelines applicable to United States banking organizations. In addition, those regulatory agencies may from time to time require that a banking organization maintain capital above the minimum levels because of its financial condition or actual or anticipated growth. Under the risk-based capital requirements of these federal bank regulatory agencies, the Company and each of the Community Banks are required to maintain a minimum ratio of total capital to risk-weighted assets of at least 8.0%. At least half of the total capital is required to be “Tier 1 capital”, which consists principally of common and certain qualifying preferred shareholders’ equity (including Trust Preferred Securities), less certain intangibles and other adjustments. The remainder (“Tier 2 capital”) consists of a limited amount of subordinated and other qualifying debt (including certain hybrid capital instruments) and a limited amount of the general loan loss allowance. The Tier 1 and total capital to risk-weighted asset ratios of the Company as of December 31, 2006 were 11.63% and 12.78%, respectively, exceeding the minimum requirements.

In addition, each of the federal regulatory agencies has established a minimum leverage capital ratio (Tier 1 capital to average adjusted assets) (“Tier 1 leverage ratio”). These guidelines provide for a minimum Tier 1 leverage ratio of 4% for banks and bank holding companies that meet certain specified criteria, including that they have the highest regulatory examination rating and are not contemplating significant growth or expansion. The Tier 1 leverage ratio of the Company as of December 31, 2006, was 9.57%, which is above the minimum requirements. The 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 levels, without significant reliance on intangible assets.

Limits on Dividends and Other Payments

The Company is a legal entity, separate and distinct from its subsidiary institutions. A significant portion of the revenues of the Company result from dividends paid to it by the Community Banks. There are various legal limitations applicable to the payment of dividends by the Community Banks to the Company, as well as the payment of dividends by the Company to its respective shareholders.

 

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The Community Banks are subject to various statutory restrictions on their ability to pay dividends to the Company. Under the current supervisory practices of the Community Banks’ regulatory agencies, prior approval from those agencies is required if cash dividends declared in any given year exceed net income for that year, plus retained net profits of the two preceding years. The payment of dividends by the Community Banks or the Company may also be limited by other factors, such as requirements to maintain capital above regulatory guidelines. Bank regulatory agencies have the authority to prohibit the Community Banks or the Company from engaging in an unsafe or unsound practice in conducting their business. The payment of dividends, depending on the financial condition of the Community Banks, or the Company, could be deemed to constitute such an unsafe or unsound practice.

Under the FDIA, insured depository institutions such as the Community Banks are prohibited from making capital distributions, including the payment of dividends, if, after making such distribution, the institution would become “undercapitalized” (as such term is used in the statute). Based on the Community Banks’ current financial condition, the Company does not expect that this provision will have any impact on its ability to obtain dividends from the Community Banks. Non-bank subsidiaries pay the parent company dividends periodically on a non-regulated basis.

In addition to dividends it receives from the Community Banks, the Company receives management fees from its affiliated companies for various services provided to them including: data processing, item processing, loan operations, deposit operations, financial accounting, human resources, funds management, credit administration, credit support, sales and marketing, collections, facilities management, call center, legal, compliance and internal audit. These fees are charged to each subsidiary based upon various specific allocation methods measuring the estimated usage of such services by that subsidiary. The fees are eliminated from the financial statements in the consolidation process.

Under federal law, the Community Banks may not, subject to certain limited exceptions, make loans or extensions of credit to, or investments in the securities of, the Company or take securities of the Company as collateral for loans to any borrower. The Community Banks are also subject to collateral security requirements for any loans or extensions of credit permitted by such exceptions.

The Community Banks

The Community Banks are supervised and regularly examined by the Federal Reserve and the SCC, except for Rappahannock National Bank, which is examined by the OCC. The various laws and regulations administered by the regulatory agencies affect corporate practices, such as the payment of dividends, incurrence of debt and acquisition of financial institutions and other companies, and affect business practices, such as the payment of interest on deposits, the charging of interest on loans, types of business conducted and location of offices.

The Community Banks are also subject to the requirements of the Community Reinvestment Act (the “CRA”). The CRA imposes on financial institutions an affirmative and ongoing obligation to meet the credit needs of the local communities, including low- and moderate-income neighborhoods, consistent with the safe and sound operation of those institutions. Each financial institution’s efforts in meeting community credit needs currently are evaluated as part of the examination process pursuant to up to ten assessment factors. These factors also are considered in evaluating mergers, acquisitions and applications to open a branch or facility. Many of the banks’ competitors, such as credit unions, are not subject to the requirements of CRA.

Deposit accounts with the Community Banks are insured by the FDIC, and therefore the banks are subject to insurance assessments imposed by the FDIC. On February 15, 2006, federal legislation to reform federal deposit insurance was enacted. This new legislation required, among other things, that the FDIC adopt regulations increasing the maximum amount of federal deposit insurance coverage per separately insured depositor to $130 thousand (with a cost of living adjustment to become effective in five years). The legislation also gave the FDIC greater discretion to identify the relative risks all institutions present to the deposit insurance fund and set risk-based premiums.

 

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On November 2, 2006, the FDIC adopted final regulations establishing a risk-based assessment system that is intended to more closely tie each bank’s deposit insurance assessments to the risk it poses to the deposit insurance fund. Under the new risk-based assessment system, which became effective in the beginning of 2007, the FDIC will evaluate each bank’s risk based on three primary factors: (1) its supervisory rating, (2) its financial ratios, and (3) its long-term debt issuer rating, if the bank has one. The new rates for most banks will vary between five and seven cents for every $100 of domestic deposits. In 2006, under prior regulations, the Company paid only the base assessment rate for “well capitalized” institutions which amounted to $195 thousand in deposit insurance premiums.

Other Safety and Soundness Regulations

The federal banking agencies have broad powers under current federal law to make prompt corrective action to resolve problems of insured depository institutions. The extent of these powers depends upon whether the institutions in question are “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” All such terms are defined under uniform regulations defining such capital levels issued by each of the federal banking agencies. The Community Banks each meet the definition of being “well capitalized” as of December 31, 2006.

The Gramm-Leach-Bliley Act

Effective on March 11, 2001, the Gramm-Leach Bliley Act (the “GLB Act”) allows a bank holding company or other company to certify its status as a financial holding company, thereby allowing such company to engage in activities that are financial in nature, that are incidental to such activities, or are complementary to such activities. The GLB Act enumerates certain activities that are deemed financial in nature, such as underwriting insurance or acting as an insurance principal, agent or broker; underwriting; dealing in or making markets in securities; and engaging in merchant banking under certain restrictions. It also authorizes the Federal Reserve to determine by regulation what other activities are financial in nature, or incidental or complementary thereto.

USA Patriot Act of 2001

In October 2001, the USA Patriot Act of 2001 was enacted in response to the terrorist attacks in New York, Pennsylvania and Northern Virginia which occurred on September 11, 2001. The Patriot Act intended to strengthen U.S. law enforcement and the intelligence communities’ abilities to work cohesively to combat terrorism on a variety of fronts. The continuing and potential impact of the Patriot Act and related regulations and policies on financial institutions of all kinds is significant and wide ranging. The Patriot Act contains sweeping anti-money laundering and financial transparency laws, and imposes various regulations, including standards for verifying client identification at account opening, and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.

Check 21

On October 28, 2003, President Bush signed into law the Check Clearing for the 21st Century Act, also known as Check 21. Check 21 gives “substitute checks,” such as a digital image of a check and copies made from that image, the same legal standing as the original paper check. Some of the major provisions of Check 21 include:

 

   

allowing check truncation without making it mandatory;

 

   

demanding that every financial institution communicate to accountholders in writing a description of its substitute check processing program and their rights under the law;

 

   

legalizing substitutions for and replacements of paper checks without agreement from consumers;

 

   

retaining in place the previously mandated electronic collection and return of checks between financial institutions only when individual agreements are in place;

 

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requiring that when accountholders request verification, financial institutions produce the original check (or a copy that accurately represents the original) and demonstrate that the account debit was accurate and valid; and

 

   

requiring recrediting of funds to an individual’s account on the next business day after a consumer proves that the financial institution has erred.

Effect of Governmental Monetary Policies

The Company’s operations are affected not only by general economic conditions, but also by the policies of various regulatory authorities. In particular, the Federal Reserve regulates money and credit conditions and interest rates in order to influence general economic conditions. These policies have a significant influence on overall growth and distribution of loans, investments and deposits, and affect interest rates charged on loans or paid for time and savings deposits. Federal Reserve monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to do so in the future. We are unable to predict the effect of possible changes in monetary policies upon the future operating results of the Company.

Proposed Legislation and Regulatory Action

New regulations and statutes are regularly proposed that contain wide-ranging proposals for altering the structures, regulations, and competitive relationships of the nation’s financial institutions. The Company cannot predict whether or in what form any proposed regulation or statute will be adopted or the extent to which the Company’s business may be affected by any new regulation or statute.

Filings with the SEC

The Company files annual, quarterly and other reports under the Securities Exchange Act of 1934 with the Securities and Exchange Commission (“SEC”). These reports are posted and are available at no cost on the Company’s website, www.ubsh.com, through the Investor Relations link, as soon as reasonably practicable after the Company files such documents with the SEC. The Company’s filings are also available through the SEC’s website at www.sec.gov.

ITEM 1A.—RISK FACTORS.

General economic conditions, either national or within the Company’s local markets could materially impact the Company’s financial condition and performance.

The Company is affected by general economic conditions in the United States and the local markets within which it operates. Significant decline in general economic conditions caused by inflation, recession, unemployment or other factors beyond the Company’s control could negatively impact the growth rate of loans (including mortgage originations) and deposits, the quality of the loan portfolio, loan and deposit pricing and other key drivers of the Company’s business. Such negative developments could adversely impact the Company’s financial condition and performance.

Changes in interest rates could adversely affect the Company’s income and cash flows.

The Company’s income and cash flows depend to a great extent on the difference between the interest rates earned on interest-earning assets such as loans and investment securities, and the interest rates paid on interest-bearing liabilities such as deposits and borrowings. These rates are highly sensitive to many factors that are beyond the Company’s control, including general economic conditions and the policies of various governmental and regulatory agencies (in particular, the Federal Reserve). Changes in monetary policy, including changes in interest rates, will influence the origination of loans, the prepayment speed of loans, the purchase of investments, the generation of deposits and the rates received on loans and investment securities and paid on deposits or other sources of funding. The impact of these changes may be magnified if the Company does not effectively manage the relative sensitivity of its assets and liabilities to changes in market interest rates. Fluctuations in these areas may adversely affect the Company and its shareholders. Community banks are often at a competitive disadvantage in managing their costs of funds compared to the large regional, super-regional or national banks that have access to the national and international capital markets.

 

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The Company generally seeks to maintain a neutral position in terms of the volume of assets and liabilities that mature or re-price during any period so that it may reasonably maintain its net interest margin; however, interest rate fluctuations, loan prepayments, loan production and deposit flows are constantly changing and influence the ability to maintain a neutral position. Generally, the Company’s earnings will be more sensitive to fluctuations in interest rates the greater the variance in volume of assets and liabilities that mature and re-price in any period. The extent and duration of the sensitivity will depend on the cumulative variance over time, the velocity and direction of interest rates, shape of the yield curve, and whether the Company is more asset sensitive or liability sensitive. Accordingly, the Company may not be successful in maintaining a neutral position and, as a result, the Company’s net interest margin may be impacted.

The Company faces substantial competition that could adversely affect the Company’s growth and/or operating results.

The Company operates in a competitive market for financial services and faces intense competition from other financial institutions both in making loans and in attracting deposits. Many of these financial institutions have been in business for many years, are significantly larger, have established customer bases, and have greater financial resources and lending limits.

The inability of the Company to successfully manage its growth or implement its growth strategy may adversely affect the results of operations and financial conditions.

The Company may not be able to successfully implement its growth strategy if unable to identify attractive markets, locations or opportunities to expand in the future. The ability to manage growth successfully also depends on whether the Company can maintain capital levels adequate to support its growth, maintain cost controls, asset quality and successfully integrate any businesses acquired into the organization.

As the Company continues to implement its growth strategy by opening new branches or acquiring branches or banks, it expects to incur increased personnel, occupancy and other operating expenses. In the case of new branches, the Company must absorb those higher expenses while it begins to generate new deposits, and there is a further time lag involved in redeploying new deposits into attractively priced loans and other higher yielding earning assets. Thus, the Company’s plans to branch could depress earnings in the short run, even if it efficiently executes a branching strategy leading to long-term financial benefits.

Difficulties in combining the operations of acquired entities with the Company’s own operations may prevent the Company from achieving the expected benefits from acquisitions.

The Company may not be able to achieve fully the strategic objectives and operating efficiencies in an acquisition. Inherent uncertainties exist in integrating the operations of an acquired entity. In addition, the markets and industries in which the Company and its potential acquisition targets operate are highly competitive. The Company may lose customers or the customers of acquired entities as a result of an acquisition. The Company also may lose key personnel, either from the acquired entity or from itself, as a result of an acquisition. These factors could contribute to the Company not achieving the expected benefits from its acquisitions within desired time frames, if at all. Future business acquisitions could be material to the Company and it may issue additional shares of common stock to pay for those acquisitions, which would dilute current shareholders’ ownership interests. Acquisitions also could require the Company to use substantial cash or other liquid assets or to incur debt. In those events, it could become more susceptible to economic downturns and competitive pressures.

The Company’s exposure to operational risk may adversely affect the Company.

Similar to other financial institutions, the Company is exposed to many types of operational risk, including reputational risk, legal and compliance risk, the risk of fraud or theft by employees or outsiders, unauthorized transactions by employees or operational errors, including clerical or record-keeping errors or those resulting from faulty or disabled computer or telecommunications systems.

 

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The Company’s dependency on its management team and the unexpected loss of any of those personnel could adversely affect operations.

The Company is a customer-focused and relationship-driven organization. Future growth is expected to be driven by a large part in the relationships maintained with customers. While the Company has assembled an experienced management team, is building the depth of that team and has management development plans in place, the unexpected loss of key employees could have a material adverse effect on the Company’s business and may result in lower revenues.

The Company’s concentration in loans secured by real estate may adversely impact earnings due to changes in the real estate markets.

The Company offers a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Many of the Company’s loans are secured by real estate (both residential and commercial) in the Company’s market area. A major change in the real estate market, resulting in deterioration in the value of this collateral, or in the local or national economy, could adversely affect the customer’s ability to pay these loans, which in turn could impact the Company. Risk of loan defaults and foreclosures are unavoidable in the banking industry, and the Company tries to limit its exposure to this risk by monitoring extensions of credit carefully. The Company cannot fully eliminate credit risk, and as a result credit losses may occur in the future.

If the Company’s allowance for loan losses becomes inadequate, the results of operations may be adversely affected.

The Company maintains an allowance for loan losses that it believes is a reasonable estimate of potential losses within the loan portfolio. Through a periodic review and consideration of the 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 customers relative to their financial obligations with the Company. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates, which may be beyond the Company’s control, and these losses may exceed current estimates. Rapidly growing loan portfolios are, by their nature, unseasoned. As a result, estimating loan loss allowances is more difficult, and may be more susceptible to changes in estimates, and to losses exceeding estimates, than more seasoned portfolios. Although the Company believes the allowance for loan losses is a reasonable estimate of known and inherent losses in the loan portfolio, it cannot fully predict such losses or that the loss allowance will be adequate in the future. Excessive loan losses could have a material impact on financial performance. Consistent with the loan loss reserve methodology, the Company expects to make additions to the allowance for loan loss as a result of its growth strategy, which may affect the Company’s short-term earnings.

