EDGAR 10-K Filing

Company CIK: 826154
Filing Year: 2021
Filename: 826154_10-K_2021_0000826154-21-000085.json

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ITEM 1. BUSINESS
ITEM 1 - BUSINESS
Orrstown Financial Services, Inc., a Pennsylvania corporation, is the holding company for its wholly-owned subsidiary Orrstown Bank. The Company’s principal executive offices are located at 77 East King Street, Shippensburg, Pennsylvania, with additional executive and administrative offices at 4750 Lindle Road, Harrisburg, Pennsylvania. The Parent Company was organized on November 17, 1987, for the purpose of acquiring the Bank and such other banks and bank-related activities as are permitted by law and desirable. The Company provides banking and bank-related services through branches located in south central Pennsylvania, principally in Berks, Cumberland, Dauphin, Franklin, Lancaster, Perry and York Counties, Pennsylvania, and in Anne Arundel, Baltimore, Howard and Washington Counties, Maryland, as well as Baltimore City, Maryland. Effective July 31, 2020, Wheatland Advisors, Inc., a registered investment advisor non-bank subsidiary, headquartered in Lancaster County, Pennsylvania was discontinued.
The Company files periodic reports with the SEC in the form of quarterly reports on Form 10-Q, annual reports on Form 10-K, annual proxy statements and current reports on Form 8-K for any significant events that may arise during the year. Copies of these reports, and any amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), may be obtained free of charge through the SEC’s Internet site at www.sec.gov or by accessing the Company’s website at www.orrstown.com as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the SEC. Information on our website shall not be considered a part of this Annual Report on Form 10-K.
Recent Merger and Acquisition Activity
On October 1, 2018, Orrstown expanded its presence in Franklin County, Pennsylvania, with the completion of its acquisition of Mercersburg Financial Corporation and the merger of its banking subsidiary, First Community Bank of Mercersburg, with and into Orrstown Bank.
On May 1, 2019, Orrstown expanded its presence into the greater Baltimore, Maryland, market with the completion of its acquisition of Hamilton Bancorp, Inc., and the merger of its banking subsidiary, Hamilton Bank, with and into Orrstown Bank.
Business
The Bank was organized in 1919 as a state-chartered bank. On March 8, 1988, in a bank holding company reorganization transaction, the Parent Company acquired 100% ownership of the Bank.
The Parent Company’s primary activity consists of owning and supervising its subsidiary, the Bank. Day-to-day management is conducted by its officers, who are also Bank officers. The Parent Company has historically derived most of its income through dividends from the Bank. At December 31, 2020, the Company had total assets of $2.8 billion, total deposits of $2.4 billion and total shareholders’ equity of $246.2 million.
The Parent Company has no employees. Its 12 officers are employees of the Bank. On December 31, 2020, the Bank had 400 full-time and 18 part-time employees.
The Bank is engaged in the commercial banking and trust business as authorized by the Pennsylvania Banking Code of 1965. This involves accepting demand, time and savings deposits, granting loans and providing wealth management services. The Bank holds commercial, residential, consumer and agribusiness loans, primarily in its market areas in south central Pennsylvania, the greater Baltimore region, Washington County, Maryland, and contiguous counties. The concentrations of credit by type of loan are included in Note 4, Loans and Allowance for Loan Losses, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data." The Bank maintains a diversified loan portfolio and evaluates each client’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon the extension of credit, is based on management’s credit evaluation of the client pursuant to collateral standards established in the Bank’s credit policies and procedures.
COVID-19 Pandemic
In December 2019, a novel strain of coronavirus, known as COVID-19, was first reported and was subsequently declared a pandemic by the World Health Organization in March 2020. To date, this outbreak has surfaced in nearly all regions around the world, and as the pandemic spread, particularly in the United States, businesses as well as federal, state and local governments implemented significant actions to attempt to mitigate this public health crisis. While the emergence of multiple vaccines and government stimulus have improved the economic outlook, the Company's operations have been and will continue to be disrupted to varying degrees.
Orrstown implemented the following steps to mitigate the potential spread of COVID-19 and help its clients during this challenging time:
•Launched an internal Pandemic Response Team at the outset of the COVID-19 pandemic;
•Waived Orrstown fees on all foreign ATM transactions from March 18, 2020 through June 1, 2020 to encourage and support the use of this key delivery channel;
•Waived late fees on all loan payments for 60 days through May 31, 2020 to assist those whose employment status and income may have been negatively impacted by the virus;
•Designated a select group of loan specialists to work with clients needing special assistance or guidance;
•Implemented strategic efforts to effectively operate most of the core operations of the Company in a remote work environment;
•Instituted extensive preventative measures for workplace health and safety;
•Conducted virtual, interactive webinars with lending clients and community groups in order to educate and support them on the SBA PPP process, including loan forgiveness;
•Conducted media interviews and launched a multi-channel advertising campaign in all markets aimed at educating the community about SBA PPP funding;
•Partnered with the American Bankers Association to execute their Banks Never Ask That campaign, aimed at educating clients and consumers on how to protect their privacy and money, especially during the pandemic as reports warn of heightened scam and fraud attempts;
•Maintaining enhanced staffing levels at our Client Service Center to manage and support our increased call volume;
•Continuing to educate clients and consumers on the various assistance programs available to them through the SBA, as well as other federal and state government resources; and
•Continuing to perform branch transactions via drive-thru lanes or scheduled appointments at branch locations.
Lending
Federal bank regulatory agencies have adopted uniform regulations prescribing standards for extensions of credit that are secured by liens or interests in real estate or made for the purpose of financing permanent improvements to real estate. Under these regulations, all insured depository institutions, such as the Bank, must adopt and maintain written policies establishing appropriate limits and standards for extensions of credit that are secured by liens or interests in real estate or are made for the purpose of financing permanent improvements to real estate. These policies must establish loan portfolio diversification standards, prudent underwriting standards (including loan-to-value limits) that are clear and measurable, loan administration procedures and documentation, approval and reporting requirements. The real estate lending policies must reflect consideration of the federal bank regulatory agencies’ Interagency Guidelines for Real Estate Lending Policies.
All secured loans are supported with appraisals or evaluations of collateral. Business equipment and machinery, inventories, accounts receivable, and farm equipment are considered appropriate security, provided borrowers meet acceptable standards for liquidity and marketability. Loans secured by real estate generally do not exceed 85% of the appraised value of the property. Loan to collateral values are monitored as part of the loan review process, and appraisals are updated as deemed appropriate under the circumstances.
Commercial Lending
The Bank makes commercial real estate, equipment, construction, working capital and other commercial purpose loans to commercial customers throughout the Bank’s various markets. The Bank has significant market share in south central Pennsylvania and has been expanding its presence geographically in recent years. Currently, growth markets include the Harrisburg region, Lancaster County and Maryland markets. The Bank's commercial lending is focused in these geographic regions or with borrowers headquartered in these geographic regions.
The Bank’s credit policy dictates the underwriting requirements for the various types of commercial loans the Bank makes available to borrowers. The policy covers such requirements as debt coverage ratios, advance rates against different forms of collateral, loan-to-value ratios and maximum term.
A majority of the Company’s loan assets are loans for business purposes. At December 31, 2020, approximately 77% of the loan portfolio was comprised of commercial loans.
On March 27, 2020, the Coronavirus Aid, Relief and Economic Security (“CARES”) Act was enacted. The CARES Act established the SBA PPP. The SBA PPP is intended to provide economic relief to small businesses nationwide adversely
impacted under the COVID-19 Emergency Declaration issued on March 13, 2020. The SBA PPP, which began on April 3, 2020, provides small businesses with funds to cover up to 24 weeks of payroll costs and other expenses, including benefits. It also provides for forgiveness of up to the full principal amount of qualifying loans. The Bank closed and funded almost 3,200 PPP loans for a total gross loan amount of $467.7 million in the year ended December 31, 2020. As these loans are 100% guaranteed by the SBA, there is no associated allowance for loan losses at December 31, 2020. These loans resulted in net fee income of $13.5 million to be recognized through net interest income over the life of the loans, which is between two and five years. During the year ended December 31, 2020, the Company recognized $7.7 million of net deferred SBA PPP fees, included in interest income on loans on the condensed consolidated statements of income. At December 31, 2020, the Bank had $5.8 million of unrecognized SBA PPP net deferred fees. The timing of the recognition of these fees is dependent upon the forgiveness process established by the SBA. The Bank has implemented the SBA's streamlined forgiveness approval process, which has made the forgiveness process easier for both borrowers and lenders. The remaining gross balance of PPP loans was reduced to $409.1 million at December 31, 2020 as a result of forgiveness.
On December 27, 2020, a new COVID relief bill was signed, which granted additional SBA PPP funding. This bill gives businesses that were not approved for the first iteration another chance to apply and allows businesses that have exhausted previous PPP funding and have been significantly impacted by the pandemic to apply for a second draw. It also makes forgiveness easier for businesses that use the majority of the money for payroll and makes the loans tax-free for the borrower. In January 2021, the Bank began originating another round of SBA PPP loans in accordance with this bill. Through March 8, 2021, 1,801 loans have been funded in this round for a total gross loan amount of $168.1 million. These loans resulted in net fee income of $7.9 million to be recognized through net interest income over the life of the loans.
Consumer Lending
The Bank provides home equity loans, home equity lines of credit and other consumer loans, primarily through its branch network and client call center. A large majority of the consumer loans are secured by either a first or second lien position on the borrower’s primary residential real estate. The Bank requires a loan-to-value ratio of no greater than 90% of the value of the real estate being taken as collateral. The Bank also, at times, purchases consumer loans to help diversify credit risk in our loan portfolio.
Residential Lending
The Bank provides residential mortgages throughout its various markets referred from retail branches and through a network of mortgage loan officers. A majority of the residential mortgages originated are sold to secondary market investors, primarily Wells Fargo and Fannie Mae. All mortgages, regardless of being sold or held in the Bank’s portfolio, are generally underwritten to secondary market industry standards for prime mortgages. The Bank generally requires a loan-to-value ratio of no greater than 80% of the value of the real estate being taken as collateral, without the borrower obtaining private mortgage insurance.
Loan Review
The Company has a loan review policy and program which is designed to identify and monitor risk in the lending function. The Management ERM Committee, comprised of executive officers and loan department personnel, is charged with the oversight of overall credit quality and risk exposure of the Company's loan portfolio. This includes the monitoring of the lending activities of all Company personnel with respect to underwriting and processing new loans and the timely follow-up and corrective action for loans showing signs of deterioration in quality. A loan review program provides the Company with an independent review of the commercial loan portfolio on an ongoing basis. Generally, consumer and residential mortgage loans are included in the Pass categories unless a specific action, such as extended delinquencies, bankruptcy, repossession or death of the borrower occurs, which heightens awareness as to a possible credit event.
Internal loan reviews are completed annually on all commercial relationships with a committed loan balance in excess of $1.0 million, which includes confirmation of risk rating by an independent credit officer. In addition, all commercial relationships greater than $500 thousand rated substandard, doubtful or loss are reviewed quarterly and corresponding risk ratings are changed or reaffirmed by the Company's Problem Loan Committee, with subsequent reporting to the Management ERM Committee and the Board of Directors.
The Bank outsources its independent loan review to a third-party provider, which monitors and evaluates loan clients on a quarterly basis utilizing risk-rating criteria established in the credit policy in order to identify deteriorating trends and detect conditions which might indicate potential problem loans. The results of the third-party loan review are reported quarterly to the Management and Board ERM Committees for review. The loan ratings provide the basis for evaluating the adequacy of the ALL.
Deposit Products
The Bank offers deposit products to retail, commercial, non-profit and government clients through its retail branch network. Product offerings for retail clients include checking accounts, money market, savings and certificates of deposit. The Company offers numerous products and treasury management solutions for commercial clients, including account analysis for demand deposit accounts, certificates of deposit, sweep accounts, money market accounts and other treasury services such as merchant banking, foreign exchange, remote deposit capture, lockbox and others. The Bank further provides various deposit solutions for government agencies and non-profits, such as demand deposit accounts, sweeps and certificates of deposit.
Investment Services
Through its trust department, the Bank renders services as trustee, executor, administrator, guardian, managing agent, custodian, investment advisor, and other fiduciary activities authorized by law under the trade name Orrstown Financial Advisors. OFA offers retail brokerage services through a third-party broker/dealer arrangement with Cetera Advisor Networks LLC. At December 31, 2020, assets under management by OFA totaled $1.7 billion.
Competition
The Bank’s principal market area consists of south central Pennsylvania, the greater Baltimore region, and Washington County, Maryland. The Bank serves a substantial number of depositors in this market area and its contiguous counties.
The Bank competes with other banks and less heavily regulated financial services companies such as credit unions and finance and trust companies, as well as mortgage banking companies, mutual funds, investment advisors, and brokerage firms, both within and outside of its primary market areas. Financial technology companies, or FinTechs, are also providing nontraditional, but increasingly strong, competition for the Bank's borrowers, depositors, and other clients.
The Bank competes for loans primarily on the basis of a combination of value and service by building client relationships as a result of addressing its clients’ banking needs, demonstrating expertise, and providing convenience to its clients.
The Bank competes for deposits similarly on the basis of a combination of value and service and by providing convenience through a banking network of branches and ATMs within its markets and digital service channels such as mobile banking.
The Company implements strategic initiatives focused on expanding our core businesses and exploring, on an ongoing basis, acquisition, divestiture, and joint venture opportunities to the extent permitted by our regulators. The Company analyzes each of the Bank's products and businesses in the context of shareholder return, client demands, competitive advantages, industry dynamics, and growth potential. The Company's management believes its market area will support growth in assets and deposits in the future, which it expects to contribute to the Company's ability to maintain or grow profitability.
Regulation and Supervision
The Parent Company is a bank holding company registered with the FRB and has elected status as a financial holding company. The Bank is a Pennsylvania-chartered commercial bank and a member of the FRB.
Regulatory Environment
The banking industry is highly regulated. Orrstown is subject to supervision, regulation, and examination by various federal and state regulators, including the FRB, SEC, CFPB, FDIC, and various state regulatory agencies. The statutory and regulatory framework that governs us is generally intended to protect depositors and clients, the FDIC's Deposit Insurance Fund, the U.S. banking and financial system, and financial markets as a whole by ensuring the safety and soundness of bank holding companies ("BHCs") and banks. Bank regulators regularly examine the operations of BHCs and banks. Regulators have broad supervisory and enforcement authority over BHCs and banks, including the power to impose nonpublic supervisory agreements, issue cease and desist orders, impose fines and other civil and criminal penalties, terminate deposit insurance, and appoint a conservator or receiver.
Engaging in unsafe or unsound practices or failing to comply with applicable laws, regulations, and supervisory agreements could subject Orrstown, its subsidiaries, and their respective officers, directors, and institution-affiliated parties to the remedies described above, and other sanctions. In addition, the FDIC may terminate a bank’s deposit insurance upon a finding that the bank’s financial condition is unsafe or unsound or that the bank has engaged in unsafe or unsound practices or has violated an applicable rule, regulation, order, or condition enacted or imposed by the bank’s regulatory agency.
Banking statutes, regulations, and policies are continually under review by Congress, state legislatures, and federal and state regulatory agencies. In addition to laws and regulations, state and federal bank regulatory agencies may issue policy
statements, interpretive letters, and similar written guidance applicable to Orrstown. Any change in statutes, regulations, or regulatory policies applicable to us, including changes in their interpretation or implementation, could have a material effect on our business or organization.
In May 2018, the Economic Growth Act was signed into law. Among other regulatory changes, the Economic Growth Act amended various sections of the Dodd-Frank Act, including section 165 of the Dodd-Frank Act, which was revised to raise the asset thresholds for determining the application of enhanced prudential standards for BHCs. Under the Economic Growth Act, BHCs with consolidated assets below $100.0 billion were immediately exempted from all of the enhanced prudential standards, except risk committee requirements, which now apply to publicly-traded BHCs with $50.0 billion or more of consolidated assets.
The Company is also subject to the disclosure and regulatory requirements of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, both as administered by the SEC, as well as the rules of Nasdaq that apply to companies with securities listed on the Nasdaq Capital Market.
Several of the more significant regulatory provisions applicable to BHCs and banks to which Orrstown and the Bank are subject are discussed below, along with certain regulatory matters concerning Orrstown and the Bank. To the extent that the following information describes statutory or regulatory provisions, such information is qualified in its entirety by reference to the particular statutes or regulations. Any change in applicable law or regulation may have a material effect on the business and prospects of the Company and the Bank.
Financial and Bank Holding Company Activities
As a FHC, we are permitted to engage, directly or through subsidiaries, in a wide variety of activities that are financial in nature or are incidental or complementary to a financial activity, in addition to all of the activities otherwise allowed to us.
As a FHC, Orrstown is generally subject to the same regulation as other BHCs, including the reporting, examination, supervision and consolidated capital requirements of the FRB. To preserve its FHC status, Orrstown must remain well-capitalized and well-managed and ensure that the Bank remains well-capitalized and well-managed for regulatory purposes and earns “satisfactory” or better ratings on its periodic Community Reinvestment Act examinations. An FHC ceasing to meet these standards is subject to a variety of restrictions, depending on the circumstances.
If the Parent Company or the Bank are either not well-capitalized or not well-managed, the Parent Company or the Bank must promptly notify the FRB. Until compliance is restored, the FRB has broad discretion to impose appropriate limitations on a FHC’s activities. If compliance is not restored within 180 days, the FRB may ultimately require the FHC to divest its depository institutions or in the alternative, to discontinue or divest any activities that are permitted only to non-FHC bank holding companies.
If the FRB determines that a FHC or its subsidiaries do not satisfy the CRA requirements, the potential restrictions are different. In that case, until all of the subsidiary institutions are restored to at least “satisfactory” CRA rating status, the FHC may not engage, directly or through a subsidiary, in any of the additional activities permissible under the BHC Act nor make additional acquisitions of companies engaged in such additional activities. However, completed acquisitions and additional activities and affiliations previously begun are left undisturbed, as the BHC Act does not require divestiture for this type of situation.
Federal Deposit Insurance
The FDIC's Deposit Insurance Fund provides insurance coverage for certain deposits, up to a standard maximum deposit insurance amount of $250 thousand per depositor and is funded through assessments on insured depository institutions, based on the risk each institution poses to the Deposit Insurance Fund. The Bank accepts client deposits that are insured by the Deposit Insurance Fund and, therefore, must pay insurance premiums. The FDIC may increase the Bank’s insurance premiums based on various factors, including the FDIC’s assessment of its risk profile.
If the FDIC is appointed conservator or receiver of a bank upon the bank’s insolvency or the occurrence of other events, the FDIC may sell some, part, or all of a bank’s assets and liabilities to another bank or repudiate or disaffirm most types of contracts to which the bank was a party if the FDIC believes such contracts are burdensome. In resolving the estate of a failed bank, the FDIC as receiver will first satisfy its own administrative expenses, and the claims of holders of U.S. deposit liabilities also have priority over those of other general unsecured creditors.
Liability for Banking Subsidiaries
Orrstown is required to serve as a source of financial and managerial strength to the Bank and, under appropriate conditions, to commit resources to support the Bank. This support may be required by the FRB at times when the Bank might
otherwise determine not to provide it or when doing so is not otherwise in the interests of Orrstown or its shareholders or creditors. The FRB may require a BHC to make capital injections into a troubled subsidiary bank and may charge the BHC with engaging in unsafe and unsound practices if the BHC fails to commit resources to such a subsidiary bank or if it undertakes actions that the FRB believes might jeopardize the BHC’s ability to commit resources to such subsidiary bank.
Under these requirements, Orrstown may in the future be required to provide financial assistance to the Bank should it experience financial distress. Capital loans by Orrstown to the Bank would be subordinate in right of payment to deposits and certain other debts of the Bank. In the event of Orrstown's bankruptcy, any commitment by Orrstown to a federal bank regulatory agency to maintain the capital of the Bank would be assumed by the bankruptcy trustee and entitled to a priority of payment.
Pennsylvania Banking Law
The Pennsylvania Banking Code contains detailed provisions governing the organization, location of offices, rights and responsibilities of directors, officers, and employees, as well as corporate powers, savings and investment operations and other aspects of the Bank and its affairs. The Pennsylvania Banking Code delegates extensive rule-making power and administrative discretion to the Pennsylvania Department of Banking and Securities so that the supervision and regulation of state chartered banks may be flexible and readily responsive to changes in economic conditions and in savings and lending practices.
The FDIA, however, prohibits state chartered banks from making new investments, loans, or becoming involved in activities as principal and equity investments which are not permitted for national banks unless the FDIC determines the activity or investment does not pose a significant risk of loss to the Deposit Insurance Fund, and the bank meets all applicable capital requirements. Accordingly, the additional operating authority provided to the Bank by the Pennsylvania Banking Code is significantly restricted by the FDIA.
Dividend Restrictions
The Parent Company is a legal entity separate and distinct from its banking and non-banking subsidiaries. Since our consolidated net income consists largely of net income of Orrstown's subsidiaries, our ability to make capital distributions, including paying dividends and repurchasing shares, depends upon our receipt of dividends from these subsidiaries. Under federal law, there are various limitations on the extent to which the Bank can declare and pay dividends to the Parent Company, including those related to regulatory capital requirements, general regulatory oversight to prevent unsafe or unsound practices, and federal banking law requirements concerning the payment of dividends out of net profits, surplus, and available earnings. Certain contractual restrictions also may limit the ability of the Bank to pay dividends to the Parent Company. No assurances can be given that the Bank will, in any circumstances, pay dividends to the Parent Company.
Orrstown's ability to declare and pay dividends to our shareholders is similarly limited by federal banking law and FRB regulations and policy. The Bank must maintain the applicable CET1 Capital Conservation Buffer to avoid becoming subject to restrictions on capital distributions, including dividends. As of January 1, 2019, the fully phased-in Capital Conservation Buffer was 2.5%.
FRB policy provides that a BHC should not pay dividends unless (1) the BHC’s net income over the last four quarters (net of dividends paid) is sufficient to fully fund the dividends, (2) the prospective rate of earnings retention appears consistent with the capital needs, asset quality, and overall financial condition of the BHC and its subsidiaries, and (3) the BHC will continue to meet minimum required capital adequacy ratios. Accordingly, a BHC should not pay cash dividends that can only be funded in ways that weaken the BHC’s financial health, such as by borrowing. The policy also provides that a BHC should inform the FRB reasonably in advance of declaring or paying a dividend that exceeds earnings for the period for which the dividend is being paid or that could result in a material adverse change to the BHC’s capital structure. BHCs also are required to consult with the FRB before increasing dividends or redeeming or repurchasing capital instruments. Additionally, the FRB could prohibit or limit the payment of dividends by a BHC if it determines that payment of the dividend would constitute an unsafe or unsound practice.
Transactions between a Bank and its Affiliates
Federal banking laws and regulations impose qualitative standards and quantitative limitations upon certain transactions between a bank and its affiliates, including between a bank and its holding company and companies that the BHC may be deemed to control for these purposes. Transactions covered by these provisions must be on arm’s-length terms and cannot exceed certain amounts which are determined with reference to the bank’s regulatory capital. Moreover, if the transaction is a loan or other extension of credit, it must be secured by collateral in an amount and quality expressly prescribed by statute, and if the affiliate is unable to pledge sufficient collateral, the BHC may be required to provide it. The Dodd-Frank Act expanded the coverage and scope of these regulations, including by applying them to the credit exposure arising under derivative transactions, repurchase and reverse repurchase agreements, and securities borrowing and lending transactions. Federal banking
laws also place similar restrictions on loans and other extensions of credit by FDIC-insured banks, such as the Bank, and their subsidiaries to their directors, executive officers, and principal shareholders.
Regulatory Capital Requirements
Compliance with respect to capital requirements is incorporated by reference from Note 17, Shareholders' Equity and Regulatory Capital, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data," and from the Capital Adequacy and Regulatory Matters section of Item 7, “Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations.”
The Bank is subject to certain risk-based capital and leverage ratio requirements under the U.S. Basel III capital rules adopted by the FRB. These rules implement the Basel III international regulatory capital standards in the U.S., as well as certain provisions of the Dodd-Frank Act. These quantitative calculations are minimums, and the FRB may determine that a banking organization, based on its size, complexity, or risk profile, must maintain a higher level of capital in order to operate in a safe and sound manner. The FRB asset-sized reporting threshold for a BHC is $3.0 billion and a company with consolidated assets under that limit is not subject to the FRB consolidated capital rules. A company with consolidated assets under the limit may continue to file reports that include capital amounts and ratios. Orrstown has elected to continue to file those reports.
Under the U.S. Basel III capital rules, Orrstown's and the Bank’s assets, exposures, and certain off-balance sheet items are subject to risk weights used to determine the institutions’ risk-weighted assets. These risk-weighted assets are used to calculate the following minimum capital ratios for Orrstown and the Bank:
• CET1 Risk-Based Capital Ratio, equal to the ratio of CET1 capital to risk-weighted assets. CET1 capital primarily includes common shareholders’ equity subject to certain regulatory adjustments and deductions, including goodwill, intangible assets, certain deferred tax assets, and AOCI.
• Tier 1 Risk-Based Capital Ratio, equal to the ratio of Tier 1 capital to risk-weighted assets. Tier 1 capital is primarily comprised of CET1 capital, perpetual preferred stock, and certain qualifying capital instruments.
• Total Risk-Based Capital Ratio, equal to the ratio of total capital, including CET1 capital, Tier 1 capital, and Tier 2 capital, to risk-weighted assets. Tier 2 capital primarily includes qualifying subordinated debt and qualifying ALL.
• Tier 1 Leverage Ratio, equal to the ratio of Tier 1 capital to quarterly average assets (net of goodwill, certain other intangible assets, and certain other deductions).
Failure to be well-capitalized or to meet minimum capital requirements could result in certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have an adverse material effect on our operations or financial condition. Failure to be well-capitalized or to meet minimum capital requirements could also result in restrictions on the Bank’s ability to pay dividends or otherwise distribute capital or to receive regulatory approval of applications.
In addition to meeting the minimum capital requirements, under the U.S. Basel III capital rules, the Bank must also maintain the required Capital Conservation Buffer to avoid becoming subject to restrictions on capital distributions and certain discretionary bonus payments to management. The Capital Conservation Buffer is calculated as a ratio of CET1 capital to risk-weighted assets, and it effectively increases the required minimum risk-based capital ratios. The Capital Conservation Buffer requirement was phased in over a three-year period that began on January 1, 2016. The phase-in period ended on January 1, 2019, and the Capital Conservation Buffer was at its fully phased-in level of 2.5% throughout 2019. The Tier 1 Leverage Ratio is not impacted by the Capital Conservation Buffer, and a banking institution may be considered well-capitalized while remaining out of compliance with the Capital Conservation Buffer.
Orrstown has the ability to provide additional capital to the Bank to maintain the Bank’s risk-based capital ratios at levels which would be considered well-capitalized.
At December 31, 2020, Orrstown's and the Bank’s regulatory capital ratios were above the well-capitalized standards and met the Capital Conservation Buffer on a fully phased-in basis.
Bank Acquisitions by Orrstown
BHCs must obtain prior approval of the Federal Reserve in connection with any acquisition that results in the BHC owning or controlling 5% or more of any class of voting securities of a bank or another BHC.
Acquisitions of Ownership of Orrstown
Acquisitions of Orrstown's voting stock above certain thresholds are subject to prior regulatory notice or approval under federal banking laws, including the BHC Act and the Change in Bank Control Act of 1978. Under the Change in Bank Control
Act, a person or entity generally must provide prior notice to the FRB before acquiring the power to vote 10% or more of our outstanding common stock. Investors should be aware of these requirements when acquiring shares in our stock.
Data Privacy
Federal and state law contains extensive consumer privacy protection provisions. The GLB Act requires financial institutions to periodically disclose their privacy policies and practices relating to sharing such information and enables retail clients to opt out of our ability to share information with unaffiliated third parties under certain circumstances. Other federal and state laws and regulations impact our ability to share certain information with affiliates and non-affiliates for marketing and/or non-marketing purposes, or to contact clients with marketing offers. These security and privacy policies and procedures for the protection of personal and confidential information are in effect across all businesses and geographic locations as applicable. Federal law also makes it a criminal offense, except in limited circumstances, to obtain or attempt to obtain client information of a financial nature by fraudulent or deceptive means. Data privacy and data protection are areas of increasing federal and state legislative focus.
Like other lenders, the Bank uses credit bureau data in its underwriting activities. Use of such data is regulated under the Fair Credit Reporting Act, which also regulates reporting information to credit bureaus, prescreening individuals for credit offers, sharing of information between affiliates, and using affiliate data for marketing purposes. Similar state laws may impose additional requirements on us.
Cybersecurity
The GLB Act requires financial institutions to implement a comprehensive information security program that includes administrative, technical, and physical safeguards to ensure the security and confidentiality of client records and information.
The Cybersecurity Information Sharing Act is intended to improve cybersecurity in the U.S. by enhanced sharing of information about security threats among the U.S. government and private sector entities, including financial institutions. The Cybersecurity Information Sharing Act also authorizes companies to monitor their own systems notwithstanding any other provision of law and allows companies to carry out defensive measures on their own systems from cyber attacks. The law includes liability protections for companies that share cyber threat information with third parties so long as such sharing activity is conducted in accordance with Cybersecurity Information Sharing Act.
In October 2016, the federal bank regulatory agencies issued an Advanced Notice of Proposed Rulemaking regarding enhanced cyber risk management standards which would apply to a wide range of large financial institutions and their third-party service providers. The proposed rules would expand existing cybersecurity regulations and guidance to focus on cyber risk governance and management, management of internal and external dependencies, and incident response, cyber resilience, and situational awareness. In addition, the proposal contemplates more stringent standards for institutions with systems that are critical to the financial sector. The FRB announced in May 2019 that it would revisit the Advanced Notice of Proposed Rulemaking in the future.
Community Reinvestment Act
The CRA is intended to encourage banks to help meet the credit needs of their service areas, including low- and moderate-income neighborhoods, consistent with safe and sound business practices. The relevant federal bank regulatory agency, the FRB in the Bank’s case, examines each bank and assigns it a public CRA rating. A bank’s record of fair lending compliance is part of the resulting CRA examination report.
The CRA requires the relevant federal bank regulatory agency to consider a bank’s CRA assessment when considering the bank’s application to conduct certain mergers or acquisitions or to open or relocate a branch office. The FRB also must consider the CRA record of each subsidiary bank of a BHC in connection with any acquisition or merger application filed by the BHC. An unsatisfactory CRA record could substantially delay or result in the denial of an approval or application by Orrstown or the Bank. The Bank received a CRA rating of “Satisfactory” in its most recent examination.
Leaders of the federal banking agencies recently have indicated their support for modernizing the CRA regulatory framework to address changing delivery systems and consumer preferences, and, in December 2019, the Office of the Comptroller of the Currency and FDIC issued a joint proposed rule that would amend the CRA regulatory framework. It is too early to tell whether and to what extent any changes will be made to applicable CRA requirements.
Anti-Money Laundering
The Bank Secrecy Act and the PATRIOT Act contain anti-money laundering and financial transparency provisions intended to detect and prevent the use of the U.S. financial system for money laundering and terrorist financing activities. The Bank Secrecy Act, as amended by the PATRIOT Act, requires depository institutions and their holding companies to undertake
activities including maintaining an anti-money laundering program, verifying the identity of clients, verifying the identity of certain beneficial owners for legal entity clients, monitoring for and reporting suspicious transactions, reporting on cash transactions exceeding specified thresholds, and responding to requests for information by regulatory authorities and law enforcement agencies. The Bank is subject to the Bank Secrecy Act and, therefore, is required to provide its employees with anti-money laundering training, designate an anti-money laundering compliance officer, and undergo an annual, independent audit to assess the effectiveness of its anti-money laundering program. The Bank has implemented policies, procedures, and internal controls that are designed to comply with these anti-money laundering requirements. Bank regulators are focusing their examinations on anti-money laundering compliance, and we will continue to monitor and augment, where necessary, our anti-money laundering compliance programs. The federal banking agencies are required, when reviewing bank and BHC acquisition or merger applications, to consider the effectiveness of the anti-money laundering activities of the applicant.
Office of Foreign Assets Control Regulation
The Office of Foreign Assets Control is responsible for administering economic sanctions that affect transactions with designated foreign countries, nationals, and others, as defined by various Executive Orders and in various legislation. Office of Foreign Assets Control-administered sanctions take many different forms. For example, sanctions may include: (1) restrictions on trade with or investment in a sanctioned country, including prohibitions against direct or indirect imports from and exports to a sanctioned country and prohibitions on U.S. persons engaging in financial transactions relating to, making investments in, or providing investment-related advice or assistance to, a sanctioned country; and (2) a blocking of assets in which the government or “specially designated nationals” of the sanctioned country have an interest, by prohibiting transfers of property subject to U.S. jurisdiction, including property in the possession or control of U.S. persons. The Office of Foreign Assets Control also publishes lists of persons, organizations, and countries suspected of aiding, harboring, or engaging in terrorist acts, known as Specially Designated Nationals and Blocked Persons. Blocked assets, for example property and bank deposits, cannot be paid out, withdrawn, set off, or transferred in any manner without a license from the Office of Foreign Assets Control. Failure to comply with these sanctions could have serious legal and reputational consequences.
Transaction Account Reserves
Effective March 26, 2020, FRB rules no longer require depository institutions to maintain reserves against their transaction accounts, primarily NOW and regular checking accounts. For 2019, the first $16.9 million of covered balances were exempt from the reserve requirement, aggregate balances between $16.9 million and $127.5 million were subject to a 3% reserve requirement, and aggregate balances above $127.5 million were subject to a 10% reserve requirement. These reserve requirements are subject to annual adjustment by the FRB. The Bank was in compliance with these requirements as of December 31, 2020 and 2019.
Consumer Protection Regulation and Supervision
We are subject to regulation by the CFPB with respect to federal consumer protection laws. We are also subject to certain state consumer protection laws, and under the Dodd-Frank Act, state attorneys general and other state officials are empowered to enforce certain federal consumer protection laws and regulations. State authorities have increased their focus on and enforcement of consumer protection rules. These federal and state consumer protection laws apply to a broad range of our activities and to various aspects of our business and include laws relating to interest rates, fair lending, disclosures of credit terms and estimated transaction costs to consumer borrowers, debt collection practices, the use and provision of information to consumer reporting agencies, and the prohibition of unfair, deceptive, or abusive acts or practices in connection with the offer, sale, or provision of consumer financial products and services.
The CFPB has promulgated many mortgage-related final rules since it was established under the Dodd-Frank Act, including rules related to the ability to repay and qualified mortgage standards, mortgage servicing standards, loan originator compensation standards, high-cost mortgage requirements, Home Mortgage Disclosure Act requirements, and appraisal and escrow standards for higher priced mortgages. The mortgage-related final rules issued by the CFPB have materially restructured the origination, servicing, and securitization of residential mortgages in the U.S. These rules have impacted, and will continue to impact, the business practices of residential mortgage lenders, including the Bank.
Future Legislation and Regulation
Changes in federal laws and regulations, as well as laws and regulations in states where the Company does business, can affect the operating environment of Orrstown in substantial ways. We cannot predict whether those changes in laws and regulations will occur, and, if they occur, the ultimate effect they would have upon the financial condition or results of operations of the Company.
Nasdaq Capital Market
The Company’s common stock is listed on the Nasdaq Capital Market under the trading symbol “ORRF” and is subject to Nasdaq’s rules for listed companies.
Available Information
We are subject to the informational requirements of the Exchange Act and, in accordance with the Exchange Act, we file annual, quarterly, and current reports, proxy statements, and other information with the SEC. The SEC maintains an Internet web site that contains reports, proxy statements, and other information about issuers, like us, who file electronically with the SEC. The address of the site is www.sec.gov. The reports and other information, including any related amendments, filed by us with, or furnished by us to, the SEC are also available free of charge at our Internet web site as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC. The address of the site is www.orrstown.com. Except as specifically incorporated by reference into this Annual Report on Form 10-K, information on those web sites is not part of this report.

