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Section 1: 10-K (10-K SMARTFINANCIAL, INC. 12.31.17)

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UNITED STATES 
SECURITIES AND EXCHANGE COMMISSION 
Washington, D.C. 20549
 
_________________________________________________________
 
FORM 10-K 
_________________________________________________________
  
 
ý
ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2017
OR
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For transition period from __________ to __________
 
Commission File Number: 001-37391 
_________________________________________________________
 
SMARTFINANCIAL, INC.
(Exact name of registrant as specified in its charter)
 
_________________________________________________________ 

Tennessee
62-1173944
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
 
5401 Kingston Pike, Suite 600
Knoxville, Tennessee
37919
(Address of principal executive offices)  
(Zip Code)
 
(865) 437-5700
(Registrant’s telephone number, including area code)
 
Securities registered pursuant to Section 12(b) of the Act:
Common Stock, $1.00 Par Value

Name of exchange where registered: 
The NASDAQ Stock Market, LLC

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $1.00 Par Value
 
Indicate by check mark if Registrant is a well known seasoned issuer, as defined in Rule 405 of the of the Securities Act.
Yes ¨ No ý
 
Indicate by check mark if Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.
Yes ¨ No ý
 
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities and Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. 
Yes ý No ¨
 
Indicate by check 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 (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files).
Yes ý No ¨
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ý

 
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 the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer ¨
Accelerated filer x
Non-accelerated filer ¨
Smaller reporting company x
  
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    
Yes  ¨  No  ý
 
As of June 30, 2017, the aggregate market value of the registrant’s voting and non-voting common stock held by non-affiliates was approximately $169.4 million. As of March 1, 2018, there were 11,229,306 shares outstanding of the registrant’s common stock, $1.00 par value.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the registrant’s Proxy Statement for the Annual Meeting of Shareholders to be held on May 24, 2018, are incorporated by reference in Part III of this Form 10-K.





TABLE OF CONTENTS
 
Item No.
 
Page No.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  


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FORWARD-LOOKING STATEMENTS
 
SmartFinancial, Inc. (“SmartFinancial”) may from time to time make written or oral statements, including statements contained in this report (including, without limitation, certain statements in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7), that constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). Any statements that do not relate to historical or current facts or matters are forward-looking statements. You can identify some of the forward-looking statements by the use of forward-looking words, such as “may,” “will,” “could,” “project,” “believe,” “anticipate,” “expect,” “estimate,” “continue,” “potential,” “plan,” “forecast,” and the like, the negatives of such expressions, or the use of the future tense. Statements concerning current conditions may also be forward-looking if they imply a continuation of a current condition. These forward-looking statements involve known and unknown risks, uncertainties, and other factors that may cause our actual results, levels of activity, performance, financial condition, or achievements to be materially different from any future results, levels of activity, performance, or achievements expressed or implied by such forward-looking statements. Such factors include, but are not limited to:
 
weakness or a decline in the U.S. economy, in particular in Tennessee, and other markets in which we operate;
the possibility that our asset quality would decline or that we experience greater loan losses than anticipated;
the impact of liquidity needs on our results of operations and financial condition;
competition from financial institutions and other financial service providers;
the impact of negative developments in the financial industry and U.S. and global capital and credit markets;
the impact of recently enacted and future legislation and regulation on our business;
negative changes in the real estate markets in which we operate and have our primary lending activities, which may result in an unanticipated decline in real estate values in our market area;
risks associated with our growth strategy, including a failure to implement our growth plans or an inability to manage our growth effectively;
claims and litigation arising from our business activities and from the companies we acquire, which may relate to contractual issues, environmental laws, fiduciary responsibility, and other matters;
expected revenue synergies and cost savings from our recently completed acquisition of Capstone Bancshares, Inc. (“Capstone”) and the proposed acquisition Tennessee Bancshares (“Tennessee Bancshares”) may not be fully realized or may take longer than anticipated to be realized;
disruption from these merger with customers, suppliers or employees or other business partners’ relationships;
the risk of successful integration of the targets’ businesses with our business;
lower than expected revenue following these mergers;
SmartFinancial’s ability to manage the combined company’s growth following the mergers;
the possibility that the Tennessee Bancshares merger may be more expensive to complete than anticipated, including as a result of unexpected factors or events;
the dilution caused by SmartFinancial’s issuance of additional shares of its common stock in connection with the Capstone merger and the Tennessee Bancshares merger;
cyber attacks, computer viruses or other malware that may breach the security of our websites or other systems we operate or rely upon for services to obtain unauthorized access to confidential information, destroy data, disable or degrade service, or sabotage our systems and negatively impact our operations and our reputation in the market;
results of examinations by our primary regulators, the Tennessee Department of Financial Institutions (the “TDFI”), the Board of Governors of the Federal Reserve System (the “Federal Reserve”), and other regulatory authorities, including the possibility that any such regulatory authority may, among other things, require us to increase our allowance for credit losses, write-down assets, require us to reimburse customers, change the way we do business, or limit or eliminate certain other banking activities;
government intervention in the U.S. financial system and the effects of and changes in trade and monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve;
our inability to pay dividends at current levels, or at all, because of inadequate future earnings, regulatory restrictions or limitations, and changes in the composition of qualifying regulatory capital and minimum capital requirements (including those resulting from the U.S. implementation of Basel III requirements);
the relatively greater credit risk of commercial real estate loans and construction and land development loans in our loan portfolio;
unanticipated credit deterioration in our loan portfolio or higher than expected loan losses within one or more segments of our loan portfolio;
unexpected significant declines in the loan portfolio due to the lack of economic expansion, increased competition, large prepayments, changes in regulatory lending guidance or other factors;
unanticipated loan delinquencies, loss of collateral, decreased service revenues, and other potential negative effects on our business caused by severe weather or other external events;

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changes in expected income tax expense or tax rates, including changes resulting from revisions in tax laws, regulations and case law;
our ability to retain the services of key personnel; and
the impact of Tennessee’s anti-takeover statutes and certain of our charter provisions on potential acquisitions of us.

For a more detailed discussion of some of the risk factors, see the section entitled “Risk Factors” below. We do not intend to update any factors, except as required by SEC rules, or to publicly announce revisions to any of our forward-looking statements. Any forward-looking statement speaks only as of the date that such statement was made. You should consider any forward looking statements in light of this explanation, and we caution you about relying on forward-looking statements.


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PART I
 
ITEM 1. BUSINESS
 
OVERVIEW
 
SmartFinancial, Inc. (“SmartFinancial” or the “Company”), formerly “Cornerstone Bancshares, Inc.,” was incorporated on September 19, 1983, under the laws of the State of Tennessee. SmartFinancial is a bank holding company registered under the Bank Holding Company Act of 1956, as amended.
 

The primary activity of SmartFinancial currently is, and is expected to remain for the foreseeable future, the ownership and operation of SmartBank. As a bank holding company, SmartFinancial intends to facilitate SmartBank’s ability to serve its customers’ requirements for financial services. The holding company structure also provides flexibility for expansion through the possible acquisition of other financial institutions and the provision of additional banking-related services, as well as certain non-banking services, which a traditional commercial bank may not provide under present laws.
 
SmartFinancial and Cornerstone Merger

In 2015, the Company operated under the name Cornerstone Bancshares, Inc., and it merged with legacy SmartFinancial, Inc. (“Legacy SmartFinancial”) (we refer to the merger as the “2015 merger”). Cornerstone Bancshares was the survivor of the 2015 merger, and immediately following that transaction, the company changed its name to “SmartFinancial, Inc.” and relocated its headquarters to Knoxville, Tennessee. Following the 2015 merger, we merged Cornerstone Community Bank with and into SmartBank, with SmartBank surviving the merger.
 
Capstone Merger

On May 22, 2017, the shareholders of the Company approved a merger with Capstone Bancshares, Inc. ("Capstone"), the one bank holding company of Capstone Bank, which was consummated on November 1, 2017. Capstone shareholders received either stock, cash, or a combination of stock and cash. After the merger, shareholders of SmartFinancial owned approximately 74 percent of the outstanding common stock of the combined entity on a fully diluted basis. The assets and liabilities of Capstone as of the effective date of the merger were recorded at their respective estimated fair values and combined with those of SmartFinancial. The excess of the purchase price over the net estimated fair values of the acquired assets and liabilities was allocated to identifiable intangible assets with the remaining excess allocated to goodwill, which was approximately $38 million. As a result of the merger Company assets increased approximately $536 million and liabilities increased approximately $466 million. The merger had a significant impact on all aspects of the Company's financial statements, and as a result, financial results after the merger may not be comparable to financial results prior to the merger.


SBLF Preferred Stock

In connection with the 2015 merger, the Company entered into an Assignment and Assumption Agreement (the “Assignment Agreement”) with Legacy SmartFinancial, pursuant to which Legacy SmartFinancial assigned to the Company, and the Company assumed, all of Legacy SmartFinancial’s rights, responsibilities, and obligations under that certain Securities Purchase Agreement (the “Securities Purchase Agreement”), dated as of August 4, 2011, by and between The United States Secretary of the Treasury (“Treasury”) and Legacy SmartFinancial. The Securities Purchase Agreement was entered into by Legacy SmartFinancial in connection with its participation in Treasury’s Small Business Lending Fund Program.
 
Under the terms of the Securities Purchase Agreement, Legacy SmartFinancial sold 12,000 shares of its Senior Non-Cumulative Perpetual Preferred Stock, Series A (“Legacy SmartFinancial SBLF Stock”), to Treasury for a purchase price of $12 million. Each share of Legacy SmartFinancial SBLF Stock was converted into one share of the Company’s Senior Non-Cumulative Perpetual Preferred Stock, Series B, having a liquidation preference of $1,000 per share (the “SBLF Preferred Stock”). On March 6, 2017, the Company redeemed the $12 million of preferred stock and paid $195 thousand in accrued dividends. More details about the SBLF Preferred Stock can be found in Note 16 in the “Notes to Consolidated Financial Statements.”

SmartBank
 
SmartBank (the "Bank") is a Tennessee-chartered commercial bank established in 2007 which has its principal executive offices in Pigeon Forge, Tennessee. The principal business of the Bank consists of attracting deposits from the general public and investing

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those funds, together with funds generated from operations and from principal and interest payments on loans, primarily in commercial loans, commercial and residential real estate loans, consumer loans and residential and commercial construction loans. Funds not invested in the loan portfolio are invested by the Bank primarily in obligations of the U.S. Government, U.S. Government agencies, and various states and their political subdivisions. In addition to deposits, sources of funds for the Bank’s loans and other investments include amortization and prepayment of loans, sales of loans or participations in loans, sales of its investment securities and borrowings from other financial institutions. The principal sources of income for the Bank are interest and fees collected on loans, fees collected on deposit accounts and interest and dividends collected on other investments. The principal expenses of the Bank are interest paid on deposits, employee compensation and benefits, office expenses and other overhead expenses.  At December 31, 2017, SmartBank had twenty-two full-service branches located in Tennessee, Alabama, and Florida, one loan production office, two mortgage loan production offices, and two service centers. 
 
Employees
 
As of December 31, 2017, SmartFinancial had 343 full-time equivalent employees and SmartBank had 343 full-time equivalent employees. The employees are not represented by a collective bargaining unit. SmartFinancial believes that its relationship with its employees is good.
 
Merger and Acquisition Strategy
 
Our strategic plan involves growing a high performing community bank through organic loan and deposit growth as well as disciplined merger and acquisition activity. We are continually evaluating business combination opportunities and may conduct due diligence activities in connection with these opportunities. As a result, business combination discussions and, in some cases, negotiations, may take place, and transactions involving cash, debt or equity securities could be expected. Any future business combinations or series of business combinations that we might undertake may be material in terms of assets acquired, liabilities assumed, or equity issued.
 
Competition
 
The markets in which we currently operate are very competitive. The Sevier County, Tennessee banking market, which is not in a MSA, is comprised of 10 financial institutions with approximately $2.4 billion in deposits in the market as of June 30, 2017, up from $2.2 billion at June 30, 2016.  As of June 30, 2017, approximately 79 percent of this deposit base was controlled by four local community banks which are headquartered in the county. At June 30, 2017, SmartBank had approximately 19.8 percent of the deposit market share in the county.

The Knoxville MSA banking market consists of 46 financial institutions with approximately $16.3 billion in deposits in the market as of June 30, 2017, unchanged from June 30, 2016.  As of June 30, 2017, approximately 57 percent of this deposit base was controlled by four financial institutions.   At June 30, 2017, SmartBank had approximately 0.7 percent of the deposit market share in the MSA. 

