FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the Year Ended December 31, 2010

Commission File No. 0-22345

SHORE BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

Maryland	52-1974638
(State or Other Jurisdiction of	(I.R.S. Employer
Incorporation or Organization)	Identification No.)

PART I

Item 1.

Business.

BUSINESS

General

The Company was incorporated under the laws of Maryland on March 15, 1996 and is a financial holding company registered under the Bank Holding Company Act of 1956, as amended (the “BHC Act”).  The Company’s primary business is acting as the parent company to several financial institution and insurance entities.  The Company engages in the banking business through CNB, a Maryland trust company with commercial banking powers, The Talbot Bank of Easton, Maryland, a Maryland commercial bank (“Talbot Bank”), and, until January 1, 2011, The Felton Bank, a Delaware commercial bank  (“Felton Bank” and, together with CNB and Talbot Bank, the “Banks”).  On January 1, 2011, Felton Bank merged into CNB, with CNB as the surviving bank.  Until December 31, 2009, CNB did business as The Centreville National Bank of Maryland, a national banking association.  It was converted to a Maryland charter on that date.

The Company engages in the insurance business through two general insurance producer firms, The Avon-Dixon Agency, LLC, a Maryland limited liability company, and Elliott Wilson Insurance, LLC, a Maryland limited liability company; one marine insurance producer firm, Jack Martin & Associates, Inc., a Maryland corporation; three wholesale insurance firms, Tri-State General Insurance Agency, LTD, a Maryland corporation, Tri-State General Insurance Agency of New Jersey, Inc., a New Jersey corporation, and Tri-State General Insurance Agency of Virginia, Inc., a Virginia corporation (collectively “TSGIA”); and two insurance premium finance companies, Mubell Finance, LLC, a Maryland limited liability company, and ESFS, Inc., a Maryland corporation (all of the foregoing are collectively referred to as the “Insurance Subsidiaries”).

The Company engages in the mortgage brokerage business under the name “Wye Mortgage Group” through a minority series investment in an unrelated Delaware limited liability company.  The Company also has three inactive subsidiaries, Wye Financial Services, LLC, Shore Pension Services, LLC, and Wye Mortgage, LLC, all of which were organized under Maryland law.

Talbot Bank owns all of the issued and outstanding securities of Dover Street Realty, Inc., a Maryland corporation that engages in the business of holding and managing real property acquired by Talbot Bank as a result of loan foreclosures.

We operate in two business segments:  community banking and insurance products and services.  Financial information related to our operations in these segments for each of the two years ended December 31, 2010 is provided in Note 25 to the Company’s Consolidated Financial Statements included in Item 8 of Part II of this report.

 

 

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Banking Products and Services

CNB commenced operations in 1876.  Talbot Bank is a Maryland commercial bank that commenced operations in 1885 and was acquired by the Company in its December 2000 merger with Talbot Bancshares, Inc. (“Talbot Bancshares”).  Felton Bank was a Delaware commercial bank that commenced operations in 1908 and was acquired by the Company in April 2004 when it merged with Midstate Bancorp, Inc.  The Banks operate 19 full service branches and 22 ATMs and provide a full range of commercial and consumer banking products and services to individuals, businesses, and other organizations in Kent County, Queen Anne’s County, Caroline County, Talbot County and Dorchester County in Maryland and in Kent County, Delaware.  The Banks’ deposits are insured by the Federal Deposit Insurance Corporation (the “FDIC”).

The Banks are independent community banks and serve businesses and individuals in their respective market areas.  Services offered are essentially the same as those offered by larger regional institutions that compete with the Banks. Services provided to businesses include commercial checking, savings, certificates of deposit and overnight investment sweep accounts. The Banks offer all forms of commercial lending, including secured and unsecured loans, working capital loans, lines of credit, term loans, accounts receivable financing, real estate acquisition development, construction loans and letters of credit.  Merchant credit card clearing services are available as well as direct deposit of payroll, internet banking and telephone banking services.

Services to individuals include checking accounts, various savings programs, mortgage loans, home improvement loans, installment and other personal loans, credit cards, personal lines of credit, automobile and other consumer financing, safe deposit boxes, debit cards, 24-hour telephone banking, internet banking, and 24-hour automatic teller machine services.  The Banks also offer nondeposit products, such as mutual funds and annuities, and discount brokerage services to their customers.  Additionally, the Banks have Saturday hours and extended hours on certain evenings during the week for added customer convenience.

Lending Activities

The Banks originate secured and unsecured loans for business purposes.  Commercial loans are typically secured by real estate, accounts receivable, inventory, equipment and/or other assets of the business.  Commercial loans generally involve a greater degree of credit risk than one to four family residential mortgage loans.  Repayment is often dependent on the successful operation of the business and may be affected by adverse conditions in the local economy or real estate market. The financial condition and cash flow of commercial borrowers is therefore carefully analyzed during the loan approval process, and continues to be monitored by obtaining business financial statements, personal financial statements and income tax returns.  The frequency of this ongoing analysis depends upon the size and complexity of the credit and collateral that secures the loan.  It is also the Company’s general policy to obtain personal guarantees from the principals of the commercial loan borrowers.

Commercial real estate loans are primarily those secured by land for residential and commercial development, agricultural purpose properties, service industry buildings such as restaurants and motels, retail buildings and general purpose business space.  The Banks attempt to mitigate the risks associated with these loans through thorough financial analyses, conservative underwriting procedures, including prudent loan to value ratio standards, obtaining additional collateral when prudent, closely monitoring construction projects to control disbursement of funds on loans, and management’s knowledge of the local economy in which the Banks lend.

The Banks provide residential real estate construction loans to builders and individuals for single family dwellings. Residential construction loans are usually granted based upon “as completed” appraisals and are secured by the property under construction.  Additional collateral may be taken if loan to value ratios exceed 80%.  Site inspections are performed to determine pre-specified stages of completion before loan proceeds are disbursed.  These loans typically have maturities of six to 12 months and may have fixed or variable rate features.  Permanent financing options for individuals include fixed and variable rate loans with three- and five-year balloon features and one-, three- and five-year adjustable rate mortgage loans.  The risk of loss associated with real estate construction lending is controlled through conservative underwriting procedures such as loan to value ratios of 80% or less at origination, obtaining additional collateral when prudent, and closely monitoring construction projects to control disbursement of funds on loans.

The Banks originate fixed and variable rate residential mortgage loans.  As with any consumer loan, repayment is dependent on the borrower’s continuing financial stability, which can be adversely impacted by job loss, divorce, illness, or personal bankruptcy.  Underwriting standards recommend loan to value ratios not to exceed 80% at origination based on appraisals performed by approved appraisers. The Banks rely on title insurance to protect their lien priorities and protect the property securing the loans by requiring fire and casualty insurance.

Wye Mortgage Group brokers long-term fixed rate residential mortgage loans for sale on the secondary market for which it receives commissions upon settlement.  The Company adjusts the balance of its investment in Wye Mortgage Group by the Company’s share of Wye Mortgage Group’s undistributed income or loss.

 

 

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A variety of consumer loans are offered to customers, including home equity loans, credit cards and other secured and unsecured lines of credit and term loans.  Careful analysis of an applicant’s creditworthiness is performed before granting credit, and on going monitoring of loans outstanding is performed in an effort to minimize risk of loss by identifying problem loans early.

Deposit Activitie s

The Banks offer a full array of deposit products including checking, savings and money market accounts, regular and IRA certificates of deposit, and Christmas Savings accounts.  The Banks also offer the CDARS program, providing up to $50 million of FDIC insurance to our customers.  In addition, we offer our commercial customers packages which include Cash Management services and various checking opportunities.

Trust Services

CNB has a trust department through which it markets trust, asset management and financial planning services to customers within our market areas using the trade name Wye Financial & Trust.

Insurance Activities

The Avon-Dixon Agency, LLC, Elliott Wilson Insurance, LLC, and Mubell Finance, LLC were formed as a result of the Company’s acquisition of the assets of The Avon-Dixon Agency, Inc., Elliott Wilson Insurance, Inc., Avon-Dixon Financial Services, Inc., Joseph M. George & Son, Inc. and 59th Street Finance Company on May 1, 2002.  In November 2002, The Avon-Dixon Agency, LLC acquired certain assets of W. M. Freestate & Son, Inc., a full-service insurance producer firm located in Centreville, Maryland.  Jack Martin & Associates, Inc., Tri-State General Insurance Agency, LTD, Tri-State General Insurance Agency of New Jersey, Inc., Tri-State General Insurance Agency of Virginia, Inc., and ESFS, Inc. were acquired on October 1, 2007.

The Insurance Subsidiaries offer a full range of insurance products and services to customers, including insurance premium financing.

Seasonality

Management does not believe that our business activities are seasonal in nature.  Demand for our products and services may vary depending on local and national economic conditions, but management believes that any variation will not have a material impact on our planning or policy-making strategies.

Employees

At February 28, 2011, we employed 345 persons, of which 304 were employed on a full-time basis.

COMPETITION

The banking business, in all of its phases, is highly competitive.  Within our market areas, we compete with commercial banks (including local banks and branches or affiliates of other larger banks), savings and loan associations and credit unions for loans and deposits, with money market and mutual funds and other investment alternatives for deposits, with consumer finance companies for loans, with insurance companies, agents and brokers for insurance products, and with other financial institutions for various types of products and services.  There is also competition for commercial and retail banking business from banks and financial institutions located outside our market areas.

The primary factors in competing for deposits are interest rates, personalized services, the quality and range of financial services, convenience of office locations and office hours.  The primary factors in competing for loans are interest rates, loan origination fees, the quality and range of lending services and personalized services.  The primary factors in competing for insurance customers are competitive rates, the quality and range of insurance products offered, and quality, personalized service.

To compete with other financial services providers, we rely principally upon local promotional activities, including advertisements in local newspapers, trade journals and other publications and on the radio, personal relationships established by officers, directors and employees with customers, and specialized services tailored to meet its customers’ needs.  In those instances in which we are unable to accommodate the needs of a customer, we will arrange for those services to be provided by other financial services providers with which we have a relationship.  We additionally rely on referrals from satisfied customers.

 

 

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The following tables set forth deposit data for FDIC-insured institutions in Kent County, Queen Anne’s County, Caroline County, Talbot County and Dorchester County in Maryland and in Kent County, Delaware as of June 30, 2010, the most recent date for which comparative information is available.