Federal and state regulators periodically review the allowance for loan losses and may require the Company to increase its provision for loan losses or recognize further loan charge-offs, based on judgments different than those of management. Any increase in the amount of the provision or loans charged-off as required by these regulatory agencies could have a negative effect on the Company’s operating results.

Legislative or regulatory changes or actions, or significant litigation, could adversely impact the Company or the businesses in which the Company is engaged.

The Company is subject to extensive state and federal regulation, supervision and legislation that govern almost all aspects of its operations. Laws and regulations may change from time to time and are primarily intended for the protection of consumers, depositors and the deposit insurance funds. The impact of any changes to laws and regulations or other actions by regulatory agencies may negatively impact the Company or its ability to increase the value of its business. Additionally, actions by regulatory agencies or

 

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significant litigation against the Company could cause it to devote significant time and resources to defending itself and may lead to penalties that materially affect the Company and its shareholders. Future changes in the laws or regulations or their interpretations or enforcement could be materially adverse to the Company and its shareholders.

Changes in accounting standards could impact reported earnings.

The accounting standard setters, including the Financial Accounting Standards Board, SEC and other regulatory bodies, periodically change the financial accounting and reporting standards that govern the preparation of the Company’s consolidated financial statements. These changes can be hard to predict and can materially impact how it records and reports its financial condition and results of operations. In some cases, the Company could be required to apply a new or revised standard retroactively, resulting in the restatement of prior period financial statements.

ITEM 1B.—UNRESOLVED STAFF COMMENTS.

The Company does not have any unresolved staff comments to report for the year ended December 31, 2006.

ITEM 2.—PROPERTIES.

The Company, through its subsidiaries, owns or leases buildings that are used in the normal course of business. The corporate headquarters is located at 212 N. Main Street, Bowling Green, Virginia, in a building owned by the Company. The Company’s subsidiaries own or lease various other offices in the counties and cities in which they operate. In addition to the properties listed below, the Company has acquired land and is constructing a new operations center in nearby Carmel Church, Virginia which it anticipates will be completed during the second quarter of 2007. See the Note 1 “Summary of Significant Accounting Policies” in the “Notes to the Consolidated Financial Statements”, of this Form 10-K for information with respect to the amounts at which bank premises and equipment are carried and commitments under long-term leases.

Unless otherwise indicated, the properties listed below are owned by the Company and its subsidiaries as of December 31, 2006.

 

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CORPORATE HEADQUARTERS

212 North Main Street

     Bowling Green, Virginia
BANKING OFFICES
Union Bank and Trust Company:     

211 North Main Street

     Bowling Green, Virginia

7349 Ladysmith Road

     Ladysmith, Virginia

U.S. Route 301

     Port Royal, Virginia

4540 Lafayette Boulevard

     Fredericksburg, Virginia

U.S. Route 1 and Ashcake Road

     Ashland, Virginia

4210 Plank Road

     Fredericksburg, Virginia

10415 Courthouse Road

     Spotsylvania, Virginia

9665 Sliding Hill Road

     Ashland, Virginia

700 Kenmore Avenue

     Fredericksburg, Virginia

U.S. Route 360

     Manquin, Virginia

9534 Chamberlayne Road

     Mechanicsville, Virginia

Cambridge and Layhill Road

     Falmouth, Virginia (leased)

Massaponax Church Road and U.S. Route 1

     Spotsylvania, Virginia (leased)

Brock Road and Route 3

     Spotsylvania, Virginia (leased)

2811 Fall Hill Avenue

     Fredericksburg, Virginia

6479 Mechanicsville Turnpike

     Mechanicsville, Virginia

10045 Kings Highway

     King George, Virginia

840 McKinney Boulevard

     Colonial Beach, Virginia

5510 Morris Road

     Spotsylvania, Virginia

4690 Pouncey Tract Road

     Glen Allen, Virginia (leased)

8300 Bell Creek Road

     Mechanicsville, Virginia

1773 Parham Road

     Richmond, Virginia

11101 Hull Street Road

     Midlothian, Virginia

13644 Hull Street Road

     Midlothian, Virginia

400 East Main Street

     Charlottesville, Virginia (leased)

1700 Seminole Trail

     Charlottesville, Virginia (leased)

124 Main Street

     Lovingston, Virginia

2151 Barracks Road

     Charlottesville, Virginia

1658 State Farm Boulevard

     Charlottesville, Virginia

5980 Thomas Jefferson Parkway

     Palmyra, Virginia

3290 Worth Crossing

     Charlottesville, Virginia

13700 Midlothian Turnpike

     Midlothian, Virginia (leased)

11163 Nuckols Road

     Glen Allen, Virginia
Northern Neck State Bank:     

5839 Richmond Road

     Warsaw, Virginia

4256 Richmond Road

     Warsaw, Virginia

17191 Kings Highway

     Montross, Virginia

1649 Tappahannock Boulevard

     Tappahannock, Virginia

1660 Tappahannock Boulevard (Wal-Mart)

     Tappahannock, Virginia (leased)

15043 Northumberland Highway

     Burgess, Virginia

284 North Main Street

     Kilmarnock, Virginia

876 Main Street

     Reedville, Virginia

485 Chesapeake Drive

     White Stone, Virginia

 

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Rappahannock National Bank:     

7 Bank Road

     Washington, Virginia

473 South Street

     Front Royal, Virginia (leased)
Bay Community Bank:     

5125 John Tyler Highway

     Williamsburg, Virginia

603 Pilot House Drive

     Newport News, Virginia (leased)

171 Monticello Avenue

     Williamsburg, Virginia (leased)

5030 George Washington Memorial Highway

     Grafton, Virginia
Prosperity Bank & Trust Company (all leased):     

5803 Rolling Road

     Springfield, Virginia

6975A Springfield Boulevard

     Springfield, Virginia

6050A Burke Commons Road

     Burke, Virginia
Union Investment Services, Inc.     

111 Davis Court

     Bowling Green, Virginia

10469 Atlee Station Road, Suite 100

     Ashland, Virginia

2811 Fall Hill Avenue

     Fredericksburg, Virginia

171 Monticello Avenue

     Williamsburg, Virginia

1658 State Farm Boulevard

     Charlottesville, Virginia

13700 Midlothian Turnpike

     Midlothian, Virginia (leased)
LOAN PRODUCTION OFFICES
Union Bank and Trust Company:     

9282 Corporate Circle, Building 7

     Manassas, Virginia (leased)
Union Mortgage Group, Inc. (all leased):     

3 Hillcrest Drive, #A100

     Frederick, Maryland

7501 Greenway Center, #140

     Greenbelt, Maryland

2670 Crain Highway, Suite 407

     Waldorf, Maryland

3120 Waccamaw Boulevard, Suite F

     Myrtle Beach, South Carolina

5440 Jeff Davis Highway, #103

     Fredericksburg, Virginia

6330 Newtown Road, #211

     Norfolk, Virginia

7619 Little River Turnpike, Suite 400

     Annandale, Virginia

1658 State Farm Boulevard

     Charlottesville, Virginia

10469 Atlee Station Road, #120

     Ashland, Virginia

11830 Canon Boulevard, Suite D

     Newport News, Virginia

760 Lynnhaven Parkway, Suite 140

     Virginia Beach, Virginia

ITEM 3.—LEGAL PROCEEDINGS.

In the ordinary course of its operations, the Company and its subsidiaries are parties to various legal proceedings. Based on the information presently available, and after consultation with legal counsel, management believes that the ultimate outcome in such proceedings, in the aggregate, will not have a material adverse effect on the business or the financial condition or results of operations of the Company.

ITEM 4.—SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 2006.

 

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PART II

ITEM 5.—MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.

The following performance graph does not constitute soliciting material and should not be deemed filed or incorporated by reference into any other Company filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent the Company specifically incorporates the performance graph by reference therein.

Five-Year Stock Performance Graph

The following chart compares the yearly percentage change in the cumulative shareholder return on the Company’s common stock during the five years ended December 31, 2006, with (1) the Total Return Index for the NASDAQ Stock Market (U.S. Companies) and (2) the Total Return Index for NASDAQ Bank Stocks. This comparison assumes $100.00 was invested on December 31, 2001, in the common stock and the comparison groups and assumes the reinvestment of all cash dividends prior to any tax effect and retention of all stock dividends. The Company’s total cumulative return was 204.1% over the five year period ending December 31, 2006 compared to 65.2% and 26.2% for the NASDAQ Bank Stocks and NASDAQ composite:

LOGO

 

     2001    2002    2003    2004    2005    2006
Union Bankshares Performance Index    100.00    170.98    194.61    247.65    281.10    304.09
The NASDAQ Stock Market Index    100.00    69.13    103.36    112.49    112.49    126.22
NASDAQ Bank Stocks Index    100.00    102.37    131.69    150.71    147.23    165.21

Information on Common Stock, Market Prices and Dividends

There were 13,303,519 shares of the Company’s common stock outstanding at the close of business on December 31, 2006, which were held by 2,432 shareholders of record. The closing price of the Company’s stock on December 31, 2006 was $30.59 per share compared to $28.73 on December 31, 2005.

On September 7, 2006, the Company’s Board of Directors declared a three-for-two stock split to shareholders of record as of the close of business on October 2, 2006. Accordingly, share and per share amounts for all periods presented have been retroactively adjusted to reflect the effect of the three-for-two split.

 

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The following table summarizes the high and low closing sales prices and dividends declared for quarterly periods during the years ended December 31, 2006 and 2005.

 

     Market Values    Declared
Dividends
     2006    2005    2006    2005
     High    Low    High    Low          

First Quarter

   $ 32.06    $ 28.89    $ 24.79    $ 20.49    $ 0.15    $ —  

Second Quarter

     29.30      25.64      26.16      19.59      0.15      0.25

Third Quarter

     30.40      26.20      29.41      25.19      0.16      —  

Fourth Quarter

     32.10      27.85      32.70      25.66      0.17      0.27
                         
               $ 0.63    $ 0.52
                         

Regulatory restrictions on the ability of the Community Banks to transfer funds to the Company at December 31, 2006, are set forth in Note 17 “Parent Company Financial Information” contained in the “Notes to the Consolidated Financial Statements”, of this Form 10-K. A discussion of certain limitations on the ability of the Community Banks to pay dividends to the Company and the ability of the Company to pay dividends on its common stock, is set forth in Part I. Business, of this Form 10-K under the headings “Supervision and Regulation - Limits on Dividends and Other Payments” and “Supervision and Regulation - The Community Banks.”

In October 2005, the Company announced that starting in 2006, it would begin paying its dividend on a quarterly basis instead of semi-annually. It is anticipated the dividends will continue to be paid near the end of February, May, August and November. In making its decision on the payment of dividends on the Company’s common stock, the Board of Directors considers operating results, financial condition, capital adequacy, regulatory requirements, shareholder returns and other factors.

Stock Repurchase Program

The Board of Directors has authorized management of the Company to buy up to 225,000 shares of its outstanding common stock in the open market at prices that management and the Board of Directors determine to be prudent. This authorization expires May 31, 2007. The Company considers current market conditions and the Company’s current capital level, in addition to other factors, when deciding whether to repurchase stock. It is anticipated that any repurchased shares will be used primarily for general corporate purposes, including the Company’s dividend reinvestment plan, incentive stock plan and other employee benefit plans. No shares have been purchased under this authorization to date.

 

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ITEM 6.—SELECTED FINANCIAL DATA.

The following table sets forth selected financial data for the Company over the past five years ended December 31, (in thousands, except per share amounts):

 

     2006     2005     2004     2003     2002  

Results of Operations

                              

Interest and dividend income

   $ 129,156     $ 102,317     $ 80,544     $ 67,017     $ 65,205  

Interest expense

     52,441       32,967       25,652       23,905       24,627  
                                        

Net interest income

     76,715       69,350       54,892       43,112       40,578  

Provision for loan losses

     1,450       1,172       2,154       2,307       2,878  
                                        

Net interest income after provision for loan losses

     75,265       68,178       52,738       40,805       37,700  

Noninterest income

     28,245       25,510       23,302       22,840       17,538  

Noninterest expenses

     67,567       58,275       51,221       40,725       35,922  
                                        

Income before income taxes

     35,943       35,413       24,819       22,920       19,316  

Income tax expense

     9,951       10,591       6,894       6,256       4,811  
                                        

Net income

   $ 25,992     $ 24,822     $ 17,925     $ 16,664     $ 14,505  
                                        

Financial Condition

                              

Assets

   $ 2,092,891     $ 1,824,958     $ 1,672,210     $ 1,234,732     $ 1,115,725  

Loans, net of unearned income

     1,549,445       1,362,254       1,264,841       878,267       714,765  

Deposits

     1,665,908       1,456,515       1,314,317       999,771       897,645  

Stockholders’ equity

     199,416       179,358       162,758       118,501       105,492  

Ratios

                              

Return on average assets

     1.30 %     1.43 %     1.19 %     1.42 %     1.41 %

Return on average equity

     13.64 %     14.49 %     12.18 %     14.88 %     14.91 %

Cash basis return on average assets (1)

     1.40 %     1.51 %     1.26 %     1.45 %     1.46 %

Cash basis return on average equity (1)

     20.31 %     19.57 %     15.78 %     16.08 %     16.43 %

Efficiency ratio (2)

     64.37 %     61.43 %     65.51 %     61.75 %     58.90 %

Equity to assets

     9.53 %     9.82 %     9.73 %     9.60 %     9.46 %

Asset Quality

                              

Allowance for loan losses

   $ 19,148     $ 17,116     $ 16,384     $ 11,519     $ 9,179  

Allowance for loan losses / total outstanding loans

     1.24 %     1.26 %     1.30 %     1.31 %     1.28 %

Per Share Data

                              

Earnings per share, basic

   $ 1.97     $ 1.89     $ 1.42     $ 1.47     $ 1.28  

Earnings per share, diluted

     1.94       1.87       1.41       1.46       1.27  

Cash basis earnings per share, diluted (1)

     2.03       1.93       1.46       1.48       1.28  

Cash dividends paid

     0.63       0.52       0.45       0.40       0.35  

Market value per share

     30.59       28.73       25.62       20.33       18.17  

Book value per share

     14.99       13.59       12.41       10.36       9.28  

Price to earnings ratio, diluted

     15.77       15.34       18.21       14.06       14.34  

Price to book value ratio

     2.04       2.11       2.07       1.96       1.96  

Dividend payout ratio

     31.98 %     27.21 %     31.92 %     27.40 %     27.08 %

Weighted average shares outstanding, basic

     13,233,101       13,142,999       12,604,187       11,404,308       11,333,859  

Weighted average shares outstanding, diluted

     13,361,773       13,275,074       12,723,213       11,513,156       11,434,754  

(1) Refer to “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation”, section

“Non GAAP Measures” for a reconciliation.

(2) The efficiency ratio is calculated by dividing noninterest expense over the sum of net interest income plus noninterest income.

 

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ITEM 7.—MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION.

The following discussion and analysis provides information about the major components of the results of operations and financial condition, liquidity and capital resources of the Company and its subsidiaries. This discussion and analysis should be read in conjunction with the “Consolidated Financial Statements” and the “Notes to the Consolidated Financial Statements” presented in Item 8. “Financial Statements and Supplementary Data”, of this Form 10-K. In addition, share and per share amounts for all periods presented have been retroactively adjusted to reflect the effect of the three-for-two stock split in October 2006.