The Bradley County, Tennessee banking market, which is not in a MSA, is comprised of 15 financial institutions with approximately $1.7 billion in deposits in the market as of June 30, 2017, which was unchanged from June 30, 2016.  As of June 30, 2017, approximately 67 percent of this deposit base was controlled by five financial institutions. At June 30, 2017, SmartBank had approximately 1.4 percent of the deposit market share in the county.

The Chattanooga MSA banking market consists of 28 financial institutions with approximately$9.7 billion in deposits in the market as of June 30, 2017, up from $9.2 billion at June 30, 2016.  As of June 30, 2017, approximately 56 percent of this deposit base was controlled by three large, multi-state banks headquartered outside of Chattanooga.  At June 30, 2017, SmartBank had approximately 3.1 percent of the deposit market share in the MSA.
 
The Tuscaloosa MSA banking market consists of 24 financial institutions with approximately $4.0 billion in deposits in the market as of June 30, 2017, up from $3.8 billion at June 30, 2016.  As of June 30, 2017, approximately 45 percent of this deposit base was controlled by three financial institutions.  At June 30, 2017, SmartBank had approximately 8.2 percent of the deposit market share in the MSA.

The Washington County, Alabama banking market, which is not in a MSA, is comprised of two financial institutions with approximately $167.9 million in deposits in the market as of June 30, 2017, which was up from $161.0 million on June 30, 2016.  At June 30, 2017, SmartBank had approximately 28.0 percent of the deposit market share in the county.


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The Clarke County, Alabama banking market, which is not in a MSA, is comprised of 5 financial institutions with approximately $482 million in deposits in the market as of June 30, 2017, down from $485 million at June 30, 2016.  As of June 30, 2017, approximately 73 percent of this deposit base was controlled by two financial institutions. At June 30, 2017, SmartBank had approximately 3.5 percent of the deposit market share in the county.

The Daphne-Fairhope-Foley MSA banking market consists of 22 financial institutions with approximately $4.3 billion in deposits in the market as of June 30, 2017, up from $4.0 billion at June 30, 2016.  As of June 30, 2017, approximately 51 percent of this deposit base was controlled by five financial institutions.  At June 30, 2017, SmartBank had approximately 0.5 percent of the deposit market share in the MSA.

The Pensacola-Ferry Pass-Brent MSA banking market consists of 19 financial institutions with approximately $5.6 billion in deposits in the market as of June 30, 2017, up from $5.4 billion at June 30, 2016.  As of June 30, 2017, approximately 65 percent of this deposit base was controlled by five financial institutions.  At June 30, 2017, SmartBank had approximately 0.3 percent of the deposit market share in the MSA. 

The Crestview-Fort Walton Beach-Destin MSA banking market is comprised of 18 financial institutions with approximately $5.2 billion in deposits in the market as of June 30, 2017, up from $4.9 billion at June 30, 2016.  As of June 30, 2017, approximately 28 percent of this deposit base was controlled by two financial institutions.  At June 30, 2017, SmartBank had approximately 1.1 percent of the deposit market share in the MSA.
 
The Panama City MSA banking market is comprised of 25 financial institutions with approximately $3.0 billion in deposits in the market as of June 30, 2017, up from $2.7 billion at June 30, 2016.  As of June 30, 2017, approximately 67 percent of this deposit base was controlled by five financial institutions.  At June 30, 2017, SmartBank had approximately 0.3 percent of the deposit market share in the MSA.

The Bank competes for deposits principally by offering depositors a variety of deposit programs with competitive interest rates, quality service and convenient locations and hours. The Bank focuses its resources in seeking out and attracting small business relationships and taking advantage of the Bank’s ability to provide flexible service that meets the needs of this customer class. Management feels this market niche is the most promising business area for the future growth of the Bank. 

SUPERVISON AND REGULATION

General

The U.S. banking industry is highly regulated under federal and state law. The following is a general summary of the material aspects of certain statutes and regulations applicable to SmartFinancial and SmartBank. This supervisory framework could materially impact the conduct and profitability of our activities. A change in applicable laws and regulations, or in the manner such laws or regulations are interpreted by regulatory agencies or courts, may have a material effect on our business, operations and earnings.

SmartFinancial is a bank holding company registered under the Bank Holding Company Act of 1956, as amended, or the BHC Act. As a result, we are subject to supervision, regulation, and examination by the Federal Reserve, and we are required to file with the Federal Reserve annual reports and such additional information as the Federal Reserve may require pursuant to the BHC Act. SmartFinancial is required to file with the Federal Reserve annual reports and such additional information as the Federal Reserve may require pursuant to the BHC Act and other applicable regulations. The Federal Reserve may also make examinations of SmartFinancial and its subsidiary. We are also under the jurisdiction of the SEC for matters relating to the offering and sale of our securities and are subject to the SEC’s rules and regulations relating to periodic reporting, reporting to shareholders, proxy solicitations, and insider-trading regulations.

SmartBank is a Tennessee-chartered commercial bank and is a member of the Federal Reserve System. As a Tennessee bank, SmartBank is subject to supervision, regulation and examination by the TDFI. As a member of the Federal Reserve System, SmartBank is also subject to supervision, regulation and examination by the Federal Reserve. In addition, SmartBank’s deposit accounts are insured up to applicable limits by the Deposit Insurance Fund of the FDIC, and SmartBank is subject to regulation by the FDIC as the insurer of its deposits.

The bank and bank holding company regulatory scheme has two primary goals: to maintain a safe and sound banking system and to facilitate the conduct of sound monetary policy. This comprehensive system of supervision and regulation is intended primarily for the protection of the FDIC’s Deposit Insurance Fund, bank depositors and the public, rather than our shareholders or creditors. To this end, federal and state banking laws and regulations control, among other things, the types of activities in which we and

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SmartBank may engage, permissible investments that we and SmartBank may make, the level of reserves that SmartBank must maintain against deposits, minimum equity capital levels, the nature and amount of collateral required for loans, maximum interest rates that can be charged, the manner and amount of the dividends that may be paid, and corporate activities regarding mergers, acquisitions and the establishment and closing of branch offices. In addition, federal and state laws impose substantial requirements on SmartBank in the areas of consumer protection and detection and reporting of potential or suspected money laundering and terrorist financing.
 
The description below summarizes certain elements of the bank regulatory framework applicable to us and SmartBank. This summary is not, however, intended to describe all laws, regulations and policies applicable to us and SmartBank, and you should refer to the full text of the statutes, regulations, and corresponding guidance for more information. These statutes and regulations are subject to change, and additional statutes, regulations, and corresponding guidance may be adopted. Proposals to change the laws and regulations governing the banking industry are frequently raised at both the state and federal level. We are unable to predict these future changes or the effects, if any, that these changes could have on our business, revenues, and financial results.

Regulation of SmartFinancial

As a regulated bank holding company, we are subject to various laws and regulations that affect our business. These laws and regulations, among other matters, prescribe minimum capital requirements, limit transactions with affiliates, impose limitations on the business activities in which we can engage, restrict our ability to pay dividends to our shareholders, restrict the ability of institutions to guarantee our debt and impose certain specific accounting requirements on us that may be more restrictive and may result in greater or earlier charges to earnings or reductions in our capital than generally accepted accounting principles, among other things.

Permitted activities

Under the BHC Act, a bank holding company that is not a financial holding company, as discussed below, is generally permitted to engage in, or acquire direct or indirect control of more than five percent of any class of the voting shares of any company that is not a bank or bank holding company and that is engaged in, the following activities (in each case, subject to certain conditions and restrictions and prior approval of the Federal Reserve):
 
banking or managing or controlling banks;
furnishing services to or performing services for its subsidiaries; and
any activity that the Federal Reserve determines by regulation or order to be so closely related to banking as to be a proper incident to the business of banking, including, for example factoring accounts receivable, making, acquiring, brokering or servicing loans and usual related activities, leasing personal or real property, operating a nonbank depository institution, such as a savings association, performing trust company functions, conducting financial and investment advisory activities, underwriting and dealing in government obligations and money market instruments, performing selected insurance underwriting activities, issuing and selling money orders and similar consumer-type payment instruments, and engaging in certain community development activities.
 
While the Federal Reserve has found these activities in the past acceptable for other bank holding companies, the Federal Reserve may not allow us to conduct any or all of these activities, which are reviewed by the Federal Reserve on a case by case basis upon application by a bank holding company.

Acquisitions subject to prior regulatory approval

The BHC Act requires the prior approval of the Federal Reserve for a bank holding company to acquire substantially all the assets of a bank or to acquire direct or indirect ownership or control of more than 5 percent of any class of the voting shares of any bank, bank holding company, savings and loan holding company or savings association, or to increase any such non-majority ownership or control of any bank, bank holding company, savings and loan holding company or savings association, or to merge or consolidate with any bank holding company.

Under the BHC Act, a bank holding company that is located in Tennessee and is “well capitalized” and “well managed”, as such terms are defined under the BHC Act and implementing regulations, may purchase a bank located outside of Tennessee. Conversely, a well-capitalized and well-managed bank holding company located outside of Tennessee may purchase a bank located inside Tennessee. In each case, however, restrictions may be placed on the acquisition of a bank that has only been in existence for a limited amount of time or will result in concentrations of deposits exceeding limits specified by statute.


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Federal and state laws, including the BHC Act and the Change in Bank Control Act, impose additional prior notice or approval requirements and ongoing regulatory requirements on any investor that seeks to acquire direct or indirect “control” of an FDIC-insured depository institution or bank holding company. “Control” of a depository institution is a facts and circumstances analysis, but generally an investor is deemed to control a depository institution or other company if the investor owns or controls 25 percent or more of any class of voting securities. Ownership or control of 10 percent or more of any class of voting securities, where either the depository institution or company is a public company, as we are, or no other person will own or control a greater percentage of that class of voting securities after the acquisition, is also presumed to result in the investor controlling the depository institution or other company, although this is subject to rebuttal.

The BHC Act was substantially amended through the Financial Services Modernization Act of 1999, commonly referred to as the Gramm-Leach Bliley Act, or the GLBA. The GLBA eliminated long-standing barriers to affiliations among banks, securities firms, insurance companies and other financial services providers. A bank holding company whose subsidiary deposit institutions are “well capitalized” and “well managed” may elect to become a “financial holding company” and thereby engage without prior Federal Reserve approval in certain banking and non-banking activities that are deemed to be financial in nature or incidental to financial activity. These “financial in nature” activities include securities underwriting, dealing and market making; organizing, sponsoring and managing mutual funds; insurance underwriting and agency; merchant banking activities; and other activities that the Federal Reserve has determined to be closely related to banking. No regulatory approval will be required for a financial holding company to acquire a company, other than a bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve. We have not elected to become a financial holding company.

A dominant theme of the GLBA is functional regulation of financial services, with the primary regulator of a company or its subsidiaries being the agency which traditionally regulates the activity in which the aompany or its subsidiaries wish to engage. For example, the SEC will regulate bank holding company securities transactions, and the various banking regulators will oversee banking activities.

Bank holding company obligations to bank subsidiaries

Under current law and Federal Reserve policy, a bank holding company is expected to act as a source of financial and managerial strength to its depository institution subsidiaries and to maintain resources adequate to support such subsidiaries, which could require us to commit resources to support SmartBank in situations where additional investments may not otherwise be warranted. As a result of these obligations, a bank holding company may be required to contribute additional capital to its subsidiaries.

Bank holding company dividends

The Federal Reserve’s policy regarding dividends is that a bank holding company should not declare or pay a cash dividend which would impose undue pressure on the capital of any bank subsidiary or would be funded only through borrowing or other arrangements that might adversely affect a bank holding company’s financial position. As a general matter, the Federal Reserve has indicated that the board of directors of a bank holding company should consult with the Federal Reserve and eliminate, defer, or significantly reduce the bank holding company’s dividends if:

its net income available to shareholders for the past four quarters, net of dividends previously paid during that period, is not sufficient to fully fund the dividends;
its prospective rate of earnings retention is not consistent with its capital needs and overall current and prospective financial condition; or
it will not meet, or is in danger of not meeting, its minimum regulatory capital adequacy ratios. 

Should an insured member bank controlled by a bank holding company be “significantly undercapitalized” under the applicable federal bank capital ratios, or if the bank subsidiary is “undercapitalized” and has failed to submit an acceptable capital restoration plan or has materially failed to implement such a plan, the Federal Reserve may require prior approval for any capital distribution by the bank holding company. For more information, see “Capitalization levels and prompt corrective action” below.

In addition, since our legal entity is separate and distinct from SmartBank and does not conduct stand-alone operations, our ability to pay dividends depends on the ability of SmartBank to pay dividends to us, which is also subject to regulatory restrictions as described below in “Bank dividends.