						% of
Kent County, Maryland		Deposits				Total
		(in thousands)
Peoples Bank of Kent County, Maryland		$	180,815				35.07	%
PNC Bank, NA			145,993				28.31
Chesapeake Bank and Trust Co.			66,443				12.89
Branch Banking & Trust			47,960				9.30
CNB			43,545				8.44
SunTrust Bank			30,886				5.99
Total		$	515,642				100.00	%

Source:  FDIC DataBook

						% of
Queen Anne’s County, Maryland		Deposits				Total
		(in thousands)
The Queenstown Bank of Maryland		$	354,227				43.27	%
CNB			200,455				24.49
Bank of America, NA			65,122				7.95
PNC Bank, NA			60,805				7.43
Bank Annapolis			45,593				5.57
M&T			43,498				5.31
Branch Banking & Trust			23,983				2.93
SunTrust Bank			8,828				1.08
Capital One Bank			8,596				1.05
Peoples Bank			7,527				0.92
Total		$	818,634				100.00	%

Source:  FDIC DataBook

						% of
Caroline County, Maryland		Deposits				Total
		(in thousands)
Provident State Bank, Inc		$	151,782				38.32	%
PNC Bank, NA			101,084				25.52
CNB			57,106				14.42
Branch Banking & Trust			30,788				7.77
M&T			23,997				6.06
Bank of America, NA			16,749				4.23
Easton Bank & Trust			11,722				2.96
The Queenstown Bank of Maryland			2,820				0.71
Total		$	396,048				100.00	%

Source:  FDIC DataBook

 

 

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						% of
Talbot County, Maryland		Deposits				Total
		(in thousands)
The Talbot Bank of Easton, Maryland		$	580,928				49.96	%
PNC Bank, NA			131,775				11.33
Easton Bank & Trust			126,394				10.87
Bank of America, NA			92,389				7.95
Branch Banking & Trust			54,401				4.68
SunTrust Bank			44,925				3.86
The Queenstown Bank of Maryland			43,328				3.73
M&T			31,897				2.74
Provident State Bank, Inc			20,863				1.79
First Mariner Bank			18,589				1.60
Capital One Bank			17,258				1.48
Total		$	1,162,747				100.00	%

Source:  FDIC DataBook

						% of
Dorchester County, Maryland		Deposits				Total
		(in thousands)
The National Bank of Cambridge		$	197,275				32.30	%
Bank of the Eastern Shore			187,630				30.72
Hebron Savings Bank			56,171				9.20
Branch Banking & Trust			44,004				7.21
Provident State Bank, Inc			39,729				6.51
Bank of America, NA			25,359				4.15
SunTrust Bank			21,994				3.60
M&T			21,000				3.44
The Talbot Bank of Easton, Maryland			17,532				2.87
Total		$	610,694				100.00	%

Source:  FDIC DataBook

						% of
Kent County, Delaware		Deposits				Total
		(in thousands)
Wilmington Trust		$	548,818				31.64	%
PNC Bank Delaware			252,719				14.57
First NB of Wyoming			238,823				13.77
RBS Citizens NA			186,751				10.77
Wells Fargo			157,370				9.07
Wilmington Savings Fund Society			111,444				6.42
The Felton Bank			73,984				4.27
Artisans Bank			59,881				3.45
TD Bank NA			43,395				2.50
County Bank			37,878				2.18
Midcoast Community Bank			19,298				1.11
Fort Sill National Bank			4,311				0.25
Total		$	1,734,672				100.00	%

Source:  FDIC DataBook

For further information about competition in our market areas, see the Risk Factor entitled “We operate in a highly competitive market and our inability to effectively compete in our markets could have an adverse impact on our financial condition and results of operations” in Item 1A of Part I of this annual report.

 

 

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SUPERVISION AND REGULATION

The following is a summary of the material regulations and policies applicable to us and is not intended to be a comprehensive discussion.  Changes in applicable laws and regulations may have a material effect on our business, financial condition and results of operations.

General

The Company is a financial holding company registered with the Board of Governors of the Federal Reserve System (the “FRB”) under the BHC Act and, as such, is subject to the supervision, examination and reporting requirements of the BHC Act and the regulations of the FRB.

CNB and Talbot Bank are Maryland commercial banks subject to the banking laws of Maryland and to regulation by the Commissioner of Financial Regulation of Maryland, who is required by statute to make at least one examination in each calendar year (or at 18-month intervals if the Commissioner determines that an examination is unnecessary in a particular calendar year).  Prior to its merger with CNB on January 1, 2011, Felton Bank was a Delaware commercial bank subject to the banking laws of Delaware and to regulation by the Delaware Office of the State Bank Commissioner, who was entitled by statute to make examinations of Felton Bank as and when deemed necessary or expedient.  The FDIC, which is also entitled to conduct regular examinations, is the primary federal regulator of CNB and Talbot Bank, and it was also the primary federal regulator of Felton Bank.  The deposits of the Banks are insured by the FDIC, so certain laws and regulations administered by the FDIC also govern their deposit taking operations.  In addition to the foregoing, the Banks are subject to numerous state and federal statutes and regulations that affect the business of banking generally.

Nonbank affiliates of the Company are subject to examination by the FRB, and, as affiliates of the Banks, may be subject to examination by the Banks’ regulators from time to time.  In addition, the Insurance Subsidiaries are each subject to licensing and regulation by the insurance authorities of the states in which they do business.  Retail sales of insurance products by the Insurance Subsidiaries to customers of the Banks are also subject to the requirements of the Interagency Statement on Retail Sales of Nondeposit Investment Products promulgated in 1994, as amended, by the FDIC, the FRB and the other federal banking agencies. Wye Mortgage Group is subject to supervision by the banking agencies of the states in which it does business.

Regulation of Financial Holding Companies

In November 1999, the federal Gramm-Leach-Bliley Act (the “GLB Act”) was signed into law.  Effective in pertinent part on March 11, 2000, the GLB Act revised the BHC Act and repealed the affiliation provisions of the Glass-Steagall Act of 1933, which, taken together, limited the securities, insurance and other non-banking activities of any company that controls an FDIC insured financial institution.  Under the GLB Act, a bank holding company can elect, subject to certain qualifications, to become a “financial holding company”.  The GLB Act provides that a financial holding company may engage in a full range of financial activities, including insurance and securities sales and underwriting activities, and real estate development, with new expedited notice procedures.

Under FRB policy, the Company is expected to act as a source of strength to its subsidiary banks, and the FRB may charge the Company with engaging in unsafe and unsound practices for failure to commit resources to a subsidiary bank when required.  In addition, under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), depository institutions insured by the FDIC can be held liable for any losses incurred by, or reasonably anticipated to be incurred by, the FDIC in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution in danger of default.  Accordingly, in the event that any insured subsidiary of the Company causes a loss to the FDIC, other insured subsidiaries of the Company could be required to compensate the FDIC by reimbursing it for the estimated amount of such loss.  Such cross guaranty liabilities generally are superior in priority to obligations of a financial institution to its stockholders and obligations to other affiliates.

Federal Regulation of Banks

Federal and state banking regulators may prohibit the institutions over which they have supervisory authority from engaging in activities or investments that the agencies believes are unsafe or unsound banking practices.  These banking regulators have extensive enforcement authority over the institutions they regulate to prohibit or correct activities that violate law, regulation or a regulatory agreement or which are deemed to be unsafe or unsound practices.  Enforcement actions may include the appointment of a conservator or receiver, the issuance of a cease and desist order, the termination of deposit insurance, the imposition of civil money penalties on the institution, its directors, officers, employees and institution-affiliated parties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the removal of or restrictions on directors, officers, employees and institution-affiliated parties, and the enforcement of any such mechanisms through restraining orders or other court actions.

 

 

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The Banks are subject to the provisions of Section 23A and Section 23B of the Federal Reserve Act.  Section 23A limits the amount of loans or extensions of credit to, and investments in, the Company and its nonbank affiliates by the Banks.  Section 23B requires that transactions between any of the Banks and the Company and its nonbank affiliates be on terms and under circumstances that are substantially the same as with non-affiliates.

The Banks are also subject to certain restrictions on extensions of credit to executive officers, directors, and principal stockholders or any related interest of such persons, which generally require that such credit extensions be made on substantially the same terms as are available to third parties dealing with the Banks and not involve more than the normal risk of repayment.  Other laws tie the maximum amount that may be loaned to any one customer and its related interests to capital levels.

As part of the Federal Deposit Insurance Company Improvement Act of 1991 (“FDICIA”), each federal banking regulator adopted non-capital safety and soundness standards for institutions under its authority.  These standards include internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, and compensation, fees and benefits.  An institution that fails to meet those standards may be required by the agency to develop a plan acceptable to meet the standards.  Failure to submit or implement such a plan may subject the institution to regulatory sanctions.  The Company, on behalf of the Banks, believes that the Banks meet substantially all standards that have been adopted.  FDICIA also imposes capital standards on insured depository institutions.

The Community Reinvestment Act (“CRA”) requires that, in connection with the examination of financial institutions within their jurisdictions, the federal banking regulators evaluate the record of the financial institution in meeting the credit needs of their communities including low and moderate income neighborhoods, consistent with the safe and sound operation of those banks.  These factors are also considered by all regulatory agencies in evaluating mergers, acquisitions and applications to open a branch or facility.  As of the date of its most recent examination report, each of the Banks has a CRA rating of “Satisfactory.”

On October 14, 2008, the FDIC announced the creation of the Temporary Liquidity Guarantee Program (the “TLGP”) to decrease the cost of bank funding and, hopefully, normalize lending.  This program is comprised of two components. The first component guarantees senior unsecured debt issued between October 14, 2008 and June 30, 2009.  The guarantee will remain in effect until June 30, 2012 for such debts that mature beyond June 30, 2009.  The second component, called the Transaction Accounts Guarantee Program (“TAG”), provided full coverage for non-interest bearing transaction deposit accounts, IOLTAs, and NOW accounts with interest rates of 0.25% or less, regardless of account balance, initially until December 31, 2009.  The TAG program expired on December 31, 2010.  We elected to participate in both programs and paid additional FDIC premiums in 2010 and 2009 as a result.  See the section below entitled “Deposit Insurance”.

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which made sweeping changes to the financial regulatory landscape and will impact all financial institutions, including the Company and the Banks.

On November 9, 2010, the FDIC issued a final rule to implement Section 343 of the Dodd-Frank Act that provides temporary unlimited deposit insurance coverage for non-interest bearing transaction accounts at all FDIC-insured depository institutions.  The coverage is automatic for all FDIC-insured institutions and does not include an opt out option.  The separate coverage for noninterest-bearing transaction accounts became effective on December 31, 2010 and terminates on December 31, 2012.

These new laws, regulations and regulatory actions will cause our regulatory expenses to increase.  Additionally, due in part to numerous bank failures throughout the country since 2008, the FDIC imposed an emergency insurance assessment to help restore the Deposit Insurance Fund and further required insured depository institutions to prepay their estimated quarterly risk-based deposit assessments through 2012 on December 30, 2009.  Given the current state of the national economy, there can be no assurance that the FDIC will not impose future emergency assessments or further revise its rate structure.

The Dodd-Frank Act’s significant regulatory changes include the creation of a new financial consumer protection agency, known as the Bureau of Consumer Financial Protection, that is empowered to promulgate new consumer protection regulations and revise existing regulations in many areas of consumer compliance.  Moreover, the Dodd-Frank Act permits states to adopt stricter consumer protection laws and states’ attorneys general may enforce consumer protection rules issued by the Bureau. The Dodd-Frank Act also imposes more stringent capital requirements on bank holding companies by, among other things, imposing leverage ratios on bank holding companies and prohibiting new trust preferred securities issuances from counting as Tier 1 capital.  These developments may limit our future capital strategies.  The Dodd-Frank Act also increases regulation of derivatives and hedging transactions, which could limit our ability to enter into, or increase the costs associated with, interest rate and other hedging transactions.

 

 

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Certain provisions of the Dodd-Frank Act, including those relating to direct supervision by the Bureau of Consumer Financial Protection, will not apply to banking organizations with assets of less than $10 billion, such as the Company and the Banks.  Nevertheless, the other provisions of the Dodd-Frank Act will increase our regulatory compliance burden and costs and may restrict the financial products and services we offer to our customers.  In particular, the Dodd-Frank Act will require us to invest significant management attention and resources so that we can evaluate the impact of this law and make any necessary changes to our product offerings and operations.

Capital Requirements

FDICIA established a system of prompt corrective action to resolve the problems of undercapitalized institutions.  Under this system, federal banking regulators are required to rate supervised institutions on the basis of five capital categories: “well -capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized;” and to take certain mandatory actions, and are authorized to take other discretionary actions, with respect to institutions in the three undercapitalized categories.  The severity of the actions will depend upon the category in which the institution is placed.  A depository institution is “well capitalized” if it has a total risk based capital ratio of 10% or greater, a Tier 1 risk based capital ratio of 6% or greater, and a leverage ratio of 5% or greater and is not subject to any order, regulatory agreement, or written directive to meet and maintain a specific capital level for any capital measure.  An “adequately capitalized” institution is defined as one that has a total risk based capital ratio of 8% or greater, a Tier 1 risk based capital ratio of 4% or greater and a leverage ratio of 4% or greater (or 3% or greater in the case of a bank with a composite CAMELS rating of 1).

