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Section 1: 10-K (FOR THE FISCAL YEAR ENDED DECEMBER 31, 2011)

j31912210k.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-K
(Mark One)
x
ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2011

o
TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from ________ to _______

Commission file number:  000-51889

COMMUNITY PARTNERS BANCORP
(Exact Name of Registrant as Specified in Its Charter)


New Jersey
 
20-3700861
(State or Other Jurisdiction of
Incorporation or Organization)
 
(I.R.S. Employer Identification Number)

 
1250 Highway 35 South, Middletown, NJ 07748
 
 
(Address of Principal Executive Offices, including Zip Code)
 

 
(732) 706-9009
 
 
(Registrant’s telephone number, including area code)
 

Securities registered pursuant to Section 12(b) of the Act:
 
Title of each class
 
Name of each exchange on which  registered
Common Stock, no par value
 
The NASDAQ Stock Market LLC

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

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o  No x
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes o  No x
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes x       No o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes x     No o
 
 
 

 
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer
 o
Accelerated filer
 o
Non-accelerated filer (Do not check if a smaller reporting company)
 o
Smaller reporting company
 x
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).   Yes o    No x
 
The aggregate market value of the registrant’s voting and non-voting common equity held by non-affiliates of the registrant, computed by reference to the price at which the common stock was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter, is $31,844,466.
 
As of March 15, 2012, 7,959,549 shares of the registrant’s common stock were outstanding.
 
Documents incorporated by reference
 
Portions of the registrant’s definitive Proxy Statement for its 2012 Annual Meeting of Shareholders are incorporated by reference into Part III of this report and will be filed within 120 days of December 31, 2011.
 


 
 

 
 
FORM 10-K

TABLE OF CONTENTS
 
 PART I
     
1
17
22
23
24
24
     
PART II
     
24
24
25
49
49
49
49
50
     
PART III
     
50
50
51
51
51
     
PART IV
     
52
     
53
     
 
 
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PART I

Forward-Looking Statements
 
When used in this and in future filings by us with the Securities and Exchange Commission (the “SEC”), in our press releases and in oral statements made with the approval of one of our authorized executive officers, the words or phrases “will,” “will likely result,” “could,” “anticipates,” “believes,” “continues,” “expects,” “plans,” “will continue,” “is anticipated,” “estimated,” “project” or “outlook” or similar expressions (including confirmations by one of our authorized executive officers of any such expressions made by a third party with respect to us) are intended to identify statements constituting “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 and that are intended to come within the safe harbor protection provided by these sections. We wish to caution readers not to place undue reliance on any such forward-looking statements, each of which speaks only as of the date made, even if subsequently made available on our website or otherwise. Such statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical earnings and those presently anticipated or projected. The forward-looking statements are and will be based on management’s then-current views and assumptions regarding future events and operating performance, and are applicable only as of the dates of such statements.
 
Factors that may cause actual results to differ from those results expressed or implied, include, but are not limited to, those listed in this report under the heading “Risk Factors”; the ability of customers to repay their obligations; the adequacy of the allowance for loan losses; developments in the financial services industry and U.S. and global credit markets; changes in the direction of the economy nationally or in New Jersey; changes in interest rates; competition; loss of management and key personnel; government regulation; environmental liability; failure to implement new technologies in our operations; changes in our liquidity; changes in our funding sources; failure of our controls and procedures; disruptions of our operational systems and relationships with vendors; and our success in managing risks involved in the foregoing. Although management has taken certain steps to mitigate any negative effect of the aforementioned items, significant unfavorable changes could severely impact the assumptions used and have an adverse effect on profitability. Such risks and other aspects of our business and operations are described in Item 1. “Business”, Item 1A. “Risk Factors” and Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this report. We have no obligation to publicly release the result of any revisions which may be made to any forward-looking statements to reflect anticipated or unanticipated events or circumstances occurring after the date of such statements.
 
Item 1.  Business.
 
The disclosures set forth in this item are qualified by Item 1A. “Risk Factors”, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other statements set forth in this report.
 
Community Partners Bancorp
 
Community Partners Bancorp, which we refer to herein as “Community Partners,” the “Company,” “we,” “us” and “our,” is a business corporation organized under the laws of the State of New Jersey in August 2005. The principal place of business of Community Partners is located at 1250 Highway 35 South, Middletown, New Jersey 07748 and its telephone number is (732) 706-9009.
 
Effective December 31, 2008, Community Partners consolidated its two wholly owned bank subsidiaries, The Town Bank (“Town Bank”), based in Westfield, New Jersey, and Two River Community Bank (“Two River”), based in Middletown, New Jersey. The two banks had been under common ownership since Community Partners was organized to acquire them, in a transaction that took place in April 2006. The consolidation streamlined operations and created administrative efficiencies and reductions in overhead costs. As a result, there is now only one New Jersey state-chartered commercial bank, Two River Community Bank, which we also refer to herein as the “Bank.”  The Town Bank branches had used the Town Bank name and had operated as a division of Two River Community Bank up until May 2009, when the Town Bank branches began operation under the Two River Community Bank title. The entire branch network comprises 15 branches in Monmouth and Union counties, New Jersey.
 
 
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Other than its investment in the Bank, Community Partners currently conducts no other significant business activities. Community Partners may determine to operate its own business or acquire other commercial banks, thrift institutions or bank holding companies, or engage in or acquire such other activities or businesses as may be permitted by applicable law, although it has no present plans or intentions to do so. When we refer to the business conducted by Community Partners in this document, including any lending or other banking activities, we are referring to the business that Community Partners conducts through the Bank.
 
As of December 31, 2011, the Company had consolidated assets of $674.6 million, total deposits of $553.9 million and shareholders’ equity of $87.1 million.
 
Employees
 
As of December 31, 2011, the Company and its subsidiaries had 138 full-time equivalent employees, of whom 133 were full-time and 10 were part-time. None of the Company's employees are represented by a union or covered by a collective bargaining agreement. Management of the Company and the Bank believe that, in general, their employee relations are good.
 
Two River Community Bank
 
Two River Community Bank was organized in January 2000 as a New Jersey state-chartered commercial bank to engage in the business of commercial and retail banking. As a community bank, the Bank offers a wide range of banking services including demand, savings and time deposits and commercial and consumer/installment loans to small and medium-sized businesses, not-for-profit organizations, professionals and individuals primarily in Monmouth, Middlesex and Union counties, New Jersey. The Bank also offers its customers numerous banking products such as safe deposit boxes, night depository, wire transfers, money orders, travelers checks, automated teller machines, direct deposit, telephone and internet banking and corporate business services. The Bank currently operates 15 banking offices in Monmouth and Union counties, New Jersey and a non-banking operations facility. The Bank’s principal banking office is located at 1250 Highway 35 South, Middletown, New Jersey. Other banking offices are located in Allaire, Atlantic Highlands, Cliffwood, Manasquan, Navesink, Port Monmouth, Red Bank, Tinton Falls (2), West Long Branch, Westfield (2), Cranford and Fanwood, New Jersey. The Bank also operates two regional lending offices in New Brunswick and Summit, New Jersey, for the purpose of expanding our presence in these communities.
 
We believe that the Bank’s customers still want to do business and have a relationship with their banker. To accomplish this objective, we emphasize to our employees the importance of delivering exemplary customer service and seeking out opportunities to build further relationships with the Bank’s customers. The Bank’s deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to the statutory limits.
 
Competition
 
The Bank faces substantial competition for deposits and creditworthy borrowers. It competes with New Jersey and regionally based commercial banks, savings banks and savings and loan associations, as well as national financial institutions, most of which have assets, capital and lending limits greater in amount than that of the Bank. Other competitors include money market mutual funds, mortgage bankers, insurance companies, stock brokerage firms, regulated small loan companies, credit unions and issuers of commercial paper and other securities.
 
Products and Services
 
The Bank offers a full range of banking services to our customers. These services include a wide variety of business and consumer lending products as well as corporate services for businesses and professionals. We offer a range of deposit products including checking, savings and money market accounts plus certificates of deposit. The Bank also participates in the Certificate of Deposit Account Registry Service (“CDARS”), a service that enables us to provide our customers with additional FDIC insurance on certificate of deposit (“CD”) products. Other products and services include remote deposit capture, safe deposit boxes, ACH services, debit and ATM cards, gift cards, traveler’s checks, money orders, direct deposit and coin counting. We also offer customers the convenience of a full complement of internet banking services that allows them to check account balances, receive email alerts, transfer funds, initiate stop payment requests, re-order checks and pay bills. The Bank invested in several additional technology solutions for our customers in 2011, including an enhanced internet banking system that allows transfers between accounts outside of the Bank and a mobile banking solution that permits customers to view accounts, set up alerts and transfer funds within their accounts. We have installed “smart” ATM’s that accept deposits without envelopes. We will continue to look for solutions and enhancements that will provide additional convenience for our customers.
 
 
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Lending Activities
 
The Bank engages in a variety of lending activities, which are primarily categorized as either commercial or residential real estate-consumer lending. The strategy is to focus our lending activities on small and medium-sized business customers and retain customers by offering them a wide range of products and personalized service. Commercial and real estate mortgage lending (consisting of commercial real estate, commercial business, construction and other commercial lending, including medical lending and private banking) are currently our main lending focus. Sources to fund loans are derived primarily from deposits, although we do occasionally borrow to fund loan growth or meet deposit outflows.
 
The Bank presently generates virtually all of our loans in the State of New Jersey, with a significant portion in Union and Monmouth counties. Loans are generated through marketing efforts, the Bank’s present base of customers, walk-in customers, referrals, the directors, founders and members of the Bank’s advisory boards. The Bank strives to maintain a high overall credit quality through the establishment of and adherence to prudent lending policies and practices. The Bank has an established written loan policy that has been adopted by the Board of Directors and is reviewed annually. Any loans to members of the Board of Directors or their affiliates must be reviewed and approved by the Bank’s Board of Directors in accordance with the loan policy as well as applicable state and federal laws. In accordance with our loan policy, approvals of affiliated transactions are made only by independent board members.
 
In managing the growth and quality of the Bank’s loan portfolio, we have focused on: (i) the application of prudent underwriting criteria; (ii) the active involvement by senior management and the Bank’s Board of Directors in the loan approval process; (iii) the active monitoring of loans to ensure timely repayment and early detection of potential problems; and (iv) a loan review process by an independent loan review firm, which conducts in-depth reviews of portions of the loan portfolio on a quarterly basis.
 
 Our principal earning assets are loans originated or participated in by the Bank. The risk that certain borrowers will not be able to repay their loans under the existing terms of the loan agreement is inherent in the lending function. Risk elements in a loan portfolio include non-accrual loans (as defined below), past due and restructured loans, potential problem loans, loan concentrations (by industry or geographically) and other real estate owned acquired through foreclosure or a deed in lieu of foreclosure. Because the vast majority of the loans are made to borrowers located in Union and Monmouth counties, New Jersey, each loan or group of loans presents a geographical and credit risk based upon the condition of the local economy. The local economy is influenced by conditions such as housing prices, employment conditions and changes in interest rates.
 
Construction Loans
 
We originate fixed-rate and adjustable-rate loans to individuals and builders to finance the construction of residential dwellings. We also originate construction loans for commercial development projects, including apartment buildings, restaurants, shopping centers and owner-occupied properties used for businesses. Our construction loans generally provide for the payment of interest only during the construction phase which is usually twelve months for residential properties and twelve to eighteen months for commercial properties. At the end of the commercial construction phase, the loan generally converts to a permanent commercial loan. Before making a commitment to fund a construction loan, we require an appraisal of the property by a bank approved independent licensed appraiser, appropriate environmental due diligence, an inspection of the property before disbursement of funds during the stages of the construction process, and pre-qualification from an identified source for the permanent takeout.

Construction financing is generally considered to involve a higher degree of risk of loss than long-term financing on improved, occupied real estate. Risk of loss on a construction loan depends largely upon the accuracy of the initial estimate of the property’s value at completion of construction and the estimated cost (including interest) of construction. During the construction phase, a number of factors could result in delays and cost overruns. If the estimate of construction costs proves to be inaccurate, we may be required to advance funds beyond the amount originally committed to permit completion of the building. If the estimate of value proves to be inaccurate, we may be confronted, at or before the maturity of the loan, with a building having a value which is insufficient to assure full repayment. If we are forced to foreclose on a building before or at completion due to a default, there can be no assurance that we will be able to recover all of the unpaid balance of, and accrued interest on, the loan as well as related foreclosure and holding costs.
 
 
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Commercial Loans
 
The Bank makes commercial business loans to professionals, sole proprietorships and small businesses in our market areas. We extend commercial business loans on a secured and unsecured basis. Secured commercial loans are generally collateralized by residential and nonresidential real estate, marketable securities, accounts receivable, inventory, industrial/commercial machinery and equipment, and furniture and fixtures. To further enhance our security position, we generally require personal guarantees of the principal owners of the entities to which we extend credit. These loans are made on both lines of credit and fixed-term basis ranging from one to five years in duration. When making commercial business loans, we consider the financial statements and/or tax returns of the borrower, the borrower’s payment history along with the principal owners’ payment history, the debt service capabilities of the borrower, the projected cash flows of the business, the value of the collateral and the financial strength of the guarantor.

Commercial real estate loans are made to local commercial, retail and professional firms and individuals for the acquisition of new property or the refinancing of existing property. These loans are typically related to commercial businesses and secured by the underlying real estate used in these businesses or real property of the principals. These loans are generally offered on a fixed or variable rate basis, subject to rate re-adjustments every five years and amortization schedules ranging from 10 to 20 years.

Our established written underwriting guidelines for commercial loans are periodically reviewed and enhanced as needed. Pursuant to these guidelines, in granting commercial loans we look primarily to the borrower’s cash flow as the principal source of loan repayment. To monitor cash flows on income properties, we require borrowers and loan guarantors of loan relationships to provide annual financial statements, rent rolls and/or tax returns. Collateral and personal guarantees of the principals of the entities to which we lend are consistent with the requirements of our loan policy.

Commercial loans are often larger and may involve greater risks than other types of lending. Because payments of such loans are often dependent on the successful operation of the business involved, repayment of such loans may be more sensitive than other types of loans and are subject to adverse conditions in the real estate market or the general economy. We are also involved with off-balance sheet financial instruments, which include collateralized commercial and standby letters of credit. We seek to minimize these risks through our underwriting guidelines and prudent risk management techniques. Any collateral securing such loans may depreciate over time, may be difficult to appraise and may fluctuate in value. Environmental surveys and inspections are obtained when circumstances suggest the possible presence of hazardous materials. There can be no assurances, however, of success in the efforts to minimize these risks.

Unlike residential mortgage loans, which generally are made on the basis of the borrower’s ability to make repayment from his or her employment or other income and which are secured by real property the value of which tends to be more easily ascertainable, commercial loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business operation. As a result, the availability of funds for the repayment of commercial loans may depend substantially on the success of the business itself as the primary source of repayment. Further, any collateral securing such loans may depreciate over time, may be difficult to appraise and may fluctuate in value.

Residential Real Estate and Consumer Loans

We offer a full range of residential real estate and consumer loans. These loans consist of residential mortgages, home equity lines of credit, home equity loans, personal loans, automobile loans and overdraft protection. We do not originate subprime or negative amortization loans.

Each residential mortgage loan is evidenced by a promissory note secured by a mortgage or deed of trust creating a first lien on one-to-four family residential property. Residential real estate properties underlying residential mortgage loans consist of single-family detached units, individual condominium units, two-to-four family dwelling units and townhouses.

Our home equity revolving lines of credit come with a floating interest rate tied to the prime rate. Lines of credit are available to qualified applicants in amounts up to $500,000 for up to 15 years. We also offer fixed rate home equity loans in amounts up to $350,000 for a term of up to 15 years. Credit is based on the income and cash flow of the individual borrowers, real estate collateral supporting the mortgage debt and past credit history.
 