Under Tennessee law, we are not permitted to pay cash dividends if, after giving effect to such payment, we would not be able to pay our debts as they become due in the usual course of business or our total assets would be less than the sum of our total liabilities plus any amounts needed to satisfy any preferential rights if we were dissolving.

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Dodd-Frank Act

On July 21, 2010, the President signed into law the Dodd-Frank Act. The Dodd-Frank Act has imposed new restrictions on and expanded regulatory oversight for financial institutions, including depository institutions like SmartBank. Although the Dodd-Frank Act is primarily aimed at the activities of investment banks and large commercial banks, many of the provisions of the legislation impact operations of community banks like SmartBank. In addition to the Volcker Rule, which is discussed in more detail below, the following aspects of the Dodd-Frank Act are related to our operations:

Tier 1 capital treatment for “hybrid” capital items like trust preferred securities is eliminated, subject to various grandfathering and transition rules.
The deposit insurance assessment base calculation now equals the depository institution’s average consolidated total assets minus its average tangible equity during the assessment period. Previously, the deposit insurance assessment was calculated based on the insured deposits held by the institution.
The ceiling on the size of the Deposit Insurance Fund was removed and the minimum designated reserve ratio of the Deposit Insurance Fund increased 20 basis points to 1.35 percent of estimated annual insured deposits or assessment base. The FDIC also was directed to “offset the effect” of the increased reserve ratio for insured depository institutions with total consolidated assets of less than $10 billion.
Bank holding companies and banks must be “well capitalized” and “well managed” in order to acquire banks located outside of their home state, which codified long-standing Federal Reserve policy. Any bank holding company electing to be treated as a financial holding company must be and remain “well capitalized” and “well managed.”
Capital requirements for insured depository institutions are now countercyclical, such that capital requirements increase in times of economic expansion and decrease in times of economic contraction.
The Federal Reserve established interchange transaction fees for electronic debit transactions under a restrictive “reasonable and proportional cost” per transaction standard.
The “opt in” provisions of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1997 have been eliminated, which allows state banks to establish de novo branches in states other than the bank’s home state if the law of such other state would permit a bank chartered in that state to open a branch at that location.
The Durbin Amendment limits interchange fees payable on debit card transactions for financial institutions with more than $10 billion in assets. While the Durbin Amendment does not directly apply to SmartBank, competitive market forces related to the reduction mandated by the Durbin Amendment may result in a decrease in revenue from interchange fees for smaller financial institutions.
The prohibition on the payment of interest on demand deposit accounts was repealed effective one year after enactment, thereby permitting depository institutions to pay interest on business checking and other accounts.
A new federal agency was created, the Consumer Financial Protection Bureau, or CFPB, which has broad rulemaking, supervisory and enforcement authority over consumer financial products and services, including deposit products, residential mortgages, home-equity loans and credit cards. The CFPB is also responsible for examining large financial institutions (i.e., those with more than $10 billion in assets) and enforcing compliance with federal consumer financial protection.
The regulation of consumer protections regarding mortgage originations, addressing loan originator compensation, minimum repayment standards including restrictions on variable-rate lending by requiring the ability to repay be determined based on the maximum rate that will apply during the first five years of a variable-rate loan term, prepayment consideration, and new disclosures, has been expanded.
 
The foregoing provisions may have the consequence of increasing our expenses, decreasing our revenues and changing the activities in which we choose to engage. The environment in which banking organizations will now operate, including legislative and regulatory changes affecting capital, liquidity, supervision, permissible activities, corporate governance and compensation, changes in fiscal policy and steps to eliminate government support for banking organizations, may have long-term effects on the profitability of banking organizations that cannot now be foreseen. The ultimate effect of the Dodd-Frank Act and its implementing regulations on the financial services industry in general, and on us in particular, is uncertain at this time.

The Volcker Rule

On December 10, 2013, the Federal Reserve and the other federal banking regulators as well as the SEC each adopted a final rule implementing Section 619 of the Dodd-Frank Act, commonly referred to as the “Volcker Rule.” Generally speaking, the final rule prohibits a bank and its affiliates from engaging in proprietary trading and from sponsoring certain “covered funds” or from acquiring or retaining any ownership interest in such covered funds. Most private equity, venture capital, and hedge funds are considered “covered funds” as are bank trust preferred collateralized debt obligations. The final rule required banking entities to divest disallowed securities by July 21, 2015, subject to extension upon application. The Volcker Rule did not impact any of our

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activities nor do we hold any securities that we were required to sell under the rule, but it does limit the scope of permissible activities in which we might engage in the future.

U.S. Basel III capital rules

The U.S. Basel III capital rules, effective January 1, 2015, apply to all national and state banks and savings associations and most bank holding companies, which we collectively refer to herein as “covered banking organizations.” The requirements in the U.S. Basel III capital rules started to phase in on January 1, 2015, for many covered banking organizations, including SmartFinancial and SmartBank. The requirements in the U.S. Basel III capital rules will be fully phased in by January 1, 2019.

The U.S. Basel III capital rules impose higher risk-based capital and leverage requirements than those previously in place. Specifically, the rules impose the following minimum capital requirements:

a new common equity Tier 1 risk-based capital ratio of 4.5 percent;
a Tier 1 risk-based capital ratio of 6 percent (increased from the then-current 4 percent requirement);
a total risk-based capital ratio of 8 percent (unchanged from the then-current requirements);
a leverage ratio of 4 percent; and
a new supplementary leverage ratio of 3 percent applicable to advanced approaches banking organizations, resulting in a leverage ratio requirement of 7 percent for such institutions.

Under the U.S. Basel III capital rules, Tier 1 capital is redefined to include two components: common equity Tier 1 capital and additional Tier 1 capital. The new and highest form of capital, Common Equity Tier 1 capital, or CET1 capital, consists solely of common stock (plus related surplus), retained earnings, accumulated other comprehensive income, and limited amounts of minority interests that are in the form of common stock. Additional Tier 1 capital includes other perpetual instruments historically included in Tier 1 capital, such as non-cumulative perpetual preferred stock.

The rules permit bank holding companies with less than $15.0 billion in total consolidated assets, such as us, to continue to include trust-preferred securities and cumulative perpetual preferred stock issued before May 19, 2010 in Tier 1 capital, but not in CET1 capital, subject to certain restrictions. Tier 2 capital consists of instruments that currently qualify in Tier 2 capital plus instruments that the rule has disqualified from Tier 1 capital treatment.

In addition, in order to avoid restrictions on capital distributions or discretionary bonus payments to executives, a covered banking organization must maintain a capital conservation buffer on top of its minimum risk-based capital requirements. This buffer must consist solely of Tier 1 Common Equity, but the buffer applies to all three measurements (Common Equity Tier 1, Tier 1 capital, and total capital). The capital conservation buffer will be phased in incrementally over time, becoming fully effective on January 1, 2019, and will consist of an additional amount of common equity equal to 2.5 percent of risk-weighted assets.

The U.S. Basel III capital standards require certain deductions from or adjustments to capital. As a result, deductions from CET1 capital will be required for goodwill (net of associated deferred tax liabilities); intangible assets such as non-mortgage servicing assets and purchased credit card relationships (net of associated deferred tax liabilities); deferred tax assets that arise from net operating loss and tax credit carryforwards (net of any related valuations allowances and net of deferred tax liabilities); any gain on sale in connection with a securitization exposure; any defined benefit pension fund net asset (net of any associated deferred tax liabilities) held by a bank holding company (this provision does not apply to a bank or savings association); the aggregate amount of outstanding equity investments (including retained earnings) in financial subsidiaries; and identified losses. Other deductions will be necessary from different levels of capital. The U.S. Basel III capital rules also increase the risk weight for certain assets, meaning that more capital must be held against such assets. For example, commercial real estate loans that do not meet certain underwriting requirements must be risk-weighted at 150 percent rather than the 100 percent that was the case prior to these rules becoming effective.

Additionally, the U.S. Basel III capital standards provide for the deduction of three categories of assets: (i) deferred tax assets arising from temporary differences that cannot be realized through net operating loss carrybacks (net of related valuation allowances and of deferred tax liabilities), (ii) mortgage servicing assets (net of associated deferred tax liabilities) and (iii) investments in more than 10 percent of the issued and outstanding common stock of unconsolidated financial institutions (net of associated deferred tax liabilities). The amount in each category that exceeds 10 percent of CET1 capital must be deducted from CET1 capital. The remaining, non-deducted amounts are then aggregated, and the amount by which this total amount exceeds 15 percent of CET1 capital must be deducted from CET1 capital. Amounts of minority investments in consolidated subsidiaries that exceed certain limits and investments in unconsolidated financial institutions may also have to be deducted from the category of capital to which such instruments belong.


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Accumulated other comprehensive income, or AOCI, is presumptively included in CET1 capital and often would operate to reduce this category of capital. The U.S. Basel III capital rules provided a one-time opportunity at the end of the first quarter of 2015 for covered banking organizations to opt out of much of this treatment of AOCI. We elected to opt out. The rules also have the effect of increasing capital requirements by increasing the risk weights on certain assets, including high volatility commercial real estate, mortgage servicing rights not includable in CET1 capital, equity exposures, and claims on securities firms, which are used in the denominator of the three risk-based capital ratios.

When fully phased in on January 1, 2019, the U.S. Basel III capital rules will require us and SmartBank to maintain (i) a minimum ratio of CET1 capital to risk-weighted assets of at least 4.5 percent, plus the 2.5 percent capital conservation buffer, effectively resulting in a minimum ratio of CET1 capital to risk-weighted assets of at least 7 percent, (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0 percent, plus the capital conservation buffer, effectively resulting in a minimum Tier 1 capital ratio of 8.5 percent, (iii) a minimum ratio of Total capital (that is, Tier 1 plus Tier 2) to risk-weighted assets of at least 8.0 percent, plus the capital conservation buffer, effectively resulting in a minimum total capital ratio of 10.5 percent and (iv) a minimum leverage ratio of 4 percent, calculated as the ratio of Tier 1 capital to average assets. Management believes that we and SmartBank would meet all capital adequacy requirements under the U.S. Basel III capital rules on a fully phased-in basis if such requirements were currently effective.

The U.S. Basel III capital rules also make important changes to the “prompt corrective action” framework discussed below in “Regulation of SmartBank-Capitalization levels and prompt corrective action.”

Anti-tying restrictions.

Bank holding companies and their affiliates are prohibited from tying the provision of certain services, such as extensions of credit, to other nonbanking services offered by a bank holding company or its affiliates.

Executive compensation and corporate governance

The Dodd-Frank Act requires public companies to include, at least once every three years, a separate non-binding “say on pay” vote in their proxy statement by which shareholders may vote on the compensation of the public company’s named executive officers. In addition, if such public companies are involved in a merger, acquisition, or consolidation, or if they propose to sell or dispose of all or substantially all of their assets, shareholders have a right to an advisory vote on any golden parachute arrangements in connection with such transaction (frequently referred to as “say-on-golden parachute” vote). Other provisions of the act may impact our corporate governance. For instance, the act requires the SEC to adopt rules prohibiting the listing of any equity security of a company that does not have an independent compensation committee; and requiring all exchange-traded companies to adopt clawback policies for incentive compensation paid to executive officers in the event of accounting restatements based on material non-compliance with financial reporting requirements.

Regulation of SmartBank

As a Tennessee-chartered commercial bank, SmartBank is subject to supervision, regulation, and examination by the TDFI, and, as a member of the Federal Reserve System, SmartBank is also subject to supervision, regulation, and examination by the Federal Reserve. Federal and state law and regulation affect virtually all of SmartBank’s activities including capital requirements, the ability to pay dividends, mergers and acquisitions, limitations on the amount that can be loaned to a single borrower and related interests, permissible investments, and geographic and new product expansion, among other things. SmartBank must submit an application to, and receive the approval of, the TDFI and Federal Reserve before opening a new branch office or merging with another financial institution. The Commissioner of the TDFI and the Federal Reserve have the authority to enforce laws and regulations by ordering SmartBank or a director, officer, or employee of SmartBank to cease and desist from violating a law or regulation or from engaging in unsafe or unsound banking practices and by imposing other sanctions including civil money penalties.
 
Tennessee law contains limitations on the interest rates that may be charged on various types of loans and restrictions on the nature and amount of loans that may be granted and on the type of investments which may be made. The operations of banks are also affected by various consumer laws and regulations, including those relating to equal credit opportunity and regulation of consumer lending practices. SmartBank’s deposits are insured by the FDIC under the Federal Deposit Insurance Act.
 
State banks are subject to regulation by the TDFI with regard to capital requirements and the payment of dividends. Tennessee has adopted the provisions of the Federal Reserve’s Regulation O with respect to restrictions on loans and other extensions of credit to bank “insiders.” Further, under Tennessee law, state banks are prohibited from lending to any one person, firm, or corporation amounts more than 15 percent of the bank’s equity capital accounts, except (i) in the case of certain loans secured by

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negotiable title documents covering readily marketable nonperishable staples, or (ii) with the prior approval of the bank’s board of directors or finance committee (however titled), the bank may make a loan to any person, firm or corporation of up to 25 percent of its equity capital accounts.