CRITICAL ACCOUNTING POLICIES

General

The accounting and reporting policies of the Company and its subsidiaries are in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and conform to general practices within the banking industry. The Company’s financial position and results of operations are affected by management’s application of accounting policies, including estimates, assumptions and judgments made to arrive at the carrying value of assets and liabilities and amounts reported for revenues, expenses and related disclosures. Different assumptions in the application of these policies could result in material changes in the Company’s consolidated financial position and/or results of operations.

The more critical accounting and reporting policies include the Company’s accounting for the allowance for loan losses, and merger and acquisitions, and goodwill and intangibles. The Company’s accounting policies are fundamental to understanding the Company’s consolidated financial position and consolidated results of operations. Accordingly, the Company’s significant accounting policies are discussed in detail in Note 1 “Summary of Significant Accounting Policies” in the “Notes to the Consolidated Financial Statements”.

The following is a summary of the Company’s critical accounting policies that are highly dependent on estimates, assumptions and judgments.

Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two basic principles of accounting: (i) Statement of Financial Accounting Standard (“SFAS”) No. 5, Accounting for Contingencies (“SFAS No. 5”), which requires that losses be accrued when occurrence is probable and can be reasonably estimated and (ii) SFAS No. 114, Accounting by Creditors for Impairment of a Loan (“SFAS No. 114”), as amended, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

The Company’s allowance for loan losses is the accumulation of various components that are calculated based on independent methodologies. All components of the allowance represent an estimation performed pursuant to either SFAS No. 5 or SFAS No. 114. Management’s estimate of each SFAS No. 5 component is based on certain observable data that management believes are most reflective of the underlying credit losses being estimated. This evaluation includes credit quality trends; collateral values; loan volumes; geographic, borrower and industry concentrations; seasoning of the loan portfolio; the findings of internal credit quality assessments and results from external bank regulatory examinations. These factors, as well as historical losses and current economic and business conditions, are used in developing estimated loss factors used in the calculations.

The Company adopted SFAS No. 114, which has been amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan – Income Recognition and Disclosures (“SFAS No. 118”). SFAS No.

 

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114, as amended, requires that the impairment of loans that have been separately identified for evaluation is to be measured based on the present value of expected future cash flows or, alternatively, the observable market price of the loans or the fair value of the collateral. However, for those loans that are collateral dependent (that is, if repayment of those loans is expected to be provided solely by the underlying collateral) and for which management has determined foreclosure is probable, the measure of impairment is to be based on the net realizable value of the collateral. SFAS No. 114, as amended, also requires certain disclosures about investments in impaired loans and the allowance for loan losses and interest income recognized on loans.

Reserves for commercial loans are determined by applying estimated loss factors to the portfolio based on management’s evaluation and “risk grading” of the commercial loan portfolio. Reserves are provided for noncommercial loan categories using historical loss factors applied to the total outstanding loan balance of each loan category. Additionally, environmental factors based on national and local economic activity, as well as portfolio specific attributes are considered in the allowance for loan losses. Specific reserves are determined on a loan-by-loan basis based on management’s evaluation of the Company’s exposure for each credit, given the current payment status of the loan and the net realizable value of any underlying collateral.

While management uses the best information available to establish the allowance for loan and lease losses, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the valuations or, if required by regulators, based upon information available to them at the time of their examinations. Such adjustments to original estimates, as necessary, are made in the period in which these factors and other relevant considerations indicate that loss levels may vary from previous estimates.

Mergers and Acquisitions

The Company’s strategy focuses on high growth areas with strong market demographics and targets organizations that have a comparable corporate culture, strong performance and good asset quality, among other factors.

The Company accounts for acquisitions under the purchase method of accounting and accordingly is required to record the assets acquired, including identified intangible assets and liabilities assumed at their fair value, which often involves estimates based on third party valuations, such as appraisals, or internal valuations based on discounted cash flow analyses or other valuation techniques, which are inherently subjective. The amortization of identified intangible assets is based upon the estimated economic benefits to be received, which is also subjective. These estimates also include the establishment of various accruals and allowances based on planned facility dispositions and employee severance considerations, among other acquisition-related items. In addition, purchase acquisitions typically result in goodwill, which is subject to at least annual impairment testing, or more frequently if certain indicators are in evidence, based on the fair value of net assets acquired compared to the carrying value of goodwill.

The Company and the acquired entity also incur merger-related costs during an acquisition. The Company capitalizes direct costs of the acquisition, such as investment banker and attorneys’ fees and includes them as part of the purchase price. Other merger-related internal costs associated with acquisitions are expensed as incurred. Some examples of these merger-related costs include, but are not limited to, systems conversions, integration planning consultants and advertising fees. These merger-related costs are included within the Consolidated Statement of Income classified within the noninterest expense line. The acquired entity records merger-related costs which result from a plan to exit an activity, involuntarily terminate or relocate employees and are recognized as liabilities assumed as of the consummation date of the acquisition.

The Company’s merger-related costs for the years ended December 31, 2006, 2005 and 2004 were $263 thousand, $17 thousand, and $343 thousand, respectively. Prior to the mergers, the acquired entities, Prosperity and Guaranty, recorded merger-related costs of approximately $807 thousand and $1.3 million and principally related to employee severance and investment banker fees.

 

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Goodwill and Intangible Assets

SFAS No. 141, Business Combinations, requires the purchase method of accounting be used for all business combinations initiated after June 30, 2001. For purchase acquisitions, the Company is required to record assets acquired, including identifiable intangible assets, and liabilities assumed at their fair value, which in many instances involves estimates based on third party valuations, such as appraisals, or internal valuations based on discounted cash flow analysis or other valuation techniques. Effective January 1, 2001, the Company adopted SFAS No. 142, Goodwill and Other Intangible Asset (“SFAS 142”), which prescribes the accounting for goodwill and intangible assets subsequent to initial recognition. The provisions of SFAS No. 142 discontinue the amortization of goodwill and intangible assets with indefinite lives but require at least an annual impairment review and more frequently if certain impairment indicators are in evidence. Additionally, the Company adopted SFAS No. 147, Acquisitions of Certain Financial Institutions, on January 1, 2002 and determined that core deposit intangibles will continue to be amortized over their estimated useful lives.

Goodwill totaled $50.0 million and $31.3 million at the years ended December 31, 2006 and 2005, respectively. Based on the testing of goodwill for impairment, there were no impairment charges for 2006, 2005 or 2004. Core deposit intangible assets are being amortized over the period of expected benefit, which ranges from 5 to 15 years. Core deposit intangibles, net of amortization, amounted to $12.3 million and $8.5 million at the years ended December 31, 2006 and 2005, respectively. Amortization expense of core deposit intangibles for the years ended December 31, 2006, 2005 and 2004 totaled $1.7 million, $1.2 million and $1.0 thousand, respectively.

RESULTS OF OPERATIONS

Net Income

For the year ended December 31, 2006 compared to the year ended December 31, 2005, net income increased $1.2 million, or 4.7%, from $24.8 million to $26.0 million, which represented an increase in earnings per share, on a diluted basis, of $.07, or 3.7%, from $1.87 to $1.94. Return on average equity for the year ended December 31, 2006 was 13.64% and return on average assets was 1.30%, compared to 14.49% and 1.43%, respectively, for the same period in 2005.

The acquisition of Prosperity and its related operating results have been reflected in the financial statements since April 1, 2006. Prosperity’s net income included in the Company’s financial statements amounted to $1.1 million since acquisition. In addition, the Company incurred other expenses relating to the acquisition of Prosperity, including interest expense in connection with the issuance of a Trust Preferred Capital Note and merger-related costs. Since acquisition, the interest expense and merger related costs were $1.8 million and $263 thousand before taxes, respectively.

The Company’s continued expansion in both new and existing markets also impacted results for the year. Three new bank branches were opened in 2006, following the opening of two branches in 2005. The costs associated with these branches include personnel, occupancy, marketing and other related expenses and are typically greater than the revenue generated for the first 18-24 months as the branch expands the customer base in those markets. Additionally, during 2006 the Company completed the relocation of its Ladysmith branch in Caroline County to a new facility adjacent to the former location and relocated its Arlington Boulevard branch in the City of Charlottesville to a new building on Barracks Road.

 

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Net Interest Income

Net interest income, which represents the principal source of earnings for the Company, is the amount by which interest income exceeds interest expense. The net interest margin is net interest income expressed as a percentage of average earning assets. Changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as their respective yields and rates, have a significant impact on the level of net interest income, the net interest margin and net income.

For the year ended December 31, 2006 compared to the same period in 2005, the net interest margin, on a tax equivalent basis (TEQ), declined 9 basis points from 4.46% to 4.37%. Net interest income (TEQ) increased $7.5 million, or 10.5%, from $71.4 million to $79.0 million. Average interest-earning assets grew $205.4 million, or 12.8%, ($110.1 million from the Prosperity acquisition), while average interest-bearing and noninterest-bearing liabilities grew $203.1 million, or 15.6%, ($63.7 million from the Prosperity acquisition) and $38.5 million, or 15.7%, respectively. Furthermore, the yields on average interest-earning assets and the costs on average interest-bearing liabilities increased 75 and 95 basis points, to 7.28% and 3.47%, respectively. The interest rate spread compression together with average interest-bearing liabilities growing at a faster pace than average interest-earning assets are contributing factors associated with the decline in the net interest margin. For the years ended December 31, 2006 and 2005, the Company collected $464 thousand and $311 thousand of foregone interest, respectively, which has been excluded from the net interest margin calculation.

Management carefully analyzes its local markets and the potential impact economic indicators (i.e. interest rates, housing sales, etc.) present. The Federal funds tightening cycle increased rates a quarter percentage point seventeen consecutive times beginning in June 2004. Economic indicators show signs of a slowing economy, particularly in the residential housing market where inventory levels remain high and demand has waned. During much of this period of rising interest rates, the Company’s net interest margin benefited from the delay between increases in asset yields and the lagging increases in funding costs on its deposit products. As customers have shifted out of lower cost deposit transaction accounts to higher rate CD products, the Company’s funding costs have risen, negatively impacting the margin. With long-term rates virtually the same (or lower) than short-term rates, the current interest rate environment will continue to put pressure on the interest margin throughout the industry. Management anticipates continued declines in the Company’s net interest margin (albeit at a slower pace than recent declines) until the yield curve assumes its more normal shape with short-term rates lower than long-term rates.

 

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The following table shows interest income on earning assets and related average yields, as well as interest expense on interest-bearing liabilities and related average rates paid for the years ended December 31, (dollars in thousands):

 

     2006     2005     2004  
     Average
Balance
    Interest
Income /
Expense
   Yield /
Rate
    Average
Balance
    Interest
Income /
Expense
   Yield /
Rate
    Average
Balance
    Interest
Income /
Expense
   Yield /
Rate
 

Assets:

                     

Securities:

                     

Taxable

   $ 188,461     $ 9,883    5.24 %   $ 154,954     $ 7,791    5.03 %   $ 159,709     $ 7,709    4.83 %

Tax-exempt

     89,407       6,546    7.32 %     74,936     $ 5,677    7.58 %     80,224       6,049    7.54 %
                                                   

Total securities

     277,868       16,429    5.91 %     229,890     $ 13,468    5.86 %     239,933       13,758    5.73 %

Loans, net (2) (3)

     1,489,794       111,771    7.50 %     1,315,695     $ 88,089    6.70 %     1,104,942       67,114    6.07 %

Loans held for sale

     25,129       1,572    6.26 %     38,975     $ 2,367    6.07 %     34,326       1,917    5.58 %

Federal funds sold

     8,837       1,438    5.35 %     11,143     $ 349    3.13 %     8,090       102    1.26 %

Money market investments

     151       3    2.24 %     73     $ 2    2.79 %     101       1    0.99 %

Interest-bearing deposits in other banks

     1,104       57    5.13 %     1,665     $ 49    2.92 %     3,645       29    0.80 %

Other interest-bearing deposits

     2,598       129    4.96 %     2,598     $ 81    3.13 %     1,889       33    1.75 %
                                                   

Total earning assets

     1,805,481       131,399    7.28 %     1,600,039     $ 104,405    6.53 %     1,392,926       82,954    5.96 %
                                 

Allowance for loan losses

     (18,468 )          (16,687 )          (14,167 )     

Total non-earning assets

     211,055            154,653            126,098       
                                       

Total assets

   $ 1,998,068          $ 1,738,005          $ 1,504,857       
                                       

Liabilities and Stockholders’ Equity:

 

                  

Interest-bearing deposits:

                     

Checking

   $ 204,023       911    0.45 %   $ 198,969     $ 704    0.35 %   $ 175,659       488    0.28 %

Money market savings

     175,163       3,945    2.25 %     187,673     $ 3,174    1.69 %     159,111       1,555    0.98 %

Regular savings

     116,569       1,061    0.91 %     119,309     $ 998    0.84 %     112,953       726    0.64 %

Certificates of deposit:

                     

$100,000 and over

     387,023       17,603    4.55 %     259,185     $ 9,427    3.64 %     190,506       6,582    3.46 %

Under $100,000

     405,930       16,210    3.99 %     365,758     $ 11,605    3.17 %     352,589       10,678    3.03 %
                                                   

Total interest-bearing deposits

     1,288,708       39,730    3.08 %     1,130,894     $ 25,908    2.29 %     990,818       20,029    2.02 %

Other borrowings

     220,632       12,711    5.85 %     175,309     $ 7,059    4.03 %     160,213       5,623    3.51 %
                                                   

Total interest-bearing liabilities

     1,509,340       52,441    3.47 %     1,306,203     $ 32,967    2.52 %     1,151,031       25,652    2.23 %
                                 

Noninterest-bearing liabilities:

                     

Demand deposits

     284,094            245,587            196,520       

Other liabilities

     14,074            14,994            10,140       
                                       

Total liabilities

     1,807,508            1,566,784            1,357,691       

Stockholders’ equity

     190,560            171,221            147,166       
                                       

Total liabilities and stockholders’ equity

   $ 1,998,068          $ 1,738,005          $ 1,504,857       
                                       

Net interest income

     $ 78,958        $ 71,438        $ 57,302   
                                 

Interest rate spread (1)

        3.81 %        4.01 %        3.73 %

Interest expense as a percent of average earning assets

        2.90 %        2.06 %        1.84 %

Net interest margin

        4.37 %        4.46 %        4.11 %

(1) Income and yields are reported on a taxable equivalent basis using the statutory federal corporate tax rate of 35%.
(2) Foregone interest on previously charged off credits of $464 thousand and $311 thousand has been excluded for 2006 and 2005, respectively.
(3) Nonaccrual loans are included in average loans outstanding.