 
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Consumer loans may entail greater risk than do residential mortgage loans, particularly in the case of consumer loans that are unsecured or secured by assets that depreciate rapidly. In such cases, repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan and the remaining deficiency often does not warrant further substantial collection efforts against the borrower. In addition, consumer loan collections depend on the borrower’s continuing financial stability, and therefore are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount that can be recovered on such loans.

Participation Loans

The Bank underwrites all loan participations in accordance with our underwriting standards. We will not participate in a loan transaction unless each participant has a substantial interest in the loan relationship. In addition, we also consider the financial strength and reputation of the lead lender. To monitor cash flows on loan participations, we look for the lead lender to provide at a minimum, tax returns and annual financial statements for the borrower. Generally, we also conduct an annual internal loan review for participations.

Small Business Administration (“SBA”) Loans

In June 2010, the Bank announced the formation of the SBA Lending Division, which is consistent with the Bank’s mandate of community lending in Monmouth and Union County. During the fourth quarter of 2011, the Bank achieved Preferred Lending status, which allows us to have delegated authority to approve and close SBA loans up to $5.0 million. Our risk philosophy in SBA lending is an extension of our existing credit culture and focused on the cash flow of the businesses while maintaining our commitment to providing small and mid-sized companies access to the credit they need to expand and hire.

Asset Quality

We believe that high asset quality is a key to long-term financial success. We have sought to grow and diversify the loan portfolio, while maintaining a high level of asset quality and moderate credit risk, using underwriting standards that we believe are conservative and diligent monitoring and collection efforts. As we continue to grow and leverage our capital, we envision that loans will continue to be our principal earning assets. An inherent risk in lending is the borrower’s ability to repay the loan under its existing terms. Risk elements in a loan portfolio include non-accrual loans (as defined below), past due and restructured loans, potential problem loans, loan concentrations (by industry or geographically) and other real estate owned acquired through foreclosure or a deed in lieu of foreclosure.

Non-performing assets include loans that are not accruing interest (non-accrual loans) as a result of principal or interest being in default for a period of 90 days or more, loans past due 90 days or more and still accruing and other real estate owned, which consists of real estate acquired as the result of a defaulted loan. When a loan is classified as non-accrual, interest accruals cease and all past due interest is reversed and charged against current income. Until the loan becomes current as to principal or interest, as applicable, any payments received from the borrower are applied to outstanding principal and fees and costs to the Bank, unless we determine that the financial condition of the borrower and other factors merit recognition of such payments as interest. During 2011, the Bank adopted Financial Accounting Standards Board (“FASB”) guidance on determination of whether a restructuring is a troubled debt restructuring (“TDR”). The guidance was applicable to restructurings on or after January 1, 2011. A TDR is a loan in which the contractual terms have been modified resulting in the Bank granting a concession to a borrower who is experiencing financial difficulties in order for the Bank to have a greater opportunity of collecting the indebtedness from the borrower. Non-accruing TDR’s are included in non-performing loans.  Non-performing assets are further discussed within the “Asset Quality” section under Item 7 of this report.

We utilize a risk system, as described below under the section titled “Allowance for Loan Losses”, as an analytical tool to assess risk and set appropriate reserves. In addition, the FDIC has a classification system for problem loans and other lower quality assets, classifying them as “substandard,” “doubtful” or “loss.” A loan is classified as “substandard” when it is inadequately protected by the current value and paying capacity of the obligor or of the collateral pledged, if any. Loans with this classification have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that some loss may occur if the deficiencies are not corrected. A loan is classified “doubtful” when it has all the weaknesses inherent in a loan classified as substandard with the added characteristics that the weaknesses make collection or liquidation in full, on the basis of currently existing factors, conditions, and values, highly questionable and improbable. A loan is classified as “loss” when it is considered uncollectible and of such little value that the loan’s continuance as an asset on the balance sheet is not warranted.
 
 
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In addition to categories for non-accrual loans and loans past due 90 days or more that are still accruing interest, we maintain a “watch list” of performing loans where management has identified conditions which potentially could cause such loans to be downgraded into higher risk categories in future periods. Loans on this list are subject to heightened scrutiny and more frequent review by management. See Note 1-H in the Notes to Consolidated Financial Statements for more information.

Allowance for Loan Losses

We maintain an allowance for loan losses at a level that we believe is adequate to provide for probable losses inherent in the loan portfolio. Loan losses are charged directly to the allowance when they occur and any recovery is credited to the allowance when realized. Risks from the loan portfolio are analyzed on a continuous basis by the Bank’s senior management, outside independent loan review auditors, the directors’ loan committee, and the Board of Directors.
 
The level of the allowance is determined by assigning specific reserves to impaired loans and general reserves on all other loans. The portion of the allowance that is allocated to impaired loans is determined by estimating the inherent loss on each credit after giving consideration to the value of the underlying collateral. A risk system, consisting of multiple grading categories, is utilized as an analytical tool to assess risk and set appropriate general reserves. Along with the risk system, senior management evaluates risk characteristics of the loan portfolio under current and anticipated economic conditions and considers such factors as the financial condition of the borrower, past and expected loss experience, and other factors management feels deserve recognition in establishing an appropriate reserve. These estimates are reviewed at least quarterly, and as adjustments become necessary, they are realized in the periods in which they become known. Additions to the allowance are made by provisions charged to expense and the allowance is reduced by net charge-offs (i.e., loans judged to be uncollectible and charged against the reserve, less any recoveries on such loans).
 
Although management attempts to maintain the allowance at a level deemed adequate to cover any losses, future additions to the allowance may be necessary based upon any changes in market conditions, either generally or specific to our area, or changes in the circumstances of particular borrowers. In addition, various regulatory agencies periodically review our allowance for loan losses, and may require us to take additional provisions based on their judgments about information available to them at the time of their examination. See Note 1-I in the Notes to Consolidated Financial Statements for more information.

Risk Management

Managing risk is an essential part of a successful financial institution. Our most prominent risk exposures are credit risk, interest rate risk and market risk. Credit risk is the risk of not collecting the interest and/or the principal balance of a loan or investment when it is due. Interest rate risk is the potential reduction of net interest income as a result of changes in interest rates. Market risk arises from fluctuations in interest rates that may result in changes in the values of financial instruments, such as available for sale securities that are accounted for on a fair value basis. Other risks that we face are operational risks, liquidity risks and reputation risk. Operational risks include risks related to fraud, regulatory compliance, processing errors, and technology and disaster recovery. Liquidity risk is the possible inability to fund obligations to depositors or borrowers. Reputation risk is the risk that negative publicity or press, whether true or not, could cause a decline in our customer base or revenue.
 
Credit Risk Management

Our strategy for credit risk management focuses on having well-defined credit policies and uniform underwriting criteria and providing prompt attention to potential problem loans. The Bank internally conducts semi-annual commercial real estate stress testing. To further enhance our credit risk management strategy, we engage a third party loan review firm to provide additional portfolio surveillance. When a borrower fails to make a required loan payment, we take a number of steps to attempt to have the borrower cure the delinquency and restore the loan to current status. When the loan becomes 15 days past due, a late charge notice is generated and sent to the borrower and a representative of the Bank attempts to communicate by phone with the borrower to discuss the late payment. If payment is not then received by the 30th day of delinquency, a further notification is sent to the borrower. If no resolution can be achieved, after a loan becomes 90 days delinquent, we may commence foreclosure or other legal proceedings. If a foreclosure action is instituted and the loan is not brought current, paid in full, or refinanced before the foreclosure sale, the real property securing the loan generally is sold at foreclosure. We may consider loan workout arrangements with certain borrowers under certain circumstances.

Management reports to the Board of Directors monthly regarding the amount of loans delinquent more than 30 days, all loans in foreclosure and all foreclosed and repossessed property that we own.

 
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Investment Portfolio
 
Our investment portfolio consists primarily of obligations of U.S. Government sponsored agencies as well as municipal and government authority bonds, with high grade corporate bonds accounting for less than 10% of the portfolio. Government regulations limit the type and quality of instruments in which the Company may invest its funds.

We conduct our asset/liability management through consultation with members of our Board of Directors, senior management and an outside financial advisor. The asset/liability investment committee, commonly known as an ALCO committee, is comprised of the president, senior officers and certain members of our Board of Directors. The ALCO committee, in consultation with our Board of Directors, is responsible for the review of interest rate risk and evaluates future liquidity needs over various time periods.

We have established a written investment policy which is reviewed annually by the ALCO committee and our Board of Directors that applies to Community Partners and the Bank. The investment policy identifies investment criteria and states specific objectives in terms of risk, interest rate sensitivity and liquidity and emphasizes the quality, term and marketability of the securities acquired for our investment portfolio.

The ALCO committee is responsible for monitoring the investment portfolio and ensuring that investments comply with the investment policy. The ALCO committee may from time to time consult with investment advisors.  The Bank’s president and its chief financial officer working with the financial advisor may purchase or sell securities in accordance with the guidelines of the ALCO committee. The Board of Directors reviews the components, including new transactions of the investment portfolio on a monthly basis.

Deposit Products

We emphasize relationships with commercial and individual customers and seek to obtain transaction accounts, which are frequently non-interest bearing deposits or lower cost interest bearing checking, savings and money market deposit accounts.

Deposits are the primary source of funds used in lending and other general business purposes. In addition to deposits, we may derive additional funds from principal repayments on loans, the sale of investment securities and borrowings from other financial institutions. Loan amortization payments have historically been a relatively predictable source of funds. The level of deposit liabilities can vary significantly and is influenced by prevailing interest rates, money market conditions, general economic conditions and competition.

The Bank’s deposits consist of checking accounts, savings accounts, money market accounts and certificates of deposit. During the first half of 2012, we expect to offer a suite of online only deposit products that we believe will be attractive to customers who prefer doing their banking online. All deposits, including the online accounts, are obtained from individuals, partnerships, corporations and unincorporated businesses in our market area. The Bank participates in CDARS, a service that enables us to provide our customers with additional FDIC insurance on CD products. We attempt to control the flow of deposits primarily by pricing our accounts to remain generally competitive with other financial institutions in our market area.

Business Growth Strategy

Our current plan for growth includes expanding our deposit product line and looking for opportunities to expand our branching network. We will focus on establishing a market presence in the communities between Union and Monmouth Counties, New Jersey by adding strategically located new office(s) and considering selective acquisitions that would be accretive to earnings within the first full year of combined operations. During 2011, the Bank opened two regional lending offices in New Brunswick and Summit, New Jersey, for the purpose of expanding our presence in these communities. We believe that this strategy will continue to build shareholder value and increase revenues and earnings per share by creating a larger base of lending and deposit relationships and achieving economics of scale and other efficiencies. Our efforts include looking for potential new retail banking offices in Middlesex County, New Jersey and other attractive markets where we have established lending relationships, as well as exploring opportunities to grow and add other profitable banking-related businesses. We believe that by establishing banking offices and making selective acquisitions in attractive growth markets while providing exemplary customer service, our core deposits will naturally increase. In addition, we will be launching online account opening capabilities in the first half of 2012 on our website to attract a wider consumer base with the convenience of being able to open deposit accounts 24 hours a day. Our current strategy is to permit account openings in existing and contiguous markets.
 
 
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Supervision and Regulation
 
Overview
 
Community Partners operates within a system of banking laws and regulations intended to protect bank customers and depositors, and these laws and regulations govern the permissible operations and management, activities, reserves, loans and investments of the Company.
 
Community Partners is a bank holding company under the Federal Bank Holding Company Act of 1956 (“BHCA”), as amended by the Financial Modernization Act of 1999, known as the Gramm-Leach-Bliley Act, and is subject to the supervision of the Board of Governors of the Federal Reserve System (the “Federal Reserve”). In general, the BHCA limits the business of bank holding companies to banking, managing or controlling banks, and performing certain servicing activities for subsidiaries and, as a result of the Gramm-Leach-Bliley Act amendments, permits bank holding companies that are also financial holding companies to engage in any activity, or acquire and retain the shares of any company engaged in any activity, that is either (1) financial in nature or incidental to such financial activity or (2) complementary to a financial activity and does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally. In order for a bank holding company to engage in the broader range of activities that are permitted by the BHCA for bank holding companies that are also financial holding companies, upon satisfaction of certain regulatory criteria, the bank holding company must file a declaration with the Federal Reserve Board that it elects to be a “financial holding company.” Community Partners does not presently intend to seek a “financial holding company” designation at this time, and does not believe that the current decision not to seek a financial holding company designation will adversely affect its ability to compete in its chosen markets. We believe that seeking such a designation for Community Partners would not position it to compete more effectively in the offering of products and services currently offered by the Bank. Community Partners is also subject to other federal laws and regulations as well as the corporate laws and regulations of New Jersey, the state of its incorporation.
 
The BHCA prohibits the Company, with certain exceptions, from acquiring direct or indirect ownership or control of more than five percent of the voting shares of any company which is not a bank and from engaging in any business other than that of banking, managing and controlling banks or furnishing services to subsidiary banks. The BHCA requires prior approval by the Federal Reserve Board of the acquisition by the Company of more than five percent of the voting stock of any other bank. Satisfactory capital ratios, Federal Community Reinvestment Act ratings and anti-money laundering policies are generally prerequisites to obtaining federal regulatory approval to make acquisitions.
 
The Bank is a commercial bank chartered under the laws of the State of New Jersey and is subject to the New Jersey Banking Act of 1948 (the “Banking Act”). As such, it is subject to regulation, supervision and examination by the New Jersey Department of Banking and Insurance and by the FDIC. Each of these agencies regulates aspects of activities conducted by the Bank and Community Partners, as discussed below. The Bank is not a member of the Federal Reserve Bank of New York.
 
The following descriptions summarize the key laws and regulations to which the Bank is subject, and to which Community Partners is subject as a registered bank holding company. These descriptions are not intended to be complete and are qualified in their entirety by reference to the full text of the statutes and regulations. Future changes in these laws and regulations, or in the interpretation and application thereof by their administering agencies, cannot be predicted, but could have a material effect on the business and results of Community Partners and the Bank.
 
 
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Small Business Lending Fund
 
On August 11, 2011, the Company received $12 million under the Small Business Lending Fund (“SBLF”). The SBLF was created in the fall of 2010 as part of the Small Business Jobs Act. The SBLF provides Tier 1 capital to community banks with assets of $10 billion or less, and provides incentives for making small business loans, defined as certain loans of up to $10 million to businesses with up to $50 million in annual revenues. In exchange for the $12 million, the Company issued to the U.S. Department of the Treasury (“Treasury”) 12,000 shares of its Non-Cumulative Perpetual Preferred Stock, Series C, having a $1,000 liquidation preference per share (the “SBLF Preferred Shares”). The SBLF Preferred Shares qualify as Tier 1 capital.

Unlike the Troubled Asset Relief Program Capital Purchase Plan (“TARP CPP”), under the SBLF program, Treasury did not receive any warrants in exchange for SBLF funding. Dividend rates on the SBLF Preferred Shares will be determined by the bank’s lending practices with small business loans. The Company used a portion of the proceeds of the SBLF funds to redeem the full $9.0 million of its outstanding shares of Senior Preferred Stock, Series A (the “TARP Preferred Shares”), previously issued to the Treasury under TARP CPP. The TARP Preferred Shares, issued under TARP CPP qualified as Tier 1 capital and paid cumulative dividends at a rate of 5% per annum for the first five years. Dividends on the TARP Preferred Shares were payable on February 15, May 15, August 15 and November 15 of each year. As a result of the redemption of the TARP Preferred Shares, the Company is no longer subject to the executive compensation requirements in connection with the TARP CPP.

