UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C.  20549





FORM
10-K





Annual
Report Pursuant to Section 13 or 15(d)


of
the Securities Exchange Act of 1934





For the
fiscal year ended December 31, 2009








Commission
File Number 000-27622





HIGHLANDS
BANKSHARES, INC.


(Exact
name of registrant as specified in its charter)





Virginia
              (State
      or other jurisdiction
              of
      incorporation or organization)
            54-1796693
              (I.R.S.
      Employer
              Identification
      No.)340
      West Main Street
              Abingdon,
      Virginia
              (Address
      of principal executive offices)
            24210-1128
              (Zip
      Code)





Registrant’s telephone number,
including area code:(276) 628-9181








Securities
registered pursuant to Section 12(g) of the Act:


Common
Stock, $0.625 par value


(Title of
class)





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





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  o No  ý





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  ý No  o





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and


posted
pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the
preceding 12 months (or for such shorter period that the registrant was required
to submit


and post
such files).


Yes o      No
o


Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant’s


knowledge,
in definitive proxy or information statements incorporated by reference in Part
III of this Form 10-K or any amendment to this Form 10-K.  ý





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer or smaller reporting company. (See
definition of “large


accelerated
filer, accelerated filer and smaller reporting company” in Rule 12b-2 of the
Act).


Large
Accelerated Filer  o   Accelerated
Filer  o    Non-Accelerated
Filer o  Smaller
Reporting Company  ý





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





State the
aggregate market value of the voting and non-voting common equity held by
non-affiliates computed by reference to the price at which the common equity was
last


sold, or
the average bid and asked price of such common equity, as of the last business
day of the registrant’s most recently completed second fiscal quarter.$34,624,085.





Indicate
the number of shares outstanding of each of the registrant’s classes of common
stock as of the latest practicable date.  As of March 10, 2010, there
were 5,011,152


shares of
Common Stock outstanding.





DOCUMENTS
INCORPORATED BY REFERENCE


Annual
Financial Statements for year ended December 31, 2009 – Part II


Proxy
Statement for the 2010 Annual Meeting of Shareholders—Part III





Table
      of ContentsPage
      NumberPart
      IItem
      1.
            Business
            2Item
      1A.
            Risk
      Factors
            15Item
      1B.
            Unresolved
      Staff Comments
            19Item
      2.
            Properties
            19Item
      3.
            Legal
      Proceedings
            20Item
      4.
            Reserved
            20Part
      IIItem
      5.
            Market
      for Registrant’s Common Equity, Related Stockholder
              Matters
      and Issuer Purchases of Equity Securities
            20Item
      6.
            Selected
      Financial Data
            21Item
      7.
            Management’s
      Discussion and Analysis of Financial Condition
              and
      Results of Operations
            21Item
      7A.
            Quantitative
      and Qualitative Disclosures About Market Risk
            42Item
      8.
            Financial
      Statements and Supplementary Data
            42Item
      9A
            Changes
      in and Disagreements with Accountants on
              Accounting
      and Financial Disclosure
            42Item
      9A.(T)
            Controls
      and Procedures
            42Item
      9B.
            Other
      Information
            43Part
      IIIItem
      10.
            Directors,
      Executive Officers and Corporate Governance
            43Item
      11.
            Executive
      Compensation
            43Item
      12.
            Security
      Ownership of Certain Beneficial Owners and
              Management
      and Related Stockholder Matters
            43Item
      13.
            Certain
      Relationships and Related Transactions, and Director
              Independence
            44Item
      14.
            Principal
      Accounting Fees and Services
            44Part
      IVItem
      15.
            Exhibits,
      Financial Statement Schedules
            44





























Part I.





Item
I.  Business





History and
Business




Highlands Bankshares, Inc. (the
“Company”) is a one-bank holding company organized under the laws of Virginia in
1995 and registered under the Bank Holding Company Act (BHCA). The Company
conducts the majority of its business operations through its wholly-owned bank
subsidiary, Highlands Union Bank (the “Bank”). The Company has two direct
subsidiaries as of December 31, 2009: the Bank, which was formed in 1985, and
Highlands Capital Trust I (HCTI), a statutory business trust (the “Trust”) which
was formed in 1998.






Highlands
Union Bank






The Bank is a Virginia state chartered
bank that was incorporated in 1985. The Bank operates a full-service banking
business from its headquarters in Abingdon, Virginia, and its twelve area full
service branch offices. The Bank offers general retail and commercial banking
services to individuals, businesses and local government unit customers. These
products and services include accepting deposits in the form of checking
accounts, money market deposit accounts, interest-bearing demand deposit
accounts, savings accounts and time deposits; making real estate, commercial,
revolving, consumer, credit card and agricultural loans; offering letters of
credit; providing other consumer financial services, such as automatic funds
transfer, collections, night depository, safe deposit, travelers checks and
savings bond sales; and providing other miscellaneous services normally offered
by commercial banks. The Bank makes loans in all major loan categories,
including commercial, commercial and residential real estate, construction and
consumer loans.






Highlands
Union Insurance Services, Inc.






Highlands
Union Insurance Services, Inc., a wholly owned subsidiary of the Bank, was
formed in 1999. The Bank, through HUIS, joined a consortium of approximately
forty-seven other financial institutions to form Bankers’ Insurance, LLC.
Bankers’ Insurance, LLC, as of December 31, 2009, had purchased eight full
service insurance agencies across the state of Virginia. HUIS is used to sell
insurance services through Bankers’ Insurance, LLC.  The number of
owner banks involved with Bankers’ Insurance, LLC was thirty-four as of December
31, 2009.






Highlands
Union Financial Services, Inc.






The Bank
operated a financial services department for the purpose of brokering various
investment vehicles until January 2, 2001.  At that time, Highlands
Union Financial Services, Inc., a wholly-owned subsidiary of the Bank, was
created to convert that department into a separate legal entity in order to
offer third –party mutual funds and other financial services to its customers in
all market areas served.  During 2004, changes to the NASD rules
required financial services to be operated underneath the bank structure once
again. The only activity in Highlands Union Financial Services now relates to
commissions from the sale of life insurance.






In
February 2005, the Bank became an equity owner in Bankers’ Investments, LLC,
headquartered in Richmond, Virginia. The Bank’s equity investment was $250,000
for two units of ownership. Bankers’ Investments, LLC was formed for the purpose
of providing owner banks the ability to offer a full line of financial services
to their customers. During 2007, Bankers




2


Investments
was acquired by Infinex, LLC, a full service provider of a wide array of
investment sevices. Infinex, LLC is owned by member banks and banking
associations.






Lending
Activities






Commercial
Loans






The Bank
makes both secured and unsecured loans to businesses and to individuals for
business purposes. Loan requests are granted based upon several factors
including credit history, past and present relationships with the Bank,
marketability of collateral and the cash flow of the borrowers. Unsecured
commercial loans must be supported by a satisfactory balance sheet and income
statement. Collateralized business loans may be secured by a security interest
in marketable investments, accounts receivable, business equipment and/or
general intangibles of the business. In addition, or as an alternative, the loan
may be secured by a deed of trust lien on business real estate. The risks
associated with commercial loans are related to the strength of the individual
business, the value of loan collateral and the general health of the
economy.






Residential
Real Estate Loans






Loans secured by residential real
estate are originated and held by the Bank. Residential real estate loans carry
risks associated with the continued credit–worthiness of the borrower and
changes in the value of collateral. The Bank also offers secondary market fixed
rate mortgages through multiple sources. These loans and servicing rights are
generally sold immediately into the secondary market and fees received are
recorded as income. These loans must meet certain criteria generally set by the
secondary market.






Construction
Loans






The Bank
makes loans for the purpose of financing the construction of business and
residential structures to financially responsible business entities and
individuals. These loans are subject to the same credit criteria as commercial
and residential real estate loans. In addition to the risks associated with all
real estate loans, construction loans bear the risks that the project will not
be finished according to schedule, the project will not be finished according to
budget or the value of the collateral may at any point in time be less than the
principal amount of the loan. Construction loans also bear the risk that the
general contractor, who may or may not be the Bank's loan customer, is unable to
finish the construction project as planned because of financial pressures
unrelated to the project. Loans to customers that are made as permanent
financing of construction loans may likewise under certain circumstances be
affected by external financial pressures. During the current economic crisis,
the Company has seen a decline in the area of construction lending.






Consumer
Loans






The Bank
routinely makes consumer loans, both secured and unsecured. The credit history,
cash flow and character of individual borrowers is evaluated as a part of the
credit decision. Loans used to purchase vehicles or other specific personal
property and loans associated with real estate are usually secured with a lien
on the subject vehicle or property. Negative changes in a customer's financial
circumstances due to a large number of factors, such as illness or loss of
employment, can place the repayment of a consumer loan at risk. In addition,
deterioration in collateral value adds risk to consumer loans.




3




Participation
Loans






The Bank
will occasionally buy or sell all or a portion of a loan. The Bank will consider
selling a loan or a participation in a loan, if: (i) the full amount of the loan
to a single borrower will exceed the Bank's legal lending limit,which
is 15 percent of the unimpaired capital and unimpaired surplus of the bank; (ii)
the full amount of the loan, when combined with a borrower's previously
outstanding loans, will exceed the Bank's legal lending limit to a single
borrower; (iii) the Board of Directors or an internal Loan Committee believes
that a particular borrower has a sufficient level of debt with the Bank; (iv)
the borrower requests the sale; (v) the loan to deposit ratio is at or above the
optimal level as determined by Bank management; and/or (vi) the loan may create
too great a concentration of loans in one particular location, one industry or
in one particular type of loan. The Bank will consider purchasing a
participation in a loan from another financial institution if the loan meets all
applicable credit quality standards and (i) the Bank's loan to deposit ratio is
at a level where additional loans would be desirable; and/or (ii) a common
customer requests the purchase.






The
following table sets forth, for the two fiscal years ended December 31, 2009 and
2008, the percentage of total operating revenue contributed by each class of
similar services which contributed 15% or more of total operating revenues of
the Company during such periods.




Period
            Class
      of Service
            Percentage of Total RevenuesDecember
      31, 2009
            Interest
      and Fees on Loans
            83.75%December
      31, 2008
            Interest
      and Fees on Loans
            86.76%




Market
Area






Highlands
Union Bank Market Area




The
Bank’s primary market area consists of:





·
            all
      of Washington County, Virginia


·
            portions
      of Smyth County, Virginia


·
            the
      City of Bristol, Virginia


·
            the
      City of Bristol, Tennessee and adjacent portions of Sullivan County,
      Tennessee


·
            the
      Town of Rogersville, Tennessee and adjacent portions of Hawkins
      County,  Tennessee


·
            the
      City of Sevierville, Tennessee and adjacent portions of Sevier County,
      Tennessee,


·
            the
      City of Knoxville, Tennessee and adjacent portions of Knox County,
      Tennessee


·
            the
      Town of Banner Elk, North Carolina and adjacent portions of Avery County,
      North Carolina


·
            the
      Town of Boone, North Carolina and adjacent portions of Watauga County,
      North Carolina


·
            the
      Town of West Jefferson, North Carolina and adjacent portions of Ashe
      County, North Carolina




The
economy in the markets we serve is diverse and is oriented toward retail and
service, light manufacturing, higher education and agriculture.




4




The
independent city of Bristol, Virginia is located in far southwestern Virginia
and lies directly on the Virginia-Tennessee state line. Washington County
surrounds Bristol to the west, north and east. In the Bristol/Washington County
community, manufacturing, retail trade, healthcare services, and Governmental
sectors are the largest industries, in terms of total number of jobs in
2009.  These sectors contribute at total 61.2% of the total
city/county employment. The latest unemployment figures as of December 2009
reflect an unemployment rate of 10.0% and 9.3% for the Bristol, Virginia and
Washington County, Virginia respectively.





The
Bank has a branch office located in Marion which is the county seat of Smyth
County, Virginia. Marion is approximately 30 miles northeast of Abingdon,
Virginia.  The latest unemployment figures reflect an unemployment
rate of 10.9% reported as of December 2009. In Smyth County, manufacturing is
the largest employment industry and makes up 27.3% of all jobs throughout the
county, totaling 3,175 individuals. The educational and Governmental sectors
account for 25.6% of the total jobs, totaling 2,972 individuals.





Bristol, Tennessee is located in
Sullivan County, Tennessee and is Bristol, Virginia’s twin city. Bristol,
Tennessee’s three largest employment sectors are services, manufacturing and
retail trade. The latest unemployment figures reflect an unemployment rate of
9.3% as of  December 2009.  The healthcare services and
manufacturing sectors make up 42.4% of all jobs throughout the
county.





Rogersville, Tennessee is located in
Hawkins County approximately 45 miles southwest of Bristol, Tennessee.
Rogersville is the county seat for Hawkins County.  Rogersville’s
three largest employment sectors are services, manufacturing and retail trade.
The latest unemployment figures reflect an unemployment rate of 10.4% as of
December 2009. In Hawkins County, manufacturing, education, and retail trade are
the largest sectors, in terms of total employment. These sectors combined make
up 69.7% of all jobs throughout the county.





Sevierville, Tennessee is located in
Sevier County, Tennessee. Sevierville, Tennessee is located approximately 20
miles east of Knoxville, Tennessee. Sevierville serves as the county seat and is
the largest city located in Sevier County. Major employers for the county
include tourism, retail, and service related industries, which make up 69.2% of
all jobs throughout the county. There is some industrial base that mitigates
some of the seasonal employment fluctuation from the tourism and related
businesses. The latest unemployment figures reflect an unemployment rate of
10.7% as of December 2009.





Knoxville, Tennessee is located in Knox
County, Tennessee.  Knoxville, Tennessee is located approximately 20
miles west of Sevierville, Tennessee.  Knoxville serves as the county
seat and is the third largest city in the state of Tennessee.  Major
employers for the county include healthcare services, retail trade,
accommodation/food services and warehousing/distributing
industries.  These sectors contribute to 51.9% of all jobs throughout
the county.  The latest unemployment figures reflect an unemployment
rate of 8.1% as of December 2009.  Knoxville’s central location to two
major interstate highways which link the eastern half of the United States
continues to provide many opportunities for economic growth in the
future.





Boone,
North Carolina is located in Watauga County in the northwestern mountains of
North Carolina.  Watauga County, North Carolina has an estimated
population of 45,190 as of December 2008.  Watauga County’s three
largest employment sectors are private industry, education services and retail
trade. The latest unemployment figures reflect an unemployment rate of 7.4% as
of December 2009. Watauga County’s largest employer is Appalachian State
University. Appalachian State is the sixth largest university in the University
of North Carolina


5


system.
Employment at Appalachian State University has remained relatively stable over
the past four years.