 

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The Volume Rate Analysis table presents changes in interest income and interest expense, and distinguishes between the changes related to increases or decreases in average outstanding balances of interest-earning assets and interest-bearing liabilities (volume), and the changes related to increases or decreases in average interest rates on such assets and liabilities (rate). Changes attributable to both volume and rate have been allocated proportionately. Results, on a taxable equivalent basis, are as follows in this Volume Rate Analysis table for the years ended December 31, (dollars in thousands):

 

     2006 vs. 2005 Increase (Decrease) Due to Change
in:
    2005 vs. 2004 Increase (Decrease) Due to Change
in:
 
     Volume     Rate     Total     Volume     Rate    Total  

Earning Assets:

             

Securities:

             

Taxable

   $ 1,744     $ 348     $ 2,092     $ (233 )   $ 315    $ 82  

Tax-exempt

     1,065       (196 )     869       (400 )     28      (372 )
                                               

Total securities

     2,809       152       2,961       (633 )     343      (290 )

Loans, net

     12,398       11,284       23,682       13,653       7,322      20,975  

Loans held for sale

     (864 )     69       (795 )     274       176      450  

Federal funds sold

     400       689       1,089       51       196      247  

Money market investments

     1       —         1       —         1      1  

Interest-bearing deposits in other banks

     (20 )     28       8       (22 )     42      20  

Other interest-bearing deposits

     1       47       48       16       32      48  
                                               

Total earning assets

   $ 14,725     $ 12,269     $ 26,994     $ 13,339     $ 8,112    $ 21,451  
                                               

Interest Bearing Liabilities:

             

Interest-bearing deposits:

             

Checking

   $ 19     $ 188     $ 207     $ 71     $ 145    $ 216  

Money market savings

     (223 )     994       771       321       1,298      1,619  

Regular savings

     (22 )     85       63       43       229      272  

Certificates of deposit:

             

$100,000 and over

     5,426       2,750       8,176       2,486       359      2,845  

Under $100,000

     1,372       3,233       4,605       408       519      927  
                                               

Total interest-bearing deposits

     6,572       7,250       13,822       3,329       2,550      5,879  

Other borrowings

     2,028       3,624       5,652       561       875      1,436  
                                               

Total interest-bearing liabilities

     8,600       10,874       19,474       3,890       3,425      7,315  
                                               

Change in net interest income

   $ 6,125     $ 1,395     $ 7,520     $ 9,449     $ 4,687    $ 14,136  
                                               

Interest Sensitivity

An important element of earnings performance and the maintenance of sufficient liquidity is proper management of the interest sensitivity gap and liquidity gap. The interest sensitivity gap is the difference between interest-sensitive assets and interest-sensitive liabilities in a specific time interval. This gap can be managed by re-pricing assets or liabilities, which are variable rate instruments, by replacing an asset or liability at maturity or by adjusting the interest rate during the life of the asset or liability. Matching the amounts of assets and liabilities maturing in the same time interval helps to hedge interest rate risk and to minimize the impact of rising or falling interest rates on net interest income.

The Company determines the overall magnitude of interest sensitivity risk and then formulates policies and practices governing asset generation and pricing, funding sources and pricing, and off-balance sheet commitments. These decisions are based on management’s expectations regarding future interest rate movements, the state of the national, regional and local economy, and other financial and business risk factors. The Company uses computer simulation modeling to measure and monitor the effect of various interest rate scenarios and business strategies on net interest income. This modeling reflects interest rate changes and the related impact on net interest income and net income over specified time horizons.

At December 31, 2006 and 2005, the Company was in an asset sensitive position. As described in the table below, management’s simulation model indicates net interest income will increase as rates increase. An asset sensitive company generally will be impacted favorably by increasing interest rates while a

 

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liability-sensitive company’s net interest margin and net interest income generally will be impacted favorably by declining interest rates. Although the static gap report indicates $193.1 million and $56.5 million at December 31, 2006 and 2005, respectively, more liabilities than assets re-pricing within one year, computer simulation modeling shows the Company’s net interest income tends to increase when interest rates rise and fall when interest rates decline. The explanation for this is that interest rate changes affect bank products differently. For example, if the prime rate changes by 1.00% (100 basis points or bps), the change on certificates of deposit may only be 0.75% (75 bps), while other interest bearing deposit accounts may only change 0.10% (10 bps). Also, despite their fixed terms, loan products are often refinanced as rates decline, but rarely refinanced as rates rise. Assets and liabilities re-price throughout the year resulting in changes in the earning asset rate, the cost of funds rate, and the net interest margin.

Earnings Simulation Analysis

Management uses simulation analysis to measure the sensitivity of net interest income to changes in interest rates. The model calculates an earnings estimate based on current and projected balances and rates. This method is subject to the accuracy of the assumptions that underlie the process, but it provides a better analysis of the sensitivity of earnings to changes in interest rates than other analysis, such as the static gap analysis discussed above.

Assumptions used in the model are derived from historical trends and management’s outlook and include loan and deposit growth rates and projected yields and rates. Such assumptions are monitored and periodically adjusted as appropriate. All maturities, calls and prepayments in the securities portfolio are assumed to be reinvested in like instruments. Mortgage loans and mortgage backed securities prepayment assumptions are based on industry estimates of prepayment speeds for portfolios with similar coupon ranges and seasoning. Different interest rate scenarios and yield curves are used to measure the sensitivity of earnings to changing interest rates. Interest rates on different asset and liability accounts move differently when the prime rate changes and are reflected in the different rate scenarios.

The Company uses its simulation model to estimate earnings in rate environments where rates ramp up or down around a “most likely” rate scenario, based on implied forward rates. The analysis assesses the impact on net interest income over a 12 month time horizon by applying 12 month rate ramps (with interest rates rising gradually versus an immediate increase or “shock” in rates) of 50 basis points up to 200 basis points. The following table represents the interest rate sensitivity on net interest income for the Company across the rate paths modeled for the year ended December 31, 2006 (dollars in thousands):

 

     Change In Net Interest Income  
     %     $  

Change in Yield Curve:

    

+200 basis points

   4.32 %   $ 3,481  

+50 basis points

   0.71 %     569  

Most likely rate scenario

   0.00 %     —    

-50 basis points

   -0.74 %     (598 )

-200 basis points

   -3.08 %     (2,478 )

Economic Value Simulation

Economic value simulation is used to calculate the estimated fair value of assets and liabilities over different interest rate environments. Economic values are calculated based on discounted cash flow analysis. The net economic value of equity is the economic value of all assets minus the economic value of all liabilities. The change in net economic value over different rate environments is an indication of the longer term earnings capability of the balance sheet. The same assumptions are used in the economic value simulation as in the earnings simulation. The economic value simulation uses instantaneous rate shocks to the balance sheet where the earnings simulation uses rate ramps over 12 months. The following chart reflects the estimated change in net economic value over different rate environments using economic value simulation (dollars in thousands):

 

     Change In Economic Value Of Equity  
     %     $  

Change in Yield Curve:

    

+200 basis points

   -2.95 %   $ (10,505 )

+50 basis points

   -0.69 %     (2,459 )

Most likely rate scenario

   0.00 %     —    

-50 basis points

   -0.15 %     (518 )

-200 basis points

   -2.26 %     (8,046 )

 

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Noninterest Income

For the year ended December 31, 2006 compared to the same period in 2005, noninterest income increased $2.7 million, or 10.7%, from $25.5 million to $28.2 million. This increase was driven by increases in other service charges and commissions and fees (brokerage commissions, ATM charges, and debit card income) of $2.0 million, bank-owned life insurance (“BOLI”) income of $507 thousand, insurance proceeds of $328 thousand and Small Business Investment Company (“SBIC”) income of $150 thousand, coupled with increased gains on sales of real estate and securities of $837 thousand and $662 thousand, respectively. These increases were partially offset by reduced gains on loan sales within the mortgage segment of $1.7 million. Prosperity noninterest income was $396 thousand since acquisition.

For the year ended December 31, 2005 noninterest income increased by $2.2 million, or 9.5%, from $23.3 in 2004 to $25.5 million. This increase was largely due to a $1.1 million, or 9.6% increase in gains on the sale of loans which grew to $13 million for the year. Mortgage loan originations increased 12.2%, or $60.6 million driving the increased gains on loan sales. Additionally, other service charges and fees increased $929 thousand, or 27% from $3.4 million to $4.4 million. This increase is principally due to income received from debit cards (due to increased acceptance), letters of credit, exchange fees and brokerage commissions from Union Investment Services, Inc. Service charges on deposit accounts decreased $36 thousand, but contributed $6.8 million for the year ended December 31, 2005. Other operating income increased $197 thousand or 17.4%, including income from Bay Community Bank’s investment in Johnson Mortgage Company, LLC, of $92 thousand and an increase in cash surrender value of BOLI of $71 thousand.

Noninterest Expense

For the year ended December 31, 2006 compared to the same period in 2005, noninterest expenses increased $9.3 million, or 15.9%, from $58.3 million to $67.6 million. Salaries and benefits increased $4.1 million, or 12.2%, principally driven by additional employees, both new and acquired, normal compensation adjustments, profit sharing, and equity compensation expenses, offset to a lesser extent by lower mortgage commissions paid and reduced incentive compensation expenses. Prosperity’s noninterest expenses were $3.2 million since acquisition. Other operating expense was $20.4 million, up $3.8 million from $16.6 million in 2005.

Of the $3.8 million increase in operating expenses, $1.5 million relates to Prosperity since acquisition and includes conversion costs of approximately $263 thousand. The remaining $2.3 million resulted from communication costs, data processing fees, professional fees, marketing expenses, ATM processing fees, amortization of core deposit premiums and merger-related costs. These increases were partially offset by lower incurred losses relating to fraud compared to the fourth quarter of 2005. Additionally, occupancy expenses increased $858 thousand, while furniture and equipment expenses increased $576 thousand, mainly due to the expansion of the Company’s footprint.

 

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Noninterest expenses were up $7.1 million or 13.8% to $58.3 million in 2005, compared to $51.2 million in 2004. Salaries and benefits were $33.6 million in 2005, up $4.4 million or 15.2% compared to $29.1 million in 2004. The increase in salary and benefits is due to the opening of additional branches, hiring support staff, increased commissions in the mortgage segment related to increased loan production, as well as compensation adjustments. Other contributing factors include increased health insurance expense and increases in profit sharing expenses correlating to the improvements in net income. Occupancy expenses were at $4.1 million, up $721 thousand from 2004. The opening of two additional branches in the current year and a full year’s expense for the Guaranty branches, accounted for approximately $535 thousand of the increase in occupancy expense. Furniture and equipment expense was $3.9 million compared to $3.4 million in 2004. This increase of $483 thousand is due to the branch expansion efforts previously mentioned, software purchases and enhancements and additional equipment maintenance. Other operating expense was $16.6 million, up $1.4 million from $15.2 million in 2004.

Of the $1.4 million increase in operating expenses, approximately $527 thousand resulted from increased courier services, internet activity and communication activity with customers, $465 thousand in other bank losses related primarily to customer fraud activity, $304 thousand from media and advertising campaigns, $213 thousand related to amortizing additional core deposit intangibles related to the Guaranty acquisition, $196 thousand from increased directors’ fees as the compensation structure was modified in May 2005, and $181 thousand was from increased ATM processing and placement of additional ATM machines within the Company’s existing footprint. An additional $112 thousand was due to data processing costs related to increased activity in the bankcard department. Other expense increases relate to training and seminars of $100 thousand, as well as mileage reimbursement of $75 thousand. These expenses were offset by lower data processing costs of $445 thousand and conversion charges of $326 thousand both relating to the Guaranty acquisition in 2004.

SEGMENT INFORMATION

Community Bank Segment

For the year ended December 31, 2006 compared to the same period in 2005, net income for the community banking segment increased $2.2 million, or 9.1%, from $23.7 million to $25.9 million. Net interest income increased an additional $8.0 million, or 11.7%, mainly driven by increases in asset yields resulting from rising interest rates and loan growth. The interest rate spread compressed 20 basis points due to increases in high interest-bearing liability products and borrowings (e.g. certificates of deposit greater than $100 thousand and Federal Home Loan Bank of Atlanta (“FHLB”) advances), partially offsetting the increase in interest income. The provision for loan losses increased $278 thousand over the same period, principally driven by loan growth. Noninterest income increased $4.5 million, or 35.4%, principally due to increases in commissions and fees, more gains on the sale of real estate and securities, and income from both SBIC and BOLI. Noninterest expense increased $10.1 million, or 21.8%, mainly driven by increases in salaries and benefits, the Company’s continued execution of its growth strategy, all of which required increases in costs such as communication, amortization of core deposit premiums, data processing, professional fees, and marketing and merger-related expenses. These increases were partially offset by lower fraud losses and reduced marketing expenses from those recorded during the fourth quarter of 2005.

Mortgage Segment

For the year ended December 31, 2006 compared to the same period in 2005, net income for the mortgage segment decreased $992 thousand, or 87.8%, from $1.1 million to $138 thousand. Net interest income decreased $672 thousand, or 74.9%, from $897 thousand to $225 thousand as interest margins tightened. Loan originations decreased $72.1 million, or 12.9%, from $556.8 million to $484.7 million, which in turn decreased revenue for the sale of loans by $1.7 million, or 13.1%, and was partially offset by lower commissions paid of $1.1 million. During 2006, interest rates were markedly higher than in the prior year, thereby delaying buyers from entering the housing market. Though interest rates returned to previously low levels by the end of the fourth quarter, any resulting

 

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gains in originations are expected to be realized in the coming year. In addition, housing inventory in the Company’s primary markets increased significantly from the prior period as property appreciation decelerated, leading to increased consumer uncertainty and fewer origination opportunities.

BALANCE SHEET

Balance Sheet Overview

As of December 31, 2006, total assets were $2.1 billion compared to $1.8 billion as of December 31, 2005. Total assets acquired in connection with Prosperity were $128.2 million. Securities available for sale increased $36.8 million, or 15.0%, to $282.8 million from December 31, 2005. Gross loans increased $187.2 million, or 13.7% to $1.5 billion from December 31, 2005. Loan growth was concentrated in the commercial real estate and construction portfolios and included $76.5 million (primarily commercial real estate) acquired from Prosperity. Deposits increased $209.4 million, or 14.4% to $1.7 billion from December 31, 2005. Deposit growth was mainly concentrated in certificates of deposit and included $111.4 million acquired from Prosperity. The Company’s capital position remained strong – the equity to assets ratio was 9.53%.

The following table presents the Company’s contractual obligations and scheduled payment amounts due at the various intervals over the next five years and beyond as of December 31, 2006 (dollar in thousands):

 

     Total    Less than 1
year
   1-3 years    4-5 years    More than 5
years

Long-term debt

   $ 149,160    $ —      $ 51,850    $ 32,000    $ 65,310

Operating leases

     7,732      1,592      3,931      1,648      561

Repurchase agreements

     62,696      62,696      —        —        —  
                                  

Total contractual obligations

   $ 219,588    $ 64,288    $ 55,781    $ 33,648    $ 65,871
                                  

For more information pertaining to the previous table, reference Note 5 “Bank Premise and Equipment” and Note 8 “Borrowings” in the “Notes to the Consolidated Financial Statements”.

Loan Portfolio

As of December 31, 2006 compared to December 31, 2005, loans, net of unearned income increased $187.2 million, or 13.7%, to $1.5 billion from $1.4 billion. Excluding the acquired portfolio of Prosperity, the increase in loans, net of unearned income, increased $111.5 million or 8.2%. Of the acquired portfolio of approximately $76 million, 64% or $49 million consisted of mortgage loans secured by real estate. At December 31, 2006, loans secured by real estate continue to represent the Company’s largest category, comprising 79.2% of the total loan portfolio. At December 31, 2006, residential 1-4 family loans, not including home equity lines, comprised 17.0% of total loans and decreased $8.0 million, or 2.9% compared to the prior year. At December 31, 2006, mortgage loans secured by commercial real estate comprised 29.0% of the total loans, and increased $54.6 million, or 13.9% compared to the prior year. Excluding the Prosperity acquisition, the total increase in mortgages secured by commercial real estate would have been $5.6 million or 1.4%. These consist of income producing properties, as well as commercial and industrial loans where real estate constitutes a secondary source of collateral. At December 31, 2006, real estate construction loans accounted for 20.9% of total loans.