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ITEM 1A. RISK FACTORS
ITEM 1A - RISK FACTORS
An investment in our common stock is subject to risks inherent in our business. The material risks and uncertainties that management believes affect us are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair our business operations. This report is qualified in its entirety by these risk factors.
If any of the following risks actually occur, our business, financial condition and results of operations could be materially and adversely affected. If this were to happen, the market price of our common stock could decline significantly, and you could lose all or part of your investment.
Risks Related to Credit
If our allowance for loan losses is not sufficient to cover actual losses, our earnings would decrease.
There is no precise method of predicting loan losses. The required level of reserves, and the related provision for loan losses, can fluctuate from year to year, based on charge-offs and/or recoveries, loan volume, credit administration practices, and local and national economic conditions, among other factors. The ALL, which is a reserve established through a provision for loan losses charged to expense, represents management’s best estimate of probable incurred losses within the existing portfolio of loans. The level of the allowance reflects management’s evaluation of, among other factors, the status of specific impaired loans, historical loss experience, delinquency, credit concentrations and economic conditions within our market area. The determination of the appropriate level of the ALL inherently involves a high degree of subjectivity and judgment and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require us to increase our ALL.
In addition, bank regulatory agencies periodically review our ALL and may require us to increase the provision for loan losses or to recognize further loan charge-offs, based on judgments that differ from those of, or information not available to, management. If loan charge-offs in future periods exceed the ALL, there would be a need to record additional provisions to increase our ALL. Furthermore, growth in the loan portfolio would generally lead to an increase in the provision for loan losses. Generally, increases in our ALL will result in a decrease in net income and stockholders’ equity, and may have a material adverse effect on our financial condition and results of operations.
The deterioration of one or more of our significant lending relationships could result in a significant increase in the nonperforming loans and the provisions for loan losses, which would negatively impact our results of operations. A significant portion of our loan customers have been negatively impacted by protocols either required or recommended due to COVID-19. Some industries or sectors have been impacted more than others. In many cases, the projects supporting these loans are not generating adequate cash flow to service the debt. If conditions do not improve or more government assistance is not provided, we may have to look to secondary sources of repayment, including liquidation of collateral or collection from guarantors. Going to secondary sources of repayment typically increases our risk of loss. Some of the industries most impacted and our related loan volume to such industries are in the hospitality sector and commercial real estate.
Further, we have elected to delay implementation of ASU 2016-13, Measurement of Credit Losses on Financial Instruments, under the three-year delay permitted by the FASB in 2019. For a more complete description of the potential impact ASU 2016-13 may have on our financial statements and ALL, please refer to the "Changes in our accounting policies or in accounting standards could materially affect how we report our financial results and condition" risk factor below and Note 1, Summary of Significant Accounting Policies, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data" appearing elsewhere in this Form 10-K.
Commercial real estate lending may expose us to a greater risk of loss and impact our earnings and profitability.
Our business strategy includes making loans secured by commercial real estate. These types of loans generally have higher risk-adjusted returns and shorter maturities than other loans. Loans secured by commercial real estate properties are generally for larger amounts and may involve a greater degree of risk than other loans. Payments on loans secured by these properties are often dependent on the income produced by the underlying properties which, in turn, depends on the successful operation and management of the properties. Accordingly, repayment of these loans is subject to conditions in the real estate market or the local economy. In challenging economic conditions, these loans represent higher risk and could result in an increase in our total net charge-offs, requiring us to increase our ALL, which could have a material adverse effect on our financial condition or results of operations. While we seek to minimize these risks in a variety of ways, there can be no assurance that these measures will protect against credit-related losses.
The credit risk related to commercial and industrial loans is greater than the risk related to residential loans.
Commercial and industrial loans generally carry larger loan balances and involve a greater degree of risk of nonpayment or late payment than home equity loans or residential mortgage loans.
Commercial and industrial loans include advances to local and regional businesses for general commercial purposes and include permanent and short-term working capital, machinery and equipment financing, and may be either in the form of lines of credit or term loans. Although commercial and industrial loans may be unsecured to our highest rated borrowers, the majority of these loans are secured by the borrower’s accounts receivable, inventory and machinery and equipment. In a significant number of these loans, the collateral also includes the business real estate or the business owner’s personal real estate or assets. Commercial and industrial loans are more susceptible to risk of loss during a downturn in the economy, as borrowers may have greater difficulty in meeting their debt service requirements and the value of the collateral may decline. We attempt to mitigate this risk through our underwriting standards, including evaluating the creditworthiness of the borrower and, to the extent available, credit ratings on the business. Additionally, monitoring of the loans through annual renewals and meetings with the borrowers are typical. However, these procedures cannot entirely eliminate the risk of loss associated with commercial and industrial lending.
As a participating lender in the SBA Paycheck Protection Program (“PPP”), we are subject to additional risks of litigation from our clients or other parties regarding our processing of loans for the PPP and risks that the SBA may not fund some or all PPP loan guaranties.
On March 27, 2020, President Trump signed the CARES Act, which included a $349 billion loan program administered through the SBA referred to as the PPP. Under the PPP, small businesses and other entities and individuals can apply for loans from existing SBA lenders and other approved regulated lenders that enroll in the program, subject to numerous limitations and eligibility criteria. We are a participating as a lender in the PPP. The PPP opened on April 3, 2020; however, because of the short timeframe between the passing of the CARES Act and the opening of the PPP, there is some ambiguity in the laws, rules and guidance regarding the operation of the PPP, which exposes the Company to risks relating to noncompliance with the PPP. On or about April 16, 2020, the SBA notified lenders that the $349 billion earmarked for the PPP was exhausted. Congress has approved additional funding for the PPP and President Trump signed the new legislation on April 24, 2020. Since the opening of the PPP, several larger banks have been subject to litigation regarding the process and procedures that such banks used in processing applications for the PPP. We may be exposed to the risk of litigation, from both clients and non-clients that approached us regarding PPP loans, regarding our process and procedures used in processing applications for the PPP. If any such litigation is filed against us and is not resolved in a manner favorable to us, it may result in significant financial liability or adversely affect our reputation. In addition, litigation can be costly, regardless of outcome. Any financial liability, litigation costs or reputational damage caused by PPP related litigation could have a material adverse impact on our business, financial condition and results of operations.
We also have credit risk on PPP loans if a determination is made by the SBA that there is a deficiency in the manner in which the loan was originated, funded, or serviced by us, such as an issue with the eligibility of a borrower to receive a PPP loan, which may or may not be related to the ambiguity in the laws, rules and guidance regarding the operation of the PPP. In the event of a loss resulting from a default on a PPP loan and a determination by the SBA that there was a deficiency in the manner in which the PPP loan was originated, funded, or serviced by us, the SBA may deny its liability under the guaranty,
reduce the amount of the guaranty, or, if it has already paid under the guaranty, seek recovery of any loss related to the deficiency from us.
Risks Related to Interest Rates and Investments
Changes in interest rates could adversely impact the Company’s financial condition and results of operations.
Our operations are subject to risks and uncertainties surrounding our exposure to changes in the interest rate environment. Operating income, net income and liquidity depend to a great extent on our net interest margin, i.e., the difference between the interest yields we receive on interest-earning assets, such as loans and securities, and the interest rates we pay on interest-bearing liabilities, such as deposits and borrowings. These rates are highly sensitive to many factors beyond our control, including competition, general economic conditions, and monetary and fiscal policies of various governmental and regulatory authorities, including the FRB. If the rate of interest we pay on our interest-bearing liabilities increases more than the rate of interest we receive on our interest-earning assets, our net interest income, and therefore our earnings and liquidity, could be materially adversely affected. Our earnings and liquidity could also be materially adversely affected if the rates on interest-earning assets fall more quickly than those on our interest-bearing liabilities.
Changes in interest rates also can affect our ability to originate loans; the ability of borrowers to repay adjustable or variable rate loans; our ability to obtain and retain deposits in competition with other available investment alternatives; and the value of interest-earning assets, which would negatively impact stockholders’ equity, and the ability to realize gains from the sale of such assets. Based on our interest rate sensitivity analyses, an increase in the general level of interest rates will negatively affect the market value of the investment portfolio because of the relatively higher duration of certain securities included in the investment portfolio.
Our subordinated notes, issued in December 2018, have a 6.0% fixed interest rate through December 2023, after which the interest rate will convert to a variable rate of the London Interbank Offered Rate (“LIBOR”) plus 3.16% through maturity in December 2028. Depending on our financial condition at the time of the rate changing from fixed to variable, an increase in the interest rate on our subordinated debt could have a material adverse effect on our liquidity and results of operations.
The expected discontinuance of LIBOR presents risks to the financial instruments originated, issued or held by us that use LIBOR as a reference rate.
LIBOR is used as a reference rate for many of our transactions, which means it is the base on which relevant interest rates are determined. Transactions include those in which we lend and borrow money and issue, purchase and sell securities. LIBOR is the subject of recent national and international regulatory guidance and proposals for reform. The United Kingdom Financial Conduct Authority, which regulates the process for setting LIBOR, announced in July 2017 that it intends to stop persuading or compelling banks to submit rates for the calculation of LIBOR to the administrator of LIBOR after 2021. In November 2020, the FRB announced that LIBOR will be phased out and eventually replaced by June 2023. Banks were instructed to stop writing contracts using LIBOR by the end of 2021.
LIBOR is expected to be replaced by the Secured Overnight Financing Rate, or SOFR, which is a median of rates that market participants pay to borrow cash on an overnight basis, using US Treasury Securities as collateral.
If SOFR does not achieve wide acceptance as the alternative to LIBOR, there likely will be disruption to all of the markets relying on the availability of a broadly accepted reference rate. Should SOFR ultimately replace LIBOR, risks will remain for us with respect to outstanding loans or other instruments using LIBOR. Those risks arise in connection with transitioning those instruments to a new reference rate and the corresponding value transfer that may occur in connection with that transition. Risks related to transitioning instruments to SOFR or to how LIBOR is calculated and its availability include impacts on the yield on loans or securities held by us and amounts paid on securities we have issued. The value of loans, securities, or borrowings tied to LIBOR and the trading market for LIBOR-based securities could also be negatively impacted upon its discontinuance or phase out.
Further, it is possible that LIBOR quotes will become unavailable prior to 2022 if a sufficient number of banks decline to make submissions to the LIBOR administrator. In that case, the risks associated with the transition from LIBOR would be accelerated and magnified. These risks may also be increased due to the shorter time frame for preparing for the transition.
Risks Related to Competition and to Our Business Strategy
Difficult economic and market conditions can adversely affect the financial services industry and may materially and adversely affect the Company.
Our operations are sensitive to general business and economic conditions in the U.S. If the growth of the U.S. economy slows, or if the economy worsens or enters into a recession, our growth and profitability could be constrained. In addition,
economic conditions in foreign countries can affect the stability of global financial markets, which could impact the U.S. economy and financial markets. Weak economic conditions are characterized by deflation, fluctuations in debt and equity capital markets, including a lack of liquidity and/or depressed prices in the secondary market for mortgage loans, increased delinquencies on mortgage, consumer and commercial loans, residential and commercial real estate price declines and lower home sales and commercial activity. All of these factors are detrimental to our business. Our business is significantly affected by monetary and related policies of the U.S. federal government, its agencies and government-sponsored entities. Changes in any of these policies could have a material adverse effect on our business, financial position, results of operations and cash flows.
In particular, we may face the following risks in connection with volatility in the economic environment:
•Loan delinquencies could increase;
•Problem assets and foreclosures could increase;
•Demand for our products and services could decline; and
•Collateral for loans made by us, especially real estate, could decline in value, reducing client borrowing power, and reducing the value of the assets and collateral associated with our loans.
Because our business is concentrated in south central Pennsylvania, the greater Baltimore region, and Washington County, Maryland, our financial performance could be materially adversely affected by economic conditions and real estate values in these market areas.
Our operations and the properties securing our loans are primarily located in south central Pennsylvania, the greater Baltimore region, and Washington County, Maryland. Our operating results depend largely on economic conditions and real estate valuations in these and surrounding areas. A deterioration in the economic conditions in these market areas could materially adversely affect our operations and increase loan delinquencies, increase problem assets and foreclosures, increase claims and lawsuits, decrease the demand for our products and services and decrease the value of collateral securing loans, especially real estate, in turn reducing clients’ borrowing power, the value of assets associated with nonperforming loans and collateral coverage.
Competition from other banks and financial institutions in originating loans, attracting deposits and providing other financial services may adversely affect our profitability and liquidity.
We experience substantial competition in originating both commercial and consumer loans in our market area. This competition comes principally from other banks, savings institutions, credit unions, mortgage banking companies and other lenders. Some of our competitors enjoy advantages, including greater financial resources and higher lending limits, a wider geographic presence, more accessible branch office locations, the ability to offer a wider array of services or more favorable pricing alternatives, as well as lower origination and operating costs. This competition could reduce our net income and liquidity by decreasing the number and size of loans that we originate and the interest rates we are able to charge on these loans.
As we expand our online lending capabilities, we will face competition, particularly in residential mortgage lending, from non-bank lenders (financial institutions that only make loans and do not offer deposit accounts such as a savings account or checking account) and financial technology companies that use new technology and innovation with available resources in order to compete in the marketplace of traditional financial institutions and intermediaries in the delivery of financial services. This competition could similarly reduce our net income and liquidity.
In attracting business and consumer deposits, we face substantial competition from other insured depository institutions such as banks, savings institutions and credit unions, as well as institutions offering uninsured investment alternatives, including money market funds. Some of our competitors enjoy advantages, including more expansive marketing campaigns, better brand recognition and more branch locations. These competitors may offer higher interest rates than we do, which could decrease the deposits that we attract or require us to increase our rates to retain existing deposits or attract new deposits. Increased deposit competition could materially adversely affect our ability to generate the funds necessary for lending operations. As a result, we may need to seek other sources of funds that may be more expensive to obtain and could increase our cost of funds.
The Company’s business strategy includes the continuation of moderate growth plans, and our financial condition and results of operations could be negatively affected if we fail to grow or fail to manage our growth effectively.
Over the long term, we expect to continue to experience organic growth in loans and total assets, the level of our deposits and the scale of our operations. Achieving our growth targets requires us to successfully execute our business strategies, which includes continuing to grow our loan portfolio. Our ability to successfully grow will also depend on the continued availability of loan opportunities that meet underwriting standards. In addition, we may consider the acquisition of other financial
institutions and branches within or outside of our market area to the extent permitted by our regulators. The success of any such acquisition will depend on a number of factors, including our ability to integrate the acquired institutions or branches into the current operations of the Company; our ability to limit the outflow of deposits held by clients of the acquired institution or branch locations; our ability to control the incremental increase in noninterest expense arising from any acquisition; and our ability to retain and integrate the appropriate personnel of the acquired institution or branches. We believe we have the resources and internal systems in place to successfully achieve and manage our future growth. If we do not manage our growth effectively, we may not be able to achieve our business plan goals and our business and prospects could be harmed.
The Company may be adversely affected by technological advances.
Technological advances impact our business. The banking industry undergoes constant technological change with frequent introductions of new technology-driven products and services. In addition to improving client services, the effective use of technology increases efficiency and enables financial institutions to reduce costs. Our future success may depend, in part, on our ability to address the needs of our current and prospective clients by using technology to provide products and services that will satisfy demands for convenience, as well as to create additional efficiencies in operations.
We face security risks, including denial of service attacks, hacking, social engineering attacks targeting our colleagues and clients, malware intrusion or data corruption attempts, and identity theft that could result in the disclosure of confidential information, adversely affect our business or reputation, and create significant legal and financial exposure.
Our computer systems and network infrastructure and those of third parties, on which we are highly dependent, are subject to security risks and could be susceptible to cyber attacks, such as denial of service attacks, hacking, terrorist activities, or identity theft. Our business relies on the secure processing, transmission, storage, and retrieval of confidential, proprietary, and other information in our computer and data management systems and networks, and in the computer and data management systems and networks of third parties. In addition, in order to access our network, products, and services, our clients and other third parties may use personal mobile devices or computing devices that are outside of our network environment and are subject to their own cybersecurity risks.
We, our clients, regulators, and other third parties, including other financial services institutions and companies engaged in data processing, have been subject to, and are likely to continue to be the target of, cyber attacks. These cyber attacks include computer viruses, malicious or destructive code, phishing attacks, denial of service or information, ransomware, improper access by employees or vendors, attacks on personal email of employees, ransom demands to not expose security vulnerabilities in our systems or the systems of third parties or other security breaches that could result in the unauthorized release, gathering, monitoring, misuse, loss, or destruction of confidential, proprietary, and other information of ours, our employees, our clients, or of third parties, damage our systems or otherwise materially disrupt our or our clients’ or other third parties’ network access or business operations. As cyber threats continue to evolve, we may be required to expend significant additional resources to continue to modify or enhance our protective measures or to investigate and remediate any information security vulnerabilities or incidents. Despite efforts to ensure the integrity of our systems and implement controls, processes, policies, and other protective measures, we may not be able to anticipate all security breaches, nor may we be able to implement sufficient preventive measures against such security breaches, which may result in material losses or consequences for us.
Cybersecurity risks for banking organizations have significantly increased in recent years in part because of the proliferation of new technologies, and the use of the internet and telecommunications technologies to conduct financial transactions. For example, cybersecurity risks may increase in the future as we continue to increase our mobile-payment and other internet-based product offerings to meet client demand and expand our internal usage of web-based products and applications. In addition, cybersecurity risks have significantly increased in recent years, in part due to the increased sophistication and activities of organized crime affiliates, terrorist organizations, hostile foreign governments, disgruntled employees or vendors, activists, and other external parties, including those involved in corporate espionage. Even the most advanced internal control environment may be vulnerable to compromise. Due to increasing geopolitical tensions, nation state cyber attacks and ransomware are both increasing in sophistication and prevalence. Targeted social engineering and email attacks (i.e. “spear phishing” attacks) are becoming more sophisticated and are extremely difficult to prevent. In such an attack, an attacker will attempt to fraudulently induce colleagues, clients, or other users of our systems to disclose sensitive information in order to gain access to its data or that of its clients. Persistent attackers may succeed in penetrating defenses given enough resources, time, and motive. The techniques used by cyber criminals change frequently, may not be recognized until launched, and may not be recognized until well after a breach has occurred. The speed at which new vulnerabilities are discovered and exploited often before security patches are published continues to rise. The risk of a security breach caused by a cyber attack at a vendor or by unauthorized vendor access has also increased in recent years. Additionally, the existence of cyber attacks or security breaches at third-party vendors with access to our data may not be disclosed to us in a timely manner.
We also face indirect technology, cybersecurity, and operational risks relating to the clients and other third parties with whom we do business or upon whom we rely to facilitate or enable our business activities, including, for example, financial
counterparties, regulators, and providers of critical infrastructure such as internet access and electrical power. As a result of increasing consolidation, interdependence, and complexity of financial entities and technology systems, a technology failure, cyber attack, or other information or security breach that significantly degrades, deletes, or compromises the systems or data of one or more financial entities could have a material impact on counterparties or other market participants, including us. This consolidation, interconnectivity, and complexity increases the risk of operational failure, on both individual and industry-wide bases, as disparate systems need to be integrated, often on an accelerated basis. Any third-party technology failure, cyber attack, or other information or security breach, termination, or constraint could, among other things, adversely affect our ability to effect transactions, service our clients, manage our exposure to risk, or expand our business.
Cyber attacks or other information or security breaches, whether directed at us or third parties, may result in a material loss or have material consequences. Furthermore, the public perception that a cyber attack on our systems has been successful, whether or not this perception is correct, may damage our reputation with clients and third parties with whom we do business. Hacking of personal information and identity theft risks, in particular, could cause serious reputational harm. A successful penetration or circumvention of system security could cause us serious negative consequences, including our loss of clients and business opportunities, costs associated with maintaining business relationships after an attack or breach; significant business disruption to our operations and business, misappropriation, exposure, or destruction of our confidential information, intellectual property, funds, and/or those of our clients; or damage to our or our clients’ and/or third parties’ computers or systems, and could result in a violation of applicable privacy laws and other laws, litigation exposure, regulatory fines, penalties or intervention, loss of confidence in our security measures, reputational damage, reimbursement or other compensatory costs, additional compliance costs, and could adversely impact our results of operations, liquidity and financial condition. In addition, we may not have adequate insurance coverage to compensate for losses from a cybersecurity event.
Cybersecurity and data privacy are areas of heightened legislative and regulatory focus.
As cybersecurity and data privacy risks for banking organizations and the broader financial system have significantly increased in recent years, cybersecurity and data privacy issues have become the subject of increasing legislative and regulatory focus. The federal bank regulatory agencies have proposed regulations that would enhance cyber risk management standards, which would apply to a wide range of large financial institutions and their third-party service providers and would focus on cyber risk governance and management, management of internal and external dependencies, and incident response, cyber resilience, and situational awareness. Several states have also proposed or adopted cybersecurity legislation and regulations, which require, among other things, notification to affected individuals when there has been a security breach of their personal data.
We receive, maintain, and store non-public personal information of our clients and counterparties, including, but not limited to, personally identifiable information and personal financial information. The sharing, use, disclosure, and protection of these types of information are governed by federal and state law. Both personally identifiable information and personal financial information are increasingly subject to legislation and regulation, the intent of which is to protect the privacy of personal information and personal financial information that is collected and handled.
We may become subject to new legislation or regulation concerning cybersecurity or the privacy of personally identifiable information and personal financial information or of any other information we may store or maintain. We could be adversely affected if new legislation or regulations are adopted or if existing legislation or regulations are modified such that we are required to alter our systems or require changes to our business practices or privacy policies. If cybersecurity, data privacy, data protection, data transfer, or data retention laws are implemented, interpreted, or applied in a manner inconsistent with our current practices, we may be subject to fines, litigation, or regulatory enforcement actions or ordered to change our business practices, policies, or systems in a manner that adversely impacts our operating results.
We may become subject to claims and litigation pertaining to fiduciary responsibility.
We provide fiduciary services through OFA. From time to time, clients may make claims and take legal action with regard to the performance of our fiduciary responsibilities. Whether such claims and legal actions are founded or unfounded, if such claims or legal actions are not resolved in a manner favorable to us, the claims or related actions may result in significant financial expense and liability to us and/or adversely affect our reputation in the marketplace, as well as adversely impact client demand for our products and services. Any financial liability or reputation damage could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.
Interest rate volatility stemming from COVID-19 could negatively affect our net interest income, lending activities, deposits and profitability.
Our net interest income, lending activities, deposits and profitability could be negatively affected by volatility in interest rates caused by uncertainties stemming from COVID-19. In March 2020, the FRB lowered the target range for the federal funds rate to a range from 0 to 0.25 percent, citing concerns about the impact of COVID-19 on markets and stress in the energy
sector. A prolonged period of extremely volatile and unstable market conditions would likely increase our funding costs and negatively affect market risk mitigation strategies. Higher income volatility from changes in interest rates and spreads to benchmark indices could cause a loss of future net interest income and a decrease in current fair market values of our assets. Fluctuations in interest rates will impact both the level of income and expense recorded on most of our assets and liabilities and the market value of all interest-earning assets and interest-bearing liabilities, which in turn could have a material adverse effect on our net income, operating results, or financial condition.
Risks Related to Mergers and Acquisitions
On October 1, 2018, we completed the acquisition of Mercersburg, and on May 1, 2019, we completed the acquisition of Hamilton Bancorp, Inc.
Growing by acquisition involves risks.
We intend to pursue a growth plan consistent with our business strategy, including growth by acquisition, as well as leveraging our existing branch network and adding new branch locations in current and future markets we choose to serve.
Our ability to manage growth successfully will depend on our ability to attract qualified personnel and maintain cost controls and asset quality while attracting additional loans and deposits on favorable terms, as well as on factors beyond our control, such as economic conditions and competition. If we grow too quickly and are not able to attract qualified personnel, control costs and maintain asset quality, this continued rapid growth could materially adversely affect our financial performance.
Goodwill incurred in acquisitions may negatively affect our financial condition.
To the extent that merger consideration, consisting of cash and shares of our common stock, exceeds the fair value of the net assets acquired, including identifiable intangibles, that amount will be reported as goodwill by us. In accordance with current accounting guidance, goodwill will not be amortized but will be evaluated for impairment annually or more frequently if events or circumstances warrant. A failure to realize expected benefits of the mergers could adversely impact the carrying value of the goodwill recognized in the mergers and, in turn, negatively affect our financial results.
We may be unable to successfully integrate the operations of acquired entities over time.
Acquisitions involve the integration with Orrstown of companies that previously operated independently. The difficulties of combining the operations of the acquired companies with Orrstown include:
•integrating personnel with diverse business backgrounds;
•integrating departments, systems, operating procedures and information technologies;
•combining different corporate cultures;
•retaining existing clients and attracting new clients; and
•retaining key employees.
The process of integrating operations could cause an interruption of, or loss of momentum in, the activities of the combined company and the loss of key personnel. The diversion of management’s attention and any delays or difficulties encountered in connection with the merger and the integration process could have a material adverse effect on the business and results of operations of the combined company.
The success of acquisitions depends, in part, on our ability to realize the anticipated benefits and cost savings from combining the businesses acquired with Orrstown. If we are unable to successfully execute on integration, the anticipated earnings and cost savings to be derived from acquisitions may not be realized fully or may take longer to realize than expected. In addition, as with regard to any acquisition, a significant change in interest rates or economic conditions or decline in asset valuations may also cause us not to realize expected benefits and result in the acquisitions not meeting expectations.
The market price of our common stock after acquisitions may be affected by factors different from those affecting our shares currently.
The businesses of the Company and acquired entities may differ and, accordingly, the results of operations of the combined company and the market price of the shares of common stock of the combined company may be affected by factors different from those currently affecting the independent results of operations and market prices of common stock of each separate entity. The market value of our common stock fluctuates based upon various factors, including changes in our business, operations or prospects, market assessments of the merger, regulatory considerations, market and economic
considerations, and other factors. Further, the market price of our common stock after an acquisition may be affected by factors different from those currently affecting our common stock.
Additionally, future business acquisitions may result in the issuance and payment of additional shares of stock, which would dilute current shareholders’ ownership interests, and may involve the payment of a premium over book and market values. Therefore, dilution of our tangible book value and net income per common share could occur in connection with any future transaction.
Risks Related to Regulatory Compliance and Legal Matters
Governmental regulation and regulatory actions against us may impair our operations or restrict our growth.
The Company is subject to regulation and supervision under federal and state laws and regulations. The requirements and limitations imposed by such laws and regulations limit the manner in which we conduct our business, undertake new investments and activities and obtain financing. These regulations are designed primarily for the promotion of the safety and soundness of financial institutions and the protection of the deposit insurance funds and consumers, and not to benefit our shareholders.
Applicable laws and regulations impose capital adequacy requirements and restrict our ability to repurchase stock or to receive dividends from our subsidiaries. Our ability to service our obligations and pay dividends to shareholders is largely dependent on the receipt of dividends from our subsidiaries, primarily the Bank. The FRB requires a BHC to act as a source of financial and managerial strength for its subsidiary banks. The FRB could require us to commit resources to the Bank when doing so is not otherwise in the interests of our shareholders or creditors.
We are subject to supervision and examination by numerous governmental bodies. The results of these supervisory or examination activities could result in limitations on our ability to engage in new activities or expand geographically. These activities also could result in significant fines, penalties, or required corrective actions, some of which could be expensive and difficult to implement. As we expand our product and service offerings into additional states, there could be an increase in state regulation affecting our operations. Different approaches to regulation by different jurisdictions could increase our compliance costs or risks of non-compliance.
Financial institution regulation has been the subject of significant legislation in recent years and may be the subject of further significant legislation in the future, none of which is within our control. Federal and state regulatory agencies also frequently adopt changes to their regulations or change the manner in which existing regulations are applied or enforced. The Company cannot predict the substance or impact of pending or future legislation, regulation or the application thereof.
Compliance with such current and potential regulation and scrutiny may significantly increase our costs, impede the efficiency of our internal business processes, require us to increase our regulatory capital and limit our ability to pursue business opportunities in an efficient manner. Bank regulations can hinder our ability to compete with financial services companies that are not regulated in the same manner or are subject to less regulation. A failure to comply, or to have adequate policies and procedures designed to comply, with regulatory requirements and expectations could expose us to damages, fines and regulatory penalties and other regulatory or enforcement actions or consequences, such as limitations on activities otherwise permissible for us or additional requirements for engaging in new activities, and could also injure our reputation with clients and others with whom we do business.
Increases in FDIC insurance premiums may have a material adverse effect on our results of operations.
We are generally unable to control the amount of premiums that are required to be paid for FDIC insurance. If there are bank or financial institution failures, the Company may be required to pay significantly higher premiums than the levels currently imposed or additional special assessments or taxes that could adversely affect earnings. Any future increases or required prepayments in FDIC insurance premiums may materially adversely affect our results of operations.
Legislative, regulatory and legal developments involving income and other taxes could materially adversely affect the Company’s results of operations and cash flows.
The Company is subject to U.S. federal and U.S. state income, payroll, property, sales and use, and other types of taxes, including the Pennsylvania Bank Shares Tax. Significant judgment is required in determining the Company's provisions for income taxes. Changes in tax rates, enactments of new tax laws, revisions of tax regulations, and claims or litigation with taxing authorities could result in substantially higher taxes, and therefore, could have a significant adverse effect on the Company's results of operations, financial condition and liquidity. Increases in the assessment rate for the Pennsylvania Bank Shares Tax, which is calculated on the outstanding equity of the Bank, may also materially adversely affect results of operations.
The Company is required to use judgment in applying accounting policies and different estimates and assumptions in the application of these policies could result in a decrease in capital and/or other material changes to the reports of financial condition and results of operations.
Material estimates that are particularly susceptible to significant change relate to the determination of the ALL, the fair value of certain financial instruments, particularly securities, and goodwill and purchase accounting associated with acquisitions. While we have identified those accounting policies that we consider critical and have procedures in place to facilitate the associated judgments, different assumptions in the application of these policies could have a material adverse effect on our financial condition and results of operations.
Changes in our accounting policies or in accounting standards could materially affect how we report our financial results and condition.
From time to time, the FASB, SEC and other regulatory bodies change the financial accounting and reporting standards that govern the preparation of our consolidated financial statements. These changes can be operationally complex to implement and can materially impact how we record and report our financial condition and results of operations.
For example, in June 2016, the FASB issued Accounting Standards Update 2016-13, Measurement of Credit Losses on Financial Instruments, that will, upon adoption, substantially change the accounting for credit losses on loans and other financial assets held by banks, financial institutions and other organizations. The update replaces existing incurred loss impairment guidance and establishes a single allowance framework for financial assets carried at amortized cost. Upon adoption of ASU 2016-13, companies must recognize credit losses on these assets equal to management’s estimate of credit losses over the full remaining expected life. Companies must consider all relevant information when estimating expected credit losses, including details about past events, current conditions, and reasonable and supportable forecasts.
The changes were effective for most publicly-held companies on January 1, 2020. However, in July 2019, the FASB approved permitting “smaller reporting companies”, such as Orrstown, up to an additional 3 years to adopt ASU 2016-13. We elected not to adopt ASU 2016-13 on January 1, 2020, and have not yet determined if we will adopt its provisions prior to the extended implementation date of January 1, 2023.
In December 2018, the FRB, OCC and FDIC released a final rule to revise their regulatory capital rules, in part to address the upcoming change to the treatment of credit expense and allowances under ASC 2016-13. The final rule provides an optional three year phase-in period for the day-one adverse regulatory capital effects upon adopting the standard. The impact of this final rule on the Company will depend on whether we elect to phase in the impact of ASU 2016-13 over a three year period. The standard is likely to have a negative impact, potentially materially, to the ALL and our capital position at adoption. When we adopt ASU 2016-13, we will also determine whether we will elect the phase-in provisions for regulatory capital. It is possible that our ongoing reported earnings and lending activity will be negatively impacted in periods following adoption of ASU 2016-13.
The short-term and long-term impact of changing regulatory capital requirements and new capital rules is uncertain.
The Basel III Capital Rules have targeted higher levels of base capital, certain capital buffers, and a migration toward common equity as the key source of regulatory capital, as domestic and international bank regulatory agencies have sought to require financial institutions, including depository institutions, to maintain generally higher levels of capital. The application of more stringent capital requirements to the Company and the Bank could, among other things, result in lower returns on invested capital, result in the need for additional capital, and result in regulatory actions if we were to be unable to comply with such requirements, including limitations on our ability to make distributions, including paying out dividends or buying back shares. Furthermore, the imposition of liquidity requirements in connection with the implementation of Basel III could result in our having to lengthen the term of our funding, restructure our business models, and/or increase our holdings of liquid assets.
Noncompliance with the Bank Secrecy Act and other anti-money laundering statutes and regulations could cause us material financial loss.
The Bank Secrecy Act and the PATRIOT Act contain anti-money laundering and financial transparency provisions intended to detect and prevent the use of the U.S. financial system for money laundering and terrorist financing activities. The Bank Secrecy Act, as amended by the PATRIOT Act, requires depository institutions and their holding companies to undertake activities including maintaining an anti-money laundering program, verifying the identity of clients, monitoring for and reporting suspicious transactions, reporting on cash transactions exceeding specified thresholds, and responding to requests for information by regulatory authorities and law enforcement agencies. FinCEN, a unit of the Treasury Department that administers the Bank Secrecy Act, is authorized to impose significant civil money penalties for violations of those requirements and has recently engaged in coordinated enforcement efforts with the federal bank regulatory agencies, as well as the U.S. Department of Justice, Drug Enforcement Administration, and IRS.
There is also increased scrutiny of compliance with the rules enforced by the Office of Foreign Assets Control. If our policies, procedures, and systems are deemed deficient or the policies, procedures, and systems of the financial institutions that we have already acquired or may acquire in the future are deficient, we would be subject to liability, including fines and regulatory actions such as restrictions on our ability to pay dividends and the necessity to obtain regulatory approvals to proceed with certain planned business activities, including acquisition plans, which would negatively impact our business, financial condition, and results of operations. Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have serious reputational consequences for us.
Pending litigation and legal proceedings and the impact of any finding of liability or damages could adversely impact the Company and its financial condition and results of operations.
As more fully described in Note 23, Contingencies, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statement and Supplementary Data," of this Annual Report on Form 10-K, the Company believes that the allegations of the Southeastern Pennsylvania Transportation Authority's third amended complaint are without merit and it intends to vigorously defend itself against those claims. It is not possible at this time to estimate reasonably possible losses, or even a range of reasonably possible losses, in connection with the litigation. There can be no assurances, however, that the Company will not incur any losses associated with this litigation or that any losses that are incurred will not be material.
Indemnification costs associated with litigation and legal proceedings could adversely impact the Company and its financial condition and results of operations.
We are generally required, to the extent permitted by Pennsylvania law, to indemnify our current and former directors and officers who are named as defendants in lawsuits. We also have certain contractual indemnification obligations to third parties regarding litigation. Generally, insurance coverage is not available for such indemnification costs we could incur to third parties. Current or future litigation could result in indemnification expenses that could have a materially adverse impact on our financial condition and results of operations.
Risks Related to Liquidity
The Parent Company is a holding company dependent for liquidity on payments from its bank subsidiary, which is subject to restrictions.
The Parent Company is a holding company and depends on dividends, distributions and other payments from the Bank to fund dividend payments and stock repurchases, if permitted, and to fund all payments on obligations. The Bank is subject to laws that restrict dividend payments or authorize regulatory bodies to prohibit or reduce the flow of funds from it to us. In addition, our right to participate in a distribution of assets upon the Bank’s liquidation or reorganization is subject to the prior claims of the Bank’s creditors, including its depositors.
The soundness of other financial institutions could adversely affect the Company.
Our ability to engage in routine funding and other transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have historically led to market-wide liquidity problems, losses of depositor, creditor and counterparty confidence and could lead to losses or defaults by us or by other institutions. We could experience increases in deposits and assets as a result of other banks’ difficulties or failure, which would increase the capital we are required to maintain to support such growth.
Risks Related to Owning our Stock
If the Company wants, or is compelled, to raise additional capital in the future, that capital may not be available when it is needed or on terms favorable to current shareholders.
Federal banking regulators require us and our banking subsidiary to maintain adequate levels of capital to support our operations. These capital levels are determined and dictated by law, regulation and banking regulatory agencies. In addition, capital levels are also determined by our management and board of directors based on capital levels that they believe are necessary to support our business operations. At December 31, 2020, all four capital ratios for us and our banking subsidiary were above regulatory minimum levels to be deemed “well capitalized” under current bank regulatory guidelines. To be “well capitalized,” banks generally must maintain a tier 1 leverage ratio of at least 5.0%, CET1 capital ratio of 6.5%, Tier 1 risk-based capital ratio of at least 8.0%, and a total risk-based capital ratio of at least 10.0%.
The Company’s ability to raise additional capital will depend on conditions in the capital markets at that time, which are outside of our control, and on our financial performance. Accordingly, we cannot provide assurance of our ability to raise
additional capital on terms and time frames acceptable to us or to raise additional capital at all. Additionally, the inability to raise capital in sufficient amounts may adversely affect our operations, financial condition and results of operations. Our ability to borrow could also be impaired by factors that are nonspecific to us, such as severe disruption of the financial markets or negative news and expectations about the prospects for the financial services industry as a whole. If we raise capital through the issuance of additional shares of our common stock or other securities, we would likely dilute the ownership interests of current investors by diluting earnings per share of our common stock and potentially dilute book value per share, depending on the issuance price. The price at which we issue additional shares of stock could be less than the current market price of our common stock. Furthermore, a capital raise through the issuance of additional shares may have an adverse impact on our stock price.
The market price of our common stock is subject to volatility.
The market price of the Company’s common stock has been subject to fluctuations in response to numerous factors, many of which are beyond our control. These factors include actual or anticipated variations in our operational results and cash flows, changes in financial estimates by securities analysts, trading volume, large purchases or sales of our common stock, market conditions within the banking industry, the general state of the securities markets and the market for stocks of financial institutions, as well as general economic conditions.
A reduction in our credit rating could adversely affect our access to capital and could increase our cost of funds.
A credit rating agency regularly evaluates Orrstown and the Bank, and credit ratings are based on a number of factors, including our financial strength and ability to generate earnings, as well as factors not entirely within our control, including conditions affecting the financial services industry, the economy, and changes in rating methodologies. There can be no assurance that we will maintain our current credit ratings. A downgrade of the credit ratings of Orrstown or the Bank could adversely affect our access to liquidity and capital, and could significantly increase our cost of funds, trigger additional collateral or funding requirements, and decrease the number of investors and counterparties willing to lend to us or purchase our securities. This could affect our growth, profitability, and financial condition, including liquidity.
The Parent Company's primary source of income is dividends received from its bank subsidiary.
The Parent Company is a separate legal entity from the Bank and must provide for its own liquidity. In addition to its operating expenses, the Company is responsible for paying any dividends declared to its shareholders. The Company also has repurchased shares of its common stock. The Company’s primary source of income is dividends received from the Bank. Banking regulations limit the amount of dividends that may be paid from the Bank to the Company without prior approval of regulatory agencies. Restrictions on the Bank’s ability to dividend funds to the Company are included in Note 17, Shareholders' Equity and Regulatory Capital, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data."
General Risk Factors
The COVID-19 pandemic has caused a significant global and national economic downturn and unprecedented levels of unemployment, which may adversely affect our business and results of operations, and the future impact of the COVID-19 pandemic on the global, national and local economies and our business, results of operations and financial condition remain uncertain.
The COVID-19 pandemic has caused a significant global and national economic downturn and unprecedented levels of unemployment, which has adversely affected, and is expected to continue to adversely affect, the Company’s business and results of operations, and the future impact of the COVID-19 pandemic on the global, national and local economies and the Company’s business, results of operations and financial condition remain uncertain.
The COVID-19 pandemic has resulted in authorities implementing numerous measures attempting to contain the spread and impact of COVID-19, such as travel bans and restrictions, quarantines, shelter in place orders, and limitations on business activity, including closures. These measures are, among other things, severely restricting global and national economic activity, which is disrupting supply chains, lowering asset valuations, significantly increasing unemployment and underemployment levels, decreasing liquidity in markets for certain securities and causing significant volatility and disruptions in the financial markets. These measures have negatively impacted, and could continue to negatively impact, businesses, market participants, our counterparties and clients, and the global, national and local economies for a prolonged period of time. Should current economic conditions persist or continue to deteriorate, this economic environment could have a continued adverse effect on our business and operations, including, but not limited to: decreased demand for our products and services; protracted periods of lower interest rates; lower asset management fees; and increased credit losses due to deterioration in the financial condition of our consumer and commercial borrowers, including declining asset and collateral values, which may result in an increase in our provision for credit losses and net charge-offs. Additionally, our liquidity and regulatory capital could be adversely impacted by customer withdrawal of deposits, volatility and disruptions in the capital and credit markets, and customer draws on lines of
credit. To the extent the COVID-19 pandemic continues to adversely affect the economy, and/or adversely affects our business, results of operations or financial condition, it may also have the effect of increasing the likelihood and/or magnitude of other risks including those risks related to market, credit, and business operations, or risks described herein.
In response to the economic and market conditions resulting from the COVID-19 pandemic, governments and regulatory authorities, including central banks, have acted to provide fiscal and monetary stimulus to support the global and national economy. However, there can be no assurance that these measures will stimulate the global and national economy or avert recessionary conditions in markets in which we conduct operations.
We continue to closely monitor the COVID-19 pandemic and related risks as they evolve. The magnitude, duration and likelihood of the current outbreak of COVID-19, further outbreaks of COVID-19, future actions taken by governmental authorities and/or other third parties in response to the COVID-19 pandemic, and its future direct and indirect effects on the global, national and local economies and our business and results of operation are highly uncertain. The COVID-19 pandemic may cause prolonged global, national or local recessionary economic conditions or longer lasting effects on economic conditions than currently exist, which could have a material adverse effect on our business, results of operations and financial condition.
The Company may not be able to attract and retain skilled people.
Competition for the best people in most activities engaged in by us can be intense, and we may not be able to attract and hire sufficiently skilled people to fill open and newly created positions or to retain current or future employees. An inability to attract and retain individuals with the necessary skills to fill open positions, or the unexpected loss of services of one or more of our key personnel, could have a material adverse impact on our business due to the loss of their skills, knowledge of our markets, years of industry experience or the difficulty of promptly finding qualified replacement personnel.
We believe that our continued growth and future success will depend in large part on the skills of our management team and our ability to motivate and retain these individuals and other key personnel. The loss of service of one or more of our executive officers or key personnel could reduce our ability to successfully implement our long-term business strategy, our business could suffer, and the value of our stock could be materially adversely affected. Leadership changes will occur from time to time, and we cannot predict whether significant resignations will occur or whether we will be able to recruit additional qualified personnel. We believe our management team possesses valuable knowledge about the banking industry and that their knowledge and relationships could be very difficult to replicate. Our success also depends on the experience of our branch managers and lending officers and on their relationships with the clients and communities they serve. The loss of these key personnel could negatively impact our banking operations. The loss of key personnel, or the inability to recruit and retain qualified personnel in the future, could have an adverse effect on our business, financial condition, or operating results.
We could be adversely affected by a failure in our internal controls.
We rely on our employees to design, manage, and operate our systems and controls to assure that we properly enter into, record and manage processes, transactions and other relationships with clients, suppliers and other parties with whom we do business. In some cases, we rely on employees of third parties to perform these tasks. We also depend on employees and the systems and controls for which they are responsible to assure that we identify and mitigate the risks that are inherent in our relationships and activities. These concerns are increased when we change processes or procedures, introduce new products or services, or implement new technologies, as we may fail to adequately identify or manage operational risks resulting from such changes.
As a result of our necessary reliance on employees, whether ours or those of third parties, to perform these tasks and manage resulting risks, we are subject to human vulnerabilities. These range from innocent human error to misconduct or malfeasance, potentially leading to operational breakdowns or other failures. Our controls may not be adequate to prevent problems resulting from human involvement in our business, including risks associated with the design, operation and monitoring of automated systems.
Errors by our employees or others responsible for systems and controls on which we depend and any resulting failures of those systems and controls could result in significant harm to us. This could include client remediation costs, regulatory fines or penalties, litigation or enforcement actions, or limitations on our business activities. We could also suffer damage to our reputation, impacting our ability to attract and retain clients and employees.
We continue to devote a significant amount of effort and resources to constantly strengthening our controls and ensuring compliance with complex accounting standards and regulations. However, these efforts may not be effective in preventing a breach in, or failure of, our controls.
Negative public opinion could damage our reputation and adversely affect our earnings.
Reputational risk, or the risk to the Company's earnings and capital from negative public opinion, is inherent in our business. Negative public opinion can result from the actual or perceived manner in which we conduct our business activities, including banking operations and trust and investment operations, our management of actual or potential conflicts of interest and ethical issues, and our protection of confidential client information. Negative public opinion can adversely affect the Company's ability to keep and attract clients and can expose the Company to litigation and regulatory action. Although we take steps to minimize reputation risk in the way we conduct our business activities and deal with our clients, communities and vendors, these steps may not be effective.
Acts of terrorism, natural disasters, global climate change, pandemics and global conflicts may have a negative impact on our business and operations.
Acts of terrorism, natural disasters, global climate change, pandemics, global conflicts or other similar events could have a negative impact on our business and operations. While we have in place business continuity plans, such events could still damage our facilities, disrupt or delay the normal operations of our business (including communications and technology), result in harm to, or cause travel limitations on, our employees, and have a similar impact on our clients, suppliers, third-party vendors and counterparties. These events also could impact us negatively to the extent that they result in reduced capital markets activity, lower asset price levels, or disruptions in general economic activity in the U.S. or abroad, or in financial market settlement functions. In addition, these or similar events may impact economic growth negatively, which could have an adverse effect on our business and operations, and may have other adverse effects on us in ways that we are unable to predict.

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ITEM 1B. UNRESOLVED STAFF COMMENTS
ITEM 1B - UNRESOLVED STAFF COMMENTS
None.

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ITEM 2. PROPERTIES
ITEM 2 - PROPERTIES
Our principal executive offices are located at 77 East King Street, Shippensburg, Pennsylvania, with additional executive and administrative offices at 4750 Lindle Road, Harrisburg, Pennsylvania. These facilities are owned by the Bank, which also maintains its principal and additional executive and administrative offices at those locations.
We own or lease other premises for use in conducting our business activities, including bank branches, an operations center, and offices in Berks, Cumberland, Dauphin, Franklin, Lancaster, Perry, and York Counties, Pennsylvania and Anne Arundel, Baltimore, Howard, and Washington Counties, Maryland, as well as Baltimore City, Maryland. We believe that the properties currently owned and leased are adequate for present levels of operation. We are constantly evaluating the best and most efficient mix of branch locations to service our clients due to evolving trends in our industry and increased client engagement through digital channels.
In October 2019, Orrstown announced the consolidation of five Pennsylvania branches in Franklin and Perry Counties that averaged less than $20.0 million in deposits per location into other, larger Orrstown Bank branches, as well as the sale of an operation's center facility. Orrstown expects that these efforts will improve the profitability of the remaining branch locations and eliminate close to 50,000 square feet of excess back office space. The branch consolidations were completed in January 2020, and the sale of the operations center facility was completed in the second quarter of 2020. In October 2020, the Company announced the consolidation of an additional six branch locations, the discontinuance of three loan production offices, and a reduction in back-office real estate. These facilities were closed in the first quarter of 2021.

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ITEM 3. LEGAL PROCEEDINGS
ITEM 3 - LEGAL PROCEEDINGS
Information regarding legal proceedings is included in Note 23, Contingencies, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statement and Supplementary Data."

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ITEM 4. MINE SAFETY DISCLOSURE
ITEM 4 - MINE SAFETY DISCLOSURES
Not applicable.
PART II

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ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY
ITEM 5 - MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
Our common stock is traded on the NASDAQ Capital Market under the symbol “ORRF.” At the close of business on March 11, 2021, there were 0 shareholders of record.
The Board declared cash dividends of $0.68 and $0.60 per common share in 2020 and 2019, respectively. Our Board is currently committed to continuing to pay regular cash dividends; however, there can be no assurance as to future dividends because they are dependent on our future earnings, capital requirements and financial condition. Restrictions on the payment of dividends are discussed in Note 17, Shareholders' Equity and Regulatory Capital, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data." On January 20, 2021, the Board declared a cash dividend of $0.18 per common share, which was paid on February 8, 2021, to shareholders of record as of February 1, 2021.
Securities Authorized for Issuance under Equity Compensation Plans
Information regarding the Company's equity compensation plans is included in Part III, Item 12, Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
Issuer Purchases of Equity Securities
In September 2015, the Board of Directors of the Company authorized a share repurchase program under which the Company may repurchase up to 5% of the Company's outstanding shares of common stock, or approximately 416,000 shares, in accordance with all applicable securities laws and regulations, including Rule 10b-18 of the Securities Exchange Act of 1934, as amended. When and if appropriate, repurchases may be made in open market or privately negotiated transactions, depending on market conditions, regulatory requirements and other corporate considerations, as determined by management. Share repurchases may not occur and the share repurchase program may be discontinued at any time.
No shares were repurchased from October 1, 2020 to December 31, 2020. As of December 31, 2020, 154,680 shares had been repurchased under the program at a total cost of $2.6 million, or $16.88 per share and the maximum number of shares that may yet be purchased under the plan is 261,320 shares.
PERFORMANCE GRAPH
The performance graph below compares the cumulative total shareholder return on our common stock with other indexes: the SNL index of banks with assets between $1.0 billion and $5.0 billion, the S&P 500 Index, and the NASDAQ Composite index. The graph assumes an investment of $100 on December 31, 2015 and reinvestment of dividends on the date of payment without commissions. Shareholder returns on our common stock are based on trades on the NASDAQ Stock Market. The performance graph represents past performance and should not be considered to be an indication of future performance.
Period Ending
Index 12/31/15 12/31/16 12/31/17 12/31/18 12/31/19 12/31/20
Orrstown Financial Services, Inc. 100.00 127.95 146.81 108.11 138.22 105.80
SNL Bank $1B-$5B Index 100.00 143.87 153.37 134.37 163.35 138.81
S&P 500 Index 100.00 111.96 136.40 130.42 171.49 203.04
NASDAQ Composite Index 100.00 108.87 141.13 137.12 187.44 271.64
Source: S&P Global Market Intelligence © 2021
In accordance with the rules of the SEC, this section captioned “Performance Graph” shall not be incorporated by reference into any of our future filings made under the Exchange Act or the Securities Act. The Performance Graph and its accompanying table are not deemed to be soliciting material or to be considered filed under the Exchange Act or the Securities Act.
Recent Sales of Unregistered Securities
The Company has not sold any equity securities within the past three years which were not registered under the Securities Act.