Various state and federal consumer laws and regulations also affect the operations of SmartBank, including state usury laws, consumer credit and equal credit opportunity laws, and fair credit reporting. In addition, the Federal Deposit Insurance Corporation Improvement Act of 1991, or FDICIA, generally prohibits insured state chartered institutions from conducting activities as principal that are not permitted for national banks.

Capitalization levels and prompt corrective action

Federal law and regulations establish a capital-based regulatory scheme designed to promote early intervention for troubled banks and require the FDIC to choose the least expensive resolution of bank failures. The capital-based regulatory framework contains five categories of regulatory capital requirements, including “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized.” To qualify as a “well capitalized” institution for these purposes, a bank must have a leverage ratio of no less than 5 percent, a Tier 1 capital ratio of no less than 6 percent, and a total risk-based capital ratio of no less than 10 percent, and a bank must not be under any order or directive from the appropriate regulatory agency to meet and maintain a specific capital level.

Immediately upon becoming undercapitalized, a depository institution becomes subject to the provisions of Section 38 of the Federal Deposit Insurance Act, or FDIA, which: (i) restrict payment of capital distributions and management fees; (ii) require that the appropriate federal banking agency monitor the condition of the institution and its efforts to restore its capital; (iii) require submission of a capital restoration plan; (iv) restrict the growth of the institution’s assets; and (v) require prior approval of certain expansion proposals. Bank holding companies controlling financial institutions can be called upon to boost the institutions’ capital and to partially guarantee the institutions’ performance under their capital restoration plans. The appropriate federal banking agency for an undercapitalized institution also may take any number of discretionary supervisory actions if the agency determines that any of these actions is necessary to resolve the problems of the institution at the least possible long-term cost to the deposit insurance fund, subject in certain cases to specified procedures. These discretionary supervisory actions include: (i) requiring the institution to raise additional capital; (ii) restricting transactions with affiliates; (iii) requiring divestiture of the institution or the sale of the institution to a willing purchaser; (iv) requiring the institution to change and improve its management; (iv) prohibiting the acceptance of deposits from correspondent banks; (v) requiring prior Federal Reserve approval for any capital distribution by a bank holding company controlling the institution; and (vi) any other supervisory action that the agency deems appropriate. These and additional mandatory and permissive supervisory actions may be taken with respect to significantly undercapitalized and critically undercapitalized institutions.

Notably, the thresholds for each of the five categories for regulatory capital requirements were revised pursuant to the U.S. Basel III capital rules. See the discussion under the heading “U.S. Basel III capital rules” above. Under these rules, which started to phase in on January 1, 2015, a well-capitalized insured depository institution is one (i) having a total risk-based capital ratio of 10 percent or greater, (ii) having a Tier 1 risk-based capital ratio of 8 percent or greater, (iii) having a CET1 capital ratio of 6.5 percent or greater, (iv) having a leverage capital ratio of 5 percent or greater and (v) that is not subject to any order or written directive to meet and maintain a specific capital level for any capital measure. A state member bank is considered “adequately capitalized” if it has a leverage ratio of at least 4 percent, a CET1 capital ratio of 4.5 percent or better, a Tier 1 risk-based capital ratio of at least 6.0 percent, a total risk-based capital ratio of at least 8.0 percent and does not meet the definition of a well-capitalized bank.

It should be noted that the minimum ratios referred to above in this section are merely guidelines, and the bank regulators possess the discretionary authority to require higher capital ratios.

Bank reserves

The Federal Reserve requires all depository institutions, even if not members of the Federal Reserve System, to maintain reserves against some transaction accounts (primarily negotiable order of withdrawal (NOW) and Super NOW checking accounts). The balances maintained to meet the reserve requirements imposed by the Federal Reserve may be used to satisfy liquidity requirements. An institution may borrow from the Federal Reserve Bank “discount window” as a secondary source of funds, provided that the institution meets the Federal Reserve Bank’s credit standards.

Bank dividends


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The Federal Reserve prohibits any distribution that would result in the bank being “undercapitalized” (<4 percent leverage ratio, <4.5 percent CET1 capital ratio, <6 percent Tier 1 risk-based capital ratio, or <8 percent total risk-based capital ratio). Tennessee law places restrictions on the declaration of dividends by state chartered banks to their shareholders, including, but not limited to, that the board of directors of a Tennessee-chartered bank may only make a dividend from the surplus profits arising from the business of the bank, and may not declare dividends in any calendar year that exceeds the total of its retained net income of that year combined with its retained net income of the preceding two years without the prior approval of the commissioner of the TDFI. Tennessee laws regulating banks require certain charges against and transfers from an institution’s undivided profits account before undivided profits can be made available for the payment of dividends. Furthermore, the TDFI also has authority to prohibit the payment of dividends by a Tennessee bank when it determines such payment to be an unsafe and unsound banking practice.
 
Insurance of accounts and other assessments

SmartBank pays deposit insurance assessments to the Deposit Insurance Fund, which is determined through a risk-based assessment system. SmartBank’s deposit accounts are currently insured by the Deposit Insurance Fund, generally up to a maximum of $250,000 per separately insured depositor. SmartBank pays assessments to the FDIC for such deposit insurance. Under the current assessment system, the FDIC assigns an institution to a risk category based on the institution’s most recent supervisory and capital evaluations, which are designed to measure risk. Under the FDIA, the FDIC may terminate a bank’s deposit insurance upon a finding that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order, agreement or condition imposed by the FDIC.

In addition, all FDIC-insured institutions are required to pay assessments to the FDIC to fund interest payments on bonds issued by the Financing Corporation, or FICO, a federal government corporation established to recapitalize the predecessor to the Savings Association Insurance Fund. These assessments will continue until the FICO bonds mature in 2017 through 2019.

Restrictions on transactions with affiliates

SmartBank is also subject to federal laws that restrict certain transactions between it and its nonbank affiliates. An affiliate of a bank is any company or entity that controls, is controlled by or is under common control with the bank, including in the case of SmartBank, SmartFinancial. Under sections 23A and 23B of the Federal Reserve Act, or FRA, and the Federal Reserve’s Regulation W, covered transactions by SmartBank with a single nonbank affiliate are generally limited to 10 percent of SmartBank’s capital and surplus and 20 percent of capital and surplus for all covered transactions with all nonbank affiliates. The definition of “covered transactions” includes transactions like a loan by a bank to an affiliate, an investment by a bank in an affiliate, or a purchase by a bank of assets from an affiliate. A loan by a bank to a nonbank affiliate must be secured by collateral valued at 100 percent to 130 percent of the loan amount, depending on the type of collateral and certain low quality assets and any securities of an affiliate may not serve as collateral.

All such transactions must generally be consistent with safe and sound banking practices and must be on terms that are no less favorable to the bank than those that would be available from nonaffiliated third parties. Moreover, state banking laws impose restrictions on affiliate transactions similar to those imposed by federal law. Federal Reserve policies also forbid the payment by bank subsidiaries of management fees which are unreasonable in amount or exceed the fair market value of the services rendered or, if no market exists, actual costs plus a reasonable profit.

Loans to insiders

Loans to executive officers, directors or to any person who directly or indirectly, or acting through or in concert with one or more persons, owns, controls or has the power to vote more than 10 percent of any class of voting securities of a bank, or to any related interest of those persons, including any company controlled by that person, are subject to Sections 22(g) and 22(h) of the FRA and their corresponding regulations, which is referred to as Regulation O. Among other things, these loans must be made on terms substantially the same as those prevailing on transactions made to unaffiliated individuals and certain extensions of credit to those persons must first be approved in advance by a disinterested majority of the entire board of directors. Regulation O prohibits loans to any of those individuals where the aggregate amount exceeds an amount equal to 15 percent of an institution’s unimpaired capital and surplus plus an additional 10 percent of unimpaired capital and surplus in the case of loans that are fully secured by certain readily marketable collateral, or when the aggregate amount on all of the extensions of credit outstanding to all of these persons would exceed the bank’s unimpaired capital and unimpaired surplus. Section 22(g) identifies limited circumstances in which the bank is permitted to extend credit to executive officers.

Community Reinvestment Act


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The Community Reinvestment Act, or CRA, and its corresponding regulations are intended to encourage banks to help meet the credit needs of their service areas, including low and moderate-income neighborhoods, consistent with safe and sound operations. These regulations provide for regulatory assessment of a bank’s record in meeting the credit needs of its service area. Federal banking agencies are required to make public a rating of a bank’s performance under the CRA. The federal banking agencies consider a bank’s CRA rating when a bank submits an application to establish banking centers, merge, or acquire the assets and assume the liabilities of another bank. In the case of a bank holding company, the CRA performance record of all banks involved in the merger or acquisition are reviewed in connection with the filing of an application to acquire ownership or control of shares or assets of a bank or to merge with any other financial holding company. An unsatisfactory record can substantially delay, block or impose conditions on the transaction. SmartBank received a satisfactory rating on its most recent CRA assessment.

Branching

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, or Riegle-Neal Act, provides that adequately capitalized and managed bank holding companies are permitted to acquire banks in any state. Previously, under the Riegle-Neal Act, a bank’s ability to branch into a particular state was largely dependent upon whether the state “opted in” to de novo interstate branching. Many states did not “opt-in,” which resulted in branching restrictions in those states. The Dodd-Frank Act amended the Riegle-Neal legal framework for interstate branching to permit national banks and state banks to establish branches in any state if that state would permit the establishment of the branch by a state bank chartered in that state. Under current Tennessee law, our bank may open branch offices throughout Tennessee with the prior approval of the TDFI. All branching remains subject to applicable regulatory approval and adherence to applicable legal requirements.

Bank Secrecy Act

The Currency and Foreign Transactions Reporting Act of 1970, better known as the Bank Secrecy Act, or BSA, requires all United States financial institutions to assist United States government agencies to detect and prevent money laundering. Specifically, BSA requires financial institutions to keep records of cash purchases of negotiable instruments, file reports of cash transactions exceeding a daily aggregate amount of $10,000, and to report suspicious activity that might signify money laundering, tax evasion, or other criminal activities.


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Anti-money laundering and economic sanctions

The USA PATRIOT Act provides the federal government with additional powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing and broadened anti-money laundering requirements. By way of amendments to the BSA, the USA PATRIOT Act imposed new requirements that obligate financial institutions, such as banks, to take certain steps to control the risks associated with money laundering and terrorist financing.
Among other requirements, the USA PATRIOT Act and implementing regulations require banks to establish anti-money laundering programs that include, at a minimum:

internal policies, procedures and controls designed to implement and maintain the bank's compliance with all of the requirements of the USA PATRIOT Act, the BSA and related laws and regulations;
systems and procedures for monitoring and reporting of suspicious transactions and activities;
designated compliance officer;
employee training;
an independent audit function to test the anti-money laundering program;
procedures to verify the identity of each customer upon the opening of accounts; and
heightened due diligence policies, procedures and controls applicable to certain foreign accounts and relationships.

Additionally, the USA PATRIOT Act requires each financial institution to develop a customer identification program, or CIP, as part of the bank's anti-money laundering program. The key components of the CIP are identification, verification, government list comparison, notice and record retention. The purpose of the CIP is to enable the financial institution to determine the true identity and anticipated account activity of each customer. To make this determination, among other things, the financial institution must collect certain information from customers at the time they enter into the customer relationship with the financial institution. This information must be verified within a reasonable time through documentary and non-documentary methods. Furthermore, all customers must be screened against any CIP-related government lists of known or suspected terrorists. Financial institutions are also required to comply with various reporting and recordkeeping requirements. The Federal Reserve and the FDIC consider an applicant's effectiveness in combating money laundering, among other factors, in connection with an application to approve a bank merger or acquisition of control of a bank or bank holding company.