Commercial business loans increased $9.5 million in 2006, due largely to the acquired portfolio from Prosperity. Excluding the acquired portfolio, this category declined approximately 5.1%. Commercial business loans comprised 8.8% of total loans at the end of 2006, down from 9.3% at the end of 2005. The Company’s consumer loan portfolio consists principally of installment loans. Such loans to individuals for household, family and other personal expenditures totaled 10.6% of total loans at December 31, 2006, up from 10.0% in 2005. Loans to the agricultural industry totaled less than 1.0% of the loan portfolio in each of the last five years.

 

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The following table presents the composition of the Company’s loans, net of unearned income and as a percentage of the Company’s total gross loans as of December 31, (dollars in thousands):

 

     2006     2005     2004     2003     2002  

Mortgage loans on real estate:

                         

Residential 1-4 family

   $ 263,770    17.0 %   $ 271,721    19.9 %   $ 270,341    21.4 %   $ 211,162    24.0 %   $ 172,582    24.1 %

Commercial

     448,691    29.0 %     394,094    28.9 %     368,816    29.2 %     239,804    27.3 %     200,125    28.0 %

Construction

     324,606    20.9 %     273,262    20.1 %     221,190    17.5 %     105,417    12.0 %     85,335    11.9 %

Second mortgages

     35,584    2.3 %     24,088    1.8 %     18,017    1.4 %     16,288    1.9 %     17,845    2.5 %

Equity lines of credit

     112,079    7.2 %     96,490    7.1 %     90,042    7.1 %     48,034    5.5 %     32,320    4.5 %

Multifamily

     29,263    1.9 %     14,648    1.1 %     18,287    1.4 %     11,075    1.3 %     3,066    0.4 %

Agriculture

     12,903    0.8 %     11,145    0.8 %     5,530    0.4 %     6,745    0.8 %     4,466    0.6 %
                                                                 

Total real estate loans

     1,226,896    79.2 %     1,085,448    79.7 %     992,223    78.4 %     638,525    72.7 %     515,739    72.1 %

Commercial Loans

     136,617    8.8 %     127,048    9.3 %     135,907    10.7 %     112,760    12.8 %     78,289    11.0 %

Consumer installment loans

                         

Personal

     153,865    9.9 %     126,174    9.3 %     113,841    9.0 %     110,285    12.6 %     102,528    14.3 %

Credit cards

     9,963    0.6 %     9,388    0.7 %     8,655    0.7 %     7,004    0.8 %     5,350    0.7 %
                                                                 

Total consumer installment loans

     163,828    10.6 %     135,562    10.0 %     122,496    9.7 %     117,289    13.4 %     107,878    15.1 %

All other loans

     22,104    1.4 %     14,196    1.0 %     14,219    1.1 %     9,719    1.1 %     12,964    1.8 %
                                                                 

Gross loans

     1,549,445    100.0 %     1,362,254    100.0 %     1,264,845    100.0 %     878,293    100.0 %     714,870    100.0 %

Less unearned income on loans

     —          —          4        26        106   
                                             

Loans, net of unearned income

   $ 1,549,445      $ 1,362,254      $ 1,264,841      $ 878,267      $ 714,764   
                                             

The following table presents the remaining maturities and type of rate (variable or fixed) on commercial and real estate constructions loans as of December 31, 2006 (dollars in thousands):

 

               Variable Rate    Fixed Rate
     Total
Maturities
   Less than 1
year
   Total    1-5 years    More than 5
years
   Total    1-5 years    More than 5
years

Real Estate Construction

   $ 324,606    $ 308,121    $ 5,870    $ 5,730    $ 140    $ 10,615    $ 7,293    $ 3,322

Commercial

   $ 136,617    $ 72,675    $ 4,709    $ 3,772    $ 937    $ 59,233    $ 52,388    $ 6,845

The Company is focused on providing community-based financial services and discourages the origination of portfolio loans outside of its principal trade area. The Company maintains a policy not to originate or purchase loans to foreign entities or loans classified by regulators as highly leveraged transactions. To manage the growth of the real estate loans in the loan portfolio, facilitate asset/liability management and generate additional fee income, the Company sells a portion of conforming first mortgage residential real estate loans to the secondary market as they are originated. Union Mortgage serves as a mortgage brokerage operation, selling the majority of its loan production in the secondary market or selling loans to the Community Banks that meet the banks’ current asset/liability management needs. This venture has provided the Community Banks’ customers with enhanced mortgage products and the Company with improved efficiencies through the consolidation of this function.

Asset Quality (Allowance of Loan Losses and Nonperforming Assets)

The allowance for loan losses represents management’s estimate of the amount adequate to provide for potential losses inherent in the loan portfolio. The Company’s management has established an allowance for loan losses which it believes is adequate for the risk of loss inherent in the loan portfolio. Among other factors, management considers the Company’s historical loss experience, the size and composition of the loan portfolio, the value and adequacy of collateral and guarantors, non-performing credits and current and anticipated economic conditions. There are additional risks of future loan losses, which cannot be precisely quantified or attributed to particular loans or classes of loans. Because those risks include general economic trends, as well as conditions affecting individual borrowers, the allowance for loan losses is an estimate. The allowance is also 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 size of the allowance in comparison to peer companies identified by regulatory agencies.

For the year ended December 31, 2006, the allowance for loan losses was $19.1 million or 1.24% of total loans as compared to $17.1 million, or 1.26% in 2005. For the year ended December 31, 2006 compared to the same period in 2005, provision for loan losses increased $278 thousand from $1.2 million to $1.5

 

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million ($20 thousand resulted from the Prosperity acquisition). Gross loans grew $187.2 million, or 13.7% and compares to the allowance for loan loss growth rate of 11.9% when compared to the December 31, 2005. Net charge-offs were $203 thousand for the twelve months ended December 31, 2006 compared to net charge-offs of $440 thousand in the same periods for 2005. For the years ended December 31, 2006 and 2005, the Company collected $464 thousand and $311 thousand of foregone interest, respectively, which was excluded from the net interest margin calculation.

The following table rolls forward the allowance for loan losses over the past five years ended December 31, (dollars in thousands):

 

     2006     2005     2004     2003     2002  

Balance, beginning of year

   $ 17,116     $ 16,384     $ 11,519     $ 9,179     $ 7,336  

Allowance from acquired bank

     785       —         2,040       —         —    

Loans charged-off:

          

Commercial

     22       25       167       77       310  

Real estate

     —         6       5       1       —    

Consumer

     600       809       1,002       877       1,271  
                                        

Total loans charged-off

     622       840       1,174       955       1,581  
                                        

Recoveries:

          

Commercial

     102       43       1,388       684       245  

Real estate

     —         —         42       —         33  

Consumer

     317       357       415       304       268  
                                        

Total recoveries

     419       400       1,845       988       546  
                                        

Net charge-offs (recoveries)

     203       440       (671 )     (33 )     1,035  

Provision for loan losses

     1,450       1,172       2,154       2,307       2,878  
                                        

Balance, end of year

   $ 19,148     $ 17,116     $ 16,384     $ 11,519     $ 9,179  
                                        

Allowance for loan losses to loans

     1.24 %     1.26 %     1.30 %     1.31 %     1.28 %

Net charge-offs (recoveries) to average loans

     0.01 %     0.03 %     -0.06 %     0.00 %     0.16 %

The following table shows an allocation among loan categories based upon analysis of the loan portfolio’s composition, historical loan loss experience, and other factors, as well as, the ratio of the related outstanding loan balances to total loans as of December 31, (dollars in thousands).

 

     2006     2005     2004     2003     2002  
     $    % (1)     $    % (1)     $    % (1)     $    % (1)     $    % (1)  

Commercial, financial and agriculture

   $ 4,523    8.9 %   $ 4,320    9.3 %   $ 4,971    10.8 %   $ 4,500    12.9 %   $ 3,249    11.1 %

Real estate construction

   $ 10,635    20.9 %     9,229    20.1 %     7,998    17.5 %     4,176    12.0 %     3,492    11.9 %

Real estate mortgage

   $ 605    58.2 %     541    59.7 %     518    61.0 %     493    60.7 %     426    60.2 %

Consumer & other

   $ 3,385    11.9 %     3,026    10.9 %     2,897    10.7 %     2,350    14.4 %     2,012    16.8 %
                                                                 

Total

   $ 19,148    100.0 %   $ 17,116    100.0 %   $ 16,384    100.0 %   $ 11,519    100.0 %   $ 9,179    100.0 %
                                             

(1) The percent represents the loan balance divided by total loans

The Company’s asset quality remains good. Management maintains a list of loans that have potential weaknesses that may need special attention. This list is used to monitor such loans and is used in the determination of the adequacy of the Company’s allowance for loan losses. At December 31, 2006, nonperforming assets totaled $10.9 million, including a single credit relationship totaling $10.6 million in loans. The loans to this relationship are secured by real estate (two assisted living facilities and other real estate). Based on the information currently available, management has allocated $1.3 million in specific reserves to this relationship. The Company entered into a workout agreement with the borrower in March 2004. Under the terms of the agreement, the Company extended further credit secured by additional property with significant equity. The Company continues to have constructive dialogue with the borrower towards resolution of the affiliated loans; however, bankruptcy filings in 2005 by some affiliates of the borrower delayed the accomplishment

 

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of targeted actions. The Company continues to anticipate that this workout will ultimately result in a reduction of the Company’s overall exposure to the borrower. During the first quarter of 2006, a comprehensive Loan Modification Agreement was signed and the Company believes it has improved its overall collateral position. The Company remains cautious, however, and has not yet reduced allocated reserves due to uncertainties about the borrower’s ability to meet agreed upon progress targets.

The following table presents a five-year comparison of nonperforming assets as of December 31, (dollars in thousands):

 

     2006     2005     2004     2003     2002  

Nonaccrual loans

   $ 10,873     $ 11,255     $ 11,169     $ 9,174     $ 136  

Foreclosed properties

     —         —         14       444       774  
                                        

Total nonperforming assets

   $ 10,873     $ 11,255     $ 11,183     $ 9,618     $ 910  
                                        

Loans past due 90 days and accruing interest

   $ 208     $ 150     $ 822     $ 957     $ 896  
                                        

Nonperforming assets to loans, foreclosed properities & real estate investments

     0.70 %     0.83 %     0.88 %     1.09 %     0.13 %

Allowance for loan losses to nonaccrual loans

     176.11 %     152.07 %     146.69 %     125.56 %     6749.26 %

Securities Available for Sale

At December 31, 2006, the Company had securities available for sale, at fair value in the amount of $282.8 million, or 13.5% of total assets, as compared to $246.0 million, or 13.0% of total assets as of December 31, 2005. The Company seeks to diversify its portfolio to minimize risk and to maintain a large amount of securities issued by states and political subdivisions due to the tax benefits. It also focuses on purchasing mortgage-backed securities because of the reinvestment opportunities from the cash flows and the higher yield offered from these securities. The investment portfolio has a high percentage of municipals and mortgage-backed securities; therefore a higher taxable equivalent yield exists on the portfolio compared to its peers. The Company does not engage in structured derivative or hedging activities. The following table sets forth a summary of the securities available for sale, at fair value as of December 31, (dollar in thousands):

 

     2006    2005    2004

U.S. government and agency securities

   $ 9,829    $ 1,935    $ 8,020

Obligations of states and political subdivisions

     104,222      86,218      83,338

Corporate and other bonds

     27,202      40,779      38,673

Mortgage-backed securities

     130,610      106,706      92,923

Federal Reserve Bank stock

     3,097      2,213      2,153

Federal Home Loan Bank stock

     7,554      7,392      7,474

Other securities

     310      774      886
                    

Total securities available for sale, at fair value

   $ 282,824    $ 246,017    $ 233,467
                    

Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. The following table summarizes the contractual maturity of securities available for sale, at fair value and their weighted average yields as of December 31, 2006 (dollar in thousands):

 

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     1 Year or Less     1 - 5 Years     5 - 10 Years     Over 10 Years
and Equity
Securities
    Total  

U.S. government and agency securities:

          

Amortized cost

   $ 5,740     $ 4,233     $ —       $ —       $ 9,973  

Fair value

     5,674       4,155       —         —         9,829  

Weighted average yield (1)

     3.45 %     4.01 %     —         —         3.68 %

Mortgage backed securities:

          

Amortized cost

   $ —       $ 20,280     $ 40,484     $ 71,425     $ 132,189  

Fair value

     —         19,995       40,102       70,513       130,610  

Weighted average yield (1)

     —         4.55 %     4.89 %     4.91 %     4.85 %

Obligations of states and political subdivisions:

          

Amortized cost

   $ 3,904     $ 10,215     $ 41,920     $ 45,582     $ 101,621  

Fair value

     3,910       10,306       43,034       46,972       104,222  

Weighted average yield (1)

     5.01 %     4.98 %     4.91 %     4.45 %     4.71 %

Other securities:

          

Amortized cost

   $ 2,007     $ —       $ —       $ 34,673     $ 36,680  

Fair value

     2,000       —         —         36,163       38,163  

Weighted average yield (1)

     3.59 %     —         —         6.59 %     6.43 %

Total securities available for sale:

          

Amortized cost

   $ 11,651     $ 34,728     $ 82,404     $ 151,680     $ 280,463  

Fair value

     11,584       34,456       83,136       153,648       282,824  

Weighted average yield (1)

     4.00 %     4.61 %     4.90 %     5.16 %     4.97 %

(1) Yields on tax-exempt securities have been computed on a tax-equivalent basis.

Deposits

As of December 31, 2006, total deposits were $1.7 billion compared to $1.5 billion as of December 31, 2005. This growth was principally attributed to the acquisition of Prosperity, competitive pricing and increased interest rates, which resulted in both increases and composition swings from money markets and savings accounts to certificates of deposit greater than $100 thousand. Total deposits consist of noninterest-bearing demand deposits of $292.3 million or 17.5% and interest-bearing deposits of $1.4 billion or 82.5%.

As of December 31, 2006 compared to December 31, 2005, average interest-bearing deposits increased $157.8 million, or 14.0%, to $1.3 billion from $1.1 billion. Average money market and savings accounts decreased $12.5 million and $2.7 million, respectively, while time deposits of $100,000 and over and other time deposit accounts increased $127.8 million and $4.6 million, respectively. This composition swing was principally driven by rising interest rates, which in turn increased consumer demand on higher yielding products (i.e. time deposits of $100,000 and over). The average noninterest-bearing demand deposits increased by $38.5 million, or 15.7%, to $284.1 million year over year, primarily driven by the Prosperity acquisition. The Company has no brokered deposits.

The average deposits and rates paid for the past three years and maturities of certificates of deposit of $100,000 and over as of December 31, 2006 are as follows (dollars in thousands):

 

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     2006     2005     2004  
     Amount    Rate     Amount    Rate     Amount    Rate  

Noninterest-bearing demand deposits

   $ 284,094      $ 245,587      $ 196,520   

Interest-bearing deposits:

               

NOW accounts

     204,023      0.45 %     198,969      0.35 %     175,659    0.28 %

Money market accounts

     175,163      2.25 %     187,673      1.69 %     159,111    0.98 %

Savings accounts

     116,569      0.91 %     119,309      0.84 %     112,953    0.64 %

Time deposits of $100,000 and over

     387,023      4.55 %     259,185      3.64 %     190,506    3.46 %

Other time deposits

     405,930      3.99 %     365,758      3.17 %     352,589    3.03 %
                           

Total interest-bearing

     1,288,708      3.08 %     1,130,894      2.29 %     990,818    2.02 %
                           

Total average deposits

   $ 1,572,802      $ 1,376,481      $ 1,187,338   
                           
     Within 3
Months
   3 -6 Months     6 -12 Months    Over 12
Months
    Total    Percent Of
Total Deposits
 

Maturities of time deposits of $100,000 and over

   $ 119,618    $ 113,673     $ 175,664    $ 33,997     $ 442,953    26.59 %

Capital Resources

Capital resources represent funds, earned or obtained, over which financial institutions can exercise greater or longer control in comparison with deposits and borrowed funds. The adequacy of the Company’s capital is reviewed by management on an ongoing basis with reference to size, composition, and quality of the Company’s resources and consistency with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and to absorb potential losses, yet allow management to effectively leverage its capital to maximize return to shareholders.