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ITEM 6. SELECTED FINANCIAL DATA
ITEM 6 - SELECTED FINANCIAL DATA
At or For The Year Ended December 31,
2020 2019 2018 2017 2016
Summary of Operations
Interest income $ 99,631 $ 92,994 $ 65,667 $ 51,453 $ 42,276
Interest expense 16,024 23,699 13,510 7,644 5,417
Net interest income 83,607 69,295 52,157 43,809 36,859
Provision for loan losses 5,325 900 800 1000 250
Net interest income after provision for loan losses
78,282 68,395 51,357 42,809 36,609
Investment securities gains (16) 4,749 1,006 1,190 1,420
Noninterest income 28,325 23,790 20,018 18,759 18,005
Noninterest expenses
74,080 77,300 57,936 50,330 48,140
Income before income tax expense
32,511 19,634 14,445 12,428 7,894
Income tax expense 6,048 2,710 1,640 4,338 1,266
Net income $ 26,463 $ 16,924 $ 12,805 $ 8,090 $ 6,628
Per Share Information
Basic earning per share $ 2.42 $ 1.63 $ 1.53 $ 1.00 $ 0.82
Diluted earnings per share 2.40 1.61 1.50 0.98 0.81
Dividends paid per share 0.68 0.60 0.51 0.42 0.35
Book value per share 21.98 19.93 18.39 17.34 16.28
Weighted average shares outstanding - basic 10,942 10,362 8,360 8,070 8,059
Weighted average shares outstanding - diluted 11,034 10,514 8,537 8,226 8,145
Stock Price Statistics
Close $ 16.55 $ 22.62 $ 18.21 $ 25.25 $ 22.40
High 22.88 23.48 27.05 26.95 23.75
Low 11.40 17.30 18.10 19.05 16.60
Price earnings ratio at close 6.8 13.9 11.9 25.3 27.3
Diluted price earnings ratio at close 6.9 14.0 12.1 25.8 27.7
Price to book at close 0.8 1.1 1.0 1.5 1.4
Year-End Information
Total assets $ 2,750,572 $ 2,383,274 $ 1,934,388 $ 1,558,849 $ 1,414,504
Loans 1,979,690 1,644,330 1,247,657 1,010,012 883,391
Total investment securities 477,028 506,570 476,686 425,305 408,124
Deposits - noninterest-bearing 456,778 249,450 204,843 162,343 150,747
Deposits - interest-bearing 1,900,102 1,626,072 1,353,913 1,057,172 1,001,705
Total deposits 2,356,880 1,875,522 1,558,756 1,219,515 1,152,452
Repurchase agreements 19,466 8,269 9,069 43,576 35,864
Borrowed money 89,948 241,514 170,309 133,815 76,163
Total shareholders’ equity 246,249 223,249 173,433 144,765 134,859
Assets under management - market value 1,719,832 1,613,223 1,330,595 1,370,950 1,174,143
Financial Ratios
Average equity / average assets 8.58 % 9.26 % 8.75 % 9.49 % 10.41 %
Return on average equity 11.66 % 8.21 % 8.56 % 5.73 % 4.80 %
Return on average assets 1.00 % 0.76 % 0.75 % 0.54 % 0.50 %