Banner Elk, North Carolina is located
in Avery County in the northwestern mountains of North
Carolina.  Avery County, North Carolina had an estimated population of
17,884 as of December 2008.  In Avery County, education, health and
social services, retail trade, and the accommodation and food services sectors
are the largest industries, in terms of total number of jobs in
2008.  The latest unemployment figures reflect an unemployment rate of
9.7% as of December 2009.





West Jefferson, North Carolina is
located in Ashe County in the northwestern mountains of North
Carolina.  Ashe County, North Carolina had a population that was
estimated at 25,702 as of December 2008.In Ashe County,
manufacturing, education and health services, and public administration are the
largest employment industries. The latest unemployment figures reflect an
unemployment rate of 12.3% as of December 2009.





Competition





The
banking and financial service business in the markets we serve is highly
competitive. The increasingly competitive environment is a result of changes in
regulation, changes in technology and product delivery systems and new
competition from non-traditional financial services. The Bank competes for loans
and deposits with other commercial banks, savings and loan associations,
securities and brokerage companies, mortgage companies, money market funds,
credit unions and other non-bank financial service providers. Many of these
competitors are much larger in total assets and capitalization, have greater
access to capital markets and offer a broader array of financial services than
the Bank. In order to compete, the Bank relies upon service-based business
philosophies, personal relationships with customers, specialized services
tailored to meet customers' needs and the convenience of office locations and
extended hours of operation. In addition, the Bank is generally competitive with
other financial institutions in its market areas with respect to interest rates
paid on deposit accounts, interest rates charged on loans and other service
charges on loans and deposit accounts. Deposit market share for each of the
Bank’s market areas can be found on the FDIC’s website at  www.fdic.gov
under the Industry Analysis/Summary of Deposits section.





Certain
Regulatory Considerations





The
Company and the Bank are subject to various state and federal banking laws and
regulations which impose specific requirements or restrictions on and provide
for general regulatory oversight with respect to virtually all aspects of
operations. As a result of the substantial regulatory burdens on banking,
financial institutions, including the Company and the Bank, are disadvantaged
relative to other competitors who are not as highly regulated, and their costs
of doing business are much higher.





The
following is a summary of the material provisions of certain statutes, rules and
regulations which affect the Company and the Bank. This summary is qualified in
its entirety by reference to the particular statutory and regulatory provisions
referred to below, and is not intended to be an exhaustive description of the
statutes or regulations which are applicable to the businesses of the Company
and the Bank. Any change in applicable laws or regulations may have a material
adverse effect on the business and prospects of the Company and the
Bank.





6


Highlands
Bankshares, Inc.





The
Company is a bank holding company within the meaning of the Bank Holding Company
Act of 1956 and Chapter 13 of the Virginia Banking Act, as amended (the Virginia
Banking Act). The activities of the Company also are governed by the
Gramm-Leach-Bliley Act of 1999.





The Bank Holding Company
Act.  The BHCA is administered by the Federal Reserve Board,
and the Company is required to file with the Federal Reserve Board an annual
report and any additional information the Federal Reserve Board may require
under the BHCA. The Federal Reserve Board also is authorized to examine the
Company and its subsidiaries. The BHCA requires every bank holding company to
obtain the approval of the Federal Reserve Board before (i) it or any of its
subsidiaries (other than a bank) acquires substantially all the assets of any
bank; (ii) it acquires ownership or control of any voting shares of any bank if
after the acquisition it would own or control, directly or indirectly, more than
5% of the voting shares of the bank; or (iii) it merges or consolidates with any
other bank holding company.




The BHCA
and the Change in Bank Control Act, together with regulations promulgated by the
Federal Reserve Board, require that, depending on the particular circumstances,
either Federal Reserve Board approval must be obtained or notice must be
furnished to the Federal Reserve Board and not disapproved prior to any person
or company acquiring "control" of a bank holding company, such as the Company,
subject to certain exemptions. Control is conclusively presumed to exist if an
individual or company acquires 25% or more of any class of voting securities of
the Company. Control is rebuttably presumed to exist if a person acquires 10% or
more, but less than 25%, of any class of voting securities of the Company. The
regulations provide a procedure for challenging the rebuttable control
presumption.




Under the
BHCA, a bank holding company is generally prohibited from engaging in, or
acquiring direct or indirect control of more than 5% of the voting shares of any
company engaged in non-banking activities, unless the Federal Reserve Board, by
order or regulation, has found those activities to be so closely related to
banking or managing or controlling banks as to be incident to banking. The
Federal Reserve Board imposes certain capital requirements on the Company under
the BHCA, including a minimum leverage ratio and a minimum ratio of "qualifying"
capital to risk-weighted assets. Subject to its capital requirements and certain
other restrictions, the Company can borrow money to make a capital contribution
to the Bank, and these loans may be repaid from dividends paid from the Bank to
the Company (although the ability of the Bank to pay dividends are subject to
regulatory restrictions). The Company can raise capital for contribution to the
Bank by issuing securities without having to receive regulatory approval,
subject to compliance with federal and state securities laws.





The Gramm-Leach-Bliley Act.
The Gramm-Leach-Bliley Act (the GLBA) permits significant combinations among
different sectors of the financial services industry; allows for significant
expansion of financial service activities by bank holding companies and provides
for a regulatory framework by various governmental authorities responsible for
different financial activities; and offers certain financial privacy protections
to consumers. The GLBA repealed affiliation and management interlock
prohibitions of the Depression-era Glass-Steagall Act and, by amending the Bank
Holding Company Act, the GLBA added new substantive provisions to the
non-banking activities permitted under the BHCA with the creation of the
financial holding company. The GLBA preempts most state laws that prohibit
financial holding companies from engaging in insurance activities. The GLBA
permits affiliations between banks and securities firms within the same holding
company structure, and the GLBA permits financial holding companies to directly
engage in a broad range of securities and merchant banking activities. The
Company has not elected to become a financial holding company.


7


The
Gramm-Leach-Bliley Act has led to important changes in the manner in which
financial services are delivered in the United States. Bank holding companies
and their subsidiary banks are able to offer a much broader array of financial
services; however, there is greater competition in all sectors of the financial
services market.





The Virginia Banking Act. All
Virginia bank holding companies must register with the Virginia State
Corporation Commission (the “Commission”) under the Virginia Banking Act. A
registered bank holding company must provide the Commission with information
with respect to the financial condition, operations, management and
inter-company relationships of the holding company and its subsidiaries. The
Commission also may require such other information as is necessary to keep
itself informed about whether the provisions of Virginia law and the regulations
and orders issued under Virginia law by the Commission have been complied with,
and may make examinations of any bank holding company and its subsidiaries. The
Virginia Banking Act allows bank holding companies located in any state to
acquire a Virginia bank or bank holding company if the Virginia bank or bank
holding company could acquire a bank holding company in their state and the
Virginia bank or bank holding company to be acquired has been in existence and
continuously operated for more than two years. The Virginia Banking Act permits
bank holding companies from throughout the United States to enter the Virginia
market, subject to federal and state approval.





Sarbanes-Oxley Act of 2002.
The Sarbanes-Oxley Act of 2002 (the “SOX Act”) implemented legislative reforms
intended to address corporate and accounting fraud. In addition to the
establishment of a new accounting oversight board that enforces auditing,
quality control and independence standards and is funded by fees from all
publicly traded companies, the law restricts provision of both auditing and
consulting services by accounting firms. To ensure auditor independence, any
non-audit services being provided to an audit client requires pre-approval by
the issuer’s audit committee members and the SOX Act also restricts certain
services that the audit firm may perform. In addition, the audit partners must
be rotated. The SOX Act requires chief executive officers and chief financial
officers, or their equivalent, to certify to the accuracy of periodic reports
filed with the SEC, subject to civil and criminal penalties if they knowingly or
willfully violate this certification requirement. In addition, under the SOX
Act, legal counsel is required to report evidence of a material violation of the
securities laws or a breach of fiduciary duty by a company to its chief
executive officer or its chief financial officer, and, if such officer does not
appropriately respond, to report such evidence to the audit committee or other
similar committee of the board of directors or the board itself.





Troubled Asset Relief  and
Temporary Liquidity Guarantee Programs.  On October 3, 2008,
President Bush signed into law the Emergency Economic Stabilization Act of 2008
(the “EESA”).  The legislation was the result of a proposal by
Treasury Secretary Henry Paulson to the U.S. Congress in response to the
financial crises affecting the banking system and financial markets and threats
to investment banks and other financial institutions.  Pursuant to the
EESA, the U.S. Treasury had authority to among other things, purchase up to $700
billion of mortgages, mortgage-backed securities and certain other financial
instruments from financial institutions for the purpose of stabilizing and
providing liquidity to the U.S. financial markets.  On October 14,
2008 the U.S. Department of Treasury announced a program under the EESA pursuant
to which it would make senior preferred stock investments in participating
financial institutions (the “TARP Capital Purchase Program”).  On
October 14, 2008, the Federal Deposit Insurance Corporation announced the
development of a guarantee program under the systemic risk exception to the
Federal Deposit Act (“FDA”) pursuant to which the FDIC would offer a guarantee
of certain financial institution indebtedness in exchange for an insurance
premium to be paid to the FDIC by issuing financial institutions (the “FDIC
Temporary Liquidity Guarantee Program”).


8





Under the
TARP Capital Purchase Program, the Treasury made $250 billion of capital
available to U.S. financial institutions in the form of preferred stock and
warrants (from the $700 billion authorized by the
EESA).   Participating financial institutions are required to
adopt the Treasury’s standards for executive compensation and corporate
governance for the period during which the Treasury holds equity issued under
the TARP Capital Purchase Program.





The
American Reinvestment and Recovery Act of 2009 (the “AARA”) was enacted on
February 17, 2009. The ARRA included a wide variety of programs intended to
stimulate the economy and provide for extensive infrastructure, energy, health,
and education needs. In addition, the ARRA amended the compensation and
corporate governance obligations on all current and future TARP Capital Purchase
Program recipients.





There can
be no assurance, however, as to the actual long - term impact that the EESA,
ARRA and their implementing regulations, the FDIC programs, or any other
governmental program will have on the financial markets.  The failure
to the EESA, ARRA, the FDIC, or the U.S. government to stabilize the financial
markets and a continuation or worsening of current financial market conditions
could materially and adversely affect our business, financial condition, results
of operations, access to credit or the trading price of our common
stock.  Additionally, if EESA fails to bring stability to the
financial markets, additional burdensome regulation may be enacted.





In
December of 2008, the Company applied for and received preliminary approval to
issue up to $14.4 million of preferred stock to the U. S. Treasury. During the
first quarter of 2009, the Company began the process of requesting shareholder
approval to amend its Articles of Incorporation to issued preferred shares.
After careful consideration, the Company’s Board of Directors decided to not
participate.


The Company
and Bank elected to participate in the Temporary Liquidity Guarantee
Program.  The program provides full FDIC insurance to all non-interest
bearing transaction accounts and all deposit transaction accounts with an
interest rate up to .50%. Beginning in December of 2008, the Bank began taking
full advantage of this additional insurance.


Highlands
Union Bank.





General.The Bank, as a state
chartered member of the Federal Reserve, is subject to regulation and
examination by the Virginia State Corporation Commission and the Federal Reserve
Board. In addition, the Bank is subject to the rules and regulations of the
Federal Deposit Insurance Corporation. Deposits in the Bank are insured by the
FDIC up to a maximum amount (generally $250,000 per depositor, subject to
aggregation rules). The Federal Reserve Board and the Virginia Bureau of
Financial Institutions regulate or monitor all areas of the Bank’s operations,
including security devices and procedures, adequacy of capitalization and loss
reserves, loans, investments, borrowings, deposits, mergers, issuances of
securities, payment of dividends, interest rates paid on deposits, interest
rates or fees charged on loans, establishment of branches, corporate
reorganizations and maintenance of books and records. The Federal Reserve Board
requires the Bank to maintain certain capital ratios. The Bank is required by
the Federal Reserve Board to prepare quarterly reports on the Bank’s financial
condition and to conduct an annual audit of its financial affairs in compliance
with minimum standards and procedures prescribed by the Federal Reserve Board.
The Bank also is required by the Federal Reserve Board to adopt internal control
structures and procedures in order to safeguard assets and monitor and reduce
risk exposure. While appropriate for safety and soundness of banks, these
requirements impact banking overhead costs.


9


The Bank is
organized as a Virginia-chartered banking corporation and is regulated and
supervised by the Bureau of Financial Institutions (BFI) of the Virginia State
Corporation Commission. In addition, as a federally insured bank, the Bank is
regulated and supervised by the Federal Reserve Board, which serves as its
primary federal regulator, and is subject to certain regulations promulgated by
the FDIC. Under the provisions of federal law, federally insured banks are
subject, with certain exceptions, to certain restrictions on extensions of
credit to their affiliates, on investments in the stock or other securities of
affiliates and on the taking of such stock or securities as collateral from any
borrower. In addition, these banks are prohibited from engaging in certain
tie-in arrangements in connection with any extension of credit or the providing
of any property or service.





The
Virginia State Corporation Commission and the Federal Reserve Board conduct
regular examinations of the Bank reviewing the adequacy of the loan loss
reserves, quality of the loans and investments, propriety of management
practices, compliance with laws and regulations and other aspects of the bank's
operations. In addition to these regular examinations, Virginia chartered banks
must furnish to the Federal Reserve Board quarterly reports containing detailed
financial statements and schedules.





Community Reinvestment Act.
The Bank is subject to the provisions of the Community Reinvestment Act of 1977
(the “CRA”), which requires the appropriate federal bank regulatory agency, in
connection with its regular examination of a bank, to assess the bank's record
in meeting the credit needs of the community served by the bank, including low
and moderate-income neighborhoods. The focus of the regulations is on the volume
and distribution of a bank's loans, with particular emphasis on lending activity
in low and moderate-income areas and to low and moderate-income persons. The
regulations place substantial importance on a bank's product delivery system,
particularly branch locations. The regulations require banks to comply with
significant data collection requirements. The regulatory agency's assessment of
the bank's record is made available to the public. Further, this assessment is
required for any bank which has applied to, among other things, establish a new
branch office that will accept deposits, relocate an existing office, or merge,
consolidate with or acquire the assets or assume the liabilities of a federally
regulated financial institution. Management expects that the Bank’s compliance
with the CRA, as well as other fair lending laws, will face ongoing government
scrutiny and that costs associated with compliance will continue to increase.
The Bank received "Satisfactory" CRA ratings in the last examination by bank
regulators.