Likewise, the Treasury's Office of Foreign Assets Control, or OFAC, is responsible for helping to ensure that United States entities do not engage in transactions with the subjects of U.S. sanctions, as defined by various Executive Orders and Acts of Congress. Currently, OFAC administers and enforces comprehensive U.S. economic sanctions programs against certain specified countries/regions. In addition to the country/region-wide sanctions programs, OFAC also administers complete embargoes against individuals and entities identified on OFAC's list of Specially Designated Nationals and Blocked Persons, or SDN List. The SDN List includes over 7,000 parties that are located in many jurisdictions throughout the world, including in the United States and Europe. SmartBank is responsible for determining whether any potential and/or existing customers appear on the SDN List or are owned or controlled by a person on the SDN List. If any customer appears on the SDN List or is owned or controlled by a person or entity on the SDN List, such customer's account must be placed on hold and a blocking or rejection report, as appropriate and if required, must be filed within 10 business days with OFAC. In addition, if a customer is a citizen of, has provided an address in, or is organized under the laws of any country or region for which OFAC maintains a comprehensive sanctions program, the Bank must take certain actions with respect to such customers as dictated under the relevant OFAC sanctions program. SmartBank must maintain compliance with OFAC by implementing appropriate policies and procedures and by establishing a recordkeeping system that is reasonably appropriate to administer the Bank's compliance program. SmartBank has adopted policies, procedures and controls to comply with the BSA, the USA PATRIOT Act and OFAC regulations.

Privacy and data security

Under the GLBA, federal banking regulators adopted rules limiting the ability of banks and other financial institutions to disclose nonpublic information about consumers to nonaffiliated third parties. The rules require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to nonaffiliated third parties. The GLBA also directed federal regulators, including the FDIC, to prescribe standards for the security of consumer information. SmartBank is subject to such standards, as well as standards for notifying customers in the event of a security breach.

Consumer laws and regulations

SmartBank is also subject to other federal and state consumer laws and regulations that are designed to protect consumers in transactions with banks. While the list set forth below is not exhaustive, these laws and regulations include the Truth in Lending Act, or TILA, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Check Clearing for the 21st Century Act, the Fair Credit Reporting Act, the Fair Debt Collection Practices Act, the Equal Credit Opportunity Act,

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the Fair Housing Act, the Home Mortgage Disclosure Act, the Fair and Accurate Transactions Act, the Servicemembers Civil Relief Act, the Military Lending Act, the Mortgage Disclosure Improvement Act, and the Real Estate Settlement Procedures Act, among others. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with consumers when offering consumer financial products and services.

Rulemaking authority for these and other consumer financial protection laws transferred from the prudential regulators to the CFPB on July 21, 2011. In some cases, regulators such as the Federal Trade Commission, the U.S. Department of Housing and Urban Development, and the U.S. Department of Justice also retain certain rulemaking or enforcement authority. The CFPB also has broad authority to prohibit unfair, deceptive and abusive acts and practices, or UDAAP, and to investigate and penalize financial institutions that violate this prohibition. While the statutory language of the Dodd-Frank Act sets forth the standards for acts and practices that violate the prohibition on UDAAP, certain aspects of these standards are untested, and thus it is currently not possible to predict how the CFPB will exercise this authority. In addition, consumer compliance examination authority remains with the prudential regulators for smaller depository institutions ($10 billion or less in total assets). The possibility of changes in the authority of the CFPB going forward after President-elect Trump is sworn into office is uncertain, and we cannot ascertain the impact, if any, changes to the CFPB may have on our business, revenues, operations, or results.

The Dodd-Frank Act also authorized the CFPB to establish certain minimum standards for the origination of residential mortgages, including a determination of the borrower’s ability to repay. Under the Dodd-Frank Act, financial institutions may not make a residential mortgage loan unless they make a “reasonable and good faith determination” that the consumer has a “reasonable ability” to repay the loan. The act allows borrowers to raise certain defenses to foreclosure but provides a full or partial safe harbor from such defenses for loans that are “qualified mortgages.” On January 10, 2013, the CFPB published final rules to, among other things, specify the types of income and assets that may be considered in the ability-to-repay determination, the permissible sources for verification, and the required methods of calculating the loan’s monthly payments. Since then the CFPB made certain modifications to these rules. The rules extend the requirement that creditors verify and document a borrower’s “income and assets” to include all “information” that creditors rely on in determining repayment ability. The rules also provide further examples of third-party documents that may be relied on for such verification, such as government records and check-cashing or funds-transfer service receipts. The new rules were effective beginning on January 10, 2014. The rules also define “qualified mortgages,” imposing both underwriting standards-for example, a borrower’s debt-to-income ratio may not exceed 43 percent-and limits on the terms of their loans. Points and fees are subject to a relatively stringent cap, and the terms include a wide array of payments that may be made in the course of closing a loan. Certain loans, including interest-only loans and negative amortization loans, cannot be qualified mortgages.

On October 3, 2015, the CFPB implemented a final rule combining the mortgage disclosures consumers previously received under TILA and the Real Estate Settlement Procedures Act, or RESPA. For more than 30 years, the TILA and RESPA mortgage disclosures had been administered separately by, respectively, the Federal Reserve and the U.S. Department of Housing and Urban Development. The final rule requires lenders to provide applicants with the new Loan Estimate and Closing Disclosure and generally applies to most closed-end consumer mortgage loans for which the creditor or mortgage broker receives an application on or after October 3, 2015.

Volcker Rule

The Volcker Rule generally prohibits a “banking entity” (which includes any insured depository institution, such as SmartBank, or any affiliate or subsidiary of such depository institution, such as SmartFinancial) from engaging in proprietary trading and acquiring or retaining any ownership interest in, sponsoring, or engaging in certain transactions with, a “covered fund”. Both the proprietary trading and covered fund-related prohibitions are subject to a number of exemptions and exclusions. The Volcker Rule became effective by statute in July 2012, and on December 10, 2013, five federal regulators including the FDIC and the Federal Reserve jointly adopted the final regulations to implement the Volcker Rule. The final regulations contain exemptions for, among others, market making, risk-mitigating hedging, underwriting, and trading in U.S. government and agency obligations and also permit certain ownership interests in certain types of funds to be retained. They also permit the offering and sponsoring of funds under certain conditions. In addition, the final regulations impose significant compliance and reporting obligations on banking entities.

The final regulations became effective on April 1, 2014, and banking entities were required to conform their proprietary trading activities and investments in and relationships with covered funds that were in place after December 31, 2013 by July 21, 2015. For those banking entities whose investments in and relationships with covered funds were in place prior to December 31, 2013 (“legacy covered funds”), the Volcker Rule conformance period was recently extended by the Federal Reserve to July 21, 2017 for such legacy covered funds. In addition, the Federal Reserve has also indicated its intention to grant two additional one-year extensions of the conformance period to July 21, 2017, for banking entities to conform ownership interests in and sponsorship of

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activities of collateralized loan obligations, or CLOs, that are backed in part by non-loan assets and that were in place as of December 31, 2013.

FIRREA and FDICIA

Far-reaching legislation, including the Financial Institutions Reform, Recovery and Enforcement Act of 1989, or FIRREA, and the Federal Deposit Insurance Corporation Improvement Act of 1991, or FDICIA, have impacted the business of banking for years. FIRREA primarily affected the regulation of savings institutions rather than the regulation of commercial banks and bank holding companies like SmartBank and SmartFinancial, but did include provisions affecting deposit insurance premiums, acquisitions of thrifts by banks and bank holding companies, liability of commonly controlled depository institutions, receivership and conservatorship rights and procedures and substantially increased penalties for violations of banking statutes, regulations and orders.

FDICIA resulted in extensive changes to the federal banking laws. The primary purpose of FDICIA was to authorize additional borrowings by the FDIC in order to assist in the resolution of failed and failing financial institutions. However, the law also instituted certain changes to the supervisory process and contained various provisions affecting the operations of banks and bank holding companies.

The additional supervisory powers and regulations mandated by FDICIA include a “prompt corrective action” program based upon five regulatory zones for banks, in which all banks are placed largely based on their capital positions. Regulators are permitted to take increasingly harsh action as a bank’s financial condition declines. Regulators are also empowered to place in receivership or require the sale of a bank to another depository institution when a bank’s ratio of tangible equity to total assets reaches two percent. Better capitalized institutions are generally subject to less onerous regulation and supervision than banks with lesser amounts of capital. The Federal Reserve has adopted regulations implementing the prompt corrective action provisions of the FDICIA, which place financial institutions into one of the following five categories based upon capitalization ratios as these ratios have been amended following regulations implementing the requirements of Basel III: (1) a “well capitalized” institution has a total risk-based capital ratio of at least 10 percent, a Tier 1 risk-based capital ratio of at least 8 percent, a leverage ratio of at least 5 percent and a CET1 capital ratio of at least 6.5 percent; (2)  an “adequately capitalized” institution has a total risk-based ratio of at least 8 percent, a Tier 1 risk-based ratio of at least 6 percent, a leverage ratio of at least 4 percent and a CET1 capital ratio of at least 4.5 percent; (3) an “undercapitalized” institution has a total risk-based capital ratio of under 8 percent, a Tier 1 risk-based capital ratio of under 6 percent, a leverage ratio of under 4 percent or a CET1 capital ratio of less than 4.5 percent; (4) a “significantly undercapitalized” institution has a total risk-based capital ratio of under 6 percent, a Tier 1 risk-based ratio of under 4 percent, a leverage ratio of under 3 percent or a CET1 capital ratio of less than 3 percent; and (5) a “critically undercapitalized” institution has a ratio of tangible equity to total assets of 2 percent or less. Institutions in any of the three undercapitalized categories would generally be prohibited from declaring dividends or making capital distributions. The regulations also establish procedures for “downgrading” an institution to a lower capital category based on supervisory factors other than capital.


Various other sections of the FDICIA impose substantial audit and reporting requirements and increase the role of independent accountants and outside directors. Set forth below is a list containing certain other significant provisions of the FDICIA:

annual on-site examinations by regulators (except for smaller, well-capitalized banks with high management ratings, which must be examined every 18 months);
mandated annual independent audits by independent public accountants and an independent audit committee of outside directors for institutions with more than $500,000,000 in assets;
uniform disclosure requirements for interest rates and terms of deposit accounts;
a requirement that the FDIC establish a risk-based deposit insurance assessment system;
authorization for the FDIC to impose one or more special assessments on its insured banks to recapitalize the bank insurance fund (now called the Deposit Insurance Fund);
a requirement that each institution submit to its primary regulators an annual report on its financial condition and management, which report will be available to the public;
a ban on the acceptance of brokered deposits except by well capitalized institutions and by adequately capitalized institutions with the permission of the FDIC, and the regulation of the brokered deposit market by the FDIC;
restrictions on the activities engaged in by state banks and their subsidiaries as principal, including insurance underwriting, to the same activities permissible for national banks and their subsidiaries unless the state bank is well capitalized and a determination is made by the FDIC that the activities do not pose a significant risk to the insurance fund;
a review by each regulatory agency of accounting principles applicable to reports or statements required to be filed with federal banking agencies and a mandate to devise uniform requirements for all such filings;

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the institution by each regulatory agency of noncapital safety and soundness standards for each institution it regulates which cover (1) internal controls, (2) loan documentation, (3) credit underwriting, (4) interest rate exposure, (5) asset growth, (6) compensation, fees and benefits paid to employees, officers and directors, (7) operational and managerial standards, and (8) asset quality, earnings and stock valuation standards for preserving a minimum ratio of market value to book value for publicly traded shares (if feasible);
uniform regulations regarding real estate lending; and
a review by each regulatory agency of the risk-based capital rules to ensure they take into account adequate interest rate risk, concentration of credit risk, and the risks of non-traditional activities.

Jumpstart Our Business Startups Act of 2012

The Jumpstart Our Business Startups Act, or JOBS Act, increased the threshold under which a bank or bank holding company may terminate registration of a security under the Securities Exchange Act of 1934, as amended, to 1,200 shareholders of record from 300. The JOBS Act also raised the threshold requiring companies to register to 2,000 shareholders from 500. Since the JOBS Act was signed, numerous banks or bank holding companies have filed to deregister their common stock.

Future legislative developments

Legislative acts that impact SmartFinancial and SmartBank are introduced in Congress and the Tennessee legislature from time to time. This legislation may change banking statutes and the environment in which we operate in substantial and unpredictable ways. Due to the outcome of the 2016 presidential election, changes to legislation surrounding taxes, consumer protection laws, regulation of financial institutions, and other topics relevant to our company will likely be considered in Congress in the coming four years. We cannot determine the ultimate effect that potential changes to legislation, if enacted, or implementing regulations and interpretations with respect thereto, would have our financial condition or results of operations.

ITEM 1A. RISK FACTORS
 
Investing in our common stock involves various risks which are particular to SmartFinancial, its industry, and its market area. Several risk factors regarding investing in our securities are discussed below. This listing should not be considered as all-inclusive. If any of the following risks were to occur, we may not be able to conduct our business as currently planned and our financial condition or operating results could be negatively impacted. These matters could cause the trading price of our securities to decline in future periods.
 
Risks Related to Our Industry
 
Our net interest income could be negatively affected by interest rate adjustments by the Federal Reserve Board.
 