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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS
ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis is intended to assist readers in understanding the consolidated financial condition and results of operations of Orrstown and should be read in conjunction with our Consolidated Financial Statements and notes thereto included in this Annual Report on Form 10-K. Certain prior period amounts presented in this discussion and analysis have been reclassified to conform to current period classifications.
Overview
The results of our operations are highly dependent on economic conditions and market interest rates. Our profitability for the years ended December 31, 2020, 2019 and 2018 was influenced by our continued organic growth and ongoing expansion into targeted markets, the acquisitions of Mercersburg and Hamilton, and a continued focus on maintaining strong asset quality. These and other matters are discussed more fully below.
During the year ended December 31, 2020, the Company recognized charges associated with the consolidation of six branch locations, the discontinuance of three loan production offices, a reduction in back-office real estate and staffing reductions. These actions were initiated due to evolving client preferences for the digital delivery of products and services. In addition, the anticipated future cost reductions resulting from these actions will prepare the Company for a challenging operating environment in 2021. A charge of $1.6 million was recorded in the year ended December 31, 2020, which included $1.3 million related to branch consolidations.
Critical Accounting Estimates
The Company's consolidated financial statements are prepared in accordance with GAAP, and follow general practices within the financial services industry. The most significant accounting policies followed by the Company are presented in Note 1, Summary of Significant Accounting Policies, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data." In applying those accounting policies, the Company's management is required to exercise judgment in determining many of the methodologies, assumptions and estimates to be utilized. Certain of the critical accounting estimates are more dependent on such judgment and, in some cases, may contribute to volatility in our reported financial performance should the assumptions and estimates used change over time due to changes in circumstances. Some of the more significant areas in which the Company's management applies critical assumptions and estimates include the following.
Accounting for loan losses - The loan portfolio is the largest asset on the Company's consolidated balance sheets. The allowance for loan losses represents the amount that, in management’s judgment, appropriately reflects credit losses inherent in the loan portfolio at the balance sheet date. A provision for credit losses is recorded to adjust the level of the ALL as deemed necessary by management. In estimating losses inherent in the loan portfolio, assumptions and judgment are applied to measure amounts and timing of expected future cash flows, collateral values and other factors used to determine the borrowers’ abilities to repay obligations. Historical loss trends are also considered, as are economic conditions, industry trends, portfolio trends and borrower-specific financial data. Loans acquired at a discount, that is, in part, attributable to credit quality, are initially recorded at fair value with no carry-over of an acquired entity’s previously established ALL. Cash flows expected at acquisition, in excess of estimated fair value, are recognized as interest income over the remaining lives of the loans. Subsequent decreases in the expected principal cash flows require the Company to evaluate the need for additions to the ALL. Subsequent improvements in expected cash flows result, first, in the recovery of any applicable ALL and, then, in the recognition of additional interest income over the remaining lives of the loans. Changes in the circumstances considered when determining management’s estimates and assumptions, could result in changes to those estimates and assumptions, and also in adjustment of the ALL, or, in the case of loans acquired at a discount, increases in interest income in future periods. The Company has delayed the implementation of ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The implementation deadline of ASU 2016-13 was extended for smaller reporting and other companies until the fiscal year and interim periods beginning after December 15, 2022.
Valuation methodologies - Management applies various valuation methodologies to assets and liabilities which often involve a significant degree of judgment, particularly when liquid markets do not exist for the particular items being valued. Quoted market prices are referred to when estimating fair values for certain assets, such as most investment securities. However, for those items for which an observable liquid market does not exist, management utilizes significant estimates and assumptions to value such items. Examples of these items include derivatives and mortgage servicing assets. These valuations require the use of various assumptions, including, among others, discount rates, rates of return on assets, repayment rates, cash flows, default rates, costs of servicing and liquidation values. The use of different assumptions could produce significantly different results, which could have material positive or negative effects on our results of operations, financial condition or disclosures of fair value information. In addition to valuation, the Company must assess whether there are any declines in value
below the carrying value of certain assets that should be considered other than temporary or otherwise require an adjustment in carrying value and recognition of a loss in the consolidated statements of income. Examples include investment securities, mortgage servicing rights, goodwill and core deposit intangible assets, among others.
Readers of the Company's consolidated financial statements should be aware that the estimates and assumptions used may need to be updated in future financial presentations for changes in circumstances, business or economic conditions, in order to fairly represent the condition of the Company at that time.
Economic Climate, Inflation and Interest Rates
Preliminary real GDP for the fourth quarter of 2020 resulted in an annualized increase of 4.0%. This is a substantial decrease from an increase of 38.3% for the third quarter of 2020, which reflected the impact of government stimulus and the gradual re-opening of the economy from COVID-19 related shutdowns as multiple vaccines have been approved. Overall, real GDP decreased by 3.5 % for 2020 as compared to an increase of 2.2% in 2019.The increase in fourth quarter of 2020 reflected both the continued economic recovery from the sharp declines earlier in the year and the ongoing impact of the COVID-19 pandemic, including new restrictions and closures that took effect in some parts of the country. The full economic effects of the COVID-19 pandemic cannot be quantified in the GDP estimate for the fourth quarter of 2020 because the impacts are generally embedded in source data and cannot be separately identified. As restrictions continue to be lifted and the world population gets vaccinated, there is hope that the leisure, travel and entertainment industries will recover. Weekly jobless claims remain high but the Labor Department announced a decline to 730,000 on February 25, 2021, a decline of 110,000 claims from the previous report. Also, the prospects for a new government stimulus packages have recently been renewed, but remain uncertain.
The pace of U.S. economic growth weakened substantially late in the first quarter of 2020 and into the second quarter of 2020 as over 30 million people in the U.S filed for unemployment since mid-March 2020. Early in 2020, a novel coronavirus (“COVID-19”) emerged and spread, first in China and then around the globe. The fast spread of the virus and the fear that resulted combined to create a high level of uncertainty about the near and intermediate future economic outlook. Because of this uncertainty, markets were pricing in a wide range of potential outcomes by buying sovereign government bonds, especially U.S. Treasuries, and selling stocks and bonds not issued by sovereign governments. The COVID-19 pandemic has adversely affected, and is likely to continue to adversely affect, economic activity globally, nationally and locally. Actions taken around the world to help mitigate the spread of COVID-19 include restrictions on travel, quarantines in certain areas, and forced closures for certain types of public places and businesses, as well as shelter-in-place orders by many states. These restrictions have slowly been lifted as multiple vaccines have been rolled out late in the fourth quarter of 2020.
The decline in second quarter GDP reflected the response to COVID-19, as shelter-in-place orders issued in March and April were partially lifted in some areas of the country in May and June, and government pandemic assistance payments were distributed to households and businesses. This led to shifts in economic activity, as businesses remained closed or operated remotely and consumers and businesses significantly reduced or redirected their spending. Actions taken to mitigate the spread of COVID-19 have had, and are expected to continue to have, an adverse impact on the economies and financial markets of many countries, including the geographical area in which the Company operates.
Due to the COVID-19 pandemic, market interest rates have declined significantly, with the 10-year Treasury bond falling for the first time below 1.00% on March 3, 2020; it was at 0.69% on September 30, 2020. On March 3, 2020, in reaction to the increase in uncertainty, the Federal Reserve cut the Fed Funds rates by 50 basis points between regularly scheduled meetings to a target range of 1.00% to 1.25%. On March 11, 2020, the World Health Organization declared COVID-19 a global pandemic. On March 13, 2020, a national emergency was declared by President Trump under the National Emergencies Act. On March 15, 2020, the Federal Reserve responded by again reducing the Fed Funds rate, this time by 100 basis points, to 0% to 0.25%. The Fed Funds rate was left unchanged in future meetings with rates expected to remain at this level for an extended period of time. These reductions in interest rates and other effects of the COVID-19 pandemic may adversely affect the Company's financial condition and results of operations in future periods. It is unknown how long the adverse conditions associated with the COVID-19 pandemic will last and what the complete financial effect will be to the Company. It is reasonably foreseeable that estimates made in the financial statements could be materially and adversely impacted in the near term as a result of these conditions, including expected credit losses on loans and the fair value of financial instruments that are carried at fair value.
The majority of the assets and liabilities of a financial institution are monetary in nature, and therefore, differ greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories. However, inflation does have an impact on the growth of total assets and on noninterest expenses, which tend to rise during periods of general inflation. Inflationary pressures remain modest and there is great uncertainty about when, or if, inflation will increase and pressure interest rates to move higher.
As the Company’s balance sheet consists primarily of financial instruments, interest income and interest expense are greatly influenced by the level of interest rates and the slope of the yield curve as well as the mix of assets and funding. The Company has been able to grow its net interest income by $14.3 million from 2019 to 2020, through a combination of organic
commercial loan growth and the recognition of SBA PPP processing fee income. Competition for quality lending opportunities and deposits remains intense, which, together with a flattening yield curve, will continue to challenge our ability to grow our net interest margin and to leverage our overhead expenses.
Results of Operations
Summary
Earnings in 2020 reflected continuing increased interest income from expanding loan and investment portfolios, partially offset by the impact of decreasing interest rates and an overall increase in interest expense. In addition, the comparability of operating results for 2020 with 2019 has been impacted by the Hamilton acquisition, which was completed on May 1, 2019. Hamilton added loans and deposits totaling $347.1 million and $388.2 million, respectively.
The Company recorded net income of $26.5 million, $16.9 million and $12.8 million for 2020, 2019 and 2018, respectively. Diluted earnings per share totaled $2.40, $1.61 and $1.50 for 2020, 2019 and 2018, respectively.
Net interest income totaled $83.6 million, $69.3 million and $52.2 million for 2020, 2019 and 2018, respectively, principally reflecting our expanded geographic footprint, organic growth in commercial loans from an expanded sales force as we continued to take advantage of market opportunities, and SBA PPP processing fee income. As previously noted, interest rates increased throughout 2018 and 2019 and decreased throughout 2020, contributing to fluctuations in yields on loans and investments, and, to a lesser extent, costs of interest-bearing liabilities.
Asset quality trends continue to exhibit low levels of charge-offs and non-performing loans. The provision for loan losses totaled $5.3 million, $900 thousand and $800 thousand in 2020, 2019 and 2018, respectively. The increase in provision for loan losses in 2020 was primarily a result of increased uncertainty related to the COVID-19 pandemic.
Noninterest expenses totaled $74.1 million, $77.3 million and $57.9 million for 2020, 2019 and 2018, respectively. The changes in certain components of noninterest expenses between years reflect the Hamilton acquisition, and the Company's continued focus on aligning its talent and locations with its business model. Salaries and employee benefits expense increased $7.0 million from 2018 to 2019 and by $3.9 million from 2019 to 2020. Occupancy and furniture and fixture costs increased $1.9 million from 2018 to 2019 and $0.5 million from 2019 to 2020 as new and acquired branch locations were brought on line. In 2020, the Company incurred $1.3 million in pretax branch consolidation expenses, with $9.0 million incurred in 2019 for pretax merger related and branch consolidation expenses. During 2020, the Company recorded a loss of $736 thousand associated with the sale of an operations facility.
Income tax expense totaled $6.0 million, $2.7 million and $1.6 million for 2020, 2019 and 2018, or an effective tax rate of 18.6%, 13.8% and 11.4% respectively. The Company’s effective tax rate is less than the 21% federal statutory rate, principally due to tax-free income, which includes interest income on tax-free loans and securities and income from life insurance policies, federal income tax credits, and the impact of non-tax deductible expenses, including merger related expenses. The difference in the effective tax rate in 2020 from prior years was primarily due to an increase in estimated earnings before income taxes.
Net Interest Income
Net interest income is the primary component of Orrstown's revenue. Interest-earning assets include loans, securities and federal funds sold. Interest-bearing liabilities include deposits and borrowed funds.
Net interest income is affected by changes in interest rates, volumes of interest-earning assets and interest-bearing liabilities, and the composition of those assets and liabilities. “Net interest spread” and “net interest margin” are two common statistics related to changes in net interest income. Net interest spread represents the difference between the yields earned on interest-earning assets and the rates paid for interest-bearing liabilities. Net interest margin is the ratio of net interest income to average earning asset balances. Through the use of noninterest-bearing demand deposits and shareholders' equity, the net interest margin exceeds the net interest spread, as these funding sources are noninterest-bearing.
The FRB influences the general market rates of interest, including the deposit and loan rates offered by many financial institutions. Our loan portfolio is affected by changes in the prime interest rate. In 2018, the prime rate rose with 25 basis point increases in each of March, June, September and December, ending the year at 5.50%. In 2019, 25 basis point reductions occurred in August, September and October and the prime rate ended the year at 4.75%. In March 2020, the prime rate was reduced by 150 basis points and ended the year at 3.25%.
Core deposits are deposits that are stable, lower cost and generally reprice more slowly than other deposits when interest rates change. Core deposits, which exclude certificates of deposit, are typically funds of local clients who also have a borrowing or other relationship with the Bank. We are primarily funded by core deposits, with noninterest-bearing demand deposits
historically being a significant source of funds. This lower-cost funding base is expected to have a positive impact on our net interest income and net interest margin in a rising interest rate environment.
Net interest income totaled $83.6 million, $69.3 million and $52.2 million in 2020, 2019 and 2018, respectively. The following table presents net interest income, net interest spread and net interest margin on a taxable-equivalent basis for 2020, 2019 and 2018. Taxable-equivalent adjustments are the result of increasing income from tax-free loans and investments by an amount equal to the taxes that would be paid if the income were fully taxable based on a 21% federal corporate tax rate for 2020, 2019 and 2018, reflecting our statutory tax rates for those years.
2020 2019 2018
Average
Balance
Taxable-
Equivalent
Interest
Taxable-
Equivalent
Rate
Average
Balance
Taxable-
Equivalent
Interest
Taxable-
Equivalent
Rate
Average
Balance
Taxable-
Equivalent
Interest
Taxable-
Equivalent
Rate
Assets
Federal funds sold and interest-bearing bank balances
$ 32,519 $ 115 0.35 % $ 57,765 $ 1331 2.30 % $ 16,442 $ 327 1.99 %
Taxable securities 438,565 10,458 2.38 436,174 14,538 3.33 359,852 10,858 3.02
Tax-exempt securities (1)
55,807 1,982 3.55 63,443 2,600 4.10 119,665 4,873 4.07
Total securities 494,372 12,440 2.52 499,617 17,138 3.43 479,517 15,731 3.28
Taxable loans (2)(3)
1,878,692 85,956 4.58 1,432,951 73,201 5.11 1,053,308 49,151 4.67
Tax-exempt loans (1)(2)(3)
49,794 1,944 3.90 59,864 2,367 3.95 47,318 1,875 3.96
Total loans 1,928,486 87,900 4.56 1,492,815 75,568 5.06 1,100,626 51,026 4.64
Total interest-earning assets 2,455,377 100,455 4.09 2,050,197 94,037 4.59 1,596,585 67,084 4.20
Cash and due from banks 26,954 25,046 18,951
Bank premises and equipment 36,627 40,982 35,399
Other assets 143,919 123,362 72,960
Allowance for loan losses (17,030) (14,466) (13,298)
Total $ 2,645,847 $ 2,225,121 $ 1,710,597
Liabilities and Shareholders’ Equity
Interest-bearing demand deposits
$ 1,156,292 4,755 0.41 $ 920,025 8,253 0.90 $ 767,863 4,968 0.65
Savings deposits 163,133 246 0.15 146,185 296 0.20 109,819 195 0.18
Time deposits (4)
452,298 7,008 1.55 542,513 10,761 1.98 316,488 5,066 1.60
Securities sold under agreements to repurchase 18,064 86 0.48 8,830 113 1.28 9,715 80 0.82
FHLB Advances and other 179,457 1,923 1.07 103,807 2,289 2.21 155,097 3,129 2.02
Subordinated notes 31,874 2,006 6.29 31,842 1,987 6.24 1,139 73 6.41
Total interest-bearing liabilities 2,001,118 16,024 0.80 1,753,202 23,699 1.35 1,360,121 13,511 0.99
Noninterest-bearing demand deposits
381,869 234,354 183,387
Other 35,960 31,544 17,427
Total Liabilities 2,418,947 2,019,100 1,560,935
Shareholders’ Equity 226,900 206,021 149,662
Total $ 2,645,847 $ 2,225,121 $ 1,710,597
Taxable-equivalent net interest income / net interest spread
84,431 3.29 % 70,338 3.24 % 53,573 3.21 %
Taxable-equivalent net interest margin
3.44 % 3.43 % 3.36 %
Taxable-equivalent adjustment
(824) (1,043) (1,417)
Net interest income
$ 83,607 $ 69,295 $ 52,156
Ratio of average interest-earning assets to average interest-bearing liabilities 123 % 117 % 117 %
NOTES TO ANALYSIS OF NET INTEREST INCOME:
(1) Yields and interest income on tax-exempt assets have been computed on a taxable-equivalent basis assuming a 21% tax rate.
(2) Average balances include nonaccrual loans.
(3) Interest income on loans includes prepayment and late fees.
(4) For the year ended December 31, 2019, expenses associated with the early redemption of brokered time deposits totaled $0.2 million and increased the cost of funds by five basis points.
The following table presents changes in net interest income on a taxable-equivalent basis for 2020, 2019 and 2018 by rate and volume components.
2020 Versus 2019 Increase (Decrease)
Due to Change in 2019 Versus 2018 Increase (Decrease)
Due to Change in
Average
Volume
Average
Rate
Total Average
Volume
Average
Rate
Total
Interest Income
Federal funds sold and interest-bearing bank balances $ (581) $ (633) $ (1,214) $ 822 $ 180 $ 1,002
Taxable securities 80 (4,146) (4,066) 2,303 1,364 3,667
Tax-exempt securities (313) (306) (619) (2,289) 18 (2,272)
Taxable loans 22,777 (10,045) 12,732 17,715 6,357 24,073
Tax-exempt loans (398) (23) (421) 497 (8) 490
Total interest income 21,565 (15,153) 6,412 19,048 7,911 26,960
Interest Expense
Interest-bearing demand deposits 2,126 (5,652) (3,526) 984 2,328 3,312
Savings deposits 34 (80) (46) 65 29 95
Time deposits (1,786) (1,948) (3,734) 3,616 2,062 5,678
Securities sold under agreements to repurchase 118 (145) (27) (7) 41 33
FHLB Advances and other 1,672 (2,043) (371) (1,036) 197 (839)
Subordinated notes 2 17 19 1,968 (54) 1,914
Total interest expense 2,166 (9,851) (7,685) 5,590 4,603 10,193
Taxable-Equivalent Net Interest Income $ 19,399 $ (5,302) $ 14,097 $ 13,458 $ 3,308 $ 16,766
Note: The change attributed to volume is calculated by taking the average change in average balance times the prior year's
average rate and the remainder is attributable to rate.
2020 versus 2019
In 2020, net interest income increased $14.3 million, or 20.7%, compared with 2019. Net interest income for 2020 on a taxable-equivalent basis increased $14.1 million, or 20.0%, compared with 2019. The Company’s net interest spread increased five basis points to 3.29% for 2020 compared with 2019. Taxable-equivalent yields on interest-earning assets and costs of interest-bearing liabilities both increased from 2019 to 2020, reflecting increased average balances from SBA PPP loans, organic growth and acquisitions, partially offset by changes in the interest rate environment between years. Other factors impacting the comparison of taxable-equivalent yields between 2019 and 2020 include the effect of purchase accounting related to the Hamilton acquisition and the timing of our adjustments to rates paid on interest-bearing deposits in response to market demand.
Interest income on a taxable-equivalent basis on loans increased $12.3 million, or 16.3%, from 2019 to 2020. The increase resulted from SBA PPP loans originated in 2020, which drove an increase in average loan volume and a decrease in yield, with average loans increasing $435.7 million, or 29.2%, and yield decreasing 50 basis points from 5.06% in 2019 to 4.56% in 2020. For the year ended December 31, 2020, SBA PPP loans had an average balance of $318.4 million and an average yield of 3.5%. Accretion of purchase accounting adjustments in connection with acquisitions increased interest income by $2.3 million, $3.8 million and $335 thousand in 2020, 2019 and 2018, respectively.
Interest income earned on a taxable-equivalent basis on securities decreased by $4.7 million, or 27.4%, from 2019 to 2020, with both average volume and yield decreasing. Average securities decreased by $5.2 million, or 1.0%, and the taxable-equivalent yield decreased from 3.43% in 2019 to 2.52% in 2020. Contributing to the overall decrease in interest income on securities was a decrease in average securities balances of $5.2 million from 2019 to 2020. This was partially offset by declines in the yield on floating rate securities, which fell as the FRB reduced short-term rates by 75 basis points in the second half of 2019 and an additional 150 basis points in the first half of 2020.
Interest expense on deposits and borrowings decreased by $7.7 million from 2019 to 2020, despite an increase in the average balance of interest-bearing liabilities of $247.9 million, or 14.1%. The cost of interest-bearing liabilities declined by 55 basis points from 1.35% in 2019 to 0.80% in 2020 due to a decline in market interest rates. In addition, there was an increase in non-interest bearing liabilities of $147.5 million, or 62.9% from 2019 to 2020 due primarily to the funding of SBA PPP loans in 2020.
The Company's ability to attract new deposits in all categories, but in particular interest-bearing demand deposits, resulted in an increase in average interest-bearing deposits totaling $236.3 million, or 25.7%, in 2020. Interest expense for these deposits decreased by $3.5 million, with the cost of funds decreasing from 0.90% in 2019 to 0.41% in 2020. The decrease was driven by the decreasing market rates from 2019 through 2020 due to the rate decreases commenced by the FRB.
The Company also increased its average FHLB advances in 2020. Borrowings generally have higher interest rates associated with them than interest-bearing deposits. Interest expense on all borrowings decreased $374 thousand in 2020, with average balances decreasing $9.2 million for short-term borrowings while FHLB advances increased $75.7 million. The average rate paid on short-term borrowings decreased from 1.28% in 2019 to 0.48% in 2020 and the average rate paid on FHLB advances decreased from 2.21% in 2019 to 1.07% in 2020.
2019 versus 2018
In 2019, net interest income increased $17.1 million, or 32.9%, compared with 2018. Net interest income for 2019 on a taxable-equivalent basis increased $16.8 million, or 31.3%, compared with 2018. The Company’s net interest spread increased three basis points to 3.24% for 2019 compared with 2018. Taxable-equivalent yields on interest-earning assets and costs of interest-bearing liabilities both increased from 2018 to 2019, reflecting increased average balances from organic growth and acquisitions, partially offset by changes in the interest rate environment between years. Other factors impacting the comparison of taxable-equivalent yields between 2018 and 2019 include the effect of purchase accounting related to the Mercersburg and Hamilton acquisitions and the timing of our adjustments to rates paid on interest-bearing deposits in response to market demand.
Interest income on a taxable-equivalent basis on loans increased $24.5 million, or 48.1%, from 2018 to 2019. The increase resulted from an increase in both average loan volume and yield, with average loans increasing $392.2 million, or 35.6%, and interest income on loans increasing 42 basis points from 4.64% in 2018 to 5.06% in 2019. The Company's geographic expansion and sales efforts with additional loan officers continued to drive loan growth in 2019 across most loan classes. Increases in prime lending rates in 2018 contributed to an increased yield in the first half of 2019, but were partially offset by rate decreases in the second half. In addition, the middle of the yield curve inverted for much of 2019, which lowered the rate on new loans more than the rate on new deposits, which pressured net interest margin. Accretion of purchase accounting adjustments in connection with the acquisitions increased 2019 interest income by $3.8 million compared with $335 thousand in 2018.
Interest income earned on a taxable-equivalent basis on securities increased $1.4 million, or 8.9%, from 2018 to 2019, with both average volume and yield increasing. Average securities increased $19.8 million, or 4.1%, and the taxable-equivalent yield increased from 3.28% in 2018 to 3.43% in 2019. Contributing to the overall increase in interest income on securities was the purchase of higher yielding, longer maturity, tax-free state and political subdivisions investments in the third quarter of 2018, that were subsequently sold in the third quarter of 2019. This was partially offset by declines in the yield of floating rate securities, which fell as the FRB reduced short-term rates by 75 basis points in the second half of 2019.
Interest expense on deposits and borrowings increased $10.2 million from 2018 to 2019, as the average balance of interest-bearing liabilities increased $393.1 million, or 28.9%. Interest expense on interest-bearing deposits declined less than the decline in market rates due to competitive factors in the marketplace.
Our ability to attract new deposits in all categories, but in particular interest-bearing demand deposits, resulted in an increase in average interest-bearing deposits totaling $152.2 million, or 19.8% in 2019, of which approximately $51.0 million was acquired in the Hamilton acquisition. Interest expense for these deposits increased $3.3 million, with the cost of funds increasing from 0.65% in 2018 to 0.90% in 2019. The increase was driven by increasing market rates throughout 2018, followed by falling short-term rates once the FRB began to decrease rates in the second half of 2019. As noted, yields on
interest-bearing deposits did not fall as much as market rates due to competitive factors. As a result, interest was paid at higher rates on interest-bearing deposits in 2019 than in 2018.
We also decreased our average short-term borrowings in 2019 in favor of brokered deposits at more attractive rates in early 2019. In late 2018, we issued $32.5 million in aggregate principal amount of subordinated notes, the proceeds of which were designated for the cash portion of merger and acquisition activity and for general corporate purposes. Borrowings generally have higher interest rates associated with them than interest-bearing deposits. Interest expense on all borrowings increased $1.1 million in 2019, with average balances decreasing $49.2 million for short-term borrowings while long-term borrowings also decreased $3.0 million. The average rate paid on short-term borrowings increased from 1.94% in 2018 to 1.95% in 2019 and the average rate paid on long-term borrowings increased from 1.95% in 2018 to 2.21% in 2019.
Provision for Loan Losses
The Company recorded a provision for loan losses of $5.3 million, $900 thousand and $800 thousand in 2020, 2019, and 2018, respectively. In calculating the provision for loan losses, both quantitative and qualitative factors, including the Company's favorable historical charge-off data and stable economic and market conditions, were considered in the determination of the adequacy of the ALL. Net charge-offs and loan growth resulted in the determination that a provision expense was required in 2020, 2019 and 2018. The increase in provision from 2019 to 2020 was due primarily to the impact of COVID-19 on the Company's loan portfolio as a new qualitative factor was created to address the associated risk.
See further discussion in the “Asset Quality” and “Credit Risk Management” sections of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Noninterest Income
The following table compares noninterest income for 2020, 2019 and 2018.
2020 2019 2018 $ Change % Change
2020-2019 2019-2018 2020-2019 2019-2018
Service charges on deposit accounts $ 2,874 $ 3,404 $ 3,233 $ (530) $ 171 (15.6) % 5.3 %
Interchange income 3,423 3,281 2,821 142 460 4.3 % 16.3 %
Other service charges, commissions and fees 683 805 907 (122) (102) (15.2) % (11.2) %
Swap fee income 847 1,197 - (350) 1,197 (29.2) % - %
Trust and investment management income 6,912 7,255 6,576 (343) 679 (4.7) % 10.3 %
Brokerage income 2,821 2,426 2,035 395 391 16.3 % 19.2 %
Mortgage banking activities 5,274 3,047 2,663 2,227 384 73.1 % 14.4 %
Gain on sale of commercial loans 2,803 - - 2,803 - - % - %
Income from life insurance 2,261 2,044 1,463 217 581 10.6 % 39.7 %
Other income 427 331 320 96 11 29.0 % 3.4 %
Subtotal before securities gains 28,325 23,790 20,018 4,535 3,772 19.1 % 18.8 %
Investment securities (losses) gains (16) 4,749 1,006 (4,765) 3,743 (100.3) % 372.1 %
Total noninterest income $ 28,309 $ 28,539 $ 21,024 $ (230) $ 7,515 (0.8) % 35.7 %
2020 versus 2019
Noninterest income decreased by $230 thousand from 2019 to 2020. The Company continues to focus on growth in relationship fee-based revenue for commercial and retail clients. The following were significant factors in that net decrease.
•A decline of $530 thousand in service charges on deposit accounts reflects the impact of COVID-19, as the Company waived certain fees for a period of time and experienced an overall decline in account usage.
•Interchange income reflected an overall increase in our clients' activity and card usage due to COVID-19.
•Mortgage banking income increased by $2.7 million due to an increase in loans sold to $205.2 million in 2020 from $106.7 million in 2019 as interest rate declines led to significant refinancing activity.
•Swap fee income declined by $350 thousand from 2019 to 2020. In 2020, Orrstown began entering into interest rate swap agreements directly with its commercial customers. This offering replaced the third party swap transactions
initiated in the prior year. This fee revenue will fluctuate from quarter to quarter, but client demand to fix loan interest rates declined slightly in the current rate environment.
•Trust and brokerage income reflected increased revenue from strong stock market performance.
•Income from life insurance included death benefit proceeds of $58 thousand in 2020 and $255 thousand in 2019.
•There was a decline of $4.8 million in investment gains from 2019 to 2020 due to prior year asset/liability management strategies which resulted in net gains of $4.8 million on sales of securities, as market conditions presented opportunities to improve responsiveness of the portfolio to interest rate conditions.
2019 versus 2018
Noninterest income increased $7.5 million from 2018 to 2019. We continue to focus on growth in relationship fee-based revenue for commercial and retail clients. In addition to the impact of the Mercersburg and Hamilton acquisitions, the following were significant factors in that net increase.
•Service charges on deposit accounts and interchange on debit card income reflected an overall increase in the Company's clients' activity and card usage from our organic growth as well as the expanded client base from the acquisitions. These stable sources of fee revenue should grow over time as we add retail and commercial clients.
•Gains on SBA loan sales, which are included in other service charges, commissions and fees, decreased approximately $300 thousand from 2018 to 2019.
•The Company began offering interest rate hedging products through a third party in the second half of 2019, whereby its receives a fee at loan closing.
•Trust and brokerage income reflected increased revenue from generally improved market conditions, additional advisors and increased estate fees in 2019. We continue to look to build this business over the coming years and have recently begun efforts to offer wealth management products in our acquired Baltimore market area.
•The increase in mortgage banking activities reflects the increase in loans sold from $93.1 million in 2018 to $106.7 million in 2019. With interest rates currently at low levels and recent market expansion efforts, we see opportunities to increase our market share with existing clients by increasing our focus on branch referrals and local market outreach efforts.
•Income from life insurance included death benefit proceeds in both 2019 and 2018, with the increase between years principally attributable to life insurance assets obtained through acquisitions.
•In both 2019 and 2018, asset/liability management strategies resulted in net gains on sales of securities, as market conditions presented opportunities to improve responsiveness of the portfolio to interest rate conditions, while also considering funding requirements of anticipated lending activity.
Noninterest Expenses
The following table compares noninterest expenses for 2020, 2019 and 2018.
$ Change % Change
2020 2019 2018 2020-2019 2019-2018 2020-2019 2019-2018
Salaries and employee benefits $ 43,350 $ 39,495 $ 32,524 $ 3,855 $ 6,971 9.8 % 21.4 %
Occupancy 4,760 4,325 3,084 435 1,241 10.1 % 40.2 %
Furniture and equipment 4,756 4,723 4,079 33 644 0.7 % 15.8 %
Data processing 3,574 3,599 2,674 (25) 925 (0.7) % 34.6 %
Automated teller machine and interchange fees 1,057 1,015 806 42 209 4.1 % 25.9 %
Advertising and bank promotions 1,660 1,967 1,592 (307) 375 (15.6) % 23.6 %
FDIC insurance 686 367 681 319 (314) 86.9 % (46.1) %
Other professional services 3,120 2,954 1,847 166 1,107 5.6 % 59.9 %
Directors' compensation 921 1,003 984 (82) 19 (8.2) % 1.9 %
Taxes other than income 1,144 1,018 1,012 126 6 12.4 % 0.6 %
Intangible asset amortization 1,569 1,570 286 (1) 1,284 (0.1) % 449.0 %
Merger related and branch consolidation expenses 1,310 8,964 3,197 (7,654) 5,767 (85.4) % 180.4 %
Insurance claim receivable (recovery) write off (486) 615 - (1,101) 615 (179.0) % - %
Other operating expenses 6,659 5,685 5,170 974 515 17.1 % 10.0 %
Total noninterest expenses $ 74,080 $ 77,300 $ 57,936 $ (3,220) $ 19,364 (4.2) % 33.4 %
2020 versus 2019
Noninterest expenses decreased by $3.2 million from 2019 to 2020. The following were significant factors in that net decrease.
•The salaries and employee benefit increase includes the impact in 2020 of additional employees, including new client-facing employees in new branches in targeted expansion markets and others that were hired throughout 2019, as well as additional new relationship managers. Higher costs in 2020 also include annual merit and incentive compensation increases in 2020, increased stock compensation expense from additional share-based awards granted in 2020, and higher medical costs for claims activity and the expanded workforce.
•Occupancy expense in 2020 reflects a full period of expense for our expanded presence in Lancaster County, Pennsylvania, with two branch banking locations added in the first quarter of 2019. In addition, lease termination costs of $588 thousand were recognized in 2020 as a part of the Company's restructuring plan.
•Advertising and bank promotions expense declined from 2019 to 2020 due to additional costs incurred in 2019 for the celebration of the Bank's 100th anniversary year, as well as marketing associated with the acquisitions.
•FDIC insurance expense reflects credits received in the second half of 2019 under the FDIC's regulations to provide credits, when the reserve ratio reaches 1.38%, to banks with consolidated assets below $10 billion. FDIC insurance expense increased in 2020 after the remaining credits were used to partially offset first quarter 2020 expense.
•In 2020, branch consolidation costs totaled $1.3 million and there were no merger related costs. These costs primarily represented lease termination costs. Merger related costs incurred in 2019 totaled $8.0 million. In the fourth quarter of 2019, the Company recorded $1.0 million in expenses associated with the announced consolidation of five branches into other, larger Bank branches, which was completed in January 2020. The expenses principally represented owned real estate write downs, lease termination costs, severance benefits for impacted employees and other branch exit related expenses.
•The insurance claim receivable (recovery) write off relates to an expense recorded in 2019 to write off an insurance claim receivable from a 2018 cyber security incident. In 2019, the Company received reimbursement totaling $59 thousand for the write off. In February 2020, the Company received an additional $486 thousand reimbursement in a final settlement of the matter.
•Other line items within noninterest expenses are generally attributable to normal fluctuations in the ordinary course of business.
2019 versus 2018
Noninterest expenses increased $19.4 million from 2018 to 2019. In addition to the impact of the Mercersburg and Hamilton acquisitions, the following were significant factors in that net increase.
•The salaries and employee benefits increase includes the impact in 2019 of additional employees, including new client-facing employees in new branches in targeted expansion markets and others that were hired throughout 2018 and 2019, as well as additional new relationship managers. Higher costs in 2019 also include annual merit and incentive compensation increases in 2019, increased stock compensation expense from additional share-based awards granted in 2019, and higher medical costs for claims activity and the expanded workforce.
•Occupancy and furniture and equipment expenses in 2019 reflect a full period of expense for our expanded presence in Lancaster County, Pennsylvania, with two branch banking locations added in the third and fourth quarters of 2018 and two in the first quarter of 2019.
•Increases in data processing reflect volume increases and physical growth and costs associated with more sophisticated product and service offerings.
•Advertising and bank promotions expense includes additional costs incurred in 2019 for the celebration of the Bank's 100th anniversary year, as well as marketing associated with the acquisitions.
•FDIC insurance expense reflects credits received in the second half of 2019 under the FDIC's regulations to provide credits, when the reserve ratio reaches 1.38%, to banks with consolidated assets below $10 billion.
•Intangible asset amortization increased due to the core deposit intangibles recorded in the Mercersburg and Hamilton acquisitions.
•Merger related costs incurred in 2019 totaled $8.0 million and represented principally data processing contract termination costs, employee contract termination costs and legal and consulting fees for the Hamilton acquisition and system conversion expenses for both the Mercersburg and Hamilton acquisitions. In the fourth quarter of 2019, the Company recorded $988 thousand in expenses associated with the announced consolidation of five branches into other, larger Bank branches, which was completed in January 2020. The expenses principally represented owned real estate write downs, lease termination costs, severance benefits for impacted employees and other branch exit related expenses.
•The insurance claim receivable write off relates to an expense recorded in 2019 to write off an insurance claim receivable from a 2018 cyber security incident. In 2019, the Company received reimbursement totaling $59 thousand for the write off. In February 2020, the Company received an additional $486 thousand reimbursement in a final settlement of the matter.
•Other line items within noninterest expenses are generally attributable to normal fluctuations in the ordinary course of business.
Income Taxes
Income tax expense totaled $6.0 million, $2.7 million and $1.6 million for 2020, 2019 and 2018, respectively. The effective tax rate for 2020 was 18.6% compared with 13.8% for 2019 and 11.4% for 2018. Generally, the Company’s effective tax rate is less than the 21% federal statutory rate, principally due to tax-free income, which includes interest income on tax-free loans and securities and income from life insurance policies, federal income tax credits, and the impact of non-tax deductible expenses, including merger related expenses. The difference in the effective tax rate in 2020 from prior years was primarily due to an increase in estimated earnings before income taxes. In 2019, the Company's effective tax rate increased principally due to increased profitability, offset partially by benefits realized from a $185 thousand expense reduction related to a favorable tax law clarification on the treatment of life insurance assets of an acquired entity, as well as a $334 thousand expense reduction related to an increase in deferred state income taxes due to a state tax rate change resulting from the Hamilton acquisition.
Note 8, Income Taxes, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data," includes a reconciliation of our federal statutory tax rate to the Company's effective tax rate, which is a meaningful comparison between years and measures income tax expense as a percentage of pretax income.
Financial Condition
Management devotes substantial time to overseeing the investment of funds in loans and securities and the formulation of policies directed toward the profitability and management of the risks associated with these investments.
Securities Available for Sale
The Company utilizes securities available for sale to manage interest rate risk, to enhance income through interest and dividend income, to provide liquidity and to provide collateral for certain deposits and borrowings.
The Company has established investment policies and an asset management policy to assist in administering our investment portfolio. Decisions to purchase or sell these securities are based on economic conditions and management’s strategy to respond to changes in interest rates, liquidity, pledges to secure deposits and repurchase agreements and other factors while trying to maximize return on the investments. We may segregate our investment portfolio into three categories: “securities held to maturity,” “trading securities” and “securities available for sale.” At December 31, 2020, management has classified the entire securities portfolio as available for sale, which is accounted for at current market value with unrealized gains and losses excluded from earnings and reported in OCI, net of income taxes.
Our securities available for sale portfolio includes debt investments that are subject to varying degrees of credit and market risks, which arise from general market conditions, and factors impacting specific industries, as well as news that may impact specific issues. Management monitors its debt securities, using various indicators in determining whether a debt security is other-than-temporarily impaired, including the amount of time the security has been in an unrealized loss position, and the extent of the unrealized loss. In addition, management assesses whether it is likely we will have to sell the security prior to recovery, or if we are able to hold the security until the price recovers. For those debt securities in which management concludes the security is other-than-temporarily impaired, it recognizes the credit component of an OTTI impairment in earnings and the remaining portion in OCI. Management considers the asset quality of our debt security portfolio to be strong; therefore, the Company did not record any OTTI expense in 2020, 2019 or 2018.
The following table summarizes the fair value of securities available for sale at December 31, 2020, 2019 and 2018.
2020 2019 2018
States and political subdivisions $ 112,670 $ 87,863 $ 145,004
GSE residential mortgage-backed securities
4,293 - -
GSE residential CMOs 58,011 68,154 108,064
Non-agency CMOs 16,918 17,087 -
Private label residential CMOs - - 143
Private label commercial CMOs 62,236 86,629 75,045
Asset-backed 211,966 230,515 137,571
Other 371 637 17
Total debt securities $ 466,465 $ 490,885 $ 465,844
The Company decreased its investment portfolio in 2020, with the average balance of securities decreasing from $499.6 million for the year ended December 31, 2019 to $494.4 million for the year ended December 31, 2020.
In late 2018, the Company increased its holdings of longer maturity state and political subdivisions in anticipation of falling interest rates. In 2019, interest rates fell and the attractiveness of tax-free state and political subdivisions declined. In response, we reduced our holdings of longer maturity tax-free state and political subdivisions at a gain. These securities were replaced with additional asset-backed and private label commercial CMOs that were either floating rate or had shorter average lives than the state and political subdivision investments.
Asset-backed securities and CMOs provide monthly cash flows that may be used, in part, to meet anticipated loan demand in 2020, as management anticipates the loan portfolio will continue to grow.
The following table shows the maturities of investment securities at book value at December 31, 2020, and weighted average yields of such securities. Yields are shown on a tax equivalent basis, assuming a 21% federal income tax rate.
Within 1
year
After 1 year
but within 5
years
After 5 years
but within
10 years
After 10
years
Total
States and political subdivisions
Book value $ - $ - $ 27,419 $ 77,285 $ 104,704
Yield - % - % 4.38 % 3.73 % 3.90 %
Average maturity (years) - - 7.6 16.9 14.4
GSE residential mortgage-backed securities
Book value $ - $ - $ - $ 4,197 $ 4,197
Yield - % - % - % 1.84 % 1.84 %
Average maturity (years) - - - 0.3 0.3
GSE residential CMOs
Book value $ - $ - $ - $ 56,856 $ 56,856
Yield - % - % - % 2.16 % 2.16 %
Average maturity (years) - - - 23.1 23.1
Non-agency CMOs
Book value $ - $ - $ - $ 16,505 $ 16,505
Yield - % - % - % 1.09 % 1.09 %
Average maturity (years) - - - 4.5 4.5
Private label commercial CMOs
Book value $ - $ 3,894 $ 987 $ 59,060 $ 63,941
Yield - % 1.09 % 1.28 % 1.40 % 1.38 %
Average maturity (years) - 4.5 9.5 15.2 14.4
Asset-backed
Book value $ - $ 1,113 $ 2,732 $ 210,580 $ 214,425
Yield - % 4.11 % 4.50 % 1.01 % 1.07 %
Average maturity (years) - 4.2 5.2 21.2 20.9
Other
Book value $ - $ 249 $ - $ 122 $ 371
Yield - % 2.45 % - % - % 1.64 %
Average maturity (years) - 2.4 - - 1.6
Total
Book value $ - $ 5,256 $ 31,138 $ 424,605 $ 460,999
Yield - % 1.79 % 4.29 % 1.82 % 1.99 %
Average maturity (years) - 4.4 7.4 20.2 19.2
The average maturity is based on the contractual terms of the debt or mortgage-backed securities, and does not factor in required repayments or anticipated prepayments. At December 31, 2020, the weighted average estimated life is 20 years for mortgage-backed and CMO securities, and 21 years for asset-backed securities, based on current interest rates and anticipated prepayment speeds.
The following table summarizes the credit ratings and collateral associated with the Company's investment portfolio, excluding equity securities, at December 31, 2020:
Sector Portfolio Mix Amortized Book Fair Value Credit Enhancement AAA AA A BBB NR Collateral Type
Unsecured ABS 1 % $ 6,730 $ 6,806 44 % 2 % - % - % - % 98 % Unsecured Consumer Debt
Student Loan ABS 2 % $ 11,222 $ 11,137 26 % - % - % - % - % 100 % Seasoned Student Loans
Federal Family Education Loan ABS 39 % $ 180,031 $ 177,519 6 % 4 % 73 % 23 % - % - % Federal Family Education Loan (1)
PACE Loan ABS 1 % $ 5,147 $ 5,243 5 % 100 % - % - % - % - % PACE Loans
Non-Agency CMBS 14 % $ 63,941 $ 62,236 53 % 97 % - % 3 % - % - % Commercial Real Estate
Non-Agency RMBS 4 % $ 16,505 $ 16,919 37 % 100 % - % - % - % - % Reverse Mortgages (2)
Municipal - General Obligation 12 % $ 53,789 $ 59,186 3 % 85 % 12 % - % - %
Municipal - Revenue 11 % $ 50,915 $ 53,483 - % 61 % 19 % - % 20 %
SBA ReRemic 3 % $ 11,295 $ 11,262 - % 100 % - % - % - % SBA Guarantee (3)
Agency MBS 13 % $ 61,054 $ 62,304 - % 100 % - % - % - % Residential Mortgages (3)
Bank CDs - % $ 249 $ 249 - % - % - % - % 100 % FDIC Insured CD
100 % $ 460,878 $ 466,344 20 % 61 % 13 % - % 6 %
(1) Minimum of 97% guaranteed by U.S. government
(2) Reverse mortgages fund over time and credit enhancement is estimated based on prior experience.
(3) 100% guaranteed by U.S. government agencies
Note : Ratings in table are the lowest of the six rating agencies (Standard & Poors, Moody's, Morningstar, DBRS, KBRA and Fitch). Standard & Poors rates U.S. government obligations at AA+
Loan Portfolio
The Company offers a variety of products to meet the credit needs of its borrowers, principally commercial real estate loans, commercial and industrial loans, and retail loans consisting of loans secured by residential properties, and to a lesser extent, installment loans. No loans are extended to non-domestic borrowers or governments.
Generally, we are permitted under applicable law to make loans to single borrowers (including certain related persons and entities) in aggregate amounts of up to 15% of the sum of total capital and the ALL. The Company’s legal lending limit to one borrower was $34.7 million at December 31, 2020. No borrower had an outstanding exposure exceeding the limit at year-end.
The risks associated with lending activities differ among loan classes and are subject to the impact of changes in interest rates, market conditions of collateral securing the loans and general economic conditions. Any of these factors may adversely impact a borrower’s ability to repay loans, and also impact the associated collateral. A further discussion on the classes of loans the Company makes and related risks is included in Note 1, Summary of Significant Accounting Policies, and Note 4, Loans and Allowance for Loan Losses, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data."
The following table presents the loan portfolio, excluding residential LHFS, by segments and classes at December 31.
2020 2019 2018 2017 2016
Commercial real estate:
Owner-occupied $ 174,908 $ 170,884 $ 129,650 $ 116,811 $ 112,295
Non-owner occupied 409,567 361,050 252,794 244,491 206,358
Multi-family 113,635 106,893 78,933 53,634 47,681
Non-owner occupied residential 114,505 120,038 100,367 77,980 62,533
Acquisition and development:
1-4 family residential construction 9,486 15,865 7,385 11,730 4,663
Commercial and land development 51,826 41,538 42,051 19,251 26,085
Commercial and industrial (1)
647,368 214,554 160,964 115,663 88,465
Municipal 20,523 47,057 50,982 42,065 53,741
Residential mortgage:
First lien 244,321 336,372 235,296 162,509 139,851
Home equity - term 10,169 14,030 12,208 11,784 14,248
Home equity - lines of credit 157,021 165,314 143,616 132,192 120,353
Installment and other loans 26,361 50,735 33,411 21,902 7,118
Total loans $ 1,979,690 $ 1,644,330 $ 1,247,657 $ 1,010,012 $ 883,391
(1) Includes $403.3 million and $0 of SBA PPP loans, net of deferred fees and costs, as of December 31, 2020 and 2019, respectively.
The loan portfolio at December 31, 2020 increased by $335.4 million, or 20.4%, from December 31, 2019 due primarily to the origination of SBA PPP loans in 2020, which was partially offset by a reduction in mortgage loans resulting from significant refinancing activity in the low interest rate environment. The increase in the loan portfolio from 2018 to 2019 was approximately 75% attributable to loans acquired in the Hamilton transaction. The Mercersburg acquisition in 2018 and Hamilton acquisition in 2019 increased the loan portfolio, principally in the residential mortgage - first lien and commercial real estate - owner and non-owner occupied classes. The Company's organic growth has occurred in both core and newer markets, such as Lancaster County, Pennsylvania, principally in commercial real estate, and in commercial and industrial loans and installment and other loans as we focused on increasing diversification in the portfolio. The growth in installment and other loans in 2018 through 2020 was principally attributable to purchased automobile financing loans at higher returns than comparable cash flows in the investment portfolio.
Competition for new business opportunities remains strong, which may temper loan growth in future quarters.
In addition to monitoring our loan portfolio by loan class as noted above, we also monitor concentrations by segment. The Bank’s lending policy reports segment concentrations that exceeds 20% of the Bank’s total risk-based capital ("RBC"). The following segments met this criterion at December 31, 2020.
Balance % of Total Loans % of Total RBC
Office space $ 161,399 8.2% 63.0%
Strip retail shopping centers 61,268 3.1% 23.9%
Multi-family commercial real estate 115,671 5.8% 45.1%
1-4 Family rentals 114,394 5.8% 44.6%
Senior housing and care 56,627 2.9% 22.1%
Loans outside of market area 66,761 3.4% 26.0%
The following table presents expected maturities of certain loan classes by fixed rate or adjustable rate categories at December 31, 2020.
Due In
One Year
or Less
One
Year Through
Five Years
After Five
Years
Total
Acquisition and development:
1-4 family residential construction
Fixed rate $ - $ - $ 1,471 $ 1,471
Adjustable and floating rate 6,185 1,830 - 8,015
6,185 1,830 1,471 9,486
Commercial and land development
Fixed rate 504 1,886 7,227 9,617
Adjustable and floating rate 3,712 26,100 12,397 42,209
4,216 27,986 19,624 51,826
Commercial and industrial
Fixed rate 3,561 487,553 43,626 534,740
Adjustable and floating rate 54,200 20,110 38,318 112,628
57,761 507,663 81,944 647,368
$ 68,162 $ 537,479 $ 103,039 $ 708,680
The final maturity is used in the determination of maturity of acquisition and development loans that convert from construction to permanent status. Variable rate loans shown above include semi-fixed loans that contractually will adjust with prime or LIBOR after the interest lock period, which may be up to 10 years. At December 31, 2020, these semi-fixed loans totaled $29.8 million.
Asset Quality
Risk Elements
The Company’s loan portfolio is subject to varying degrees of credit risk. Credit risk is managed through our underwriting standards, on-going credit reviews, and monitoring of asset quality measures. Additionally, loan portfolio diversification, which limits exposure to a single industry or borrower, and collateral requirements also mitigate our risk of credit loss.
The following table presents the Company’s risk elements and relevant asset quality ratios at December 31.
2020 2019 2018 2017 2016
Nonaccrual loans $ 10,310 $ 10,657 $ 5,165 $ 9,843 $ 7,043
OREO - 197 130 961 346
Total nonperforming assets 10,310 10,854 5,295 10,804 7,389
Restructured loans still accruing 934 979 1,132 1,183 930
Loans past due 90 days or more and still accruing (1)
554 2,232 57 - -
Total nonperforming and other risk assets $ 11,798 $ 14,065 $ 6,484 $ 11,987 $ 8,319
Loans 30-89 days past due $ 10,291 $ 17,527 $ 5,186 $ 5,277 $ 1,218
Asset quality ratios:
Total nonperforming loans to total loans 0.52 % 0.65 % 0.41 % 0.97 % 0.80 %
Total nonperforming assets to total assets 0.37 % 0.46 % 0.27 % 0.69 % 0.52 %
Total nonperforming assets to total loans and OREO 0.52 % 0.66 % 0.42 % 1.07 % 0.84 %
Total risk assets to total loans and OREO 0.60 % 0.86 % 0.52 % 1.19 % 0.94 %
Total risk assets to total assets 0.43 % 0.59 % 0.34 % 0.77 % 0.59 %
Allowance for loan losses to total loans 1.02 % 0.89 % 1.12 % 1.27 % 1.45 %
Allowance for loan losses to nonperforming loans 195.45 % 137.52 % 271.33 % 130.00 % 181.39 %
Allowance for loan losses to nonperforming loans and restructured loans still accruing
179.22 % 125.95 % 222.55 % 116.05 % 160.23 %
(1) Includes $456 thousand and $2.0 million, respectively, of purchased credit impaired loans at December 31, 2020 and 2019.
The following table provides detail of impaired loans at December 31, 2020 and 2019.
2020 2019
Nonaccrual
Loans
Restructured
Loans Still
Accruing
Total Nonaccrual
Loans
Restructured
Loans Still
Accruing
Total
Commercial real estate:
Owner occupied $ 3,232 $ 28 $ 3,260 $ 5,842 $ 30 $ 5,872
Multi-family - - - 345 - 345
Non-owner occupied residential
268 - 268 235 - 235
Acquisition and development
Commercial and land development 814 - 814 - - -
Commercial and industrial 3,639 - 3,639 1,763 - 1,763
Residential mortgage:
First lien 1,730 898 2,628 1,659 931 2,590
Home equity - term 10 - 10 13 - 13
Home equity - lines of credit 600 8 608 715 18 733
Installment and other loans 17 - 17 85 - 85
$ 10,310 $ 934 $ 11,244 $ 10,657 $ 979 $ 11,636
Nonperforming assets include nonaccrual loans and foreclosed real estate. Risk assets, which include nonperforming assets and restructured and loans past due 90 days or more and still accruing, totaled $11.8 million at December 31, 2020, an increase of $2.3 million or 16.1%, from $14.1 million at December 31, 2019. Nonaccrual loans totaled $10.3 million at December 31, 2020, a decrease of $347 thousand from December 31, 2019. The change in nonaccrual loan amounts also impacted other asset quality ratios detailed above.
The ALL totaled $20.2 million at December 31, 2020, a $5.5 million increase from $14.7 million at December 31, 2019, resulting from net recoveries of $171 thousand and a provision for loan losses of $5.3 million for 2020. The ALL is higher as a percentage of the total loan portfolio at December 31, 2020 than in prior years, reflecting the increased ALL balance. An
increase in special mention loans and loan modifications due to COVID-19 led to the inclusion of $2.8 million in qualitative reserves associated with COVID-19 in the ALL at December 31, 2020. Management believes its coverage ratios are adequate for the risk profile of the loan portfolio given ongoing monitoring of the portfolio and its quantitative and qualitative analysis performed at December 31, 2020. As new information is learned about borrowers or updated appraisals on real estate with lower fair values are obtained, the Company may experience an increase in impaired loans.
For the years ended December 31, 2020, 2019, and 2018, recoveries of $1.2 million, $606 thousand and $882 thousand, respectively, were credited to the ALL. These recoveries on previously charged-off relationships are the result of successful loan monitoring and workout solutions. Recoveries are difficult to predict, and any additional recoveries that the Company receives will be used to replenish the ALL. Recoveries favorably impact historical charge-off factors, and contribute to changes in the quantitative and qualitative factors used in our allowance adequacy analysis. However, as the loan portfolio continues to grow, future provisions for loan losses may result.
The Company takes partial charge-offs on collateral-dependent loans when carrying value exceeds estimated fair value, as determined by the most recent appraisal adjusted for current (within the quarter) conditions, less costs to dispose. Impairment reserves remain in place if updated appraisals are pending, and represent management’s estimate of potential loss.
The following table presents exposure to relationships with an impaired loan balance, partial charge-offs taken to date and specific reserves established on the relationships at December 31, 2020 and 2019.
# of
Relationships
Recorded
Investment
Partial
Charge-offs
to Date
Specific
Reserves
December 31, 2020
Relationships greater than $1 million 2 $ 5,639 $ - $ -
Relationships greater than $500 thousand but less than $1 million 2 1,211 17 -
Relationships greater than $250 thousand but less than $500 thousand 2 637 - -
Relationships less than $250 thousand 65 3,757 545 33
71 $ 11,244 $ 562 $ 33
December 31, 2019
Relationships greater than $1 million 2 $ 5,218 $ - $ -
Relationships greater than $500 thousand but less than $1 million 2 $ 1,516 $ 17 $ -
Relationships greater than $250 thousand but less than $500 thousand 3 980 - -
Relationships less than $250 thousand 68 3,922 781 36
75 $ 11,636 $ 798 $ 36
Internal loan reviews are completed annually on all commercial relationships with a committed loan balance in excess of $1.0 million, which includes confirmation of risk rating by an independent credit officer. In addition, all commercial relationships greater than $500 thousand rated Substandard, Doubtful or Loss are reviewed and corresponding risk ratings are reaffirmed by the Bank's Problem Loan Committee, with subsequent reporting to the Management ERM Committee.
In its individual loan impairment analysis, the Company determines the extent of any full or partial charge-offs that may be required, or any reserves that may be needed. The determination of the Company’s charge-offs or impairment reserve include an evaluation of the outstanding loan balance and the related collateral securing the credit. Through a combination of collateral securing the loans and partial charge-offs taken to date, the Company believes that it has adequately provided for the potential losses that it may incur on these relationships at December 31, 2020. However, over time, additional information may result in increased reserve allocations or, alternatively, it may be deemed that the reserve allocations exceed those that are needed.
The Company’s foreclosed real estate balance at December 31, 2020 was zero for both residential and commercial properties. During 2020, no expense was recorded for the write-down of other real estate owned properties.
In an effort to assist clients which were negatively impacted by the COVID-19 pandemic, the Bank offered various mitigation options, including a loan payment deferral program. Under this program, most commercial deferrals were for a 90-day period, while most consumer deferrals were for a 180-day period. As of December 31, 2020, the Company had loan deferrals under this program for commercial and consumer clients with a total loan balance of $15.7 million and $2.5 million, respectively. In accordance with the revised Interagency Statement on Loan Modifications by Financial Institutions Working with Customers Affected by the Coronavirus issued on April 7, 2020, these deferrals are exempt from TDR status as they meet the specified requirements. Below is a summary of select loan concentrations and the deferrals within those categories at December 31, 2020.
The following table summarizes COVID-19 related modifications, including deferrals and forbearances:
Loan Type Amount of Loans Percent of Non-PPP Loans
December 31, 2020
September 30, 2020
December 31, 2020
September 30, 2020
Commercial $ 15,702 $ 61,597 1.4 % 5.6 %
Consumer Portfolio Loans 2,504 16,845 0.6 3.6
Total Loans $ 18,206 $ 78,442 1.2 % 5.0 %
The following table summarizes COVID-19 related deferral balances within certain industry segments at December 31, 2020:
Industry Segment Balance % of Total non-PPP Loans $ Non-PPP Segment Total % of non-PPP Segment
Hotel/Motel $ 9,497 0.6 % $ 48,379 19.6 %
Restaurant/Bar 774 0.1 33,400 2.3
Commercial construction 499 - 51,826 1.0
Mixed use 376 - 21,875 1.7
Multi-Family CRE - - 115,671 -
Strip Center/Retail - - 61,268 -
Senior Housing - - 43,814 -
Credit Risk Management
Allowance for Loan Losses
The Company maintains the ALL at a level deemed adequate by management for probable incurred credit losses. The ALL is established and maintained through a provision for loan losses which is charged to earnings. On a quarterly basis, management assesses the adequacy of the ALL utilizing a defined methodology which considers specific credit evaluation of impaired loans, historical loss experience and qualitative factors. Management addresses the requirements for loans individually identified as impaired, loans collectively evaluated for impairment, and other bank regulatory guidance in its assessment.
The ALL is evaluated based on review of the collectability of loans in light of historical experience; the nature and volume of the loan portfolio; adverse situations that may affect a borrower’s ability to repay; estimated value of any underlying collateral; and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. A description of the methodology for establishing the allowance and provision for loan losses and related procedures in establishing the appropriate level of reserve is included in Note 4, Loans and Allowance for Loan Losses, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data."
The following table summarizes the Company’s internal risk ratings at December 31, 2020 and 2019.
Pass Special
Mention
Non-Impaired
Substandard
Impaired -
Substandard
Doubtful PCI Loans Total
December 31, 2020
Commercial real estate:
Owner-occupied $ 148,846 $ 12,491 $ 7,855 $ 3,260 $ - $ 2,456 $ 174,908
Non-owner occupied 351,860 57,378 - - - 329 409,567
Multi-family 92,769 20,224 642 - - - 113,635
Non-owner occupied residential 107,557 3,948 1,422 268 - 1,310 114,505
Acquisition and development:
1-4 family residential construction 9,101 385 - - - - 9,486
Commercial and land development 49,832 655 525 814 - - 51,826
Commercial and industrial 617,213 17,561 6,118 3,639 - 2,837 647,368
Municipal 20,523 - - - - - 20,523
Residential mortgage:
First lien 236,381 - - 2,628 - 5,312 244,321
Home equity - term 10,076 - 64 10 - 19 10,169
Home equity - lines of credit 156,264 95 54 608 - - 157,021
Installment and other loans 26,283 - - 17 - 61 26,361
$ 1,826,705 $ 112,737 $ 16,680 $ 11,244 $ - $ 12,324 $ 1,979,690
Pass Special
Mention
Non-Impaired
Substandard
Impaired -
Substandard
Doubtful PCI Loans Total
December 31, 2019
Commercial real estate:
Owner-occupied $ 151,161 $ 4,513 $ 3,163 $ 5,872 $ - $ 6,175 $ 170,884
Non-owner occupied 342,753 17,152 - - - 1,145 361,050
Multi-family 100,361 4,822 682 345 - 683 106,893
Non-owner occupied residential 111,697 4,534 1,115 235 - 2,457 120,038
Acquisition and development:
1-4 family residential construction 15,865 - - - - - 15,865
Commercial and land development 39,939 206 1,393 - - - 41,538
Commercial and industrial 198,951 1,133 8,899 1,763 - 3,808 214,554
Municipal 42,649 4,408 - - - - 47,057
Residential mortgage:
First lien 323,040 978 - 2,590 - 9,764 336,372
Home equity - term 13,774 74 149 13 - 20 14,030
Home equity - lines of credit 164,469 74 38 733 - - 165,314
Installment and other loans 50,497 - - 85 - 153 50,735
$ 1,555,156 $ 37,894 $ 15,439 $ 11,636 $ - $ 24,205 $ 1,644,330
Non-Impaired Substandard loans are performing loans which have characteristics that cause management concern over the ability of the borrower to perform under present loan repayment terms and which may result in the reporting of these loans as
nonperforming, or impaired, loans in the future. Generally, management feels that substandard loans that are currently performing and not considered impaired result in some doubt as to the borrower’s ability to continue to perform under the terms of the loan, and represent potential problem loans. Non-impaired Substandard loans totaled $16.7 million at December 31, 2020.
Additionally, the Special Mention classification is intended to be a temporary classification reflective of loans that have potential weaknesses that may, if not monitored or corrected, weaken the asset or inadequately protect the Company’s position at some future date. Special mention loans represent an elevated risk, but their weakness does not yet justify a more severe, or classified, rating. These loans require inquiry by lenders on the cause of the potential weakness and, once analyzed, the loan classification may be downgraded to Substandard or, alternatively, could be upgraded to Pass. Special mention loans increased by $74.8 million from December 31, 2019 to December 31, 2020 due primarily to the economic weakness created by COVID-19 as well as related loan modifications completed in 2020. Any loans with second modifications that are COVID-19 related are classified as special mention.
The following tables summarize the average recorded investment in impaired loans and interest income recognized, on a cash basis, and interest income earned but not recognized for years ended December 31, 2020, 2019, 2018, 2017 and 2016.
Average
Impaired
Balance
Interest
Income
Recognized
Interest
Earned
But Not
Recognized
December 31, 2020
Commercial real estate:
Owner-occupied $ 4,636 $ 1 $ 172
Non-owner occupied 83 - -
Multi-family 205 - -
Non-owner occupied residential 388 - 21
Acquisition and development:
Commercial and land development 641 - 23
Commercial and industrial 1,196 - 20
Residential mortgage:
First lien 2,995 48 92
Home equity - term 11 - 1
Home equity - lines of credit 692 1 36
Installment and other loans 25 - 1
$ 10,872 $ 50 $ 366
December 31, 2019
Commercial real estate:
Owner-occupied $ 2,455 $ 2 $ 387
Non-owner occupied 46 - -
Multi-family 152 - 24
Non-owner occupied residential 217 - 21
Acquisition and development:
1-4 family residential construction - - -
Commercial and land development 21 - -
Commercial and industrial 683 - 130
Residential mortgage:
First lien 2,582 50 91
Home equity - term 13 - 1
Home equity - lines of credit 750 2 64
Installment and other loans 13 - 2
$ 6,932 $ 54 $ 720
Average
Impaired
Balance
Interest
Income
Recognized
Interest
Earned
But Not
Recognized
December 31, 2018
Commercial real estate:
Owner-occupied $ 1,495 $ 2 $ 156
Non-owner occupied 1,842 - 236
Multi-family 148 - 20
Non-owner occupied residential 346 - 36
Acquisition and development:
1-4 family residential construction 181 - -
Commercial and land development 1 - 1
Commercial and industrial 322 - 29
Residential mortgage:
First lien 3,234 59 130
Home equity - term 19 - 2
Home equity - lines of credit 657 2 52
Installment and other loans 4 - 5
$ 8,249 $ 63 $ 667
December 31, 2017
Commercial real estate:
Owner-occupied $ 1,000 $ 6 $ 114
Non-owner occupied 392 - 10
Multi-family 182 - 19
Non-owner occupied residential 418 - 35
Acquisition and development:
1-4 family residential construction 154 - 7
Commercial and industrial 413 - 25
Residential mortgage:
First lien 4,012 58 136
Home equity - term 61 - 1
Home equity - lines of credit 488 2 26
Installment and other loans 10 - 3
$ 7,130 $ 66 $ 376
December 31, 2016
Commercial real estate:
Owner-occupied $ 1,758 $ - $ 124
Non-owner occupied 6,831 - 326
Multi-family 216 - 17
Non-owner occupied residential 645 - 35
Acquisition and development:
Commercial and land development 3 - 1
Commercial and industrial 575 - 25
Residential mortgage:
First lien 4,525 33 175
Home equity - term 98 - 6
Home equity - lines of credit 455 - 19
Installment and other loans 12 - 3
$ 15,118 $ 33 $ 731
The following table summarizes activity in the ALL for years ended December 31, 2020, 2019, 2018, 2017 and 2016.
Commercial Consumer
Commercial
Real Estate
Acquisition
and
Development
Commercial
and
Industrial
Municipal Total Residential
Mortgage
Installment
and Other
Total Unallocated Total
December 31, 2020
Balance, beginning of year
$ 7,634 $ 959 $ 2,356 $ 100 $ 11,049 $ 3,147 $ 319 $ 3,466 $ 140 $ 14,655
Provision for loan losses
2,745 146 2,096 (60) 4,927 203 117 320 78 5,325
Charge-offs (3) - (748) - (751) (114) (146) (260) - (1,011)
Recoveries 775 9 238 - 1,022 126 34 160 - 1,182
Balance, end of year
$ 11,151 $ 1,114 $ 3,942 $ 40 $ 16,247 $ 3,362 $ 324 $ 3,686 $ 218 $ 20,151
December 31, 2019
Balance, beginning of year
$ 6,876 $ 817 $ 1,656 $ 98 $ 9,447 $ 3,753 $ 244 $ 3,997 $ 570 $ 14,014
Provision for loan losses
515 139 841 2 1,497 (347) 180 (167) (430) 900
Charge-offs (25) - (299) - (324) (386) (155) (541) - (865)
Recoveries 268 3 158 - 429 127 50 177 - 606
Balance, end of year
$ 7,634 $ 959 $ 2,356 $ 100 $ 11,049 $ 3,147 $ 319 $ 3,466 $ 140 $ 14,655
December 31, 2018
Balance, beginning of year
$ 6,763 $ 417 $ 1,446 $ 84 $ 8,710 $ 3,400 $ 211 $ 3,611 $ 475 $ 12,796
Provision for loan losses
(442) 396 209 14 177 363 165 528 95 800
Charge-offs (17) (7) - - (24) (148) (292) (440) - (464)
Recoveries 572 11 1 - 584 138 160 298 - 882
Balance, end of year
$ 6,876 $ 817 $ 1,656 $ 98 $ 9,447 $ 3,753 $ 244 $ 3,997 $ 570 $ 14,014
December 31, 2017
Balance, beginning of year
$ 7,530 $ 580 $ 1,074 $ 54 $ 9,238 $ 2,979 $ 144 $ 3,123 $ 414 $ 12,775
Provision for loan losses
38 (167) 333 30 234 531 174 705 61 1,000
Charge-offs (835) - (85) - (920) (180) (166) (346) - (1,266)
Recoveries 30 4 124 - 158 70 59 129 - 287
Balance, end of year
$ 6,763 $ 417 $ 1,446 $ 84 $ 8,710 $ 3,400 $ 211 $ 3,611 $ 475 $ 12,796
December 31, 2016
Balance, beginning of year
$ 7,883 $ 850 $ 1,012 $ 58 $ 9,803 $ 2,870 $ 121 $ 2,991 $ 774 $ 13,568
Provision for loan losses
107 (270) 129 (4) (38) 532 116 648 (360) 250
Charge-offs (872) - (79) - (951) (577) (194) (771) - (1,722)
Recoveries 412 - 12 - 424 154 101 255 - 679
Balance, end of year
$ 7,530 $ 580 $ 1,074 $ 54 $ 9,238 $ 2,979 $ 144 $ 3,123 $ 414 $ 12,775
The following table summarizes asset quality ratios for years ended December 31, 2020, 2019, 2018, 2017 and 2016.
2020 2019 2018 2017 2016
Ratio of net charge-offs (recoveries) to average loans outstanding
(0.01) % 0.02 % (0.04) % 0.10 % 0.13 %
Provision for loan losses to net charge-offs (recoveries) (3,114.04) % 347.49 % (191.39) % 102.15 % 23.97 %
Ratio of ALL to total loans outstanding at December 31
1.02 % 0.89 % 1.12 % 1.27 % 1.45 %
The Company recorded a provision for loan losses expense of $5.3 million, $900 thousand, $800 thousand, $1.0 million and $250 thousand for 2020, 2019, 2018, 2017 and 2016, respectively. In addition, in certain cases, loans were successfully
worked out with smaller charge-offs than the reserve established on them. From 2016 to 2019, the Company has benefited from organic loan portfolio growth and favorable historical charge-off data combined with relatively stable economic conditions over the periods presented above. This was a principal factor in management's determination that a negative or modest provision could be recorded despite net charge-offs recorded in 2016. In 2017, management determined that a provision expense that offset net charge-offs for the year would maintain an adequate ALL, principally due to a charge-off in connection with one commercial credit downgraded to nonaccrual status during the year. In 2018 and 2019, our continued organic loan portfolio growth was a key factor in the quantitative and qualitative considerations used by management in the determination of the provision expense required to maintain an adequate allowance for loan losses. In 2020, the severe economic impact of COVID-19 on the loan portfolio drove an increase in qualitative assumptions. These variations in net charge-offs (recoveries) and provision expense (recovery) resulted in the fluctuations in the ratios presented in the tables above.
See further discussion in the “Provision for Loan Losses” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations. Also, see Note 4, Loans and Allowance for Loan Losses, in the Notes to Consolidated Financial Statements for additional information on the COVID-19 qualitative assumptions.
The following table shows the allocation of the ALL by loan class, as well as the percent of each loan class in relation to the total loan balance at December 31, 2020, 2019, 2018, 2017 and 2016.
2020 2019 2018 2017 2016
Amount % of
Loan
Type to
Total
Loans
Amount % of
Loan
Type to
Total
Loans
Amount % of
Loan
Type to
Total
Loans
Amount % of
Loan
Type to
Total
Loans
Amount % of
Loan
Type to
Total
Loans
Commercial real estate:
Owner-occupied $ 2,072 9 % $ 1,539 10 % $ 1,491 10 % $ 1,488 12 % $ 1,591 13 %
Non-owner occupied 6,049 21 % 3,965 22 % 3,683 20 % 4,059 24 % 4,380 23 %
Multi-family 1,846 6 % 974 7 % 792 6 % 444 5 % 604 5 %
Non-owner occupied residential
1,184 6 % 1,156 7 % 910 8 % 772 8 % 955 7 %
Acquisition and development:
1-4 family residential construction
144 - % 239 1 % 104 1 % 169 1 % 102 1 %
Commercial and land development
970 3 % 720 3 % 713 3 % 248 2 % 478 3 %
Commercial and industrial 3,942 32 % 2,356 13 % 1,656 13 % 1,446 12 % 1,074 10 %
Municipal 40 1 % 100 3 % 98 4 % 84 4 % 54 6 %
Residential mortgage:
First lien 1,627 12 % 1,635 20 % 2,002 19 % 1,855 16 % 1,624 16 %
Home equity - term 63 1 % 59 1 % 109 1 % 119 1 % 151 1 %
Home equity - lines of credit 1,672 8 % 1,453 10 % 1,642 12 % 1,426 13 % 1,204 14 %
Installment and other loans 324 1 % 319 3 % 244 3 % 211 2 % 144 1 %
Unallocated 218 140 570 475 414
$ 20,151 100 % $ 14,655 100 % $ 14,014 100 % $ 12,796 100 % $ 12,775 100 %
The following table summarizes the ending loan balance individually or collectively evaluated for impairment by loan class and the ALL allocation for each at December 31, 2020 and 2019.
Commercial Consumer
Commercial
Real Estate
Acquisition
and
Development
Commercial
and
Industrial
Municipal Total Residential
Mortgage
Installment
and Other
Total Unallocated Total
December 31, 2020
Loans allocated by:
Individually evaluated for impairment
$ 3,528 $ 814 $ 3,639 $ - $ 7,981 $ 3,246 $ 17 $ 3,263 $ - $ 11,244
Collectively evaluated for impairment
809,087 60,498 643,729 20,523 1,533,837 408,265 26,344 434,609 - 1,968,446
$ 812,615 $ 61,312 $ 647,368 $ 20,523 $ 1,541,818 $ 411,511 $ 26,361 $ 437,872 $ - $ 1,979,690
Allowance for loan losses allocated by:
Individually evaluated for impairment
$ - $ - $ 1 $ - $ 1 $ 33 $ - $ 33 $ - $ 34
Collectively evaluated for impairment
11,151 1,114 3,941 40 16,246 3,329 324 3,653 218 20,117
$ 11,151 $ 1,114 $ 3,942 $ 40 $ 16,247 $ 3,362 $ 324 $ 3,686 $ 218 $ 20,151
December 31, 2019
Loans allocated by:
Individually evaluated for impairment
$ 6,452 $ - $ 1,763 $ - $ 8,215 $ 3,336 $ 85 $ 3,421 $ - $ 11,636
Collectively evaluated for impairment
752,413 57,403 212,791 47,057 1,069,664 512,380 50,650 563,030 - 1,632,694
$ 758,865 $ 57,403 $ 214,554 $ 47,057 $ 1,077,879 $ 515,716 $ 50,735 $ 566,451 $ - $ 1,644,330
Allowance for loan losses allocated by:
Individually evaluated for impairment
$ - $ - $ - $ - $ - $ 36 $ - $ 36 $ - $ 36
Collectively evaluated for impairment
7,634 959 2,356 100 11,049 3,111 319 3,430 140 14,619
$ 7,634 $ 959 $ 2,356 $ 100 $ 11,049 $ 3,147 $ 319 $ 3,466 $ 140 $ 14,655
In addition to the reserve allocations on impaired loans noted above, 11 loans, with aggregate outstanding principal balances of $1.2 million, have had cumulative partial charge-offs to the ALL totaling $562 thousand at December 31, 2020. As updated appraisals were received on collateral-dependent loans, partial charge-offs were taken to the extent the loans’ principal balance exceeded their fair value.
Management believes the allocation of the ALL between the various loan classes adequately reflects the probable incurred credit losses in each portfolio and is based on the methodology outlined in Note 4, Loans and Allowance for Loan Losses, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data." Management re-evaluates and makes certain enhancements to its methodology used to establish a reserve to better reflect the risks inherent in the different segments of the portfolio, particularly in light of increased charge-offs, with noticeable differences between the different loan classes. Management believes these enhancements to the ALL methodology improve the accuracy of quantifying probable incurred credit losses inherent in the portfolio. Management charges actual loan losses to the reserve and bases the provision for loan losses on its overall analysis.
The largest component of the ALL for the years presented has been allocated to the commercial real estate segment, particularly the non-owner occupied loan classes. The higher allocations in these classes as compared with the other classes is consistent with the inherent risk associated with these loans, as well as generally higher levels of impaired and criticized loans for the periods presented. There has generally been a decrease in the ALL allocated to the commercial real estate portfolio, as the level of classified assets has declined, and historical loss rates have improved as a result of improving economic and market conditions.
The unallocated portion of the ALL reflects estimated inherent losses within the portfolio that have not been detected, as well as the risk of error in the specific and general reserve allocation, other potential exposure in the loan portfolio, variances in management’s assessment of national and local economic conditions and other factors management believes appropriate at the time. The unallocated portion of the allowance increased from $140 thousand at December 31, 2019 to $218 thousand at December 31, 2020 and represents 1.1% of the ALL at December 31, 2020, compared with 1.0% at December 31, 2019. Changes in qualitative factors of certain loan categories were made during 2019 to reflect limited credit losses in recent history.
The Company monitors the unallocated portion of the ALL, and by policy, has determined it should not exceed 3% of the total reserve. Future negative provisions for loan losses may result if the unallocated portion was to increase, and management determined the reserves were not required for the anticipated risk in the portfolio.
Management believes the Company’s ALL is adequate based on information currently available. Future adjustments to the ALL and enhancements to the methodology may be necessary due to changes in economic conditions, regulatory guidance, or management’s assumptions as to future delinquencies or loss rates.
Deposits
Total deposits grew $481.4 million, or 25.7%, from $1.9 billion at December 31, 2019 to $2.4 billion at December 31, 2020. This increase was primarily due to deposits generated through the SBA PPP during 2020. In 2019, the Company acquired $388.2 million in deposits from Hamilton. At December 31, 2019, those acquired accounts totaled approximately $332.0 million. During 2019, brokered deposits were reduced by $110.6 million and subscription service CDs declined by $21.9 million. Organic growth totaled approximately $147.7 million in 2019.
The following table presents average deposits for years ended December 31, 2020, 2019, and 2018.
2020 2019 2018
Demand deposits $ 381,869 $ 234,354 $ 183,387
Interest-bearing demand deposits 1,156,292 920,025 767,863
Savings deposits 163,133 138,761 102,189
Time deposits 452,298 549,937 324,118
Total deposits $ 2,153,592 $ 1,843,077 $ 1,377,557
Average total deposits increased $310.5 million, or 16.8%, from 2019 to 2020. SBA PPP loan funding was the principal driver of this increase. Average time deposits less than $250 thousand grew from $287.9 million in 2018 to $483.9 million in 2019 and average time deposits in excess of $250 thousand increased from $36.3 million in 2018 to $66.0 million in 2019.
In addition to deposits from acquisitions, the Bank has been able to garner organic growth in both interest-bearing and noninterest-bearing deposit relationships from enhanced cash management offerings as we continued to develop commercial relationships. We also continued to grow core funding deposits through marketing campaigns and improvement in our product delivery with investments in technology and increased sales efforts. We have also been able to increase interest-free funds as we expanded our commercial and industrial loan portfolio.
In 2020, the Bank reduced its brokered deposit balances to zero at December 31, 2020 compared with $16.1 million at December 31, 2019, and averaged $3.2 million for 2020 compared with $100.8 million for 2019. Given interest rate conditions and asset/liability strategies, the Bank borrowed additional funds from FHLB of Pittsburgh to replace called brokered deposits from the second half of 2019 through 2020.
Management evaluates its utilization of brokered deposits, taking into consideration the interest rate curve and regulatory views on non-core funding sources, and balances this funding source with its funding needs based on growth initiatives. The Company anticipates that as loan growth increases, it will be able to generate core deposit funding by offering competitive rates.
The following table presents maturities of time deposits of $250,000 or more at December 31, 2020.
Total
Three months or less $ 25,828
Over three months through six months 15,734
Over six months through one year 12,057
Over one year 8,319
Total $ 61,938
Borrowings
In addition to deposit products, the Company uses short-term borrowing sources to meet liquidity needs and for temporary funding. Sources of short-term borrowings include the FHLB of Pittsburgh, federal funds purchased, and to a lesser extent, the FRB discount window. Short-term borrowings also include securities sold under agreements to repurchase with deposit clients, in which a client sweeps a portion of a deposit balance into a repurchase agreement, which is a secured borrowing with a pool of securities pledged against the balance.
The Company also utilizes long-term debt, consisting principally of FHLB fixed and amortizing advances to fund its balance sheet with original maturities greater than one year. The Company evaluates its funding needs, interest rate movements, the cost of options, and the availability of attractive structures when considering the timing and extent of when it enters into long-term borrowings.
In December 2018, we issued unsecured subordinated notes payable totaling $32.5 million, the proceeds of which were designated for general corporate use, including funding of cash consideration for mergers and acquisitions.
For additional information about borrowings, refer to Note 13, Short-Term Borrowings, Note 14, Long-Term Debt, and Note 15, Subordinated Notes, to the Consolidated Financial Statements appearing in Part II, Item 8, "Financial Statements and Supplementary Data."
Shareholders' Equity
In 2020, total shareholders’ equity increased $23.0 million, or 10.3%. Net income increased equity by $26.5 million. AOCI increased by $3.8 million due to an increase of $4.8 million in unrealized gains on securities partially offset by $1.0 million in unrealized losses on derivatives during 2020. Dividends paid to shareholders decreased equity by $7.6 million.
In September, 2015, the Board of Directors authorized a stock repurchase program which is more fully described in Item 5 under Issuer Purchases of Equity Securities. The maximum number of shares that may yet be purchased under the plan is 261,320 shares at December 31, 2020.
The following table includes additional information for shareholders’ equity for years ended December 31, 2020, 2019, and 2018.
2020 2019 2018
Average shareholders’ equity $ 226,900 $ 206,021 $ 149,662
Net income 26,463 16,924 12,805
Cash dividends paid 7,610 6,150 4,375
Average equity to average assets ratio 8.58 % 9.26 % 8.75 %
Dividend payout ratio 28.12 % 36.81 % 33.33 %
Return on average equity 11.66 % 8.21 % 8.56 %
Capital Adequacy and Regulatory Matters
Capital management in a regulated financial services industry must properly balance return on equity to its shareholders while maintaining sufficient levels of capital and related risk-based regulatory capital ratios to satisfy statutory regulatory requirements. The Company’s capital management strategies have been developed to provide attractive rates of returns to its shareholders, while maintaining a “well capitalized” position of regulatory strength.
Effective with the third quarter of 2018, the FRB raised the consolidated asset limit on small bank holding companies from $1 billion to $3 billion, and a company with assets under the revised limits is not subject to the FRB consolidated capital rules. A company with consolidated assets under the revised limit may continue to file reports that include capital amounts and ratios. The Company has elected to continue to file those reports.
Management believes the Company and the Bank met all capital adequacy requirements to which they are subject at December 31, 2020 and December 31, 2019. At December 31, 2020, the Bank was considered well capitalized under applicable banking regulations.
Tables presenting the Company’s and the Bank’s capital amounts and ratios at December 31, 2020 and 2019 are included in Note 17 Shareholders' Equity and Regulatory Capital, to the Consolidated Financial Statements appearing in Part II, Item 8, "Financial Statements and Supplementary Data."
The Company routinely evaluates its capital levels in light of its risk profile to assess its capital needs. In addition to the minimum capital ratio requirement and minimum capital ratio to be well capitalized presented in the tables in Note 17, we must maintain a capital conservation buffer as noted in Item 1 - Business under the topic Basel III Capital Rules. At December 31, 2020, the Company's and the Bank's capital conservation buffer, based on the most restrictive capital ratio, was 6.5% and 6.7%, which is above the regulatory requirement of 2.50% at December 31, 2020.
Liquidity and Rate Sensitivity
Liquidity. The primary function of asset/liability management is to ensure adequate liquidity and manage the Company’s sensitivity to changing interest rates. Liquidity management involves the ability to meet the cash flow requirements of customers who may be either depositors wanting to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. The Company's primary sources of funds consist of deposit inflows, loan repayments, maturities and sales of investment securities, the sale of mortgage loans and borrowings from the FHLB of Pittsburgh. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition. The Company's maximum borrowing capacity from the FHLB is $830.3 million at December 31, 2020.
The Company regularly adjusts its investments in liquid assets based upon its assessment of expected loan demand, expected deposit flows, yields available on interest-earning deposits and securities and the objectives of its asset/liability management policy.
At December 31, 2020, outstanding loan commitments totaled $596.2 million, which included $89.5 million in undisbursed loans, $223.2 million in unused home equity lines of credit, $268.9 million in commercial lines of credit, and $14.5 million in standby letters of credit. Time deposits due within one year after December 31, 2020 totaled $310.3 million, or 78% of time deposits. The large percentage of time deposits that mature within one year reflects clients’ preference not to invest funds for long periods in the current interest rate environment. If these maturing deposits do not remain with us, we will be required to seek other sources of funds, including other time deposits and lines of credit. Depending on market conditions, we may be required to pay higher rates on such deposits or other borrowings than we currently pay on time deposits outstanding at December 31, 2020. We believe, however, based on past experience that a significant portion of our time deposits will remain with us. We have the ability to attract and retain deposits by adjusting the interest rates we offer.
Our most liquid assets are cash and cash equivalents. The levels of these assets depend on our operating, financing, lending and investing activities during any given period. At December 31, 2020, cash and cash equivalents totaled $125.3 million, compared with $56.5 million at December 31, 2019. Securities classified as available for sale, net of pledging requirements, provide additional sources of liquidity, and totaled $67.8 million at December 31, 2020. Also at December 31, 2020, the Company had the ability to borrow up to a total of $830.3 million from the FHLB of Pittsburgh, of which $151.4 million in advances and letters of credit were outstanding. The Company’s ability to borrow from the FHLB is dependent on having sufficient qualifying collateral, which generally consists of mortgage loans. In addition, the Company had $30.0 million in available unsecured lines of credit with other banks at December 31, 2020.
The Company is a separate legal entity from the Bank and must provide for its own liquidity. In addition to its operating expenses, the Company is responsible for paying any dividends declared to its shareholders and interest on its borrowings. The Company also has repurchased shares of its common stock. The Company’s primary source of income is dividends received from the Bank. Restrictions on the Bank’s ability to dividend funds to the Company are included in Note 17, Shareholders' Equity and Regulatory Capital, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data."
Interest Rate Sensitivity. Interest rate sensitivity management requires the maintenance of an appropriate balance between interest sensitive assets and liabilities. Management, through its asset/liability management process, attempts to manage the level of repricing and maturity mismatch so that fluctuations in net interest income are maintained within policy limits in current and expected market conditions. For further discussion, see Part II, Item 7A, "Quantitative and Qualitative Disclosures About Market Risk."
Contractual Obligations
The Company enters into contractual obligations in the normal course of business to fund loan growth, for asset/liability management purposes, to meet required capital needs and for other corporate purposes. The following table presents significant fixed and determinable contractual obligations of principal by payment date at December 31, 2020. Further discussion of the
nature of each obligation is included in the referenced Note to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data" referenced in the following table.
Payments Due
Note
Reference
Less than 1
year
2-3 years 4-5 years More than
5 years
Total
Time deposits 11 $ 310,287 $ 72,651 $ 10,944 $ 2,336 $ 396,218
Short-term borrowings 13 75,195 - - - 75,195
Long-term debt 14 421 903 992 - 2,316
Subordinated notes 15 - - - 32,500 32,500
Operating lease obligations 6 1,208 1,592 1,666 9,449 13,915
Total $ 387,111 $ 75,146 $ 13,602 $ 44,285 $ 520,144
The contractual obligations table above does not include off-balance sheet commitments to extend credit that are detailed in the following section. These commitments generally have fixed expiration dates and many will expire without being drawn upon, therefore the total commitment does not necessarily represent future cash requirements and is excluded from the contractual obligations table.
Off-Balance Sheet Arrangements
The Company is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its clients. These financial instruments include commitments to extend credit and standby letters of credit.
The following table details significant commitments at December 31, 2020.
Contract or Notional
Amount
Commitments to fund:
Home equity lines of credit $ 223,216
1-4 family residential construction loans 28,928
Commercial real estate, construction and land development loans 60,606
Commercial, industrial and other loans 268,931
Standby letters of credit 14,491
A discussion of the nature, business purpose, and guarantees that result from the Company’s off-balance sheet arrangements is included in Note 19, Financial Instruments with Off-Balance Sheet Risk, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data."
Recently Adopted and Recently Issued Accounting Standards
Recently adopted and recently issued accounting standards are included in Note 1, Summary of Significant Accounting Policies, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data."
Supplemental Reporting of Non-GAAP Measures
As a result of prior acquisitions, the Company had intangible assets consisting of goodwill and core deposit and other intangible assets totaling $26.9 million and $27.1 million at December 31, 2020 and 2019, respectively.
Management believes providing certain “non-GAAP” information will assist investors in their understanding of the effect of acquisition activity on reported results, particularly to overcome comparability issues related to the influence of intangibles (principally goodwill) created in acquisitions.
Tangible book value per share and net interest margin excluding the impact of purchase accounting, as used by the Company in this supplemental reporting, are not GAAP measures. While we believe this information is a useful supplement to the GAAP based measures presented in Item 6, Selected Financial Data and Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, readers are cautioned that this non-GAAP disclosure has limitations as an
analytical tool, should not be viewed as a substitute for financial measures determined in accordance with GAAP, and should not be considered in isolation or as a substitute for analysis of our results and financial condition as reported under GAAP, nor are such measures necessarily comparable to non-GAAP performance measures that may be presented by other companies. This supplemental presentation should not be construed as an inference that our future results will be unaffected by similar adjustments to be determined in accordance with GAAP.
The following table presents the computation of each non-GAAP based measure shown together with its most directly comparable GAAP based measure.
2020 2019 2018
Tangible book value per common share
Shareholders' equity $ 246,249 $ 223,249 $ 173,433
Less: Goodwill 18,724 19,925 12,592
Other intangible assets 5,458 7,180 3,910
Related tax effect (1,146) (1,508) (804)
Tangible common equity (non-GAAP) $ 223,213 $ 197,652 $ 157,735
Common shares outstanding 11,201 11,200 9,430
Book value per share (most directly comparable GAAP based measure) $ 21.98 $ 19.93 $ 18.39
Intangible assets per share 2.05 2.28 1.66
Tangible book value per share (non-GAAP) $ 19.93 $ 17.65 $ 16.73
2020 2019 2018
Taxable-Equivalent Net Interest Margin (excluding the effect of purchase accounting)
Taxable-equivalent net interest income/margin, as reported $ 84,431 3.44 % $ 70,338 3.43 % $ 53,573 3.36 %
Effect of purchase accounting:
Loans Income (5,547) (0.24) % (3,758) (0.21) % (372) 0.18 %
Time deposits Expenses 81 - % (102) 0.01 % 855 0.21 %
Purchase accounting effect on taxable-equivalent income/ margin (5,628) (0.24) % (3,656) (0.20) % (1,227) 0.39 %
Taxable-equivalent net interest income/margin (excluding the effect of purchase accounting) (non-GAAP) $ 78,803 3.20 % $ 66,682 3.23 % $ 52,346 3.75 %
December 31, 2020
Allowance to unguaranteed loans
Allowance for loan losses $ 20,151
Gross loans $ 1,979,690
less: SBA guaranteed loans (404,205)
Unguaranteed loans $ 1,575,485
Allowance to unguaranteed loans 1.3 %
December 31, 2020 December 31, 2019
Allowance plus purchase accounting marks to unguaranteed loans:
Allowance for loan losses $ 20,151 $ 14,655
Purchase accounting marks 7,784 18,160
Allowance plus purchase accounting marks 27,935 32,815
Gross loans 1,979,690 1,644,330
less: SBA guaranteed loans (404,205) (1,559)
Unguaranteed loans $ 1,575,485 $ 1,642,771
Allowance plus purchase accounting marks to unguaranteed loans: 1.8 % 2.0 %