Federal Deposit Insurance
Corporation Improvement Act of 1991. The difficulties encountered
nationwide by financial institutions from the 1980s through 1991 prompted
federal legislation designed to reform the banking industry and to promote the
viability of the industry and of the deposit insurance system.  The
Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) bolstered
the deposit insurance fund, tightened bank and thrift regulation and trimmed the
scope of federal deposit insurance as summarized below.





FDICIA requires each federal banking
regulatory agency to prescribe, by regulation, standards for all insured
depository institutions and depository institution holding companies relating to
(i) internal controls, information systems and audit systems; (ii) loan
documentation; (iii) credit underwriting; (iv) interest rate exposure; (v) asset
growth; (vi) compensation, fees and benefits; and (vii) such other operational
and managerial standards as the agency determines to be
appropriate.  The compensation standards would prohibit employment
contracts, compensation or benefit arrangements, stock option plans, fee
arrangements or other compensatory arrangements


10


that
provide excessive compensation, fees or benefits or could lead to material
financial loss.  In addition, each federal banking regulatory agency
must prescribe by regulation standards specifying (i) a maximum ratio of
classified assets to capital; (ii) minimum earnings sufficient to absorb losses
without impairing capital; (iii) to the extent feasible, a minimum ratio of
market value to book value for publicly traded shares of depository institutions
and depository institution holding companies; and (iv) such other standards
relating to asset quality, earnings and valuation as the agency determines to be
appropriate.  If an insured institution fails to meet any of the
standards promulgated by regulation, then such institution will be required to
submit a plan to its federal regulatory agency specifying the steps it will take
to correct the deficiency.





Prompt
corrective action measures adopted in FDICIA impose significant restrictions and
requirements on depository institutions that fail to meet their minimum capital
requirements.  Under Section 38 of the Federal Deposit Insurance Act
(the FDI Act), the federal banking regulatory agencies have developed a
classification system pursuant to which all depository institutions are placed
into one of five categories based on their capital levels and other supervisory
criteria:  well capitalized, adequately capitalized; undercapitalized;
significantly undercapitalized; and critically undercapitalized.





The Bank met the requirements at
December 31, 2009 to be classified as “well capitalized.”  This
classification is determined solely for the purposes of applying the prompt
corrective action regulations and may not constitute an accurate representation
of the Bank’s overall financial condition.





If its principal federal regulator
determines that an adequately capitalized institution is in an unsafe or unsound
condition or is engaging in an unsafe or unsound practice, it may require the
institution to submit a corrective action plan, restrict its asset growth and
prohibit branching, new acquisitions and new lines of business.  An
institution’s principal federal regulator may deem it to be engaging in unsafe
or unsound practices if it receives a less than satisfactory rating for asset
quality, management, earnings or liquidity in its most recent
examination.





Section
36 of FDICIA significantly affects financial institutions with more than $500
million in total assets. The Bank came under the provisions beginning in January
2004. Effective December 28, 2005, the FDIC lessened the requirements of Part
363 by raising the asset size threshold from $500 million to $1 billion for
internal control assessments by management and external auditors. For
institutions under $1 billion, management is no longer required to assess and
report on the effectiveness of internal control over financial reporting, the
external auditors are no longer required to examine and attest to management’s
internal control assertions, and only a majority of the outside directors on the
audit committee must be independent of management.  Section 36 of
FDICIA requires insured depository institutions with at least $500 million but
less than $1 billion in total assets to file annual reports that must include
the following:





1.
            Audited
      comparative annual financial
statements.


2.
            The
      independent public accountant’s report on the audited financial
      statements.


3.
            A
      management report that contains a statement of management’s
      responsibilities for preparing the financial statement, establishing and
      maintaining an adequate internal control structure over financial
      reporting and complying with the laws and regulations designed by the FDIC
      and appropriate banking regulators.


4.
            An
      assessment by management of the institutions compliance with the
      designated laws and regulations during the
year.





These
amendments provide relief for covered institutions of less than $1 billion in
assets only for purposes of this section of Part 363.  These covered
institutions must continue to fully


11


comply with the remaining provisions of
Part 363 including the annual financial statement audit requirement. These
amendments do not relieve public companies of their obligations to comply with
the SOX Act and the SEC’s rules on internal control reporting and audit
committee independence.





The Riegle-Neal Interstate Banking
and Branching Efficiency Act of 1994 (the Interstate Act) allows bank
holding companies to acquire banks in any state, without regard to state law,
except that if the state has a minimum requirement for the amount of time a bank
must be in existence, that law must be preserved. Under the Virginia Banking
Act, a Virginia bank or all of the subsidiaries of Virginia holding companies
sought to be acquired must have been in continuous operation for more than two
years before the date of such proposed acquisition. The Interstate Act also
permits banks to acquire out-of-state branches through interstate mergers, if
the state has not opted out of interstate branching. De novo branching, where an
out-of-state bank holding company sets up a new branch in another state,
requires a state's specific approval. An acquisition or merger is not permitted
under the Interstate Act if the bank, including its insured depository
affiliates, will control more than 10% of the total amount of deposits of
insured depository institutions in the United States, or will control 30% or
more of the total amount of deposits of insured depository institutions in any
state.





Virginia
has, by statute, elected to opt-in fully to interstate branching under the
Interstate Act. Under the Virginia statute, Virginia state banks may, with the
approval of the Virginia State Corporation Commission, establish and maintain a
de novo branch or acquire one or more branches in a state other than Virginia,
either separately or as part of a merger. Procedures also are established to
allow out-of-state domiciled banks to establish or acquire branches in Virginia,
provided the "home" state of the bank permits Virginia banks to establish or
acquire branches within its borders. The activities of these branches are
subject to the same laws as Virginia domiciled banks, unless such activities are
prohibited by the law of the state where the bank is organized. The Virginia
State Corporation Commission has the authority to examine and supervise
out-of-state state banks to ensure that the branch is operating in a safe and
sound manner and in compliance with the laws of Virginia. The Virginia statute
authorizes the Bureau of Financial Institutions to enter into cooperative
agreements with other state and federal regulators for the examination and
supervision of out-of-state banks with Virginia operations, or Virginia
domiciled banks with operations in other states. Likewise, national banks, with
the approval of the OCC, may branch into and out of the state of Virginia. Any
Virginia branch of an out-of-state state chartered bank is subject to Virginia
law (enforced by the Virginia Bureau of Financial Institutions) with respect to
intrastate branching, consumer protection, fair lending and community
reinvestment as if it were a branch of a Virginia bank, unless preempted by
federal law.





Deposit
Insurance.The Bank’s deposits are insured up to applicable
limits by the Deposit Insurance Fund (DIF) of the FDIC. The DIF was created by
the merger of the Bank Insurance Fund (BIF) and Savings Association Insurance
Fund (SAIF) provided for in the Federal Deposit Insurance Reform Act of 2005
(FDIRA), as enacted in February 2006. This legislation also increased coverage
for retirement accounts to $250,000 and indexed the insurance levels for
inflation, among other changes. In addition, as a result of the FDIRA, the FDIC
has adopted a revised, risk-based assessment system to determine assessment
rates to be paid by member institutions, such as the Bank.  Under this
revised assessment system, risk is defined and measured using an institution’s
supervisory ratings, combined with certain other risk measures, including
certain financial ratios and long-term debt issuer ratings.




During
2008, the FDIC increased the “base” amount of FDIC insurance from $100,000 to
$250,000. This additional coverage is extended until December 31, 2013. The FDIC
has also issued revisions to its premium scale which will approximately double
the amount of FDIC premium that the Bank is currently paying.  The new
FDIC rates are effective in 2009. Currrently the Bank is categorized in the
highest or most beneficial classification in terms of deposit


12


insurance
premiums. On February 27th,
2009, the FDIC also approved a special assessment to all banks payable on
September 30th,
2009 to replenish the fund to an acceptable level during this time of economic
crisis and numerous bank failures.  The Bank expensed a total of $1.18
million during 2009 to cover both the increased annual assessment and the
special assessment.  At the end of December 2009, the FDIC also collected a
full 3 years of prepaid premiums from FDIC insured institutions to replenish the
fund. This prepayment will be expensed thru 2012.





Gramm- Leach- Bliley Act. The
Gramm-Leach-Bliley Act of 1999 (the GLBA) allows banks, with primary regulator
approval, to acquire financial subsidiaries to engage in any activity that is
financial in nature or incidental to a financial activity, as defined in the
Bank Holding Act, except (i) insurance underwriting, (ii) merchant or insurance
portfolio investments, and (iii) real estate development or investment.
Well-capitalized banks are also given the authority to engage in municipal bond
underwriting.




To
establish or acquire a financial subsidiary, a bank must be well-managed, and
the consolidated assets of its financial subsidiary must not exceed the lesser
of 45% of the consolidated total assets of the bank or $50 billion. The
relationship between a bank and a financial subsidiary are subject to a variety
of supervisory enhancements from regulators.





USA Patriot Act. The USA
Patriot Act facilitates the sharing of information among government entities and
financial institutions to combat terrorism and money laundering. The USA Patriot
Act creates an obligation on banks to report customer activities that may
involve terrorist activities or money laundering.





Government Policies. The
operations of the Bank are affected not only by general economic conditions, but
also by the policies of various regulatory authorities. In particular, the
Federal Reserve Board regulates money and credit 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 Board monetary policies have had a significant effect
on the operating results of commercial banks in the past and are expected to
continue to do so in the future.





Limits on Dividends and Other
Payments. As a state member bank subject to the regulations of the
Federal Reserve Board, the Bank must obtain the approval of the Federal Reserve
Board for any dividend if the total of all dividends declared in any calendar
year would exceed the total of its net profits, as defined by the Federal
Reserve Board, for that year, combined with its retained net profits for the
preceding two years. In addition, a state member bank may not pay a dividend in
an amount greater than its undivided profits then on hand after deducting its
losses and bad debts. For this purpose, bad debts are generally defined to
include the principal amount of loans which are in arrears with respect to
interest by six months or more, unless such loans are fully secured and in the
process of collection. Moreover, for purposes of this limitation, a state member
bank is not permitted to add the balance in its allowance for loan losses
account to its undivided profits then on hand; however, it may net the sum of
its bad debts as so defined against the balance in its allowance for loan losses
account and deduct from undivided profits only bad debts as so defined in excess
of that account.




In
addition, the Federal Reserve Board is authorized to determine, under certain
circumstances relating to the financial condition of a state member bank, that
the payment of dividends would be an unsafe or unsound practice and to prohibit
payment thereof. The payment of dividends that depletes a bank's capital base
could be deemed to constitute such an unsafe or


13


unsound
practice. The Federal Reserve Board has indicated that banking organizations
should generally pay dividends only out of current operating
earnings.





Virginia
law also imposes restrictions on the ability of the Bank to pay dividends. A
Virginia state bank is permitted to declare a dividend out of its "net undivided
profits", after providing for all expenses, losses, interest and taxes accrued
or due by the bank. In addition, a deficit in capital originally paid in must be
restored to its initial level, and no dividend can be paid which could impair
the Bank's paid in capital. The Bureau of Financial Institutions further has
authority to limit the payment of dividends by a Virginia bank if it determines
the limitation is in the public interest and is necessary to ensure the bank's
financial soundness.





The
Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) provides
that no insured depository institution may make any capital distribution (which
would include a cash dividend) if, after making the distribution, the
institution would not satisfy one or more of its minimum capital
requirements.





Capital Requirements. The
Federal Reserve Board has adopted risk-based capital guidelines which are
applicable to the Company and the Bank. The Federal Reserve Board guidelines
redefine the components of capital, categorize assets into different risk
classes and include certain off-balance sheet items in the calculation of
risk-weighted assets. The minimum ratio of qualified total capital to
risk-weighted assets (including certain off-balance sheet items, such as standby
letters of credit) is 8.0%. At least half of the total capital must be comprised
of Tier 1 capital for a minimum ratio of Tier 1 Capital to risk-weighted assets
of 4.0%. The remainder may consist of a limited amount of subordinated debt,
other preferred stock, certain other instruments and a limited amount of loan
and lease loss reserves.





In
addition, the Federal Reserve Board has established minimum leverage ratio (Tier
1 capital to total average assets less intangibles) guidelines that are
applicable to the Company and the Bank. These guidelines provide for a minimum
ratio of 4.0% for banks that meet certain specified criteria, including that
they have the highest regulatory CAMELS rating and are not anticipating or
experiencing significant growth and have well-diversified risk. All other banks
will be required to maintain an additional cushion of at least 100 to 200 basis
points, based upon their particular circumstances and risk profiles. The
guidelines also provide that banks 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.





Other
Legislative and Regulatory Concerns





Other
legislative and regulatory proposals regarding changes in banking and the
regulation of banks, thrifts and other financial institutions are periodically
considered by the executive branch of the federal government, Congress and
various state governments, including Virginia. New proposals could significantly
change the regulation of banks and the financial services industry. It cannot be
predicted what might be proposed or adopted or how these proposals would affect
the Company.





Registrant's
Organization and Employment





The
Company, the Bank, HCTI, HUFS and HUIS are organized in a holding
company/subsidiary structure. As of December 31, 2009, the Company had no
employees, except for officers, and it conducted substantially all of its
operations through its subsidiaries. All cash


14


compensation
paid to the Company’s officers was paid by the subsidiary bank, including fees
paid to its directors. In previous years, stock based compensation, through the
form of stock options, was paid/granted through the Company.  At
December 31, 2009, the Bank employed 227 full time equivalent employees at its
main office, operations center and branch offices. The Company, HCTI, HUFS and
HUIS had no employees at this time.





The
Company’s relationship with its employees is considered to be good. Employment
has remained very stable over the last several years with very little turnover.
There are no employment contracts in existence for any employee or
officer.





Company
Website





The Bank
maintains a website at www.hubank.com. The Company makes available through the
Bank’s  website its annual report on Form 10-K, quarterly reports on
Form 10-Q, current reports on Form 8-K, and all amendments to those reports,
free of charge, as soon as reasonably practicable after the material is
electronically filed with the Securities and Exchange Commission.





Item 1A.  Risk
Factors





The
current economic environment poses significant challenges for the Company and
could adversely affect its financial condition and results of
operations.