FDICIA generally prohibits a depository institution from making any capital distribution, including the payment of cash dividends, or paying a management fee to its holding company if the depository institution would thereafter be undercapitalized.  Undercapitalized depository institutions are subject to growth limitations and are required to submit capital restoration plans.  For a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee (subject to certain limitations) that the institution will comply with such capital restoration plan.

Significantly undercapitalized depository institutions may be subject to a number of other requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized and requirements to reduce total assets and stop accepting deposits from correspondent banks.  Critically undercapitalized depository institutions are subject to the appointment of a receiver or conservator, generally within 90 days of the date such institution is determined to be critically undercapitalized.

As of December 31, 2010, the Banks were each deemed to be “well capitalized.”  For more information regarding the capital condition of the Company, see Note 17 of Consolidated Financial Statements appearing in Item 8 of Part II of this report.

Deposit Insurance

The deposits of the Banks are insured to a maximum of $250,000 per depositor through the Deposit Insurance Fund, which is administered by the FDIC, and the Banks are required to pay quarterly deposit insurance premium assessments to the FDIC.  The Deposit Insurance Fund was created pursuant to the Federal Deposit Insurance Reform Act of 2005 (the “Reform Act”).  This law (i) required the then-existing $100,000 deposit insurance coverage to be indexed for inflation (with adjustments every five years, commencing January 1, 2011), and (ii) increased the deposit insurance coverage for retirement accounts to $250,000 per participant, subject to adjustment for inflation.  Effective October 3, 2008, however, the Emergency Economic Stabilization Act of 2008 (the “EESA”) was enacted and, among other things, temporarily raised the basic limit on federal deposit insurance coverage from $100,000 to $250,000 per depositor.  EESA initially contemplated that the coverage limit would return to $100,000 after December 31, 2009, but the expiration date has since been extended to December 31, 2013.  The coverage for retirement accounts did not change and remains at $250,000.  On July 21, 2010, as part of the Dodd-Frank Act, the current standard maximum deposit insurance amount was permanently raised to $250,000.

The Reform Act also gave the FDIC greater latitude in setting the assessment rates for insured depository institutions which could be used to impose minimum assessments.  On May 22, 2009, the FDIC imposed an emergency insurance assessment of five basis points in an effort to restore the Deposit Insurance Fund to an acceptable level.  On November 12, 2009, the FDIC adopted a final rule requiring insured depository institutions to prepay their estimated quarterly risk-based deposit assessments for the fourth quarter of 2009, and for all of 2010, 2011, and 2012, on December 30, 2009, along with each institution’s risk based deposit insurance assessment for the third quarter of 2009.  It was also announced that the assessment rate will increase by 3 basis points effective January 1, 2011.  The prepayment will be accounted for as a prepaid expense to be amortized quarterly.  The prepaid assessment will qualify for a zero risk weight under the risk-based capital requirements.  The Banks’ three-year prepaid assessment was $5.4 million.  The Banks paid a total of $1.8 million in FDIC premiums during 2010.

 

 

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USA PATRIOT Act

Congress adopted the USA PATRIOT Act (the “Patriot Act”) on October 26, 2001 in response to the terrorist attacks that occurred on September 11, 2001.  Under the Patriot Act, certain financial institutions, including banks, are required to maintain and prepare additional records and reports that are designed to assist the government’s efforts to combat terrorism.  The Patriot Act includes sweeping anti-money laundering and financial transparency laws and required additional regulations, including, among other things, standards for verifying client identification when opening an account and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.

Federal Securities Laws

The shares of the Company’s common stock are registered with the Securities and Exchange Commission (the “SEC”) under Section 12(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and listed on the NASDAQ Global Select Market.  The Company is subject to information reporting requirements, proxy solicitation requirements, insider trading restrictions and other requirements of the Exchange Act, including the requirements imposed under the federal Sarbanes-Oxley Act of 2002.  Among other things, loans to and other transactions with insiders are subject to restrictions and heightened disclosure, directors and certain committees of the Board must satisfy certain independence requirements, and the Corporation is generally required to comply with certain corporate governance requirements.

Governmental Monetary and Credit Policies and Economic Controls

The earnings and growth of the banking industry and ultimately of the Bank are affected by the monetary and credit policies of governmental authorities, including the FRB.  An important function of the FRB is to regulate the national supply of bank credit in order to control recessionary and inflationary pressures. Among the instruments of monetary policy used by the FRB to implement these objectives are open market operations in U.S. Government securities, changes in the federal funds rate, changes in the discount rate of member bank borrowings, and changes in reserve requirements against member bank deposits.  These means are used in varying combinations to influence overall growth of bank loans, investments and deposits and may also affect interest rates charged on loans or paid for deposits.  The monetary policies of the FRB authorities have had a significant effect on the operating results of commercial banks in the past and are expected to continue to have such an effect in the future.  In view of changing conditions in the national economy and in the money markets, as well as the effect of actions by monetary and fiscal authorities, including the FRB, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or their effect on the business and earnings of the Company and its subsidiaries.

AVAILABLE INFORMATION

The Company maintains an Internet site at www.shbi. com on which it makes available, free of charge, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to the foregoing as soon as reasonably practicable after these reports are electronically filed with, or furnished to, the SEC.  In addition, stockholders may access these reports and documents on the SEC’s web site at www.sec.gov .

Item 1A.    RISK FACTORS.

The following factors may impact our business, financial condition and results of operations and should be considered carefully in evaluating an investment in shares of common stock of the Company.

Risks Relating to Our Business

The Company’s future depends on the successful growth of its subsidiaries

The Company’s primary business activity for the foreseeable future will be to act as the holding company of CNB, Talbot Bank, and its other subsidiaries.  Therefore, the Company’s future profitability will depend on the success and growth of these subsidiaries.  In the future, part of the Company’s growth may come from buying other banks and buying or establishing other companies.  Such entities may not be profitable after they are purchased or established, and they may lose money, particularly at first.  A new bank or company may bring with it unexpected liabilities, bad loans, or bad employee relations, or the new bank or company may lose customers.

 

 

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A majority of our business is concentrated in Maryland and Delaware, a significant amount of which is concentrated in real estate lending, so a decline in the local economy and real estate markets could adversely impact our financial condition and results of operations

Because most of our loans are made to customers who reside on the Eastern Shore of Maryland and in Delaware, a decline in local economic conditions may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions whose loan portfolios are geographically diverse.  Further, we make many real estate secured loans, including construction and land development loans, all of which are in greater demand when interest rates are low and economic conditions are good.  The national and local economies have significantly weakened during the past three years in large part due to the widely-reported problems in the sub-prime mortgage loan market and the meltdown of the financial industry as a whole.  As a result, real estate values across the country, including in our market areas, have decreased and the general availability of credit, especially credit to be secured by real estate, has also decreased.  These conditions have made it more difficult for real estate owners and owners of loans secured by real estate to sell their assets at the times and at the prices they desire.  In addition, these conditions have increased the risk that the market values of the real estate securing our loans may deteriorate, which could cause us to lose money in the event a borrower fails to repay a loan and we are forced to foreclose on the property.  There can be no guarantee as to when or whether economic conditions will improve.

Our concentrations of commercial real estate loans could subject us to increased regulatory scrutiny and directives, which could force us to preserve or raise capital and/or limit our future commercial lending activities.

The FRB and the FDIC, along with the other federal banking regulators, issued guidance in December 2006 entitled “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices” directed at institutions who have particularly high concentrations of commercial real estate loans within their lending portfolios.  This guidance suggests that these institutions face a heightened risk of financial difficulties in the event of adverse changes in the economy and commercial real estate markets.  Accordingly, the guidance suggests that institutions whose concentrations exceed certain percentages of capital should implement heightened risk management practices appropriate to their concentration risk.  The guidance provides that banking regulators may require such institutions to reduce their concentrations and/or maintain higher capital ratios than institutions with lower concentrations in commercial real estate.  Based on our concentration of commercial real estate and construction lending as of December 31, 2010, we may be subject to heightened supervisory scrutiny during future examinations and/or be required to take steps to address our concentration and capital levels.  Management cannot predict the extent to which this guidance will impact our operations or capital requirements.  Further, we cannot guarantee that any risk management practices we implement will be effective to prevent losses relating from concentrations in our commercial real estate portfolio.

Interest rates and other economic conditions will impact our results of operations

The national economy and the local economy have significantly weakened during the past three years, primarily as a result of the widely reported financial institution meltdown.  This weakening has caused real estate values to drop, decreased the demand for credit, and caused public anxiety regarding the health and future of the financial services industry as a whole.

Our results of operations may be materially and adversely affected by changes in prevailing economic conditions, including declines in real estate values, rapid changes in interest rates and the monetary and fiscal policies of the federal government.  Our profitability is in part a function of the spread between the interest rates earned on assets and the interest rates paid on deposits and other interest-bearing liabilities ( i.e. , net interest income), including advances from the Federal Home Loan Bank (the “FHLB”) of Atlanta.  Interest rate risk arises from mismatches ( i.e. , the interest sensitivity gap) between the dollar amount of repricing or maturing assets and liabilities and is measured in terms of the ratio of the interest rate sensitivity gap to total assets.  More assets repricing or maturing than liabilities over a given time period is considered asset-sensitive and is reflected as a positive gap, and more liabilities repricing or maturing than assets over a given time period is considered liability-sensitive and is reflected as negative gap.  An asset-sensitive position ( i.e. , a positive gap) could enhance earnings in a rising interest rate environment and could negatively impact earnings in a falling interest rate environment, while a liability-sensitive position ( i.e. , a negative gap) could enhance earnings in a falling interest rate environment and negatively impact earnings in a rising interest rate environment.  Fluctuations in interest rates are not predictable or controllable.  We have attempted to structure our asset and liability management strategies to mitigate the impact on net interest income of changes in market interest rates, but there can be no assurance that these attempts will be successful in the event of future changes.

 

 

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The Banks may experience credit losses in excess of their allowances, which would adversely impact our financial condition and results of operations

The risk of credit losses on loans varies with, among other things, general economic conditions, the type of loan being made, the creditworthiness of the borrower over the term of the loan and, in the case of a collateralized loan, the value and marketability of the collateral for the loan.  Management of each of the Banks bases the allowance for credit losses upon, among other things, historical experience, an evaluation of economic conditions and regular reviews of delinquencies and loan portfolio quality.  Based upon such factors, management makes various assumptions and judgments about the ultimate collectability of the loan portfolio and provides an allowance for credit losses based upon a percentage of the outstanding balances and for specific loans when their ultimate collectability is considered questionable.  If management’s assumptions and judgments prove to be incorrect and the allowance for credit losses is inadequate to absorb future losses, or if the bank regulatory authorities, as a part of their examination process, require our bank subsidiaries to increase their respective allowance for credit losses, our earnings and capital could be significantly and adversely affected.  Moreover, future adjustments may be necessary if economic conditions differ substantially from the assumptions used or adverse developments arise with respect to the Banks’ nonperforming or performing loans.  Material additions to the allowance for credit losses of one of the Banks would result in a decrease in that Bank’s net income and capital and could have a material adverse effect on our financial condition.

The market value of our investments might decline

As of December 31, 2010, we had classified 94% of our investment securities as available-for-sale pursuant to the Financial Accounting Standards Board’s Accounting Standards Codification Topic 320 (“ASC 320”)  relating to accounting for investments. ASC 320 requires that unrealized gains and losses in the estimated value of the available-for-sale portfolio be “marked to market” and reflected as a separate item in stockholders’ equity (net of tax) as accumulated other comprehensive income.   The remaining investment securities are classified as held-to-maturity in accordance with ASC 320 and are stated at amortized cost.

In the past, gains on sales of investment securities have not been a significant source of income for us.   There can be no assurance that future market performance of our investment portfolio will enable us to realize income from sales of securities.  Stockholders’ equity will continue to reflect the unrealized gains and losses (net of tax) of these investments.  There can be no assurance that the market value of our investment portfolio will not decline, causing a corresponding decline in stockholders’ equity.