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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk comprises exposure to interest rate risk, foreign currency exchange rate risk, commodity price risk, and other relevant market rate or price risks. In the banking industry, a major risk exposure is changing interest rates. The primary objective of monitoring our interest rate sensitivity, or risk, is to provide management the tools necessary to manage the balance sheet to minimize adverse changes in net interest income as a result of changes in the direction and level of interest rates. FRB monetary control efforts, the effects of deregulation, economic uncertainty and legislative changes have been significant factors affecting the task of managing interest rate sensitivity positions in recent years.
Interest Rate Risk
Interest rate risk is the exposure to fluctuations in the Company’s future earnings (earnings at risk) and value (value at risk) resulting from changes in interest rates. This exposure results from differences between the amounts of interest-earning assets and interest-bearing liabilities that reprice within a specified time period as a result of scheduled maturities, scheduled and unscheduled repayments, the propensity of borrowers and depositors to react to changes in their economic interests, and loan contractual interest rate changes.
We attempt to manage the level of repricing and maturity mismatch through our asset/liability management process so that fluctuations in net interest income are maintained within policy limits across a range of market conditions, while satisfying liquidity and capital requirements. Management recognizes that a certain amount of interest rate risk is inherent, appropriate and necessary to ensure the Company’s profitability. Thus, the goal of interest rate risk management is to evaluate the amount of reward for taking risk and adjusting both the size and composition of the balance sheet relative to the level of reward available for taking risk.
Management endeavors to control the exposure to changes in interest rates by understanding, reviewing and making decisions based on its risk position. The Company primarily uses its securities portfolio, FHLB advances, interest rate swaps and brokered deposits to manage its interest rate risk position. Additionally, pricing, promotion and product development activities are directed in an effort to emphasize the loan and deposit term or repricing characteristics that best meet current interest rate risk objectives.
We use simulation analysis to assess earnings at risk and net present value analysis to assess value at risk. These methods allow management to regularly monitor both the direction and magnitude of our interest rate risk exposure. These analyses require numerous assumptions including, but not limited to, changes in balance sheet mix, prepayment rates on loans and securities, cash flows and repricing of all financial instruments, changes in volumes and pricing, future shapes of the yield curve, relationship of market interest rates to each other (basis risk), credit spread and deposit sensitivity. Assumptions are based on management’s best estimates but may not accurately reflect actual results under certain changes in interest rate due to the timing, magnitude and frequency of rate changes and changes in market conditions and management strategies, among other factors. However, the analyses are useful in quantifying risk and providing a relative gauge of our interest rate risk position over time.
Our asset/liability committee operates under management policies, approved by the Board of Directors, which define guidelines and limits on the level of risk. The committee meets regularly and reviews our interest rate risk position and monitors various liquidity ratios to ensure a satisfactory liquidity position. By utilizing our analyses, we can determine changes that may need to be made to the asset and liability mixes to mitigate the change in net interest income under various interest rate scenarios. Management continually evaluates the condition of the economy, the pattern of market interest rates and other
economic data to inform the committee on the selection of investment securities. Regulatory authorities also monitor our interest rate risk position along with other liquidity ratios.
Net Interest Income Sensitivity
Simulation analysis evaluates the effect of upward and downward changes in market interest rates on future net interest income. The analysis involves changing the interest rates used in determining net interest income over the next twelve months. The resulting percentage change in net interest income in various rate scenarios is an indication of our short-term interest rate risk. The analysis assumes recent pricing trends in new loan and deposit volumes will continue while balances remain constant. Additional assumptions are applied to modify pricing under the various rate scenarios.
The simulation analysis results are presented in the Net Interest Income table below. At December 31, 2020, these results indicate the Company would be better positioned, over the next 12 months, in a moderately declining rate environment than it would be if interest rates increased. At December 31, 2019, the results indicated we would be better positioned in a moderately increasing rate environment than if rates decreased moderately or increased more substantially.
Economic Value
Net present value analysis provides information on the risk inherent in the balance sheet that might not be considered in the simulation analysis due to the short time horizon used in that analysis. The net present value of the balance sheet incorporates the discounted present value of expected asset cash flows minus the discounted present value of expected liability cash flows. The analysis involves changing the interest rates used in determining the expected cash flows and in discounting the cash flows. The resulting percentage change in net present value in various rate scenarios is an indication of the longer term repricing risk and options embedded in the balance sheet.
At December 31, 2020, similar to at December 31, 2019, these results indicate the Company would be better positioned in a rising interest rate environment than it would be if interest rates decreased.
Earnings at Risk Value at Risk
% Change in Net Interest Income % Change in Market Value
Change in Market Interest Rates December 31, 2020 December 31, 2019 Change in Market Interest Rates December 31, 2020 December 31, 2019
(100) (0.8) % (0.5) % (100) (99.6) % (21.7) %
100 1.7 % (1.3) % 100 70.7 % 10.9 %
200 2.4 % (3.8) % 200 116.4 % 15.1 %
Further discussion related to the quantitative and qualitative disclosures about market risk is included under the heading of Liquidity and Rate Sensitivity in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations.