The
Company is operating in a challenging and uncertain economic environment,
including generally uncertain national and local conditions. Financial
institutions continue to be affected by sharp declines in the real estate market
and constrained financial markets. Dramatic declines in the housing market, with
falling home prices and increasing foreclosures and unemployment, have resulted
in significant write-downs of asset values by financial institutions. Continued
declines in real estate values, home sales volumes, and financial stress on
borrowers as a result of the uncertain economic environment could have an
adverse effect on the Company’s borrowers or their customers, which could
adversely affect the Company’s financial condition and results of operations. A
worsening of these conditions would likely exacerbate the adverse effects on the
Company and others in the financial institutions industry. For example, further
deterioration in local economic conditions in the Company’s markets could drive
losses beyond that which is provided for in its allowance for loan losses. The
Company may also face the following risks in connection with these
events:





•
            Economic
      conditions that negatively affect housing prices and the job market have
      resulted, and may continue to result, in a deterioration in credit quality
      of the Company’s loan portfolios, and such deterioration in credit quality
      has had, and could continue to have, a negative impact on the Company’s
      business.•
            Market
      developments may affect consumer confidence levels and may cause adverse
      changes in payment patterns, causing increases in delinquencies and
      default rates on loans and other credit facilities.•
            The
      processes the Company uses to estimate allowance for loan losses and
      reserves may no longer be reliable because they rely on complex judgments,
      including forecasts of economic conditions, which may no longer be capable
      of accurate estimation.








15





•
            The
      Company’s ability to assess the creditworthiness of its customers may be
      impaired if the models and approaches it uses to select, manage, and
      underwrite its customers become less predictive of future
      charge-offs.•
            The
      Company expects to face increased regulation of its industry, and
      compliance with such regulation may increase our costs, limit our ability
      to pursue business opportunities, and increase compliance
      challenges.





As these
conditions or similar ones continue to exist or worsen, the Company could
experience continuing or increased adverse effects on its financial
condition.





Changes
in interest rates could have an adverse effect on our income.





If market
interest rates rise, our net interest income can be negatively affected in the
short term. The direction and speed of interest rate changes affect our net
interest margin and net interest income. In the short term, rising interest
rates can negatively affect our net interest income, because our
interest-bearing liabilities (generally deposits) reprice sooner than our
interest-earning assets (generally loans).





We
may become subject to additional regulatory oversight.





We are
subject to extensive supervision by several governmental regulatory agencies at
the federal and state levels. Due to the difficult economic conditions and
the effects of these conditions on us, we may become subject to additional
regulatory oversight by one or more of these agencies.  While we do
not know what form or content such oversight may take, it could, among other
things, limit our ability to grow our assets, open new branch offices or pay
dividends and may adversely affect our operations and our financial results. In
addition, our management and board of directors may be required to focus
considerable time and attention on taking actions to respond to and comply with
the our regulators requirements.





Our
failure to maintain adequate capital could have adverse effects on our financial
condition.





Highlands
Bankshares, Inc. and its bank subsidiary are subject to regulatory capital
adequacy guidelines. If the Bank fails to meet capital adequacy guidelines, it
could have a material effect on our financial condition and could subject us to
a variety of enforcement actions, as well as impose restrictions on our
business. In addition, it could lead to a decline in the confidence that our
customers have in us and a reduction in the demand for our products and
services. If we are not in compliance with governmental regulation, we can be
subject to fines, penalties or restrictions of our business.





If
our allowance for loan losses becomes inadequate, our results of operations may
be adversely affected.





We
maintain an allowance for loan losses that we believe is a reasonable estimate
of known and inherent losses in our loan portfolio.  Through a
periodic review and consideration of 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 our clients relative to their financial obligations
with us.






16


The
amount of future losses is susceptible to changes in economic, operating and
other conditions, including changes in interest rate; that may be beyond our
control, and these losses may exceed our current estimates.  Although
we believe the allowance for loan losses is a reasonable estimate of known and
inherent losses in our loan portfolio, we cannot fully predict such losses or
that our loan loss allowance will be adequate in the
future.  Excessive loan losses could have a material impact on our
financial performance.  Federal and state regulators periodically
review our allowance for loan losses and may require us to increase our
provision for loan losses or recognize further loan charge-offs, based on
judgments different from those of our management.  Any increase in the
amount of our provision or loans charged-off as required by these regulatory
agencies could have a negative effect on our operating results.





Regulation
of the financial services industry is undergoing major changes, and future
legislation could increase our cost of doing business or harm our competitive
position.




In 2009, many emergency government
programs enacted in 2008 in response to the financial crisis and the recession
slowed or wound down, and global regulatory and legislative focus has generally
moved to a second phase of broader reform and a restructuring of financial
institution regulation. Legislators and regulators in the United States are
currently considering a wide range of proposals that, if enacted, could result
in major changes to the way banking operations are regulated. Some of these
major changes may take effect as early as 2010, and could materially impact the
profitability of our business, the value of assets we hold or the collateral
available for our loans, require changes to business practices or force us to
discontinue businesses and expose us to additional costs, taxes, liabilities,
enforcement actions and reputational risk.




Certain
reform proposals under consideration could result in our becoming subject to
stricter capital requirements and leverage limits, and could also affect the
scope, coverage, or calculation of capital, all of which could require us to
reduce business levels or to raise capital, including in ways that may adversely
impact our shareholders or creditors. In addition, we anticipate the enactment
of certain reform proposals under consideration that would introduce stricter
substantive standards, oversight and enforcement of rules governing consumer
financial products and services, with particular emphasis on retail extensions
of credit and other consumer-directed financial products or services. We cannot
predict whether new legislation will be enacted and, if enacted, the effect that
it, or any regulations, would have on our business, financial condition, or
results of operations.





Our
profitability and the value of your investment may suffer because of rapid and
unpredictable changes in the highly regulated environment in which we
operate.





Our
businesses are subject to stringent regulation by federal and state governmental
and regulatory agencies and self-regulatory organizations. In addition, our
customers have a number of complex confidentiality and fiduciary requirements.
We have established policies, procedures and systems that are designed to comply
with these regulatory and operational risk requirements. However, as a financial
services institution, we face complexity and costs related to our compliance
efforts. We also face the potential for loss resulting from failed or inadequate
internal processes and from external events, which could have a material impact
on our results of operations. Adverse publicity and damage to our reputation
from the failure or perceived failure to comply with legal, regulatory or
capital requirements could affect our ability to attract or maintain customers
or maintain access to capital markets, or could result in enforcement actions,
fines, penalties and lawsuits.





Our
business is subject to various lending and other economic risks that could
adversely impact our results of operations and financial condition.





17





We do business in a small geographic
area, and a large percentage of our loans are made in our market area. If the
region suffers a significant or prolonged period of economic downturn, there is
a greater likelihood that more of our customers could become delinquent on their
loans or other
obligations which could adversely affect our performance. If more competitors
come into our market area, our business could suffer.





Our
future success is dependent on our ability to compete effectively in the highly
competitive banking industry





The banking and financial service
business in the markets we serve is highly competitive. The increasingly
competitive environment is a result of changes in regulation, changes in
technology and product delivery systems and new competition from non-traditional
financial services. The Bank competes for loans and deposits with other
commercial banks, savings and loan associations, securities and brokerage
companies, mortgage companies, money market funds, credit unions and other
non-bank financial service providers. Many of these competitors are much larger
in total assets and capitalization, have greater access to capital markets and
offer a broader array of financial services than the Bank. In order to compete,
the Bank relies upon service-based business philosophies, personal relationships
with customers, specialized services tailored to meet customers' needs and the
convenience of office locations and extended hours of operation. In addition,
the Bank is generally competitive with other financial institutions in its
market areas with respect to interest rates paid on deposit accounts, interest
rates charged on loans and other service charges on loans and deposit
accounts.





Inadequate
disaster recovery plans could significantly impact our operations.





If the
disaster recovery plans that we have in place are not adequate to continue our
operations in the event of a disaster, the business disruption can adversely
impact our operations. Natural or man-made disasters, such as fires, storms,
terrorist or military actions could cause damage to our physical facilities, or
could cause delays or disruptions to operational functions, including
information processing and / or check settlements. In addition, our vendors
could suffer from such events. Should these events affect us or the vendors with
whom we do business, our results of operations could be negatively
impacted.





An
interruption or breach of our information systems may result in a loss of
customers.





We rely
heavily on communications and information systems to conduct our business. In
addition, we rely on third parties to provide key components of our
infrastructure, including internet connections and network access. Any
disruption in service of these key components could adversely affect our ability
to deliver products and services to our customers and otherwise to conduct our
operations. Furthermore, any security breach of our information systems or data,
whether managed by us or by third parties, could harm our reputation or cause a
decrease in the number of customers that choose to do business withus.





Our
liquidity is dependent on dividends from the Bank.





The
Bank’s ability to pay dividends to the Company is limited by various statutes
and regulations. Currently, the Bank must obtain
approval from the Federal Reserve Board to pay a dividend to the Company because
any dividend would exceed the aggregate of the Bank’s net profit for the most
recent fiscal year and itsretained net profits for the two preceding
years.  This restriction may have a
negative impact on the Company’s liquidity and could have a material
adverse effect on the market price of our common stock.


18


Our
performance depends on attracting and retaining key employees and skilled
personnel to operate our business effectively.





There are
a limited number of qualified personnel in the markets we serve, so our success
depends in part on the continued services of many of our current management and
other key employees. Failure to maintain our key officers and employees and
maintain adequate staffing of qualified personnel could adversely impact our
operations and ability to compete.





Uncertainty
in the financial markets could adversely affect our investment portfolio
values.





The
upheaval in the financial markets over the past year has adversely impacted
investor demand for all classes of securities and has resulted in volatility in
the fair values of our investment securities. Significant prolonged reduction in
investor demand could result in lower fair values for these securities and may
result in recognition of an other-than-temporary impairment charge, which would
have a direct adverse impact on results of operations.








Item
1B.  Unresolved Staff Comments





None





Item 2.
Properties





The
Company’s and the Bank’s headquarters are located at 340 W. Main Street,
Abingdon, Virginia. In addition to the Bank's Main Office location, the Bank
owns twelve branch offices: one in the Town of Abingdon, Virginia; one in
Washington County, Virginia; two in the City of Bristol, Virginia; one in the
Town of Glade Spring, Virginia; one in the Town of Marion, Virginia; one in the
City of Bristol, Tennessee; one in the Town of Rogersville, Tennessee; one in
the Town of Boone, North Carolina; one in the Town of Banner Elk, North
Carolina; two in the City of Sevierville, Tennessee; and one in the City of
Knoxville, Tennessee. The Bank owns the land and buildings of all of these
branch offices as well as the main office for the Company and Bank.





The Bank
also owns the land and 2 buildings used for its Collections, Human Resources,
Customer Call Center, IRA Operations, Internal Audit and Facilities departments
in Abingdon, Virginia. The Bank owns a vacant piece of land in Bristol,
Tennessee and two parcels in Washington County, Virginia that are being held for
potential future branch sites. The Bank leases office space in West Jefferson,
North Carolina for a loan production office.





The Bank
also owns the land and buildings used as the Bank’s Operations Center and
Technology House in Abingdon, Virginia. The Bank owns approximately 14 acres of
vacant land in Abingdon, Virginia for future possible development of a corporate
headquarters. The Bank also owns an additional lot in Boone, North Carolina
(approximately 1 acre) for future branching.





All of
the existing properties are in good operating condition and are adequate for the
Company’s present and anticipated future needs.





The Bank
owns all its computer and data processing hardware and is a licensee of the
software it utilizes.


19


Item 3.  Legal
Proceedings





The
Company is not currently involved in any pending legal proceedings, other than
routine litigation incidental to the Bank’s banking business. These proceedings
are not material to the Company or the Bank.





Item
4.  Reserved








Part
II





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





Common
Stock Information and Dividends





Trades in
the Company’s common stock are reported on the Over-The-Counter Bulletin Board
(OTCBB) and in the Pinksheets by at least five broker dealers under the symbol
HBKA.OB. In addition, the Company maintains a list of individuals who are
interested in purchasing its common stock and connects these people with
shareholders who are interested in selling their stock. These parties negotiate
the per share price independent of the Company. The stock transfer agent of the
Company attempts to keep a record of stock sales by asking the parties about the
trade price per share.  Please refer to the table below entitled
Common Stock Performance for a summary of sales prices known to the Company for
each of the four quarters of 2009 and 2008.





Common
      Stock Performance – 2009High
            Low
            Quarterly Average
            Dividends per ShareFirst
      Quarter
            $14.00
            $  9.10
            $11.30
            $        -Second
      Quarter
            $  9.34
            $  9.00
            $  9.19
            $        -Third
      Quarter
            $14.00
            $
      8.89
            $11.81
            $    .11Fourth
      Quarter
            $13.00
            $
      9.00
            $11.96
            $        -





Common
      Stock Performance – 2008High
            Low
            Quarterly Average
            Dividends
      per ShareFirst
      Quarter
            $17.00
            $14.25
            $16.94
            $        -Second
      Quarter
            $18.00
            $13.20
            $16.77
            $   0.22Third
      Quarter
            $17.00
            $
      8.50
            $15.79
            $        -





Fourth
      Quarter
            $17.00
            $
      8.16
            $10.79
            $        -





20


The
Company historically has paid cash dividends on an annual basis. During 2009,
the Company announced a change in which dividends would be considered at the end
of the second and fourth quarters of each fiscal year. The final determination
of the timing, amount and payment of dividends on the Common Stock is at the
discretion of the Company’s Board of Directors and will depend upon the earnings
of the Company and its subsidiaries, principally the Bank, the financial
condition of the Company and other factors, including general economic
conditions and applicable governmental regulations and policies as discussed in
Item 1. “Business – Certain Regulatory Considerations,” above. In July 2009, the
Board declared a cash dividend of $0.11 per share. In February, the 2010,
however, the Board announced that it had suspended its cash dividend as a result
of the challenging economic environment. The Board will be further considering
the current economic downturn and its effect on the earnings stream of the
Company.





Due to
the economic environment, the Board has also determined that, effective April
15th, 2010, the Company will defer interest payments on the junior subordinated
debt securities held by the Company’s subsidiary, Highlands Capital Trust
I.  As a result, distribution payments to holders of the Highlands
Capital Trust I 9.25% Capital Securities will also be deferred.





As of
March 10, 2010, the Company had approximately 1,482 shareholders of
record.