The noncumulative dividend rate on the SBLF Preferred Shares will be adjusted to reflect the amount of a change in the Company’s qualified small business lending from its baseline, determined based upon the Company’s qualified small business lending for each of the four full quarters ending June 30, 2010. Accordingly, the dividend rate will change as follows:

   
Dividend Rate Following Investment Date
Increase in Qualified Small Business Lending
from the Baseline
 
First 9
Quarters*
 
Quarter 10
to Year 4.5
 
After Year
4.5
0% or less
 
5%
 
7%
 
9%
More than 0%, but less than 2.5%
 
5%
 
5%
 
9%
2.5% or more, but less than 5%
 
4%
 
4%
 
9%
5% or more, but less than 7.5%
 
3%
 
3%
 
9%
7.5% or more, but less than 10%
 
2%
 
2%
 
9%
10% or more
 
1%
 
1%
 
9%
* For the first nine quarters, the dividend rate will be adjusted quarterly.
 
After 10 years, if the SBLF Preferred Shares are not redeemed, the dividend rate will increase to the highest possible dividend rate as permitted by the Company’s regulators. Dividends are payable quarterly on January 1, April 1, July 1 and October 1 of each year.

On October 31, 2011, the Company repurchased the outstanding warrant to purchase 311,972 additional shares of common stock previously issued to the Treasury as part of the original TARP funding for $460,000.
 
 
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Incentive Compensation
 
In June 2010, the Federal Reserve, the Office of the Currency Comptroller and FDIC issued comprehensive final guidance on incentive compensation policies intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization’s incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors. Also, in April 2011, the FDIC published a proposed interagency rule to implement certain incentive compensation requirements of the Dodd-Frank Act. Under the proposed rule, financial institutions must prohibit incentive-based compensation arrangements that encourage inappropriate risk taking that are deemed excessive or that may lead to material losses.
 
The Federal Reserve will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as us, that are not “large, complex banking organizations.” These reviews will be tailored to each organization based on the scope and complexity of the organization’s activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the organization’s supervisory ratings, which can affect the organization’s ability to make acquisitions and take other actions. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.

The scope and content of the U.S. banking regulators’ policies on executive compensation are continuing to develop and are likely to continue evolving in the near future. It cannot be determined at this time whether compliance with such policies will adversely affect the ability of the Company and the Bank to hire, retain and motivate their key employees.

Dividend Restrictions
 
The primary source of cash to pay dividends, if any, to the Company’s shareholders and to meet the Company’s obligations is dividends paid to the Company by the Bank. Dividend payments by the Bank to the Company are subject to the laws of the State of New Jersey, the Banking Act, the Federal Deposit Insurance Act (“FDIA”) and the regulation of the New Jersey State Department of Banking and Insurance and of the Federal Reserve. Under the Banking Act and the FDIA, a bank may not pay any dividends if, after paying such dividends, it would be undercapitalized under applicable capital requirements. In addition to these explicit limitations, the federal regulatory agencies are authorized to prohibit a banking subsidiary or bank holding company from engaging in unsafe or unsound banking practices. Depending upon the circumstances, the agencies could take the position that paying a dividend would constitute an unsafe or unsound banking practice.
 
It is the policy of the Federal Reserve Board that bank holding companies should pay cash dividends on common stock only out of income available from the immediately preceding year and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. The policy provides that bank holding companies should not maintain a level of cash dividend that undermines the bank holding company’s ability to serve as a source of strength to its banking subsidiary. A bank holding company may not pay dividends when it is insolvent.

The terms of the SBLF Preferred Shares impose limits on the ability of the Company to pay dividends and repurchase shares of common stock.  Under the terms of the SBLF Preferred Shares, no repurchases may be effected, and no dividends may be declared or paid on preferred shares ranking pari passu with the SBLF Preferred Shares, junior preferred shares, or other junior securities (including the common stock) during the current quarter and for the next three quarters following the failure to declare and pay dividends on the SBLF Preferred Shares, except that, in any such quarter in which the dividend is paid, dividend payments on shares ranking pari passu may be paid to the extent necessary to avoid any resulting material covenant breach.
 
Under the terms of the SBLF Preferred Shares, the Company may only declare and pay a dividend on the common stock or other stock junior to the SBLF Preferred Shares, or repurchase shares of any such class or series of stock, if, after payment of such dividend, the dollar amount of the Company’s Tier 1 Capital would be at least 90% of the Signing Date Tier 1 Capital, which is approximately $54.4 million, excluding any subsequent net charge-offs and any redemption of the SBLF Preferred Shares (the “Tier 1 Dividend Threshold”).  Beginning on the first day of the eleventh dividend period, the amount of the Tier 1 Dividend Threshold will be reduced by 10% for each one percent increase in qualified small business lending from the baseline level through the ninth dividend period.

Community Partners did not pay any cash dividends to common shareholders in 2011 and does not contemplate the payment of cash dividends to common shareholders in 2012. On November 10, 2011, Community Partners declared a 3% stock dividend, which was distributed on December 30, 2011 to common shareholders of record as of December 13, 2011. 
 
 
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Transactions with Affiliates
 
Banking laws and regulations impose certain restrictions on the ability of bank holding companies to borrow from and engage in other transactions with their subsidiary banks. Generally, these restrictions require that any extensions of credit must be secured by designated amounts of specified collateral and be limited to (i) 10% of the bank’s capital stock and surplus per non-bank affiliated borrower, and (ii) 20% of the bank’s capital stock and surplus aggregated as to all non-bank affiliated borrowers. In addition, certain transactions with affiliates must be on terms and conditions, including credit standards, at least as favorable to the institution as those prevailing for arms-length transactions.

FIRREA

Under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (“FIRREA”), a depository institution insured by the FDIC can be held liable for any loss incurred by, or reasonably expected 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. These provisions have commonly been referred to as FIRREA’s “cross guarantee” provisions.  Further, under FIRREA, the failure to meet capital guidelines could subject a bank to a variety of enforcement remedies available to federal regulatory authorities.
 
FIRREA also imposes certain independent appraisal requirements upon a bank’s real estate lending activities and further imposes certain loan-to-value restrictions on a bank’s real estate lending activities. The bank regulators have promulgated regulations in these areas.
 
Deposit Insurance
 
All U.S. banks are required to have their deposits insured by the FDIC.  On July 21, 2010, the President signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).  As a result of changes made by the Dodd-Frank Act, the maximum amount of deposit insurance per depositor is $250,000, an increase from the old limit of $100,000.  In addition, all non-interest bearing transaction account balances (basically, business checking accounts) are insured to an unlimited amount through 2012.  The FDIC charges premiums or “assessments” to pay for the deposit insurance provided.  In the past and up through the first quarter of 2011, deposit insurance assessment rates were based on the total deposits of a bank.  Beginning with the second quarter of 2011 and thereafter, the assessments are based on the average total assets of a bank minus the bank’s average tangible equity.
 
Deposit insurance assessments have been “risk based,” in that the riskier a bank’s perceived business activities, the higher deposit insurance rate it has to pay.  All banks are assigned to one of four “risk categories” by the FDIC, pursuant to their capital levels and examination results.  The assignment to a particular risk category is made by the FDIC each quarter based on the most recent information available.  Then, the FDIC applies certain adjustments to each bank based on its specific asset attributes to determine a final assessment ratio. Beginning with the second quarter of 2011, the assessment is based on assets, not deposits, and the assessment rates will range from 2.5 basis points to 45 basis points.  (The actual dollar amount paid by each small bank is expected to be very close to the amounts paid when the assessment base was composed of deposits.)  In addition, the assessment rate for large banks (those over $10 billion in assets) is derived from a formula that that further takes into account specific activities and asset quality of a particular bank. Our bank is well below the $10 billion threshold for this additional assessment calculation.
 
The Dodd-Frank Act requires the deposit insurance fund to reach a reserve level of 1.35% of all insured deposits by September 2020, and authorizes the FDIC to implement changes in assessment rates in order to achieve such level. The Dodd-Frank Act authorizes the FDIC to establish a “designated reserve ratio” (which the FDIC has now set at 2.0%), and to reduce or eliminate assessments if the designated reserve ratio is met.  If the deposit fund reserve ratio is 2.5% or more, the FDIC is authorized, but not required, to return assessments to banks.  Given that most experts believe that the deposit fund will continue to incur losses over the short term for bank failures that have occurred and will occur from the financial crisis, it is expected that all banks will have to pay significant amounts of deposit insurance assessments for the foreseeable future, with little likelihood of reductions in deposit insurance assessments (or return of assessments paid) unless there is a material improvement in the economy and the health of the financial industry.

Capital Adequacy
 
The Federal Reserve Board has adopted risk-based capital guidelines for banks and bank holding companies. The minimum guideline for the ratio of total capital to risk-weighted assets is 8%. At least half of the total capital is to be comprised of common stock, retained earnings, minority interests in the equity accounts of consolidated subsidiaries, noncumulative perpetual preferred stock and a limited amount of qualifying cumulative perpetual preferred stock, less goodwill and certain other intangibles (“Tier 1 Capital”). The remainder may consist of other preferred stock, certain other instruments and a portion of the loan loss allowance (“Tier II Capital”). “Total Capital” is the sum of Tier I Capital and Tier II Capital.
 
 
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In addition, the Federal Reserve Board has established minimum leverage ratio guidelines for banks and bank holding companies. These guidelines provide for a minimum ratio of Tier 1 Capital to average total  assets of 3% for banks that meet certain specified criteria, including having the highest regulatory rating. All other banks and bank holding companies generally are required to maintain a leverage ratio of at least 3% plus an additional cushion of 100 to 200 basis points. At December 31, 2011, Community Partners’ leverage ratio was 10.39%. As a result of the Dodd-Frank Act and the continuing concern about the state of the financial industry, we expect that over the next few years, the Federal banking regulators will adopt changes (increases) to the capital requirements that apply to all banks.
 
The Company’s and the Bank’s capital ratios at December 31, 2011 and 2010 are set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Capital Resource”. Both the Company and the Bank were “well-capitalized” at December 31, 2011.
 
Prompt Corrective Action
 
The Federal Deposit Insurance Act (FDIA) requires federal banking regulators to take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements. Failure to meet minimum requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have an adverse material effect on Community Partners’ financial condition. Under the FDIA’s Prompt Corrective Action Regulations, the Bank must meet specific capital guidelines that involve quantitative measures of its assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices.
 
The Prompt Corrective Action Regulations define specific capital categories based on an institution’s capital ratios. The capital categories, in declining order, are “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized.” The FDIA imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the capital category by which the institution is classified. Institutions categorized as “undercapitalized” or worse may be subject to requirements to file a capital plan with their primary federal regulator, prohibitions on the payment of dividends and management fees, restrictions on asset growth and executive compensation, and increased supervisory monitoring, among other things. Other restrictions may be imposed on the institution by the regulatory agencies, including requirements to raise additional capital, sell assets or sell the entire institution. Once an institution becomes “critically undercapitalized,” it generally must be placed in receivership or conservatorship within 90 days.
 
The Prompt Corrective Action Regulations provide that an institution is “well capitalized” if the institution has a total risk-based capital ratio of 10.0% or greater, a Tier I risk-based capital ratio of 6.0% or greater, and a leverage ratio of 5.0% or greater. The institution also may not be subject to an order, written agreement, and capital directive or prompt corrective action directive to meet and maintain a specific level for any capital measure. An institution is “adequately capitalized” if it has a total risk-based capital ratio of 8.0% or greater, a Tier I risk-based capital ratio of 4.0% or greater, and a leverage ratio of 4.0% or greater (or a leverage ratio of 3.0% or greater if the institution is rated composite 1 in its most recent report of examination, subject to appropriate federal banking agency guidelines), and the institution does not meet the definition of a well-capitalized institution. An institution is deemed “undercapitalized” if it has a total risk-based capital ratio that is less than 8.0%, a Tier I risk-based capital ratio of less than 4.0%, or a leverage ratio of less than 4.0% (or a leverage ratio of 3.0% or greater if the institution is rated composite 1 in its most recent report of examination, subject to appropriate federal banking agency guidelines), and the institution does not meet the definition of a significantly undercapitalized or critically undercapitalized institution. An institution is “significantly undercapitalized” if the institution has a total risk-based capital ratio that is less than 6.0%, a Tier I risk-based capital ratio of less than 3.0%, or a leverage ratio less than 3.0% and the institution does not meet the definition of a critically undercapitalized institution, and is “critically undercapitalized” if the institution has a ratio of tangible equity to total assets that is equal to or less than 2.0%.

The appropriate federal banking agency may, under certain circumstances, reclassify a well-capitalized insured depository institution as adequately capitalized. The appropriate agency is also permitted to require an adequately capitalized or undercapitalized institution to comply with the supervisory provisions as if the institution were in the next lower category (but not to treat a significantly undercapitalized institution as critically undercapitalized) based on supervisory information other than an institution’s capital levels.
 
Unsafe and Unsound Practices
 
Notwithstanding its Prompt Corrective Action Regulations category dictated by risk-based capital ratios, the FDIA permits the appropriate bank regulatory agency to reclassify an institution if it determines, after notice and a hearing, that the condition of the institution is unsafe or unsound, or if it deems the institution to be engaging in an unsafe or unsound practice. Also, if a federal regulatory agency with jurisdiction over a depository institution believes that the depository institution will engage, is engaging, or has engaged in an unsafe or unsound practice, the regulator may require that the bank cease and desist from such practice, following notice and a hearing on the matter.
 
 
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The USA PATRIOT Act
 
On October 26, 2001, the President of the United States signed into law certain comprehensive anti-terrorism legislation known as the USA PATRIOT Act of 2001. Title III of the USA PATRIOT Act substantially broadened the scope of the U.S. anti-money-laundering laws and regulations by imposing significant new compliance and due diligence obligations on financial institutions, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States. The Treasury has issued a number of implementing regulations which apply various requirements of the USA PATRIOT Act to financial institutions such as the Bank. Those regulations impose new obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing.
 
Failure of a financial institution to comply with the USA PATRIOT Act’s requirements could have serious legal consequences for the institution and adversely affect its reputation. Community Partners and the Bank adopted appropriate policies, procedures and controls to address compliance with the requirements of the USA PATRIOT Act under the existing regulations and will continue to revise and update its policies, procedures and controls to reflect changes required by the USA PATRIOT Act and by Treasury regulations.
 
Community Reinvestment Act
 
The Federal Community Reinvestment Act (“CRA”) requires banks to respond to the full range of credit and banking needs within their communities, including the needs of low and moderate-income individuals and areas. A bank’s failure to address the credit and banking needs of all socio-economic levels within its markets may result in restrictions on growth and expansion opportunities for the bank, including restrictions on new branch openings, relocation, formation of subsidiaries, mergers and acquisitions. Upon completion of a CRA examination, an overall CRA rating is assigned using a four-tiered rating system. These ratings are:  Outstanding, Satisfactory, Needs to Improve, and Substantial Noncompliance.
 
In the latest CRA performance evaluation examination report with respect to the Bank, dated April 2, 2009, the Bank received a rating of Satisfactory.

Consumer Privacy

In addition to fostering the development of “financial holding companies,” the Gramm-Leach-Bliley Act modified laws relating to financial privacy. Its financial privacy provisions generally prohibit financial institutions, including Community Partners and the Bank, from disclosing or sharing nonpublic personal financial information to third parties for marketing or other purposes not related to transactions, unless customers have an opportunity to “opt out” of authorizing such disclosure, and have not elected to do so. It has never been the policy of Community Partners or the Bank, to release such information except as may be required by law.

Loans to One Borrower
 
Federal banking laws limit the amount a bank may lend to a single borrower to 15% of the bank’s capital base, unless the entire amount of the loan is secured by adequate amounts of readily marketable collateral. However, no loan to one borrower may exceed 25% of a bank’s statutory capital, notwithstanding collateral pledged to secure it.
 