CNB and Talbot Bank are members of the FHLB of Atlanta.  Prior to its merger with CNB, Felton Bank was a member of the FHLB of Pittsburgh.  A member of the FHLB system is required to purchase stock issued by the relevant FHLB bank based on how much it borrows from the FHLB and the quality of the collateral pledged to secure that borrowing.  Accordingly, our investments include stock issued by the FHLB of Atlanta and the FHLB of Pittsburgh.  These investments could be subject to future impairment charges and there can be no guaranty of future dividends.

Management believes that several factors will affect the market values of our investment portfolio.  These include, but are not limited to, changes in interest rates or expectations of changes, the degree of volatility in the securities markets, inflation rates or expectations of inflation and the slope of the interest rate yield curve (the yield curve refers to the differences between shorter-term and longer-term interest rates; a positively sloped yield curve means shorter-term rates are lower than longer-term rates).  Also, the passage of time will affect the market values of our investment securities, in that the closer they are to maturing, the closer the market price should be to par value.  These and other factors may impact specific categories of the portfolio differently, and management cannot predict the effect these factors may have on any specific category.

The banking industry is heavily regulated; significant regulatory changes could adversely affect our operations

Our operations are and will be affected by current and future legislation and by the policies established from time to time by various federal and state regulatory authorities.  The Company is subject to supervision by the FRB; and CNB and Talbot Bank are subject to supervision and periodic examination by the Maryland Commissioner and the FDIC.  Banking regulations, designed primarily for the safety of depositors, may limit a financial institution’s growth and the return to its investors by restricting such activities as the payment of dividends, mergers with or acquisitions by other institutions, investments, loans and interest rates, interest rates paid on deposits, expansion of branch offices, and the offering of securities or trust services.  The Company and the Banks are also subject to capitalization guidelines established by federal law and could be subject to enforcement actions to the extent that those institutions are found by regulatory examiners to be undercapitalized.  It is not possible to predict what changes, if any, will be made to existing federal and state legislation and regulations or the effect that such changes may have on our future business and earnings prospects.  Management also cannot predict the nature or the extent of the effect on our business and earnings of future fiscal or monetary policies, economic controls, or new federal or state legislation.  Further, the cost of compliance with regulatory requirements may adversely affect our ability to operate profitably.

 

 

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We operate in a highly competitive market, and our inability to effectively compete in our markets could have an adverse impact on our financial condition and results of operations

We operate in a competitive environment, competing for loans, deposits, insurance products and customers with commercial banks, savings associations and other financial entities.  Competition for deposits comes primarily from other commercial banks, savings associations, credit unions, money market and mutual funds and other investment alternatives.  Competition for loans comes primarily from other commercial banks, savings associations, mortgage banking firms, credit unions and other financial intermediaries.  Competition for other products, such as insurance and securities products, comes from other banks, securities and brokerage companies, insurance companies, insurance agents and brokers, and other nonbank financial service providers in our market areas.  Many of these competitors are much larger in terms of total assets and capitalization, have greater access to capital markets, and/or offer a broader range of financial services than those offered by us.  In addition, banks with a larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the needs of larger customers.  Our growth and profitability will depend upon our ability to attract and retain skilled managerial, marketing and technical personnel.  Competition for qualified personnel in the financial services industry is intense, and there can be no assurance that we will be successful in attracting and retaining such personnel.

In addition, current banking laws facilitate interstate branching, merger activity among banks, and expanded activities.  Since September 1995, certain bank holding companies have been authorized to acquire banks throughout the United States.  Since June 1, 1997, certain banks have been permitted to merge with banks organized under the laws of different states.  As a result, interstate banking is now an accepted element of competition in the banking industry and the Corporation may be brought into competition with institutions with which it does not presently compete.  Moreover, as discussed above, the GLB Act revised the BHC Act in 2000 and repealed the affiliation provisions of the Glass-Steagall Act of 1933, which, taken together, limited the securities, insurance and other non-banking activities of any company that controls an FDIC insured financial institution.  These laws may increase the competition we face in our market areas in the future, although management cannot predict the degree to which such competition will impact our financial condition or results of operations.

Our regulatory expenses will likely increase due to federal laws, rules and programs that have been enacted or adopted in response to the recent banking crisis and the current national recession

In response to the banking crisis that began in 2008 and the resulting national recession, the federal government took drastic steps to help stabilize the credit market and the financial industry.  These steps included the enactment of EESA, which, among other things, raised the basic limit on federal deposit insurance coverage to $250,000, and the FDIC’s adoption of the TLGP, which, under the TAG portion, provides full deposit insurance coverage through June 30, 2010 for non-interest bearing transaction deposit accounts, IOLTAs, and NOW accounts with interest rates of 0.50% or less, regardless of account balance. The TLGP was extended to December 31, 2010 and includes non-interest bearing transaction deposit accounts, IOLTAs, and NOW accounts with interest rates of 0.25% or less, regardless of account balance.  The TLGP requires participating institutions, like us, to pay 10 basis points per annum for the additional insured deposits.  These actions will cause our regulatory expenses to increase.  Additionally, due in part to the failure of depository institutions around the country since the banking crisis began, the FDIC imposed an emergency insurance assessment to help restore the Deposit Insurance Fund and further required insured depository institutions to prepay their estimated quarterly risk-based deposit assessments through 2012 on December 30, 2009.  Given the current state of the national economy, there can be no assurance that the FDIC will not impose future emergency assessments or further revise its rate structure.

In addition, and as noted above, the Dodd-Frank Act recently became law and implements significant changes in the financial regulatory landscape that will impact all financial institutions, including the Company and the Banks.  The Dodd-Frank Act is likely to increase our regulatory compliance burden.  It is too early, however, for us to assess the full impact that the Dodd-Frank Act may have on our business, financial condition or results of operations.  Many of the Dodd-Frank Act’s provisions require subsequent regulatory rulemaking.  The Dodd-Frank Act’s significant regulatory changes include the creation of a new financial consumer protection agency, known as the Bureau of Consumer Financial Protection, that is empowered to promulgate new consumer protection regulations and revise existing regulations in many areas of consumer compliance, which will increase our regulatory compliance burden and costs and may restrict the financial products and services we offer to our customers.  Moreover, the Dodd-Frank Act permits states to adopt stricter consumer protection laws and states’ attorneys general may enforce consumer protection rules issued by the Bureau. The Dodd-Frank Act also imposes more stringent capital requirements on bank holding companies by, among other things, imposing leverage ratios on bank holding companies and prohibiting new trust preferred issuances from counting as Tier 1 capital.  These restrictions may limit our future capital strategies.  The Dodd-Frank Act also increases regulation of derivatives and hedging transactions, which could limit our ability to enter into, or increase the costs associated with, interest rate and other hedging transactions.  Although certain provisions of the Dodd-Frank Act, such as direct supervision by the Bureau of Consumer Financial Protection, will not apply to banking organizations with less than $10 billion of assets, such as the Company and the Banks, the changes resulting from the legislation will impact our business.  These changes will require us to invest significant management attention and resources to evaluate and make necessary changes.

 

 

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Recent amendments to the FRB’s Regulation E may negatively impact our non-interest income.

On November 12, 2009, the FRB announced the final rules amending Regulation E (“Reg E”) that prohibit financial institutions from charging fees to consumers for paying overdrafts on automated teller machine and one-time debit card transactions, unless a consumer consents, or opts-in, to the overdraft service for those types of transactions.  Compliance with this regulation is effective July 1, 2010 for new consumer accounts and August 15, 2010 for existing consumer accounts.  The impact of these new rules has the potential to reduce our non-interest income and this reduction could be material.

Customer concern about deposit insurance may cause a decrease in deposits held at the Banks

With recent increased concerns about bank failures, customers increasingly are concerned about the extent to which their deposits are insured by the FDIC.  Customers may withdraw deposits from the Banks in an effort to ensure that the amount they have on deposit with us is fully insured.  Decreases in deposits may adversely affect our funding costs and net income.

Our funding sources may prove insufficient to replace deposits and support our future growth

We rely on customer deposits, advances from the FHLB, and lines of credit at other financial institutions to fund our operations.  Although we have historically been able to replace maturing deposits and advances if desired, no assurance can be given that we would be able to replace such funds in the future if our financial condition or the financial condition of the FHLB or market conditions were to change.  Our financial flexibility will be severely constrained and/or our cost of funds will increase if we are unable to maintain our access to funding or if financing necessary to accommodate future growth is not available at favorable interest rates.  Finally, if we are required to rely more heavily on more expensive funding sources to support future growth, our revenues may not increase proportionately to cover our costs. In this case, our profitability would be adversely affected.

The loss of key personnel could disrupt our operations and result in reduced earnings

Our growth and profitability will depend upon our ability to attract and retain skilled managerial, marketing and technical personnel.  Competition for qualified personnel in the financial services industry is intense, and there can be no assurance that we will be successful in attracting and retaining such personnel.  Our current executive officers provide valuable services based on their many years of experience and in-depth knowledge of the banking industry.  Due to the intense competition for financial professionals, these key personnel would be difficult to replace and an unexpected loss of their services could result in a disruption to the continuity of operations and a possible reduction in earnings.

We may lose key personnel because of our participation in the Troubled Asset Relief Program Capital Purchase Program

On January 9, 2009, we participated in the Troubled Asset Relief Program (“TARP”) Capital Purchase Program (the “CPP”) adopted by the U.S. Department of Treasury (“Treasury”) by selling $25 million in shares of our Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the “Series A Preferred Stock”) to Treasury and issuing a 10-year common stock purchase warrant (the “Warrant”) to Treasury.  As part of these transactions, we adopted Treasury’s standards for executive compensation and corporate governance for the period during which Treasury holds any shares of the Series A Preferred Stock and/or any shares of common stock that may be acquired upon exercise of the Warrant.  On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (the “Recovery Act”) was signed into law, which, among other things, imposes additional executive compensation restrictions on institutions that participate in TARP for so long as any TARP assistance remains outstanding.  Among these restrictions is a prohibition against making most severance payments to our “senior executive officers”, which term includes our Chairman and Chief Executive Officer, our Chief Financial Officer and, generally, the three next most highly compensated executive officers, and to the next five most highly compensated employees.  The restrictions also limit the type, timing and amount of bonuses, retention awards and incentive compensation that may be paid to our five most highly compensated employees.

On April 15, 2009, the Company redeemed all of the outstanding Series A Preferred Stock from the Treasury, so the foregoing restrictions ceased to apply.  However, the Treasury still holds the Warrant which, if exercised, would again subject us to these restrictions.  If the Treasury were to exercise the Warrant for shares of our common stock, these restrictions, coupled with the competition we face from other institutions, including institutions that did not participate in TARP, may make it more difficult for us to attract and/or retain exceptional key employees.

 

 

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Our lending activities subject us to the risk of environmental liabilities

A significant portion of our loan portfolio is secured by real property.  During the ordinary course of business, we may foreclose on and take title to properties securing certain loans.  In doing so, there is a risk that hazardous or toxic substances could be found on these properties.  If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage.  Environmental laws may require us to incur substantial expenses and may materially reduce the affected property’s value or limit our ability to use or sell the affected property.  In addition, future laws or more stringent interpretations of enforcement policies with respect to existing laws may increase our exposure to environmental liability.  Although we have policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards.  The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our financial condition and results of operations.

We may be subject to other claims

We may from time to time be subject to claims from customers for losses due to alleged breaches of fiduciary duties, errors and omissions of employees, officers and agents, incomplete documentation, the failure to comply with applicable laws and regulations, or many other reasons.  Also, our employees may knowingly or unknowingly violate laws and regulations.  Management may not be aware of any violations until after their occurrence.  This lack of knowledge may not insulate the Company or our subsidiaries from liability.  Claims and legal actions may result in legal expenses and liabilities that may reduce our profitability and hurt our financial condition.