As a financial institution, our earnings are dependent upon our net interest income, which is the difference between the interest income that we earn on interest-earning assets, such as investment securities and loans, and the interest expense that we pay on interest-bearing liabilities, such as deposits and borrowings. Therefore, any change in general market interest rates, including changes resulting from changes in the Federal Reserve Board’s policies, affects us more than non-financial institutions and can have a significant effect on our net interest income and total income. Our assets and liabilities may react differently to changes in overall market rates or conditions because there may be mismatches between the repricing or maturity characteristics of our assets and liabilities. As a result, an increase or decrease in market interest rates could have a material adverse effect on our net interest margin and results of operations. Actions by monetary and fiscal authorities, including the Federal Reserve Board, could have an adverse effect on our deposit levels, loan demand, business and results of operations.
 
The Federal Reserve Board raised interest rates by 100 basis points since December 2016 after having held interest rates at almost zero over recent years. However, the consistently low rate environment has negatively impacted our net interest margin, notwithstanding decreases in nonperforming loans and improvements in deposit mix. Any reduction in net interest income will negatively affect our business, financial condition, liquidity, results of operations, and/or cash flows.
 
Changes in the level of interest rates also may negatively affect our ability to originate loans, the value of our assets, and our ability to realize gains from the sale of our assets, all of which ultimately affect our earnings. A decline in the market value of our assets may limit our ability to borrow additional funds. As a result, we could be required to sell some of our loans and investments under adverse market conditions, upon terms that are not favorable to us, in order to maintain our liquidity. If those sales are made at prices lower than the amortized costs of the investments, we will incur losses.



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The primary tool that management uses to measure short-term interest rate risk is a net interest income simulation model prepared by an independent third party provider. As of December 31, 2017, SmartFinancial is considered to be in an asset-sensitive position, meaning income is generally expected to increase with an increase in short-term interest rates and, conversely, to decrease with a decrease in short-term interest rates. Based on the results of this simulation model, which assumed a static environment with no contemplated asset growth or changes in our balance sheet management strategies, if short-term interest rates immediately increased by 200 basis points, we could expect net income to increase by approximately $4.0 million over a 12-month period. This result is primarily due to the floating rate securities and loans which we anticipate would reprice at a quicker rate than our interest bearing liabilities. The actual amount of any increase or decrease may be higher or lower than predicted by our simulation model.
 
The final Basel III capital rules generally require insured depository institutions and their holding companies to hold more capital, which could adversely affect our financial condition and operations.
 
In July 2013, the federal banking agencies published new regulatory capital rules based on the international standards, known as Basel III, that had been developed by the Basel Committee on Banking Supervision. The new rules raised the risk-based capital requirements and revised the methods for calculating risk-weighted assets, usually resulting in higher risk weights. The new rules became effective on January 1, 2015, with a phase in period that generally extends from January 1, 2015 through January 1, 2019. 

The Basel III-based rules increase capital requirements and include two new capital measurements that will affect us, a risk-based common equity Tier 1 ratio and a capital conservation buffer. As an example, the Tier 1 capital ratio minimum requirement of 4 percent on January 1, 2015 will increase to 8.5 percent by 2019. SmartFinancial has approximately $157.8 million of Tier 1 capital. Under the previous standard, we could have grown SmartBank's total asset size to approximately $3.9 billion with our current capital but will be limited to $1.9 billion in assets under the new Basel III standards to be fully phased in by 2019. In 2017, 91 percent of our average assets were earning assets and over 90 percent of our revenue was generated from net interest income. Therefore, a future reduction of potential earning assets by approximately 53 percent could drastically reduce our future income. More details about the new capital requirements can be found in Note 13 in the “Notes to Consolidated Financial Statements.”

We are dependent on our information technology and telecommunications systems and third-party servicers, and systems failures, interruptions or breaches of security could have an adverse effect on our financial condition and results of operations.
 
Our operations rely on the secure processing, storage and transmission of confidential and other information in our computer systems and networks. Although we take protective measures and endeavor to modify these systems as circumstances warrant, the security of our computer systems, software and networks may be vulnerable to breaches, unauthorized access, misuse, computer viruses or other malicious code and other events that could have a security impact.  We outsource many of our major systems, such as data processing, loan servicing and deposit processing systems. The failure of these systems, or the termination of a third-party software license or service agreement on which any of these systems is based, could interrupt our operations. Because our information technology and telecommunications systems interface with and depend on third-party systems, we could experience service denials if demand for such services exceeds capacity or such third-party systems fail or experience interruptions. If sustained or repeated, a system failure or service denial could result in a deterioration of our ability to process new and renewal loans, gather deposits and provide customer service, compromise our ability to operate effectively, damage our reputation, result in a loss of customer business and/or subject us to additional regulatory scrutiny and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
 
In addition, we provide our customers the ability to bank remotely, including over the Internet or through their mobile device. The secure transmission of confidential information is a critical element of remote and mobile banking. Our network could be vulnerable to unauthorized access, computer viruses, phishing schemes, spam attacks, human error, natural disasters, power loss and other security breaches. We may be required to spend significant capital and other resources to protect against the threat of security breaches and computer viruses, or to alleviate problems caused by security breaches or viruses. To the extent that our activities or the activities of our customers involve the storage and transmission of confidential information, security breaches (including breaches of security of customer systems and networks) and viruses could expose us to claims, litigation and other possible liabilities. Any inability to prevent security breaches or computer viruses could also cause existing customers to lose confidence in our systems and could adversely affect our reputation, results of operations and ability to attract and maintain customers and businesses. In addition, a security breach could also subject us to additional regulatory scrutiny, expose us to civil litigation and possible financial liability and cause reputational damage.
 
Risks Related to Our Company
 
If our allowance for loan and lease losses and fair value adjustments with respect to acquired loans is not sufficient to cover actual loan losses, our earnings will be adversely affected.
 

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Our success depends significantly on the quality of our assets, particularly loans. Like other financial institutions, we are exposed to the risk that our borrowers may not repay their loans according to their terms, and the collateral securing the payment of these loans may be insufficient to fully compensate us for the outstanding balance of the loan plus the costs to dispose of the collateral. As a result, we may experience significant loan losses that may have a material adverse effect on our operating results and financial condition.
 
We maintain an allowance for loan and lease losses with respect to our loan portfolio, in an attempt to cover loan losses inherent in our loan portfolio. In determining the size of the allowance, we rely on an analysis of our loan portfolio, our experience and our evaluation of general economic conditions. We also make various assumptions and judgments about the collectability of our loan portfolio, including the diversification in our loan portfolio, the effect of changes in the economy on real estate and other collateral values, the results of recent regulatory examinations, the effects on the loan portfolio of current economic conditions and their probable impact on borrowers, the amount of charge-offs for the period and the amount of nonperforming loans and related collateral security.
 
The application of the acquisition method of accounting in our acquisitions has impacted our allowance for loan and lease losses. Under the acquisition method of accounting, all acquired loans were recorded in our consolidated financial statements at their fair values at the time of acquisition and the related allowance for loan and lease losses was eliminated because credit quality, among other factors, was considered in the determination of fair value. To the extent that our estimates of fair values are too high, we will incur losses associated with the acquired loans. The allowance, if any, associated with our purchased credit impaired loans reflects deterioration in cash flows since acquisition resulting from our quarterly re-estimation of cash flows which involves complex cash flow projections and significant judgment on timing of loan resolution.
 
If our analysis or assumptions prove to be incorrect, our current allowance may not be sufficient, and adjustments may be necessary to allow for different economic conditions or adverse developments in our loan portfolio. Material additions to the allowance for loan and lease losses would materially decrease our net income and adversely affect our general financial condition. As an example, an increase in the amount of the reserve to organic loans of 0.05 percent in 2017 would have resulted in a reduction of approximately 3 percent to pre-tax income.
 
In addition, federal and state regulators periodically review our allowance for loan and lease losses and may require us to increase our allowance for loan and lease losses or recognize further loan charge-offs, based on judgments different than those of our management. Any increase in our allowance for loan and lease losses or loan charge-offs required by these regulatory agencies could have a material adverse effect on our operating results and financial condition.

Our success depends significantly on economic conditions in our market areas.
 
Unlike larger organizations that are more geographically diversified, our branches are currently concentrated in Eastern Tennessee and the Florida Panhandle. As a result of this geographic concentration, our financial results will depend largely upon economic conditions in these market areas. If the communities in which we operate do not grow or if prevailing economic conditions, locally or nationally, deteriorate, this may have a significant impact on the amount of loans that we originate, the ability of our borrowers to repay these loans and the value of the collateral securing these loans. A return to economic downturn conditions caused by inflation, recession, unemployment, government action, natural disasters or other factors beyond our control would likely contribute to the deterioration of the quality of our loan portfolio and reduce our level of deposits, which in turn would have an adverse effect on our business. As an example, the Florida Panhandle area has been and will continue to be susceptible to major hurricanes, floods, and tropical storms. In 2016, certain of our markets in Eastern Tennessee were disrupted by wildfires which damaged homes and businesses. In addition, some portions of our target market are in areas which a substantial portion of the economy is dependent upon tourism. The tourism industry tends to be more sensitive than the economy as a whole to changes in unemployment, inflation, wage growth, and other factors which affect consumer’s financial condition and sentiment.

Our organic loan growth may be limited by regulatory constraints

During 2017 many of the regulatory agencies, including ours, increased their focus on the application of an interagency guidance issued in 2006, titled “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices.” The 2006 interagency guidance focuses on the risks of high levels of concentration in CRE lending at banking institutions, and specifically addresses two supervisory criteria:

Construction concentration criterion: Loans for construction, land, and land development (CLD or “construction”) represent 100 percent or more of a banking institution’s total risk-based capital, commonly referred to as the "100 ratio"

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Total CRE concentration criterion: Total nonowner-occupied CRE loans (including CLD loans), as defined in the 2006 guidance (“total CRE”), represent 300 percent or more of the institution’s total risk-based capital, and growth in total CRE lending has increased by 50 percent or more during the previous 36 months, commonly referred to as the "300 ratio"

The guidance states that banking institutions exceeding the concentration levels mentioned in the two supervisory criteria should have in place enhanced credit risk controls, including stress testing of CRE portfolios. The guidance also states that institutions with CRE concentration levels above those specified in the two supervisory criteria may be identified for further supervisory analysis. Under the guidance for every $1 in increased capital only $1 can be leveraged to construction lending and only $3 can be lent to total CRE lending. In comparison $1 of capital can be leveraged into about $10 other types of lending. At the end of 2017 our loan portfolio was below both the 100 and 300 ratio as laid out in the guidance, but given the guidance our ability to grow those loan types could well be constrained by the amount we are also able to grow capital.

To the extent that we are unable to identify and consummate attractive acquisitions, or increase loans through organic loan growth, we may be unable to successfully implement our growth strategy, which could materially and adversely affect us.
 
A substantial part of our historical growth has been a result of acquisitions and we intend to continue to grow our business through strategic acquisitions of banking franchises coupled with organic loan growth. Previous availability of attractive acquisition targets may not be indicative of future acquisition opportunities, and we may be unable to identify any acquisition targets that meet our investment objectives. To the extent that we are unable to find suitable acquisition candidates, an important component of our strategy may be lost. If we are able to identify attractive acquisition opportunities, we must generally satisfy a number of conditions prior to completing any such transaction, including certain bank regulatory approvals, which have become substantially more difficult, time-consuming and unpredictable as a result of the recent financial crisis. Additionally, any future acquisitions may not produce the revenue, earnings or synergies that we anticipated. As our purchased credit impaired loan portfolio, which produces substantially higher yields than our organic and purchased non-credit impaired loan portfolios, is paid down, we expect downward pressure on our income. If we are unable to replace our purchased credit impaired loans and the related accretion with a significantly higher level of new performing loans and other earning assets due to our inability to identify attractive acquisition opportunities, a decline in loan demand, competition from other financial institutions in our markets, stagnation or continued deterioration of economic conditions, or other conditions, our financial condition and earnings may be adversely affected.
 
Our strategic growth plan contemplates additional acquisitions, which could expose us to additional risks.
 
We periodically evaluate opportunities to acquire additional financial institutions. As a result, we may engage in negotiations or discussions that, if they were to result in a transaction, could have a material effect on our operating results and financial condition, including short and long-term liquidity. Our acquisition activities could be material and could require us to use a substantial amount of common stock, cash, other liquid assets, and/or incur debt.
 
Our acquisition activities could involve a number of additional risks, including the risks of:

incurring time and expense associated with identifying and evaluating potential acquisitions and negotiating potential transactions, resulting in management's attention being diverted from the operation of our existing business;
using inaccurate estimates and judgments to evaluate credit, operations, management and market risks with respect to the target institution or assets;
incurring time and expense required to integrate the operations and personnel of the combined businesses, creating an adverse short-term effect on results of operations; and
losing key employees and customers as a result of an acquisition that is poorly received.