New Jersey banking law limits the total loans and extensions of credit by a bank to one borrower at one time to 15% of the capital funds of the bank when the loan is fully secured by collateral having a market value at least equal to the amount of the loans and extensions of credit. Such loans and extensions of credit are limited to 10% of the capital funds of the bank when the total loans and extensions of credit by a bank to one borrower at one time are fully secured by readily available marketable collateral having a market value (as determined by reliable and continuously available price quotations) at least equal to the amount of funds outstanding. This 10% limitation is separate from and in addition to the 15% limitation noted in the beginning of this paragraph. If a bank’s lending limit is less than $500,000, the bank may nevertheless have total loans and extensions of credit outstanding to one borrower at one time not to exceed $500,000. At December 31, 2011, the Bank’s lending limit to one borrower was $11.3 million.
 
Sarbanes-Oxley Act of 2002
 
The Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”), which became law on July 30, 2002, created new legal requirements affecting corporate governance, accounting and corporate reporting for companies with publicly traded securities.
 
The Sarbanes-Oxley Act provides for, among other things:
 
 
·
a prohibition on personal loans made or arranged by the issuer to its directors and executive officers (except for loans made by a bank subject to Regulation O);
 
 
·
independence requirements for audit committee members;
 
 
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·
disclosure of whether at least one member of the audit committee is a “financial expert” (as such term is defined by the SEC) and if not, why not;
 
 
·
independence requirements for outside auditors;
 
 
·
certification of financial statements and reports on Forms 10-K and 10-Q by the chief executive officer and the chief financial officer;
 
 
·
the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer’s securities by directors and senior officers in the twelve month period following initial publication of any financial statements that later require restatement due to corporate misconduct;
 
 
·
disclosure of a code of ethics for financial officers and filing a Form 8-K for a change or waiver of such code; and
 
 
·
various increased criminal penalties for violations of securities laws.

Additionally, Section 404 of the Sarbanes-Oxley Act requires that a public company subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), include in its annual report (i) a management’s report on internal control over financial reporting assessing the company’s internal controls, and (ii) for larger publicly traded companies, an auditor’s attestation report, completed by the independent registered public accounting firm that prepares or issues an accountant’s report that is included in the company’s annual report, attesting to the effectiveness of management’s internal controls over financial reporting. Because we are neither a “large accelerated filer” nor an “accelerated filer”, compliance with the auditor’s attestation report requirement is not required.

All of the national stock exchanges, including the Nasdaq Capital Market where our common stock is listed, have implemented corporate governance rules, including rules strengthening director independence requirements for boards, and the adoption of charters for the nominating, corporate governance, and audit committees. The rule changes are intended to, among other things, make the Board of Directors independent of management and allow shareholders to more easily and efficiently monitor the performance of companies and directors. These increased burdens have increased our legal and accounting fees and the amount of time that our Board of Directors and management must devote to corporate governance issues.
 
Dodd-Frank Act
 
The Dodd-Frank Act, which was enacted in July 2010, significantly restructured financial regulation in the United States, including through the creation of a new resolution authority, mandating higher capital and liquidity requirements, and requiring banks to pay increased fees to regulatory agencies.
 
The implications of the Dodd-Frank Act for the Company’s businesses will depend to a large extent on the manner in which rules adopted pursuant to the Dodd-Frank Act are implemented by the primary U.S. financial regulatory agencies, as well as potential changes in market practices and structures in response to the requirements of the Dodd-Frank Act and financial reforms in other jurisdictions. Among other things:
 
 
·
The Dodd-Frank Act repealed the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts.  Depending on competitive responses, this significant change to existing law could have an adverse impact on the Company’s interest expense.
 
 
·
The Dodd-Frank Act also broadens the base for FDIC insurance assessments.  Assessments will now be based on the average consolidated total assets less tangible equity capital of a financial institution.
 
 
·
The Dodd-Frank Act also permanently increases the maximum amount of deposit insurance for banks, savings institutions and credit unions to $250,000 per depositor, retroactive to January 1, 2008, and non-interest bearing transaction accounts have unlimited deposit insurance through December 31, 2012.
 
 
·
Bank and thrift holding companies with assets of less than $15 billion as of December 31, 2009, such as the Company, will be permitted to include trust preferred securities that were issued before May 19, 2010, as Tier 1 capital; however, trust preferred securities issued by a bank or thrift holding company (other than those with assets of less than $500 million) after May 19, 2010, will no longer count as Tier 1 capital. Trust preferred securities still will be entitled to be treated as Tier 2 capital.
 
 
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·
The Dodd-Frank Act centralized responsibility for consumer financial protection by creating a new agency, the Consumer Financial Protection Bureau (“CFPB”), and giving it responsibility for implementing, examining and enforcing compliance with federal consumer protection laws.
 
 
·
The “Durbin Amendment” provisions of the Dodd-Frank Act provided that debit card interchange fees must be reasonable and proportional to the cost incurred by the issuer with respect to the transaction. In June 2011, the Federal Reserve adopted regulations setting the maximum permissible interchange fee as the sum of 21 cents per transaction and 5 basis points multiplied by the value of the transaction, with an additional adjustment of up to one cent per transaction, with an additional adjustment of up to one cent per transaction if the issuer implements certain fraud-prevention standards.
 
 
·
The Dodd-Frank Act created a new systemic risk oversight body, the Financial Stability Oversight Council (“FSOC”), to oversee and coordinate the efforts of the primary U.S. financial regulatory agencies in establishing regulations to address financial stability concerns.
 
 
·
The Dodd-Frank Act directs the FSOC to make recommendations to the Federal Reserve as to enhanced supervision and prudential standards applicable to large, interconnected financial institutions, including bank holding companies with total consolidated assets of $50 billion or more, and authorizes the Federal Reserve to establish such standards either on its own or upon the recommendations of the FSOC.
 
 
·
The Dodd-Frank Act includes provisions permitting national and insured state banks to engage in de novo interstate branching if, under the laws of the state where the new branch is to be established, as state bank chartered in that state would be permitted to establish a branch.
 
 
·
The Dodd-Frank Act requires various U.S. financial regulatory agencies to implement comprehensive rules governing the supervision, structure, trading and regulation of swap and over the-counter derivative markets and participants. The Dodd-Frank Act requires a large number of rules in this area, many of which are not yet final.
 
 
·
The Dodd-Frank Act requires the federal financial regulatory agencies to adopt rules that prohibit banks and their affiliates from engaging in proprietary trading and investing in and sponsoring certain unregistered investment companies (defined as hedge funds and private equity funds), with implementation starting as early as July 2012. The statutory provision is commonly referred to as the “Volcker Rule”. In October 2011, federal regulators proposed rules to implement the Volcker Rule. We do not currently anticipate that the Volcker Rule will have a material effect on our operations. However, until a final rule is adopted, the precise financial impact of the rule cannot be determined.
 
 
·
In October 2011, the Federal Reserve issued a final rule implementing resolution planning requirements in the Dodd-Frank Act. The final rule requires bank holding companies with assets of $50 billion or more and nonbank financial firms designated by FSOC for supervision by the Federal Reserve to annually submit resolution plans to the FDIC and Federal Reserve. Each plan shall describe the company’s strategy for rapid and orderly resolution in bankruptcy during times of financial distress. Under the final rule, companies will submit their initial resolution plans on a staggered basis.
 
Executive Compensation.  The Dodd-Frank Act provides for a say on pay for shareholders of all public companies. Under the Dodd-Frank Act, each company must give its shareholders the opportunity to vote on the compensation of its executives at least once every three years. The Dodd-Frank Act also adds disclosure and voting requirements for golden parachute compensation that is payable to named executive officers in connection with sale transactions.  For smaller reporting companies like us, we are not required to conduct say-on-pay and frequency votes until annual meetings occurring on or after January 21, 2013.
 
The Dodd-Frank Act also requires the SEC to issue rules directing the stock exchanges to prohibit listing classes of equity securities if a company’s compensation committee members are not independent. The Dodd-Frank Act also provides that a company’s compensation committee may only select a compensation consultant, legal counsel or other advisor after taking into consideration factors to be identified by the SEC that affect the independence of a compensation consultant, legal counsel or other advisor.
 
The SEC is required under the Dodd-Frank Act to issue rules obligating companies to disclose in proxy materials for annual meetings of shareholders information that shows the relationship between executive compensation actually paid to their named executive officers and their financial performance, taking into account any change in the value of the shares of a company’s stock and dividends or distributions.
 
 
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The Dodd-Frank Act provides that the SEC must issue rules directing the stock exchanges to prohibit listing any security of a company unless the company develops and implements a policy providing for disclosure of the policy of the company on incentive-based compensation that is based on financial information required to be reported under the securities laws and that, in the event the company is required to prepare an accounting restatement due to the material noncompliance of the company with any financial reporting requirement under the securities laws, the company will recover from any current or former executive officer of the company who received incentive-based compensation during the three-year period preceding the date on which the company is required to prepare the restatement based on the erroneous data, any exceptional compensation above what would have been paid under the restatement.
 
Corporate Governance.  The Dodd-Frank Act requires the SEC, by rule, to require that each company disclose in the proxy materials for its annual meetings whether an employee or board member is permitted to purchase financial instruments designed to hedge or offset decreases in the market value of equity securities granted as compensation or otherwise held by the employee or board member.
 
The Dodd-Frank Act clarifies that the SEC may, but is not required to, promulgate rules that would require that a company’s proxy materials include a nominee for the board of directors submitted by a shareholder. Although the SEC promulgated rules to accomplish this, these rules were invalidated by a federal appeals court decision. The SEC has said that they will not challenge the ruling, but has not ruled out the possibility that new rules could be proposed.
 
The Dodd-Frank Act requires stock exchanges to have rules prohibiting their members from voting securities that they do not beneficially own (unless they have received voting instructions from the beneficial owner) with respect to the election of a member of the board of directors (other than an uncontested election of directors of an investment company registered under the Investment Company Act of 1940), executive compensation or any other significant matter, as determined by the SEC by rule.
 
FDIC Matters and Resolution Planning.  The Dodd-Frank Act creates an orderly liquidation process that the FDIC can employ for failing financial companies that are not insured depository institutions. The Dodd-Frank Act gives the FDIC new authority to create a widely available emergency financial stabilization program to guarantee the obligations of solvent depository institutions and their holding companies and affiliates during times of severe economic stress. Additionally, Dodd-Frank also codifies many of the temporary changes that had already been implemented, such as permanently increasing the amount of deposit insurance to $250,000.
 
In September 2011, the FDIC approved an interim final rule that requires an insured depository institution with $50 billion or more in total assets to submit periodic contingency plans to the FDIC for resolution in the event of the institution’s failure. The rule became effective in January 2012, however, submission of plans will be staggered over a period of time. The Bancorp’s banking subsidiary is subject to this rule.
 
New laws or regulations or changes to existing laws and regulations (including changes in interpretation or enforcement) could materially adversely affect our financial condition or results of operations. Many aspects of the Dodd-Frank Act are subject to further rulemaking and interpretation, and will take effect over several years. The overall financial impact on the Company and its subsidiaries or the financial services industry generally cannot be anticipated at this time.
 
Overall Impact of New Legislation and Regulations
 
Various legislative initiatives are from time to time introduced in Congress and in the New Jersey State Legislature. It cannot be predicted whether or to what extent the business and condition of Community Partners or the Bank will be affected by new legislation or regulations, and legislation or regulations as yet to be proposed or enacted. Given that the financial industry remains under stress and severe scrutiny, and given that the U.S. economy has not yet fully recovered to pre-crisis levels of activity, we fully suspect that there will be significant legislation and regulatory actions that will materially affect the banking industry generally and our bank specifically for the foreseeable future.
 
Available Information
 
The Company maintains a website at www.tworiverbank.com. The Company makes available on its website free of charge its annual reports on Form 10-K, quarterly reports on Form 10-Q, Extensible Business Reporting Language (“XBRL”), a standards-based way to communicate and exchange business information between business systems, and current reports on Form 8-K, and amendments to those reports which are filed with or furnished to the SEC pursuant to Section 13(a) of the Securities Exchange Act of 1934. These documents are made available on the Company’s website as soon as reasonably practicable after they are electronically filed with or furnished to the SEC. Also available on the website are our Code of Conduct, our Shareholder Communications Policy and the charters of our Nominating and Corporate Governance Committee, Audit Committee, and Compensation Committee.

 
16

 
 
Item 1A.  Risk Factors.
 
The following are some important factors that could cause the Company’s actual results to differ materially from those referred to or implied in any forward-looking statement. These are in addition to the risks and uncertainties discussed elsewhere in this Annual Report on Form 10-K and the Company’s other filings with the SEC.

Our dependence on loans secured by real estate subjects us to risks relating to fluctuations in the real estate market and related interest rates and legislation that could result in significant additional costs and capital requirements that could adversely affect our financial condition and results of operations.
 
Approximately 70.1% of our loan portfolio as of December 31, 2011 was comprised of loans collateralized by real estate, with 100% of the real estate located in New Jersey. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. The real estate markets in New Jersey deteriorated in the last several years. A continued weakening of the real estate market in our primary market areas could have an adverse effect on the demand for new loans, the ability of borrowers to repay outstanding loans, the value of real estate and other collateral securing the loans and the value of real estate owned by us. As real estate values decline, it is also more likely that we would be required to make provisions for additional loan losses, which could adversely affect our financial condition and results of operations.
 
Current market conditions include an over-supply of land, lots and finished homes in many markets, including those where we do business. As of December 31, 2011, we had $51.2 million, or 9.6%, of our total loans in real estate construction loans. Of this amount, $1.9 million were land loans and $33.4 million were made to finance residential construction with an identified purchaser. Substantially all of these loans are located in Monmouth and Union counties, New Jersey. Further, $15.9 million of real estate construction loans were made to finance commercial construction. Construction loans are subject to risks during the construction phase that are not present in standard residential real estate and commercial real estate loans. These risks include:
 
 
·
the viability of the contractor;
 
·
the value of the project being subject to successful completion;
 
·
the contractor’s ability to complete the project, to meet deadlines and time schedules and to stay within cost estimates; and
 
·
concentrations of such loans with a single contractor and its affiliates.
 
Real estate construction loans also present risks of default in the event of declines in property values or volatility in the real estate market during the construction phase. If we are forced to foreclose on a project prior to completion, we may not be able to recover the entire unpaid portion of the loan, may be required to fund additional amounts to complete a project and may have to hold the property for an indeterminate amount of time. If any of these risks were to occur, it could adversely affect our financial condition, results of operations and cash flows.
 
The federal banking agencies have issued guidance regarding high concentrations of commercial real estate loans within bank loan portfolios. The guidance requires financial institutions that exceed certain levels of commercial real estate lending compared with their total capital to maintain heightened risk management practices that address the following key elements: including board and management oversight and strategic planning, portfolio management, development of underwriting standards, risk assessment and monitoring through market analysis and stress testing, and maintenance of increased capital levels as needed to support the level of commercial real estate lending. If there is any deterioration in our commercial real estate or real estate construction portfolios or if our regulators conclude that we have not implemented appropriate risk management practices, it could adversely affect our business and result in a requirement of increased capital levels, and such capital may not be available at that time.
 
Our commercial real estate and commercial loans expose us to increased credit risks, and these risks will increase if we succeed in increasing these types of loans.
 
We focus our lending efforts on commercial-related loans and intend to grow commercial real estate and commercial loans further as a proportion of our portfolio. As of December 31, 2011, commercial real estate loans and commercial and industrial loans totaled $407.6 million. In general, commercial real estate loans and commercial and industrial loans yield higher returns and often generate a deposit relationship, but also pose greater credit risks than do owner-occupied residential real estate loans. As our various commercial-related loan portfolios increase, the corresponding risks and potential for losses from these loans will also increase.
 
We make both secured and some unsecured commercial and industrial loans. Unsecured loans generally involve a higher degree of risk of loss than do secured loans because, without collateral, repayment is wholly dependent upon the success of the borrowers’ businesses. Secured commercial and industrial loans are generally collateralized by accounts receivable, inventory, equipment or other assets owned by the borrower and include a personal guaranty of the business owner. Compared to real estate, that type of collateral is more difficult to monitor, its value is harder to ascertain, it may depreciate more rapidly and it may not be as readily saleable if repossessed. Further, commercial and industrial loans generally will be serviced primarily from the operation of the business, which may not be successful, and commercial real estate loans generally will be serviced from income on the properties securing the loans.
 