We may be adversely affected by other recent legislation

As discussed above, the GLB Act repealed restrictions on banks affiliating with securities firms and it also permitted bank holding companies that become financial holding companies to engage in additional financial activities, including insurance and securities underwriting and agency activities, merchant banking, and insurance company portfolio investment activities that are currently not permitted for bank holding companies.  Although the Company is a financial holding company, this law may increase the competition we face from larger banks and other companies.  It is not possible to predict the full effect that this law will have on us.

The Sarbanes-Oxley Act of 2002 requires management of publicly traded companies to perform an annual assessment of their internal controls over financial reporting and to report on whether the system is effective as of the end of the Company’s fiscal year.  Disclosure of significant deficiencies or material weaknesses in internal controls could cause an unfavorable impact to shareholder value by affecting the market value of our stock.

The Patriot Act requires certain financial institutions, such as the Banks, to maintain and prepare additional records and reports that are designed to assist the government’s efforts to combat terrorism. This law includes sweeping anti-money laundering and financial transparency laws and required additional regulations, including, among other things, standards for verifying client identification when opening an account and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.  If we fail to comply with this law, we could be exposed to adverse publicity as well as fines and penalties assessed by regulatory agencies.

We may not be able to keep pace with developments in technology in which case we may become less competitive and lose customers

We use various technologies in our business, including telecommunication, data processing, computers, automation, internet-based banking, and debit cards.  Technology changes rapidly.  Our ability to compete successfully with other banks and non-bank entities may depend on whether we can exploit technological changes.  We may not be able to exploit technological changes, and any investment we do make may not make us more profitable.  We converted to a new core data processing system during the second quarter of 2009.  Although management expects that this system will improve operating efficiencies, there can be no guaranty that it will do so or that software, hardware or other technical problems will not delay its effectiveness.

Risks Relating to the Company’s Securities

The Company’s shares of common stock and the Warrant are not insured

The shares of the Company’s common stock and the Warrant are not deposits and are not insured against loss by the FDIC or any other governmental or private agency.

 

 

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The Company’s ability to pay dividends is limited by applicable banking and corporate law

The Company’s stockholders are entitled to dividends on their shares of common stock if, when, and as declared by the Company’s Board of Directors out of funds legally available for that purpose.  The Company’s current ability to pay dividends to stockholders is largely dependent upon its earnings in future periods and upon the receipt of dividends from the Banks.  FRB guidance requires a bank holding company, like the Company, to consult with the FRB before paying dividends if the Company’s earnings do not exceed the aggregate amount of the proposed dividend.  The FRB has the ability to prohibit a dividend in such a situation.  Both federal and state laws impose restrictions on the ability of the Banks to pay dividends.  Federal law prohibits the payment of a dividend by an insured depository institution if the depository institution is considered “undercapitalized” or if the payment of the dividend would make the institution “undercapitalized”.  Maryland banking law provides that a state-chartered bank may pay dividends out of undivided profits or, with the prior approval of the Maryland Commissioner, from surplus in excess of 100% of required capital stock.  If, however, the surplus of a Maryland bank is less than 100% of its required capital stock, then cash dividends may not be paid in excess of 90% of net earnings.  In addition to these specific restrictions, bank regulatory agencies also have the ability to prohibit proposed dividends by a financial institution that would otherwise be permitted under applicable regulations if the regulatory body determines that such distribution would constitute an unsafe or unsound practice.  Because of these limitations, there can be no guarantee that the Company’s Board will declare dividends in any fiscal quarter.

There is no market for the Warrant, and the common stock is not heavily traded

There is no established trading market for the Warrant.  The Company’s common stock is listed on the NASDAQ Global Select Market, but shares of the common stock are not heavily traded.  Securities that are not heavily traded can be more volatile than stock trading in an active public market.  Factors such as our financial results, the introduction of new products and services by us or our competitors, and various factors affecting the banking industry generally may have a significant impact on the market price of the shares of the common stock.  Management cannot predict the extent to which an active public market for any of the Company’s securities will develop or be sustained in the future.  Accordingly, holders of the Company’s securities may not be able to sell such securities at the volumes, prices, or times that they desire.

The Company’s Articles of Incorporation and By-Laws and Maryland law may discourage a corporate takeover

The Company’s Amended and Restated Articles of Incorporation, as supplemented (the “Charter”), and Amended and Restated By-Laws, as amended (the “By-Laws”), contain certain provisions designed to enhance the ability of the Board of Directors to deal with attempts to acquire control of the Company.  The Charter and By-Laws provide for the classification of the Board into three classes; directors of each class generally serve for staggered three-year periods.  No director may be removed except for cause and then only by a vote of at least two-thirds of the total eligible stockholder votes.  The Charter gives the Board certain powers in respect of the Company’s securities.  First, the Board has the authority to classify and reclassify unissued shares of stock of any class or series of stock by setting, fixing, eliminating, or altering in any one or more respects the preferences, rights, voting powers, restrictions and qualifications of, dividends on, and redemption, conversion, exchange, and other rights of, such securities.  Second, a majority of the Board, without action by the stockholders, may amend the Charter to increase or decrease the aggregate number of shares of stock or the number of shares of stock of any class that the Company has authority to issue.  The Board could use these powers, along with its authority to authorize the issuance of securities of any class or series, to issue securities having terms favorable to management to persons affiliated with or otherwise friendly to management.

Maryland law also contains anti-takeover provisions that apply to the Company.  The Maryland Business Combination Act generally prohibits, subject to certain limited exceptions, corporations from being involved in any “business combination” (defined as a variety of transactions, including a merger, consolidation, share exchange, asset transfer or issuance or reclassification of equity securities) with any “interested shareholder” for a period of five years following the most recent date on which the interested shareholder became an interested shareholder.  An interested shareholder is defined generally as a person who is the beneficial owner of 10% or more of the voting power of the outstanding voting stock of the corporation after the date on which the corporation had 100 or more beneficial owners of its stock or who is an affiliate or associate of the corporation and was the beneficial owner, directly or indirectly, of 10% percent or more of the voting power of the then outstanding stock of the corporation at any time within the two-year period immediately prior to the date in question and after the date on which the corporation had 100 or more beneficial owners of its stock.  The Maryland Control Share Acquisition Act applies to acquisitions of “control shares”, which, subject to certain exceptions, are shares the acquisition of which entitle the holder, directly or indirectly, to exercise or direct the exercise of the voting power of shares of stock of the corporation in the election of directors within any of the following ranges of voting power:  one-tenth or more, but less than one-third of all voting power; one-third or more, but less than a majority of all voting power or a majority or more of all voting power.  Control shares have limited voting rights.  The By-Laws exempt the Company’s capital securities from the Maryland Control Share Acquisition Act, but the Board has the authority to eliminate the exemption without stockholder approval.

 

 

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Although these provisions do not preclude a takeover, they may have the effect of discouraging, delaying or deferring a tender offer or takeover attempt that a shareholder might consider in his or her best interest, including those attempts that might result in a premium over the market price for the common stock.  Such provisions will also render the removal of the Board of Directors and of management more difficult and, therefore, may serve to perpetuate current management.  These provisions could potentially adversely affect the market price of the Company’s common stock.

Item 1B.       Unresolved Staff Comments.

None.

Item 2.          Properties.

Our offices are listed in the tables below.  The Company’s main office is the same as Talbot Bank’s main office.  The Company owns real property at 28969 Information Lane in Easton, Maryland, which houses the Operations, Information Technology and Finance departments of the Company and its subsidiaries, and certain operations of The Avon-Dixon Agency, LLC.

The Talbot Bank of Easton, Maryland
Branches
Main Office 18 East Dover Street Easton, Maryland 21601	Tred Avon Square Branch 212 Marlboro Road Easton, Maryland 21601	St. Michaels Branch 1013 South Talbot Street St. Michaels, Maryland 21663
Elliott Road Branch 8275 Elliott Road Easton, Maryland 21601	Sunburst Branch 424 Dorchester Avenue Cambridge, Maryland 21613	Tilghman Branch 5804 Tilghman Island Road Tilghman, Maryland 21671
	Trappe Branch 29349 Maple Avenue, Suite 1 Trappe, Maryland  21673
	ATMs
Memorial Hospital at Easton 219 South Washington Street Easton, Maryland 21601	Talbottown 218 North Washington Street Easton, Maryland 21601

 

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CNB
Branches
Main Office 109 North Commerce Street Centreville, Maryland 21617	Route 213 South Branch 2609 Centreville Road Centreville, Maryland 21617	Chester Branch 300 Castle Marina Road Chester, Maryland 21619
Chestertown Branch 305 High Street Chestertown, Maryland 21620	Denton Branch 850 South 5 th Avenue Denton, Maryland 21629	Grasonville Branch 202 Pullman Crossing Grasonville, Maryland 21638
Stevensville Branch 408 Thompson Creek Road Stevensville, Maryland 21666	Tuckahoe Branch 22151 WES Street Ridgely, Maryland  21660	Washington Square Branch 899 Washington Avenue Chestertown, Maryland 21620
Felton Branch 120 West Main Street Felton, Delaware 19943 (formerly Felton Bank)	Milford Branch 698-A  North Dupont Boulevard Milford, Delaware 19963 (formerly Felton Bank)	Camden Wal-Mart Supercenter 263 Wal-Mart Drive Camden, Delaware 19934 (formerly Felton Bank)
Division Office - Wye Financial & Trust 16 North Washington Street, Suite 1 Easton, Maryland 21601
ATM Queenstown Harbor Golf Links Queenstown, Maryland 21658

The Avon-Dixon Agency, LL C
Headquarters 28969 Information Lane Easton, Maryland 21601	Easton Office 106 North Harrison Street Easton, Maryland 21601	Chestertown Office 899 Washington Avenue Chestertown, Maryland 21620
Grasonville Office 202 Pullman Crossing Grasonville, Maryland 21638	Centreville Office 105 Lawyers Row Centreville, Maryland 21617
Elliott-Wilson Insurance, LLC 106 North Harrison Street  Easton, Maryland 21601	Mubell Finance, LLC 106 North Harrison Street  Easton, Maryland 21601	Wye Mortgage Group 17 East Dover Street, Suite 101  Easton, Maryland 21601
Jack Martin & Associates, Inc. 135 Old Solomon’s Island Road Annapolis, Maryland 21401	Tri-State General Insurance Agencies and ESFS, Inc. One Plaza East, 4 th Floor Salisbury, Maryland 21802

Talbot Bank owns the real property on which all of its offices are located, except that it operates under leases at its St. Michaels, Tilghman and Trappe branches.  CNB owns the real property on which all of its Maryland offices are located, except that it operates under a lease at the office of Wye Financial and Trust in Easton.  CNB leases the real property on which all of its Delaware offices (former offices of Felton Bank) are located. The Insurance Subsidiaries do not own any real property, but operate under leases.  For information about rent expense for all leased premises, see Note 5 to the Consolidated Financial Statements appearing in Item 8 of Part II of this report.

 

 

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Item 3.

Legal Proceedings.

We are at times, in the ordinary course of business, subject to legal actions.  Management, upon the advice of counsel, believes that losses, if any, resulting from current legal actions will not have a material adverse effect on our financial condition or results of operations.

 

Item 4.

[Removed and Reserved]

PART II

Item 5.

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

MARKET PRICE, HOLDERS AND CASH DIVIDENDS

The shares of the common stock of the Company are listed on the NASDAQ Global Select Market under the symbol “SHBI”.  As of February 28, 2011, the Company had approximately 1,648 holders of record.  The high and low sales prices for the shares of common stock of the Company, as reported on the NASDAQ Global Select Market, and the cash dividends declared on those shares for each quarterly period of 2010 and 2009 are set forth in the table below.