Our recent acquisition and future expansion may result in additional risks.

Over the last three years we have completed the acquisitions of Legacy SmartFinancial and Capstone, and we anticipate consummating our proposed merger with Tennessee Bancshares in the second quarter of 2018, subject to customary closing conditions. We expect to continue to expand in our current markets and in other select markets through additional branches or through additional acquisitions of all or part of other financial institutions. These types of expansions involve various risks, including the risks detailed below.

Growth. As a result of our merger activity, we may be unable to successfully:

maintain loan quality in the context of significant loan growth;
obtain regulatory and other approvals;

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attract sufficient deposits and capital to fund anticipated loan growth;
maintain adequate common equity and regulatory capital;
avoid diversion or disruption of our existing operations or management as well as those of the acquired institution;
maintain adequate management personnel and systems to oversee and support such growth;
maintain adequate internal audit, loan review and compliance functions; and
implement additional policies, procedures and operating systems required to support such growth.

Results of Operations. There is no assurance that existing offices or future offices will maintain or achieve deposit levels, loan balances or other operating results necessary to avoid losses or produce profits. Our growth strategy necessarily entails growth in overhead expenses as we routinely add new offices and staff. Our historical results may not be indicative of future results or results that may be achieved as we continue to increase the number and concentration of our branch offices in our newer markets.

Development of offices. There are considerable costs involved in opening branches, and new branches generally do not generate sufficient revenues to offset their costs until they have been in operation for at least a year or more. Accordingly, any new branches we establish can be expected to negatively impact our earnings for some period of time until they reach certain economies of scale. The same is true for our efforts to expand in these markets with the hiring of additional seasoned professionals with significant experience in that market. Our expenses could be further increased if we encounter delays in opening any of our new branches. We may be unable to accomplish future branch expansion plans due to a lack of available satisfactory sites, difficulties in acquiring such sites, failure to receive any required regulatory approvals, increased expenses or loss of potential sites due to complexities associated with zoning and permitting processes, higher than anticipated merger and acquisition costs or other factors. Finally, we have no assurance any branch will be successful even after it has been established or acquired, as the case may be.

Regulatory and economic factors. Our growth and expansion plans may be adversely affected by a number of regulatory and economic developments or other events. Failure to obtain required regulatory approvals, changes in laws and regulations or other regulatory developments and changes in prevailing economic conditions or other unanticipated events may prevent or adversely affect our continued growth and expansion. Such factors may cause us to alter our growth and expansion plans or slow or halt the growth and expansion process, which may prevent us from entering into or expanding in our targeted markets or allow competitors to gain or retain market share in our existing markets.

Failure to successfully address these and other issues related to our expansion could have a material adverse effect on our financial condition and results of operations, and could adversely affect our ability to successfully implement our business strategy. Also, if our growth occurs more slowly than anticipated or declines, our results of operations and financial condition could be materially adversely affected.

Integrating Capstone Bank and, if our pending merger with Tennessee Bancshares is completed, Southern Community Bank into SmartBank’s may be more difficult, costly, or time-consuming than anticipated.

We are still in the process of integrating Capstone Bank’s business with that of SmartBank, and if the merger with Tennessee Bancshares is completed as planned, we will begin the process of integrating Southern Community Bank with that of SmartBank as well. A successful integration of these businesses with ours will depend substantially on our ability to consolidate operations, corporate cultures, systems and procedures and to eliminate redundancies and costs. We may not be able to combine our business with one or both of the targets’ businesses without encountering difficulties, such as:

the loss of key employees;
disruption of operations and business;
inability to maintain and increase competitive presence;
loan and deposit attrition, customer loss and revenue loss, including as a result of any decision we may make to close one or more locations;
possible inconsistencies in standards, control procedures and policies;
unexpected problems with costs, operations, personnel, technology and credit; and/or
problems with the assimilation of new operations, sites or personnel, which could divert resources from regular banking operations.

Additionally, general market and economic conditions or governmental actions affecting the financial industry generally may inhibit our successful integration of one or both of the targets’ businesses. Further, we acquired Capstone and intend to acquire Tennessee Bancshares with the expectation that the acquisitions will result in various benefits including, among other things, benefits relating to enhanced revenues, a strengthened market position for the combined company, cross selling opportunities, technological efficiencies, cost savings and operating efficiencies. Achieving the anticipated benefits of this acquisition is subject to a number of uncertainties, including whether we integrate Capstone’s and/or Southern Community Bank’s businesses, including

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its organizational culture, operations, technologies, services and products, in an efficient and effective manner, our ability to achieve the estimated noninterest expense savings we believe we can achieve, and general competitive factors in the marketplace. Failure to achieve these anticipated benefits on the anticipated timeframe, or at all, could result in a reduction in the price of our shares as well as in increased costs, decreases in the amount of expected revenues and diversion of management’s time and energy and could materially and adversely affect our business, results of operations and financial condition. Additionally, we made fair value estimates of certain assets and liabilities in recording our acquisition of Capstone and will make fair value estimates of certain assets and liabilities in recording our acquisition of Southern Community Bank. Actual values of these assets and liabilities could differ from our estimates, which could result in our not achieving the anticipated benefits of the acquisition. Finally, any cost savings that are realized may be offset by losses in revenues or other charges to earnings.

We may face risks with respect to future acquisitions.

When we attempt to expand our business through mergers and acquisitions (as we have done over the last three years), we seek targets that are culturally similar to us, have experienced management and possess either market presence or have potential for improved profitability through economies of scale or expanded services. In addition to the general risks associated with our growth plans which are highlighted above, in general acquiring other banks, businesses or branches, particularly those in markets with which we are less familiar, involves various risks commonly associated with acquisitions, including, among other things:

the time and costs associated with identifying and evaluating potential acquisition and merger targets;
inaccuracies in the estimates and judgments used to evaluate credit, operations, management and market risks with respect to the target institution;
the time and costs of evaluating new markets, hiring experienced local management, including as a result of de novo expansion into a market, and opening new bank locations, and the time lags between these activities and the generation of sufficient assets and deposits to support the significant costs of the expansion that we may incur, particularly in the first 12 to 24 months of operations;
our ability to finance an acquisition and possible dilution to our existing shareholders;
the diversion of our management’s attention to the negotiation of a transaction and integration of an acquired company’s operations with ours;
the incurrence of an impairment of goodwill associated with an acquisition and adverse effects on our results of operations;
entry into new markets where we have limited or no direct prior experience;
closing delays and increased expenses related to the resolution of lawsuits filed by our shareholders or shareholders of companies we may seek to acquire;
the inability to receive regulatory approvals timely or at all, including as a result of community objections, or such approvals being restrictively conditional; and
risks associated with integrating the operations, technologies and personnel of the acquired business.

We expect to continue to evaluate merger and acquisition opportunities that are presented to us in our current markets as well as other markets throughout the region and conduct due diligence activities related to possible transactions with other financial institutions. As a result, merger or acquisition discussions and, in some cases, negotiations may take place and future mergers or acquisitions involving cash or equity securities and related capital raising transactions may occur at any time. Generally, acquisitions of financial institutions involve the payment of a premium over book and market values, and, therefore, some dilution of our book value and fully diluted earnings per share may occur in connection with any future transaction. Failure to realize the expected revenue increases, cost savings, increases in product presence and/or other projected benefits from an acquisition could have a material adverse effect on our financial condition and results of operations.

In addition, we may face significant competition from numerous other financial services institutions, many of which may have greater financial resources than we do, when considering acquisition opportunities. Accordingly, attractive acquisition opportunities may not be available to us. There can be no assurance that we will be successful in identifying or completing any potential future acquisitions.

Our concentration in loans secured by real estate, particularly commercial real estate and construction and development, is subject to risks that could adversely affect our results of operations and financial condition.
 
We offer a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Many of our loans are secured by real estate (both residential and commercial) in our market areas. Consequently, declines in economic conditions in these market areas may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions whose real estate loan portfolios are more geographically diverse. 


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At December 31, 2017, approximately 81 percent of our loans had real estate as a primary or secondary component of collateral, with 11 percent of our loans secured by construction and development collateral. 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. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected. Real estate values declined significantly during the recent economic crisis and may decline similarly in future periods. Although real estate prices in most of our markets have stabilized or are improving, a renewed decline in real estate values would expose us to further deterioration in the value of the collateral for all loans secured by real estate and may adversely affect our results of operations and financial condition.
 
Commercial real estate loans are generally viewed as having more risk of default than residential real estate loans, particularly when there is a downturn in the business cycle. They are also typically larger than residential real estate loans and consumer loans and depend on cash flows from the owner’s business or the property to service the debt. Cash flows may be affected significantly by general economic conditions and a downturn in the local economy or in occupancy rates in the local economy where the property is located, each of which could increase the likelihood of default on the loan. Because our loan portfolio contains a number of commercial real estate loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in the percentage of nonperforming loans. An increase in nonperforming loans could result in a loss of earnings from these loans, an increase in the provision for loan losses and an increase in charge-offs, all of which could have a material adverse effect on our results of operations and financial condition, which could negatively affect our stock price.
 
If a commercial real estate loan did default there would be legal expenses associated with obtaining the real estate which is typically collateral for the loan. In the last several years the amount of these legal expenses has been low, compared to periods when the defaults of commercial real estate loans have been higher. Once we obtain the collateral for the commercial real estate loan it is put into foreclosed assets. Foreclosed assets generally do not produce income but do have the costs associated with the ownership of real estate, principally real estate taxes and maintenance costs. Since these assets have a cost to maintain our goal is to keep costs at a minimum by liquidating the assets as soon as possible. Generally, in spite of our best efforts and intentions, foreclosed assets are sold at a loss. Among other reasons the rate of loan defaults increase as the economy worsens and declining economic environment and political turmoil generally results in downward pressure on foreclosed asset values and increased marketing periods. In simple terms for banks like ours who have a large amount of commercial real estate loans a worsening economy will typically lead to higher loan delinquencies, followed by increases in loan defaults and greater legal expenses, leading to higher foreclosed asset levels with an increased expense to maintain the properties, ending in a sale of the foreclosed assets - most likely at a loss.
 
Our largest loan relationships currently make up a significant percentage of our total loan portfolio.

As of December 31, 2017, our 10 largest borrowing relationships totaled approximately $149 million in commitments (including unfunded commitments), or approximately 11 percent of our total loan portfolio. The concentration risk associated with having a small number of relatively large loan relationships is that, if one or more of these relationships were to become delinquent or suffer default, we could be at risk of material losses. The allowance for loan losses may not be adequate to cover losses associated with any of these relationships, and any loss or increase in the allowance could have a material adverse effect on our business, financial condition, results of operations and prospects.

Our corporate structure provides for decision-making authority by our regional presidents and banking teams. Our business, financial condition, results of operations and prospects could be negatively affected if our employees do not follow our internal policies or are negligent in their decision-making.

We attract and retain our management talent by empowering them to make certain business decisions on a local level. Lending authorities are assigned to relationship managers,  regional and presidents and regional credit officers to make credit decisions based on their experience. Additionally, all loans not in full compliance with the bank’s loan policy must be approved by an additional level of authority with adequate credit authority for the exposure and any exposure in excess of $2.8 Million in Total Relationship Exposure  with some sample loans below this amount are reviewed by our Chief Credit Officer in Knoxville, Tennessee. Moreover, for decisions that fall outside of the assigned individual authorities at every level, our teams are required to obtain approval from our. Officer Loan Committee and/or Directors Loan Committee.  Our local bankers may not follow our internal procedures or otherwise act in our best interests with respect to their decision-making. A failure of our employees to follow our internal policies, or actions taken by our employees that are negligent could have a material adverse effect on our business, financial condition, results of operations and prospects.


Declines in the businesses or industries of our customers could cause increased credit losses and decreased loan balances, which could adversely affect our financial results.

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The small to medium-sized businesses that we lend to may have fewer resources to weather adverse business developments, which may impair a borrower’s ability to repay a loan, and such impairment could have an adverse effect on our business, financial condition and results of operations. A substantial focus of our marketing and business strategy is to serve small to medium-sized businesses in our market areas. As a result, a relatively high percentage of our loan portfolio consists of commercial loans to such businesses. We further anticipate an increase in the amount of loans to small to medium-sized businesses during 2018.

Small to medium-sized businesses frequently have smaller market shares than their competition, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience substantial volatility in operating results, any of which may impair a borrower’s ability to repay a loan. In addition, the success of a small and medium-sized business often depends on the management skills, talents and efforts of one or two people or a small group of people, and the death, disability or resignation of one or more of these people could have an adverse impact on the business and its ability to repay its loan. If general economic conditions negatively impact the markets in which we operate and small to medium-sized businesses are adversely affected or our borrowers are otherwise harmed by adverse business developments, this, in turn, could have an adverse effect on our business, financial condition and results of operations.