 
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Our financial condition and results of operations would be adversely affected if our allowance for loan losses is not sufficient to absorb actual losses or if we are required to increase our allowance.
 
Despite our underwriting criteria, we may experience loan delinquencies and losses. In order to absorb losses associated with non-performing loans, we maintain an allowance for loan losses based on, among other things, historical experience, an evaluation of economic conditions, and regular reviews of delinquencies and loan portfolio quality. Determination of the allowance inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. At any time there are likely to be loans in our portfolio that will result in losses but that have not been identified as non-performing or potential problem credits. We cannot be sure that we will be able to identify deteriorating credits before they become non-performing assets or that we will be able to limit losses on those loans that are identified. 

We may be required to increase our allowance for loan losses for any of several reasons. State and federal regulators, in reviewing our loan portfolio as part of a regulatory examination, may request that we increase our allowance for loan losses. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in our allowance. In addition, if charge-offs in future periods exceed our allowance for loan losses, we will need additional increases in our allowance for loan losses. Any increases in our allowance for loan losses will result in a decrease in our net income and, possibly, our capital, and may materially affect our results of operations in the period in which the allowance is increased.

Negative developments in the financial services industry and the U.S. and global credit markets may adversely impact our operations and results.

Since 2008, negative developments in the capital markets have resulted in uncertainty in the financial markets in general with the expectation of the general economic uncertainty continuing through much of 2011. Loan portfolio performances have deteriorated at many institutions resulting from, amongst other factors, a weak economy and a decline in the value of the collateral supporting their loans. The competition for our deposits has increased significantly due to liquidity concerns at many of these same institutions.  Stock prices of bank holding companies, like ours, have been negatively affected by the current condition of the financial markets, as has our ability, if needed, to raise capital or borrow in the debt markets compared to recent years. As a result, there is a potential for new federal or state laws and regulations regarding lending and funding practices and liquidity standards, and financial institution regulatory agencies are expected to be very aggressive in responding to concerns and trends identified in examinations, including the expected issuance of many formal enforcement actions. Negative developments in the financial services industry and the impact of new legislation in response to those developments could negatively impact our operations by restricting our business operations, including our ability to originate or sell loans, and adversely impact our financial performance.

Difficult market conditions and economic trends in the real estate market have adversely affected our industry and our business.
 
We are particularly affected by downturns in the U. S. real estate market. Dramatic declines in the real estate market over the past two years, with decreasing property values and increasing delinquencies and foreclosures, may have a negative impact on the credit performance of commercial and construction, mortgage, and consumer loan portfolios resulting in significant write-downs of assets by many financial institutions. In addition, the values of real estate collateral supporting many loans have declined and may continue to decline. General downward economic trends, reduced availability of commercial credit and increased unemployment levels may negatively impact the credit performance of commercial and consumer credit, resulting in additional write-downs. Concerns over the stability of the financial markets and the economy have resulted in decreased lending by financial institutions to their customers. This market turmoil and tightening of credit has led to increased commercial and consumer deficiencies, lack of customer confidence, increased market volatility and widespread reduction in general business activity. The resulting economic pressure on consumers and businesses and the lack of confidence in the financial markets may adversely affect our business, financial condition, results of operations and stock price. A worsening of these economic conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the industry. Our ability to properly assess the creditworthiness of customers and to estimate the losses inherent in our credit exposure is made more complex by these difficult market and economic conditions. Accordingly, if these market conditions and trends continue, we may experience increases in foreclosures, delinquencies and customer bankruptcies, as well as more restricted access to funds.
 
 
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The Company’s profitability depends significantly on local economic conditions.
 
The Company’s success depends primarily on the general economic conditions of the primary markets in New Jersey in which it operates and where its loans are concentrated. Unlike nationwide banks that are more geographically diversified, the Company provides banking and financial services to customers primarily in Monmouth and Union counties, New Jersey. The local economic conditions in these areas have a significant impact on the Company’s commercial and industrial, real estate and construction loans, the ability of its borrowers to repay their loans and the value of the collateral securing these loans. In addition, if the population or income growth in the Company’s market areas is slower than projected, income levels, deposits and housing starts could be adversely affected and could result in a reduction of the Company’s expansion, growth and profitability. Although economic conditions in Monmouth and Union counties, New Jersey have not deteriorated to the same extent as in other areas of the country, such conditions could decline further. If the Company’s market areas experience a downturn or a recession for a prolonged period of time, the Company could experience significant increases in nonperforming loans, which could lead to operating losses, impaired liquidity and eroding capital. A significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, outbreaks of hostilities or other international or domestic calamities, unemployment, monetary and fiscal policies of the federal government or other factors could impact these local economic conditions and could negatively affect the Company’s financial condition, results of operations and cash flows.
 
The small to medium-sized businesses that the Company lends to may have fewer resources to weather a downturn in the economy, which may impair a borrower’s ability to repay a loan to the Company that could materially harm the Company’s operating results.
 
The Company targets its business development and marketing strategy primarily to serve the banking and financial services needs of small to medium-sized businesses. These small to medium-sized businesses frequently have smaller market share than their competition, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience significant volatility in operating results. Any one or more of these factors may impair the borrower’s ability to repay a loan. In addition, the success of a small to medium-sized business often depends on the management talents and efforts of one or two persons or a small group of persons, and the death, disability or resignation of one or more of these persons could have a material adverse impact on the business and its ability to repay a loan. Economic downturns and other events that negatively impact the Company’s market areas could cause the Company to incur substantial credit losses that could negatively affect the Company’s results of operations and financial condition.
 
We currently do not intend to pay dividends on our common stock. In addition, our future ability to pay dividends is subject to restrictions.
 
We have not paid any dividends to our holders of common stock in the past and we currently do not intend to pay any dividends on our common stock in the foreseeable future. In the event that we decide to pay dividends, there are a number of restrictions on our ability to pay dividends. It is the policy of the Federal Reserve that bank holding companies should pay cash dividends on common stock only out of income available over the past year and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. The policy provides that bank holding companies should not maintain a level of cash dividends that undermines the bank holding company’s ability to serve as a source of strength to its banking subsidiaries. If we fail to pay dividends on our SBLF Preferred Shares, we will be prohibited from paying dividends on our common stock.
 
Our principal source of funds to pay dividends on our common stock will be cash dividends that we receive from the Bank. The payment of dividends by the Bank to us is subject to certain restrictions imposed by federal and state banking laws, regulations and authorities. The federal banking statutes prohibit federally insured banks from making any capital distributions (including a dividend payment) if, after making the distribution, the institution would be “under capitalized” as defined by statute. In addition, the relevant federal regulatory agencies have authority to prohibit an insured bank from engaging in an unsafe or unsound practice, as determined by the agency, in conducting an activity. The payment of dividends could be deemed to constitute such an unsafe or unsound practice, depending on the financial condition of the Bank. Regulatory authorities could impose administratively stricter limitations on the ability of the Bank to pay dividends to us if such limits were deemed appropriate to preserve certain capital adequacy requirements.
 
The dividend rate on the SBLF Preferred Shares we issued in connection with the SBLF will fluctuate initially from 1% to 5% based on our level of “Qualified Small Business Lending,” or “QSBL,” as compared to our “baseline” level. The cost of the capital we received from the SBLF Preferred Shares will increase if the level of our “QSBL” as of June 30, 2013 does not represent an increase from our “baseline” level. This cost also will increase if we have not redeemed the SBLF Preferred Shares within 4.5 years of the closing of the SBLF transaction.
 
The per annum dividend rate on the SBLF Preferred Shares can fluctuate on a quarterly basis during the first ten quarters during which the SBLF Preferred Shares is outstanding, based upon changes in the amount of qualified small business lending (QSBL), as defined in the Supplemental Reports related to the SBLF transaction, from a “baseline” level (QSBL Baseline). The dividend rate for the initial dividend period was 3.2% per annum. For the second dividend period through the tenth dividend period, the annual dividend rate may be adjusted to between 1% and 5%, to reflect the amount of percentage change in the Bank’s level of QSBL from the QSBL Baseline to the level as of the end of the second quarter preceding the dividend period in question. For the eleventh dividend period through 4.5 years after the closing of the SBLF transaction, the annual dividend rate will be fixed at between 1% and 5%, based upon the percentage increase in QSBL from the QSBL Baseline to the level as of the end of the ninth dividend period (i.e., as of September 30, 2013); however, if there is no increase in QSBL from the QSBL Baseline to the level as of the end of the ninth dividend period (or if QSBL has decreased during that time period), the dividend rate will be fixed at 7%. Further, the potential dividend rate reduction in any period is limited, such that the reduction will not apply to any Series B Preferred Stock proceeds that exceed the dollar amount of the increase in QSBL for that period as compared to the QSBL Baseline.
 
 
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In addition, if our QSBL is not above the QSBL Baseline at the end of March 31, 2013, because of our participation in TARP CPP, we must also pay a lending incentive fee of 2% per annum (payable quarterly), calculated based on the liquidation value of the outstanding SBLF Preferred Shares as of the end of that quarter, beginning with dividend payment dates on or after April 1, 2014 and ending on April 1, 2016. After 4.5 years from the closing of the SBLF transaction, the annual dividend rate will be fixed at 9%, regardless of the level of QSBL. Depending on our financial condition at the time, any such increases in the dividend rate could have a material negative effect on our liquidity.
 
Future dividend payments and common stock repurchases are subject to certain restrictions by the terms of the Secretary of the Treasury’s equity investment in us.
 
Under the terms of the SBLF, for so long as any preferred stock issued under the SBLF remains outstanding, we are prohibited from making a dividend payment or share repurchase if, after the payment or repurchase, our Tier 1 capital would not be at least 90% of the amount existing at the time immediately after September 27, 2011, excluding any subsequent net charge-offs and partial repayments of the SBLF funding. This 90% limitation will decrease by a dollar amount equal to 10% of the SBLF funding for every 1% increase in QSBL that we have achieved over the QSBL Baseline. These restrictions will no longer apply to us after we have repaid the SBLF funding in full.
 
Failure to pay dividends on our SBLF Preferred Shares may have negative consequences, including external involvement in the Company’s board of directors.
 
If dividends on the SBLF Preferred Shares are not paid in full for six quarterly dividend periods, whether or not consecutive, and if the aggregate liquidation preference amount of the then-outstanding shares of SBLF Preferred Shares is at least $25.0 million, the total number of positions on our board of directors will automatically increase by two and the holders of the SBLF Preferred Shares, acting as a single class, will have the right to elect two individuals to serve in the new director positions. This right and the terms of such directors will end when we have paid full dividends for at least four consecutive quarterly dividend periods. If full dividends have not been paid on the SBLF Preferred Shares for five or more quarterly dividend periods, whether or not consecutive, we must invite a representative selected by the holders of a majority of the outstanding shares of SBLF Preferred Shares, voting as a single class, to attend all meetings of our board of directors in a nonvoting observer capacity. Any such representative would not be obligated to attend any board meeting to which he or she is invited, and this right will end when we have paid full dividends for at least four consecutive dividend periods.
 
Our preferred shares impact net income available to our common stockholders and our earnings per share.
 
The dividends declared on the SBLF Preferred Shares reduce net income available to common shareholders and our earnings per common share. The SBLF Preferred Shares will also receive preferential treatment in the event of liquidation, dissolution or winding up of the Company.

Changes in interest rates could reduce our income, cash flows and asset values.
 
Our income and cash flows and the value of our assets depend to a great extent on the difference between the interest rates we earn on interest-earning assets, such as loans and investment securities, and the interest rates we pay on interest-bearing liabilities such as deposits and borrowings. These rates are highly sensitive to many factors which are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Federal Reserve. Changes in monetary policy, including changes in interest rates, will influence not only the interest we receive on our loans and investment securities and the amount of interest we pay on deposits and borrowings but will also affect our ability to originate loans and obtain deposits and the value of our investment portfolio. If the rate of interest we pay on our deposits and other borrowings increases more than the rate of interest we earn on our loans and other investments, our net interest income, and therefore our earnings, could be adversely affected. Our earnings also could be adversely affected if the rates on our loans and other investments fall more quickly than those on our deposits and other borrowings.

Competition may decrease our growth or profits.
 
We face substantial competition in all phases of our operations from a variety of different competitors, including commercial banks, savings and loan associations, mutual savings banks, credit unions, consumer finance companies, factoring companies, leasing companies, insurance companies and money market mutual funds. There is very strong competition among financial services providers in our principal service area. Our competitors may have greater resources, higher lending limits or larger branch systems than we do. Accordingly, they may be able to offer a broader range of products and services as well as better pricing for those products and services than we can.
 
 
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In addition, some of the financial services organizations with which we compete are not subject to the same degree of regulation as is imposed on federally insured financial institutions such as the Bank. As a result, those non-bank competitors may be able to access funding and provide various services more easily or at less cost than we can, adversely affecting our ability to compete effectively.

We rely on our management and other key personnel, and the loss of any of them may adversely affect our operations.

We are and will continue to be dependent upon the services of our executive management team. The Company’s performance is largely dependent on the talents and efforts of highly skilled individuals. There is intense competition in the financial services industry for qualified employees. In addition, the Company faces increasing competition with businesses outside the financial services industry for the most highly skilled individuals. The unexpected loss of services of any key management personnel or commercial loan officers could have an adverse effect on our business and financial condition because of their skills, knowledge of our market, years of industry experience and the difficulty of promptly finding qualified replacement personnel. The Company’s business operations could be adversely affected if it were unable to attract new employees and retain and motivate its existing employees.
 
We may be adversely affected by government regulation.
 
The banking industry is heavily regulated. Banking regulations are primarily intended to protect the federal deposit insurance funds and depositors, not shareholders. Changes in the laws, regulations, and regulatory practices affecting the banking industry may increase our costs of doing business or otherwise adversely affect us and create competitive advantages for others. Regulations affecting banks and financial services companies undergo continuous change, and we cannot predict the ultimate effect of these changes, which could have a material adverse effect on our profitability or financial condition.

The anti-money laundering, or AML, and bank secrecy, or BSA, laws have imposed far-reaching and substantial requirements on financial institutions. The enforcement policy with respect to AML/BSA compliance has been vigorously applied throughout the industry, with regulatory action taking various forms. We believe that our policies and procedures with respect to combating money laundering are effective and that our AML/BSA policies and procedures are reasonably designed to comply with current applicable standards. We cannot provide assurance that in the future we will not face a regulatory action, adversely affecting our ability to acquire banks or open new branches.

Environmental liability associated with lending activities could result in losses.
 
In the course of our business, we may foreclose on and take title to properties securing our loans. If hazardous substances were discovered on any of these properties, we could be liable to governmental entities or third parties for the costs of remediation of the hazard, as well as for personal injury and property damage. Many environmental laws can impose liability regardless of whether we knew of, or were responsible for, the contamination. In addition, if we arrange for the disposal of hazardous or toxic substances at another site, we may be liable for the costs of cleaning up and removing those substances from the site even if we neither own nor operate the disposal site. Environmental laws may require us to incur substantial expenses and may materially limit use of properties we acquire through foreclosure, reduce their value or limit our ability to sell them in the event of a default on the loans they secure. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability.
 
Failure to implement new technologies in our operations may adversely affect our growth or profits.
 
The market for financial services, including banking services and consumer finance services is increasingly affected by advances in technology, including developments in telecommunications, data processing, computers, automation, Internet-based banking and telebanking. Our ability to compete successfully in our markets may depend on the extent to which we are able to exploit such technological changes. However, we can provide no assurance that we will be able to properly or timely anticipate or implement such technologies or properly train our staff to use such technologies. Any failure to adapt to new technologies could adversely affect our business, financial condition or operating results.

A limited market exists for our common stock.