		2010												2009
		Price Range								Dividends				Price Range								Dividends
		High				Low				Paid				High				Low				Paid
First Quarter		$	14.75			$	10.21			$	0.06			$	24.43			$	11.00			$	0.16
Second Quarter			14.80				11.75				0.06				21.46				15.18				0.16
Third Quarter			12.10				9.20				0.06				20.72				16.64				0.16
Fourth Quarter			10.73				9.25				0.06				17.71				13.52				0.16
										$	0.24											$	0.64

On February 28, 2011, the closing sales price for the shares of common stock as reported on the NASDAQ Global Select Market was $9.98 per share.

Stockholders received cash dividends totaling $2.0 million and $5.4 million in 2010 and 2009, respectively.  Dividends paid per share exceeded earnings per share in 2010.  The ratio of dividends paid per share to earnings per share was 100.00% in 2009. Cash dividends are typically declared on a quarterly basis and are at the discretion of the Board of Directors, based upon such factors as operating results, financial condition, capital adequacy, regulatory requirements, and stockholder return.  The Company’s ability to pay dividends is limited by federal banking and state corporate law and is generally dependent on the ability of the Company’s subsidiaries, particularly the Banks, to declare dividends to the Company.  For more information regarding these limitations, see Item 1A of Part I of this report under the headings, “The Company’s ability to pay dividends is limited by applicable banking and corporate law”, which is incorporated herein by reference.

In an effort to preserve the Company’s capital, the quarterly common stock dividend was reduced to $0.06 from $0.16 per share, effective for the dividend payable February 26, 2010.

The transfer agent for the Company’s common stock is:

Registrar & Transfer Company

10 Commerce Drive

Cranford, New Jersey 07016

Investor Relations:  1-800-368-5948

E-mail for investor inquiries: info@rtco.com .

 

 

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The performance graph below compares the cumulative total shareholder return on the common stock of the Company with the cumulative total return on the equity securities included in the NASDAQ Composite Index (reflecting overall stock market performance), the NASDAQ Bank Index (reflecting changes in banking industry stocks), and the SNL Small Cap Bank Index (reflecting changes in stocks of banking institutions of a size similar to the Company) assuming in each case an initial $100 investment on December 31, 2005 and reinvestment of dividends as of the end of the Company’s fiscal years.  Returns are shown on a total return basis.   The performance graph represents past performance and should not be considered to be an indication of future performance.

						Period Ending
Index		12/31/05				12/31/06				12/31/07				12/31/08				12/31/09				12/31/10
Shore Bancshares, Inc.			100.00				145.85				108.85				122.31				76.74				56.96
NASDAQ Composite			100.00				110.39				122.15				73.32				106.57				125.91
NASDAQ Bank			100.00				113.82				91.16				71.52				59.87				68.34
SNL Small Cap Bank			100.00				114.14				82.53				69.37				48.76				59.56

ISSUER REPURCHASES

On February 2, 2006, the Company’s Board of Directors authorized the Company to repurchase up to 165,000 shares of its common stock over a period not to exceed 60 months.  Shares may be repurchased in the open market or in privately negotiated transactions at such times and in such amounts per transaction as the President of the Company determines to be appropriate, subject to Board oversight.  The Company intends to use the repurchased shares to fund the Company’s employee benefit plans and for other general corporate purposes.  No shares were repurchased by or on behalf of the Company and its affiliates (as defined by Exchange Act Rule 10b-18) during 2010.

EQUITY COMPENSATION PLAN INFORMATION

Pursuant to the SEC’s Regulation S-K Compliance and Disclosure Interpretation 106.01, the information regarding the Corporation’s equity compensation plans required by this Item pursuant to Item 201(d) of Regulation S-K is located in Item 12 of Part III of this annual report and is incorporated herein by reference.

 

 

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Item 6.           Selected Financial Data.

The following table sets forth certain selected financial data for the five years ended December 31, 2010, and is qualified in its entirety by the detailed statistical and other information contained in this report, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing in Item 7 of Part II of this report and the financial statements and notes thereto appearing in Item 8 of Part II of this report.

 

		Years Ended December 31,
(Dollars in thousands, except per share data)		2010				2009				2008				2007				2006
RESULTS OF OPERATIONS:
Interest income		$	55,461			$	58,789			$	61,474			$	65,141			$	57,971
Interest expense			12,822				17,411				21,555				24,105				19,074
Net interest income			42,639				41,378				39,919				41,036				38,897
Provision for credit losses			21,119				8,986				3,337				1,724				1,493
Net interest income after provision for credit losses			21,520				32,392				36,582				39,312				37,404
Noninterest income			18,041				19,541				20,350				14,679				12,839
Noninterest expense			41,720				40,248				38,370				32,539				28,535
(Loss) income before income taxes			(2,159	)			11,685				18,562				21,452				21,708
Income tax (benefit) expense			(492	)			4,412				7,092				8,002				8,154
Net (loss) income			(1,667	)			7,273				11,470				13,450				13,554
Preferred stock dividends and discount accretion			-				1,876				-				-				-
Net (loss) income available to common shareholders		$	(1,667	)		$	5,397			$	11,470			$	13,450			$	13,554
PER COMMON SHARE DATA:
Net income – basic		$	(0.20	)		$	0.64			$	1.37			$	1.61			$	1.62
Net income – diluted			(0.20	)			0.64				1.37				1.60				1.61
Dividends paid			0.24				0.64				0.64				0.64				0.59
Book value (at year end)			14.51				15.18				15.16				14.35				13.28
Tangible book value (at year end) 1			12.32				12.64				12.55				11.68				11.67
FINANCIAL CONDITION (at year end):
Loans		$	895,404			$	916,557			$	888,528			$	776,350			$	699,719
Assets			1,130,311				1,156,516				1,044,641				956,911				945,649
Deposits			979,516				990,937				845,371				765,895				774,182
Long-term debt			932				1,429				7,947				12,485				25,000
Stockholders’ equity			122,513				127,810				127,385				120,235				111,327
PERFORMANCE RATIOS (for the year):
Return on average total assets			(0.15	)%			0.48	%			1.13	%			1.42	%			1.52	%
Return on average stockholders’ equity			(1.33	)			4.00				9.22				11.79				12.66
Net interest margin			4.02				3.90				4.23				4.64				4.70
Efficiency ratio 2			68.75				66.07				63.66				58.40				55.15
Dividend payout ratio			(120.00	)			100.00				46.72				39.75				36.42
Average stockholders’ equity to average total assets			11.05				11.96				12.30				12.04				11.98

1 Total stockholders’ equity, net of goodwill and other intangible assets, divided by the number of shares of common stock outstanding at year end.

2 Noninterest expense as a percentage of total revenue (net interest income plus total noninterest income).  Lower ratios indicate improved productivity.

 

 

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

The following discussion compares the Company’s financial condition at December 31, 2010 to its financial condition at December 31, 2009 and the results of operations for the years ended December 31, 2010, 2009, and 2008.  This discussion should be read in conjunction with the Consolidated Financial Statements and the Notes thereto appearing in Item 8 of Part II of this report.

PERFORMANCE OVERVIEW

The Company recorded a net loss of $1.7 million in 2010, compared to net income of $5.4 million and $11.5 million for 2009 and 2008, respectively.  The basic and diluted loss per common share for 2010 was $0.20, compared to basic and diluted earnings per common share of $0.64 for 2009 and $1.37 for 2008.

For 2010, the main contributors to the net loss were goodwill impairment charges and a higher provision for credit losses when compared to the prior two years.  During the third quarter of 2010, the Company recorded goodwill impairment charges of $3.0 million and other intangible assets impairment charges of $51 thousand.  The provision for credit losses for 2010, 2009 and 2008 was $21.1 million, $9.0 million and $3.3 million, respectively.  During 2010, the ongoing economic recession created more   credit quality issues that resulted in higher loan charge offs and a higher provision for credit losses than in 2009 and 2008.

During 2009, net income available to common stockholders was negatively impacted by dividends and discount accretion associated with the sale and subsequent redemption of the Company’s Series A Preferred Stock issued to the Treasury under the TARP Capital Purchase Plan (the “CPP”).  The impact on 2009 earnings from the preferred stock activity was $1.9 million.

Return on average assets was (0.15)% for 2010, compared to 0.48% for 2009 and 1.13% for 2008.  Return on average stockholders’ equity for 2010 was (1.33)%, compared to 4.00% for 2009 and 9.22% for 2008.  Comparing the year ended December 31, 2010 to the year ended December 31, 2009, average assets increased slightly to $1.137 billion, average loans decreased slightly to $906.7 million, average deposits increased 3.2% to $980.3 million, and average stockholders’ equity decreased 7.0% to $125.6 million.  Comparing 2009 to 2008, average assets increased 11.7%, average loans increased 9.1%, average deposits increased 16.4%, and average stockholders’ equity increased 8.5%.

CRITICAL ACCOUNTING POLICIES

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and follow general practices within the industries in which it operates. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes.  These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments.  Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event.  Carrying assets and liabilities at fair value inherently results in more financial statement volatility.  The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available.

The most significant accounting policies that the Company follows are presented in Note 1 to the Consolidated Financial Statements.  These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined.  Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has determined that the accounting policy with respect to the allowance for credit losses to be the accounting area that requires the most subjective or complex judgments, and, as such, could be most subject to revision as new information becomes available.  Accordingly, the allowance for credit losses is considered to be a critical accounting policy, along with goodwill and other intangible assets and fair value, as discussed below.

The allowance for credit losses represents management’s estimate of credit losses inherent in the loan portfolio as of the balance sheet date.  Determining the amount of the allowance for credit losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change.  The loan portfolio also represents the largest asset type on the consolidated balance sheets.  Note 1 to the Consolidated Financial Statements describes the methodology used to determine the allowance for credit losses and a discussion of the factors driving changes in the amount of the allowance for credit losses is included in the Provision for Credit Losses and Risk Management section of this discussion.

 

 

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Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired.  Other intangible assets represent purchased assets that also lack physical substance but can be distinguished from goodwill because of contractual or other legal rights or because the asset is capable of being sold or exchanged either on its own or in combination with a related contract, asset or liability.  Goodwill and other intangible assets are required to be recorded at fair value.  Determining fair value is subjective, requiring the use of estimates, assumptions and management judgment.  Goodwill and other intangible assets with indefinite lives are tested at least annually for impairment, usually during the third quarter, or on an interim basis if circumstances dictate.  Intangible assets that have finite lives are amortized over their estimated useful lives and also are subject to impairment testing.  Impairment testing requires that the fair value of each of the Company’s reporting units be compared to the carrying amount of its net assets, including goodwill.  The Company’s reporting units were identified based on an analysis of each of its individual operating segments.  If the fair value of a reporting unit is less than book value, an expense may be required to write down the related goodwill or purchased intangibles to record an impairment loss.

The Company measures certain financial assets and liabilities at fair value, with the measurements made on a recurring or nonrecurring basis.  Significant financial instruments measured at fair value on a recurring basis are investment securities and interest rate caps.  Impaired loans and other real estate and other assets owned are significant financial instruments measured at fair value on a nonrecurring basis.  Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an 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.  In determining fair value, the Company is required to maximize the use of observable inputs and minimize the use of unobservable inputs, reducing subjectivity.

RECENT ACCOUNTING PRONOUNCEMENTS AND DEVELOPMENTS

The Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification became effective on July 1, 2009.  At that date, the codification became FASB’s officially recognized source of authoritative U.S. generally accepted accounting principles (“GAAP”) applicable to all public and non-public non-governmental entities, superseding existing FASB, American Institute of Certified Public Accountants (“AICPA”), Emerging Issues Task Force (“EITF”) and related literature. Rules and interpretive releases of the SEC under the authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. All other accounting literature is considered non-authoritative. The switch to the codification affects the way companies refer to U.S. GAAP in financial statements and accounting policies. Citing particular content in the codification involves specifying the unique numeric path to the content through the Topic, Subtopic, Section and Paragraph structure.