Issuer
Repurchases of Equity Securities





The Company had no repurchases of
common stock during the three months ended December 31, 2009.  The
Company does not anticipate any significant repurchases during 2010 in an effort
to retain regulatory capital.





The
Company currently has 5,011,152 shares of common stock outstanding.





Item 6. Selected Financial
Data





Not Applicable





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





The
purpose of this discussion is to provide information about the financial
condition and results of operations of the Company and its wholly-owned
subsidiaries and other information included in this report. This discussion
should be read in conjunction with the Company’s Consolidated Financial
Statements and Notes to Consolidated Financial Statements.





Caution
About Forward-Looking Statements





This
Annual Report on Form 10-K contains forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934, includeing certain plans, expectations, goals
and projections, which are inherently subject to numerous assumptions, risks and
uncertainties. The Company's actual results could differ materially from those
set forth or implied in the forward-looking statements.





Such
forward-looking statements involve known and unknown risks including, but not
limited to, the following factors:


21


·
            Difficult
      market conditions in our industry;


·
            Unprecedented
      levels of market volatility;


·
            Effects
      of soundness of other financial
institutions;


·
            Uncertain
      outcome of recently enacted legislation to stabilize the U.S. financial
      system;


·
            Potential
      impact on us of recently enacted
legislation;


·
            Further
      deterioration in the housing
market;


·
            Continued
      problems related to the national credit crisis and deepening
      recession;


·
            Unemployment
      continuing to rise;


·
            The
      ability to successfully manage the Company’s growth or implement its
      growth strategies if it is unable to identify attractive markets,
      locations or opportunities to expand in the
  future;


·
            The
      ability to continue to attract low cost core deposits to fund asset
      growth;


·
            The
      ability to attract and maintain capital levels adequate to support the
      Company’s growth;


·
            Maintaining
      cost controls and asset qualities as the Company opens or acquires new
      branches;


·
            Reliance
      on the Company’s management team, including its ability to attract and
      retain key personnel;


·
            The
      successful management of interest rate
risk;


·
            Changes
      in general economic and business conditions in the Company’s market
      area;


·
            Changes
      in interest rates and interest rate
policies;


·
            Risks
      inherent in making loans such as repayment risks and fluctuating
      collateral values;


·
            Competition
      with other banks and financial institutions, and companies outside of the
      banking industry, including those companies that have substantially
      greater access to capital and other
resources;


·
            Demand,
      development and acceptance of new products and
  services;


·
            Problems
      with technology utilized by the
Company;


·
            Changing
      trends in customer profiles and behavior;
and


·
            Changes
      in banking and other laws and regulations applicable to the
      Company.








Overview





At
December 31, 2009, the Bank had total assets of $648.21 million. Total deposits
at this date were $521.31 million. The Bank’s net loss for 2009 was $5.74
million which produced a return on average assets of -.86% and a return on
average stockholders' equity of –13.07%. Refer to Note 21 of the Notes to
Consolidated Financial Statements for the Bank’s risk-based capital
ratios.





The Bank offers general retail and
commercial banking services to individuals, businesses and local government
units. These products and services include accepting deposits in the form of
checking accounts, money market deposit accounts, interest-bearing demand
deposit accounts, savings accounts and time deposits; making real estate,
commercial, revolving, consumer, credit card and agricultural loans; offering
letters of credit; providing other consumer financial services, such as
automatic funds transfer, collections, night depository, safe deposit, travelers
checks and savings bond sales; and providing other miscellaneous services
normally


22


offered
by commercial banks. The Bank makes loans in all major loan categories,
including commercial, commercial and residential real estate, construction and
consumer loans.





The
Company makes money primarily by earning an interest rate spread between the
interest rates it earns on loans and securities and interest rates it pays on
deposits and other borrowed money. The Company also earns money through fees,
service charges and other non-interest income.





The
Company plans to reduce the asset size of the bank in the next couple of years
in an effort to increase its regulatory capital ratios. The Company plans to
reduce its commercial real estate loan portfolio and its time deposits over the
next several months. The Company also plans to make a concerted effort to reduce
its non-performing assets.








Critical
Accounting Policies





General





The
financial condition and results of operations presented in the Consolidated
Financial Statements, accompanying Notes to Consolidated Financial Statements
and management’s discussion and analysis are, to a large degree, dependent upon
the accounting policies of the Company.  The selection and application
of these accounting policies involve judgments, estimates, and uncertainties
that are susceptible to change.





Presented
below is a discussion of the Accounting Policy that management believes is
important to the understanding of the Company’s financial condition and results
of operations.  This critical accounting policy requires management’s
most difficult, subjective and complex judgments about matters that are
inherently uncertain.  In the event that different assumptions or
conditions were to prevail, and depending upon the severity of such changes, the
possibility of materially different financial condition or results of operations
is a reasonable likelihood.  See also Note 1 of the Notes to
Consolidated Financial Statements.





Allowance for Loan
Losses





The
Company monitors and maintains an allowance for loan losses to absorb the
estimate of probable losses inherent in the loan portfolio.  The
allowance for loan losses is based on management’s judgment and analysis of
current and historical loss experience, risk characteristics of the loan
portfolio, concentrations of credit and asset quality, as well as other internal
and external factors, such as general economic conditions. The Company
recognizes the inherent imprecision in estimates of losses due to various
uncertainties, and variability related to the factors used. If different
assumptions or conditions were to prevail and it is determined that the
allowance is not adequate to absorb the new estimate of probable losses, an
additional provision for loan losses would be made, which amount may be material
to the Consolidated Financial Statements.




Other than Temporary
Impairment
  On a
quarterly basis the Company reviews any securities which are considered to be
impaired as defined by accounting guidance. During this review, the Company
determines if the impairment is deemed to be other-than-temporary. If it is
determined that the impairment is other-than-temporary, i.e. impaired because of
credit issues, the investment is written down through the Statement of
Operations in accordance with accounting guidance.
  23
  Performance
Summary





The
following table shows the Company’s key performance ratios for the years ended
December 31, 2009 and 2008:














2009
            2008
            2007Return
      on Average Assets
            (-0.96%)
            0.02%
            0.76%Return
      on Average Equity
            (-16.02%)
            0.27%
            10.61%Basic
      Earnings  (Loss) Per Share
            ($-1.27)
            $
      0.02
            $0.95Fully
      Diluted Earnings (Loss) Per Share
            ($-1.27)
            $
      0.02
            $0.94Net
      Interest Margin (1)
            3.28%
            3.41%
            3.43%(1)  
      Net Interest Margin - Year-to-date tax equivalent net interest income
      divided by year-to-date average earning assets.
              .
            5.98%
            6.30
            7.13%





24


Growth





The
following table shows the Company’s key growth indicators for the years ended
December 31, 2009 and 2008:





(dollar
amounts in thousands)





12/31/09
            12/31/08Securities
            $      70,948
            $    106,647Loans,
      net
            $   
      474,438
            $   
      485,254Deposits
            $   
      519,904
            $  
      522,736Assets
            $   
      645,307
            $  
      668,996





Asset
Quality





The
following table shows the Company’s key asset quality indicators for the years
ended December 31, 2009 and 2008:


(dollar
amounts in thousands)





12/31/09
            12/31/08Non-
      accrual loans
            $ 
      11,559
            $  
      6,278Loans
      past due over 90 days
            4,260
            656Other
      real estate owned
            6,847
            3,792Allowance
      for loan losses to total loans
            2.40%
            1.05%Net
      charge-off ratio
            0.63%
            0.21%





For further
information see the discussion under "Provision and Allowances for Loan
Losses".








2008-2009
Economic Environment-





In
response to the financial crises affecting the banking system and financial
markets, the Emergency Economic Stabilization Act of 2008 ( “EESA”) was signed
into law in October 2008.  Pursuant to EESA, the U.S. Treasury was
given the authority to, among other things, purchase up to $700 billion of
mortgages, mortgage-backed securities and certain other financial instruments
from financial institutions for the purpose of stabilizing and providing
liquidity to the U.S. financial markets.  Of that $700 billion, the
Treasury made $250 billion of capital available to financial institutions in the
form of preferred stock and warrants through the Troubled Asset Relief Program
Capital Purchase Program (the “TARP Capital Purchase
Program”).  Participating financial institutions were required to
adopt the Treasury’s standards for executive compensation and corporate
governance pursuant to EESA, as amended by the American Reinvestment and  25
 
 In
November 2008, the Federal Deposit Insurance Corporation (the “FDIC”)
established the Temporary Liquidity Guarantee Program (“TLGP”).  Under
the TLGP, the FDIC will fully guarantee, all non-interest-bearing transaction
accounts, including NOW accounts with interest rates of
0.5 percent or less and IOLTAs (lawyer trust accounts).  On December
3, 2008, the Bank elected to participate in both guarantee
programs.





In
addition, the limit on FDIC coverage has been temporarily increased to $250,000
for all accounts through December 31, 2013.  The costs
association with bank resolutions or failures also have substantially depleted
the Deposit Insurance Fund.  As a result, the FDIC has been
implementing and considering different methodologies by which it may increase
premium amounts.  The FDIC almost doubled its assessment rate on
well-capitalized institutions by raising the assessment rate 7 basis points at
the beginning of 2009.  In May 2009, the FDIC issued a final rule
regarding a special assessment of 5 basis points on an institution’s total
assets minus its Tier 1 capital as of June 30, 2009.  The FDIC adopted
another final rule effective April 1, 2009, to change the way that the
FDIC’s assessment system differentiates for risk, make corresponding changes to
assessment rates beginning with the second quarter of 2009, as well as other
changes to the deposit insurance assessment rules.  In
November 2009, the FDIC voted to require insured depository institutions to
prepay slightly over three years of estimated insurance assessments.
Additionally, the FDIC has proposed using executive compensation as a factor in
assessing the premiums paid by insured depository institutions to the Deposit
Insurance Fund.





Many of these
emergency government programs enacted in 2008 in response to the financial
crisis and the recession slowed or wound down in 2009, and global regulatory and
legislative focus has generally moved to a second phase of broader reform and a
restructuring of financial institution regulation. Legislators and regulators in
the United States are currently considering a wide range of proposals that, if
enacted, could result in major changes to the way banking operations are
regulated. Some of these major changes may take effect as early as
2010.  Certain reform proposals under consideration could result in
our becoming subject to stricter capital requirements and leverage limits, and
could also affect the scope, coverage, or calculation of capital, all of which
could require us to reduce business levels or to raise capital.  In
addition, the enactment of certain reform proposals under consideration could
introduce stricter substantive standards, oversight and enforcement of rules
governing consumer financial products and services, with particular emphasis on
retail extensions of credit and other consumer-directed financial products or
services.





26





Results
of Operations





Net Interest
Income


(dollar
amounts in thousands)





Net
interest income for 2009 was $18,329 or a decrease of $1.360 million over 2008.
During 2009 interest income decreased by $4,843. This was a result of both
existing interest earning assets re-pricing at lower rates and new loans made
and securities purchased at lower rates. Average interest earning assets
decreased approximately $22,575 from 2008.. Additionally, the amount of
non-accruing assets increased over 2008. Interest-bearing liabilities also
re-priced downward, causing a decrease in interest expense of $3,478.The average
balance of interest earning assets declined only 169 thousand from 2008. During
the latter part of 2007, the Federal Reserve Board began lowering interest rates
due to recessionary fears and the current weaknesses in the economy. The Fed
continued to lower rates during 2008 with the Fed Funds target rate falling to
historic lows due the credit crisis / recession. The net result of these changes
was a decrease in the Company’s net interest margin to 3.28% in 2009 from 3.41%
in 2008. During December 2009, the Company decreased its net funding from the
FHLB by pre-paying 2 advances totaling $13,000. The Company paid these advances
off by selling approximately 13,000 of available for sale securities. Both
advances carried interest rates exceeding 6%. The continued competition for
deposits in the Company’s market areas has slowed deposit growth.  The
tax equivalent yield on earning assets for 2009 was 5.99%, decreasing 59 basis
points during the year.
During the same period, the yield on interest bearing liabilities was 3.00%,
which was a decrease of 65 basis points. During 2008, the Bank also became a
member of the CDARS network, both to provide alternative funding and to provide
its customers with full FDIC insurance by “swapping” deposits with other FDIC
insured banks”. The Bank utilized the CDARS program throughout
2009.  See additional information on the CDARS network in the
“Deposits” section below. The Bank continues to look for alternative funding
sources in an effort to reduce its cost of funds.








Analysis of Net Interest
Earnings





The
following table shows the major categories of interest-earning assets and
interest-bearing liabilities, the interest earned or paid, the average yield or
rate on the average balance outstanding, net interest income and net yield on
average interest-earning assets and average interest spread for the years
indicated.








Year
      Ended December 31,2009
            2008
            2007(Dollars
      in Thousands)Average
              Balance
            Interest
      Income/Expense
            Yield/
              Rate
            Average
              Balance
            Interest
      Income/Expense
            Yield/
              Rate
            Average
              Balance
            Interest
      Income/Expense
            Yield/
              RateASSETSInterest
      earning assets
              (taxable-equivalent
      basis):Loans
      (net of unearned
              discount
      (1)
            $490,481
            $
      30,338
            6.19%
            $477,027
            $
      32,937
            6.90%
            $441,308
            $
      32,832
            7.44%Securities
      (2)(3)
            98,791
            4,126
            5.41
            137,664
            6,296
            5.60
            148,500
            7,175
            5.89Federal
      funds sold
            6,838
            10
            0.15
            4,163
            85
            2.04
            6,521
            338
            5.18Total
      interest-earning
              assets
            $596,110
            $  34,474
            5.99%
            $618,854
            $  39,318
            6.58%
            $596,329
            $  40,345
            7.03%LIABILITIESInterest
      bearing
              liabilities:Interest
      bearing deposits
            $434,983
            $
      11,246
            2.59%
            $430,347
            $
      14,823
            3.44%
            $426,116
            $
      16,886
            3.96%Other
      interest bearing
              liabilities
            103,071
            4,899
            4.75
            107,876
            4,800
            4.45
            88,694
            4,555
            5.14Total
      interest-bearing
              liabilities
            $538,054
            $  16,145
            3.00%
            $538,223
            $  19,623
            3.65%
            $514,810
            $  21,441
            4.16%Net
      interest income
            
            $ 18,329
            
            
            $ 19,694
            
            
            $ 18,904Net
      margin on interest
              earning
      assets on a
              tax
      equivalent basis
            
            
            3.28%
            
            
            3.41%
            
            
            3.43%Average
      interest spread
            
            
            2.99%
            
            
            2.93%
            
            
            2.87%(1)
      For the purposes of these computations, non-accruing loans are included in
      the daily average loan amounts outstanding.(2)Tax
      equivalent adjustments (using 34% federal tax rates) have been made in
      calculating yields on tax-free investments. Virginia banks are exempt from
      state income tax.(3)The
      yield on securities classified as available for sale is computed based on
      the average balance of the historical amortized cost balance without the
      effects of the fair value adjustment required by Financial Accounting
      Standard 115.