Our common stock commenced trading on the NASDAQ Capital Market on April 4, 2006 and trading volumes since that time have been modest. The limited trading market for our common stock may cause fluctuations in the market value of our common stock to be exaggerated, leading to price volatility in excess of that which would occur in a more active trading market. Accordingly, you may have difficulty selling our common stock at prices which you find acceptable or which accurately reflect the value of the Company.

 
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We are subject to liquidity risk.

Liquidity risk is the potential that we will be unable to meet our obligations as they become due, capitalize on growth opportunities as they arise, or pay regular cash dividends because of an inability to liquidate assets or obtain adequate funding in a timely basis, at a reasonable cost and within acceptable risk tolerances.

Liquidity is required to fund various obligations, including credit commitments to borrowers, mortgage and other loan originations, withdrawals by depositors, repayment of borrowings, dividends to shareholders, operating expenses and capital expenditures. Liquidity is derived primarily from retail deposit growth and retention; principal and interest payments on loans; principal and interest payments on and the sale, maturity and prepayment of investment securities; net cash provided from operations and access to other funding sources.
 
Our access to funding sources in amounts adequate to finance our activities could be impaired by factors that affect us specifically or the financial services industry in general. Factors that could detrimentally impact our access to liquidity sources include a decrease in the level of our business activity due to a market downturn or adverse regulatory action against us. Our ability to borrow could also be impaired by factors that are not specific to us, such as a severe disruption of the financial markets or negative views and expectations about the prospects for the financial services industry as a whole as evidenced by turmoil faced by banking organizations in 2008 in the domestic and worldwide credit markets.

Future offerings of debt or other securities may adversely affect the market price of our stock.
 
In the future, we may attempt to increase our capital resources or, if our or the Bank’s capital ratios fall below the required minimums, we or the Bank could be forced to raise additional capital by making additional offerings of debt or preferred equity securities, including medium-term notes, trust preferred securities, senior or subordinated notes and preferred stock. Upon liquidation, holders of our debt securities and shares of preferred stock and lenders with respect to other borrowings will receive distributions of our available assets prior to the holders of our common stock. Additional equity offerings may dilute the holdings of our existing shareholders or reduce the market price of our common stock, or both. Holders of our common stock are not entitled to preemptive rights or other protections against dilution.
 
The Company may lose lower-cost funding sources.

Checking, savings, and money market deposit account balances and other forms of customer deposits can decrease when customers perceive alternative investments, such as the stock market, as providing a better risk/return tradeoff. If customers move money out of bank deposits and into other investments, the Company could lose a relatively low-cost source of funds, increasing its funding costs and reducing the Company’s net interest income and net income.

The Company is subject to operational risk.

The Company faces the risk that the design of its controls and procedures, including those to mitigate the risk of fraud by employees or outsiders, may prove to be inadequate or are circumvented, thereby causing delays in detection of errors or inaccuracies in data and information. Management regularly reviews and updates the Company’s internal controls, disclosure controls and procedures, and corporate governance policies and procedures.  Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the Company’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Company’s business, results of operations and financial condition.
 
The Company may also be subject to disruptions of its systems arising from events that are wholly or partially beyond its control (including, for example, computer viruses or electrical or telecommunications outages), which may give rise to losses in service to customers and to financial loss or liability. The Company is further exposed to the risk that its external vendors may be unable to fulfill their contractual obligations (or will be subject to the same risk of fraud or operational errors by their respective employees as is the Company) and to the risk that the Company’s (or its vendors’) business continuity and data security systems prove to be inadequate.

Item 1B.  Unresolved Staff Comments.
 
Not applicable.
 
 
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Item 2.  Properties.
 
The following table provides certain information with respect to properties used by the Company or the Bank in their operations:
 
Office Location
 
Address
 
Description
 
Opened
The Bank’s Main Office:
 
1250 Highway 35 South
Middletown, NJ
 
5,300 sq. ft. first-floor stand- alone building (leased)
 
02/00
             
Operations Center:
 
178 Office Max Plaza
Suite 3-A
Eatontown, NJ
 
7,200 sq. ft.
shopping center (leased)
 
06/02
             
Allaire:
 
Monmouth Executive Airport
229 Airport Road, Bldg 13
Farmingdale, NJ
 
3,800 sq. ft. building (leased)
 
02/04
             
Atlantic Highlands:
 
84 First Avenue
Atlantic Highlands, NJ
 
700 sq. ft. store front (leased)
 
03/02
             
Cliffwood:
 
Angel Street & Route 35
Aberdeen, NJ
 
2,500 sq. ft. building (leased)
 
11/04
             
Cranford Office:
 
104 Walnut Avenue
Cranford, NJ
 
800 sq. ft. storefront
(leased)
 
11/07
             
Fanwood:
 
328 South Avenue
Fanwood, NJ
 
2,966 sq. ft. stand-alone  building (leased)
 
03/08
             
Manasquan:
 
240 Route 71
Manasquan, NJ
 
4,300 sq. ft. stand-alone  building (leased)
 
06/08
             
Navesink:
 
East Pointe Shopping Center
2345 Route 36
Atlantic Highlands, NJ
 
2,080 sq. ft in strip shopping  center (leased)
 
09/05
             
Port Monmouth:
 
357 Highway 36
Port Monmouth, NJ
 
2,180 sq. ft. stand-alone  building (leased)
 
06/01
             
Red Bank:
 
City Centre Plaza
100 Water Street
Red Bank, NJ
 
512 sq. ft. in strip shopping  center (leased)
 
09/02
             
Tinton Falls:
 
4050 Asbury Avenue
Tinton Falls, NJ
 
3,400 sq. ft. stand-alone  building (leased)
 
10/06
             
Tinton Falls:
 
656 Shrewsbury Avenue
Tinton Falls, NJ
 
3,650 sq. ft. stand-alone  building (leased)
 
08/00
             
West Long Branch:
 
359 Monmouth Road
West Long Branch, NJ
 
3,100 sq. ft. in strip shopping  center (leased)
 
01/04
             
Westfield:
 
520 South Avenue
Westfield, NJ
 
3,000 sq. ft. stand-alone  building (leased)
 
10/98
             
Westfield:
 
44 Elm Street
Westfield, NJ
 
3,000 sq. ft. downtown  building (owned)
 
04/01

The Company owns property located at 245-249 North Avenue in Cranford, New Jersey, which is classified as assets held for sale in other assets. The Company executed a lease for 17,626 square feet of office space located at 766 Shrewsbury Avenue in Tinton Falls, New Jersey to be used as the future site for corporate offices and Bank operations. The term of the lease is 10.5 years with an anticipated start date in October 2012.
 
 
23

 
 
Item 3.  Legal Proceedings.
 
The Company may, in the ordinary course of business, become a party to litigation involving collection matters, contract claims and other legal proceedings relating to the conduct of its business. The Company may also have various commitments and contingent liabilities which are not reflected in the accompanying consolidated balance sheet. At December 31, 2011, we were not involved in any material legal proceedings.
 
Item 4.  Mine Safety Disclosures.

Not applicable
 
PART II
 
Item 5.  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
 
The common stock of the Company trades on the Nasdaq Capital Market under the trading symbol “CPBC”. The following are the high and low sales prices per share, which have been adjusted for the 3% stock dividend declared November 10, 2011.

   
2011
   
2010
 
   
High
   
Low
   
High
   
Low
 
First Quarter
 
$
5.19
   
$
4.34
   
$
3.56
   
$
2.83
 
Second Quarter
   
5.06
     
4.32
     
4.55
     
3.44
 
Third Quarter
   
5.10
     
4.38
     
5.09
     
3.51
 
Fourth Quarter
   
4.75
     
4.47
     
5.11
     
4.38
 

As of March 15, 2012, there were approximately 561 record holders of the Company’s common stock.

On November 10, 2011, Community Partners declared a 3% stock dividend, which was paid on December 30, 2011 to shareholders of record as of December 13, 2011.

Community Partners did not pay any cash dividends to common shareholders in 2011. In addition, please refer to the discussion under the heading “Dividend Restrictions” for restrictions on the payment of cash dividends.

Item 6.  Selected Financial Data.
 
Not required.
 
 
24

 
 
Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations.
 
The following management’s discussion and analysis of financial condition and results of operations is intended to provide a better understanding of the significant changes and trends relating to the financial condition, results of operations, capital resources, liquidity and interest rate sensitivity of Community Partners Bancorp as of December 31, 2011 and 2010 and for the years then ended. The following information should be read in conjunction with the audited consolidated financial statements as of and for the years ended December 31, 2011 and 2010, including the related notes thereto.
 
Executive Summary
 
The Company reported net income to common shareholders of $3.5 million for the year ended December 31, 2011, compared to a net income to common shareholders of $3.0 million in 2010, an increase of $455,000, or 15.0%. Basic and diluted earnings per common share after preferred stock dividends and accretion were both $0.44 for the year ended December 31, 2011 compared to basic and diluted earnings of $0.39 per common share for the same period in 2010. As a result of the TARP CPP redemption, the remaining discount accretion of $301,000, or $0.04 per diluted share, on the associated preferred stock was recognized during the third quarter 2011. Net income to common shareholders excluding the accelerated discount accretion (non-GAAP) for the twelve months ended December 31, 2011 amounted to $3.8 million, or $0.48 per diluted share. For the year ended December 31, 2011, net interest income increased by $723,000, or 2.9%, to $25.8 million from $25.1 million recorded for the year ended December 31, 2010. Our results for 2011 were primarily affected by increased net interest income and non-interest income due primarily to the strong loan and core deposit growth, a decrease in the provision for loan losses and an increase in non-interest income due primarily to net securities gains, gains on the sale of SBA loans and net gains on sale of OREO properties. These increases were partially offset by an increase in non-interest expense primarily due to higher salary and benefit costs resulting in part to the expansion of our lending division, as well as an increase in OREO and loan workout expenses. All per share amounts have been retroactively adjusted to reflect the 3% and 5% stock dividends paid by Community Partners in 2011 and 2010, respectively.
 
Total assets increased by $37.7 million, or 5.9%, to $674.5 million at December 31, 2011 from $636.8 million at December 31, 2010. The increase in total assets was primarily the result of the strong deposit growth which helped fund the strong loan and investment securities growth during the year.
 
Total loans amounted to $530.1 million at December 31, 2011, which was an increase of $17.1 million, or 3.3%, compared to the December 31, 2010 amount of $513.0 million. During 2011, $1.7 million of net loans were transferred to other real estate owned. The Company continues to provide commercial and consumer lending to our market customers in addition to maintaining our high credit standards in a challenging market. The allowance for loan losses totaled $7.3 million, or 1.38% of total loans, at December 31, 2011, compared to $6.2 million or 1.22% of total loans, at December 31, 2010. The increase in the allowance for loan losses is the result of growth in the loan portfolio and an increase in impaired loans requiring specific reserves.
 
Deposits increased to $553.9 million at December 31, 2011 from $524.5 million at December 31, 2010, an increase of $29.4 million, or 5.6%. The increase in deposits is primarily attributable to the growth in our core checking deposits resulting primarily from increased business and consumer activity.

Critical Accounting Policies and Estimates
 
The following discussion is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses.
 
Note 1 to our audited consolidated financial statements contains a summary of the Company’s significant accounting policies. Management believes the following critical accounting policies encompass the more significant judgments and estimates used in the preparation of our consolidated financial statements.
 
Allowance for Loan Losses. Management believes our policy with respect to the methodology for the determination of the allowance for loan losses (“ALLL”) involves a high degree of complexity and requires management to make difficult and subjective judgments which often require assumptions or estimates about highly uncertain matters. Changes in these judgments, assumptions or estimates could materially impact the results of operations. This critical policy and its application are reviewed quarterly with our audit committee and Board of Directors.
 
 
25

 
 
Management is responsible for preparing and evaluating the ALLL on a quarterly basis in accordance with Bank policy, and the Interagency Policy Statement on the ALLL released by the Board of Governors of the Federal Reserve System on December 13, 2006 as well as GAAP. We believe that our allowance for loan losses is adequate to cover specifically identifiable loan losses, as well as estimated losses inherent in our portfolio for which certain losses are probable but not specifically identifiable. The allowance for loan losses is based upon management’s evaluation of the adequacy of the allowance account, including an assessment of known and inherent risks in the portfolio, giving consideration to the size and composition of the loan portfolio, actual loan loss experience, level of delinquencies, detailed analysis of individual loans for which full collectability may not be assured, the existence and estimated net realizable value of any underlying collateral and guarantees securing the loans, and current economic and market conditions. Although management utilizes the best information available, the level of the allowance for loan losses remains an estimate that is subject to significant judgment and short term change. Various regulatory agencies may require us and our banking subsidiaries to make additional provisions for loan losses based upon information available to them at the time of their examination. Furthermore, the majority of our loans are secured by real estate in New Jersey, primarily in Monmouth and Union counties. Accordingly, the collectability of a substantial portion of the carrying value of our loan portfolio is susceptible to changes in local market conditions and may be adversely affected should real estate values decline or the New Jersey and/or our local market areas experience economic shock.
 
Stock Based Compensation. Stock based compensation cost has been measured using the fair value of an award on the grant date and is recognized over the service period, which is usually the vesting period. The fair value of each option is amortized into compensation expense on a straight-line basis between the grant date for the option and each vesting date. The Company estimates the fair value of stock options on the date of grant using the Black-Scholes option pricing model. The model requires the use of numerous assumptions, many of which are highly subjective in nature.
 
Goodwill Impairment. Although goodwill is not subject to amortization, the Company must test the carrying value for impairment at least annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. Impairment testing requires that the fair value of our reporting unit be compared to the carrying amount of its net assets, including goodwill. Our reporting unit was identified as our community bank operations. If the fair value of the reporting unit exceeds the book value, no write-down of recorded goodwill is necessary. If the fair value of a reporting unit is less than book value, an expense may be required on the Company’s books to write-down the related goodwill to the proper carrying value. Impairment testing during 2011 and 2010 for goodwill and intangibles was completed and the Company did not require any impairment charge during the years ended December 31, 2011 and 2010.
 
Investment Securities Impairment Valuation. Securities are evaluated on at least a quarterly basis, and more frequently when market conditions warrant such an evaluation, to determine whether a decline in their value is other-than-temporary. The analysis of other-than-temporary impairment requires the use of various assumptions including, but not limited to, the length of time the investment’s book value has been greater than fair value, the severity of the investment’s decline and the credit deterioration of the issuer. For debt securities, management assesses whether (a) it has the intent to sell the security and (b) it is more likely than not that it will be required to sell the security prior to its anticipated recovery. These steps are done before assessing whether the entity will recover the cost basis of the investment.
 
In instances when a determination is made that an other-than-temporary impairment exists but the investor does not intend to sell the debt security and it is not more likely than not that it will be required to sell the debt security prior to its anticipated recovery, the other-than-temporary impairment is separated into (a) the amount of the total other-than-temporary impairment related to a decrease in cash flows expected to be collected from the debt security (the credit loss) and (b) the amount of the total other-than-temporary impairment related to all other factors. The amount of the total other-than-temporary impairment related to the credit loss is recognized in earnings. The amount of the total other-than-temporary impairment related to all other factors is recognized in other comprehensive income.

 Other Real Estate Owned (“OREO”). OREO includes real estate acquired through foreclosure. Real estate owned is carried at the lower of cost or fair value, less estimated costs to sell. When a property is acquired, the excess of the loan balance over fair value is charged to the allowance for loan losses. Operating results from real estate owned including rental income, operating expenses, and gains and losses realized from the sales of real estate owned are recorded as incurred. OREO is periodically reviewed to ensure that the fair value of the property supports the carrying value.
 
Deferred Tax Assets and Liabilities. We recognize deferred tax assets and liabilities for future tax effects of temporary differences, net operating loss carry forwards and tax credits. Deferred tax assets are subject to management’s judgment based upon available evidence that future realization is more likely than not. If management determines that we may be unable to realize all or part of net deferred tax assets in the future, a direct charge to income tax expense may be required to reduce the recorded value of the net deferred tax asset to the expected realizable amount.
 