Note 1 to the Consolidated Financial Statements discusses new accounting policies that the Company adopted during 2010 and the expected impact of accounting policies recently issued or proposed but not yet required to be adopted.  To the extent the adoption of new accounting standards materially affects our financial condition, results of operations or liquidity, the impacts are discussed in the applicable section(s) of this discussion and Notes to the Consolidated Financial Statements.

RESULTS OF OPERATIONS

Net Interest Income and Net Interest Margin

During 2010 and 2009, the FRB made no changes to the fed funds rate, unlike in 2008 when the FRB reduced the fed funds rate by 400 basis points.  The New York Prime rate, the primary index used for variable rate loans, also remained unchanged during 2010 and 2009 but declined 400 basis points during 2008.  Reflecting the continuing lower interest rate environment, our overall yields earned and rates paid during 2010 decreased when compared to 2009 and 2008.

Net interest income remains the most significant component of our earnings.  It is the excess of interest and fees earned on total earning assets (loans, investment securities, federal funds sold and interest-bearing deposits with other banks) over interest owed on interest-bearing liabilities (deposits and borrowings).  As shown in the table below, tax equivalent net interest income for 2010 was $42.9 million, a 2.9% increase over 2009.  The increase was primarily due to lower rates paid on interest-bearing liabilities offsetting the decline in yields on earning assets.  Tax equivalent net interest income for 2009 was $41.7 million, a 3.4% increase over 2008.  During 2009, the increase in the volume of earning assets and lower rates paid on interest-bearing liabilities were sufficient to offset the decline in yields on earning assets.

Our net interest margin ( i.e. , tax equivalent net interest income divided by average earning assets) represents the net yield on earning assets.  The net interest margin is managed through loan and deposit pricing and asset/liability strategies and in 2010, the net interest margin benefited from the Company’s effort to reduce deposit pricing structures.  The net interest margin was 4.02% for 2010, compared to 3.90% for 2009 and 4.23% for 2008. The increase in net interest income was enough to improve the net interest margin 12 basis points in 2010 when compared to 2009 which was not the case in 2009 because the net interest margin declined 33 basis points when compared to 2008.  The net interest spread, which is the difference between the average yield on earning assets and the rate paid for interest-bearing liabilities, was 3.76% for 2010, 3.52% for 2009 and 3.68% for 2008.

 

 

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The following table sets forth the major components of net interest income, on a tax equivalent basis, for the years ended December 31, 2010, 2009, and 2008.

		2010												2009												2008
		Average				Interest				Yield/				Average				Interest				Yield/				Average				Interest				Yield
(Dollars in thousands)		Balance				(1)				Rate				Balance				(1)				Rate				Balance				(1)				/Rate
Earning assets
Loans (2) (3)		$	906,732			$	52,118				5.75	%		$	913,631			$	55,369				6.06	%		$	837,739			$	57,041				6.81	%
Investment securities:
Taxable			101,162				3,209				3.17				84,283				3,184				3.78				85,105				3,788				4.45
Tax-exempt			6,080				321				5.29				8,071				458				5.67				11,031				646				5.86
Federal funds sold			39,770				60				0.15				59,416				84				0.14				16,427				308				1.87
Interest-bearing deposits			14,520				18				0.12				3,200				11				0.35				3,666				92				2.51
Total earning assets			1,068,264				55,726				5.22	%			1,068,601				59,106				5.53	%			953,968				61,875				6.49	%
Cash and due from banks			16,567												17,049												14,829
Other assets			65,774												54,016												50,275
Allowance for credit losses			(13,689	)											(10,754	)											(8,270	)
Total assets		$	1,136,916											$	1,128,912											$	1,010,802
Interest-bearing liabilities
Demand deposits		$	130,297				315				0.24	%		$	124,758				315				0.25	%		$	113,002				437				0.39	%
Money market and savings deposits			258,650				1,970				0.76				218,125				1,354				0.62				175,376				2,406				1.37
Certificates of deposit, $100,000 or more			256,393				5,128				2.00				258,879				7,670				2.96				193,678				7,955				4.11
Other time deposits			214,121				5,268				2.46				234,468				7,679				3.28				226,201				9,079				4.01
Interest-bearing deposits			859,461				12,681				1.48				836,230				17,018				2.04				708,257				19,877				2.81
Short-term borrowings			16,348				83				0.51				25,519				127				0.50				47,765				1,147				2.40
Long-term debt			1,304				58				4.41				4,792				266				5.55				11,598				531				4.58
Total interest-bearing liabilities			877,113				12,822				1.46	%			866,541				17,411				2.01	%			767,620				21,555				2.81	%
Noninterest-bearing deposits			120,871												113,430												107,430
Other liabilities			13,346												13,963												11,388
Stockholders’ equity			125,586												134,978												124,364
Total liabilities and stockholders’ equity		$	1,136,916											$	1,128,912											$	1,010,802
Net interest spread						$	42,904				3.76	%						$	41,695				3.52	%						$	40,320				3.68	%
Net interest margin											4.02	%											3.90	%											4.23	%

(1) All amounts are reported on a tax equivalent basis computed using the statutory federal income tax rate of 34.0% for 2010; 34.2% for 2009 and 35% for 2008, exclusive of the alternative minimum tax rate and nondeductible interest expense.  The taxable equivalent adjustment amounts utilized in the above table to compute yields aggregated $265 thousand in 2010, $317 thousand in 2009, and $401 thousand in 2008.

(2) Average loan balances include nonaccrual loans.

(3) Interest income on loans includes amortized loan fees, net of costs, and yields are stated to include all.

On a tax equivalent basis, total interest income was $55.7 million for 2010, compared to $59.1 million for 2009 and $61.9 million for 2008.  The Company’s largest source of interest income is loans.  The tax equivalent yield on loans decreased to 5.75% for 2010, compared to 6.06% for 2009 and 6.81% for 2008.  The decrease of $6.9 million in average loans and the decrease of 31 basis points in the yield on loans was the primary reason for the decline in interest income in 2010.  Interest income in 2009 also declined when compared to 2008 because the $75.9 million increase in average loans during 2009 was not enough to offset the decrease of 75 basis points in the yield on loans for that year.  The changes in all other average earning assets included increases in taxable investment securities and interest-bearing deposits with other banks of $16.9 million and $11.3 million, respectively, when compared to 2009 and decreases in federal funds sold and tax-exempt investment securities of $19.6 million and $2.0 million, respectively, when compared to 2009.  For 2009, average federal funds sold increased while average investment securities and interest-bearing deposits with other banks decreased.  As a percentage of total average earning assets, loans, investment securities and federal funds sold were 84.9%, 10.0%  and 3.7%, respectively, for 2010, compared to 85.5%, 8.6% and 5.6%, respectively, for 2009 and 87.8%, 10.1% and 1.7%, respectively, for 2008.  The yields on all other earning assets in 2010 declined when compared to 2009 except for the yield on federal funds sold which increased one basis point.  The yields on all other earning assets decreased in 2009 when compared to yields in 2008.  When comparing 2010 to 2009, the overall decrease in yields on earning assets produced $3.4 million less in interest income, almost all of which was due to lower rates, as seen in the Rate/Volume Variance Analysis below.  In 2009, the overall decrease in yields on earning assets produced $2.8 million less in interest income, $7.7 million of which was due to lower rates net of $4.9 million due to increased volume.

 

 

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Interest expense was $12.8 million for 2010, compared to $17.4 million for 2009 and $21.6 million for 2008. Although overall volume increased, lower rates paid for interest-bearing liabilities, primarily time deposits (certificates of deposit of $100,000 or more and other time deposits), was the main reason for the decrease in interest expense in 2010. A similar situation prevailed during 2009, with overall volumes increasing but rates decreasing enough to reduce interest expense.  The Company incurs the largest amount of interest expense from time deposits. The average rate paid for certificates of deposit of $100,000 or more decreased 96 basis points to 2.00% for 2010 from 2.96% for 2009 and decreased 115 basis points in 2009 from 4.11% for 2008. The rate paid for all other time deposits decreased 82 basis points to 2.46% for 2010, compared to 3.28% for 2009, and decreased 73 basis points in 2009 from 4.01% for 2008.   During 2010, the overall decrease in rates on interest-bearing liabilities produced $4.6 million less in interest expense, $4.8 million of which was due to lower rates net of $211 thousand due to increased volume, as shown in the table below.  In 2009, the overall decrease in rates on interest bearing liabilities produced $4.1 million less in interest expense, $6.5 million of which was due to lower rates net of $2.4 million due to increased volume.

The following Rate/Volume Variance Analysis identifies the portion of the changes in tax equivalent net interest income attributable to changes in volume of average balances or to changes in the yield on earning assets and rates paid on interest- bearing liabilities.

		2010 over (under) 2009												2009 over (under) 2008
		Total				Caused By								Total				Caused By
(Dollars in thousands)		Variance				Rate				Volume				Variance				Rate				Volume
Interest income from earning assets:
Loans		$	(3,251	)		$	(2,768	)		$	(483	)		$	(1,672	)		$	(6,583	)		$	4,911
Taxable investment securities			25				(558	)			583				(604	)			(568	)			(36	)
Tax-exempt investment securities			(137	)			(29	)			(108	)			(188	)			(20	)			(168	)
Federal funds sold			(24	)			6				(30	)			(224	)			(479	)			255
Interest-bearing deposits			7				(11	)			18				(81	)			(71	)			(10	)
Total interest income			(3,380	)			(3,360	)			(20	)			(2,769	)			(7,721	)			4,952
Interest expense on deposits and borrowed funds:
Interest-bearing demand deposits			-				(13	)			13				(122	)			(164	)			42
Money market and savings deposits			616				90				526				(1,052	)			(1,627	)			575
Time deposits			(4,953	)			(4,834	)			(119	)			(1,685	)			(4,278	)			2,593
Short-term borrowings			(44	)			3				(47	)			(1,020	)			(604	)			(416	)
Long-term debt			(208	)			(46	)			(162	)			(265	)			95				(360	)
Total interest expense			(4,589	)			(4,800	)			211				(4,144	)			(6,578	)			2,434
Net interest income		$	1,209			$	1,440			$	(231	)		$	1,375			$	(1,143	)		$	2,518

The rate and volume variance for each category has been allocated on a consistent basis between rate and volume variances, based on a percentage of rate, or volume, variance to the sum of the absolute two variances.

Noninterest Income

Noninterest income decreased $1.5 million, or 7.7%, in 2010, compared to a decrease of $809 thousand, or 4.0%, in 2009.  The decrease in noninterest income in 2010 when compared to 2009 was mainly due to a decline in insurance agency commissions of $1.0 million, a decline in mortgage broker fees of $666 thousand and a mark to market gain of $420 thousand on interest rate swaps in 2009.  The decline in insurance agency commissions reflected the continuing soft market in the insurance industry.  Mortgage broker fees declined because the Company terminated the operations of its mortgage subsidiary during 2010 and now conducts brokerage activities through a minority series investment in an unrelated Delaware limited liability company under the name “Wye Mortgage Group”.  During 2010, Wye Mortgage Group generated a $6 thousand loss which was reported in other noninterest income.  The decrease in noninterest income was partially offset by increases in trust and investment fee income and other noninterest income of $403 thousand and $417 thousand, respectively.  Other noninterest income included a $224 thousand gain relating to the surrender of directors’ life insurance policies.

 

 

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A decline in insurance agency commissions of $959 thousand and net gains on asset sales of $524 thousand in 2008 accounted for most of the decrease in 2009 when compared to 2008.  This decrease was partially offset by an increase of $652 thousand in other noninterest income.  The net gains in 2008 included a $1.3 million gain on the sale of a bank branch, offset by a combined $386 thousand other than temporary impairment and subsequent loss on the sale of Freddie Mac Preferred Stock and a $337 thousand loss on the sale of the Company’s investment in Delmarva Bank Data Processing Center, Inc., an unconsolidated subsidiary.  The increase in other noninterest income in 2009 when compared to 2008 included a $420 thousand mark to market gain on interest rate swaps and a $273 thousand increase in revenue from the mortgage subsidiary.