27


Analysis of Changes in
Interest Income and Interest Expense





The
Company's primary source of revenue is net interest income, which is the
difference between the interest and fees earned on loans and investments and the
interest paid on deposits and other funds. The Company's net interest income is
affected by changes in the amount and mix of interest-earning assets and
interest-bearing liabilities and by changes in yields earned on interest-earning
assets and rates paid on interest-bearing liabilities. The following table sets
forth, for the years indicated, a summary of the changes in interest income and
interest expense resulting from changes in average asset and liability balances
(volume) and changes in average interest rates (rate).







Increase/(Decrease)
Due to Volume and Rate







2009
      Compared to 2008Increase (Decrease) in
            Increase
      (decrease) due to change in volume
            Increase
      (decrease) due to change in rate
            Net
      increase
              (decrease)(Dollars
      in Thousands)INTEREST
      INCOME
              Securities
            $     
      (2,104)
            $         (66)
            $    (2,170)Federal
      funds sold
            4
            (78)
            (74)Loans
            832
            (3,431)
            (
      2,599)Total
      Income Change
            $     (1,268)
            $    (3,575)
            $     (4,843)INTEREST
      EXPENSE
              Savings
      and time deposits
            $        120
            $    (3,697)
            $    (3,577)Other
      interest-bearing
              liabilities
            (228)
            327
            99Total
      Expense Change
            $       (108)
            $   (3,370)
            $    (3,478)Increase
      (Decrease) in
              Net
      Interest Income
            $    (1,160)
            $       (205)
            $    (1,365)





28


2008
      Compared to 2007Increase (Decrease) in
            Increase
      (decrease) due to change in volume
            Increase
      (decrease) due to change in rate
            Net
      increase
              (decrease)(Dollars
      in Thousands)INTEREST
      INCOME
              Securities
            $       (607)
            $       (272)
            $      (879)Federal
      funds sold
            (48)
            (205)
            (253)Loans
            2,466
            (2,361)
            105Total
      Income Change
            $       1,811
            $    (2,838)
            $   (1,027)INTEREST
      EXPENSE
              Savings
      and time deposits
            $          146
            $    (2,209)
            $   (2,063)





Other
      interest-bearing
              liabilities
            853
            (608)
            245Total
      Expense Change
            $         999
            $    (2,817)
            $   (1,818)Increase
      (Decrease) in
              Net
      Interest Income
            $        812
            $         (21)
            $        791





Non-interest
Income


(dollar
amounts in thousands)





Non-interest
income for 2009 included an “other-than-temporary-impairment charge” in the
amount of $5.62 million. The entire $5.62 million write-down was related to
our TRUP CDOs, which represent trust preferred securities issued primarily by
banks and a limited number of insurance companies and real estate investment
trusts. The cash flow projections for the pooled trust preferred securities
utilize a discounted cash flow test that uses variables such as the estimate of
future cash flows, creditworthiness of the underlying banks and determination of
probability of default of the underlying collateral. Cash flows are constructed
in an INTEX cash flow model. It includes each individual deal’s structural
features updated with trustee information, including asset-by-asset detail, as
it becomes available. The modeled cash flows are then used to determine if all
the scheduled principal and interest payments of our investments will be
returned.





The
expected future default assumptions for the pooled trust preferred securities
are based upon the Company’s best estimate of future bank deferrrals. Banks
currently in default or deferring interest payments are assigned a 100%
probability of default. In all cases, a 15% projected recovery rate is applied
to current deferrals and projected defaults.





In
addition, the risk of future OTTI may be influenced by additional bank failures,
prolonged recession in the U.S. economy, changes in real estate values, interest
deferrals, and whether the federal government provides assistanceto certain financial institutions.(See Footnote 2 in the Company’s Consolidated Financial Report for
further discussion concerning OTTI).





In
2008 the Company made the decision to record a $5.99 million “other than
temporary impairment” charge on its holdings of preferred stock  of
the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and the Federal
National Mortgage Corporation (Fannie Mae”), both government sponsored
enterprises (“GSE”). The decision to recognize the unrealized mark-to-market
loss on these securities as an “other-than-temporary impairment (“OTTI”) was
based on the significant decline in the market value of the securities caused by
recent events.







29


Excluding
OTTI charges, the Company’s non-interest income increased by $1.01 million from
2008 to 2009. The majority of this increase was related to life insurance
benefits in the amount of $656 and a gain on the sale of a parcel of land in the
amount of $292. Service charges on deposit accounts (primarily NSF fees)
decreased $189 as compared to 2008. The number of checks processed continues to
decline as the number of electronic transactions increases.  Debit
card fee income increased by $86 over 2008 due to increases in visa check card
interchange fees. The use of debit cards continued to increase significantly
over the prior period.    The Company also introduced a
rewards points program related to signature based debit card transactions during
the latter part of 2008. This program is geared to increase the Company’s debit
card fee income in future periods.





Earnings
related to the Company’s holdings of Bank Owned Life Insurance totaled $458 in
2009 and $499 in 2008.





Net
securities gains totaled $380 in 2009 compared to $137 in 2008.


Non-interest
Expense


(dollar
amounts in thousands)





Non-interest
expense is comprised of salaries and employee benefit costs, occupancy expenses,
furniture and equipment expenses and other operating expenses. Non-interest
expense for 2009 was $20,349, an increase of $2,172 over
2008.  Salaries and employee benefits increased by 2.93% or $301
primarily due to the Company opening a new branch  in Sevierville, TN
in the fourth quarter of 2008. Expenditures related to these branch expansions
also increased occupancy expense and furniture and fixtures expense over 2008.
Medical insurance costs increased $302 over 2008. Recent technology
enhancements, however, have allowed the bank to leverage its existing personnel
base to help minimize overall increases in personnel costs. As a result of the
severe economic recession and the numerous bank failures, FDIC premiums
increased $852 over 2008.  OREO write-downs and subsequent losses on
sales of OREO increased $911 over 2008. The drop in market values resulting from
the economic recession has made the selling of OREO very challenging even after
significantly lowering asking prices.





Income
Taxes


(dollar
amounts in thousands)





Income
tax expense for 2009 decreased $3,691 when compared to 2008 as a result
of  the decrease in pretax income. Significant increases in the
provision for loan losses and OTTI charges during 2009 were the primary
contributors to the Company’s net loss before taxes. Life insurance benefits,
interest income from tax exempt municipal bonds and earnings related to the
Company’s investment in BOLI are the primary elements of tax exempt
income.





Provision and Allowance for
Loan Losses


(dollar
amounts in thousands)





The
adequacy of the allowance for loan losses is based on management's judgment and
analysis of current and historical loss experience, risk characteristics of the
loan portfolio, concentrations of credit and asset quality, as well as other
internal and external factors, such as general economic
conditions.  The internal credit review department performs
pre-approval analyses of large credits and also conducts credit review
activities that provide management with an early warning of loan deterioration.
The internal credit review department also prepares regular analyses of the
adequacy of the allowance for loans losses. These analyses include calculations
based upon a mathematical formula that considers identified potential losses on
specific loans and makes pool allocations for historical losses for various loan
types. In recent years, the Company has used a rolling three year history by
loan category in determining pool allocation factors. However, due to the severe
economic recession, the Company based its pool allocations as of December 31,
2009 to more closely match 2009 losses. In addition, an amount is allocated
based upon such factors as changing trends in the loan mix, the effects of
changes in business conditions and market area, unemployment trends, the effects
of any changes in loan policies, the effects of competition, regulatory factors,
and environment factors on the loan portfolio. As a result of the continued
recession, the Company increased its 2009 provision for loan losses by $8.02
million over 2008 due to the significant increase in
non-performing  and past due loans.





The
internal credit review department as well as management has determined that the
Company's allowance for loan losses is sufficient.





30





The
following table presents the Company’s loan loss experience for the past five
years:





Years
      Ended December 31,
              (Dollars
      in Thousands)2009
            2008
            2007
            2006
            2005Allowance
      for loan losses at
              beginning
      of year
            $     
      5,171
            $      
      4,630
            $    
        4,565
            $      
      4,359
            $     
      4,181Loans
      charged off:Commercial
            698
            195
            47
            206
            131Real
      Estate – mortgage
            1,659
            283
            99
            58
            205Consumer
            670
            607
            444
            539
            791Other
            220
            231
            242
            277
            0Total
            $      3,247
            $
            1,316
            $          832
            $   
         1,080
            $ 
           1,127Recoveries
      of loans previously
              charged
      off:Commercial
            $            12
            $          122
            $            36
            $            14
            $   
               17Real
      Estate – mortgage
            1
            1
            54
            10
            10Consumer
            114
            144
            121
            115
            123Other
            16
            0
            1
            0
            0Total
            $    
           143
            $       
        267
            $ 
              212
            $  
             139
            $   
            150Net
      loans charged off
            $   
         3,104
            $     
       1,049
            $      
         620
            $     
          941
            $      
         977Provision
      for loan losses
            9,614
            1,590
            685
            1,147
            1,155Allowance
      for loan losses end of year
            $      11,681
            $   
         5,171
            $  
          4,630
            $   
         4,565
            $ 
           4,359Average
      total loans (net of unearned income)
            $   
      490,481
            $ 
       477,027
            $ 
       441,308
            $  
      422,525
            $  
      400,759Total
      loans (net of unearned income) at year-end
            $   
      486,119
            $
        490,425
            $  
      451,291
            $  
      437,599
            $  
      411,633Ratio
      of net charge-offs to average loans
            0.633%
            0.220%
            0.140%
            0.223%
            0.244%Ratio
      of provision for loan losses to average loans
            1.960%
            0.333%
            0.155%
            0.271%
            0.288%Ratio
      of provision for loan losses to net charge-off
            309.729%
            151.573%
            110.484%
            121.892%
            118.219%Allowance
      for loan losses to year-end loans
            2.402%
            1.054%
            1.026%
            1.043%
            1.059%





Non-performing
loans


(dollar
amounts in thousands)





The loan portfolio of the Bank is
reviewed regularly by senior officers to monitor loan performance. The frequency
of the review is based on the rating of credit worthiness of the borrower
utilizing various factors such as net worth, credit history and customer
relationship. The evaluations emphasize different factors depending upon the
type of loan involved. Commercial and real estate loans are reviewed on the
basis of projections of cash flow and estimated net realizable value through an
evaluation of collateral and the financial strength of the
borrower.


Installment
loans are evaluated largely on the basis of delinquency data because of the
large number of such loans and relatively small size of each individual
loan.





Management’s review of commercial and
other loans may result in a determination that a loan should be placed
on  non-accrual. It is the policy of the Bank to discontinue the
accrual of interest on any loan on which full repayment of principal and / or
interest is doubtful. Subsequent collection of interest is recognized as income
on a cash basis upon receipt. Placing a loan on non-accrual status for the
purpose of income recognition is not in itself a reliable indication of
potential loss of principal. Other factors, such as the value of the collateral
securing the loan and


31


the
financial condition of the borrower, serve as more reliable indications of
potential loss of principal.




The
policy of the Bank is that non-performing loans consist of loans accounted for
on a non-accrual basis and loans which are contractually past due 90 days or
more in regards to interest and/or principal payments. The following table
presents non-performing loans at December 31.









2009
            2008
            2007
            2006
            2005(Amounts
      in thousands)Non-performing
      loans
            $   15,819
            $     6,934
            $     8,117
            $     3,400
            $     4,201Non-accrual
      loans
            $   11,559
            $     6,278
            $     7,849
            $     2,696
            $     2,920Loans
      past-due 90 days and more and still accruing
            $     4,260
            $        656
            $        268
            $        704
            $     1,281Interest
      income lost on non-accruing loans
            $        497
            $        417
            $        333
            $        234
            $        227Troubled
      Debt Restructurings
            $     6,010
            $   
      4,393
            --
            --
            --


The 2
most significant components of the Bank’s non-performing assets at December 31,
2009 are two large commercial credits. The first credit totals approximately
$4.2 million. The Company is currently acquiring the property through
foreclosure and bankruptcy proceedings. Approximately $1.3 million of the
balance was transferred to OREO in June of 2008. The second credit totals
approximately $4.24 million and is currently past due in excess of 90 days. In
the event the collateral value is over-estimated or deteriorates management
believes a sufficient amount of loan loss reserve has been allocated to the
remainder of the credits to cover any potential future losses. The Company has
seen the greatest deterioration of its commercial real estate portfolio in its
Sevierville TN market area.





Due to the
significant increase in non-performing loans the Company significantly increased
its loan loss provision and reserve balance during 2009. Management feels that
at December 31, 2009, reserves are adequate to absorb future losses. The
adequacy of the loan loss reserve is reviewed and approved quarterly by the
Board of Directors.





32





Allocation of the allowance
for loan losses





The following table provides an
allocation of the allowance for loan losses at December 31, 2009, 2008, 2007,
2006 and 2005.