The Federal Reserve, along with the OCC and the FDIC, have adopted capital guidelines to supplement the existing definitions of capital for regulatory purposes and to establish minimum capital standards. Specifically, the guidelines categorize assets and off-balance sheet items into four risk-weighted categories. The minimum ratio of qualifying total assets is 8.0%, of which 4.0% must be Tier 1 capital, consisting of common equity, retained earnings and a limited amount of perpetual preferred stock, less certain intangible items. The Company had a ratio of total capital to risk-weighted assets of 12.78% and 12.14% on December 31, 2006 and 2005, respectively. The Company’s ratio of Tier 1 capital to risk-weighted assets was 11.63% and 10.97% at December 31, 2006 and 2005, respectively, allowing the Company to meet the definition of “well-capitalized” for regulatory purposes. Both of these ratios exceeded the fully phased-in capital requirements in 2006 and 2005. The Company’s current strategic plan includes a targeted equity to asset ratio between 8% and 9%. As of December 31, 2006, that ratio was 9.53%.

In connection with the two most recent acquisitions, Prosperity and Guaranty, the Company has issued trust preferred capital notes to fund the cash portion of those acquisitions, collectively totaling $58.5 million. The total of the trust preferred capital notes currently qualify for Tier 1 capital of the Company for regulatory purposes.

The following summarizes the Company’s regulatory capital and related ratios over the past three years ended December 31, (dollars in thousands):

 

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     2006     2005     2004  

Tier 1 capital:

      

Common stock

   $ 17,716     $ 17,595     $ 17,488  

Surplus

     38,047       35,426       33,716  

Retained earnings

     142,168       124,531       106,460  
                        

Total equity

     197,931       177,552       157,664  

Plus: qualifying trust preferred capital notes

     58,500       22,500       22,500  

Less: core deposit intangibles/goodwill

     62,390       39,801       40,714  
                        

Total Tier 1 capital

     194,041       160,251       139,450  
                        

Tier 2 capital:

      

Allowance for loan losses

     19,148       17,116       16,384  
                        

Total Tier 2 capital

     19,148       17,116       16,384  
                        

Total risk-based capital

   $ 213,189     $ 177,367     $ 155,834  
                        

Risk-weighted assets

   $ 1,668,699     $ 1,460,607     $ 1,339,900  
                        

Capital ratios:

      

Tier 1 risk-based capital ratio

     11.63 %     10.97 %     10.41 %

Total risk-based capital ratio

     12.78 %     12.14 %     11.63 %

Leverage ratio (Tier 1 capital to average adjusted assets)

     9.57 %     9.09 %     8.60 %

Equity to total assets

     9.53 %     9.82 %     9.73 %

Commitments and off-balance sheet obligations

In the normal course of business, the Company is a party to financial instruments with off-balance sheet risk to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contractual amounts of these instruments reflect the extent of the Company’s involvement in particular classes of financial instruments. For more information pertaining to these commitments, reference Note 11 “Financial Instruments with Off-Balance Sheet Risk” in the “Notes to the Consolidated Financial Statements”.

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and letters of credit written is represented by the contractual amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Unless noted otherwise, the Company does not require collateral or other security to support off-balance sheet financial instruments with credit risk.

At December 31, 2006, Union Mortgage had rate lock commitments to originate mortgage loans amounting to $22.8 million and loans held for sale of $20.1 million. Union Mortgage has entered into corresponding mandatory commitments on a best-efforts basis to sell loans on a servicing released basis totaling approximately $42.9 million. These commitments to sell loans are designed to eliminate the mortgage company’s exposure to fluctuations in interest rates in connection with rate lock commitments and loans held for sale.

The following table represents the Company’s other commitments with balance sheet or off-balance sheet risk as of December 31, 2006 (dollars in thousands):

 

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     Amount

Commitments with off-balance sheet risk:

  

Commitments to extend credit (1)

   $ 688,804

Standby letters of credit

     32,603

Commitments to purchase securities

     —  

Mortgage loan rate lock commitments

     22,771
      

Total commitments with off-balance sheet risk

     744,178
      

Commitments with balance sheet risk:

  

Loans held for sale

     20,084
      

Total commitments with balance sheet risk

     20,084
      

Total other commitments

   $ 764,262
      

(1)    Includes unfunded overdraft protection.

  

Liquidity

Liquidity represents an institution’s ability to meet present and future financial obligations through either the sale or maturity of existing assets or the acquisition of additional funds through liability management. Liquid assets include cash, interest-bearing deposits with banks, money market investments, Federal funds sold, securities available for sale, loans held for sale and loans maturing or re-pricing within one year. Additional sources of liquidity available to the Company include its capacity to borrow additional funds when necessary through Federal funds lines with several correspondent banks and a line of credit with the FHLB. Management considers the Company’s overall liquidity to be sufficient to satisfy its depositors’ requirements and to meet its customers’ credit needs.

At December 31, 2006, cash and cash equivalents and securities classified as available for sale comprised 17.1% of total assets, compared to 17.3% at December 31, 2005. Asset liquidity is also provided by managing loan and securities maturities and cash flows.

Additional sources of liquidity available to the Company include its capacity to borrow additional funds when necessary. The Community Banks maintain Federal funds lines with several regional banks totaling approximately $56.7 million as of December 31, 2006. There was no outstanding balance under these lines as of December 31, 2006. The Company had outstanding borrowings pursuant to securities sold under agreements to repurchase transactions with a maturity of one day of $62.7 million as of December 31, 2006. Lastly, the Company had a line of credit with the FHLB for $576.1 million as of December 31, 2006. There was $88.9 million outstanding under this line at December 31, 2006.

NON GAAP MEASURES

SFAS No. 141, Business Combinations (“SFAS No. 141”), requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. Prior to the issuance of SFAS No. 141, the Company accounted for most of its acquisition activity using the pooling method of accounting. The acquisitions of Prosperity and Guaranty are the two business combinations accounted for using the purchase method of accounting. At December 31, 2006, core deposit intangible assets and goodwill totaled $12.3 million and $50.0, respectively, compared to $8.5 million and $31.3 million, respectively, in 2005.

In reporting the results of 2006 and 2005, the Company has provided supplemental performance measures on an operating or tangible basis. Such measures exclude amortization expense related to intangible assets, such as core deposit intangibles. The Company believes these measures are useful to investors as they exclude non-operating adjustments resulting from acquisition activity and allow investors to see the combined economic results of the organization. Cash basis operating earnings per share was $2.03 for the

 

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year ended December 31, 2006 compared to $1.93 in 2005. Cash basis return on average tangible equity and assets for the year ended December 31, 2006 was 20.31% and 1.40%, respectively, compared to 19.57% and 1.51%, respectively, in 2005.

These measures are a supplement to GAAP used to prepare the Company’s financial statements and should not be viewed as a substitute for GAAP measures. In addition, the Company’s non-GAAP measures may not be comparable to non-GAAP measures of other companies. The following table reconciles these non-GAAP measures from their respective GAAP basis measures for the years ended December 31, (dollars in thousands):

 

     2006     2005  

Net income

   $ 25,992     $ 24,822  

Plus: core deposit intangible amortization, net of tax

     1,090       792  
                

Cash basis operating earnings

     27,082       25,614  
                

Average assets

     1,998,068       1,738,005  

Less: average goodwill

     45,360       31,227  

Less: average core deposit intangibles

     11,863       9,112  
                

Average tangible assets

     1,940,845       1,697,666  
                

Average equity

     190,560       171,221  

Less: average goodwill

     45,360       31,227  

Less: average core deposit intangibles

     11,863       9,112  
                

Average tangible equity

   $ 133,337     $ 130,882  
                

Weighted average shares outstanding, diluted

     13,361,773       13,275,074  

Cash basis earnings per share, diluted

   $ 2.03     $ 1.93  

Cash basis return on average tangible assets

     1.40 %     1.51 %

Cash basis return on average tangible equity

     20.31 %     19.57 %

 

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QUARTERLY RESULTS

The following table presents the Company’s quarterly performance for the years ended December 31, 2006 and 2005 (dollars in thousands, except per share amounts):

 

     First    Second    Third    Fourth    Total

For the Year of 2006

                        

Interest and dividend income

   $  28,290    $  32,347    $  34,169    $  34,350    $  129,156

Interest expense

     10,242      12,378      14,404      15,417      52,441
                                  

Net interest income

     18,048      19,969      19,765      18,933      76,715

Provision for loan losses

     538      273      485      154      1,450
                                  

Net interest income after provision for loan losses

     17,510      19,696      19,280      18,779      75,265

Noninterest income

     6,975      6,907      7,019      7,344      28,245

Noninterest expenses

     15,620      17,209      17,441      17,297      67,567
                                  

Income before income taxes

     8,865      9,394      8,858      8,826      35,943

Income tax expense

     2,557      2,681      2,330      2,383      9,951
                                  

Net income

   $ 6,308    $ 6,713    $ 6,528    $ 6,443    $ 25,992
                                  

Earnings per share, basic

   $ 0.48    $ 0.51    $ 0.49    $ 0.49    $ 1.97

Earnings per share, diluted

   $ 0.47    $ 0.50    $ 0.49    $ 0.48    $ 1.94

For the Year of 2005

                        

Interest and dividend income

   $ 23,432    $ 24,888    $ 26,437    $ 27,560    $ 102,317

Interest expense

     7,141      7,866      8,517      9,443      32,967
                                  

Net interest income

     16,291      17,022      17,920      18,117      69,350

Provision for loan losses

     332      135      430      275      1,172
                                  

Net interest income after provision for loan losses

     15,959      16,887      17,490      17,842      68,178

Noninterest income

     5,348      7,017      7,287      5,858      25,510

Noninterest expenses

     13,470      14,494      14,816      15,495      58,275
                                  

Income before income taxes

     7,837      9,410      9,961      8,205      35,413

Income tax expense

     2,384      2,798      3,078      2,331      10,591
                                  

Net income

   $ 5,453    $ 6,612    $ 6,883    $ 5,874    $ 24,822
                                  

Earnings per share, basic

   $ 0.41    $ 0.50    $ 0.53    $ 0.45    $ 1.89

Earnings per share, diluted

   $ 0.41    $ 0.50    $ 0.52    $ 0.44    $ 1.87

ITEM 7A. —QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

This information is incorporated herein by reference from Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Form 10-K.

 

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ITEM 8.—FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

LOGO

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders

Union Bankshares Corporation

Bowling Green, Virginia

We have audited the accompanying consolidated balance sheets of Union Bankshares Corporation and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2006. We also have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that Union Bankshares Corporation and subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control— Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Union Bankshares Corporation and subsidiaries’ management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements, an opinion on management’s assessment, and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audits. We did not audit the financial statements of Union Mortgage Group, Inc. (formerly Mortgage Capital Investors, Inc.), a consolidated subsidiary, for the year ended December 31, 2004, which reflects total revenue constituting 13% of the related consolidated total. That statement was audited by other auditors whose report has been furnished to us, and our opinion for 2004, insofar as it relates to the amounts included for Union Mortgage Group, Inc., is based solely on the report of the other auditors.

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 audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits and the report of the other auditors provide a reasonable basis for our opinions.

 

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A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, based on our audits and the report of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Union Bankshares Corporation and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, based on our audit, management’s assessment that Union Bankshares Corporation and subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Furthermore, in our opinion, based on our audit, Union Bankshares Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

LOGO

Winchester, Virginia

February 28, 2007

 

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UNION BANKSHARES CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

AS OF DECEMBER 31, 2006 AND 2005

(Dollars in thousands, except share amounts)

 

     2006    2005

ASSETS

     

Cash and cash equivalents:

     

Cash and due from banks

   $ 55,511    $ 47,731

Interest-bearing deposits in other banks

     950      578

Money market investments

     322      94

Other interest-bearing deposits

     2,598      2,598

Federal funds sold

     16,509      18,537
             

Total cash and cash equivalents

     75,890      69,538
             

Securities available for sale, at fair value

     282,824      246,017
             

Loans held for sale

     20,084      28,068
             

Loans, net of unearned income

     1,549,445      1,362,254

Less allowance for loan losses

     19,148      17,116
             

Net loans

     1,530,297      1,345,138
             

Bank premises and equipment, net

     63,461      45,332

Core deposit intangibles, net

     12,341      8,504

Goodwill

     50,049      31,297

Other assets

     57,945      51,064
             

Total assets

   $ 2,092,891    $ 1,824,958
             

LIABILITIES

     

Noninterest-bearing demand deposits

   $ 292,262    $ 258,085

Interest-bearing deposits:

     

NOW accounts

     212,328      197,888

Money market accounts

     165,202      178,346

Savings accounts

     107,163      117,046

Time deposits of $100,000 and over

     442,953      333,709

Other time deposits

     446,000      371,441
             

Total interest-bearing deposits

     1,373,646      1,198,430
             

Total deposits

     1,665,908      1,456,515
             

Securities sold under agreements to repurchase

     62,696      60,828

Other short-term borrowings

     —        42,600

Trust preferred capital notes

     60,310      23,196

Long-term borrowings

     88,850      47,000

Other liabilities

     15,711      15,461
             

Total liabilities

     1,893,475      1,645,600
             

Commitments and contingencies

     

STOCKHOLDERS’ EQUITY

     

Common stock, $1.33 par value, shares authorized 36,000,000; issued and outstanding, 13,303,520 shares at December 31, 2006 and 13,195,987 shares at December 31, 2005

     17,716      17,595

Surplus

     38,047      35,426

Retained earnings

     142,168      124,531

Accumulated other comprehensive income

     1,485      1,806
             

Total stockholders’ equity

     199,416      179,358
             

Total liabilities and stockholders’ equity

   $ 2,092,891    $ 1,824,958
             

See accompanying notes to consolidated financial statements.

 

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UNION BANKSHARES CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004

(Dollars in thousands, except per share amounts)

 

     2006    2005    2004

Interest and dividend income:

        

Interest and fees on loans

   $ 113,392    $ 90,355    $ 68,738

Interest on Federal funds sold

     1,438      349      102

Interest on deposits in other banks

     57      49      29

Interest on money market investments

     3      2      1

Interest on other interest-bearing deposits

     129      81      33

Interest and dividends on securities:

        

Taxable

     9,883      7,791      7,709

Nontaxable

     4,254      3,690      3,932
                    

Total interest and dividend income

     129,156      102,317      80,544
                    

Interest expense:

        

Interest on deposits

     39,729      25,908      20,029

Interest on Federal funds purchased

     1,256      171      146

Interest on short-term borrowings

     4,168      1,842      551

Interest on long-term borrowings

     7,288      5,046      4,926
                    

Total interest expense

     52,441      32,967      25,652
                    

Net interest income

     76,715      69,350      54,892

Provision for loan losses

     1,450      1,172      2,154
                    

Net interest income after provision for loan losses

     75,265      68,178      52,738
                    

Noninterest income:

        

Service charges on deposit accounts

     7,186      6,790      6,826

Other service charges, commissions and fees

     6,009      4,360      3,431

Gains on securities transactions, net

     688      26      49

Gains on sales of loans

     11,277      12,973      11,836

Gains on sales of other real estate owned and bank premises, net

     870      33      29

Other operating income

     2,215      1,328      1,131
                    

Total noninterest income

     28,245      25,510      23,302
                    

Noninterest expenses:

        

Salaries and benefits

     37,635      33,556      29,128

Occupancy expenses

     5,006      4,148      3,427

Furniture and equipment expenses

     4,503      3,927      3,444

Other operating expenses

     20,423      16,644      15,222
                    

Total noninterest expenses

     67,567      58,275      51,221
                    

Income before income taxes

     35,943      35,413      24,819

Income tax expense

     9,951      10,591      6,894
                    

Net income

   $ 25,992    $ 24,822    $ 17,925
                    

Earnings per share, basic

   $ 1.97    $ 1.89    $ 1.42
                    

Earnings per share, diluted

   $ 1.94    $ 1.87    $ 1.41
                    

See accompanying notes to consolidated financial statements.