The following table summarizes our noninterest income for the years ended December 31.

		Years Ended												Change from Prior Year
														2010/09								2009/08
(Dollars in thousands)		2010				2009				2008				Amount				Percent				Amount				Percent
Service charges on deposit accounts		$	3,257			$	3,424			$	3,600			$	(167	)			(4.9	)%		$	(176	)			(4.9	)%
Trust and investment fee income			1,503				1,100				951				403				36.6				149				15.7
Gains (losses) on sales of investment securities			-				49				(15	)			(49	)			(100.0	)			64				426.7
Other than temporary impairment of securities			-				-				(371	)			-				-				371				100.0
Insurance agency commissions income			10,113				11,131				12,090				(1,018	)			(9.1	)			(959	)			(7.9	)
Gains (losses) on disposals of premises and equipment			-				-				1,247				-				-				(1,247	)			(100.0	)
Loss on sale of investment in unconsolidated subsidiary			-				-				(337	)			-				-				337				100.0
Other noninterest income:
Interest rate swaps			-				420				-				(420	)			(100.0	)			420				-
Mortgage broker fees			182				848				575				(666	)			(78.5	)			273				47.5
Other			2,986				2,569				2,610				417				16.2				(41	)			(1.6	)
Total			3,168				3,837				3,185				(669	)			(17.4	)			652				20.5
Total		$	18,041			$	19,541			$	20,350			$	(1,500	)			(7.7	)		$	(809	)			(4.0	)

Noninterest Expense

Total noninterest expense increased $1.5 million, or 3.7%, in 2010, which was lower than the increase of $1.9 million, or 4.9%, in 2009.  A significant portion of the increase in 2010 was due to goodwill and other intangible assets impairment charges of $3.1 million when compared to 2009.  As a result of the annual assessment for goodwill and other intangible assets impairment, it was determined that goodwill at Felton Bank was impaired and goodwill and other intangible assets were impaired at TSGIA.  The Company recorded goodwill impairment charges of $1.5 million at Felton Bank and goodwill impairment charges of $1.5 million and other intangible assets impairment charges of $51 thousand at TSGIA.  Other noninterest expenses for 2010 increased $723 thousand when compared to 2009, over half of which included expenses related to collection and other real estate owned activities. Partially offsetting these increases in expense were a decrease in salaries and wages of $1.1 million and a decrease in employee benefits of $802 thousand reflecting lower expenses accrued for bonus and profit sharing plans which are a part of overall cost containment measures taken by the Company.  Insurance agency commissions expense and FDIC insurance premium expense decreased $344 thousand and $244 thousand, respectively.

A significant portion of the increase in 2009 was due to increased FDIC insurance premium expense of $1.7 million when compared to 2008.  The increase in FDIC insurance premiums was attributable to higher overall rates, a one-time special assessment of $513 thousand and growth in our deposits.  Other noninterest expenses for 2009 increased $490 thousand when compared to 2008, over half of which included expenses related to collection and other real estate owned activities.  Occupancy expense increased $145 thousand mainly due to one additional bank branch and usual annual rent increases.  Partially offsetting these increases in expense were lower insurance agency commissions expense of $335 thousand and lower employee benefits expense of $264 thousand.  Employee benefits declined from 2009 amounts primarily due to less expense accrued for the Company’s profit sharing plan contribution for 2009.

 

 

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Amortization of intangible assets relates to Felton Bank and the Insurance Subsidiaries.  See Note 7 to the Consolidated Financial Statements for further information regarding the impact of goodwill and other intangible assets on the financial statements.

We had 321 full-time equivalent employees at December 31, 2010, compared to 335 and 333 at December 31, 2009 and 2008, respectively.

The following table summarizes our noninterest expense for the years ended December 31.

		Years Ended												Change from Prior Year
														2010/09								2009/08
(Dollars in thousands)		2010				2009				2008				Amount				Percent				Amount				Percent
Salaries and wages		$	17,477			$	18,488			$	18,426			$	(1,011	)			(5.5	)%		$	62				0.3	%
Employee benefits			3,829				4,631				4,895				(802	)			(17.3	)			(264	)			(5.4	)
Occupancy expense			2,328				2,324				2,179				4				0.2				145				6.7
Furniture and equipment expense			1,200				1,183				1,185				17				1.4				(2	)			(0.2	)
Data processing			2,607				2,463				2,323				144				5.8				140				6.0
Directors’ fees			412				478				558				(66	)			(13.8	)			(80	)			(14.3	)
Goodwill and other intangible assets impairment			3,051				-				-				3,051				-				-				-
Amortization of intangible assets			515				515				515				-				-				-				-
Insurance agency commissions expense			1,569				1,913				2,248				(344	)			(18.0	)			(335	)			(14.9	)
FDIC insurance premium expense			1,834				2,078				356				(244	)			(11.7	)			1,722				483.7
Other noninterest expense			6,898				6,175				5,685				723				11.7				490				8.6
Total		$	41,720			$	40,248			$	38,370			$	1,472				3.7			$	1,878				4.9

Income Taxes

The Company reported an income tax benefit of $492 thousand for 2010, compared to an income tax expense of $4.4 million and $7.1 million for 2009 and 2008, respectively. The effective tax rate was a 22.8% benefit for 2010 and a 37.8% and 38.2% expense for 2009 and 2008, respectively.  The tax benefit rate for 2010 reflected that $1.5 million of the goodwill impairment charge was not tax deductible.  The effective tax rate decreased in 2009 mainly because the Company’s federal income tax rate was 34.2% compared to 35.0% for 2008.

REVIEW OF FINANCIAL CONDITION

Asset and liability composition, asset quality, capital resources, liquidity, market risk and interest sensitivity are all factors that affect our financial condition.

Assets

Total assets decreased 2.3% from $1.157 billion at December 31, 2009 to $1.130 billion at December 31, 2010.  Total assets increased 10.7% from the end of 2008 to the end of 2009.  Average total assets for the year ended December 31, 2010 were $1.137 billion, slightly higher than the $1.129 billion for 2009.  Average total assets increased 11.7% in 2009 over 2008.  The loan portfolio is the primary source of our income, and it represented 84.9%, 85.5% and 87.8% of average earning assets for 2010, 2009 and 2008, respectively.

Funding for loans is provided primarily by core deposits.  Additional funding is obtained through short-term and long-term borrowings.  Average total deposits increased 3.2% to $980.3 million at December 31, 2010, compared to a 16.4% increase for 2009.   Deposits provided funding for approximately 91.8%, 88.9% and 85.5% of average earning assets for 2010, 2009 and 2008, respectively.

The following table sets forth the average balance of the components of average earning assets as a percentage of total average earning assets for the year ended December 31.

		2010				2009				2008				2007				2006
Loans			84.9	%			85.5	%			87.8	%			81.6	%			79.6	%
Investment securities			10.0				8.6				10.1				14.1				14.8
Federal funds sold			3.7				5.6				1.7				2.4				3.4
Interest-bearing deposits with other banks			1.4				0.3				0.4				1.9				2.2
			100.0	%			100.0	%			100.0	%			100.0	%			100.0	%

 

 

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Interest-Bearing Deposits With Other Banks and Federal Funds Sold

We invest excess cash balances ( i.e ., the excess cash remaining after funding loans and investing in securities with deposits and borrowings) in interest-bearing accounts and federal funds sold offered by our correspondent banks.  These liquid investments are maintained at a level necessary to meet immediate liquidity needs.  Average interest-bearing deposits with other banks and federal funds sold decreased $8.3 million to $54.3 million for the year ended December 31, 2010, compared to an increase of $42.5 million in 2009.  The fluctuations in these accounts reflected that there was less excess cash in 2010 than in 2009.

Investment Securities

The investment portfolio is structured to provide us with liquidity and also plays an important role in the overall management of interest rate risk.  Investment securities available for sale are stated at estimated fair value based on quoted market prices.  They represent securities which may be sold as part of the asset/liability management strategy or which may be sold in response to changing interest rates.  Net unrealized holding gains and losses on these securities are reported net of related income taxes as accumulated other comprehensive income, a separate component of stockholders’ equity.  Investment securities in the held to maturity category are stated at cost adjusted for amortization of premiums and accretion of discounts.  We have the intent and current ability to hold such securities until maturity.  At December 31, 2010, 94% of the portfolio was classified as available for sale and 6% as held to maturity, compared to 92% and 8%, respectively, at December 31, 2009 and 88% and 12%, respectively, at December 31, 2008.  The percentage of securities designated as available for sale reflects the amount needed to support our anticipated growth and liquidity needs.  With the exception of municipal securities, our general practice is to classify all newly purchased securities as available for sale.

Investment securities available for sale increased $1.5 million, or 1.5%, in 2010, totaling $99.1 million at December 31, 2010, compared to $97.6 million at December 31, 2009.  In 2009, investment securities available for sale increased $21.7 million, or 28.6%.  The fluctuations in investment securities available for sale reflected that purchases were slightly more than maturities in 2010 but purchases were considerably more than maturities in 2009.

Investment securities held to maturity, consisting primarily of tax-exempt municipal bonds, totaled $6.7 million at December 31, 2010, compared to $8.9 million at December 31, 2009 and $10.3 million at December 31, 2008.  There were only maturities and no purchases of investment securities held to maturity during 2010 and more maturities than purchases in 2009.  We do not typically invest in structured notes or other derivative securities.

The following table sets forth the maturities and weighted average yields of the bond investment portfolio as of December 31, 2010.

		1 Year or Less								1-5 Years								5-10 Years								Over 10 Years
		Carrying				Average				Carrying				Average				Carrying				Average				Carrying				Average
(Dollars in thousands)		Amount				Yield				Amount				Yield				Amount				Yield				Amount				Yield
Available for sale:
U.S. Government agencies		$	10,185				3.16	%		$	28,568				2.03	%		$	16,996				3.68	%		$	3,155				4.26	%
Mortgage-backed securities			811				3.36				10,160				4.13				7,014				3.91				21,592				3.62
Total available for sale		$	10,996				3.18			$	38,728				2.57			$	24,010				3.75			$	24,747				3.70
Held to maturity:
Obligations of states and political subdivisions 1		$	1,163				5.12	%		$	3,840				5.12	%		$	1,219				4.80	%		$	505				5.38	%

1 Yields adjusted to reflect a tax equivalent basis assuming a federal tax rate of 34.0%.

Loans

During 2010, loans declined when compared to the prior year as the ongoing economic recession created fewer loan opportunities and more loan charge offs.  Loans, net of unearned income, totaled $895.4 million at December 31, 2010, a decrease of $21.2 million, or 2.3%, from 2009.  Loans increased $28.0 million, or 3.2%, in 2009 when compared to 2008.  Most of our loans are secured by real estate.  Real estate loans are classified as construction, residential or commercial real estate loans.  Total real estate loans decreased $8.8 million, or 1.1%, from year-end 2009 to year-end 2010.  Construction loans decreased $17.5 million, or 10.8%, during the same period, offsetting the increases in residential and commercial real estate loans.  Commercial loans, which include financial and agricultural loans, decreased $8.8 million, or 9.6%, and consumer loans, a small percentage of the overall loan portfolio, decreased $3.6 million, or 18.0%, from the end of 2009 to the end of 2010.  At the end of 2009, real estate loans increased $31.5 million, or 4.1%, commercial loans remained relatively flat and consumer loans decreased $3.6 million or, 15.6%, when compared to the end of 2008.  At December 31, 2010, 54.1% of the loan portfolio had fixed interest rates and 45.9% had adjustable interest rates.  At December 31, 2010 and 2009, there were no loans held for sale. We do not engage in foreign or subprime lending activities.

 

 

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