 
26

 
 
Results of Operations
 
Our principal source of revenue is net interest income, the difference between interest income on interest earning assets and interest expense on deposits and borrowings. Interest earning assets consist primarily of loans, investment securities and federal funds sold. Sources to fund interest earning assets consist primarily of deposits and borrowed funds. Our net income is also affected by our provision for loan losses, non-interest income and non-interest expenses. Non-interest income consists primarily of service charges, commissions and fees, while non-interest expenses are comprised of salaries and employee benefits, occupancy costs and other operating expenses.

The following table provides certain performance ratios for the dates and periods indicated.

   
2011
 
2010
 
2009
                   
Return on average assets
   
0.65
%
   
0.56
%
   
(0.82
%)
Return on average tangible assets (1)
   
0.67
%
   
0.57
%
   
(0.85
%)
Return on average equity
   
5.16
%
   
4.60
%
   
(6.29
%)
Return on average tangible equity (1)
   
6.64
%
   
6.05
%
   
(8.95
%)
Net interest margin
   
4.21
%
   
4.15
%
   
3.69
%
Average equity to average assets
   
12.54
%
   
12.08
%
   
13.03
%
Average tangible equity to average tangible assets (1)
   
10.02
%
   
9.45
%
   
9.54
%

 
(1)   
The following table provided the reconciliation of Non-GAAP Financial Measures for the dates indicated:

   
2011
 
2010
 
2009
                   
Net income (loss) available to common shareholders
 
 $
3,494
   
 $
3,039
   
 $
(5,651
)
Effect of accelerated portion of discount accretion
   
301
     
-
     
-
 
Net income (loss) available to common shareholders
                       
     excluding accelerated discount accretion
 
 $
3,795
   
 $
3,039
   
 $
(5,651
)
                         
Diluted earnings (loss)  per common share
 
 $
0.44
   
 $
0.39
   
 $
(0.73
)
Effect of accelerated portion of discount accretion
   
.04
     
                -
     
-
 
Diluted earnings (loss) per common share
                       
     excluding accelerated discount accretion
 
 $
0.48
   
 $
0.39
   
 $
(0.73
)
                         
Return on average assets
   
0.65
%
   
0.56
%
   
(0.82
%)
Effect of intangible assets
   
0.02
%
   
0.01
%
   
(0.03
%)
Return on average tangible assets
   
0.67
%
   
0.57
%
   
(0.85
%)
                         
Return on average equity
   
5.16
%
   
4.60
%
   
(6.29
%)
Effect of  average intangible assets
   
1.48
%
   
1.45
%
   
(2.66
%)
Return on average tangible equity
   
6.64
%
   
6.05
%
   
(8.95
%)
                         
Average equity to average assets
   
12.54
%
   
12.08
%
   
13.03
%
Effect of intangible assets
   
(2.52
%)
   
(2.63
%)
   
(3.49
%)
Average tangible equity to average tangible assets
   
10.02
%
   
9.45
%
   
9.54
%
                         

This Report contains certain financial information determined by methods other than in accordance with generally accepted accounting policies in the United States (GAAP). These non-GAAP financial measures are “net income available to common shareholders excluding accelerated discount accretion,” “diluted earnings per common share excluding accelerated discount accretion,” “return on average tangible assets,” “return on average tangible equity,” and  “average tangible equity to average tangible assets.”  This non-GAAP disclosure has limitations as an analytical tool and should not be considered in isolation or as a substitute for analysis of the Company’s results as reported under GAAP, nor is it necessarily comparable to non-GAAP performance measures that may be presented by other companies. Our management uses these non-GAAP measures in its analysis of our performance because it believes these measures are material and will be used as a measure of our performance by investors.

We anticipate that our performance ratios will remain challenged as we expect income from continuing operations in 2012 to continue to be impacted by poor economic conditions in the New Jersey real estate market, high unemployment and low consumer confidence. In addition, should a further general decline in economic conditions in New Jersey continue throughout 2012 and beyond, the Company may suffer higher default rates on its loans, decreased value of assets it holds as collateral, and reduced loan originations as we continue to pursue only quality loans based on our guidelines.
 
 
27

 
 
Year Ended December 31, 2011 Compared to Year Ended December 31, 2010
 Net Income
 
The Company reported net income to common shareholders of $3.5 million for the year ended December 31, 2011, compared to a net income to common shareholders of $3.0 million in 2010, an increase of $455,000, or 15.0%. Basic and diluted earnings per common share after preferred stock dividends and accretion were both $0.44 for the year ended December 31, 2011 compared to basic and diluted earnings of $0.39 per common share for the same period in 2010. As a result of the TARP CPP redemption, the remaining discount accretion of $301,000, or $0.04 per diluted share, on the associated preferred stock was recognized during the third quarter 2011. Net income to common shareholders excluding the accelerated discount accretion (non-GAAP) for the twelve months ended December 31, 2011 amounted to $3.8 million, or $0.48 per diluted share. The primary reasons for the increase in net income was due to an improvement in our net interest income resulting primarily from loan and core deposit growth, a decrease in the provision for loan losses and an increase in non-interest income due primarily to securities gains, gains on sale of SBA loans and net gains on the sale of OREO properties. These increases were partially offset by an increase in non-interest expense primarily due to higher salary and benefit costs resulting in part to the expansion of our lending division, as well as an increase in OREO and loan workout expenses.
 
Net Interest Income
 
For the year ended December 31, 2011, we recognized net interest income of $25.8 million, as compared to $25.1 million for the year ended December 31, 2010. Our net interest income increased $723,000, or 2.9%, primarily as a result of lower deposit rates, higher level of core checking deposits and an improvement in the mix of average interest-earning assets. As general economic conditions continued to remain weak, the Federal Reserve kept short term interest rates at 0.25% throughout 2011. Our average earning assets increased by $9.3 million, or 1.5%, to $613.2 million for the year ended December 31, 2011 from $603.9 million for the year ended December 31, 2010, while our net interest spread increased by 7 basis points to 3.99% for the year ended December 31, 2011 as compared to 3.92% for the same period in 2010. The net interest margin increased by 6 basis points to 4.21% for year ended December 31, 2011 as compared to 4.15% for the same period in 2010, primarily as a result of both lower deposit costs and growth in core deposits, specifically checking accounts.
 
For the year ended December 31, 2011, total interest income decreased to $31.0 million from $31.3 million for the year ended December 31, 2010. This slight decrease of $233,000, or 0.7%, was primarily due to interest rate-related decreases in interest income of $692,000, partially offset by volume-related increases in interest income of $459,000 for the year ended December 31, 2011 as compared to the prior year. The average yield on our interest earning assets decreased by 12 basis points to 5.06% for the year ended December 31, 2011 from 5.18% for the prior year.
 
Interest and fees on loans decreased by $169,000, or 0.6%, to $29.4 million for the year ended December 31, 2011 compared to $29.6 million for the same period in 2010. Of the $169,000 decrease in interest and fees on loans, $446,000 was attributable to rate-related decreases partially offset by $277,000 of volume-related increases. The average balance of the loan portfolio for the year ended December 31, 2011 increased by $4.8 million, or 0.9%, to $519.4 million from $514.6 million for the same period in 2010. The average annualized yield on the loan portfolio decreased to 5.66% for the year ended December 31, 2011, from 5.75% for the same period in 2010. The average balance of non-accrual loans remained unchanged at $5.8 million for the years ended December 31, 2011 and 2010, respectively. The average balance in OREO amounted to $7.8 million and $2.3 million for the years ended December 31, 2011 and 2010, respectively, which impacted the Company’s loan yield for both periods presented.
 
Interest income on Federal funds sold and interest bearing deposits was $103,000 for the year ended December 31, 2011, representing a decrease of $2,000, or 1.9%, from $105,000 for the same period in 2010. For the year ended December 31, 2011, Federal funds sold had an average balance of $3.1 million with an average annualized yield of 0.22%, compared to $12.7 million with an average annualized yield of 0.21%, for the same period in 2010. During the second quarter of 2011, in order to maximize earnings on excess liquidity and increased safety of our funds, the Bank transferred its entire Federal funds sold balance to the Federal Reserve Bank of New York, which paid a higher return than our correspondent banks. Accordingly, for the year ended December 31, 2011, interest bearing deposits had an average balance of $37.8 million and an average annualized yield of 0.25% as compared to $30.8 million and an average annualized yield of 0.25% in 2010.
 
Interest income on investment securities totaled $1.5 million for the year ended December 31, 2011, compared to $1.6 million for year ended December 31, 2010. The $62,000 decrease in interest income on investment securities was primarily attributable to new purchases which replaced maturities, calls, principal paydowns and sales of existing securities. These new purchases were made at lower rates resulting from the lower rate environment, therefore causing the decline in interest income. For the year ended December 31, 2011, investment securities had an average balance of $52.9 million with an average annualized yield of 2.90%, compared to an average balance of $45.9 million with an average yield of 3.48%, for the year ended December 31, 2010.
 
 
28

 
 
Total interest expense amounted to $5.2 million for the year ended December 31, 2011, compared to $6.2 million for the corresponding period in 2010, a decrease of $956,000, or 15.4%. Of this decrease in interest expense, $1.0 million was due to rate-related decreases on interest-bearing liabilities primarily resulting from lower deposit costs. This decrease was partially offset by $72,000 of volume-related increases on interest-bearing liabilities.

The average balance of interest-bearing liabilities increased to $491.5 million for the year ended December 31, 2011, from $490.7 million for the same period last year, an increase of $829,000, or 0.2%. The average balance in NOW deposits during 2011 increased $8.8 million from $48.6 million with an average annualized yield of 0.61% for the year ended December 31, 2010, to $57.4 million with an average annualized yield of 0.45% for the same period in 2011. Additionally, the average balance on savings deposit accounts increased from $199.4 million with an average annualized yield of 1.11% for the year ended December 31, 2010, to $199.6 million with an average annualized yield of 0.86% for the year ended December 31, 2011. During 2011, average demand deposits reached $86.7 million, an increase of $8.6 million, or 11.1%, over the same period last year. These average balance increases were partially offset by decreases in certificates of deposit by $1.6 million, or 1.4%, to $116.3 million with an average annualized yield of 1.89% for the year ended December 31, 2011, from $117.9 million with an average annualized yield of 1.94% for the same period in 2010. Average money market deposits decreased by $11.6 million, or 11.6%, to $88.1 million with an average annualized yield of 0.58% for the year ended December 31, 2011, from $99.7 million with an average annualized yield of 0.89% for the same period in 2010. For the year ended December 31, 2011, the average yield on our interest-bearing liabilities was 1.07%, compared to 1.26% for the year ended December 31, 2010.
 
Our strategies for increasing and retaining core relationship deposits, managing loan originations within our acceptable credit criteria and loan category concentrations, and our planned branch network growth have combined to meet our liquidity needs. The Company also offers agreements to repurchase securities, commonly known as repurchase agreements, to its customers as an alternative to other insured deposits. Average balances of repurchase agreements for the year ended December 31, 2011 increased to $16.6 million, with an average interest rate of 0.71%, compared to $15.4 million, with an average interest rate of 1.07%, for the same prior year period.

The Company also utilizes FHLB term borrowings as an additional funding source. Average FHLB term borrowings increased to $13.5 million for the year ended December 31, 2011, with an average yield of 3.21%, compared to $9.7 million, with an average yield of 3.60%, for the same prior year period.
 
 
 
 
 
 
 
29

 
 
The following table reflects, for the periods presented, the components of our net interest income, setting forth: (1) average assets, liabilities, and shareholders’ equity, (2) interest income earned on interest-earning assets and interest expense paid on interest-bearing liabilities, (3) average yields earned on interest-earning assets and average rates paid on interest-bearing liabilities, (4) our net interest spread (i.e., the average yield on interest-earning assets less the average rate on interest-bearing liabilities), and (5) our yield on interest-earning assets. There have been no tax equivalent adjustments made to yields.
 
   
Years ended December 31,
 
   
2011
   
2010
   
2009
 
   
Average
 balance
   
Interest
 income/
 expense
   
Average
 rates
 earned/
 paid
   
Average
 balance
   
Interest
 income/
 expense
   
Average
 rates
 earned/
 paid
   
Average
 balance
   
Interest
income/
expense
   
Average
 rates
 earned/
 paid
 
   
(in thousands, except for percentages)
 
ASSETS
                                                     
Interest-Earning Assets:
                                                     
Interest bearing deposits in banks
  $ 37,801     $ 96       0.25%     $ 30,808     $ 78       0.25%     $ -     $ -       -  
Federal funds sold
    3,145       7       0.22%       12,704       27       0.21%       35,610       59       0.17%  
Investment securities
    52,932       1,534       2.90%       45,885       1,596       3.48%       57,512       2,397       4.17%  
Loans, net of unearned fees (1) (2)
    519,364       29,409       5.66%       514,553       29,578       5.75%       484,258       27,726       5.73%  
                                                                         
Total Interest-Earning Assets
    613,242       31,046       5.06%       603,950       31,279       5.18%       577,380       30,182       5.23%  
                                                                         
Non-Interest-Earning Assets:
                                                                       
Allowance for loan loss
    (6,682 )                     (6,869 )                     (6,887 )                
Other assets
    59,723                       54,173                       53,913                  
                                                                         
Total Assets
  $ 666,283                     $ 651,254                     $ 624,406                  
                                                                         
LIABILITIES & SHAREHOLDERS’ EQUITY
                                                                       
Interest-Bearing Liabilities:
                                                                       
NOW deposits
  $ 57,378       257       0.45%     $ 48,638       297       0.61%     $ 40,763       318       0.78%  
Savings deposits
    199,641       1,720       0.86%       199,380       2,212       1.11%       176,199       3,186       1.81%  
Money market deposits
    88,095       508       0.58%       99,659       882       0.89%       97,794       1,592       1.63%  
Time deposits
    116,331       2,202       1.89%       117,946       2,288       1.94%       130,373       3,186       2.44%  
Securities sold under agreements to repurchase
    16,593       118       0.71%       15,367       165       1.07%       15,233       273       1.79%  
Long-term debt
    13,500       433       3.21%       9,719       350       3.60%       7,500       302       4.03%  
                                                                         
Total Interest-Bearing Liabilities
    491,538       5,238       1.07%       490,709       6,194       1.26%       467,862       8,857       1.89%  
                                                                         
Non-Interest-Bearing Liabilities:
                                                                       
Demand deposits
    86,687                       78,052                       71,189                  
Other liabilities
    4,525                       3,854                       3,992                  
                                                                         
Total Non-Interest-Bearing Liabilities
    91,212                       81,906                       75,181                  
                                                                         
Shareholders’ Equity
    83,533                       78,639                       81,363                  
                                                                         
Total Liabilities and Shareholders’ Equity
  $ 666,283                     $ 651,254                     $ 624,406                  
                                                                         
NET INTEREST INCOME
          $ 25,808                     $ 25,085                     $ 21,325          
                                                                         
NET INTEREST SPREAD (3)
                    3.99%                       3.92%                       3.34%  
                                                                         
NET INTEREST MARGIN (4)
                    4.21%                       4.15%                       3.69%  
 
(1)
Included in interest income on loans are loan fees.
(2)
Includes non-performing loans.
(3)
The interest rate spread is the difference between the weighted average yield on average interest-earning assets and the weighted average cost of average interest-bearing liabilities.
(4)
The interest rate margin is calculated by dividing net interest income by average interest-earning assets.
 
 
30

 
 
Analysis of Changes in Net Interest Income
 
The following table sets forth for the periods indicated the amounts of the total change in net interest income that can be attributed to changes in the volume of interest-earning assets and interest-bearing liabilities and the amount of the change that can be attributed to changes in interest rates.
 