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
SUMMARY OF QUARTERLY FINANCIAL DATA
The following table presents unaudited quarterly results of operations for years ended December 31.
Quarter Ended 2019
Quarter Ended
December September June March December September June March
Interest income $ 26,426 $ 24,216 $ 25,022 $ 23,967 $ 24,028 $ 24,836 $ 24,472 $ 19,658
Interest expense 2,697 3,398 4,224 5,705 6,087 6,757 5,957 4,898
Net interest income 23,729 20,818 20,798 18,262 17,941 18,079 18,515 14,760
Provision for loan losses 300 2,200 1,900 925 - 300 200 400
Net interest income after provision for loan losses 23,429 18,618 18,898 17,337 17,941 17,779 18,315 14,360
Investment securities gains (losses) 28 (13) 9 (40) 18 2,328 2,064 339
Other noninterest income 7,153 6,874 7,184 7,114 7,012 6,274 5,710 4,796
Merger related and branch consolidation expenses - 1,310 - - 988 471 6,860 645
Other noninterest expenses 18,080 17,955 18,431 18,304 18,721 17,669 16,432 15,516
Income before income tax expense 12,530 6,214 7,660 6,107 5,262 8,241 2,797 3,334
Income tax expense 2,471 1,237 1,301 1,039 1,028 1,340 110 232
Net income $ 10,059 $ 4,977 $ 6,359 $ 5,068 $ 4,234 $ 6,901 $ 2,687 $ 3,102
Per share information:
Basic earnings per share (a)
$ 0.92 $ 0.45 $ 0.58 $ 0.46 $ 0.39 $ 0.63 $ 0.26 $ 0.34
Diluted earnings per share (a)
$ 0.91 $ 0.45 $ 0.58 $ 0.46 $ 0.38 $ 0.62 $ 0.26 $ 0.33
Dividends paid per share $ 0.17 $ 0.17 $ 0.17 $ 0.17 $ 0.15 $ 0.15 $ 0.15 $ 0.15
(a) Sum of the quarters may not equal the total year due to rounding.
Index to Financial Statements and Supplementary Data
Page
Management’s Report on Internal Control over Financial Reporting
Report of Crowe LLP, Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Comprehensive Income
Consolidated Statements of Changes in Shareholders’ Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Management’s Report on Internal Control Over Financial Reporting
The management of Orrstown Financial Services, Inc., together with its consolidated subsidiaries (the "Company"), has the responsibility for establishing and maintaining an adequate internal control structure and procedures for financial reporting. Management maintains a comprehensive system of internal control to provide reasonable assurance of the proper authorization of transactions, the safeguarding of assets and the reliability of the financial records. The system of internal control provides for appropriate division of responsibility and is documented by written policies and procedures that are communicated to employees. The Company maintains an internal auditing program, under the supervision of the Audit Committee of the Board of Directors, which independently assesses the effectiveness of the system of internal control and recommends possible improvements.
Under the supervision and with the participation of the Company’s management, including its Chief Executive Officer and Chief Financial Officer, the Company has evaluated the effectiveness of its internal control over financial reporting at December 31, 2020, using the Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based upon this evaluation, management has concluded that, at December 31, 2020, the Company’s internal control over financial reporting is effective based on the criteria established in Internal Control-Integrated Framework (2013).
Crowe LLP has audited the effectiveness of the Company’s internal control over financial reporting as of December 31, 2020, as stated in their report dated March 15, 2021.
/s/ Thomas R. Quinn, Jr. /s/ Thomas R. Brugger
Thomas R. Quinn, Jr. Thomas R. Brugger
President and Chief Executive Officer Executive Vice President and Chief Financial Officer
March 15, 2021
Report of Independent Registered Public Accounting Firm
Shareholders and Board of Directors of Orrstown Financial Services, Inc.
Shippensburg, Pennsylvania
Opinions on the Financial Statements and Internal Control over Financial Reporting
We have audited the accompanying consolidated balance sheets of Orrstown Financial Services, Inc. (the "Company") as of December 31, 2020 and 2019, the related consolidated statements of income, comprehensive income, changes in shareholders’, and cash flows for each of the years in the three-year period ended December 31, 2020, and the related notes (collectively referred to as the "financial statements"). We also have audited the Company’s internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework: (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2020 and 2019, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2020 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework: (2013) issued by COSO.
Basis for Opinions
The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) ("PCAOB") and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.
Our audits of the financial statements included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
Definition and Limitations of Internal Control Over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Critical Audit Matter
The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that: (i) relates to accounts or disclosures that are material to the consolidated financial statements and (ii) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.
Allowance for Loan Losses - Adjustments for qualitative factors
As more fully described in Note 1 and Note 4 to the consolidated financial statements, the Company estimates and records an allowance for loan losses for loans collectively evaluated for impairment by developing a loss rate based on historical losses and qualitative factors. Qualitative factors are used to adjust historical loss rates considering relevant factors such as nature and volume of loans; national and local economic conditions; concentrations of credit and changes within credit concentrations; quality of loan review; delinquency trends; classified loan trends; underwriting standards and recovery practices; and experience, ability and depth of management and lending staff. The application of the adjustments for qualitative factors to the historical loss rate calculation is subjective.
The principal considerations for our determination that auditing the adjustments to the historical loss rates is a critical audit matter is the high degree of judgment involved in the assessment of the risk of loss associated with each risk factor. Our audit procedures included both control and substantive testing related to the adjustments for qualitative factors. Procedures included, among others:
•Testing the following controls:
◦Management’s review of the accuracy of data inputs used to adjust historical loss rates.
◦Management’s review of the appropriateness and adequacy of the adjustments to the historical loss rates
◦Management’s approval of the conclusions reached over the allowance for loan losses for loans collectively evaluated for impairment.
•Substantive tests included:
◦Data inputs used to adjust historical loss rates were agreed to source documentation.
◦The adjustments to historical loss rates were evaluated for reasonableness and appropriateness including both directional consistency and the magnitude of the adjustments.
◦Analytical procedures were performed to evaluate changes that occurred in the allowance for loan losses for loans collectively evaluated for impairment.
Crowe LLP
We have served as the Company's auditor since 2014.
Washington, D.C.
March 15, 2021
Consolidated Balance Sheets
ORRSTOWN FINANCIAL SERVICES, INC.
December 31,
(Dollars in thousands, except per share amounts) 2020 2019
Assets
Cash and due from banks $ 26,203 $ 25,969
Interest-bearing deposits with banks 99,055 29,994
Cash and cash equivalents 125,258 55,963
Restricted investments in bank stocks 10,563 16,184
Securities available for sale (amortized cost of $460,999 and $491,492 at December 31, 2020 and 2019, respectively)
466,465 490,885
Loans held for sale, at fair value 11,734 9,364
Loans 1,979,690 1,644,330
Less: Allowance for loan losses (20,151) (14,655)
Net loans 1,959,539 1,629,675
Premises and equipment, net 35,149 37,524
Cash surrender value of life insurance 68,554 63,613
Goodwill 18,724 19,925
Other intangible assets, net 5,458 7,180
Accrued interest receivable 8,927 6,040
Other assets 40,201 46,921
Total assets $ 2,750,572 $ 2,383,274
Liabilities
Deposits:
Noninterest-bearing $ 456,778 $ 249,450
Interest-bearing 1,900,102 1,626,072
Total deposits 2,356,880 1,875,522
Securities sold under agreements to repurchase 19,466 8,269
FHLB advances and other 58,045 209,667
Subordinated notes 31,903 31,847
Other liabilities 38,029 34,720
Total liabilities 2,504,323 2,160,025
Commitments and contingencies
Shareholders’ Equity
Preferred stock, $1.25 par value per share; 500,000 shares authorized; no shares issued or outstanding
- -
Common stock, no par value-$0.05205 stated value per share 50,000,000 shares authorized; 11,257,046 shares issued and 11,201,317 outstanding at December 31, 2020; 11,220,604 shares issued and 11,199,874 outstanding at December 31, 2019
586 584
Additional paid-in capital 189,066 188,365
Retained earnings 54,099 35,246
Accumulated other comprehensive income (loss) 3,346 (480)
Treasury stock- 55,729 and 20,730 shares, at cost, at December 31, 2020 and 2019, respectively
(848) (466)
Total shareholders’ equity 246,249 223,249
Total liabilities and shareholders’ equity $ 2,750,572 $ 2,383,274
The Notes to Consolidated Financial Statements are an integral part of these statements.
Consolidated Statements of Income
ORRSTOWN FINANCIAL SERVICES, INC.
Years Ended December 31,
(Dollars in thousands, except per share amounts) 2020 2019 2018
Interest income
Loans $ 87,492 $ 75,071 $ 50,632
Investment securities - taxable 10,458 14,538 10,858
Investment securities - tax-exempt 1,566 2,054 3,850
Short term investments 115 1,331 327
Total interest income 99,631 92,994 65,667
Interest expense
Deposits 12,009 19,310 10,228
Securities sold under agreements to repurchase 85 623 81
FHLB advances and other 1,924 1,779 3,128
Subordinated notes 2,006 1,987 73
Total interest expense 16,024 23,699 13,510
Net interest income 83,607 69,295 52,157
Provision for loan losses 5,325 900 800
Net interest income after provision for loan losses 78,282 68,395 51,357
Noninterest income
Service charges on deposit accounts 2,874 3,404 3,233
Interchange income 3,423 3,281 2,821
Other service charges, commissions and fees 683 805 907
Swap fee income 847 1,197 -
Trust and investment management income 6,912 7,255 6,576
Brokerage income 2,821 2,426 2,035
Mortgage banking activities 5,274 3,047 2,663
Gain on sale of portfolio loans 2,803 - -
Income from life insurance 2,261 2,044 1,463
Investment securities (losses) gains (16) 4,749 1,006
Other income 427 331 320
Total noninterest income 28,309 28,539 21,024
Noninterest expenses
Salaries and employee benefits 43,350 39,495 32,524
Occupancy 4,760 4,325 3,084
Furniture and equipment 4,756 4,723 4,079
Data processing 3,574 3,599 2,674
Automated teller and interchange fees 1,057 1,015 806
Advertising and bank promotions 1,660 1,967 1,592
FDIC insurance 686 367 681
Other professional services 3,120 2,954 1,847
Directors' compensation 921 1,003 984
Taxes other than income 1,144 1,018 1,012
Intangible asset amortization 1,569 1,570 286
Merger related and branch consolidation expenses 1,310 8,964 3,197
Insurance claim (recovery) receivable write-off (486) 615 -
Other operating expenses 6,659 5,685 5,170
Total noninterest expenses 74,080 77,300 57,936
Income before income tax expense 32,511 19,634 14,445
Income tax expense 6,048 2,710 1,640
Net income $ 26,463 $ 16,924 $ 12,805
Per share information:
Basic earnings per share $ 2.42 $ 1.63 $ 1.53
Diluted earnings per share 2.40 1.61 1.50
Dividends paid per share 0.68 0.60 0.51
The Notes to Consolidated Financial Statements are an integral part of these statements.
Consolidated Statements of Comprehensive Income
ORRSTOWN FINANCIAL SERVICES, INC.
Years Ended December 31,
(Dollars in thousands) 2020 2019 2018
Net income $ 26,463 $ 16,924 $ 12,805
Other comprehensive income, net of tax:
Unrealized gains (losses) on securities available for sale arising during the period 6,057 7,905 (6,359)
Reclassification adjustment for losses (gains) realized in net income 16 (4,749) (1,006)
Net unrealized gains (losses) on securities available for sale 6,073 3,156 (7,365)
Tax effect (1,275) (664) 1,548
Total other comprehensive income (loss), net of tax and reclassification adjustments on securities available for sale 4,798 2,492 (5,817)
Unrealized losses on interest rate swaps used in cash flow hedges (1,347) - -
Reclassification adjustment for losses realized in net income 117 - -
Net unrealized losses on interest rate swaps used in cash flow hedges (1,230) - -
Tax effect 258 - -
Total other comprehensive loss, net of tax and reclassification adjustments on interest rate swaps (972) - -
Total other comprehensive income (loss), net of tax and reclassification adjustments 3,826 2,492 (5,817)
Total comprehensive income $ 30,289 $ 19,416 $ 6,988
The Notes to Consolidated Financial Statements are an integral part of these statements.
Consolidated Statements of Changes in Shareholders’ Equity
ORRSTOWN FINANCIAL SERVICES, INC.
Years Ended December 31, 2020, 2019, and 2018
(Dollars in thousands, except per share amounts) Common
Stock
Additional
Paid-In
Capital
Retained
Earnings
Accumulated
Other
Comprehensive
Income (Loss)
Treasury
Stock
Total
Shareholders’
Equity
Balance, January 1, 2018 $ 435 $ 125,458 $ 16,042 $ 2,845 $ (15) $ 144,765
Net income - - 12,805 - - 12,805
Total other comprehensive loss, net of taxes - - - (5,817) - (5,817)
Cash dividends ($0.51 per share)
- - (4,375) - - (4,375)
Issuance of stock (1,052,635 common shares) to acquire Mercersburg Financial Corporation
55 24,998 - - - 25,053
Share-based compensation plans:
38,764 net common shares issued and 8,214 net treasury shares acquired, including compensation expense totaling $1,493
1 1,222 - - (221) 1,002
Balance, December 31, 2018 491 151,678 24,472 (2,972) (236) 173,433
Net income - - 16,924 - - 16,924
Total other comprehensive income, net of taxes - - - 2,492 - 2,492
Cash dividends ($0.60 per share)
- - (6,150) - - (6,150)
Issuance of stock (1,765,704 common shares) to acquire Hamilton Bancorp, Inc
92 36,530 - - - 36,622
Share-based compensation plans:
15,645 net common shares issued and 11,699 net treasury shares acquired, including compensation expense totaling $1,586
1 157 - - (230) (72)
Balance, December 31, 2019 584 188,365 35,246 (480) (466) 223,249
Net income - - 26,463 - - 26,463
Total other comprehensive income, net of taxes - - - 3,826 - 3,826
Cash dividends ($0.68 per share)
- - (7,610) - - (7,610)
Share-based compensation plans:
36,442 net common shares issued and 34,999 net treasury shares acquired, including compensation expense totaling $2,092
2 701 - - (382) 321
Balance, December 31, 2020 $ 586 $ 189,066 $ 54,099 $ 3,346 $ (848) $ 246,249
The Notes to Consolidated Financial Statements are an integral part of these statements.
Consolidated Statements of Cash Flows
ORRSTOWN FINANCIAL SERVICES, INC.
Years Ended December 31,
(Dollars in thousands) 2020 2019 2018
Cash flows from operating activities
Net income $ 26,463 $ 16,924 $ 12,805
Adjustments to reconcile net income to net cash provided by operating activities:
Net discount (accretion) premium amortization (4,481) (2,547) 1,406
Depreciation and amortization expense 6,573 5,547 3,642
Impairment of intangibles 153 - -
Provision for loan losses 5,325 900 800
Share-based compensation 2,092 1,586 1,493
Gain on sales of loans originated for sale (6,067) (2,613) (2,144)
Mortgage loans originated for sale (207,051) (112,568) (90,305)
Proceeds from sales of loans originated for sale 208,987 108,885 94,727
Gain on sale of portfolio loans (2,803) - (291)
Net loss (gain) on disposal of OREO 152 (156) (108)
Writedown of OREO 544 - 24
Net loss on disposal of premises and equipment 2 139 12
Deferred income taxes (1,973) 1,776 543
Investment securities losses (gains) 16 (4,749) (1,006)
Gains on termination of rate swap (226) - -
Income from life insurance (2,261) (2,044) (1,463)
(Increase) decrease in accrued interest receivable (2,887) 1,248 (879)
Increase (decrease) in accrued interest payable and other liabilities 953 (5,291) 2,696
Other, net 6,660 2,053 535
Net cash provided by operating activities 30,171 9,090 22,487
Cash flows from investing activities
Proceeds from sales of AFS securities - 199,429 156,364
Maturities, repayments and calls of AFS securities 56,239 33,265 18,373
Purchases of AFS securities (26,691) (190,530) (226,014)
Net cash and cash equivalents received from acquisitions - 29,442 12,407
Net purchases of restricted investments in bank stocks 5,621 (2,684) (592)
Net decrease (increase) in loans (349,947) (46,157) (99,828)
Proceeds from sales of portfolio loans 22,665 - 3,589
Purchases of bank premises and equipment (1,303) (2,911) (4,791)
Proceeds from disposal of OREO 4,096 1,318 1,413
Proceeds from sale of rate swap 218 - -
Purchases of bank owned life insurance (3,636) (3,280) (900)
Death benefit proceeds from life insurance contracts 391 571 576
Other - - 7
Net cash provided by (used in) investing activities (292,347) 18,463 (139,396)
Cash flows from financing activities
Net increase (decrease) in deposits 481,277 (71,561) 178,798
Net (decrease) increase n borrowings with original maturities less than 90 days (135,402) 115,800 (14,507)
Proceeds from other short-term borrowings 126,599 20,000 25,000
Payments on other short-term borrowings (131,622) (116,776) (40,365)
Proceeds from subordinated notes, net of issuance costs - - 31,857
Payment of subordinated notes issuance costs - (59) -
Dividends paid (7,610) (6,150) (4,375)
Acquisition of treasury stock (1,170) - -
Treasury shares repurchased for employee taxes associated with restricted stock vesting (717) (1,772) (651)
Proceeds from issuance of stock for option exercises and employee stock purchase plan 116 113 160
Net cash (used in) provided by financing activities 331,471 (60,405) 175,917
Net increase (decrease) in cash and cash equivalents 69,295 (32,852) 59,008
Cash and cash equivalents at beginning of year 55,963 88,815 29,807
Cash and cash equivalents at end of year $ 125,258 $ 55,963 $ 88,815
Years Ended December 31,
(Dollars in thousands) 2020 2019 2018
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Interest $ 16,665 $ 24,313 $ 12,930
Income taxes 550 - 60
Supplemental schedule of noncash investing and financing activities:
OREO acquired in settlement of loans - 161 539
Premises and equipment transferred to held for sale - 4,894 1,003
Lease liabilities arising from obtaining ROU assets 400 7,380 -
The Notes to Consolidated Financial Statements are an integral part of these statements.
Notes to Consolidated Financial Statements
(All dollar amounts presented in the tables, except share and per share amounts, are in thousands)
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
See the Glossary of Defined Terms at the beginning of this Report for terms used throughout the consolidated financial statements and related notes of this Form 10-K.
Nature of Operations - Orrstown Financial Services, Inc. is a financial holding company that operates Orrstown Bank, a commercial bank with banking and financial advisory offices in Berks, Cumberland, Dauphin, Franklin, Lancaster, Perry and York Counties, Pennsylvania, and in Anne Arundel, Baltimore, Howard and Washington Counties, Maryland, as well as Baltimore City, Maryland. The Company operates in the community banking segment and engages in lending activities, including commercial, residential, commercial mortgages, construction, municipal, and various forms of consumer lending, and deposit services, including checking, savings, time, and money market deposits. The Company also provides fiduciary services, investment advisory, insurance and brokerage services. Effective July 31, 2020, Wheatland Advisors, Inc., a registered investment advisor non-bank subsidiary, headquartered in Lancaster County, Pennsylvania was discontinued. The Company and the Bank are subject to regulation by certain federal and state agencies and undergo periodic examinations by such regulatory authorities.
Basis of Presentation - The accompanying consolidated financial statements include the accounts of Orrstown Financial Services, Inc. and its wholly owned subsidiary, the Bank. The accounting and reporting policies of the Company conform to GAAP and, where applicable, to accounting and reporting guidelines prescribed by bank regulatory authorities. All significant intercompany transactions and accounts have been eliminated. Certain reclassifications have been made to prior year amounts to conform with current year classifications. In October 2018, the Company acquired Mercersburg Financial Corporation and its wholly-owned subsidiary, First Community Bank of Mercersburg, based in Mercersburg, Pennsylvania. In May 2019, the Company acquired Hamilton Bancorp, Inc., and its wholly-owned subsidiary, Hamilton Bank, based in Towson, Maryland. The results of operations and assets acquired and liabilities assumed from acquired entities are included only from the date of acquisition. The comparability of the Company's results of operations for the years ended December 31, 2020, to 2019 and 2018 have been impacted by these acquisitions.
The Company's management has evaluated all activity of the Company and concluded that subsequent events are properly reflected in the Company's consolidated financial statements and notes as required by GAAP.
To prepare financial statements in conformity with accounting principles generally accepted in the United States of America, management makes estimates and assumptions based on available information. These estimates and assumptions affect the amounts reported in the financial statements and the disclosures provided, and actual results could differ.
Concentration of Credit Risk - The Company grants commercial, residential, construction, municipal, and various forms of consumer lending to clients primarily in its market area in south central Pennsylvania and in the greater Baltimore region and Washington County, Maryland. Therefore, the Company's exposure to credit risk is significantly affected by changes in the economy in those areas. Although the Company maintains a diversified loan portfolio, a significant portion of its clients’ ability to honor their contracts is dependent upon economic sectors for commercial real estate, including office space, retail strip centers, sales finance, sub-dividers and developers, and multi-family, hospitality, and residential building operators. Management evaluates each clients' creditworthiness on a case-by-case basis. The amount of collateral obtained upon the extension of credit is based on management’s credit evaluation of the client. Types of collateral held varies, but generally includes real estate and equipment.
The types of securities the Company invests in are included in Note 3, Securities Available for Sale, and the types of lending the Company engages in are included in Note 4, Loans and Allowance for Loan Losses.
Cash and Cash Equivalents - Cash and cash equivalents include cash, balances due from banks, federal funds sold and interest-bearing deposits due on demand, all of which have original maturities of 90 days or less. Net cash flows are reported for client loan and deposit transactions, loans held for sale, redemption (purchases) of restricted investments in bank stocks, and short-term borrowings.
Cash and cash equivalents includes amounts that the Company is required to maintain on hand or on deposit at the Federal Reserve Bank to meet certain regulatory reserve balance requirements. At December 31, 2020 and 2019, the Company had reserve requirements of zero and $9.2 million, respectively.
Balances with correspondent banks may, at times, exceed federally insured limits. The Company considers this to be a normal business risk and reviews the financial condition of its correspondent banks on a quarterly basis.
Restricted Investments in Bank Stocks - Restricted investments in bank stocks consist of Federal Reserve Bank of Philadelphia stock, FHLB of Pittsburgh stock and Atlantic Community Bankers Bank stock. Federal law requires a member institution of the district Federal Reserve Bank and FHLB to hold stock according to predetermined formulas. Atlantic Community Bankers Bank requires its correspondent banking institutions to hold stock as a condition of membership. The restricted investment in bank stocks is carried at cost. On a quarterly basis, management evaluates the bank stocks for impairment based on assessment of the ultimate recoverability of cost rather than by recognizing temporary declines in value. The determination of whether a decline affects the ultimate recoverability of cost is influenced by criteria such as operating performance, liquidity, funding and capital positions, stock repurchase history, dividend history, and impact of legislative and regulatory changes.
Securities - The Company typically classifies debt securities as available for sale on the date of purchase. At December 31, 2020 and 2019, the Company had no held to maturity or trading securities. AFS securities are reported at fair value. Interest income and dividends on debt securities are recognized in interest income on an accrual basis. Purchase premiums and discounts on debt securities are amortized to interest income using the interest method over the terms of the securities and approximate the level yield method.
Changes in unrealized gains and losses, net of related deferred taxes, for AFS securities are recorded in AOCI. Realized gains and losses on securities are recorded on the trade date using the specific identification method and are included in noninterest income on the consolidated statements of income.
AFS securities include investments that management intends to use as part of its asset/liability management strategy. Securities may be sold in response to changes in interest rates, changes in prepayment rates and other factors. The Company does not have the intent to sell any of its AFS securities that are in an unrealized loss position and it is more likely than not that the Company will not be required to sell these securities before recovery of their amortized cost.
Management evaluates securities for OTTI on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as an impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components: OTTI related to other factors, which is recognized in OCI, and the remaining OTTI, which is recognized in earnings. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis.
The Company’s securities are exposed to various risks, such as interest rate risk, market risk, and credit risk. Due to the level of risk associated with certain investments and the level of uncertainty related to changes in the value of investments, it is at least reasonably possible that changes in risks in the near term would materially affect investment assets reported in the consolidated financial statements.
Loans Held for Sale - Effective October 1, 2019, The Company adopted the fair value option on these loans which allows the Company to record the mortgage loans held for sale portfolio at fair market value as opposed to the lower of cost or market. The Company economically hedges its residential loans held for sale portfolio with forward sale agreements which are reported at fair value. A lower of cost or market accounting treatment would not allow the Company to record the excess of the fair market value over book value but would require the Company to record the corresponding reduction in value on the hedges. Both the loans and related hedges are carried at fair value which reduces earnings volatility as the amounts more closely offset, particularly in environments when interest rates are declining. For loans held for sale for which the fair value option has been elected, the aggregate fair value exceeded the aggregate principal balance by $436 thousand. There were no loans held for sale that were nonaccrual or 90 or more days past due as of December 31, 2020. In previous periods, loans originated and intended for sale in the secondary market were carried at the lower of aggregate cost or fair value. Gains and losses on loan sales (sales proceeds minus carrying value) are recorded in noninterest income. Interest income on these loans is recognized in interest and fees on loans in the consolidated statements of operations.
Loans - Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding unpaid principal balances adjusted for charge-offs, the ALL, and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and amortized as a yield adjustment over the respective term of the loan. For purchased loans that are not deemed impaired at the acquisition date, premiums and discounts are amortized or accreted as adjustments to interest income using the effective yield method.
For all classes of loans, the accrual of interest income on loans, including impaired loans, ceases when principal or interest is past due 90 days or more or immediately if, in the opinion of management, full collection is unlikely. Interest will continue to
accrue on loans past due 90 days or more if the collateral is adequate to cover principal and interest, and the loan is in the process of collection. Interest accrued, but not collected, at the date of placement on nonaccrual status, is reversed and charged against interest income, unless fully collateralized. Subsequent payments received are either applied to the outstanding principal balance or recorded as interest income, depending upon management’s assessment of the ultimate collectability of principal. Loans are returned to accrual status, for all loan classes, when all the principal and interest amounts contractually due are brought current, the loan has performed in accordance with the contractual terms of the note for a reasonable period of time, generally six months, and the ultimate collectability of the total contractual principal and interest is reasonably assured. Past due status is based on the contractual terms of the loan.
Loans, the terms of which are modified, are classified as TDRs if a concession was granted in connection with the modification, for legal or economic reasons, related to the debtor’s financial difficulties. Concessions granted under a TDR typically involve a temporary deferral of scheduled loan payments, an extension of a loans' stated maturity date, a temporary reduction in interest rates, or granting of an interest rate below market rates given the risk of the transaction. If a modification occurs while the loan is on accrual status, it will continue to accrue interest under the modified terms. Nonaccrual TDRs may be restored to accrual status if scheduled principal and interest payments, under the modified terms, are current for six months after modification, and the borrower continues to demonstrate its ability to meet the modified terms. TDRs are evaluated individually for impairment on a quarterly basis including monitoring of performance according to their modified terms.
Allowance for Loan Losses - The ALL is evaluated on at least a quarterly basis, as losses are estimated to be probable and incurred, and, if deemed necessary, is increased or decreased through the provision for loan losses on the consolidated statements of income. Loan losses are charged against the ALL when management determines that all or a portion of the loan is uncollectible. Recoveries on previously charged-off loans are credited to the ALL when received. The ALL is allocated to loan portfolio classes on a quarterly basis, but the entire balance is available to cover losses from any of the portfolio classes when those losses are confirmed.
Management uses internal policies and bank regulatory guidance in periodically evaluating loans for collectability and incorporates historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
See Note 4, Loans and Allowance for Loan Losses, for additional information.
Acquired Loans - Loans acquired in connection with business combinations are recorded at fair value with no carryover of any allowance for loan losses. Fair value of the loans involves estimating the amount and timing of principal and interest cash flows expected to be collected on the loans and discounting those cash flows at a market rate of interest.
The excess of cash flows expected at acquisition over the estimated fair value is referred to as the accretable discount and is recognized into interest income over the remaining life of the loan. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the nonaccretable discount. These loans are accounted for under ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality ("ASC 310-30"). The nonaccretable discount includes estimated future credit losses expected to be incurred over the life of the loan. Subsequent decreases in expected cash flows will require us to evaluate the need for an addition to the allowance for loan losses. Subsequent improvement in expected cash flows will result in the reversal of a corresponding amount of the nonaccretable discount, which we will then reclassify as accretable discount to be recognized into interest income over the remaining life of the loan.
Loans acquired through business combinations that do meet the specific criteria of ASC 310-30 are individually evaluated each period to analyze expected cash flows. To the extent that the expected cash flows of a loan have decreased due to credit deterioration, the Company establishes an allowance.
Loans acquired through business combinations that do not meet the specific criteria of ASC 310-30 are accounted for under ASC 310-20, Receivables - Nonrefundable Fees and Other Costs. These loans are initially recorded at fair value, and include credit and interest rate marks associated with acquisition accounting adjustments. Purchase premiums or discounts are subsequently amortized as an adjustment to yield over the estimated contractual lives of the loans. There is no allowance for loan losses established at the acquisition date for acquired performing loans. An allowance for loan losses is recorded for any credit deterioration in these loans subsequent to acquisition.
Acquired loans that meet the criteria for impairment or nonaccrual of interest prior to the acquisition may be considered performing upon acquisition, regardless of whether the client is contractually delinquent if the Company expects to fully collect the new carrying value (i.e., fair value) of the loans. As such, the Company may no longer consider the loan to be nonperforming and may accrue interest on these loans, including the impact of any accretable discount. In addition, charge-offs on such loans would be first applied to the nonaccretable difference portion of the fair value adjustment.
Loan Commitments and Related Financial Instruments - Financial instruments include off-balance sheet credit commitments issued to meet client financing needs, such as commitments to make loans and commercial letters of credit. These financial instruments are recorded when they are funded. The face amount represents the exposure to loss, before considering client collateral or ability to repay. The Company maintains a reserve for probable losses on off-balance sheet commitments which is included in other liabilities on the consolidated balance sheets.
Loans Serviced - The Bank administers secondary market mortgage programs available through the FHLB and the Federal National Mortgage Association and offers residential mortgage products and services to clients. The Bank originates single-family residential mortgage loans for immediate sale in the secondary market and retains the servicing of those loans. At December 31, 2020 and 2019, the balance of loans serviced for others totaled $441.1 million and $360.1 million, respectively.
Transfers of Financial Assets - Transfers of financial assets are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Cash Surrender Value of Life Insurance - The Company has purchased life insurance policies on certain employees. Life insurance is recorded at the cash surrender value adjusted for other charges or other amounts due that are probable at settlement.
Derivatives - FASB ASC 815, Derivatives and Hedging (“ASC 815”), provides the disclosure requirements for derivatives and hedging activities with the intent to provide users of financial statements with an enhanced understanding of: (a) how and why an entity uses derivative instruments, (b) how the entity accounts for derivative instruments and related hedged items, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. Further, qualitative disclosures are required that explain the Company’s objectives and strategies for using derivatives, as well as quantitative disclosures about the fair value of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.
As required by ASC 815, the Company records all derivatives on the balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge.
The Company may enter into derivative contracts that are intended to economically hedge certain of its risk, even though hedge accounting does not apply or the Company elects not to apply hedge accounting. The Company's objectives in using interest rate derivatives are to add stability to interest income and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of fixed amounts from a counterparty in exchange for the Company making variable-rate payments over the life of the agreements without exchange of the underlying notional amount. The Company may enter into derivative contracts that are intended to economically hedge certain of its risk, even though hedge accounting does not apply or the Company elects not to apply hedge accounting.
Changes to the fair value of derivatives designated and that qualify as cash flow hedges are recorded in accumulated other comprehensive income and are subsequently reclassified into earnings in the period that the hedged transaction affects earnings. During 2020, such derivatives were used to hedge the variable cash flows associated with overnight borrowings.
Derivatives not designated as hedges are not speculative and result from a service the Company provides to certain customers. The Company executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies. Those interest rate swaps are simultaneously hedged by offsetting derivatives that the Company executes with a third party, such that the Company minimizes its net risk exposure resulting from such transactions. As the interest rate derivatives associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer derivatives and the offsetting derivatives are recognized directly in earnings.
Premises and Equipment - Buildings, improvements, equipment, furniture and fixtures are carried at cost less accumulated depreciation and amortization. Land is carried at cost. Depreciation and amortization has been recognized generally on the straight-line method and is computed over the estimated useful lives of the various assets as follows: buildings
and improvements, including leasehold improvements - 10 to 40 years; and furniture and equipment - 3 to 15 years. Leasehold improvements are amortized over the shorter of the lease term or the indicated life. Repairs and maintenance are charged to operations as incurred, while additions and improvements are typically capitalized. Gains or losses on the retirement or disposal of individual assets is recorded as income or expense in the period of retirement or disposal. Premises no longer in use and held for sale are included in other assets on the consolidated balance sheets at the lower of carrying value or fair value and no depreciation is charged on them. At December 31, 2020 and 2019, premises held for sale totaled $1.1 million and $5.2 million, respectively.
Leases - The Company evaluates its contracts at inception to determine if an arrangement is,or contains, a lease. Operating leases are included in operating lease ROU assets in other assets and operating lease liabilities in accrued interest payable and other liabilities in the consolidated balance sheets. The Company had no finance leases at December 31, 2020.
ROU assets represent the right to use an underlying asset for the lease term, and lease liabilities represent an obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. The Company's leases do not provide an implicit rate, so the Company's incremental borrowing rate is used, which approximates its fully collateralized borrowing rate, based on the information available at commencement date in determining the present value of lease payments. The incremental borrowing rate is reevaluated upon lease modification. The operating lease ROU asset also includes any initial direct costs and prepaid lease payments made less any lease incentives. In calculating the present value of lease payments, the Company may include options to extend the lease when it is reasonably certain that it will exercise that option.
In accordance with ASU 2016-02, “Leases (Topic 842)” (“ASU 2016-02”), the Company keeps leases with an initial term of 12 months or less off of the balance sheet. The Company recognizes these lease payments in the unaudited condensed consolidated statements of income on a straight-line basis over the lease term. The Company has lease agreements with lease and non-lease components and has elected the practical expedient to account for them as a single lease component.
The Company's operating leases relate primarily to bank branches and office space. Upon the adoption of ASU 2016-02 on January 1, 2019, operating lease liabilities of $10.5 million and related lease assets of $7.5 million were recognized on the consolidated balance sheets. The difference between the lease assets and lease liabilities primarily consists of deferred rent liabilities reclassified upon adoption to reduce the measurement of the lease assets. The standard did not materially impact the Company's consolidated net income and had no impact on cash flows.
Goodwill and Other Intangible Assets - Goodwill is calculated as the purchase premium, if any, after adjusting for the fair value of net assets acquired in purchase transactions. Goodwill is not amortized but is reviewed for potential impairment on at least an annual basis, with testing between annual tests if an event occurs or circumstances change that could potentially reduce the fair value of a reporting unit. Other intangible assets represent purchased assets that can be distinguished from goodwill because of contractual or other legal rights. The Company’s other intangible assets have finite lives and are amortized on either an accelerated amortization method or straight line basis over their estimated lives, generally 10 years for deposit premiums and 10 to 15 years for other client relationship intangibles.
Mortgage Servicing Rights - The estimated fair value of MSRs related to loans sold and serviced by the Company is recorded as an asset upon the sale of such loans. MSRs are amortized as a reduction to servicing income over the estimated lives of the underlying loans. MSRs are evaluated periodically for impairment by comparing the carrying amount to estimated fair value. Fair value is determined periodically through a discounted cash flow valuation performed by a third party. Significant inputs to the valuation include expected servicing income, net of expense, the discount rate and the expected life of the underlying loans. To the extent the amortized cost of the MSRs exceeds their estimated fair values, a valuation allowance is established for such impairment through a charge against servicing income on the consolidated statements of income. If the Company determines, based on subsequent valuations, that the impairment no longer exists or is reduced, the valuation allowance is reduced through a credit to earnings. MSRs totaled $2.8 million and $3.1 million at December 31, 2020 and December 31, 2019, respectively, and are included in other assets on the consolidated balance sheets.
Foreclosed Real Estate - Real estate acquired through foreclosure or other means is initially recorded at the fair value of the related real estate collateral at the transfer date less estimated selling costs, and subsequently at the lower of its carrying value or fair value less estimated costs to sell. Fair value is determined based on an independent third party appraisal of the property or, when appropriate, a recent sales offer. Costs to maintain such real estate are expensed as incurred. Costs that significantly improve the value of the properties are capitalized. Real estate acquired through foreclosure or other means totaled zero and $197 thousand at December 31, 2020 and 2019, respectively, and is included in other assets on the consolidated balance sheets.
Investments in Real Estate Partnerships - The Company has a 99% limited partner interest in several real estate partnerships in central Pennsylvania. These investments are affordable housing projects, which entitle the Company to tax deductions and credits that expire through 2025. The Company accounts for its investments in affordable housing projects
under the proportional amortization method when the criteria are met, which is limited to one investment at December 31, 2020. Other investments are accounted for under the equity method of accounting. The investment in these real estate partnerships, included in other assets on the consolidated balance sheets, totaled $3.1 million and $3.6 million at December 31, 2020 and 2019, respectively, of which $1.1 million and $1.3 million are accounted for under the proportional amortization method.
Equity method losses totaled $299 thousand, $55 thousand and $331 thousand for the years ended December 31, 2020, 2019 and 2018, respectively, and are included in other noninterest income on the consolidated income statements. Proportional amortization method losses totaled $214 thousand for the years ended December 31, 2020, 2019 and 2018, and are included in income tax expense on the consolidated income statements. During 2020, 2019 and 2018, the Company recognized federal tax credits from these projects totaling $460 thousand, $460 thousand and $578 thousand, respectively, which are included in income tax expense on the consolidated income statements.
Advertising - The Company expenses advertising as incurred. Advertising expense totaled $392 thousand, $577 thousand and $418 thousand for the years ended December 31, 2020, 2019 and 2018, respectively.
Repurchase Agreements - The Company enters into agreements under which it sells securities subject to an obligation to repurchase the same or similar securities which are included in short-term borrowings on the consolidated balance sheets. Under these agreements, the Company may transfer legal control over the assets but still retain effective control through an agreement that both entitles and obligates the Company to repurchase the assets. As a result, these repurchase agreements are accounted for as collateralized financing arrangements (i.e., secured borrowings) and not as a sale and subsequent repurchase of securities. The obligation to repurchase the securities is reflected as a liability on the Company’s consolidated balance sheets, while the securities underlying the repurchase agreements remaining are reflected in AFS securities. The repurchase obligation and underlying securities are not offset or netted as the Company does not enter into reverse repurchase agreements.
The right of setoff for a repurchase agreement resembles a secured borrowing, whereby the collateral would be used to settle the fair value of the repurchase agreement should the Company be in default (e.g., fail to make an interest payment to the counterparty). For the repurchase agreements, the collateral is held by the Company in a segregated custodial account under a third party agreement. Repurchase agreements are secured by GSE MBSs and mature overnight.
Share Compensation Plans - The Company has share compensation plans that cover employees and non-employee directors. Compensation expense relating to share-based payment transactions is measured based on the grant date fair value of the share award, including a Black-Scholes model for stock options. Compensation expense for all share awards is calculated and recognized over the employees’ or non-employee directors' service period, generally defined as the vesting period.
Income Taxes - Income tax accounting guidance results in two components of income tax expense: current and deferred. Current income tax expense reflects taxes to be paid or refunded for the current period by applying the provisions of enacted tax law to taxable income or excess of deductions over revenues. The Company determines deferred income taxes using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax bases of assets and liabilities, and enacted changes in tax rates and laws are recognized in the period in which they occur.
Deferred income tax expense results from changes in deferred tax assets and liabilities between periods. Deferred tax assets are recognized if it is more likely than not, based on the technical merits, that the tax position will be realized or sustained upon examination. The term more likely than not means a likelihood of more than 50 percent; the terms examined and upon examination also include resolution of the related appeals or litigation processes, if any. A tax position that meets the more likely than not recognition threshold is initially and subsequently measured as the largest amount of tax benefit that has a greater than 50 percent likelihood of being realized upon settlement with a taxing authority that has full knowledge of all relevant information. The determination of whether or not a tax position has met the more likely than not recognition threshold considers the facts, circumstances, and information available at the reporting date and is subject to management’s judgment. Deferred tax assets are reduced by a valuation allowance when, based on the weight of available evidence, it is more likely than not that some portion or all of a deferred tax asset will not be realized. The Company recognizes interest and penalties, if any, on income taxes as a component of income tax expense.
Loss Contingencies - Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated.
Treasury Stock - Common stock shares repurchased are recorded as treasury stock, at cost on the consolidated balance sheets.
Earnings Per Share - Basic earnings per share represents income available to common stockholders divided by the weighted average number of common shares outstanding during the period. Restricted stock awards are included in weighted average common shares outstanding as they are earned. Diluted earnings per share includes additional common shares that
would have been outstanding if dilutive potential common shares had been issued. Potential common shares that may be issued by the Company relate solely to outstanding stock options and restricted stock awards and are determined using the treasury stock method.
Treasury shares are not deemed outstanding for earnings per share calculations.
Comprehensive Income - Comprehensive income consists of net income and OCI. Unrealized gains (losses) on securities available for sale and derivatives, net of tax, were the components of AOCI at December 31, 2020. Unrealized gains(losses) on securities available for sale was the sole component of AOCI at December 31, 2019.
Fair Value - Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in the Fair Value note to the consolidated financial statements. Fair value estimates involve uncertainties and matters of significant judgment. Changes in assumptions or in market conditions could significantly affect the estimates.
Segment Reporting - The Company operates in one segment - Community Banking. The Company’s non-community banking activities are insignificant to the consolidated financial statements.
Recent Accounting Pronouncements - ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments ("ASU 2016-13"). The amendments in this update require an organization to measure all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will use forward-looking information to better inform their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. Organizations will continue to use judgment to determine which loss estimation method is appropriate for their circumstances. Additionally, the amendments in this update amend the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. For certain public companies, this update was effective for interim and annual periods beginning after December 15, 2019. The Company delayed the adoption of ASU 2016-13 as noted below.
ASU No. 2019-10, Financial Instruments-Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842): Effective Dates ("ASU 2019-10"), extended the implementation deadline of ASU 2016-13 for smaller reporting and other companies until the fiscal year and interim periods beginning after December 15, 2022. The Company meets the requirements to be considered a smaller reporting company under SEC Regulation S-K and SEC Rule 405, and did not adopt ASU 2016-13 on January 1, 2020. The Company is evaluating the impact of the delay for adoption of ASU 2016-13, and is working with a third-party vendor solution to assist with the application of ASU 2016-13 and finalizing the loss estimation models to be used. Once management determines which methods will be utilized, a third party will be contracted to perform a model validation prior to adoption. While the Company anticipates the allowance for loan losses will increase under its current assumptions, it expects the impact of adopting ASU 2016-13 will be influenced by the composition, characteristics and quality of its loan and securities portfolios, as well as general economic conditions and forecasts at the adoption date. The other provisions of ASU 2019-10 were not applicable to the Company.
ASU 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. The update simplifies how all entities assess goodwill for impairment by eliminating Step 2 from the goodwill impairment test. As amended, the goodwill impairment test will consist of one step comparing the fair value of a reporting unit with its carrying amount. An entity should recognize a goodwill impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. The adoption of this guidance, effective January 1, 2020, did not have a material impact on the Company's consolidated financial statements.
In March 2020, the FASB issued ASU No. 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting ("ASU 2020-04"). ASU 2020-04 contains optional expedients and exceptions for applying generally accepted accounting principles to contract modifications and hedging relationships, subject to meeting certain criteria, that reference LIBOR or another reference rate expected to be discontinued. The optional expedients apply consistently to all contracts or transactions within the scope of this topic, while the optional expedients for hedging relationships can be elected on an individual basis. The Company has formed a cross-functional working group to lead the transition from LIBOR to a planned adoption of an alternate index. The Company plans to replace LIBOR with SOFR in its loan agreements. The Company is in the process of implementing fallback language for loans that will mature after 2021. The Company expects to adopt the LIBOR transition relief allowed under this standard, and is currently evaluating the potential impact of this guidance on its financial statements.
NOTE 2. MERGERS AND ACQUISITIONS AND BRANCH CONSOLIDATIONS
Mercersburg Financial Corporation
On October 1, 2018, the Company acquired 100% of the outstanding common shares of Mercersburg Financial Corporation and its wholly-owned subsidiary, First Community Bank of Mercersburg, headquartered in Mercersburg, Pennsylvania. The Company issued 1,052,635 shares of its common stock and paid $4.9 million in cash for all outstanding shares of Mercersburg stock. Based on the Company's $23.80 closing stock price on Friday, September 28, 2018, the consideration paid to acquire Mercersburg totaled $29.9 million.
The fair value of assets acquired, excluding goodwill, totaled $181.4 million, including loans totaling $141.1 million and investment securities available for sale totaling $7.4 million. The fair value of liabilities assumed totaled $163.4 million, including deposits totaling $160.4 million. The Company recognized $11.9 million in initial goodwill, representing consideration transferred in excess of the fair value of the net assets acquired in the Mercersburg acquisition. The goodwill resulting from the acquisition represents the value expected from the expansion of our market in south central Pennsylvania and the enhancement of our operations through client synergies and efficiencies, thereby providing enhanced client service.
The Mercersburg acquisition was accounted for using the acquisition method of accounting and, accordingly, purchased assets, including identifiable intangible assets, and assumed liabilities were recorded at their respective acquisition date fair values. The fair value measurements of assets acquired and liabilities assumed were subject to refinement for up to one year after the closing date of the acquisition as additional information relative to closing date fair values became available. No material measurement period adjustments were made in the year ended December 31, 2020. The results of operations for the Company include Mercersburg's results from and after October 1, 2018.
Hamilton Bancorp, Inc.
On May 1, 2019, the Company acquired 100% of the outstanding common shares of Hamilton Bancorp, Inc., and its wholly-owned subsidiary, Hamilton Bank, based in Towson, Maryland. The Company acquired Hamilton to introduce our banking and financial services into the greater Baltimore area of Maryland.
Pursuant to the merger agreement, the Company issued 1,765,704 shares of its common stock and paid $14.2 million in cash for all outstanding shares of Hamilton stock and options vesting upon acquisition. Based on the Company's closing stock price of $20.74 on Tuesday, April 30, 2019, the consideration paid to acquire Hamilton totaled $50.8 million.
The fair value of assets acquired, excluding goodwill, totaled $494.0 million, including loans totaling $347.1 million. The fair value of liabilities assumed totaled $449.4 million, including deposits totaling $388.2 million. Goodwill represents consideration transferred in excess of the fair value of the net assets acquired. At May 1, 2019, the Company recognized $6.1 million in goodwill associated with the Hamilton acquisition. The goodwill resulting from the acquisition represents the value expected from the expansion of our market in the greater Baltimore area and the enhancement of our operations through client synergies and efficiencies, thereby providing enhanced client service. Goodwill acquired in the Hamilton acquisition is not deductible for tax purposes.
The Hamilton acquisition was accounted for using the acquisition method of accounting and, accordingly, purchased assets, including identifiable intangible assets, and assumed liabilities were recorded at their respective acquisition date fair values. The fair value measurements of assets acquired and liabilities assumed are subject to refinement for up to one year after the closing date of the acquisition as additional information relative to closing date fair values becomes available. The Company finalized the fair values of loans, intangible assets, other assets, income taxes and liabilities associated with Hamilton as of May 1, 2020. Measurement period adjustments made from the date of acquisition through May 1, 2020 are summarized in Note 7 - Goodwill and Other Intangible Assets. The results of operations for the Company include Hamilton's results from and after May 1, 2019.
The following table summarizes the consideration paid for Hamilton and the estimated fair values of the assets acquired and liabilities assumed at the acquisition date.
Fair value of consideration transferred:
Cash $ 14,197
Common stock issued 36,622
Total consideration transferred $ 50,819
Estimated fair values of assets acquired and liabilities assumed:
Cash and cash equivalents $ 43,140
Securities available for sale 60,882
Restricted investments in bank stocks 2,658
Loans 347,143
Premises and equipment 3,749
Core deposit intangible 4,550
Goodwill 6,132
Cash surrender value of life insurance 17,948
Deferred tax asset, net 7,257
ROU lease asset 2,793
Other assets 3,925
Total assets acquired $ 500,177
Deposits $ (388,246)
Borrowings (51,393)
Other liabilities (9,719)
Total liabilities assumed $ (449,358)
The determination of estimated fair values of the acquired loans required the Company to make certain estimates about discount rates, future expected cash flows, market conditions and other future events that are highly subjective in nature. Based on such factors as past due status, nonaccrual status, bankruptcy status, and credit risk ratings, the acquired loans were divided into loans with evidence of credit quality deterioration, which are accounted for under ASC 310-30 (purchased credit impaired), and loans that do not meet these criteria, which are accounted for under ASC 310-20 (purchased non-impaired). Expected cash flows, both principal and interest, were estimated based on key assumptions covering such factors as prepayments, default rates and severity of loss given default. These assumptions were developed using both Hamilton's historical experience and the portfolio characteristics as of the acquisition date as well as available market research. The fair value estimates for acquired loans were based on the amount and timing of expected principal, interest and other cash flows, including expected prepayments, discounted at prevailing market interest rates applicable to the types of acquired loans, which the Company considered to be level 3 fair value measurements. Deposit liabilities assumed in the Hamilton acquisition were segregated into two categories: time-deposits (i.e., deposit accounts with a stated maturity) and demand deposits, both using level 2 fair value measurements. In determining fair value of time deposits, the Company discounted the contractual cash flows of the deposit accounts using prevailing market interest rates for time deposit accounts of similar type and duration. For demand deposits, the acquisition date outstanding balance of the assumed demand deposit accounts approximates fair value. Acquisition date fair values for securities available for sale were determined using Level 1 or Level 2 inputs consistent with the methods discussed further in Note 20 - Fair Value. The remaining acquisition date fair values represent either Level 2 or Level 3 fair value measurements (premises and equipment and core deposit intangible).
The Company recognized a core deposit intangible of $4.6 million, which is being amortized using an accelerated method over a 10-year amortization period, consistent with expected future cash flows.
Loans acquired from Hamilton were measured at fair value at the acquisition date with no carryover of any ALL. Loans were segregated into those loans considered to be performing and those considered PCI. The following table presents performing and PCI loans acquired, by loan class, at May 1, 2019.
Upon completion of the Hamilton acquisition, the Company sold the acquired investment portfolio and paid off acquired borrowings at the indicated fair value amounts in conjunction with its asset/liability management strategies.
Performing PCI Total
Commercial real estate:
Owner-occupied $ 42,148 $ 5,894 $ 48,042
Non-owner occupied 45,401 770 46,171
Multi-family 10,773 - 10,773
Acquisition and development:
1-4 family residential construction 7,450 - 7,450
Commercial and land development 4,528 - 4,528
Commercial and industrial 32,316 1,914 34,230
Residential mortgage:
First lien 152,657 10,494 163,151
Home-equity - term 4,478 1 4,479
Home equity - lines of credit 13,657 - 13,657
Installment and other loans 14,467 195 14,662
Total loans acquired $ 327,875 $ 19,268 $ 347,143
The following table presents the fair value adjustments made to the amortized cost basis of loans acquired at May 1, 2019.
Gross amortized cost basis at acquisition $ 362,125
Market rate adjustment (5,309)
Credit fair value adjustment on non-credit impaired loans (3,947)
Credit fair value adjustment on impaired loans (5,726)
Estimated fair value of acquired loans $ 347,143
The market rate adjustment represents the movement in market interest rates, irrespective of credit adjustments, compared to the contractual rates of the acquired loans. The credit fair value adjustment made on non-credit impaired loans represents the changes in credit quality of the underlying borrowers from loan inception to the acquisition date. The credit fair value adjustment on PCI loans is derived in accordance with ASC 310-30 and represents the portion of the loan balance that has been deemed uncollectible based on our expectations of future cash flows for each respective loan.
The following table provides information about acquired PCI loans at May 1, 2019.
Contractually required principal and interest at acquisition $ 31,599
Contractual cash flows not expected to be collected (nonaccretable discount) (8,834)
Expected cash flows at acquisition 22,765
Interest component of expected cash flows (accretable discount) (3,497)
Estimated fair value of acquired PCI loans $ 19,268
Unaudited pro forma net income for the year ended December 31, 2019, would have totaled $20.9 million, and revenues would have totaled $102.5 million for the same period had the Hamilton acquisitions occurred January 1, 2019.
In connection with the Mercersburg and Hamilton acquisitions, the Company incurred merger related expenses. Mercersburg related merger expenses totaled $280 thousand during the year ended December 31, 2019. which is included in merger related and branch consolidation expenses on the consolidated statements of income. For December 31, 2019, the
expenses consisted primarily of $81 thousand of investment banking, legal and consulting fees; and $199 thousand of information systems expense, including canceling of contracts. Hamilton related merger expenses totaled $7.7 million for the year ended December 31, 2019, which is included in merger related and branch consolidation expenses on the consolidated statements of income. For December 31, 2019, these expenses consisted primarily $1.9 million of investment banking, legal and consulting fees; $3.7 million of information systems expense, including canceling of contracts; and $2.2 million of other expenses, including payout of employee termination contracts.
Branch Consolidation
During the year ended December 31, 2020, the Company recognized charges associated with the consolidation of six branch locations, the discontinuance of three loan production offices, a reduction in back-office real estate and staffing model adjustments. These actions were initiated due to evolving client preferences for the digital delivery of products and services. In addition, the anticipated future cost reductions resulting from these actions will prepare the Company for a challenging operating environment in 2021. A charge of $1.6 million was recorded in the year ended December 31, 2020, which included $1.3 million related to branch consolidations.
In October, 2019, the Company announced the consolidation of five branches in Franklin and Perry Counties, Pennsylvania, into other, larger branches of the Bank, as part of its ongoing evaluation of branch profitability. The Company also announced the sale/leaseback of an operations center facility to eliminate approximately 50,000 square feet of excess back office space. The branch consolidations were completed in January 2020, and the sale of the operations center facility was completed in the second quarter of 2020.
In conjunction with the consolidation and operations center facility sale/leaseback, the Company recorded $988 thousand in expenses in the fourth quarter of 2019, consisting of $762 thousand in fixed asset write downs, $126 thousand in lease termination costs, and $100 thousand in severance and other costs. At December 31, 2019, fixed assets included in this consolidation, with an estimated fair value of $4.9 million, were held for sale and carried in other assets on the consolidated balances sheets.
NOTE 3. INVESTMENT SECURITIES
At December 31, 2020 and 2019, all investment securities were classified as AFS. The following table summarizes amortized cost and fair value of AFS securities, and the corresponding amounts of gross unrealized gains and losses recognized in AOCI at December 31, 2020 and 2019.
Amortized
Cost
Gross
Unrealized
Gains
Gross
Unrealized
Losses
Fair Value
December 31, 2020
States and political subdivisions $ 104,704 $ 9,091 $ 1,125 $ 112,670
GSE residential MBSs 4,197 96 - 4,293
GSE residential CMOs
56,856 2,226 1,071 58,011
Non-agency CMOs 16,505 413 - 16,918
Private label commercial CMOs 63,941 57 1,762 62,236
Asset-backed 214,425 171 2,630 211,966
Other 371 - - 371
Totals $ 460,999 $ 12,054 $ 6,588 $ 466,465
December 31, 2019
States and political subdivisions $ 83,607 $ 4,288 $ 32 $ 87,863
GSE residential CMOs
67,928 1,000 774 68,154
Non-agency CMOs 17,210 - 123 17,087
Private label commercial CMOs 86,704 156 231 86,629
Asset-backed 235,406 138 5,029 230,515
Other 637 - - 637
Totals $ 491,492 $ 5,582 $ 6,189 $ 490,885
The following table summarizes investment securities with unrealized losses at December 31, 2020 and 2019, aggregated by major security type and length of time in a continuous unrealized loss position.
Less Than 12 Months 12 Months or More Total
# of Securities Fair
Value
Unrealized
Losses
# of Securities Fair
Value
Unrealized
Losses
# of Securities Fair
Value
Unrealized
Losses
December 31, 2020
States and political subdivisions
1 $ 9,079 $ 1,125 - $ - $ - 1 $ 9,079 $ 1,125
GSE residential CMOs
3 23,954 1,071 - - - 3 23,954 1,071
Private label commercial CMOs 1 4,314 685 10 42,403 1,077 11 46,717 1,762
Asset-backed 2 16,921 12 15 183,161 2,618 17 200,082 2,630
Totals
7 $ 54,268 $ 2,893 25 $ 225,564 $ 3,695 32 $ 279,832 $ 6,588
December 31, 2019
States and political subdivisions 1 $ 6,173 $ 32 - $ 0 $ 0 1 $ 6,173 $ 32
GSE residential CMOs
5 37,158 309 1 11,602 465 6 48,760 774
Non-agency CMOs 1 17,087 123 - - - 1 17,087 123
Private label commercial CMOs 6 26,079 67 8 39,726 164 14 65,805 231
Asset-backed 9 92,189 1,145 9 121,399 3,884 18 213,588 5,029
Totals
22 $ 178,686 $ 1,676 18 $ 172,727 $ 4,513 40 $ 351,413 $ 6,189
The Company determines whether unrealized losses are temporary in nature in accordance with FASB ASC 320-10, Investments - Overall, (“FASB ASC 320-10”) and FASB ASC 325-40, Investments - Beneficial Interests in Securitized Financial Assets, when applicable. The evaluation is based upon factors such as the creditworthiness of the underlying borrowers, performance of the underlying collateral, if applicable, and the level of credit support in the security structure. Management also evaluates other factors and circumstances that may be indicative of an OTTI condition. This includes, but is not limited to, an evaluation of the type of security, length of time and extent to which the fair value has been less than cost and near-term prospects of the issuer.
FASB ASC 320-10 requires the Company to assess if an OTTI exists by considering whether the Company has the intent to sell the security or it is more likely than not that it will be required to sell the security before recovery. If either of these situations applies, the guidance requires the Company to record an OTTI charge to earnings on debt securities for the difference between the amortized cost basis of the security and the fair value of the security. If neither of these situations applies, the Company is required to assess whether it is expected to recover the entire amortized cost basis of the security. If the Company is not expected to recover the entire amortized cost basis of the security, the guidance requires the Company to bifurcate the identified OTTI into a credit loss component and a component representing loss related to other factors. A discount rate is applied which equals the effective yield of the security. The difference between the present value of the expected flows and the amortized book value is considered a credit loss, which would be recorded through earnings as an OTTI charge. When a market price is not readily available, the market value of the security is determined using the same expected cash flows; the discount rate is a rate the Company determines from the open market and other sources as appropriate for the security. The difference between the market value and the present value of cash flows expected to be collected is recognized in accumulated other comprehensive loss on the consolidated statements of financial condition.
As of December 31, 2020, the Company had no cumulative OTTI. There were no OTTI charges recognized in earnings as a result of credit losses on investments in the years ended December 31, 2020, 2019 and 2018. During the year ended December 31, 2020, unrealized losses were substantially higher due to market uncertainty brought about by the COVID-19 pandemic. The sudden and desperate need for liquidity from many institutional pools of capital combined with the global economic implications of the COVID-19 pandemic caused significant widening of spreads.
State and Political Subdivisions. The unrealized losses presented in the table above have been caused by a widening of spreads and/or a rise in interest rates from the time these securities were purchased. Management considers the investment rating, the state of the issuer of the security and other credit support in determining whether the security is OTTI. As of December 31, 2020 and 2019, management concluded that an OTTI did not exist on any of the aforementioned securities based upon its assessment. Management also concluded that it does not intend to sell nor will it be required to sell the securities, before their recovery, which may be maturity, and management expects to recover the entire amortized cost basis of these securities.
GSE Residential CMOs. The unrealized losses presented in the table above have been caused by a widening of spreads and/or a rise in interest rates from the time these securities were purchased. The contractual terms of these securities do not permit the issuer to settle the securities at a price less than its par value basis. As of December 31, 2020 and 2019, management concluded that an OTTI did not exist on any of the aforementioned securities based upon its assessment. Management also concluded that it does not intend to sell nor will it be required to sell the securities, before their recovery, which may be maturity, and management expects to recover the entire amortized cost basis of these securities.
Non-agency CMOs. The unrealized losses presented in the table above were caused by a widening of spreads and/or a rise in interest rates from the time the securities were purchased. As of December 31, 2019, management concluded that an OTTI did not exist on any of the aforementioned securities based upon its assessment. Management also concluded that it does not intend to sell nor will it be required to sell the securities, before their recovery, which may be maturity, and management expects to recover the entire amortized cost basis of these securities.
Private Label Commercial CMOs and Asset-backed. The unrealized losses presented in the table above have been caused by a widening of spreads from the time the securities were purchased. Management considers the investment rating and other credit support in determining whether a security is other-than-temporarily impaired. Because the Company does not intend to sell these securities and it is not more likely than not that the Company will be required to sell them before recovery of their amortized cost basis, which may be maturity, the Company does not consider these securities to be OTTI at December 31, 2020 and 2019.
The following table summarizes amortized cost and fair value of investment securities by contractual maturity at December 31, 2020. Expected maturities may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties. Securities not due at a single maturity date are shown separately.
Amortized Cost Fair Value
Due in one year or less $ - $ -
Due after one year through five years 249 249
Due after five years through ten years 27,419 29,709
Due after ten years 77,407 83,083
CMOs and MBSs 141,499 141,458
Asset-backed 214,425 211,966
$ 460,999 $ 466,465
The following table summarizes proceeds from sales of investment securities and gross gains and gross losses for the years ended December 31, 2020, 2019 and 2018.
2020 2019 2018
Proceeds from sale of investment securities $ - $ 199,429 $ 156,364
Gross gains - 4,974 1,681
Gross losses 16 225 675
During the year ended December 31, 2020, a loss of $16 thousand was recorded to adjust an equity security to market value, compared to net investment security gains of $4.7 million and $1.0 million for years ended December 31, 2019 and 2018. Investment securities with a fair value of $398.7 million and $158.7 million at December 31, 2020 and 2019, respectively, were pledged to secure public funds and for other purposes as required or permitted by law.
NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES
The Company’s loan portfolio is grouped into classes to allow management to monitor the performance by the borrower and to monitor the yield on the portfolio. Consistent with ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Loan Losses, the segments are further broken down into classes to allow for differing risk characteristics within a segment.
The risks associated with lending activities differ among the various loan classes and are subject to the impact of changes in interest rates, market conditions of collateral securing the loans, and general economic conditions. All of these factors may adversely impact both the borrower’s ability to repay its loans and associated collateral.
The Company has various types of commercial real estate loans, which have differing levels of credit risk. Owner occupied commercial real estate loans are generally dependent upon the successful operation of the borrower’s business, with
the cash flows generated from the business being the primary source of repayment of the loan. If the business suffers a downturn in sales or profitability, the borrower’s ability to repay the loan could be in jeopardy.
Non-owner occupied and multi-family commercial real estate loans and non-owner occupied residential loans present a different credit risk to the Company than owner occupied commercial real estate loans, as the repayment of the loan is dependent upon the borrower’s ability to generate a sufficient level of occupancy to produce rental income that exceeds debt service requirements and operating expenses. Lower occupancy or lease rates may result in a reduction in cash flows, which hinders the ability of the borrower to meet debt service requirements, and may result in lower collateral values. The Company generally recognizes that greater risk is inherent in these credit relationships as compared to owner occupied loans mentioned above.
Acquisition and development loans consist of 1-4 family residential construction and commercial and land development loans. The risk of loss on these loans is largely dependent on the Company’s ability to assess the property’s value at the completion of the project, which should exceed the property’s construction costs. During the construction phase, a number of factors could potentially negatively impact the collateral value, including cost overruns, delays in completing the project, competition, and real estate market conditions which may change based on the supply of similar properties in the area. In the event the collateral value at the completion of the project is not sufficient to cover the outstanding loan balance, the Company must rely upon other repayment sources, if any, including the guarantors of the project or other collateral securing the loan.
Commercial and industrial loans include advances to local and regional businesses for general commercial purposes and include permanent and short-term working capital, machinery and equipment financing, and may be either in the form of lines of credit or term loans. Although commercial and industrial loans may be unsecured to our highest-rated borrowers, the majority of these loans are secured by the borrower’s accounts receivable, inventory and machinery and equipment. In a significant number of these loans, the collateral also includes the business real estate or the business owner’s personal real estate or assets. Commercial and industrial loans present credit exposure to the Company, as they are more susceptible to risk of loss during a downturn in the economy as borrowers may have greater difficulty in meeting their debt service requirements and the value of the collateral may decline. The Company attempts to mitigate this risk through its underwriting standards, including evaluating the creditworthiness of the borrower and, to the extent available, credit ratings on the business. Additionally, monitoring of the loans through annual renewals and meetings with the borrowers are typical. However, these procedures cannot eliminate the risk of loss associated with commercial and industrial lending. At December 31, 2020 and December 31, 2019, commercial and industrial loans include $403.3 million and $0, respectively, of loans, net of deferred fees and costs, originated through the U.S. Small Business Administration Paycheck Protection Program ("SBA PPP").
Municipal loans consist of extensions of credit to municipalities and school districts within the Company’s market area. These loans generally present a lower risk than commercial and industrial loans, as they are generally secured by the municipality’s full taxing authority, by revenue obligations, or by its ability to raise assessments on its clients for a specific utility.
The Company originates loans to its retail clients, including fixed-rate and adjustable first lien mortgage loans with the underlying 1-4 family owner occupied residential property securing the loan. The Company’s risk exposure is minimized in these types of loans through the evaluation of the creditworthiness of the borrower, including credit scores and debt-to-income ratios, and underwriting standards which limit the loan-to-value ratio to generally no more than 80% upon loan origination, unless the borrower obtains private mortgage insurance.
Home equity loans, including term loans and lines of credit, present a slightly higher risk to the Company than 1-4 family first liens, as these loans can be first or second liens on 1-4 family owner occupied residential property, but can have loan-to-value ratios of no greater than 90% of the value of the real estate taken as collateral. The creditworthiness of the borrower is considered including credit scores and debt-to-income ratios.
Installment and other loans’ credit risk are mitigated through prudent underwriting standards, including evaluation of the creditworthiness of the borrower through credit scores and debt-to-income ratios and, if secured, the collateral value of the assets. These loans can be unsecured or secured by assets the value of which may depreciate quickly or may fluctuate, and may present a greater risk to the Company than 1-4 family residential loans.
On March 27, 2020, the Coronavirus Aid, Relief and Economic Security (“CARES”) Act was enacted. The CARES Act established the SBA PPP. The SBA PPP is intended to provide economic relief to small businesses nationwide adversely impacted under the COVID-19 Emergency Declaration issued on March 13, 2020. The SBA PPP, which began on April 3, 2020, provides small businesses with funds to cover up to 24 weeks of payroll costs and other expenses, including benefits. It also provides for forgiveness of up to the full principal amount of qualifying loans. The Bank closed and funded almost 2,700 PPP loans for a total loan amount of $409.1 million in the year ended December 31, 2020. As these loans are 100% guaranteed by the SBA, there is no associated allowance for loan losses at December 31, 2020. These loans resulted in net fee income of $13.5 million to be recognized through net interest income over the life of the loans, which is between two and five years.
During the year ended December 31, 2020, the Company recognized $7.7 million of net deferred SBA PPP fees, included in interest income on loans on the condensed consolidated statements of income. At December 31, 2020, the Bank had $5.8 million of unrecognized SBA PPP net deferred fees. The timing of the recognition of these fees is dependent upon the forgiveness process established by the SBA. The Bank continues to closely monitor the SBA guidance regarding this process. The Bank is working on implementing the SBA's recently announced, streamlined forgiveness approval process, which is anticipated to make the forgiveness process easier for both borrowers and lenders.
In an effort to assist clients which were negatively impacted by the COVID-19 pandemic, the Bank offered various mitigation options, including a loan payment deferral program. Under this program, most commercial deferrals were for a 90-day period, while most consumer deferrals were for a 180-day period. Commercial and consumer deferrals totaled $15.7 million and $2.5 million, respectively, at December 31, 2020. In accordance with the revised Interagency Statement on Loan Modifications by Financial Institutions Working with Customers Affected by the Coronavirus issued on April 7, 2020, these deferrals are exempt from TDR status as they meet the specified requirements. In addition, modifications pursuant to the CARES Act do not represent TDRs.
The following table presents the loan portfolio by segment and class, excluding residential LHFS, at December 31, 2020 and December 31, 2019.
2020 2019
Commercial real estate:
Owner-occupied $ 174,908 $ 170,884
Non-owner occupied 409,567 361,050
Multi-family 113,635 106,893
Non-owner occupied residential 114,505 120,038
Acquisition and development:
1-4 family residential construction 9,486 15,865
Commercial and land development 51,826 41,538
Commercial and industrial (1)
647,368 214,554
Municipal 20,523 47,057
Residential mortgage:
First lien 244,321 336,372
Home equity - term 10,169 14,030
Home equity - lines of credit 157,021 165,314
Installment and other loans 26,361 50,735
Total loans $ 1,979,690 $ 1,644,330
(1) This balance includes $403.3 million and $0 of SBA PPP loans, net of deferred fees and costs, at December 31, 2020 and December 31, 2019, respectively.
In order to monitor ongoing risk associated with its loan portfolio and specific loans within the segments, management uses an internal grading system. The first several rating categories, representing the lowest risk to the Bank, are combined and given a “Pass” rating. Management generally follows regulatory definitions in assigning criticized ratings to loans, including "Special Mention," "Substandard," "Doubtful" or "Loss." The Special Mention category includes loans that have potential weaknesses that may, if not monitored or corrected, weaken the asset or inadequately protect the Bank's position at some future date. These assets pose elevated risk, but their weakness does not yet justify a more severe, or classified rating. Substandard loans are classified as they have a well-defined weakness, or weaknesses that jeopardize liquidation of the debt. These loans are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Substandard loans include loans that management has determined not to be impaired, as well as loans considered to be impaired. A Doubtful loan has a high probability of total or substantial loss, but because of specific pending events that may strengthen the asset, its classification as Loss is deferred. Loss loans are considered uncollectible, as the borrowers are often in bankruptcy, have suspended debt repayments, or have ceased business operations. Once a loan is classified as Loss, there is little prospect of collecting the loan’s principal or interest and it is charged-off.
The following summarizes the Company’s loan portfolio ratings based on its internal risk rating system at December 31, 2020 and 2019:
Pass Special
Mention
Non-Impaired
Substandard
Impaired -
Substandard
Doubtful PCI Loans Total
December 31, 2020
Commercial real estate:
Owner-occupied $ 148,846 $ 12,491 $ 7,855 $ 3,260 $ - $ 2,456 $ 174,908
Non-owner occupied 351,860 57,378 - - - 329 409,567
Multi-family 92,769 20,224 642 - - - 113,635
Non-owner occupied residential 107,557 3,948 1,422 268 - 1,310 114,505
Acquisition and development:
1-4 family residential construction 9,101 385 - - - - 9,486
Commercial and land development 49,832 655 525 814 - - 51,826
Commercial and industrial 617,213 17,561 6,118 3,639 - 2,837 647,368
Municipal 20,523 - - - - - 20,523
Residential mortgage:
First lien 236,381 - - 2,628 - 5,312 244,321
Home equity - term 10,076 - 64 10 - 19 10,169
Home equity - lines of credit 156,264 95 54 608 - - 157,021
Installment and other loans 26,283 - - 17 - 61 26,361
$ 1,826,705 $ 112,737 $ 16,680 $ 11,244 $ - $ 12,324 $ 1,979,690
December 31, 2019
Commercial real estate:
Owner-occupied $ 151,161 $ 4,513 $ 3,163 $ 5,872 $ - $ 6,175 $ 170,884
Non-owner occupied 342,753 17,152 - - - 1,145 361,050
Multi-family 100,361 4,822 682 345 - 683 106,893