December
      31,
              Percent
      of Loans on each Category
              
              (Dollars
      in Thousands)2009
            2008
            2007Allowance
      for
              Loan Loss
            Percentage
      of Total Allowance
            Percentage
      of
              Total Loans
            Allowance
      for
              Loan Loss
            Percentage
      of Total Allowance
            Percentage
      of
              Total Loans
            Allowance
      for
              Loan Loss
            Percentage
      of Total Allowance
            Percentage
      of
              Total LoansCommercial
            $        814
            6.97%
            9.21%
            $        262
            5.07%
            9.83%
            $        1,005
            21.71%
            9.46%Real
      Estate
            9,450
            80.90
            84.02
            3,401
            65.78
            82.79
            2,187
            47.22
            81.94Consumer
            918
            7.86
            6.14
            455
            8.79
            6.35
            589
            12.72
            7.42Other
      / Unallocated
            499
            4.27
            0.63
            1,053
            20.36
            1.03
            849
            18.35
            1.18Total
            $    11,681
            100.00%
            100.00%
            $    5,171
            100.00%
            100.00%
            $   
          4,630
            100.00%
            100.00%








2006
            2005Allowance
      for
              Loan Loss
            Percentage
      of Total Allowance
            Percentage
      of
              Total Loans
            Allowance
      for
              Loan Loss
            Percentage
      of Total Allowance
            Percentage
      of
              Total LoansCommercial
            $        1,691
            37.04%
            9.76%
            $        710
            16.29%
            9.38%Real
      Estate
            593
            12.99
            80.77
            1,255
            28.79
            79.42Consumer
            768
            16.82
            8.14
            858
            19.68
            10.07Other
      / Unallocated
            1,513
            33.15
            1.33
            1,536
            35.24
            1.13Total
            $     
        4,565
            100.00%
            100.00%
            $    4,359
            100.00%
            100.00%





_________________________________________________________________________________________________________________


33


Financial
Condition





Balance
Sheet


(dollar
amounts in thousands)








Total
assets for the Company decreased by $23,689 or 3.54% in 2009. During December
2009, the Company decreased its net funding from the FHLB by pre-paying 2
advances totaling $13,000. The Company paid these advances off by selling
approximately 13,000  of available for sale securities. Both advances
carried interest rates exceeding 6%. Interest earning assets decreased by
$22,744 or 3.68% for the year. The primary reason for the drop in interest
earning assets was the investment earning portfolio drastically reducing during
the year. Average interest bearing liabilities decreased by $169 or 0.03% in
2009. The Company plans to continue to reduce its asset size in 2010 and 2011 in
an effort to increase its regulatory capital ratios by reducing its holdings of
commercial real estate loans.





Loans


(dollar
amounts in thousands)








Loans net
of unearned income and deferred fees decreased by $4,306 or 0.88% in 2009. Loan
demand has significantly subsided during the economic downturn.  Loans
secured by real estate increased approximately $2,274 whereas loans secured by
collateral other than real estate and unsecured loans decreased approximately
$6,592.





Prior to
2009, the Company’s portfolio of commercial, construction and land development
loans has also experienced significant growth. During 2008, this segment of
loans grew $19,544 or 12.23%. The Company made a concerted effort over the past
2 years to reduce its construction and development portfolios as these types of
loans faced the greatest risk of loss due to the recession and began curtailing
its lending for these types of loans during 2008 as the economy began to suffer.
This segment of loans decreased by $5,586 or 3.11% during 2009. As the sales of
real estate has slowed significantly in the latter part of the year a diligent
effort was made to concentrate on permanent financing for residential mortgages
and owner occupied commercial real estate loans.





The
Company has also implemented a separate credit analysis department to review the
larger loan requests, typically loan requests in excess of $250,000. This
department operates separately from the loan origination arm of the Company and
completes independent and unbiased reviews of each new loan request. The senior
officer of this department meets monthly with the Loan Committee of the Board of
Directors.


34







Loan
Portfolio







The table below classifies gross loans
by major category and percentage distribution at December 31, for each of the
past five years:








December
      31,
              (Dollars
      in thousands)2009
            2008
            2007
            2006
            2005Amount
            Percentage
            Amount
            Percentage
            Amount
            Percentage
            Amount
            Percentage
            Amount
            PercentageReal
      Estate Secured:Residential
      1-4 family
            $
      183,983
            35.89%
            $ 176,239
            35.89%
            $163,918
            36.28%
            $
      156,753
            35.77%
            $151,815
            36.88%Multi-family
            12,895
            2.67
            13,114
            2.67
            9,420
            2.08
            10,520
            2.40
            4,148
            1.01Commercial,
      Construction
              and
      Land Development
            173,752
            36.52
            179,339
            36.52
            159,795
            35.35
            152,491
            34.80
            140,178
            34.05Second
      Mortgages
            16,980
            3.77
            18,499
            3.77
            17,964
            3.97
            15,305
            3.49
            10,962
            2.66Equity
      Line of Credit
            10,164
            2.03
            9,984
            2.03
            9,782
            2.16
            9,493
            2.17
            9,800
            2.38Farmland
            11,176
            1.93
            9,501
            1.93
            9,475
            2.10
            9,343
            2.13
            10,015
            2.43$
      408,950
            82.81%
            $
      406,676
            82.81%
            $
      370,354
            81.94%
            $
      353,905
            80.77%
            $
      326,918
            79.41%Secured,
      Other:Personal
            $   20,671
            4.45%
            $   21,854
            4.45%
            $   24,741
            5.47%
            $   27,384
            6.25%
            $   33,395
            8.11%Commercial
            30,449
            6.66
            32,725
            6.66
            26,433
            5.85
            26,943
            6.15
            25,628
            6.23Agricultural
            2,263
            0.88
            4,319
            0.88
            4,232
            0.94
            5,093
            1.16
            3,653
            .89$   53,383
            11.99%
            $   58,898
            11.99%
            $   55,406
            12.26%
            $   59,420
            13.56%
            $   62,676
            15.23%Unsecured:
            $   24,420
            5.20%
            $   25,497
            5.20%
            $   26,192
            5.80%
            $   24,845
            5.67%
            $   22,048
            5.36%Loans,
      gross
            $ 486,753
            100.00%
            $ 491,071
            100.00%
            $ 451,952
            100.00%
            $ 438,170
            100.00%
            $ 411,642
            100.00%
































35


The
following table shows the maturity of loans outstanding, inclusive of
contractual amortization, at December 31, 2009:





December
      31, 2009
              (Amounts
      in Thousands)Within
      One Year
            After
      One Year But Within Five Years
            After
      Five YearsFixed
            Floating
            Fixed
            Floating
            Fixed
            Floating
            TotalReal
      Estate Secured:Residential
      1-4 Family
            $ 
      15,556
            $ 
      4,636
            $ 
      42,310
            $ 
      7.694
            $ 
      58,833
            $ 
      54,954
            $ 
      183,983Multi-family
            1,947
            0
            6,573
            0
            1,783
            2,592
            12,895Commercial,
      Construction
              &
      Land Development
            31,590
            15,469
            79,539
            8,245
            33,582
            5,327
            173,752Second
      Mortgages
            2,279
            4,007
            5,708
            46
            4,919
            20
            16,980Equity
      Line of Credit
            0
            814
            0
            3,669
            0
            5,682
            10,164Farmland
            3,334
            1,287
            4,683
            107
            1,398
            367
            11,176Secured,
      Other:Personal
            7,747
            1
            12,148
            4
            728
            43
            20,671Commercial
            8,383
            5,934
            10,029
            43
            6,060
            0
            30,449Agricultural
            747
            1,200
            311
            6
            
            0
            2,263Unsecured
            8,115
            9,095
            4,946
            1,729
            535
            0
            24,420Loans,
      Gross
            $
      79,698
            $
      42,443
            $166,247
            $
      21,543
            $
      107,838
            $
      68,985
            $ 
      486,753












































36


Securities


(dollar
amounts in thousands)








Investment
securities available for sale decreased $35,699 (market value) from December 31,
2008 to December 31, 2009 as a result of maturities, sales, prepayments and
write-downs..  The Company made fewer purchases during 2009 primarily
due to  the worsening credit crisis and the possible need for on
balance sheet liquidity.





Yields on
typical investment securities were very low during 2009. Purchases during the
year consisted primarily of fixed rate GNMA  mortgage backed
securities. During the year, management has continued its investment strategy to
purchase securities that will not only blend in with the Company’s overall asset
liability strategy but also maximize yield. The majority of the pay downs were
contractual amortization and prepayments on variable rate securities as a result
of prepayments occurring on the underlying mortgages. GNMA securities also carry
a favorable risk weighting as it pertains to regulatory risk based
capital.





The
segment of our portfolio that contains the largest unrealized loss is our pooled
trust preferred securities (TRUP CDOs) which represent trust preferred
securities issued primarily by banks and a limited number of insurance companies
and real estate investment trusts. As of December 31, 2009, our TRUP CDOs
amortized cost totaled $5.64 million.





The Company
continues to review its investment portfolio on a quarterly basis for
indications of other-than-temporary impairment (“OTTI”).




During 2009,
the Company incurred credit-related OTTI charges of $5.62 million. The
entire $5.62 million write-down was related to the TRUP CDOs. The cash flow
projections for the pooled trust preferred securities utilize a discounted cash
flow test that uses variables such as the estimate of future cash flows,
creditworthiness of the underlying banks and determination of probability of
default of the underlying collateral.
  During the
third quarter of 2008 the Company made the decision to record a $5.99 million
“other than temporary impairment” charge on its holdings of preferred
stock  of the Federal Home Loan Mortgage Corporation (“Freddie Mac”)
and the Federal National Mortgage Corporation (Fannie Mae”), both government
sponsored enterprises (“GSE”). The decision to recognize the unrealized
mark-to-market loss on these securities as an “other-than-temporary impairment
(“OTTI”) was based on the significant decline in the market value of the
securities caused by recent events.





After
considering the impact of the 2009 and 2008 charges to earnings, both the
company and the bank remained “well capitalized” under regulatory
guidelines.  Being a non-cash impairment charge, the write-downs do
not affect the Company’s cash flows.








Investment
Portfolio








The
following table presents the maturity distribution, market value, amortized cost
and approximate tax equivalent yield (assuming a 34% federal income tax rate) of
the investment portfolio at December 31, 2009.











38


(Dollars
      in Thousands)Within
      One
              Year
            One
      Year
              Through
              Five Years
            Five
      Years
              Through
              Ten Years
            After
      Ten
              Years
            Yield
            Market
              Value
            Amortized
              CostMortgage-backed
      Sec – fixed rate
            $        309
            $      185
            $           28
            $   
       6,132
            4.12%
            $    
      6,654
            $  
       6,516Mtg.-backed
      Sec – variable rate
            -
            -
            178
            11,108
            3.64
            11,286
            11,134State
      & Municipal’s –  tax exempt
            -
            -
            1,236
            44,600
            6.21
            45,836
            46,475State
      & Municipal’s –  taxable
            -
            325
            202
            985
            5.41
            1,511
            1,527U.S.
      Agencies – fixed rate
            -
            -
            -
            1,507
            5.63
            1,507
            1,498Agency
      Preferred – variable rate
            -
            -
            -
            141
            0.00
            141
            262Corporate
      bonds – fixed rate
            -
            -
            -
            1,075
            6.98
            1,075
            1,430Corporate
      bonds – variable rate
            -
            -
            385
            1,711
            0.45
            2,096
            6,664SBA
      bonds – variable rate
            -
            -
            -
            45
            0.80
            45
            47CMO’s
      – fixed rate
            -
            -
            -
            786
            3.46
            786
            783CMO’s
      – variable rate
            -
            -
            -
            10
            3.93
            10
            10TOTAL
            309
            $        510
            $       2,029
            $ 
       68,100
            
            $  
      70,948
            $  
      76,326Total
      fixed rate securities
            $        309
            $        510
            $       1,466
            $  
      55,130
            
            $  
      57,414
            $  
      58,276Total
      variable rate securities
            $         -
            $        -
            $          563
            $  
      12,970
            
            $  
      13,534
            $  
      18,050










Deposits /
Funding


(dollar
amounts in thousands)





Total
deposits decreased by $2,832 or 0.54% in 2009. Non-interest bearing demand
deposits increased by $3,904. Interest bearing demand deposits increased by
$9,537. Total time deposits decreased by $22,213. Savings accounts increased by
$5,940 during the year. The decrease in time deposits is primarily a result of
the Company’s actions to reduce its higher cost CD’s in an effort to lower its
overall cost of funds. The Company and banks nationwide are continuing to face
the challenge of gathering deposits, especially non-interest bearing deposits.
The Company over the years has used its alternative funding sources (primarily
FHLB advances) to help facilitate growth.  However during 2009, the
Company decreased its net borrowings from the FHLB by $13,000. The $13,000 was
made up of three advances that carried rates greater than 6%.The total amount of
FHLB borrowings as of December 31, 2009 was $82,049.  See Footnotes 9
and 10 in the Company’s consolidated financial statements for a description of
the Bank’s outstanding FHLB advances. The Company secures the FHLB advances with
a selected group of residential mortgage loans and commercial real estate loans
as well as a specific group of securities available for sale. During 2008, the
Company also joined the “CDARS” network. This deposit placement service allows
banks to swap funds with each other while still allowing their customers only
one institution to deal with. All of the funds placed in the CDARS network are
fully insured by the FDIC. The Company also participates in the FDIC’s Temporary
Liquidity Guarantee Program that was implemented in the fourth quarter of 2008.
Under this program, non-interest bearing transaction accounts and transaction
accounts earning a rate of up to 0.50% are fully insured above and beyond the
existing FDIC insurance coverage amount.








39


The
following table provides a breakdown of deposits at December 31 as
indicated:





December
      31,(Amounts
      in Thousands)2009
            2008Non-interest
      bearing demand deposits
            $    84,073
            $    80,169Interest
      bearing demand deposits
            75,560
            66,023Savings
      deposits
            55,745
            49,805Time
      deposits
            304,526
            326,739Total
      Deposits
            $  519,904
            $  522,736








The
average daily amount of deposits and rates paid on such deposits is summarized
for the periods indicated in the following table:











Year
      Ended December 31,
              (Dollars
      in Thousands)2009
            2008
            2007  Amount
            
            Rate
            
            Amount
            
            Rate
            
            Amount
            
            RateNon-interest
      bearing
              demand
      deposits
            $  83,760
            
            0.00%
            
            $  85,719
            
            0.00%
            
            $  81,746
            
            0.00%Interest-bearing
      demand
              deposits
            68,059
            
            0.93
            
            62,300
            
            1.53
            
            59,468
            
            1.92Savings
      deposits
            55,187
            
            0.69
            
            50,389
            
            0.98
            
            50,497
            
            1.25Time
      deposits
            312,735
            
            3.27
            
            317,656
            
            4.21
            
            316,151
            
            4.78Total
            $519,741
            
            
            
            $516,064
            
            
            
            $507,862








The
remaining maturities of time deposits greater than or equal to $100,000 at
December 31, 2009 are as follows (Amount in thousands):





Maturity
            Amount3
      months or less
            $     29,125Over
      3 months through 6 months
            21,338Over
      6 months through 12 months
            32,351Over
      12 months
            28,823Total
            $    111,637








Effects of
Inflation





The
Company's consolidated statements of income generally reflect the effects of
inflation. Since interest rates, loan demand, and deposit levels are related to
inflation, the resulting changes are included in net income. The most
significant item which does not reflect the effects of inflation is depreciation
expense. Historical dollar values used to determine depreciation expense do not
reflect the effects of inflation on the market value of depreciable assets after
their acquisition.