   
Years ended December 31,
 
   
2011 vs. 2010
 
2010 vs. 2009
 
   
Increase (decrease) due to change in
 
       
   
Average 
volume
   
Average 
rate
   
Net
   
Average
volume
   
Average
 rate
   
Net
 
   
(in thousands)
Interest Earned On:
                                               
Interest bearing deposits in banks
 
$
18
   
$
-
   
$
18
   
$
-
   
$
78
   
$
78
 
Federal funds sold
   
 (20
)
   
-
     
(20
)
   
 (38
)
   
6
     
(32
)
Investment securities
   
 184
     
(246
)
   
(62
)
   
 (485
)
   
(316
)
   
(801
)
Loans, net of unearned fees
   
277
     
(446
   
(169
   
1,735
     
117
     
1,852
 
                                                 
Total Interest Income
   
459
     
(692
)
   
(233
   
1,212
     
(115
)
   
1,097
 
                                                 
Interest Paid On:
                                               
NOW deposits
   
53
     
(93
)
   
(40
)
   
61
     
(82
)
   
(21
)
Savings deposits
   
3
     
 (495
)
   
(492
)
   
419
     
 (1,393
)
   
(974
)
Money market deposits
   
(102
   
(272
)
   
(374
)
   
30
     
(740
)
   
(710
)
Time deposits
   
 (31
)
   
(55
)
   
(86
)
   
 (304
)
   
(594
)
   
(898
)
Securities sold under agreements to repurchase
   
13
     
(60
)
   
(47
)
   
2
     
(110
)
   
(108
)
Long-term debt
   
136
     
(53
)
   
83
     
89
     
(41
)
   
48
 
                                                 
Total Interest Expense
   
72
     
(1,028
)
   
(956
)
   
297
     
(2,960
)
   
(2,663
)
                                                 
Net Interest Income
 
$
387
   
$
336
   
$
723
   
$
915
   
$
2,845
   
$
3,760
 
 
The change in interest due to both volume and rate has been allocated proportionally to both, based on their relative absolute values.

Provision for Loan Losses
 
Our provision for loan losses for the year ended December 31, 2011 was $2.2 million, as compared to $3.1 million for the year ended December 31, 2010. The $2.2 million provision for 2011 was primarily due to our assessment of the current state of the economy, prolonged high levels of unemployment in our market, allowances related to impaired loans as well as the change in the loan portfolio composition during 2011. The provision for loan losses is determined by an allocation process whereby an estimated allowance is allocated to the specific allowance for impaired loans and the general allowance for pools of loans. The allocation reflects management’s assessment of economic conditions, credit quality and other risk factors inherent in the loan portfolio. The allowance for loan losses totaled $7.3 million, or 1.38% of total loans at December 31, 2011, compared to $6.2 million or 1.22% of total loans, at December 31, 2010. The increase of $1.1 million in the allowance for loan losses is primarily due to the additional provision of $2.2 million recorded during 2011, partially offset by net loan charge-offs and partial write-downs of $1.3 million and $111,000 in recoveries.

In management’s opinion, the allowance for loan losses, totaling $7.3 million at December 31, 2011, is adequate to cover losses inherent in the portfolio. In the current interest rate and credit quality environment, our prudent risk management philosophy has been to stay within our established credit culture. We anticipate increased loan volume during 2012 as we continue to target credit worthy customers that have become dissatisfied with their relationships with larger institutions. Management will continue to review the need for additions to our allowance for loan losses based upon its ongoing review of the loan portfolio and credit quality trends, the level of delinquencies as well as general market and economic conditions.
 
 
31

 
 
Non-Interest Income
 
Non-interest income amounted to $2.7 million for the year ended December 31, 2011, compared to $1.9 million for the year ended December 31, 2010. This increase of $766,000, or 39.1%, was primarily due to $324,000 of gains resulting from the sale of securities available for sale during 2011 as compared to no gains in 2010, $101,000 of gains on the sale of SBA loans as compared to no gains in 2010 and $381,000 of net gains resulting from the sale of six OREO properties with a carrying value of $2.5 million as compared to $48,000 in 2010. Other increases included $33,000 in service fees on deposit accounts and higher bank-owned life insurance income of $16,000, resulting from increased purchases of such investments during 2011. These increases were partially offset by a $134,000 decrease primarily in origination fees resulting from lower loan volume in our residential loan department as well as a decrease in loan exit and prepayment fees. Additionally, the Company did not record any impairment charge on securities as compared to a $72,000 charge in 2010. Management evaluates securities for other-than-temporary impairments at least on a quarterly basis, and more frequently when the economic and market concerns warrant such evaluations.

Non-Interest Expenses
 
The following table provides a summary of non-interest expenses by category for the years ended December 31, 2011 and 2010.

   
Years ended
         
%
 
   
December 31,
   
Increase
   
Increase
 
(dollars in thousands)
 
2011
   
2010
   
(Decrease)
   
(Decrease)
 
Salaries and employee benefits
  $ 10,539     $ 9,460     $ 1,079       11.4 %
Occupancy and equipment
    3,205       3,339       (134 )     -4.0 %
Professional fees
    851       936       (85     -9.1 %
Advertising and marketing
    225       232       (7 )     -3.0 %
Data processing
    641       613       28       4.6 %
Insurance
    390       383       7       1.8 %
FDIC insurance and assessments
    673       975       (302 )     -31.0 %
Outside service fees
    422       452       (30 )     -6.6 %
Amortization of identifiable intangibles
    201       239       (38 )     -15.9 %
OREO expenses, OREO impairment and loan workout
    817       529       288       54.4 %
Other operating
    1,510       1,322       188       14.2 %
                                 
Total Non-Interest Expenses
  $ 19,474     $ 18,480     $ 994       5.4 %

Non-interest expenses for year ended December 31, 2011 increased $994,000, or 5.4%, compared to the year ended December 31, 2010. Salaries and employee benefits increased $1.1 million, or 11.4%, primarily due to higher salary and benefit costs resulting in part to the expansion of our lending division, annual salary merit increases and rising medical costs as well as the $280,000 benefit recorded during 2010 from the forfeiture of certain deferred compensation plan benefits to officers whom are no longer employed with the Bank. The number of our full-time equivalent employees decreased from 148 at December 31, 2010 to 138 at December 31, 2011. During the fourth quarter of 2011, the Company streamlined the branch network resulting in a reduction in staff of eight full-time equivalent employees. Loan workout and OREO expenses increased $288,000, or 54.4%, primarily due to $275,000 of impairments relating to three existing OREO properties as well as an increase in carrying costs and workout expenses relating to our impaired loans and OREO assets. Other operating expenses increased $188,000, or 14.2% primarily due to the $100,000 write-down on a property held-for-sale. These increases were partially offset by a decrease in occupancy and equipment expense of $134,000, or 4.0%, primarily due to lower depreciation expense resulting from fully depreciated fixed assets. Professional and outside service fees, which combined declined $115,000, or 8.3%, for the year ended December 31, 2011, as compared to the same prior year period, primarily due to lower legal costs, auditing fees, network processing charges and appraisal costs. Federal Deposit Insurance Corporation (“FDIC”) insurance and assessments decreased $302,000, or 31.0%, primarily due to the change in assessment calculation from a deposit based calculation to an asset based less Tier 1 capital calculation. Amortization of intangible assets, which was the result of The Town Bank acquisition in 2006, amounted to $201,000 during 2011 as compared to $239,000 in 2010.
 
Income Tax Expense
 
 For the year ended December 31, 2011, the Company recorded $2.5 million in income tax expense, compared to $1.8 million for the year ended December 31, 2010. The effective tax rate for 2011 was 37.1% as compared to 33.8%. The increase in the effective tax rate is primarily due to a higher level of taxable income in 2011 as compared to 2010.
 
 
32

 
 
Financial Condition
December 31, 2011 Compared to December 31, 2010
 
Assets
 
At December 31, 2011, total assets were $674.6 million, an increase of $37.8 million, or 5.9% compared to total assets of $636.8 million at December 31, 2010. At December 31, 2011, total loans were $530.1 million, an increase of $17.1 million, or 3.3%, from the $513.0 million reported at December 31, 2010. Investment securities were $62.8 million at December 31, 2011 as compared to $47.3 million at December 31, 2010, an increase of $15.5 million, or 32.8%. At December 31, 2011, cash and cash equivalents totaled $38.0 million compared to $34.4 million at December 31, 2010, an increase of $3.6 million, or 10.5%, as our liquidity position continues to remain strong at December 31, 2011. Goodwill totaled $18.1 million at both December 31, 2011 and 2010.
 
Liabilities
 
Total deposits increased $29.4 million, or 5.6%, to $553.9 million at December 31, 2011, from $524.5 million at December 31, 2010. Deposits are the Company’s primary source of funds. The Company’s strategic initiative will continue to stay focused in growing market share through core deposit relationships. The Company anticipates continued loan demand increases during 2012 and beyond, and will depend on the expansion and maturation of the branch network as its primary funding source. As a secondary funding source, the Company intends to utilize borrowed funds at opportune times during changing rate cycles. The Company continues to experience change in the mix of the deposit products through its branch sales efforts, which are targeted to gain market penetration. In order to fund future quality loan demand, the Company intends to raise the most cost-effective funding available within the market area.
 
Securities Portfolio
 
Investment securities, including restricted investments, totaled $62.8 million at December 31, 2011 compared to $47.3 million at December 31, 2010, an increase of $15.5 million, or 32.8%. Investment securities purchases amounted to $37.0 million, while repayments, calls and maturities amounted to $17.8 million. In 2011, there were nine sales of securities available-for-sale totaling $4.0 million resulting in a gain on sale of $324,000 as compared to no sales during 2010.
 
The Company maintains an investment portfolio to fund increased loans and liquidity needs (resulting from decreased deposits or otherwise) and to provide an additional source of interest income. The portfolio is composed of obligations of the U.S. Government agencies and U.S. Government-sponsored entities, municipal securities and a limited amount of corporate debt securities. All of our mortgage-backed investment securities are collateralized by pools of mortgage obligations that are guaranteed by privately managed, U.S. Government-sponsored enterprises (“GSE”), such as Fannie Mae, Freddie Mac and Government National Mortgage Association. Due to these GSE guarantees, these investment securities are susceptible to less risk of non-performance and default than other corporate securities which are collateralized by private pools of mortgages. At December 31, 2011, the Company maintained $21.9 million of GSE residential mortgage-backed securities in the investment portfolio and $17.2 million of collateralized residential mortgage obligations, all of which are current as to payment of principal and interest and are performing to the terms set forth in their respective prospectuses.
 
Included within the Company’s investment portfolio are trust preferred securities, which consists of four single issue securities and one pooled issue security. These securities have an amortized cost value of $3.1 million and a fair value of $2.1 million at December 31, 2011. The unrealized loss on these securities is related to general market conditions, the widening of interest rate spreads and downgrades in credit ratings. The single issue securities are from large money center banks. The pooled instrument consists of securities issued by financial institutions and insurance companies, and we hold the mezzanine tranche of such security. Senior tranches generally are protected from defaults by over-collateralization and cash flow default protection provided by subordinated tranches, with senior tranches having the greatest protection and mezzanine tranches subordinated to the senior tranches. For the pooled trust preferred security, management reviewed expected cash flows and credit support and determined it was not probable that all principal and interest would be repaid. In this pooled trust preferred security, there are 36 of 43 banks and insurance companies that are performing at December 31, 2011. The deferrals and defaults as a percentage of original collateral at December 31, 2011 was 27.7%. As the Company does not intend to sell this security and it is more likely than not that the Company will not be required to sell this security, the total other-than-temporary impairment on this security was $411,000 at December 31, 2011, of which $228,000 was determined to be a credit loss and charged to operations in previous years and $183,000 was determined to be non-credit related and included in the other comprehensive income component.
 
 
33

 
 
Management evaluates all securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic and market concerns warrant such evaluations. As of December 31, 2011, all of these securities are current with their scheduled interest payments, with the exception of the one pooled trust preferred security with an amortized cost basis of $272,000 at December 31, 2011, which has been remitting reduced amounts of interest as some individual participants of the pool have deferred interest payments. Future deterioration in the cash flow of these instruments or the credit quality of the financial institution issuers could result in additional impairment charges in the future.
 
The Company accounts for its investment securities as available for sale or held to maturity. Management determines the appropriate classification at the time of purchase. Based on an evaluation of the probability of the occurrence of future events, we determine if we have the ability and intent to hold the investment securities to maturity, in which case we classify them as held to maturity. All other investments are classified as available for sale.
 
Securities classified as available for sale must be reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders’ equity, net of taxes. Gains or losses on the sales of securities available for sale are recognized upon realization utilizing the specific identification method. The net effect of unrealized gains or losses, caused by marking our available for sale portfolio to fair value, could cause fluctuations in the level of shareholders’ equity and equity-related financial ratios as changes in market interest rates cause the fair value of fixed-rate securities to fluctuate.
 
Securities classified as held to maturity are carried at cost, adjusted for amortization of premium and accretion of discount over the terms of the maturity in a manner that approximates the interest method.
 
The following table sets forth the carrying value of the securities portfolio as of December 31, 2010, 2009 and 2008 (in thousands).
 
   
December 31,
 
   
2011
   
2010
   
2009
 
Investment securities available for sale at fair value:
                 
U.S. Government agency securities
  $ 2,258     $ 5,786     $ 11,102  
Municipal securities
    1,307       2,016       2,025  
U.S. Government-sponsored enterprises (“GSE”) -
                       
Residential mortgage-backed securities
    21,878       16,251       19,606  
Collateralized residential mortgage obligations
    17,163       5,745       1,978  
Corporate debt securities, primarily financial institutions
    2,528       3,087       1,838  
Community Reinvestment Act (“CRA”) mutual fund
    2,321       2,194       1,141  
                         
    $ 47,455     $ 35,079     $ 37,690  
                         
Investment securities held to maturity at amortized cost:
                       
U.S. Government agency securities
  $ -     $ -     $ 1,000  
Municipal securities
    11,296       8,522       6,802  
Corporate debt securities, primarily financial institutions
    1,809       2,307       2,816  
                         
    $ 13,105     $ 10,829     $ 10,618  

 
34

 
 
The contractual maturity distribution and weighted average yields, calculated on the basis of the stated yields to maturity, taking into account applicable premiums or discounts, of the securities portfolio at December 31, 2011 is set forth in the following table (excluding restricted stock and mutual fund). Securities available for sale are carried at amortized cost in the table for purposes of calculating the weighted average yield. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. There have been no tax equivalent adjustments made to the yields on tax-exempt securities.
 
 
December 31, 2011
 
Due within 1
year
   
Due 1 – 5 years
   
Due 5 – 10 years
   
Due after 10
years
   
Total
(dollars in thousands)
 
Amortized
 cost
   
Wtd
Avg
 Yield
   
Amortized
 cost
   
Wtd
Avg
 Yield
   
Amortized
 cost
   
Wtd
Avg
 Yield
   
Amortized
 cost
   
Wtd
Avg
 Yield
   
Amortized
 cost
   
Wtd
Avg
 Yield
 
Investment securities available for sale:
                                                           
U.S. Government agency securities
  $ 1,000       0.55 %   $ -       -     $ 1,250       1.00 %   $ -       -     $ 2,250       0.80 %
Municipal securities
    175       4.63 %     -       -       -       -       1,086       4.46 %     1,261       4.48 %
GSE - Residential
                                                                               
mortgage-backed securities
    -       -       171       5.62 %     6,937       3.28 %     14,209       3.40 %     21,317       3.38 %
Collateralized residential
                                                                               
mortgage obligations
    2,114       2.25 %     -       -       -       -       14,751       2.90 %     16,865       2.82 %
Corporate debt securities
    508       3.63 %     1,294       3.26 %     -       -       1,265       1.59 %     3,067       2.63 %
                                                                                 
    $ 3,797       2.10 %   $ 1,465       3.54 %   $ 8,187       2.93 %   $ 31,311       3.13 %   $ 44,760       3.02 %
                                                                                 
Investment securities held to maturity:
                                                                               
Municipal securities
  $ 3,477       0.77 %   $ 1,494