Non-owner occupied residential 111,697 4,534 1,115 235 - 2,457 120,038
Acquisition and development:
1-4 family residential construction
15,865 - - - - - 15,865
Commercial and land development 39,939 206 1,393 - - - 41,538
Commercial and industrial 198,951 1,133 8,899 1,763 - 3,808 214,554
Municipal 42,649 4,408 - - - - 47,057
Residential mortgage:
First lien 323,040 978 - 2,590 - 9,764 336,372
Home equity - term 13,774 74 149 13 - 20 14,030
Home equity - lines of credit 164,469 74 38 733 - - 165,314
Installment and other loans 50,497 - - 85 - 153 50,735
$ 1,555,156 $ 37,894 $ 15,439 $ 11,636 $ - $ 24,205 $ 1,644,330
For commercial real estate, acquisition and development, and commercial and industrial loans, a loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Generally, loans that are more than 90 days past due are deemed impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed to determine if the loan should be placed on nonaccrual status. Nonaccrual loans in the commercial and commercial real estate portfolios and any TDRs are, by definition, deemed to be impaired. Impairment is measured on a loan-by-loan basis for commercial, construction and restructured loans by either the present value of the expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. A loan is collateral dependent if the repayment of the loan is expected to be provided solely by the underlying collateral. For loans that are deemed to be impaired for extended periods of time, periodic updates on fair values are obtained, which may include updated appraisals. Updated fair values are incorporated into the impairment analysis in the next reporting period.
Loan charge-offs, which may include partial charge-offs, are taken on an impaired loan that is collateral dependent if the loan’s carrying balance exceeds its collateral’s appraised value, the loan has been identified as uncollectible, and it is deemed to be a confirmed loss. Typically, impaired loans with a charge-off or partial charge-off will continue to be considered impaired, unless the note is split into two and management expects the performing note to continue to perform and the loan is adequately secured. The second, or non-performing note, would be charged-off. Generally, an impaired loan with a partial charge-off may continue to have an impairment reserve on it after the partial charge-off, if factors warrant.
At December 31, 2020 and 2019, nearly all of the Company’s loan impairments were measured based on the estimated fair value of the collateral securing the loan, except for TDRs. By definition, TDRs are considered impaired. All TDR impairment analyses are initially based on discounted cash flows for those loans. For real estate loans, collateral generally consists of commercial real estate, but in the case of commercial and industrial loans, it could also consist of accounts receivable, inventory, equipment or other business assets. Commercial and industrial loans may also have real estate collateral.
Updated appraisals are generally required every 18 months for classified commercial loans in excess of $250 thousand. The “as is" value provided in the appraisal is often used as the fair value of the collateral in determining impairment, unless circumstances, such as subsequent improvements or approvals, dictate that another value provided by the appraiser is more appropriate.
Generally, impaired commercial loans secured by real estate, other than new and performing TDRs, are measured at fair value using certified real estate appraisals that had been completed within the last 18 months. Appraised values are discounted for estimated costs to sell the property and other selling considerations to arrive at the property’s fair value. In those situations, in which it is determined an updated appraisal is not required for loans individually evaluated for impairment, fair values are based on either an existing appraisal or a discounted cash flow analysis as determined by management. The approaches are discussed below:
•Existing appraisal - if the existing appraisal provides a strong loan-to-value ratio (generally 70% or lower) and, after consideration of market conditions and knowledge of the property and area, it is determined by the Credit Administration staff that there has not been a significant deterioration in the collateral value, the existing certified appraised value may be used. Discounts to the appraised value, as deemed appropriate for selling costs, are factored into the fair value.
•Discounted cash flows - in limited cases, discounted cash flows may be used on projects in which the collateral is liquidated to reduce the borrowings outstanding, and is used to validate collateral values derived from other approaches.
Collateral on certain impaired loans is not limited to real estate, and may consist of accounts receivable, inventory, equipment or other business assets. Estimated fair values may be determined based on borrowers’ financial statements, inventory ledgers, accounts receivable agings or appraisals from individuals with knowledge in the business. Stated balances are generally discounted for the age of the financial information or the quality of the assets. In determining fair value, liquidation discounts are applied to this collateral based on existing loan valuation policies.
The Company distinguishes substandard loans on both an impaired and non-impaired basis, as it places less emphasis on a loan’s classification, and increased reliance on whether the loan was performing in accordance with the contractual terms. A substandard classification does not automatically meet the definition of impaired. Loss potential, while existing in the aggregate amount of substandard loans, does not have to exist in individual extensions of credit classified as substandard. As a result, the
Company’s methodology includes an evaluation of certain accruing commercial real estate, acquisition and development, and commercial and industrial loans rated substandard to be collectively evaluated for impairment. Although the Company believes these loans meet the definition of substandard, they are generally performing and management has concluded that it is likely the Company will be able to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement.
Larger groups of smaller balance homogeneous loans are collectively evaluated for impairment. Generally, the Company does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement due to financial difficulties of the borrower.
The following table, which excludes PCI loans, summarizes impaired loans by segment and class, segregated by those for which a specific allowance was required and those for which a specific allowance was not required at December 31, 2020 and 2019. The recorded investment in loans excludes accrued interest receivable due to insignificance. Related allowances established generally pertain to those loans in which loan forbearance agreements were in the process of being negotiated or updated appraisals were pending and any partial charge-off will be recorded when final information is received.
Impaired Loans with a Specific Allowance Impaired Loans with No Specific Allowance
Recorded
Investment
(Book Balance)
Unpaid
Principal Balance
(Legal Balance)
Related
Allowance
Recorded
Investment
(Book Balance)
Unpaid
Principal Balance
(Legal Balance)
December 31, 2020
Commercial real estate:
Owner-occupied $ - $ - $ - $ 3,260 $ 4,091
Non-owner occupied residential - - - 268 393
Acquisition and development:
Commercial and land development - - - 814 875
Commercial and industrial - - - 3,639 4,269
Residential mortgage:
First lien 424 508 33 2,204 3,264
Home equity-term - - - 10 13
Home equity-lines of credit - - - 608 832
Installment and other loans - - - 17 18
$ 424 $ 508 $ 33 $ 10,820 $ 13,755
December 31, 2019
Commercial real estate:
Owner-occupied $ - $ - $ - $ 5,872 $ 8,086
Multi-family - - - 345 569
Non-owner occupied residential - - - 235 422
Commercial and industrial - - - 1,763 3,361
Residential mortgage:
First lien 425 425 36 2,165 3,164
Home equity-term - - - 13 15
Home equity-lines of credit - - - 733 1,077
Installment and other loans - - - 85 97
$ 425 $ 425 $ 36 $ 11,211 $ 16,791
The following table, which excludes PCI loans, summarizes the average recorded investment in impaired loans and related recognized interest income for the years ended December 31, 2020, 2019 and 2018.
2020 2019 2018
Average
Impaired
Balance
Interest
Income
Recognized
Average
Impaired
Balance
Interest
Income
Recognized
Average
Impaired
Balance
Interest
Income
Recognized
Commercial real estate:
Owner-occupied $ 4,636 $ 1 $ 2,455 $ 2 $ 1,495 $ 2
Non-owner occupied 83 - 46 - 1,842 -
Multi-family 205 - 152 - 148 -
Non-owner occupied residential 388 - 217 - 346 -
Acquisition and development:
1-4 family residential construction - - - - 181 -
Commercial and land development 641 - 21 - 1 -
Commercial and industrial 1,196 - 683 - 322 -
Residential mortgage:
First lien 2,995 48 2,582 50 3,234 59
Home equity - term 11 - 13 - 19 -
Home equity - lines of credit 692 1 750 2 657 2
Installment and other loans 25 - 13 - 4 -
$ 10,872 $ 50 $ 6,932 $ 54 $ 8,249 $ 63
The following table presents impaired loans that are TDRs, with the recorded investment at December 31, 2020 and 2019.
2020 2019
Number of
Contracts
Recorded
Investment
Number of
Contracts
Recorded
Investment
Accruing:
Commercial real estate:
Owner-occupied 1 $ 28 1 $ 30
Residential mortgage:
First lien 9 898 9 931
Home equity - lines of credit 1 8 1 18
11 934 11 979
Nonaccruing:
Commercial real estate:
Owner-occupied - - 4 1,909
Residential mortgage:
First lien 5 320 5 359
5 320 9 2,268
16 $ 1,254 20 $ 3,247
The following table presents the number of loans modified as TDRs, and their pre-modification and post-modification investment balances for the year ended December 31, 2019. There were no loans modified as TDRs during 2020 and 2018.
Number of
Contracts
Pre-
Modification
Investment
Balance
Post-
Modification
Investment
Balance
December 31, 2019
Commercial real estate:
Owner occupied 3 $ 1,866 $ 1,881
The loans presented in the table above were considered TDRs as a result of the Company agreeing to below market interest rates given the risk of the transaction; allowing the loan to remain on interest only status; or a reduction in interest rates, in order to give the borrowers an opportunity to improve their cash flows. For new and accruing TDRs, impairment is generally assessed using a discounted cash flow analysis. For TDRs in default of their modified terms, impairment is generally determined on a collateral dependent approach. Certain loans modified during a period may no longer be outstanding at the end of the period if the loan was paid off.
Management further monitors the performance and credit quality of the loan portfolio by analyzing the length of time a portfolio is past due, by aggregating loans based on their delinquencies. The following table presents the classes of the loan portfolio summarized by aging categories of performing loans and nonaccrual loans at December 31, 2020 and 2019.
Days Past Due
Current 30-59 60-89 90+
(still accruing)
Total
Past Due
Non-
Accrual
Total
Loans
December 31, 2020
Commercial real estate:
Owner-occupied $ 168,262 $ 958 $ - $ - $ 958 $ 3,232 $ 172,452
Non-owner occupied 409,130 108 - - 108 - 409,238
Multi-family 113,635 - - - - - 113,635
Non-owner occupied residential 112,443 484 - - 484 268 113,195
Acquisition and development:
1-4 family residential construction 9,486 - - - - - 9,486
Commercial and land development 50,922 32 58 - 90 814 51,826
Commercial and industrial 640,573 9 310 - 319 3,639 644,531
Municipal 19,677 846 - - 846 - 20,523
Residential mortgage:
First lien 230,903 5,758 535 83 6,376 1,730 239,009
Home equity - term 10,099 40 - 1 41 10 10,150
Home equity - lines of credit 156,153 268 - - 268 600 157,021
Installment and other loans 26,052 168 49 14 231 17 26,300
Subtotal 1,947,335 8,671 952 98 9,721 10,310 1,967,366
Loans acquired with credit deterioration:
Commercial real estate:
Owner-occupied 2,456 - - - - - 2,456
Non-owner occupied 329 - - - - - 329
Non-owner occupied residential
1,161 - - 149 149 - 1,310
Commercial and industrial 2,837 - - - - - 2,837
Residential mortgage:
First lien 4,341 655 9 307 971 - 5,312
Home equity - term 19 - - - - - 19
Installment and other loans 57 4 - - 4 - 61
Subtotal 11,200 659 9 456 1,124 - 12,324
$ 1,958,535 $ 9,330 $ 961 $ 554 $ 10,845 $ 10,310 $ 1,979,690
Days Past Due
Current 30-59 60-89 90+
(still accruing)
Total
Past Due
Non-
Accrual
Total
Loans
December 31, 2019
Commercial real estate:
Owner-occupied $ 158,723 $ 144 $ - $ - $ 144 $ 5,842 $ 164,709
Non-owner occupied 359,425 480 - - 480 - 359,905
Multi-family 105,865 - - - - 345 106,210
Non-owner occupied residential 116,370 841 66 69 976 235 117,581
Acquisition and development:
1-4 family residential construction 15,587 278 - - 278 - 15,865
Commercial and land development 40,403 1,135 - - 1,135 - 41,538
Commercial and industrial 208,668 315 - - 315 1,763 210,746
Municipal 47,057 - - - - - 47,057
Residential mortgage:
First lien 314,473 9,092 1,234 150 10,476 1,659 326,608
Home equity - term 13,993 - 4 - 4 13 14,010
Home equity - lines of credit 163,907 417 275 - 692 715 165,314
Installment and other loans 50,224 236 37 - 273 85 50,582
Subtotal 1,594,695 12,938 1,616 219 14,773 10,657 1,620,125
Loans acquired with credit deterioration:
Commercial real estate:
Owner-occupied 6,015 - 129 31 160 - 6,175
Non-owner occupied 564 - - 581 581 - 1,145
Multi-family 683 - - - - - 683
Non-owner occupied residential 1,710 105 111 531 747 - 2,457
Commercial and industrial 3,792 - - 16 16 - 3,808
Residential mortgage:
First lien 6,308 1,857 745 854 3,456 - 9,764
Home equity - term 16 4 - - 4 - 20
Installment and other loans 131 22 - - 22 - 153
Subtotal 19,219 1,988 985 2,013 4,986 - 24,205
$ 1,613,914 $ 14,926 $ 2,601 $ 2,232 $ 19,759 $ 10,657 $ 1,644,330
The Company maintains its ALL at a level management believes adequate for probable incurred credit losses. The ALL is established and maintained through a provision for loan losses charged to earnings. On a quarterly basis, management assesses the adequacy of the ALL utilizing a defined methodology which considers specific credit evaluation of impaired loans as discussed above, historical loan loss experience, and qualitative factors. Management believes its approach properly addresses relevant accounting guidance for loans individually identified as impaired and for loans collectively evaluated for impairment, and other bank regulatory guidance.
In connection with its quarterly evaluation of the adequacy of the ALL, management reviews its methodology to determine if it properly addresses the current risk in the loan portfolio. For each loan class, general allowances based on quantitative factors, principally historical loss trends, are provided for loans that are collectively evaluated for impairment. An adjustment to historical loss factors may be incorporated for delinquency and other potential risk not elsewhere defined within the ALL methodology.
In addition to this quantitative analysis, adjustments to the ALL requirements are allocated on loans collectively evaluated for impairment based on additional qualitative factors, including:
Nature and Volume of Loans - including loan growth in the current and subsequent quarters based on the Company’s targeted growth and strategic plan, coupled with the types of loans booked based on risk management and credit culture; the number of exceptions to loan policy; and supervisory loan to value exceptions.
Concentrations of Credit and Changes within Credit Concentrations - including the composition of the Company’s overall portfolio makeup and management's evaluation related to concentration risk management and the inherent risk associated with the concentrations identified.
Underwriting Standards and Recovery Practices - including changes to underwriting standards and perceived impact on anticipated losses; trends in the number of exceptions to loan policy; supervisory loan to value exceptions; and administration of loan recovery practices.
Delinquency Trends - including delinquency percentages noted in the portfolio relative to economic conditions; severity of the delinquencies; and whether the ratios are trending upwards or downwards.
Classified Loans Trends - including internal loan ratings of the portfolio; severity of the ratings; whether the loan segment’s ratings show a more favorable or less favorable trend; and underlying market conditions and impact on the collateral values securing the loans.
Experience, Ability and Depth of Management/Lending staff - including the years’ experience of senior and middle management and the lending staff; turnover of the staff; and instances of repeat criticisms of ratings.
Quality of Loan Review - including the years of experience of the loan review staff; in-house versus outsourced provider of review; turnover of staff and the perceived quality of their work in relation to other external information.
National and Local Economic Conditions - including trends in the consumer price index, unemployment rates, the housing price index, housing statistics compared to the prior year, bankruptcy rates, regulatory and legal environment risks and competition. During the year ended December 31, 2020, this factor was increased for the commercial and consumer portfolios to account for the negative economic impact of the COVID-19 pandemic.
COVID-19 - during the year ended December 31, 2020, a qualitative allocation was implemented associated with the potential impact of the COVID-19 pandemic on the Company's commercial loan portfolio. The factor assumes downgrades of loans which were granted deferrals or forbearances based upon identified hardships resulting from the economic shutdown driven by the pandemic. The qualitative reserve on these loans will be reduced over time as sustained performance is demonstrated after the loans are removed from deferral status or the forbearance period has ended.
The following table presents activity in the ALL for the years ended December 31, 2020, 2019 and 2018.
Commercial Consumer
Commercial
Real Estate
Acquisition
and
Development
Commercial
and
Industrial
Municipal Total Residential
Mortgage
Installment
and Other
Total Unallocated Total
December 31, 2020
Balance, beginning of year
$ 7,634 $ 959 $ 2,356 $ 100 $ 11,049 $ 3,147 $ 319 $ 3,466 $ 140 $ 14,655
Provision for loan losses 2,745 146 2,096 (60) 4,927 203 117 320 78 5,325
Charge-offs (3) - (748) - (751) (114) (146) (260) - (1,011)
Recoveries 775 9 238 - 1,022 126 34 160 - 1,182
Balance, end of year
$ 11,151 $ 1,114 $ 3,942 $ 40 $ 16,247 $ 3,362 $ 324 $ 3,686 $ 218 $ 20,151
December 31, 2019
Balance, beginning of year
$ 6,876 $ 817 $ 1,656 $ 98 $ 9,447 $ 3,753 $ 244 $ 3,997 $ 570 $ 14,014
Provision for loan losses 515 139 841 2 1,497 (347) 180 (167) (430) 900
Charge-offs (25) - (299) - (324) (386) (155) (541) - (865)
Recoveries 268 3 158 - 429 127 50 177 - 606
Balance, end of year
$ 7,634 $ 959 $ 2,356 $ 100 $ 11,049 $ 3,147 $ 319 $ 3,466 $ 140 $ 14,655
December 31, 2018
Balance, beginning of year
$ 6,763 $ 417 $ 1,446 $ 84 $ 8,710 $ 3,400 $ 211 $ 3,611 $ 475 $ 12,796
Provision for loan losses (442) 396 209 14 177 363 165 528 95 800
Charge-offs (17) (7) - - (24) (148) (292) (440) - (464)
Recoveries 572 11 1 - 584 138 160 298 - 882
Balance, end of year
$ 6,876 $ 817 $ 1,656 $ 98 $ 9,447 $ 3,753 $ 244 $ 3,997 $ 570 $ 14,014
The following table summarizes the ending loan balances individually evaluated for impairment based upon loan segment, as well as the related ALL loss allocation for each at December 31, 2020 and 2019. PCI loans are excluded from loans individually evaluated for impairment.
Commercial Consumer
Commercial
Real Estate
Acquisition
and
Development
Commercial
and
Industrial
Municipal Total Residential
Mortgage
Installment
and Other
Total Unallocated Total
December 31, 2020
Loans allocated by:
Individually evaluated for impairment
$ 3,528 $ 814 $ 3,639 $ - $ 7,981 $ 3,246 $ 17 $ 3,263 $ - $ 11,244
Collectively evaluated for impairment
809,087 60,498 643,729 20,523 1,533,837 408,265 26,344 434,609 - 1,968,446
$ 812,615 $ 61,312 $ 647,368 $ 20,523 $ 1,541,818 $ 411,511 $ 26,361 $ 437,872 $ - $ 1,979,690
Allowance for loan losses allocated by:
Individually evaluated for impairment
$ - $ - $ 1 $ - $ 1 $ 33 $ - $ 33 $ - $ 34
Collectively evaluated for impairment
11,151 1,114 3,941 40 16,246 3,329 324 3,653 218 20,117
$ 11,151 $ 1,114 $ 3,942 $ 40 $ 16,247 $ 3,362 $ 324 $ 3,686 $ 218 $ 20,151
December 31, 2019
Loans allocated by:
Individually evaluated for impairment
$ 6,452 $ - $ 1,763 $ - $ 8,215 $ 3,336 $ 85 $ 3,421 $ - $ 11,636
Collectively evaluated for impairment
752,413 57,403 212,791 47,057 1,069,664 512,380 50,650 563,030 - 1,632,694
$ 758,865 $ 57,403 $ 214,554 $ 47,057 $ 1,077,879 $ 515,716 $ 50,735 $ 566,451 $ - $ 1,644,330
Allowance for loan losses allocated by:
Individually evaluated for impairment
$ - $ - $ - $ - $ - $ 36 $ - $ 36 $ - $ 36
Collectively evaluated for impairment
7,634 959 2,356 100 11,049 3,111 319 3,430 140 14,619
$ 7,634 $ 959 $ 2,356 $ 100 $ 11,049 $ 3,147 $ 319 $ 3,466 $ 140 $ 14,655
The following table provides activity for the accretable yield of purchased impaired loans for the years ended December 31, 2020 and 2019.
2020 2019
Accretable yield, beginning of period $ 6,950 $ 2,065
Additions (1)
570 3,497
Accretion of income (3,457) (2,336)
Reclassifications from nonaccretable difference due to improvement in expected cash flows 1,871 2,444
Other changes, net (2)
(2,496) 1,280
Accretable yield, end of period $ 3,438 $ 6,950
(1) The amount for the year ended December 31, 2020 reflects a measurement period adjustment for Hamilton loans that should have been in the PCI pool at the acquisition date. The amount for the year ended December 31, 2019 reflects loans acquired from Hamilton.
(2) The amount for the year ended December 31, 2020 represents the impact of purchased credit impaired loans sold during that year.
NOTE 5. PREMISES AND EQUIPMENT
The following table summarizes premises and equipment at December 31, 2020 and 2019.
2020 2019
Land $ 8,586 $ 8,786
Buildings and improvements 27,569 27,520
Leasehold improvements 6,570 6,216
Furniture and equipment 23,254 22,293
Construction in progress 115 593
66,094 65,408
Less accumulated depreciation 30,945 27,884
$ 35,149 $ 37,524
Depreciation expense totaled $3.2 million, $2.7 million, and $2.6 million for the years ended December 31, 2020, 2019 and 2018, respectively.
NOTE 6. LEASES
A lease provides the lessee the right to control the use of an identified asset for a period of time in exchange for consideration. The Company has primarily entered into operating leases for branches and office space. Most of the Company's leases contain renewal options, which the Company is reasonably certain to exercise. Including renewal options, the Company's leases range from three to 33 years. Operating lease right-of-use assets and lease liabilities are included in other assets and accrued interest and other liabilities on the Company's consolidated balance sheets.
The Company uses its incremental borrowing rate to determine the present value of the lease payments, as the rate implicit in the Company's leases is not readily determinable. Lease agreements that contain non-lease components are generally accounted for as a single lease component, while variable costs, such as common area maintenance expenses and property taxes, are expensed as incurred.
The following table summarizes the Company's right-of-use assets and related lease liabilities for the year ended December 31, 2020 and 2019.
December 31, 2020 December 31, 2019
Operating lease ROU assets $ 8,686 $ 9,222
Operating lease ROU liabilities 9,143 9,688
Weighted-average remaining lease term (in years) 16.8 17.6
Weighted-average discount rate 4.3 % 4.5 %
The following table presents information related to the Company's operating leases for the years ended December 31, 2020 and 2019:
December 31, 2020 December 31, 2019
Cash paid for operating lease liabilities $ 1,202 $ 1,122
Operating lease expense 1,620 1,405
The following table presents maturities of the Company's lease liabilities by year.
2021 $ 1,208
2022 785
2023 807
2024 827
2025 839
Thereafter 9,449
13,915
Less: imputed interest 4,772
Total lease liabilities $ 9,143
NOTE 7. GOODWILL AND OTHER INTANGIBLE ASSETS
The following table presents changes in goodwill for the years ended December 31, 2020 and 2019.
2020 2019
Balance, beginning of year $ 19,925 $ 12,592
Acquired goodwill - 7,029
Adjustments to acquired goodwill (1)
(1,201) 304
Balance, end of year $ 18,724 $ 19,925
(1) The Company finalized its purchase accounting adjustments associated with Hamilton as of May 1, 2020.
Goodwill is not amortized but is reviewed for potential impairment on at least an annual basis, with testing between annual tests if an event occurs or circumstances change that could potentially reduce the fair value of a reporting unit.
The Company typically completes its annual goodwill impairment assessment as of November 30. Due to the severe economic impact of COVID-19 and a resulting sustained decline in the Company's market value below book value, management performed a quantitative Step 1 impairment analysis of its goodwill to determine whether the Company's goodwill was impaired as of August 31, 2020. This analysis, which was performed in accordance with ASU 2017-04, Intangibles-Goodwill and Other, considered several factors, such as future cash flow projections and estimated market acquisition premiums in its analysis. In performing the analysis, management made several assumptions with respect to future operating performance, economic and market conditions and various others, many of which require significant judgment. The analysis performed and the related assumptions reflect the best currently available estimates and judgements regarding future performance of the Company. It was concluded that no impairment existed at August 31, 2020 as the calculated fair value of the reporting unit exceeded its book value. No changes occurred that would impact the results of that analysis through December 31, 2020.
The following tables present changes in and components of other intangible assets for the years ended December 31, 2020 and 2019.
2020 2019
Balance, beginning of year $ 7,180 $ 3,910
Acquired CDI - 4,550
Non-compete agreement - 290
Amortization expense (1,569) (1,570)
Impairment (153) -
Balance, end of year $ 5,458 $ 7,180
2020 2019
Gross Carrying Amount Accumulated Amortization Gross Carrying Amount Accumulated Amortization
Amortized intangible assets:
Core deposit intangibles $ 8,390 $ 2,935 $ 8,390 $ 1,493
Other client relationship intangibles 25 22 524 338
Non-compete agreement - - 290 193
Total $ 8,415 $ 2,957 $ 9,204 $ 2,024
During the year ended December 31, 2020, other client relationship intangibles with a gross carrying amount of $149 thousand were fully amortized and there was a further reduction of the gross carrying amount of $350 thousand due to the dissolution of Wheatland which resulted in an impairment charge of $153 thousand.
The following table presents future estimated aggregate amortization expense at December 31, 2020.
2021 $ 1,275
2022 1,105
2023 935
2024 766
2025 596
Thereafter 781
$ 5,458
The Company incurred amortization expense of $1.6 million, $1.6 million and $286 thousand, respectively, in the years ending December 31, 2020, 2019 and 2018.
NOTE 8. INCOME TAXES
The Company files income tax returns in the U.S. federal jurisdiction, the Commonwealth of Pennsylvania and the State of Maryland. The Company is no longer subject to tax examination by tax authorities for years before 2017.
The following table summarizes income tax expense for the years ended December 31, 2020, 2019 and 2018.
2020 2019 2018
Current expense $ 6,602 $ 934 $ 1,097
Deferred expense (554) 1,776 543
Income tax expense $ 6,048 $ 2,710 $ 1,640
The following table reconciles the Company's effective income tax rate to its statutory federal rate for the years ended December 31, 2020, 2019 and 2018.
2020 2019 2018
Statutory federal tax rate 21.0 % 21.0 % 21.0 %
Increase (decrease) resulting from:
State taxes, net of federal benefit 1.0 % (0.1) % - %
Tax exempt interest income (2.0) % (4.2) % (7.7) %
Income from life insurance (1.1) % (1.7) % (1.7) %
Disallowed interest expense 0.1 % 0.3 % 0.8 %
Low-income housing credits and related expense (0.8) % (1.3) % (2.5) %
Merger related - % 0.7 % 0.6 %
Other 0.4 % (0.9) % 0.9 %
Effective income tax rate 18.6 % 13.8 % 11.4 %
Income tax expense includes $3 thousand related to net security losses for the year ended December 31, 2020 and $997 thousand and $211 thousand related to net security gains for the years ended December 31, 2019, and 2018, respectively.
The Company recognizes, when applicable, interest and penalties related to unrecognized tax benefits in the provision for income taxes in the results of operations. There were no penalties or interest related to income taxes recorded in the consolidated income statements for the years ended December 31, 2020, 2019 and 2018 and no amounts accrued for penalties at December 31, 2020 and 2019.
The following table summarizes the Company's deferred tax assets and liabilities at December 31, 2020, and 2019.
2020 2019
Deferred tax assets:
Allowance for loan losses $ 4,457 $ 3,418
Deferred compensation 578 415
Retirement and salary continuation plans 2,536 2,357
Share-based compensation 735 631
Off-balance sheet reserves 345 234
Nonaccrual loan interest 395 697
Deferred loan fees 1,483 153
Net unrealized losses on securities available for sale - 127
Net unrealized losses on interest rate swaps 258 -
Purchase accounting adjustments 1,886 4,081
Bonus accrual 622 493
ROU liability 2,003 2,123
Net operating loss carryforward 2,472 1,872
Other 448 417
Total deferred tax assets 18,218 17,018
Deferred tax liabilities:
Depreciation 74 452
Net unrealized gains on securities available for sale 1,148 -
Mortgage servicing rights 614 694
Purchase accounting adjustments 1,206 1,599
ROU Asset 1,903 2,021
Other 340 275
Total deferred tax liabilities 5,285 5,041
Net deferred tax asset, included in other assets $ 12,933 $ 11,977
At December 31, 2020, the Company had acquired federal and state net operating loss carryforwards of $11.2 million and $9.0 million, respectively, subject to annual loss limitation limits, that expire beginning in 2033. A deferred tax asset is recognized for these carryforwards because the benefit is more likely than not to be realized.
FASB ASC 740, Income Taxes, (“ASC 740”) clarifies the accounting for income taxes by prescribing a minimum probability threshold that a tax position must meet before a financial statement benefit is recognized. The minimum threshold is defined in ASC 740 as a tax position that is more likely than not to be sustained upon examination by the applicable taxing authority, including resolution of any related appeals or litigation processes, based on the technical merits of the position. The tax benefit to be recognized is measured as the largest amount of benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. ASC 740 was applied to all existing tax positions upon initial adoption. There was no liability for uncertain tax positions and no known unrecognized tax benefits at December 31, 2020 or 2019.
NOTE 9. RETIREMENT PLANS
The Company maintains a 401(k) profit-sharing plan for all qualified employees. Employees are eligible to participate in the 401(k) profit-sharing plan following completion of one month of service and attaining age 18. Pursuant to the 401(k) profit-sharing plan, employees can contribute up to the lesser of $57 thousand, or 100% of their compensation. Substantially all of the Company’s employees are covered by the plan, which contains limited match or safe harbor provisions. The Company will match 50% of the first 6% of the base contribution that an employee contributes. The Company’s match is immediately vested and paid at the end of the year. Employer contributions to the plan are based on the performance of the Company and are at the discretion of the Board of Directors. Employer contribution expense totaled $626 thousand, $590 thousand and $479 thousand for the years ended December 31, 2020, 2019, and 2018, respectively.
The Company has deferred compensation agreements with certain present and former directors, whereby a director or his beneficiaries will receive a monthly retirement benefit beginning at age 65. The arrangement is funded by an amount of life insurance on the participating director, which is calculated to meet the Company’s obligations under the compensation agreement. The cash value of the life insurance policies is an unrestricted asset of the Company. The estimated present value of future benefits to be paid totaled $53 thousand and $68 thousand at December 31, 2020 and 2019, respectively. Expense for this plan totaled $7 thousand, $8 thousand and $9 thousand for the years ended December 31, 2020, 2019, and 2018, respectively.
The Company also has supplemental discretionary deferred compensation plans for directors and executive officers. The plans are funded annually with director fees and salary reductions which are either placed in a trust account invested by the Bank’s OFA division or recognized as a liability. The trust account balance totaled $2.5 million and $1.8 million at December 31, 2020 and 2019, respectively, and is directly offset in other liabilities. Expense for these plans totaled $61 thousand for each of the years ended December 31, 2020, 2019, and 2018.
In addition, the Company has two supplemental retirement and salary continuation plans for directors and executive officers. These plans are funded with single premium life insurance on the plan participants. The cash value of the life insurance policies is an unrestricted asset of the Company. The estimated present value of future benefits to be paid on these plans totaled $11.4 million and $10.6 million at December 31, 2020 and 2019, respectively. Expense for these plans totaled $1.5 million, $1.0 million and $872 thousand, for the years ended December 31, 2020, 2019, and 2018, respectively.
The Company has promised a continuation of life insurance coverage to certain persons post-retirement. The estimated present value of future benefits to be paid totaled $1.5 million at December 31, 2020 and 2019. Expense for this plan totaled $25 thousand, $22 thousand and $126 thousand for the years ended December 31, 2020, 2019, and 2018, respectively.
Trust account balances, and estimated present values of future benefits and deferred compensation liabilities, noted above are included in other assets and other liabilities, respectively, on the consolidated balance sheets.
NOTE 10. SHARE-BASED COMPENSATION PLANS
The Company maintains share-based compensation plans under the shareholder-approved 2011 Plan. The purpose of the share-based compensation plans is to provide officers, employees, and non-employee members of the Board of Directors of the Company with additional incentive to further the success of the Company. At December 31, 2020, 881,920 shares of the common stock of the Company were reserved to be issued and 356,479 shares were available to be issued.
The 2011 Plan incentive awards may consist of grants of incentive stock options, nonqualified stock options, stock appreciation rights, restricted stock, deferred stock units and performance shares. All employees and members of the Board of Directors of the Company and its subsidiaries, are eligible to participate in the 2011 Plan. The 2011 Plan allows for the Compensation Committee of the Board of Directors to determine the type of incentive to be awarded, its term, manner of exercise, vesting and restrictions on shares. Generally, awards are nonqualified under the IRC, unless the awards are deemed to be incentive awards to employees at the Compensation Committee’s discretion.
The following table presents a summary of nonvested restricted shares activity for 2020.
Shares Weighted Average Grant Date
Fair Value
Nonvested shares, beginning of year 228,758 $ 21.90
Granted 114,182 20.09
Forfeited (15,633) 21.4
Vested (81,731) 20.92
Nonvested shares, end of year 245,576 $ 21.45
The following table presents restricted shares compensation expense, with tax benefit information, and fair value of shares vested at December 31, 2020, 2019 and 2018.
2020 2019 2018
Restricted share award expense $ 1,710 $ 1,578 $ 1,479
Restricted share award tax benefit 359 451 374
Fair value of shares vested 1,384 2,744 1,074
At December 31, 2020 and 2019, unrecognized compensation expense related to the share awards totaled $2.0 million and $2.2 million, respectively. The unrecognized compensation expense at December 31, 2020 is expected to be recognized over a weighted-average period of 1.8 years.
The following table presents a summary of outstanding stock options activity for 2020.
Shares Weighted Average
Exercise Price
Outstanding, beginning of year 30,559 $ 21.56
Forfeited (1,000) 21.14
Expired (29,559) 25.76
Options outstanding and exercisable, end of year - $ -
The Company maintains an employee stock purchase plan to provide employees of the Company an opportunity to purchase Company common stock. Eligible employees may purchase shares in an amount that does not exceed 10% of their annual salary at the lower of 95% of the fair market value of the shares on the semi-annual offering date, or related purchase date. The Company reserved 350,000 shares of its common stock to be issued under the employee stock purchase plan. At December 31, 2020, 160,235 shares were available to be issued.
The following table presents information for the employee stock purchase plan for years ended December 31, 2020, 2019 and 2018.
2020 2019 2018
Shares purchased 7,831 5,399 5,907
Weighted average price of shares purchased $ 14.85 $ 20.69 $ 23.04
The Company issues new shares or treasury shares, depending on market conditions, in its share-based compensation plans.
NOTE 11. DEPOSITS
The following table summarizes deposits by type at December 31, 2020 and 2019.
2020 2019
Noninterest-bearing $ 456,778 $ 249,450
NOW and money market 1,327,459 963,672
Savings 176,425 142,832
Time ($250,000 or less) 334,280 450,490
Time (over $250,000) 61,938 69,078
Total $ 2,356,880 $ 1,875,522
The following table summarizes scheduled future maturities of time deposits as of December 31, 2020.
2021 $ 310,287
2022 45,029
2023 27,622
2024 6,718
2025 4,226
Thereafter 2,336
$ 396,218
Brokered time deposits totaled zero and $16.1 million at December 31, 2020 and 2019, respectively. Management evaluates brokered deposits as a funding option, taking into consideration regulatory views on such deposits as non-core funding sources. Time deposits that meet or exceed the FDIC limit of $250,000 at December 31, 2020 and 2019 totaled $61.9 million and $69.1 million, respectively.
NOTE 12. RELATED PARTY TRANSACTIONS
Directors and executive officers of the Company, including their immediate families and companies in which they have a direct or indirect material interest, are considered to be related parties. In the ordinary course of business, the Company engages in various related party transactions, including extending credit and bank service transactions. The Company relies on the directors and executive officers for the identification of their associates.
Federal banking regulations require that any extensions of credit to insiders and their related interests not be offered on terms more favorable than would be offered to non-related borrowers of similar creditworthiness. The following table presents the aggregate activity in loans to related parties during 2020.
Balance, beginning of year $ 1,318
New loans 5,432
Repayments (1,530)
Director and officer relationship changes (171)
Balance, end of year $ 5,049
None of these loans are past due, on nonaccrual status or have been restructured to provide a reduction or deferral of interest or principal because of deterioration in the financial position of the borrower. There were no loans to a related party that were considered classified loans at December 31, 2020 or 2019.
NOTE 13. SHORT-TERM BORROWINGS
The Company has short-term borrowing capability from the FHLB, federal funds purchased and the FRB discount window. The following table summarizes these short-term borrowings at and for the years ended December 31, 2020, 2019 and 2018.
2020 2019 2018
Balance at year-end $ 55,729 $ 146,600 $ 55,000
Weighted average interest rate at year-end 0.41 % 1.87 % 2.76 %
Average balance during the year $ 138,310 $ 23,171 $ 71,457
Average interest rate during the year 0.67 % 2.20 % 2.09 %
Maximum month-end balance during the year $ 178,729 $ 146,600 $ 103,000
The Company also enters into borrowing arrangements with certain of its deposit clients by agreements to repurchase ("repurchase agreements") under which the Company pledges investment securities owned and under its control as collateral against the borrowing arrangement, which generally matures within one day from the transaction date. The Company is required to hold U.S. Treasury, U.S. Agency or U.S. GSE securities as underlying securities for repurchase agreements. The following table provides additional details for repurchase agreements at and for the years ended December 31, 2020, 2019 and 2018.
2020 2019 2018
Balance at year-end $ 19,466 $ 8,269 $ 9,069
Weighted average interest rate at year-end 0.23 % 1.31 % 1.22 %
Average balance during the year $ 18,064 $ 8,830 $ 9,715
Average interest rate during the year 0.47 % 1.28 % 0.82 %
Maximum month-end balance during the year $ 24,403 $ 12,774 $ 14,591
Fair value of securities underlying the agreements at year-end 29,477 13,062 17,942
NOTE 14. LONG-TERM DEBT
The following table presents components of the Company’s long-term debt at December 31, 2020, and 2019.
Amount Weighted Average rate
2020 2019 2020 2019
FHLB fixed rate advances maturing:
2021 $ - $ 40,350 - % 1.76 %
2023 - 20,000 - % 3.06 %
- 60,350 - % 2.19 %
FHLB amortizing advance requiring monthly principal and interest payments, maturing:
2025 2,316 2,717 4.74 % 4.74 %
Total FHLB Advances $ 2,316 $ 63,067 4.74 % 2.30 %
(1) $20,000,000 of borrowings was prepaid and $40,350,000 of borrowings matured during the year ended December 31, 2020.
Except for amortizing advances, interest only is paid on a quarterly basis.
The following table summarizes the future annual principal payments required on these borrowings at December 31, 2020.
2021 $ 421
2022 441
2023 462
2024 484
2025 508
Thereafter -
$ 2,316
The Bank is a member of the FHLB of Pittsburgh and has access to the FHLB program of overnight and term advances. Under terms of a blanket collateral agreement for advances, lines and letters of credit from the FHLB, collateral for all outstanding advances, lines and letters of credit consisted of 1-4 family mortgage loans and other real estate secured loans totaling $830.3 million at December 31, 2020. The Bank had additional availability of $678.9 million at the FHLB on December 31, 2020 based on its qualifying collateral, net of short-term borrowings and long-term debt detailed above, deposit letters of credit totaling $93.0 million and non-deposit letters of credit totaling $354 thousand at December 31, 2020.
The Bank has available unsecured lines of credit, with interest based on the daily Federal Funds rate, with two correspondent banks totaling $30.0 million, at December 31, 2020. There were no borrowings under these lines of credit at December 31, 2020 and 2019.
NOTE 15. SUBORDINATED NOTES
The Company has unsecured subordinated notes payable, which mature on December 30, 2028. At December 31, 2020 and 2019, subordinated notes payable outstanding totaled $31.9 million and $31.8 million, respectively, which qualified for Tier 2 capital. The notes are recorded on the consolidated balance sheets net of remaining debt issuance costs totaling $597 thousand and $653 thousand at December 31, 2020 and 2019, respectively, which are amortized over a 10-year period on an effective yield basis. The subordinated notes have a fixed interest rate of 6.0% through December 30, 2023, which then converts to a variable rate of three-month LIBOR for the applicable interest period plus 3.16% through maturity. The Company may, at its option, redeem the notes, in whole or in part, on any interest payment date on or after December 30, 2023, and at any time upon the occurrence of certain events. There are no debt covenants on the subordinated notes payable.
NOTE 16. DERIVATIVE FINANCIAL INSTRUMENTS
The Company is exposed to certain risk arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity, and credit risk primarily by managing the amount, sources, and duration of its assets and liabilities and the use of derivative financial instruments. Specifically, the Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The Company’s derivative financial instruments are used as risk management tools by the Company to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally related to the Company’s borrowings and are not used for trading or speculative purposes.
The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps as part of its interest rate risk management strategy. The purpose of the interest rate swaps is to convert short-term debt to longer term fixed rate debt. Interest rate swaps designated as cash flow hedges involve the receipt of variable amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. At December 31, 2020, the Company had one interest rate derivative designated as a hedging instrument with a notional amount of $50.0 million. The Company had no derivative instruments at December 31, 2019. Such derivatives were used to hedge the variable cash flows associated with the Company's borrowings. At December 31, 2020, the Company had cash collateral of $1.7 million held with the counterparty for this derivative.
The Company enters into interest rate swaps that allow its commercial loan customers to effectively convert a variable-rate commercial loan agreement to a fixed-rate commercial loan agreement. Under these agreements, the Company enters into a variable-rate loan agreement with a customer in addition to an interest rate swap agreement, which serves to effectively swap
the customer’s variable-rate loan into a fixed-rate loan. The Company then enters into a corresponding swap agreement with a third party in order to economically hedge its exposure through the customer agreement. The interest rate swaps with both the customers and third parties are not designated as hedges and are marked through earnings. At December 31, 2020, the Company had three customer and three corresponding third-party broker interest rate derivatives not designated as a hedging instrument with an aggregate notional amount of $61.3 million. The Company had no such derivative instruments at December 31, 2019.
As a part of its normal residential mortgage operations, the Company will enter into an interest rate lock commitment with a potential borrower. The Company enters into a corresponding commitment to an investor to sell that loan at a specific price shortly after origination. In accordance with FASB ASC 820, adjustments are recorded through earnings to account for the net change in fair value of these transactions for the held for sale pipeline.
The following table summarizes the fair value of the Company's derivative instruments at December 31, 2020 and December 31, 2019:
December 31, 2020 December 31, 2019
Notional Amount Balance Sheet Location Fair Value Notional Amount Balance Sheet Location Fair Value
Derivatives designated as hedging instruments:
Interest rate swaps - balance sheet hedge $ 50,000 Other liabilities $ (1,234) $ - $ -
Total derivatives designated as hedging instruments $ (1,234) $ -
Derivatives not designated as hedging instruments:
Interest rate swap - commercial borrower $ 30,673 Other assets $ 708 $ - $ -
Interest rate swap - counterparty 30,673 Other liabilities (744) - -
Interest Rate lock commitments with customers 22,560 Other assets 673 4,408 Other assets 103
Forward sale commitment 10,400 Other liabilities (61) 8,969 Other assets 1
Total derivatives not designated as hedging instruments $ 576 $ 104
The following tables summarize the effect of the Company's derivative financial instruments on OCI and net income at December 31, 2020 and 2019:
Amount of (Loss) Gain Recognized in OCI on Derivative
2020 2019
Derivatives in cash flow hedging relationships:
Interest rate products $ (1,347) $ -
Total $ (1,347) $ -
Amount of Loss Reclassified from AOCI into Income Location of Loss Recognized from AOCI into Income
2020 2019
Derivatives in cash flow hedging relationships:
Interest rate products $ 117 $ - Interest expense
Total $ 117 $ -
Amount of Gain (Loss) Recognized in Income Location of Gain (Loss) Recognized in Income
2020 2019
Derivatives not designated as hedging instruments:
Interest rate products $ (56) $ - Other operating expenses
Interest rate lock commitments with customers 570 - Mortgage banking activities
Forward sale commitment (203) - Mortgage banking activities
Total $ 311 $ -
The following table is a summary of interest rate swap components at December 31, 2020 and December 31, 2019:
December 31, 2020 December 31, 2019
Weighted average pay rate 0.77 % - %
Weighted average receive rate 0.09 % - %
Weighted average maturity in years 4.2 0.0
NOTE 17. SHAREHOLDERS’ EQUITY AND REGULATORY CAPITAL
The Company maintains a stockholder dividend reinvestment and stock purchase plan. Under the plan, shareholders may purchase additional shares of the Company’s common stock at the prevailing market prices with reinvestment dividends and voluntary cash payments. The Company reserved 1,045,000 shares of its common stock to be issued under the dividend reinvestment and stock purchase plan. At December 31, 2020, approximately 665,000 shares were available to be issued under the plan.
Banks and bank holding companies are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities and certain off-balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action. Under the Basel Committee on Banking Supervision's capital guidelines for U.S. Banks ("Basel III rules"), an entity must hold a capital conservation buffer above the adequately capitalized risk-based capital ratios. The required capital conservation buffer was 1.25% for 2017, 1.875% for 2018 and 2.50% for 2019 under phase-in rules. The Company and the Bank have elected not to include net unrealized gain or loss on available for sale securities in computing regulatory capital.
Effective with the third quarter of 2018, the FRB raised the consolidated asset limit to be considered a small bank holding company from $1.0 billion to $3.0 billion, and a company with assets under the revised limits is not subject to the FRB consolidated capital rules. A company with consolidated assets under the revised limit may continue to file reports that include capital amounts and ratios. The Company has elected to continue to file those reports.
Management believes, at December 31, 2020 and 2019, that the Company and the Bank met all capital adequacy requirements to which they are subject.
Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required. At December 31, 2020, the most recent regulatory notifications categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank's classification.
The following table presents capital amounts and ratios at December 31, 2020 and 2019.
Actual For Capital Adequacy Purposes
(includes applicable capital conservation buffer)
To Be Well
Capitalized Under
Prompt Corrective
Action Regulations
Amount Ratio Amount Ratio Amount Ratio
December 31, 2020
Total risk-based capital:
Orrstown Financial Services, Inc. $ 271,184 15.6 % $ 183,099 10.5 % n/a n/a
Orrstown Bank 256,376 14.7 % 183,012 10.5 % $ 174,297 10.0 %
Tier 1 risk-based capital:
Orrstown Financial Services, Inc. 217,582 12.5 % 148,223 8.5 % n/a n/a
Orrstown Bank 234,677 13.5 % 148,152 8.5 % 139,437 8.0 %
Tier 1 common equity risk-based capital:
Orrstown Financial Services, Inc. 217,582 12.5 % 122,066 7.0 % n/a n/a
Orrstown Bank 234,677 13.5 % 122,008 7.0 % 113,293 6.5 %
Tier 1 leverage capital:
Orrstown Financial Services, Inc. 217,582 8.1 % 108,063 4.0 % n/a n/a
Orrstown Bank 234,677 8.7 % 108,148 4.0 % 135,185 5.0 %
December 31, 2019
Total risk-based capital:
Orrstown Financial Services, Inc. $ 244,003 14.1 % $ 182,028 10.5 % n/a n/a
Orrstown Bank 231,805 13.4 % 181,948 10.5 % $ 173,284 10.0 %
Tier 1 risk-based capital:
Orrstown Financial Services, Inc. 196,451 11.3 % 147,356 8.5 % n/a n/a
Orrstown Bank 216,100 12.5 % 147,291 8.5 % 138,627 8.0 %
Tier 1 common equity risk-based capital:
Orrstown Financial Services, Inc. 196,451 11.3 % 121,352 7.0 % n/a n/a
Orrstown Bank 216,100 12.5 % 121,299 7.0 % 112,635 6.5 %
Tier 1 leverage capital:
Orrstown Financial Services, Inc. 196,451 8.6 % 91,782 4.0 % n/a n/a
Orrstown Bank 216,100 9.4 % 91,798 4.0 % 114,747 5.0 %
In September 2015, the Board of Directors of the Company authorized a share repurchase program under which the Company may repurchase up to 5% of the Company's outstanding shares of common stock, or approximately 416,000 shares, in accordance with all applicable securities laws and regulations, including Rule 10b-18 of the Securities Exchange Act of 1934, as amended. When and if appropriate, repurchases may be made in open market or privately negotiated transactions, depending on market conditions, regulatory requirements and other corporate considerations, as determined by management. Share repurchases may not occur and may be discontinued at any time. At December 31, 2020, 154,680 shares had been repurchased under the program at a total cost of $2.6 million, or $16.88 per share.
On January 20, 2021, the Board declared a cash dividend of $0.18 per common share, which was paid on February 8, 2021.
Banking regulations limit the ability of the Bank to pay dividends or make loans or advances to the Parent Company. Dividends that may be paid in any calendar year are limited to the current year's net profits, combined with the retained net profits of the preceding two years. At December 31, 2020, dividends from the Bank available to be paid to the Parent Company, without prior approval of the Bank's regulatory agency, totaled $47.4 million, subject to the Bank meeting or exceeding regulatory capital requirements. The Parent Company's principal source of funds for dividend payments to shareholders is dividends received from the Bank.
At December 31, 2020, there were no loans from the Bank to any nonbank affiliate, including the Parent Company. The Bank's loans to a single affiliate may not exceed 10%, and loans to all affiliates may not exceed 20%, of the Bank’s capital
stock, surplus, and undivided profits, plus the ALL (as defined by regulation). Loans from the Bank to nonbank affiliates, including the Parent Company, are also required to be collateralized according to regulatory guidelines. At December 31, 2020, the maximum amount the Bank had available to loan nonbank affiliates totaled $199.9 million.
NOTE 18. EARNINGS PER SHARE
The following table presents earnings per share for the years ended December 31, 2020, 2019 and 2018.
2020 2019 2018
Net income $ 26,463 $ 16,924 $ 12,805
Weighted average shares outstanding - basic 10,942 10,362 8,360
Dilutive effect of share-based compensation 92 152 177
Weighted average shares outstanding - diluted 11,034 10,514 8,537
Per share information:
Basic earnings per share $ 2.42 $ 1.63 $ 1.53
Diluted earnings per share 2.40 1.61 1.50
Average outstanding stock options of approximately 16,109, 22,223 and 20,574, respectively, for the years ended December 31, 2020, 2019 and 2018 were not included in the computation of earnings per share because the effect was antidilutive, as the exercise price exceeded the average market price. The dilutive effect of share-based compensation in each year above relates principally to restricted stock awards.
NOTE 19. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its clients. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contract amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.
The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The following table presents these contractual, or notional, amounts at December 31, 2020, and 2019.
2020 2019
Commitments to fund:
Home equity lines of credit $ 223,216 $ 205,502
1-4 family residential construction loans 28,928 19,812
Commercial real estate, construction and land development loans 60,606 19,018
Commercial, industrial and other loans 268,931 222,288
Standby letters of credit 14,491 10,588
Commitments to extend credit are agreements to lend to a client as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each client’s credit-worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the client. Collateral varies but may include accounts receivable, inventory, equipment, residential real estate, and income-producing commercial properties.
Standby letters of credit and financial guarantees written are conditional commitments issued by the Company to guarantee the performance of a client to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to clients. The Company holds collateral supporting those commitments when deemed necessary by management. The liability, at December 31, 2020 and 2019, for guarantees under standby letters of credit issued was not considered to be material.
The Company maintains a reserve, based on historical loss experience of the related loan class, for off-balance sheet credit exposures that currently are not funded, in other liabilities on the condensed consolidated balance sheets. This reserve totaled $1.5 million and $1.0 million at December 31, 2020 and 2019, respectively. The net amount expensed for this off-balance sheet credit exposures reserve was $511 thousand, $39 thousand and $182 thousand for the years ended December 31, 2020, 2019 and 2018, respectively.
The Company sells loans to the FHLB of Chicago as part of its MPF Program. Under the terms of the MPF Program, there is limited recourse back to the Company for loans that do not perform in accordance with the terms of the loan agreement. Each loan that is sold under the program is “credit enhanced” such that the individual loan’s rating is raised to a minimum “BBB,” as determined by the FHLB of Chicago. Outstanding loans sold under the MPF Program totaled $18.9 million and $26.0 million at December 31, 2020 and 2019, respectively, with limited recourse back to the Company on these loans of $777 thousand at December 31, 2020 and 2019. Many of the loans sold under the MPF Program have primary mortgage insurance, which reduces the Company’s overall exposure. The net amount expensed or recovered for the Company's estimate of losses under its recourse exposure for loans foreclosed, or in the process of foreclosure, is recorded in other operating expenses on the consolidated statements of income. These amounts were not material for the years ended December 31, 2020, 2019 and 2018.
NOTE 20. FAIR VALUE
Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Certain financial instruments and all non-financial instruments are excluded from fair value disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.
The fair value hierarchy distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity's own assumptions about market participant assumptions based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are:
Level 1 - quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access at the measurement date.
Level 2 - significant other observable inputs other than Level 1 prices such as prices for similar assets and liabilities in active markets; or other inputs that are observable or can be corroborated by observable market data.
Level 3 - at least one significant unobservable input that reflects a company's own assumptions about the assumptions that market participants would use in pricing an asset or liability or quoted prices for identical or similar instruments in markets that are not active; .
In instances in which multiple levels of inputs are used to measure fair value, hierarchy classification is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company's assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.
The Company used the following methods and significant assumptions to estimate fair value for financial instruments measured on a recurring basis:
Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, securities are classified within Level 2 and fair values are estimated by using pricing models, quoted prices of securities with similar characteristics or discounted cash flow. Level 2 securities include U.S. agency securities, mortgage-backed securities, obligations of states and political subdivisions and certain corporate, asset backed and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy. All of the Company’s securities are classified as available for sale.
The Company had no fair value liabilities measured on a recurring basis at December 31, 2020 or 2019.
The following table summarizes assets measured at fair value on a recurring basis at December 31, 2020 or 2019.
Level 1 Level 2 Level 3 Total Fair
Value
Measurements
December 31, 2020
Investment securities:
States and political subdivisions $ - $ 103,591 $ 9,079 $ 112,670
GSE residential MBSs - 4,293 - 4,293
GSE residential CMOs
- 58,011 - 58,011
Non-agency CMOs - - 16,918 16,918
Private label commercial CMOs - 56,730 5,506 62,236
Asset-backed - 211,966 - 211,966
Other 371 - - 371
Loans held for sale - 11,734 - 11,734
Interest rate swaps - 690 - 690
Interest rate lock commitments on residential mortgages - - 673 673
Totals $ 371 $ 447,015 $ 32,176 $ 479,562
December 31, 2019
Investment securities:
States and political subdivisions $ - $ 87,863 $ - $ 87,863
GSE residential CMOs
- 68,154 - 68,154
Non-agency CMOs - - 17,087 17,087
Private label commercial CMOs - 79,437 7,192 86,629
Asset-backed - 230,515 - 230,515
Other 637 - - 637
Loans held for sale - 9,364 - 9,364
Interest rate lock commitments on residential mortgages - - 103 103
Totals $ 637 $ 475,333 $ 24,382 $ 500,352
The Company has CMOs measured at fair value on a recurring basis using significant unobservable inputs (Level 3) at December 31, 2020 and 2019. The Level 3 valuation is based on a non-executable broker quote, which is considered a significant unobservable input. Such quotes are updated as available and may remain constant for a period of time for certain broker-quoted securities that do not move with the market or that are not interest rate sensitive as a result of their structure or overall attributes.
Effective October 1, 2019, the Company’s residential mortgage loans held-for-sale were recorded at fair value utilizing Level 2 measurements. This fair value measurement is determined based upon third party quotes obtained on similar loans. The adoption of this accounting election resulted in an increase of $226 thousand in gain on sale of loans in the consolidated statements of income for the year ended December 31, 2019. For loans held-for-sale for which the fair value option has been elected, the aggregate fair value exceeded the aggregate principal balance by $436 thousand and $226 thousand as of December 31, 2020 and 2019, respectively.
The determination of the fair value of interest rate lock commitments on residential mortgages is based on agreed upon pricing with the respective investor on each loan and includes a pull through percentage. The pull through percentage represents an estimate of loans in the pipeline to be delivered to an investor versus the total loans committed for delivery. Significant changes in this input could result in a significantly higher or lower fair value measurement. As the pull through percentage is a significant unobservable input, this is deemed a Level 3 valuation input. The average pull through percentage, which is based upon historical experience, was 90% as of December 31, 2020. An increase or decrease of 5% in the pull through assumption would result in a positive or negative change of $42 thousand in the fair value of interest rate lock commitments at December 31, 2020. The fair value of interest rate lock commitments was $673 thousand and $103 thousand at December 31, 2020 and 2019, respectively, and is included in other assets on the consolidated balance sheets.
The following provides details of the Level 3 fair value measurement activity for the years ended December 31, 2020 or 2019.
Investment securities:
2020 2019
Balance, beginning of year $ 24,279 $ 7,209
Unrealized gain (loss) included in OCI (668) (17)
Purchases - 17,619
Net discount accretion 571 7
Principal payments (10,571) (539)
Transfers into Level 3 17,892 -
Balance, end of year $ 31,503 $ 24,279
The transfers into Level 3 for 2020 noted above relate to two CMO investment securities and one municipal bond for which trading was substantially limited during the year due to the COVID-19 pandemic. As such, older trades or trades of similar securities were utilized to approximate fair value.
Interest rate lock commitments on residential mortgages:
2020 2019
Balance, beginning of year $ 103 $ -
Total gain included in earnings 570 103
Balance, end of year $ 673 $ 103
Certain financial assets are measured at fair value on a nonrecurring basis. Adjustments to the fair value of these assets usually results from the application of lower-of-cost-or-market accounting or write-downs of individual assets. The Company used the following methods and significant assumptions to estimate fair value for these financial assets.
Impaired Loans
Loans are designated as impaired when, in the judgment of management and based on current information and events, it is probable that all amounts due, according to the contractual terms of the loan agreement, will not be collected. The measurement of loss associated with impaired loans for all loan classes can be based on either the observable market price of the loan, the fair value of the collateral, or discounted cash flows using a market rate of interest for performing TDRs. For collateral-dependent loans, fair value is measured based on the value of the collateral securing the loan, less estimated costs to sell. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The value of the real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral is a house or building in the process of construction, or if management adjusts the appraisal value, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal, if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivable collateral are based on financial statement balances or aging reports (Level 3). Impaired loans with an allocation to the ALL are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the unaudited condensed consolidated statements of income.
Changes in the fair value of impaired loans for those still held at December 31 considered in the determination of the provision for loan losses totaled $244 thousand, $77 thousand and $146 thousand for the years ended December 31, 2020, 2019, and 2018, respectively.
Foreclosed Real Estate
OREO property acquired through foreclosure is initially recorded at the fair value of the property at the transfer date less estimated selling cost. Subsequently, OREO is carried at the lower of its carrying value or the fair value less estimated selling cost. Fair value is usually determined based upon an independent third-party appraisal of the property or occasionally upon a recent sales offer. There were no specific charges to value OREO at the lower of cost or fair value on properties held at December 31, 2020 and 2019. Changes in the fair value of foreclosed real estate for those still held at December 31 charged to OREO totaled $0 for the years ended December 31, 2020, 2019, and 2018.
Mortgage Servicing Rights
The MSR fair value is estimated to be equal to its carrying value, unless the quarterly valuation model calculates the present value of the estimated net servicing income is less than its carrying value, in which case an impairment charge is taken. At December 31, 2020, a $1.1 million lower of cost or fair value reserve existed on the mortgage servicing right portfolio. In 2019, net impairment charges of $997 thousand were recorded in mortgage banking activities on the consolidated statements of income. A reserve of $70 thousand existed at December 31, 2019, and $70 thousand in impairment charges were recorded in 2019.
The following table summarizes assets measured at fair value on a nonrecurring basis at December 31, 2020 and 2019.
Level 1 Level 2 Level 3 Total
Fair Value
Measurements
December 31, 2020
Impaired loans
Commercial real estate:
Owner-occupied $ - $ - $ 846 $ 846
Non-owner occupied residential - - 36 36
Commercial and industrial - - 12 12
Residential mortgage:
First lien - - 638 638
Home equity - lines of credit - - 89 89
Total impaired loans $ - $ - $ 1,621 $ 1,621
Mortgage servicing rights $ - $ - $ 2,745 $ 2,745
December 31, 2019
Impaired loans
Commercial real estate:
Owner-occupied $ - $ - $ 938 $ 938
Multi-family - - 96 96
Non-owner occupied residential - - 103 103
Commercial and industrial - - 11 11
Residential mortgage:
First lien - - 641 641
Home equity - lines of credit - - 400 400
Installment and other loans - - 7 7
Total impaired loans $ - $ - $ 2,196 $ 2,196
Mortgage servicing rights $ - $ - $ 3,119 $ 3,119
The following table presents additional qualitative information about assets measured on a nonrecurring basis and for which the Company has utilized Level 3 inputs to determine fair value.
Fair Value
Estimate
Valuation Techniques
Unobservable Input
Range
December 31, 2020
Impaired loans $ 1,621 Appraisal of collateral Management adjustments on appraisals for property type and recent activity 5% - 25% discount
- Management adjustments for liquidation expenses 6.02% - 19.32% discount
Mortgage servicing rights
2,745 Discounted cash flows
Weighted average CPR
18.02%
Discount rate
9.56%
December 31, 2019
Impaired loans $ 2,196 Appraisal of collateral Management adjustments on appraisals for property type and recent activity 0% - 20% discount
- Management adjustments for liquidation expenses 6% - 33% discount
Mortgage servicing rights 3,119 Discounted cash flows Weighted average CPR 11.63%
Discount rate 9.54%
Fair values of financial instruments
GAAP requires disclosure of the fair value of financial assets and liabilities, including those that are not measured and reported at fair value on a recurring or nonrecurring basis. The following table presents the carrying amounts and estimated fair values of financial assets and liabilities at December 31, 2020, and 2019.
Carrying
Amount
Fair Value Level 1 Level 2 Level 3
December 31, 2020
Financial Assets
Cash and due from banks $ 26,203 $ 26,203 $ 26,203 $ - $ -
Interest-bearing deposits with banks 99,055 99,055 99,055 - -
Restricted investments in bank stock 10,563 n/a n/a n/a n/a
Investment securities 466,465 466,465 371 434,591 31,503
Loans held for sale 11,734 11,734 - 11,734 -
Loans, net of allowance for loan losses 1,959,539 1,953,860 - - 1,953,860
Interest rate lock commitments on residential mortgages 673 673 - - 673
Interest rate swaps 690 690 - 690 -
Accrued interest receivable 8,927 8,927 - 1,529 7,398
Financial Liabilities
Deposits 2,356,880 2,359,317 - 2,359,317 -
Securities sold under agreements to repurchase 19,466 19,466 - 19,466 -
FHLB advances and other 58,045 58,298 - 58,298 -
Subordinated notes 31,903 31,712 - 31,712 -
Interest rate swaps 1,956 1,956 - 1,956 -
Accrued interest payable 238 238 - 238 -
December 31, 2019
Financial Assets
Cash and due from banks $ 25,969 $ 25,969 $ 25,969 $ - $ -
Interest-bearing deposits with banks 30,493 30,493 30,493 - -
Restricted investments in bank stock 16,184 n/a n/a n/a n/a
Investment securities 490,885 490,885 637 465,969 24,279
Loans held for sale 9,364 9,364 - 9,364 -
Loans, net of allowance for loan losses 1,629,675 1,652,788 - - 1,652,788
Interest rate lock commitments on residential mortgages 103 103 - - 103
Accrued interest receivable 6,040 6,040 - 1,863 4,177
Financial Liabilities
Deposits 1,875,522 1,876,555 - 1,876,555 -
Securities sold under agreements to repurchase 8,269 8,269 - 8,269 -
FHLB advances and other 209,667 210,005 - 210,005 -
Subordinated notes 31,847 33,953 - 33,953 -
Accrued interest payable 879 879 - 879 -
The methods used to estimate the fair value of financial instruments at December 31, 2020 did not necessarily represent an exit price. In accordance with the Company's adoption of ASU 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, the methods utilized to measure the fair value of financial instruments at December 31, 2020 represents an approximation of exit price; however, an actual exit price may differ.
NOTE 21. REVENUE FROM CONTRACTS WITH CLIENTS
On January 1, 2018, the Company adopted ASU 2014-09, Revenue from Contracts with Customers (Topic 606) and all subsequent amendments (collectively “ASC 606”). The update implements a common revenue standard that clarifies the principles for recognizing revenue. The core principle of ASC 606 is that an entity should recognize revenue to depict the transfer of promised goods or services to clients in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The majority of the Company's revenue comes from interest income, including loans and securities, that are outside the scope of ASC 606. The Company's services that fall within the scope of ASC 606 are presented within noninterest income on the consolidated statements of income and are recognized as revenue as the Company satisfies its obligation to the client. Services within the scope of ASC 606 include service charges on deposit accounts, income from fiduciary investment management and brokerage activities and interchange fees from service charges on ATM and debit card transactions. ASC 606 did not result in a change to the accounting for any in-scope revenue streams; as such, no cumulative effect adjustment was recorded.
Descriptions of revenue generating activities that are within the scope of ASC 606 are as follows:
Service Charges on Deposit Accounts - The Company earns fees from its deposit clients for transaction-based, account maintenance, and overdraft services. Transaction-based fees, which include services such as ATM use fees, stop payment charges, statement rendering, and ACH fees, are recognized at the time the transaction is executed as that is the point in time the Company fulfills the client's request. Account maintenance fees, which relate primarily to monthly maintenance, are earned over the course of a month, representing the period over which the Company satisfies the performance obligation. Overdraft fees are recognized at the point in time that the overdraft occurs. Service charges on deposits are withdrawn from the client's account balance.
Interchange Income - The Company earns interchange fees from debit/credit cardholder transactions conducted through the MasterCard payment network. Interchange fees from cardholder transactions represent a percentage of the underlying transaction value and are recognized daily, concurrently with the transaction processing services provided to the cardholder. Interchange income is presented net of cardholder rewards.
Loan swap referral fees - The Company earns fees from a third-party service provider for loan hedging referrals provided to lending clients. The Company acts as an agent in arranging the relationship between our client and the third-party service provider. The Company is paid and recognizes income upon completion of the loan hedge between our client and the third-party service provider.
Trust and Investment Management Income - The Company earns wealth management and investment brokerage fees from its contracts with trust and wealth management clients to manage assets for investment, and/or to transact on their accounts. These fees are primarily earned over time as the Company provides the contracted services and are generally assessed based on a tiered scale of the market value of assets under management. Fees that are transaction based, including trade execution services, are recognized at the point in time that the transaction is executed, i.e., the trade date. Other related services provided included financial planning services and the associated fees the Company earns, which are based on a fixed fee schedule, are recognized when the services are rendered. Services are generally billed in arrears and a receivable is recorded until fees are paid.
Brokerage Income - The Company earns fees from investment management and brokerage services provided to its clients through a third-party service provider. The Company receives commissions from the third-party service provider and recognizes income on a weekly basis based upon client activity. As the Company acts as an agent in arranging the relationship between the client and the third-party service provider and does not control the services rendered to the clients, brokerage income is presented net of related costs.
Gains/Losses on Sales of OREO - The Company records a gain or loss on the sale of OREO when control of the property transfers to the buyer, which generally occurs at the time of an executed deed. If the Company finances the sale of OREO to the buyer, the Company assesses whether the buyer is committed to perform their obligations under the contract and whether collectability of the transaction price is probable. Once these criteria are met, the OREO asset is derecognized and the gain or loss on sale is recorded upon the transfer of control of the property to the buyer. In determining the gain or loss on the sale, the Company adjusts the transaction price and related gain or loss on sale if a significant financing component is present.
At December 31, 2020 and December 31, 2019, the Company had receivables from trust and wealth management clients totaling $661 thousand and $719 thousand, respectively.
The following table presents the Company's noninterest income disaggregated by revenue source for the years ended December 31, 2020, 2019 and 2018.
2020 2019 2018
Noninterest income
Service charges on deposit accounts $ 3,113 $ 3,793 $ 3,578
Loan swap referral fees 847 1,197 -
Trust and investment management income 6,912 7,255 6,576
Brokerage income 2,821 2,426 2,035
Interchange income 3,423 3,281 2,821
Revenue from contracts with clients 17,116 17,952 15,010
Other service charges 444 416 562
Mortgage banking activities 5,274 3,047 2,663
Gain on sale of commercial loans 2,803 - -
Income from life insurance 2,261 2,044 1,463
Other income 427 331 320
Investment securities gains (16) 4,749 1,006
Total noninterest income $ 28,309 $ 28,539 $ 21,024
NOTE 22. ORRSTOWN FINANCIAL SERVICES, INC. (PARENT COMPANY ONLY) CONDENSED FINANCIAL INFORMATION
Condensed Balance Sheets
December 31,
2020 2019
Assets
Cash in Orrstown Bank $ 13,961 $ 11,568
Investment in Orrstown Bank 263,346 242,041
Other assets 941 1,724
Total assets $ 278,248 $ 255,333
Liabilities
Subordinated notes $ 31,903 $ 31,847
Accrued interest and other liabilities 96 237
Total liabilities 31,999 32,084
Shareholders’ Equity
Common stock 586 584
Additional paid-in capital 189,066 188,365
Retained earnings 54,099 35,246
Accumulated other comprehensive income (loss) 3,346 (480)
Treasury stock (848) (466)
Total shareholders’ equity 246,249 223,249
Total liabilities and shareholders’ equity $ 278,248 $ 255,333
Condensed Statements of Income
For the Years Ended December 31,
2020 2019 2018
Income
Dividends from bank subsidiary $ 14,000 $ 2,000 $ 4,450
Interest income from bank subsidiary 76 257 7
Other income 62 55 102
Total income 14,138 2,312 4,559
Expenses
Interest on short-term borrowings - - 57
Interest on subordinated notes 2,006 1,987 73
Total interest expense 2,006 1,987 130
Share-based compensation 463 236 205
Management fee to bank subsidiary 1,254 1,350 1,042
Merger related expenses - 1,574 1,545
Other expenses 1,324 802 656
Total expenses 5,047 5,949 3,578
Income (loss) before income tax benefit and equity in undistributed income of subsidiaries 9,091 (3,637) 981
Income tax benefit (1,022) (1,182) (735)
(Loss) income before equity in undistributed income of subsidiaries
10,113 (2,455) 1,716
Equity in undistributed income of subsidiaries
16,350 19,379 11,089
Net income $ 26,463 $ 16,924 $ 12,805
Condensed Statements of Cash Flows
For the Years Ended December 31,
2020 2019 2018
Cash flows from operating activities:
Net income $ 26,463 $ 16,924 $ 12,805
Adjustments to reconcile net income to cash provided by (used in) operating activities:
Amortization 56 47 3
Deferred income taxes (39) 16 22
Equity in undistributed income of subsidiaries
(16,350) (19,379) (11,089)
Share-based compensation 463 236 205
Net change in other liabilities (141) (423) 12
Net change in other assets (221) 311 2,039
Net cash provided by (used in) operating activities 10,231 (2,268) 3,997
Cash flows from investing activities:
Capital contributed to subsidiaries - (100) -
Net cash paid for acquisitions (85) (8,142) (4,597)
Net cash used in investing activities (85) (8,242) (4,597)
Cash flows from financing activities:
Dividends paid (7,610) (6,150) (4,375)
Proceeds from issuance of subordinated notes, net of costs - - 31,857
Proceeds from issuance of common stock 1,628 1,463 1,448
Payments to repurchase common stock (1,887) (1,772) (651)
Other, net 116 (59) -
Net cash (used in) provided by financing activities (7,753) (6,518) 28,279
Net increase (decrease) in cash 2,393 (17,028) 27,679
Cash, beginning 11,568 28,596 917
Cash, ending $ 13,961 $ 11,568 $ 28,596
NOTE 23. CONTINGENCIES
The nature of the Company’s business generates a certain amount of litigation involving matters arising out of the ordinary course of business. Except as described below, in the opinion of management, there are no legal proceedings that might have a material effect on the results of operations, liquidity, or the financial position of the Company at this time.
On March 5, 2019, Paul Parshall, a purported individual stockholder of Hamilton, filed, on behalf of himself and all of Hamilton’s stockholders other than the named defendants and their affiliates (the “Purported Class”), a derivative and putative class action complaint in the Circuit Court for Baltimore City, Maryland, captioned Paul Parshall v. Carol Coughlin et. al., naming each Hamilton director, Orrstown, and Hamilton as defendants (the “Action”). The Action alleged, among other things, that Hamilton’s directors breached their fiduciary duties to the Purported Class in connection with the merger, and that the Proxy Statement/Prospectus omitted certain material information regarding the merger. Orrstown was alleged to have aided and abetted the Hamilton directors’ alleged breaches of their fiduciary duties. The Action sought, among other remedies, to enjoin the merger or, in the event the merger was completed, rescission of the merger or rescissory damages; unspecified damages; and costs of the lawsuit, including attorneys’ and experts’ fees. A settlement was reached on the Action in March 2020 which resulted in a payment by the Company of $135 thousand in mootness fees to the defendants in April 2020.
On May 25, 2012, SEPTA filed a putative class action complaint in the U.S. District Court for the Middle District of Pennsylvania against the Company, the Bank and certain current and former directors and officers (collectively, the “Orrstown Defendants”). The complaint alleged, among other things, that (i) in connection with the Company’s Registration Statement on Form S-3 dated February 23, 2010 and its Prospectus Supplement dated March 23, 2010, and (ii) during the purported class period of March 24, 2010 through October 27, 2011, the Company issued materially false and misleading statements regarding the Company’s lending practices and financial results, including misleading statements concerning the stringent nature of the
Bank’s credit practices and underwriting standards, the quality of its loan portfolio, and the intended use of the proceeds from the Company’s March 2010 public offering of common stock. The complaint asserted claims under Sections 11, 12(a) and 15 of the Securities Act of 1933, Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, and sought class certification, unspecified money damages, interest, costs, fees and equitable or injunctive relief. Under the Private Securities Litigation Reform Act of 1995 (“PSLRA”), the Court appointed SEPTA Lead Plaintiff on August 20, 2012.
On March 4, 2013, SEPTA filed an amended complaint. The amended complaint expanded the list of defendants in the action to include the Company’s former independent registered public accounting firm, Smith Elliott Kearns & Company, LLC (“SEK”), and the underwriters of the Company’s March 2010 public offering of common stock. In addition, among other things, the amended complaint extended the purported 1934 Exchange Act class period from March 15, 2010 through April 5, 2012.
On June 22, 2015, in a 96-page Memorandum, the Court dismissed without prejudice SEPTA’s amended complaint against all defendants, finding that SEPTA failed to state a claim under either the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended. On February 8, 2016, the Court granted SEPTA’s motion for leave to amend again and SEPTA filed its second amended complaint that same day.
On December 7, 2016, the Court issued an Order and Memorandum granting in part and denying in part defendants’ motions to dismiss SEPTA’s second amended complaint. The Court granted the motions to dismiss the Securities Act claims against all defendants, and granted the motions to dismiss the Exchange Act Section 10(b) and Rule 10b-5 claims against all defendants except Orrstown Financial Services, Inc., Orrstown Bank, Thomas R. Quinn, Jr., Bradley S. Everly, and Jeffrey W. Embly. The Court also denied the motions to dismiss the Exchange Act Section 20(a) claims against Quinn, Everly, and Embly.
On December 15, 2017, the Orrstown Defendants and SEPTA exchanged expert reports in opposition to and in support of class certification, respectively. On January 15, 2018, the parties exchanged expert rebuttal reports. SEPTA has not yet filed a motion for class certification.
On August 9, 2018, SEPTA filed a motion to compel the production of Confidential Supervisory Information (CSI) of non-parties the Board of Governors of the Federal Reserve System (FRB) and the Pennsylvania Department of Banking and Securities, in the possession of Orrstown and third parties. On August 30, 2018, the FRB filed an unopposed motion to intervene in the Action for the purpose of opposing SEPTA’s motion to compel. On February 12, 2019, the Court denied SEPTA’s motion to compel the production of CSI on the ground that SEPTA had failed to exhaust its administrative remedies.
On April 11, 2019, SEPTA filed a motion for leave to file a third amended complaint. The proposed third amended complaint seeks to reassert the Securities Act claims that the Court dismissed as to all defendants on December 7, 2016, when the Court granted in part and denied in part defendants’ motions to dismiss SEPTA’s second amended complaint. The proposed third amended complaint also seeks to reassert the Exchange Act claims against those defendants that the Court dismissed from the case on December 7, 2016.
On June 13, 2019, Orrstown filed a motion for protective order to stay discovery pending resolution of SEPTA’s motion for leave to file a third amended complaint. On July 17, 2019, the Court entered an Order partially granting Orrstown’s motion for protective order, ruling that all deposition discovery in the case was stayed pending a decision on SEPTA’s motion for leave to file a third amended complaint. Party and non-party document discovery in the case has largely been completed.
On February 14, 2020, the Court issued an Order and Memorandum granting SEPTA’s motion for leave to file a third amended complaint. The third amended complaint is now the operative complaint. It reinstates the Orrstown Defendants, as well as SEK and the underwriter defendants, previously dismissed from the case on December 7, 2016. The third amended complaint also revives the previously-dismissed 1933 Securities Act claim against the Orrstown Defendants, SEK, and the underwriter defendants. Defendants filed their motions to dismiss the third amended complaint on April 24, 2020. SEPTA’s opposition was filed on July 8, 2020, and Orrstown’s reply brief was filed on August 12, 2020. The motions to dismiss the third amended complaint are currently pending.
Additionally, on February 24, 2020, the Orrstown Defendants, and the underwriter defendants and SEK, separately filed motions under 28 U.S.C. § 1292(b) asking the District Court to certify its February 14, 2020 Order granting leave to file the third amended complaint for interlocutory appeal to the Third Circuit Court of Appeals. The District Court granted those motions on July 17, 2020, and defendants filed their Petition for Permission to Appeal with the Third Circuit on July 27, 2020. The Third Circuit granted permission to appeal the Order pursuant to 28 U.S.C. § 1292(b) on August 13, 2020. Defendants filed their joint Opening Brief in the Third Circuit on November 2, 2020, asking the Court to reverse the district court’s Order. SEPTA filed its responsive brief on December 2, 2020 and defendants filed their reply brief on December 23, 2020. Oral argument was held on February 10, 2021. The Third Circuit’s decision is pending.
The Company believes that the allegations of SEPTA’s third amended complaint are without merit and intends to defend itself vigorously against those claims. It is not possible at this time to reasonably estimate possible losses, or even a range of reasonably possible losses, in connection with the litigation.