Liquidity and Capital
Resources


(dollar
amounts in thousands)





40


Liquidity is the measure of the Bank’s
ability to generate sufficient funds in order to meet customers’ demands for
withdrawal of deposit balances and for the funding of loan requests. The Bank
maintains cash reserves, in accordance with Federal Reserve Bank guidelines, and
has sufficient flow of funds from investment security payments as well as loan
payments to meet current liquidity needs.





Management of the Bank continuously
monitors and plans the Bank’s liquidity position for the future. Liquidity is
provided from cash and due from banks, federal funds sold, loan and investment
security payments, core deposits, the national certificate of deposit market,
lines of credit with correspondent banks and lines of credit with the Federal
Home Loan Bank. Management believes that these sources of funds provide
sufficient and timely liquidity for the foreseeable future.


The Company’s
liquidity ultimately depends on dividends paid by the Bank, its wholly owned
subsidiary.  Dividend payments by the Bank are heavily regulated by
state and federal regulators, including a requirement that dividends in any
calendar year may not exceed the total of the Bank’s net profits for that year
and the Bank’s retained net profits for the two preceding years without prior
approval by the Federal Reserve Board.  Due to the Bank’s net loss for
the 2009 fiscal year, and based on our expected future results, we do not expect
that the Bank will be permitted to pay dividends to the Company without prior
approval until at least 2012.





In April
2009, the Company announced that it entered into a $7,500,000 Loan Commitment
with Community Bankers Bank (“CBB”), pursuant to which CBB agreed to extend to
the Company a Revolving Line of Credit of up to $3,000,000 and a Closed-End Term
Loan of up to $4,500,000 (collectively, the “Loans”). The Company pledged the
stock of the Bank as collateral for the Loans.  The Loan proceeds may
be down-streamed to the Bank and counted as Tier 1 capital at the Bank
level.





As of
December 31, 2009 the outstanding balances on the Loans were $0 for the Line of
Credit and $3,000,000 for the Term Loan.





The Line
of Credit accrues interest at the U.S. prime rate, subject to a floor of 5% and
a ceiling of 9%. The Term Loan accrues interest at a rate of 6.75% using a ten
year amortization period with a balloon date in five years. The Loans may be
repaid in whole or in part at any time without penalty. The Line of
Credit  matures on April 21,2012. The Term Loan matures on April 21,
2014.The
Company is currently in compliance with the terms of both of the Loans. Both
loans may be renewed assuming no conditions of default exist.





Both the
Company and the Bank remained “well capitalized” under regulatory guidelines.
(See Footnote 21 in the Company’s Consolidated Financial Report for further
discussion concerning regulatory capital requirements).





Recent
Accounting Pronouncements





See Note 1 of Notes to Consolidated
Financial Statements for information relating to recent accounting
pronouncements.





Off-Balance
Sheet Arrangements





See Note 16 of Notes to Consolidated
Financial Statements for information relating to Off-Balance Sheet
Arrangements.








41





Item 7A. Quantitative and
Qualitative Disclosures About Market Risk









Item 8. Financial Statements
and Supplementary Data





The following financial statements are
incorporated by reference from the Annual Report to Shareholders for the fiscal
year ended December 31, 2009:





Report of
Independent Registered Public Accounting Firm on the Financial
Statements;


Consolidated
Balance Sheets as of December 31, 2009 and 2008;


Consolidated
Statements of Income for the years ended December 31, 2009 and
2008;


Consolidated
Statements of Stockholders’ Equity for the years ended December 31, 2009 and
2008;


Consolidated
Statements of Cash Flows for the years ended December 31, 2009 and 2008;
and


Notes to
Consolidated Financial Statements for December 31, 2009








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





None.





Item 9A(T). Controls and
Procedures


On an
on-going basis, senior management monitors and reviews the internal controls
established for the various operating activities of the Bank. Additionally, the
Company has created a Disclosure Review Committee to review not only internal
controls but the information used by Company’s financial officers to prepare the
Company’s periodic SEC filings and corresponding financial statements. The
Committee is comprised of the Senior Management Team of the Bank and meets at
least quarterly.  Internal audits conducted by the Company’s internal
audit department are also reviewed by senior officers to assist them in
assessing the adequacy of the Company’s internal control structure. These audits
are also discussed in detail with the Company’s Audit Committee.




We have
carried out an evaluation, under the supervision and the participation of our
management, including our Executive Vice President and Chief Executive Officer,
our Chief Financial Officer and our Vice President of Accounting, of the
effectiveness of the design and operation of our disclosure controls and
procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities
Exchange Act of 1934, as amended (the “Act”), as of the end of the fiscal year
covered by this report. Based upon that evaluation, our CEO, CFO and VP
Accounting concluded that our disclosure controls and procedures are effective
in providing reasonable assurance that (a) the information required to be
disclosed by us in the reports that we file or submit under the Act is recorded,
processed, summarized and reported within the time periods specified in the
Securities and Exchange Commission’s rules and forms, and (b) such information
is accumulated and communicated to our management, including our CEO, CFO and VP
Accounting, as appropriate to allow timely decisions regarding required
disclosure.





There
were not any changes in the Company’s internal controls over financial reporting
during the fourth fiscal quarter of the fiscal year covered by this report that
have materially affected, or are reasonably likely to materially affect, our
internal control over financial reporting.







42


Item 9B. Other
Information





None





Part
III.





Item
10.  Directors, Executive Officers and Corporate
Governance





Pursuant to General Instruction G(3) of
Form 10-K, the information contained under the headings “The Nominees,”
“Executive Officers Who Are Not Directors,” “Section 16(a) Beneficial Ownership
Reporting Compliance,” “The Board of Directors and its Committees” and “Code of
Ethics” in the Company’s Proxy Statement for the 2010 Annual Meeting of
Shareholders is incorporated herein by reference.





Item 11. Executive
Compensation





Pursuant to General Instruction G(3) of
Form 10-K, the information contained under the headings  “Executive
Compensation” in the Company’s Proxy Statement for the 2010 Annual Meeting of
Shareholders is incorporated herein by reference.








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





Pursuant to General Instruction G(3) of
Form 10-K, the information contained under the heading “Security Ownership of
Management and Certain Beneficial Owners” in the Company’s Proxy Statement for
the 2010 Annual Meeting of Shareholders is incorporated herein by
reference.





The
following table sets forth information as of December 31, 2009, with respect to
compensation plans under which shares of Common Stock are authorized for
issuance.





Equity
Compensation Plan Information





Plan Category
            Number
      of Securities to Be Issued upon Exercise of Outstanding Options, Warrants and Rights
            Weighted
      Average
              Exercise
      Price of Outstanding Options, Warrants and
      Rights
            Number
      of Securities Remaining Available
              for
      Future Issuance
              Under
      Equity
              Compensation Plans (a)Equity
      Compensation Plans Approved by Shareholders
            262,779
            $  13.51
            --Equity
      Compensation Plans Not Approved by Shareholders (b)
            -
            $         -
            200,000Total
            262,779
            $  13.51
            200,000





(a)
            Amounts
      exclude any securities to be issued upon exercise of outstanding options,
      warrants and rights.


(b)
            On
      September 13, 2006, the Board of Directors of the Company approved the
      Highlands Bankshares, Inc. 2006 Equity Compensation Plan (the
      Plan).  The Plan authorizes the Personnel and Compensation
      Committee (the Committee) of the Board of Directors to grant options,
      stock appreciation rights, stock awards and stock units to directors,
      officers, key employees, consultants and advisors to the Company and its
      subsidiaries who are designated by the Committee.  The Company
      is authorized to issue under the Plan up to 200,000 shares of its Common
      Stock.  Generally, if an award is forfeited, expires or
      terminates, the shares allocated to that award under the Plan may be
      reallocated to new awards under the Plan.  Shares surrendered
      pursuant to the exercise of a stock option or other award or in
      satisfaction of tax withholding requirements under the Plan may also be
      reallocated to other awards.








43





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





Pursuant to General Instruction G(3) of
Form 10-K, the information contained under the heading “Transactions with
Related Parties” and “The Board of Directors and its Committees” in the
Company’s Proxy Statement for the 2010 Annual Meeting of Shareholders is
incorporated herein by reference.





Item 14. Principal
Accounting Fees and Services




Pursuant
to General Instruction G(3) of Form 10-K, the information contained under the
headings “Services and Fees” and “Pre-Approved Policies and Procedures” in the
Company’s Proxy Statement for the 2010 Annual Meeting of Shareholders is
incorporated herein by reference.





Part IV.





Item 15. Exhibits, Financial
Statement Schedules





(a)  (1)    The
response to this portion of Item 15 is submitted as a separate section of this
report.





(2)
            All
      applicable financial statement schedules required by Regulation S-X are
      included in the Notes to the 2008 Consolidated Financial
      Statements.





(3)
            Exhibits:





3.1
            Amended
      and Restated Articles of Incorporation of
      Highlands Bankshares, Inc., filed as Exhibit 3.1 to the Quarterly Report
      on Form 10-Q for the period ended March 31,
  2009.





3.2
            Bylaws
      of Highlands Bankshares, Inc. attached as Exhibit 3.2 to the Registration
      Statement on Form 8-A, File No. 000-27622, filed with the Commission on
      January 24, 1996, incorporated herein by
  reference.





10.1
            Highlands
      Union Bank 1995 Stock Option Plan, attached as Exhibit 10.1 to the Annual
      Report on Form 10-K for the fiscal year ended December 31, 2002, File No.
      000-27622, incorporated herein by
reference.





10.2
            Highlands
      Bankshares, Inc. 2006 Equity Compensation Plan,filed as Exhibit 3.1 to the Current Report on
      Form 8-K, File No. 000-27622, filed with the Commission on September 20,
      2006, incorporated herein by
reference.





44


13.1
            Annual
      Report to Shareholders – Financial
Statements





21
            Subsidiaries
      of the Corporation.




23.1
            Consent
      of Brown, Edwards & Company,
L.L.P.





31.1
            Section
      302 Certification of Chief Executive
Officer.





31.2
            Section
      302 Certification of Chief Financial Officer of the
      Corporation





31.3
            Section
      302 Certification of Vice President of
  Accounting





32.1
            Statement
      of Chief Executive Officer Pursuant to 18 U.S.C. §
  1350.





32.2
            Statement
      of Chief Financial Officer of the Corporation Pursuant to 18 U.S.C. §
      1350.





32.3
            Statement
      of Vice President of Accounting Pursuant to 18 U.S.C. §
    1350.





(b)                  Exhibits.





The
      response to this portion of Item 15 as listed in Item 15(a)(3) above is
      submitted  as a separate section of this
  report.





(c)                  
Financial Statement Schedules.





The
response to this portion of Item 15 is submitted as a separate section of
this   report.








45


SIGNATURES





Pursuant to the requirements of Section
13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.





HIGHLANDS BANKSHARES,
INC.





Date:  April
14th,
2010                                                          BY:/s/ Samuel L.
Neese


Samuel L.
Neese


Executive Vice President
and


Chief
Executive Officer





BY: /s/ Robert M. Little,
Jr.                                               
     BY:/s/ James R.
Edmondson


Robert M. Little, Jr.James R.
Edmondson


Chief Financial
Officer                                                                         
 Vice President of
Accounting






Pursuant to the requirements of the
Securities Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated on April 14, 2010.





Signature
              Title
              Date/s/ James D.
      Morefield
                James D. Morefield
              Chairman
      of the Board, and Director
              April
      14, 2010/s/ Dr.
      James D. Moore,
      Jr.
                Dr. James D. Moore, Jr.
              President
              April
      14, 2010/s/ J. Carter Lambert
                J. Carter Lambert
              Vice
      Chairman
              April
      14, 2010  46
 
 /s/ Samuel L.
      Neese
                Samuel L. Neese
              Executive
      Vice President, and Chief Executive Officer (principal executive
      officer)
              April
      14, 2010
 /s/ William E.
      Chaffin
                William E. Chaffin
              Director
              April
      14, 2010/s/ E. Craig
      Kendrick
                E. Craig Kendrick
              Director
              April
      14, 2010/s/ Clydes B.
      Kiser
                Clydes B. Kiser
              Director
              April
      14, 2010/s/ Charles P.
      Olinger
                Charles P. Olinger
              Director
              April
      14, 2010/s/ William J.
      Singleton
                William J. Singleton
              Director
              April
      14, 2010/s/ Dr. H. Ramsey White,
      Jr.
                Dr.
      H. Ramsey White, Jr.
              Director
              April
      14, 2010
  47


EXHIBIT
INDEX





Exhibit
No.                      Description





3.1
            Amended
      and Restated Articles of Incorporation of
      Highlands Bankshares, Inc., filed as Exhibit 3.1 to the Quarterly Report
      on Form 10-Q for the period ended March 31,
  2009.





3.2
            Bylaws
      of Highlands Bankshares, Inc. attached as Exhibit 3.2 to the Registration
      Statement on Form 8-A, File No. 000-27622, filed with the Commission on
      January 24, 1996, incorporated herein by
  reference.





10.1
            Highlands
      Union Bank 1995 Stock Option Plan, attached as Exhibit 10.1 to the Annual
      Report on Form 10-K for the fiscal year ended December 31, 2002, File No.
      000-27622, incorporated herein by
reference.





10.2
            Highlands
      Bankshares, Inc. 2006 Equity Compensation Plan, filed as Exhibit 3.1 to the Current Report on
      Form 8-K, File No. 000-27622, filed with the Commission on September 20,
      2006, incorporated herein by
reference





11
            Statement
      regarding computation of per share earnings (included as Note 1 of the
      Notes to Consolidated Financial Statements in the 2008 Annual Report to
      Shareholders and incorporated herein by
  reference).





13.1
            Annual
      Report to Shareholders – Financial
Statements





21
            Subsidiaries
      of the Corporation.





23.1
            Consent
      of Brown, Edwards & Company,
L.L.P.





31.1
            Section
      302 Certification of Chief Executive
Officer.





31.2
            Section
      302 Certification of Chief Financial Officer of the
      Corporation





31.3
            Section
      302 Certification of Vice President of Accounting of the
    Bank.





32.1
            Statement
      of Chief Executive Officer Pursuant to 18 U.S.C. §
  1350.





32.2
            Statement
      of Chief Financial Officer of the Corporation Pursuant to 18 U.S.C. §
      1350.





32.3
            Statement
      of Vice President of Accounting Pursuant to 18 U.S.C. §
    1350.




















48