 

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UNION BANKSHARES CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004

(Dollars in thousands, except share amounts)

 

     Common
Stock
    Surplus     Retained
Earnings
   

Accumulated
Other
Comprehensive
Income

(Loss)

   

Comprehensive
Income

(Loss)

    Total  

Balance—December 31, 2003

   $ 15,254     $ 2,401     $ 94,102     $ 6,744       $ 118,501  

Comprehensive income:

            

Net income

         17,925       $ 17,925       17,925  

Unrealized holding losses arising during the period (net of tax, $871)

             (1,618 )  

Reclassification adjustment for gains included in net income (net of tax, $17)

             (32 )  
                  

Other comprehensive loss (net of tax, $888)

           (1,650 )     (1,650 )     (1,650 )
                  

Total comprehensive income

           $ 16,275    
                  

Cash dividends—2004 ($.45 per share)

         (5,567 )         (5,567 )

Issuance of common stock under Dividend Reinvestment Plan (28,017 shares)

     37       529             566  

Issuance of common stock under Incentive Stock Option Plan (83,379 shares)

     134       860             994  

Issuance of common stock for services rendered (13,362 shares)

     17       292             309  

Issuance of common stock in exchange for net assets in acquisition (1,534,134 shares)

     2,046       29,634             31,680  
                                          

Balance—December 31, 2004

     17,488       33,716       106,460       5,094         162,758  

Comprehensive income:

            

Net income

         24,822       $ 24,822       24,822  

Unrealized holding losses arising during the period (net of tax, $1,762)

             (3,271 )  

Reclassification adjustment for gains included in net income (net of tax, $9)

             (17 )  
                  

Other comprehensive loss (net of tax, $1,771)

           (3,288 )     (3,288 )     (3,288 )
                  

Total comprehensive income

           $ 21,534    
                  

Cash dividends—2005 ($.52 per share)

         (6,751 )         (6,751 )

Tax benefit from exercise of stock awards

       169             169  

Accelerated vesting of stock options

       64             64  

Award of performance stock grants

       48             48  

Unearned compensation on nonvested stock, net of amortization

       (157 )           (157 )

Issuance of common stock under Dividend Reinvestment Plan (29,391 shares)

     40       683             723  

Issuance of common stock under Incentive Stock Option Plan (28,833 shares)

     38       330             368  

Issuance of common stock for services rendered (13,505 shares)

     18       392             410  

Issuance of nonvested stock under Incentive Stock Option Plan (7,995 shares)

     11       181             192  
                                          

Balance—December 31, 2005

     17,595       35,426       124,531       1,806         179,358  

Comprehensive income:

            

Net income

         25,992       $ 25,992       25,992  

Unrealized holding losses arising during the period (net of tax, $68)

             126    

Reclassification adjustment for gains on securities sold included in net income (net of tax, $241)

             (447 )  
                  

Other comprehensive loss (net of tax, $173)

           (321 )     (321 )     (321 )
                  

Total comprehensive income

           $ 25,671    
                  

Cash dividends—2006 ($.63 per share)

         (8,345 )         (8,345 )

Tax benefit from exercise of stock awards

       182             182  

Cash paid for fractional shares (206 shares)

         (10 )         (10 )

Issuance of common stock under Dividend Reinvestment Plan (33,194 shares)

     44       874             918  

Issuance of common stock under Incentive Stock Option Plan (47,466 shares)

     63       653             716  

Issuance of common stock for services rendered (18,302 shares)

     24       540             564  

SFAS No. 123R implementation adjustment

     (10 )     10             —    

Stock-based compensation expense

       362             362  
                                          

Balance—December 31, 2006

   $ 17,716     $ 38,047     $ 142,168     $ 1,485       $ 199,416  
                                          

See accompanying notes to consolidated financial statements.

 

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UNION BANKSHARES CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004

(Dollars in thousands)

 

     2006     2005     2004  

Operating activities:

      

Net income

   $ 25,992     $ 24,822     $ 17,925  

Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:

      

Depreciation and amortization of bank premises and equipment

     3,904       3,396       2,994  

Amortization, net

     2,397       1,556       1,679  

Provision for loan losses

     1,450       1,172       2,154  

Gains on the sale of investment securities

     (688 )     (26 )     (49 )

Origination of loans held for sale

     (484,696 )     (556,774 )     (496,153 )

Proceeds from sales of loans held for sale

     492,680       571,374       482,168  

Gains on sales of other real estate owned and premises, net

     (870 )     (33 )     (29 )

Stock-based compensation expenses

     362       147       —    

Issuance of common stock grants for services

     564       410       —    

Increase in other assets

     (5,975 )     (16,946 )     (335 )

Increase (decrease) in other liabilities

     (807 )     3,331       (594 )
                        

Net cash and cash equivalents provided by operating activities

     34,313       32,429       9,760  
                        

Investing activities:

      

Purchases of securities available for sale

     (51,296 )     (56,417 )     (76,574 )

Proceeds from sales of securities available for sale

     1,005       —         12,354  

Proceeds from maturities, calls and paydowns of securities available for sale

     47,614       38,545       87,806  

Net increase in loans

     (110,867 )     (97,853 )     (218,801 )

Net increase in bank premises and equipment

     (21,085 )     (7,797 )     (9,483 )

Proceeds from sales of other real estate owned

     499       61       494  

Cash paid in bank acquisition

     (35,955 )     —         (23,235 )

Cash acquired in bank acquisition

     17,148       —         16,701  
                        

Net cash and cash equivalents used in investing activities

     (152,937 )     (123,461 )     (210,738 )
                        

Financing activities:

      

Net increase (decrease) in noninterest-bearing deposits

     (18,254 )     28,030       45,129  

Net increase in interest-bearing deposits

     116,205       114,168       84,933  

Net increase (decrease) in short-term borrowings

     (45,400 )     33,890       19,936  

Net increase (decrease) in long-term borrowings

     41,850       (42,700 )     37,500  

Repayment of long-term borrowings

     —         (571 )     (13,437 )

Proceeds from trust preferred capital notes

     37,114       —         23,196  

Cash dividends paid

     (8,345 )     (6,751 )     (5,567 )

Tax benefit from exercise of stock-based awards

     182       169       —    

Cash paid for fractional shares

     (10 )     —         —    

Issuance of common stock

     1,634       1,091       1,560  
                        

Net cash and cash equivalents provided by financing activities

     124,976       127,326       193,250  
                        

Increase (decrease) in cash and cash equivalents

     6,352       36,294       (7,728 )

Cash and cash equivalents at beginning of the period

     69,538       33,244       40,972  
                        

Cash and cash equivalents at end of the period

   $ 75,890     $ 69,538     $ 33,244  
                        

Supplemental Disclosure of Cash Flow Information

      

Cash payments for:

      

Interest

   $ 51,312     $ 25,221     $ 25,404  

Income taxes

     9,935       12,178       6,896  

Supplemental schedule of noncash investing and financing activities

      

Unrealized loss on securities available for sale

   $ (417 )   $ (5,059 )   $ (2,381 )

Issuance of common stock in exchange for net assets in acquisition

     —         —         31,680  

Transactions related to the acquisition of subsidiary

      

Increase in assets and liabilities:

      

Loans

   $ 75,742     $ —       $ 165,062  

Securities

     34,003       —         19,931  

Other Assets

     26,229       —         39,220  

Noninterest bearing deposits

     52,431       —         38,503  

Interest bearing deposits

     59,011       —         145,981  

Borrowings

     4,668       —         7,000  

Other Liabilities

     1,057       —         2,130  

Issuance of common stock

     —         —         31,680  

See accompanying notes to consolidated financial statements.

 

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UNION BANKSHARES CORPORATION AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

YEARS ENDED DECEMBER 31, 2006, 2005, and 2004

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The accounting policies and practices of Union Bankshares Corporation and subsidiaries (the “Company”) conform to accounting principles generally accepted in the United States of America and follow general practice within the banking industry. Major policies and practices are described below. In addition, share and per share amounts for all periods presented in the consolidated financial statements and notes thereto have been retroactively adjusted to reflect the effect of the three-for-two stock split in October 2006.

(A) Principles of Consolidation

The consolidated financial statements include the accounts of the Company, which is a bank holding company that owns all of the outstanding common stock of its banking subsidiaries, Union Bank and Trust Company (“Union Bank”), Northern Neck State Bank, Rappahannock National Bank, Bay Community Bank (formerly Bank of Williamsburg), Prosperity Bank & Trust Company (“Prosperity”) and of Union Investment Services. Union Mortgage Group, Inc. (“Union Mortgage”) (formerly Mortgage Capital Investors, Inc.) is a wholly-owned subsidiary of Union Bank. Bay Community Bank has a non-controlling interest in Johnson Mortgage Company, LLC, which is accounted for under the equity method of accounting. The Company’s Statutory Trust I & II, wholly-owned subsidiaries of the Company, were formed for the purpose of issuing redeemable Capital Securities in connection with the Company’s acquisitions of Guaranty Financial Corporation in May 2004 and its wholly owned subsidiary, Guaranty Bank (“Guaranty”) and Prosperity in April 2006. Statement of Financial Accounting Standard (“SFAS”) Interpretation No. 46R Consolidation of Variable Interest—an interpretation of ARB No. 51 (“FIN 46R”) precludes the Company from consolidating Statutory Trust I & II. The subordinated debts payable to the trusts are reported as liabilities of the Company. All significant inter-company balances and transactions have been eliminated. The accompanying consolidated financial statements for prior periods reflect certain reclassifications in order to conform to the current presentation.

(B) Investment Securities

Debt securities that the Company has the positive intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost. The Company has no securities in this category.

Securities classified as available for sale are those debt and equity securities that management intends to hold for an indefinite period of time, including securities used as part of the Company’s asset/liability strategy, and that may be sold in response to changes in interest rates, liquidity needs or other similar factors or called by the issuer under the terms of the debt. Securities available for sale are reported at fair value, with unrealized gains or losses, net of deferred taxes, included in accumulated other comprehensive income in stockholders’ equity.

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

Purchased premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the fair value of held to maturity and available for sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. The Company has recognized no other-than-temporary losses. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.

 

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(C) Loans Held For Sale

Loans originated and intended for sale in the secondary market are sold servicing released and carried at the lower of cost or estimated fair value which is determined in the aggregate based on sales commitments to permanent investors or on current market rates for loans of similar quality and type. In addition, the Company requires a firm purchase commitment from a permanent investor before a loan can be closed, thus limiting interest rate risk. As a result, loans held for sale are stated at fair value. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income.

(D) Loans

The Company grants mortgage, commercial and consumer loans to customers. A substantial portion of the loan portfolio is represented by mortgage loans and commercial real estate loans throughout its market area. The ability of the Company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in this area.

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method.

The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90 days delinquent unless the credit is well secured and in process of collection. Credit card loans and other personal loans are typically charged-off no later than 180 days past due. In all cases, loans are placed on non-accrual status or charged-off at an earlier date if collection of principal and interest is considered doubtful.

All interest accrued but not collected for loans that are placed on non-accrual status or charged-off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

(E) Allowance For Loan Losses

The provision for loan losses charged to operations is an amount sufficient to bring the allowance for loan losses to an estimated balance that management considers adequate to absorb potential losses in the portfolio. Loans are charged against the allowance when management believes the collectibility of the principal is unlikely. Recoveries of amounts previously charged-off are credited to the allowance. Management’s determination of the adequacy of the allowance is based on an evaluation of the composition of the loan portfolio, the value and adequacy of collateral, current economic conditions, historical loan loss experience, and other risk factors. Management believes that the allowance for loan losses is adequate. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions, particularly those affecting real estate values. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as doubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or

 

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observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for various qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company generally does not separately identify individual consumer and residential loans for impairment disclosures.

(F) Bank Premises and Equipment

Bank premises and equipment is stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed using either the straight-line or accelerated method based on the type of asset involved. The Company’s policy is to capitalize additions and improvements and to depreciate the cost thereof over their estimated useful lives ranging from 3 to 40 years. Maintenance, repairs and renewals are expensed as they are incurred.

(G) Goodwill and Intangible Assets

SFAS No. 141, Business Combinations, requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. For purchase acquisitions, the Company is required to record assets acquired, including identifiable intangible assets, and liabilities assumed at their fair value, which in many instances involves estimates based on third party valuations, such as appraisals, or internal valuations based on discounted cash flow analysis or other valuation techniques. Effective January 1, 2001, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS No. 142”), which prescribes the accounting for goodwill and intangible assets subsequent to initial recognition. The provisions of SFAS No. 142 discontinue the amortization of goodwill and intangible assets with indefinite lives but require at least an annual impairment review, and more frequently if certain impairment indicators are in evidence. The Company adopted SFAS 147, Acquisitions of Certain Financial Institutions, on January 1, 2002 and determined that core deposit intangibles will continue to be amortized over the estimated useful life.

(H) Income Taxes

Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws. Deferred taxes are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.

 

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(I) Other Real Estate Owned

Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at the lower of the carrying amount or fair value at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in net expenses from foreclosed assets.

(J) Consolidated Statements of Cash Flows

For purposes of reporting cash flows, the Company defines cash and cash equivalents as cash due from banks, interest-bearing deposits in other banks, money market investments, other interest-bearing deposits, and Federal funds sold.

(K) Earnings Per Share

Basic earnings per share (“EPS”) is computed by dividing net income by the weighted average number of common shares outstanding during the year. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options and nonvested stock and are determined using the treasury stock method.

(L) Comprehensive Income (Loss)

Comprehensive income (loss) represents all changes in equity that result from recognized transactions and other economic events of the period. Other comprehensive income (loss) refers to revenues, expenses, gains and losses that under accounting principles generally accepted in the United States of America are included in comprehensive income, but excluded from net income, such as unrealized gains and losses on certain investments in debt and equity securities.

(M) Use of Estimates

The preparation of the consolidated 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 at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from these estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the valuation of goodwill and intangible assets, foreclosed real estate and deferred tax assets and liabilities.

(N) Advertising Costs

The Company follows a policy of charging the cost of advertising to expense as incurred. Total advertising costs included in other operating expenses for 2006, 2005 and 2004 were $1.3 million, $1.3 million, and $1.2 million, respectively.