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ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.

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ITEM 9A. CONTROLS AND PROCEDURES
ITEM 9A - CONTROLS AND PROCEDURES
Based on the evaluation required by Securities Exchange Act Rules 13a-15(b) and 15d-15(b), the Company's management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of our disclosure controls and procedures, as defined in Securities Exchange Act Rules 13a-15(e) and 15d-15(e), at December 31, 2020. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at December 31, 2020. There have been no changes in internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting during the fourth quarter of 2020.
Management's Report on Internal Controls Over Financial Reporting is included in Part II, Item 8, "Financial Statements and Supplementary Data." The effectiveness of the Company's internal control over financial reporting at December 31, 2020 has been audited by Crowe LLP, an independent registered public accounting firm, as stated in the Report of Independent Registered Public Accounting Firm appearing in Part II, Item 8, "Financial Statements and Supplementary Data."

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ITEM 9B. OTHER INFORMATION
ITEM 9B - OTHER INFORMATION
None.
PART III

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ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
ITEM 10 - DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The Company has adopted a code of ethics that applies to all senior financial officers (including its chief executive officer, chief financial officer, chief accounting officer, and any person performing similar functions). You can find a copy of the Code of Ethics for Senior Financial Officers by visiting our website at www.orrstown.com and following the links to “Investor Relations” and “Governance Documents.” A copy of the Code of Ethics for Senior Financial Officers may also be obtained, free of charge, by written request to Orrstown Financial Services, Inc., 77 East King Street, PO Box 250, Shippensburg, Pennsylvania 17257, Attention: Secretary. The Company intends to disclose any amendments to or waivers from a provision of the Company’s Code of Ethics for Senior Financial Officers in a timely manner.
All other information required by Item 10 is incorporated by reference from the Company’s definitive proxy statement for the 2021 Annual Meeting of Shareholders filed pursuant to Regulation 14A, under Section 16(a) Beneficial Ownership Reporting Compliance and Proposal 1 - Election of Directors - Biographical Summaries of Nominees and Directors; Information About Executive Officers; Involvement in Certain Legal Proceedings; and Proposal 1 - Election of Directors - Nomination of Directors, and Board Structure, Committees and Meeting Attendance.

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ITEM 11. EXECUTIVE COMPENSATION
ITEM 11 - EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated by reference from the Company’s definitive proxy statement for the 2021 Annual Meeting of Shareholders filed pursuant to Regulation 14A, under Proposal 1 - Election of Directors - Compensation of Directors, Compensation Discussion and Analysis, Compensation Committee Report, Executive Compensation Tables, Potential Payments Upon Termination or Change in Control and Compensation Committee Interlocks and Insider Participation.

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ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The following table presents equity compensation plan information at December 31, 2020.
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 (excluding
securities reflected in
column (a))
(a) (b) (c)
Equity compensation plan approved by security holders - n/a 881,920
Total - n/a 881,920
All other information required by Item 12 is incorporated, by reference, from the Company’s definitive proxy statement for the 2021 Annual Meeting of Shareholders filed pursuant to Regulation 14A, under Share Ownership of Certain Beneficial Owners and Management.

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ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by Item 13 is incorporated by reference from the Company’s definitive proxy statement for the 2021 Annual Meeting of Shareholders filed pursuant to Regulation 14A, under Proposal 1 - Election of Directors - Director Independence, and Transactions with Related Persons, Promoters and Certain Control Persons.

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ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
ITEM 14 - PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by Item 14 is incorporated by reference from the Company’s definitive proxy statement for the 2021 Annual Meeting of Shareholders filed pursuant to Regulation 14A, under Proposal 3 - Ratification of the Audit Committee’s Selection of Crowe LLP as the Company’s Independent Registered Public Accounting Firm for the Fiscal Year Ending December 31, 2020 - Relationship with Independent Registered Public Accounting Firm.
PART IV

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ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
ITEM 15 - EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
a.The following documents are filed as part of this report:
(1) - Financial Statements
Consolidated financial statements of the Company and subsidiaries required in response to this Item are incorporated by reference from Item 8 of this report.
(2) - Financial Statement Schedules
All financial statement schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted.
(3) - Exhibits
2.1(a) Agreement and Plan of Merger, dated May 31, 2018, by and between Orrstown Financial Services, Inc. and Mercersburg Financial Corporation, incorporated by reference to Exhibit 2.1 of the Registrant's Form 8-K filed June 1, 2018.
2.1(b) Agreement and Plan of Merger, dated October 23, 2018, by and between Orrstown Financial Services, Inc. and Hamilton Bancorp, Inc., incorporated by reference to Exhibit 2.1 of the Registrant's Form 8-K filed October 24, 2018.
3.1 Articles of Incorporation as amended, incorporated by reference to Exhibit 3.1 of the Registrant’s Form 8-K filed on January 29, 2010.
3.2 By-laws as amended, incorporated by reference to Exhibit 3.2 to the Registrant’s Report on Form 8-K filed January 30, 2018.
4.1 Specimen Common Stock Certificate, incorporated by reference to the Registrant’s Registration Statement on Form S-3 filed February 8, 2010 (File No. 333-164780).
4.2 Subordinated Indenture, dated December 19, 2018, by and between Orrstown Financial Services, Inc., and U.S. Bank, National Association, incorporated by reference to Exhibit 4.1 of the Registrant's Form 8-K filed on December 20, 2018.
4.3 Form of Global Note for subordinated notes, incorporated by reference to Exhibit 4.2 of the Registrant's Form 8-K filed December 20, 2018.
4.4 Form of Registration Rights Agreement for subordinated notes, incorporated by reference to Exhibit 10.2 of the Registrant's Form 8-K filed December 20, 2018.
10.1 Change in Control Agreement between Orrstown Financial Services, Inc., Orrstown Bank and Thomas R. Quinn, Jr. incorporated by reference to Exhibit 10.2 to the Registrant's Form 8-K filed September 27, 2019.
10.2 Change in Control Agreement between Orrstown Financial Services, Inc., Orrstown Bank and Robert G. Coradi, incorporated by reference to Exhibit 10.8 to the Registrant's Form 8-K filed June 2, 2015.
10.3 Change in Control Agreement between Orrstown Financial Services, Inc., Orrstown Bank and Adam L. Metz, incorporated by reference to Exhibit 10.2 to the Registrant's Form 8-K filed March 14, 2017.
10.4 Change in Control Agreement between Orrstown Financial Services, Inc., Orrstown Bank and Thomas R. Brugger, incorporated by reference to Exhibit 10.2 to the Registrant's Form 8-K filed June 25, 2019.
10.5 Change in Control Agreement between Orrstown Financial Services, Inc., Orrstown Bank and Christopher D. Holt dated July 15, 2019.
10.6 Salary Continuation Agreement between Orrstown Bank and Thomas R. Quinn, Jr. - incorporated by reference to Exhibit 10.1 to the Registrant’s Form 8-K filed January 8, 2010.
10.7 Salary Continuation Agreement between Orrstown Bank and Thomas R. Quinn, Jr. - incorporated by reference to Exhibit 10.1 to the Registrant’s Form 8-K filed September 27, 2019.
10.8 Salary Continuation Agreement between Orrstown Bank and Robert Coradi dated March 26, 2018 - incorporated by reference to Exhibit 10.1 to the Registrant’s Form 10-Q filed November 5, 2020.
10.9 Officer group term replacement plan for selected officers - incorporated by reference to Exhibit 10.2 to Registrant’s Form 10-K for the year ended December 31, 1999 filed March 28, 2000.
10.10 Director Retirement Agreement, as amended, between Orrstown Bank and Andrea Pugh, incorporated by reference to Exhibit 10.4(c) to the Registrant’s Form 10-K filed March 15, 2010.
10.11 Director Retirement Agreement, as amended, between Orrstown Bank and Glenn W. Snoke, incorporated by reference to Exhibit 10.4(f) to the Registrant’s Form 10-K filed March 15, 2010.
10.12 Director Retirement Agreement, as amended, between Orrstown Bank and Joel R. Zullinger, incorporated by reference to Exhibit 10.4(h) to the Registrant’s Form 10-K filed March 15, 2010.
10.13 Revenue neutral retirement plan - incorporated by reference to Exhibit 10.4 to the Registrant’s Form 10-K filed March 28, 2000.
10.14 Non-employee director stock option plan of 2000 - incorporated by reference to the Registrant’s registration statement on Form S-8 filed March 31, 2000.
10.15 Employee stock option plan of 2000 - incorporated by reference to the Registrant’s registration statement on Form S-8 filed March 31, 2000.
10.16 2011 Orrstown Financial Services, Inc. Stock Incentive Plan - incorporated by reference to Exhibit 10.1 of the Registrant’s registration statement on Form S-8 filed May 24, 2018..
10.17 Employment Agreement between Orrstown Financial Services, Inc., Orrstown Bank and Thomas R. Quinn, Jr. incorporated by reference to Exhibit 10.1 to Registrant’s Form 8-K filed June 8, 2015.
10.18 Employment Agreement between Orrstown Financial Services, Inc., Orrstown Bank and Thomas R. Brugger, incorporated by reference to Exhibit 10.1 to Registrant’s Form 8-K filed June 25, 2019.
10.19 Employment Agreement between Orrstown Financial Services, Inc., Orrstown Bank and Philip E. Fague, incorporated by reference to Exhibit 10.3 to the Registrant's Form 8-K filed June 2, 2015.
10.20 Employment Agreement between Orrstown Financial Services, Inc., Orrstown Bank and Robert G. Coradi, incorporated by reference to Exhibit 10.7 to the Registrant's Form 8-K filed June 2, 2015.
10.21 Employment Agreement between Orrstown Financial Services, Inc., Orrstown Bank and Barbara E. Brobst, incorporated by reference to Exhibit 10.9 to the Registrant's Form 8-K filed June 2, 2015.
10.22 Employment Agreement between Orrstown Financial Services, Inc., Orrstown Bank and Adam L. Metz, incorporated by reference to Exhibit 10.1 to the Registrant's Form 8-K filed March 14, 2017.
10.23 Employment Agreement between Orrstown Financial Services, Inc., Orrstown Bank and Robert J. Fignar, incorporated by reference to Exhibit 10.2 to the Registrant's Form 8-K filed June 1, 2018.
10.24 Employment Agreement between Orrstown Financial Services, Inc., Orrstown Bank and Christopher D. Holt dated July 15, 2019
10.25 Brick Plan - Deferred Income Agreement between Orrstown Bank and Joel R. Zullinger, incorporated by reference to Exhibit 10.11 to the Registrant’s Form 10-K filed March 15, 2010.
10.26 Director/Executive Officer Deferred Compensation Plan, incorporated by reference to Exhibit 10.13(a) to the Registrant’s Form 10-K filed March 15, 2010.
10.27 Trust Agreement for Director/Executive Officer Deferred Compensation Plan, incorporated by reference to Exhibit 10.13(b) to the Registrant’s Form 10-K filed March 15, 2010.
10.28 Deferred Compensation Agreement between Orrstown Bank and Thomas R. Quinn, Jr., incorporated by reference to Exhibit 10.1 to the Registrant's Form 8-K filed September 27, 2019.
10.29 Deferred Compensation Agreement between Orrstown Bank and Thomas R. Brugger, incorporated by reference to Exhibit 10.1 to the Registrant's Form 8-K filed September 18, 2020.
10.30 Deferred Compensation Agreement between Orrstown Bank and Christopher D. Holt, dated September 16, 2020.
10.31 Form of Subordinated Note Purchase Agreement, incorporated by reference to Exhibit 10.1 of the Registrant's Report of Form 8-K filed on December 20, 2018.
14 Code of Ethics Policy for Senior Financial Officers posted on Registrant’s website.
21 Subsidiaries of the registrant
23.1 Consent of Crowe LLP, Independent Registered Public Accounting Firm
31.1 Rule 13a - 14(a)/15d-14(a) Certification (Chief Executive Officer)
31.2 Rule 13a - 14(a)/15d-14(a) Certifications (Chief Financial Officer)
32.1 Section 1350 Certifications (Chief Executive Officer)
32.2 Section 1350 Certifications (Chief Financial Officer)
101.LAB XBRL Taxonomy Extension Label Linkbase
101.PRE XBRL Taxonomy Extension Presentation Linkbase
101.INS XBRL Instance Document
101.SCH XBRL Taxonomy Extension Schema
101.CAL XBRL Taxonomy Extension Calculation Linkbase
101.DEF XBRL Taxonomy Extension Definition Linkbase
All other exhibits for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted.
b.Exhibits - The exhibits to this Form 10-K begin after the signature page.
c.Financial statement schedules - None required.