(O) Off Balance Sheet Credit Related Financial Instruments

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

(P) Rate Lock Commitments

The Company enters into commitments to originate mortgage loans whereby the interest rate on the loan is determined prior to funding (rate lock commitments). Rate lock commitments on mortgage loans that are intended to be sold are considered to be derivatives. The period of time between issuance of a loan commitment and closing and sale of the loan generally ranges from 30 to 120 days. The Company protects itself from changes in interest rates through the use of best efforts forward delivery commitments, whereby the Company commits to sell a loan at the time the borrower commits to an interest rate with the intent that the buyer has assumed interest rate risk on the loan. As a result, the Company is not exposed to

 

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losses nor will it realize significant gains related to its rate lock commitments due to changes in interest rates. The correlation between the rate lock commitments and the best efforts contracts is very high due to their similarity.

The market value of rate lock commitments and best efforts contracts is not readily ascertainable with precision because rate lock commitments and best efforts contracts are not actively traded in stand-alone markets. The Company determines the fair value of rate lock commitments and best efforts contracts by measuring the change in the value of the underlying asset while taking into consideration the probability that the rate lock commitments will close. Because of the high correlation between rate lock commitments and best efforts contracts, no gain or loss occurs on the rate lock commitments.

(Q) Variable Interest Entities

In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46, Consolidation of Variable Interest Entities—an interpretation of ARB No. 51 (“FIN 46”), which states that if a business enterprise is the primary beneficiary of a variable interest entity, the assets, liabilities and results of the activities of the variable interest entity should be included in the consolidated financial statements of the business enterprise. This interpretation explains how to identify variable interest entities and how an enterprise assesses its interest in a variable interest entity to decide whether to consolidate the entity. FIN 46 also requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. Variable interest entities that effectively disperse risks will be consolidated unless a single party holds an interest or combination of interests that effectively recombines risks that were previously dispersed. Due to the significant implementation concerns, the FASB revised Interpretation No. FIN 46. Management has evaluated the Company’s investment in variable interest entities and potential variable interest entities or transactions, particularly in trust preferred securities structures, because these entities constitute the Company’s primary exposure.

Currently, other than the impact described above from the deconsolidation of the trust preferred capital notes, the adoption of FIN 46 and FIN 46R has not had a material impact on the financial condition or the operating results of the Company.

(R) Asset Prepayment Rates

The Company purchases amortizing loan pools and investment securities in which the underlying assets are residential mortgage loans subject to prepayments. The actual principal reduction on these assets varies from the expected contractual principal reduction due to principal prepayments resulting from the borrowers’ election to refinance the underlying mortgage based on market and other conditions. The purchase premiums and discounts associated with these assets are amortized or accreted to interest income over the estimated life of the related assets. The estimated life is calculated by projecting future prepayments and the resulting principal cash flows until maturity. Prepayment rate projections utilize actual prepayment speed experience and available market information on like-kind instruments. The prepayment rates form the basis for income recognition of premiums and discounts on the related assets. Changes in prepayment estimates may cause the earnings recognized on these assets to vary over the term that the assets are held, creating volatility in the net interest margin. Prepayment rate assumptions are monitored monthly and updated periodically to reflect actual activity and the most recent market projections.

(S) Concentrations of Credit Risk

Most of the Company’s activities are with customers located in portions of Central and Tidewater Virginia. Securities Available for Sale and Loans also represent concentrations of credit risk and are discussed in Notes 2 and 3, respectively.

 

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(T) Stock Compensation Plan

Effective January 1, 2006, the Company adopted SFAS No. 123R (Revised 2004), Share-Based Payment (“SFAS No. 123R”), which replaces SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123”), and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees (“APB Opinion No. 25”). SFAS No. 123R requires the costs resulting from all share-based payments to employees be recognized in the financial statements. Stock-based compensation is estimated at the date of grant, using the Black-Scholes option valuation model for determining fair value. The model employs the following assumptions:

 

   

Dividend yield—calculated as the ratio of historical dividends paid per share of common stock to the stock price on the date of grant;

 

   

Expected life (term of the option)—based on the average of the contractual life and vesting schedule for the respective option;

 

   

Expected volatility—based on the monthly historical volatility of the Company’s stock price over the expected life of the options;

 

   

Risk-free interest rate—based upon the U.S. Treasury bill yield curve, for periods within the contractual life of the option, in effect at the time of grant.

Under APB Opinion 25, compensation expense was generally not recognized if the exercise price of the option equaled or exceeded the market price of the stock on the date of grant. For the year ended December 31, 2006, the Company recognized stock-based compensation expense of $284 thousand, net of tax, or approximately $.02 per share, in accordance with SFAS No. 123R. The following table details the effect on net income and earnings per share had the stock-based compensation expense for stock awards been recorded in periods prior to 2006 based on the fair-value method under SFAS No. 123R.

 

     2005     2004  

Net income, as reported

   $ 24,822     $ 17,925  

Add: stock-based compensation included in reported net income, net of related tax effects

     118       —    

Deduct: stock-based compensation determined under fair value method for all awards, net of related tax effects

     (1,312 )     (378 )
                

Pro forma net income

   $ 23,628     $ 17,547  
                

Earning per share:

    

Basic—as reported

   $ 1.89     $ 1.42  

Basic—pro forma

     1.80       1.39  

Diluted—as reported

     1.87       1.41  

Diluted—pro forma

     1.78       1.38  

The Company has elected to adopt the modified prospective method which requires compensation expense to be recorded for the unvested portion of previously issued awards that remained outstanding as of January 1, 2006. In addition, compensation expense is recorded for any awards issued, modified, or settled after the effective date of this standard and prior periods are not restated. For awards granted prior to the effective date, the unvested portion of the awards are recognized in periods subsequent to the adoption based on the grant date fair value determined for pro forma disclosure purposes under SFAS No. 123R.

SFAS 123R requires the Company to estimate forfeitures when recognizing compensation expense and that this estimate of forfeitures be adjusted over the requisite service period or vesting schedule based on the extent to which actual forfeitures differ from such estimates. Changes in estimated forfeitures are recognized through a cumulative catch-up adjustment, which is recognized in the period of change, and also will impact the amount of estimated unamortized compensation expense to be recognized in future periods.

 

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The Company’s 2003 Stock Incentive Plan provides for the granting of incentive stock options, non-statutory stock options, and nonvested stock awards to key employees of the Company and its subsidiaries. The Company’s 2003 Stock Incentive Plan replaced the 1993 Stock Incentive Plan, and became effective on July 1, 2003, after shareholders approved the plan at the annual meeting of shareholders held in 2003. The Stock Incentive Plan makes available 525,000 shares (adjusted for the stock split), which may be awarded to employees of the Company and its subsidiaries in the form of incentive stock options intended to comply with the requirements of Section 422 of the Internal Revenue Code of 1986 (“incentive stock options”), non-statutory stock options, and nonvested stock. Under the plan, the option price cannot be less than the fair market value of the stock on the grant date. The stock option’s maximum term is ten years from the date of grant and vests in equal annual installments of twenty percent over a five year vesting schedule. The Company issues new shares to satisfy share-based awards. As of December 31, 2006, approximately 347,091 shares were available for issuance under the Company’s 2003 Stock Incentive Plan.

For more information and tables refer to Note 10 “Employee Benefits” within the “Notes to the Condensed Financial Statements”.

(U) Recent Accounting Pronouncements

In September 2006, the Securities and Exchange Commission (“SEC”) released Staff Accounting Bulletin No. 108 (“SAB 108”). SAB 108 expresses the SEC staff’s views regarding the process of quantifying financial statement misstatements. SAB 108 expresses the SEC staff’s view that a registrant’s materiality evaluation of an identified unadjusted error should quantify the effects of the error on each financial statement and related financial statement disclosures and that prior year misstatements should be considered in quantifying misstatements in current year financial statements. SAB 108 also states that correcting prior year financial statements for immaterial errors would not require previously filed reports to be amended. Such correction may be made the next time the registrant files the prior year financial statements. The cumulative effect of the initial application should be reported in the carrying amounts of assets and liabilities as of the beginning of that fiscal year and the offsetting adjustment should be made to the opening balance of retained earnings for that year. Registrants should disclose the nature and amount of each individual error being corrected in the cumulative adjustment. The SEC staff encourages early application of the guidance in SAB 108 for interim periods of the first fiscal year ending after November 15, 2006. The Company currently does not anticipate the effects of SAB 108 will have a material impact on its consolidated financial statements.

In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments – an amendment of FASB Statements No. 133 and 140 (“SFAS 155”). SFAS 155 permits fair value measurement of any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. The Statement also clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement 133. It establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. SFAS 155 also clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives. SFAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The Company does not expect the implementation of SFAS 155 to have a material impact on its consolidated financial statements.

In March 2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial Assets – an amendment of FASB Statement No. 140 (“SFAS 156”). SFAS 156 requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into certain servicing contracts. The Statement also requires all separately recognized servicing

 

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assets and servicing liabilities to be initially measured at fair value, if practicable. SFAS 156 permits an entity to choose between the amortization and fair value methods for subsequent measurements. At initial adoption, the Statement permits a one-time reclassification of available for sale securities to trading securities by entities with recognized servicing rights. SFAS 156 also requires separate presentation of servicing assets and servicing liabilities subsequently measured at fair value in the statement of financial position and additional disclosures for all separately recognized servicing assets and servicing liabilities. This Statement is effective as of the beginning of an entity’s first fiscal year that begins after September 15, 2006. The Company does not anticipate this amendment will have a material effect on its consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurement” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements but may change current practice for some entities. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those years. The Company does not expect the implementation of SFAS 157 to have a material impact on its consolidated financial statements.

In September 2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106, and 132(R) (“SFAS 158”). SFAS 158 requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. The Company does not anticipate this amendment will have a material effect on its consolidated financial statements.

In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes: An Interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with SFAS 109. The Interpretation prescribes a recognition threshold and measurement principles for the financial statement recognition and measurement of tax positions taken or expected to be taken on a tax return that are not certain to be realized. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company does not expect the implementation of FIN 48 to have a material impact on its consolidated financial statements.

In September 2006, the Emerging Issues Task Force issued EITF 06-4, Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements. This consensus concludes that for a split-dollar life insurance arrangement within the scope of this Issue, an employer should recognize a liability for future benefits in accordance with FASB Statement No. 106 (if, in substance, a postretirement benefit plan exits) or APB Opinion No. 12 (if the arrangement is, in substance, an individual deferred compensation contract) based on the substantive agreement with the employee. The consensus is effective for fiscal years beginning after December 15, 2007. The Company is currently evaluating the effect that EITF No. 06-4 will have on its consolidated financial statements when implemented.

In September 2006, The Emerging Issues Task Force issued EITF 06-5, Accounting for Purchases of Life Insurance- Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4. This consensus concludes that a policyholder should consider any additional amounts included in the contractual terms of the insurance policy other than the cash surrender value in determining the amount that could be realized under the insurance contract. A consensus also was reached that a policyholder should determine the amount that could be realized under the life insurance contract assuming the surrender of an individual-life by individual-life policy (or certificate by certificate in a group policy). The consensuses are effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the effect that EITF No. 06-5 will have on its consolidated financial statements when implemented.

 

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(V) Business Combinations

On April 1, 2006, the Company completed the acquisition of Prosperity in an all cash transaction valued at approximately $36 million. Prosperity, with nearly $130 million in assets, operates three offices in Springfield and Burke, Virginia, located in Fairfax County, a suburb of Washington, D.C. Prosperity operates as an independent bank subsidiary of the Company. The acquisition was financed with proceeds from the issuance of trust preferred capital notes. As part of the purchase price allocation for the acquisition of Prosperity, the Company recorded approximately $5.5 million in core deposit intangible assets and $18.8 million in goodwill. The core deposit intangible assets recorded in the Prosperity acquisition are being amortized over an average of 9.1 years.

On May 1, 2004, the Company completed its acquisition of Guaranty headquartered in Charlottesville, Virginia. This acquisition was accounted for using the purchase method of accounting. The total consideration paid to Guaranty stockholders in connection with the acquisition was approximately $54.9 million with approximately $23.2 million in cash and 1.5 million shares of the Company’s common stock. The Company operated Guaranty as a separate subsidiary until September 13, 2004, when the operations of Guaranty were merged with and into the Company’s largest subsidiary, Union Bank. Guaranty transactions have been included in Union Bank’s financial results since May 1, 2004. Acquired assets on May 1, 2004 totaled $248 million, including $165 million in loans and $184 million in deposits. As part of the purchase price allocation for the acquisition of Guaranty, the Company recorded approximately $5.8 million in core deposit intangible assets and $30.1 million in goodwill, in 2004. The core deposit intangible assets recorded in the Guaranty acquisition are being amortized over an average of 8.7 years.

The Company accounts for acquisitions under the purchase method of accounting and accordingly is required to record the assets acquired, including identified intangible assets and liabilities assumed at their fair value, which often involves estimates based on third party valuations, such as appraisals, or internal valuations based on discounted cash flow analyses or other valuation techniques, which are inherently subjective. The amortization of identified intangible assets is based upon the estimated economic benefits to be received, which is also subjective. These estimates also include the establishment of various accruals and allowances based on planned facility dispositions and employee severance considerations, among other acquisition-related items. In addition, purchase acquisitions typically result in goodwill, which is subject to at least annual impairment testing, or more frequently if certain indicators are in evidence, based on the fair value of net assets acquired compared to the carrying value of goodwill.

The Company and the acquired entity also incur merger-related costs during an acquisition. The Company capitalizes direct costs of the acquisition, such as investment banker and attorneys’ fees and includes them as part of the purchase price. Other merger-related internal costs associated with acquisitions are expensed as incurred. Some examples of these merger-related costs include, but are not limited to, systems conversions, integration planning consultants and advertising fees. These merger-related costs are included within the Consolidated Statement of Income classified within the noninterest expense line. The acquired entity records merger-related costs which result from a plan to exit an activity, involuntarily terminate or relocate employees and are recognized as liabilities assumed as of the consummation date of the acquisition.

The Company’s merger-related costs for the year ended December 31, 2006, 2005 and 2004 were $263 thousand, $17 thousand, and $343 thousand, respectively. Prior to the mergers, the acquired entities, Prosperity and Guaranty, recorded merger-related costs of approximately $849 thousand and $1.3 million principally related to employee severance and investment banker fees.

 

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2. SECURITIES AVAILABLE FOR SALE

The amortized cost, gross unrealized gains and losses and estimated fair value of securities available for sale at December 31, 2006 and 2005 are summarized as follows (dollars in thousands):

 

          Gross Unrealized      
     Amortized
Cost
   Gains    (Losses)     Estimated
Fair Value

As of December 31, 2006

          

U.S. government and agency securities

   $ 9,973    $ —      $ (144 )   $ 9,829

Obligations of states and political subdivisions

     101,621      2,778      (177 )     104,222

Corporate and other bonds

     25,750      1,620      (168 )     27,202

Mortgage-backed securities

     132,189      337      (1,916 )     130,610

Federal Reserve Bank stock - restricted

     3,097      —        —         3,097

Federal Home Loan Bank stock - restricted

     7,554      —        —         7,554

Other securities

     279      31      —         310
                            
   $ 280,463    $ 4,766    $ (2,405 )   $ 282,824
                            

As of December 31, 2005

          

U.S. government and agency securities

   $ 1,977    $ —      $ (42 )   $ 1,935

Obligations of states and political subdivisions

     83,908      2,487      (177 )     86,218

Corporate and other bonds

     38,423      2,603      (247 )     40,779

Mortgage-backed securities

     108,576      183      (2,053 )     106,706

Federal Reserve Bank stock - restricted

     2,213      —        —         2,213

Federal Home Loan Bank stock - restricted

     7,392      —        —         7,392

Other securities

     750      24      —         774
                            
   $ 243,239