Certain of our deposits and other funding sources may be volatile and impact our liquidity.
 
In addition to the traditional core deposits, such as demand deposit accounts, interest checking, money market savings and certificates of deposits less than $250,000, we utilize or in the past have utilized several noncore funding sources, such as brokered certificates of deposit, Federal Home Loan Bank (FHLB) of Cincinnati advances, federal funds purchased and other sources. We utilize these noncore funding sources to fund the ongoing operations and growth of SmartBank. The availability of these noncore funding sources is subject to broad economic conditions and to investor assessment of our financial strength and, as such, the cost of funds may fluctuate significantly and/or be restricted, thus impacting our net interest income, our immediate liquidity and/or our access to additional liquidity. We have somewhat similar risks to the extent high balance core deposits exceed the amount of deposit insurance coverage available.
 
We impose certain internal limits as to the absolute level of noncore funding we will incur at any point in time. Should we exceed those limitations, we may need to modify our growth plans, liquidate certain assets, participate loans to correspondents or execute other actions to allow for us to return to an acceptable level of noncore funding within a reasonable amount of time.
 
We face additional risks due to our increase in mortgage banking activities that have and could negatively impact our net income and profitability. 

We have established mortgage banking operations which expose us to risks that are different from our retail and commercial banking operations. During higher and rising interest rate environments, the demand for mortgage loans and the level of refinancing activity tends to decline, which can lead to reduced volumes of business and lower revenues, which could negatively impact our earnings. While we have been experiencing historically low interest rates, the low interest rate environment likely will not continue indefinitely. Because we sell a substantial portion of the mortgage loans we originate, the profitability of our mortgage banking operations also depends in large part on our ability to aggregate a high volume of loans and sell them in the secondary market at a gain. Thus, in addition to our dependence on the interest rate environment, we are dependent upon (a) the existence of an active secondary market and (b) our ability to profitably sell loans into that market. Our mortgage banking operations incurred additional expenses over $2.1 million in 2017 and generated noninterest income of $1,058 thousand. Profitability of our mortgage operations will depend upon our ability to increase production and thus income while holding or reducing costs. In addition, mortgages sold to third-party investors are typically subject to certain repurchase provisions related to borrower refinancing, defaults, fraud or other reasons stipulated in the applicable third-party investor agreements. If the fair value of a loan when repurchased is less than the fair value when sold, we may be required to charge such shortfall to earnings.

Any expansion into new lines of business might not be successful.
 
As part of our ongoing strategic plan, we will continue to consider expansion into new lines of business through the acquisition of third parties, or through organic growth and development. There are substantial risks associated with such efforts, including risks that (a) revenues from such activities might not be sufficient to offset the development, compliance, and other implementation costs, (b) competing products and services and shifting market preferences might affect the profitability of such activities, and (c) our internal controls might be inadequate to manage the risks associated with new activities. Furthermore, it is possible that our unfamiliarity with new lines of business might adversely affect the success of such actions. If any such expansions into new product markets are not successful, there could be an adverse effect on our financial condition and results of operations.
 
We may need additional access to capital, which we may be unable to obtain on attractive terms or at all.

26




 
We may need to incur additional debt or equity financing in the future to make strategic acquisitions or investments, for future growth or to fund losses or additional provision for loan losses in the future. Our ability to raise additional capital, if needed, will depend in part on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Accordingly, we may be unable to raise additional capital, if and when needed, on terms acceptable to us, or at all. If we cannot raise additional capital when needed, our ability to further expand our operations through internal growth and acquisitions could be materially impaired and our stock price negatively affected.
 
Any deficiencies in our financial reporting or internal controls could materially and adversely affect us, including resulting in material misstatements in our financial statements, and could materially and adversely affect the market price of our common stock.

If we fail to maintain effective internal controls over financial reporting, our operating results could be harmed and it could result in a material misstatement in our financial statements in the future. Inferior controls and procedures or the identification of accounting errors could cause our investors to lose confidence in our internal controls and question our reported financial information, which, among other things, could have a negative impact on the trading price of our common stock. Additionally, we could become subject to increased regulatory scrutiny and a higher risk of shareholder litigation, which could result in significant additional expenses and require additional financial and management resources.

We incur increased costs as a result of being a public company.
 
As a public company, we incur significant legal, accounting and other expenses, including costs associated with public company reporting requirements. We also incur costs associated with the Sarbanes-Oxley Act, the Dodd-Frank Act and related rules implemented or to be implemented by the SEC and the NASDAQ Stock Market. In addition, changing laws, regulations and standards relating to corporate governance and public disclosure are creating uncertainty for public companies, increasing legal and financial compliance costs and making some activities more time consuming. These laws, regulations and standards are subject to varying interpretations, in many cases due to their lack of specificity, and, as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies. This could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We intend to continue to invest resources to comply with evolving laws, regulations and standards and this continued investment may result in increased general and administrative expenses and a diversion of management's time and attention from revenue-generating activities to compliance activities. If our efforts to comply with new laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to their application and practice, regulatory authorities may initiate legal proceedings against us and our business may be adversely affected. In 2017 we incurred over $530 thousand in direct external costs associated with being a public company, which does not include the increased internal costs of the personnel needed to comply with being a public company.
 
Inability to retain senior management and key employees or to attract new experienced financial services professionals could impair our relationship with our customers, reduce growth and adversely affect our business.
 
We have assembled a senior management team which has substantial background and experience in banking and financial services. Moreover, much of our organic loan growth in 2012 through 2017 was the result of our ability to attract experienced financial services professionals who have been able to attract customers from other financial institutions.  Inability to retain these key personnel or to continue to attract experienced lenders with established books of business could negatively impact our growth because of the loss of these individuals' skills and customer relationships and/or the potential difficulty of promptly replacing them.
 
We may be subject to losses due to fraudulent and negligent conduct of our loan customers, deposit customers, third party service providers and employees.

When we make loans to individuals or entities, we rely upon information supplied by borrowers and other third parties, including information contained in the applicant’s loan application, property appraisal reports, title information and the borrower’s net worth, liquidity and cash flow information. While we attempt to verify information provided through available sources, we cannot be certain all such information is correct or complete. Our reliance on incorrect or incomplete information could have a material adverse effect on our financial condition or results of operations.

The value of our goodwill and other intangible assets may decline in the future.
 

27




As of December 31, 2017, we had $50.8 million of goodwill and other intangible assets. A significant decline in our financial condition, a significant adverse change in the business climate, slower growth rates or a significant and sustained decline in the price of our common stock may necessitate taking charges in the future related to the impairment of our goodwill and other intangible assets. If we were to conclude that a future write-down of goodwill and other intangible assets is necessary, we would record the appropriate charge, which could have a material adverse effect on our financial condition and results of operations. Future acquisitions could result in additional goodwill.

Risks Related to Our Stock
 
Our ability to declare and pay dividends is limited.
 
There can be no assurance of whether or when we may pay dividends on our common stock in the future. Future dividends, if any, will be declared and paid at the discretion of our board of directors and will depend on a number of factors. Our principal source of funds used to pay cash dividends on our common stock will be dividends that we receive from SmartBank. Although the Bank’s asset quality, earnings performance, liquidity and capital requirements will be taken into account before we declare or pay any future dividends on our common stock, our board of directors will also consider our liquidity and capital requirements and our board of directors could determine to declare and pay dividends without relying on dividend payments from the Bank.
 
Federal and state banking laws and regulations and state corporate laws restrict the amount of dividends we may declare and pay. For example, Federal Reserve Board regulations implementing the capital rules required under Basel III do not permit dividends unless capital levels exceed certain higher levels applying capital conservation buffers that began to apply on January 1, 2016 and are being phased in over three years. 

Further, in connection with the Capstone merger, we entered into a loan agreement for a revolving line of credit of up to $15 million. Under the terms of the loan agreement, we may not pay dividends on our common stock if we do not satisfy certain financial covenants and capital ratio requirements.

Even though our common stock is currently traded on the Nasdaq Capital Market, it has less liquidity than many other stocks quoted on a national securities exchange.
 
The trading volume in our common stock on the Nasdaq Capital Market has been relatively low when compared with larger companies listed on the Nasdaq Capital Market or other stock exchanges.  Although we have experienced increased liquidity in our stock, we cannot say with any certainty that a more active and liquid trading market for our common stock will continue to develop. Because of this, it may be more difficult for stockholders to sell a substantial number of shares for the same price at which stockholders could sell a smaller number of shares.
 
We cannot predict the effect, if any, that future sales of our common stock in the market, or the availability of shares of common stock for sale in the market, will have on the market price of our common stock. We can give no assurance that sales of substantial amounts of common stock in the market, or the potential for large amounts of sales in the market, would not cause the price of our common stock to decline or impair our future ability to raise capital through sales of our common stock.
 
The market price of our common stock has fluctuated significantly, and may fluctuate in the future. These fluctuations may be unrelated to our performance. General market or industry price declines or overall market volatility in the future could adversely affect the price of our common stock, and the current market price may not be indicative of future market prices.
 
We may issue additional shares of stock or equity derivative securities, including awards to current and future executive officers, directors and employees, which could result in the dilution of shareholders’ investment.

Our authorized capital includes 40,000,000 shares of common stock and 2,000,000 shares of preferred stock. As of December 31, 2017, we had 11,152,561 shares of common stock and no shares of preferred stock outstanding, and had reserved or otherwise set aside for issuance 316,574 shares underlying outstanding options and 2,478,030 shares that are available for future grants of stock options, restricted stock or other equity-based awards pursuant to our equity incentive plans. Subject to NASDAQ rules, our board of directors generally has the authority to issue all or part of any authorized but unissued shares of common stock or preferred stock for any corporate purpose. We anticipate that we will issue additional equity in connection with the acquisition of other strategic partners and that in the future we likely will seek additional equity capital as we develop our business and expand our operations, depending on the timing and magnitude of any particular future acquisition. These issuances would dilute the ownership interests of existing shareholders and may dilute the per share book value of the common stock. New investors also may have rights, preferences and privileges that are senior to, and that adversely affect, our then existing shareholders.
 

28




In addition, the issuance of shares under our equity compensation plans will result in dilution of our shareholders’ ownership of our Common Stock. The exercise price of stock options could also adversely affect the terms on which we can obtain additional capital. Option holders are most likely to exercise their options when the exercise price is less than the market price for our Common Stock. They may profit from any increase in the stock price without assuming the risks of ownership of the underlying shares of Common Stock by exercising their options and selling the stock immediately.

We are subject to Tennessee’s anti-takeover statutes and certain charter provisions that could decrease our chances of being acquired even if the acquisition is in the best interest of our shareholders.
 
As a Tennessee corporation, we are subject to various legislative acts that impose restrictions on and require compliance with procedures designed to protect shareholders against unfair or coercive mergers and acquisitions. These statutes may delay or prevent offers to acquire us and increase the difficulty of consummating any such offers, even if the acquisition would be in our shareholders’ best interests. Our charter also contains provisions which may make it difficult for another entity to acquire us without the approval of a majority of the disinterested directors on our board of directors. Secondly, the amount of common stock owned by, and other compensation arrangements with, certain of our officers and directors may make it more difficult to obtain shareholder approval of potential takeovers that they oppose. Agreements with our senior management also provide for significant payments under certain circumstances following a change in control. These compensation arrangements, together with the common stock and option ownership of our board of directors and management, could make it difficult or expensive to obtain majority support for shareholder proposals or potential acquisition proposals that the board of directors and officers oppose.
 
ITEM 1B. UNRESOLVED STAFF COMMENTS
 
None.
 
ITEM 2. PROPERTIES
 
As of December 31, 2017, the principal offices of SmartFinancial are located at 5401 Kingston Pike, #600, Knoxville, Tennessee 37919. This property is owned by SmartBank and also serves as a branch location for the Bank’s customers. In addition, the Bank operates twenty one full-service branches, one loan production office, two mortgage loan production offices, and two service centers which are located at:
Owned
 
Banking Branches
1011 Parkway, Sevierville, Tennessee 37862
 
570 East Parkway, Gatlinburg, Tennessee 37738
 
202 Advantage Place, Knoxville, Tennessee 37922
 
5401 Kingston Pike, #600, Knoxville, Tennessee 37919
 
4154 Ringgold Road, East Ridge, Tennessee 37412
 
5319 Highway 153, Hixson, Tennessee 37343
 
2280 Gunbarrel Road, Chattanooga, Tennessee 37421
 
8966 Old Lee Highway, Ooltewah, Tennessee 37363
 
835 Georgia Avenue, Chattanooga, Tennessee 37402
 
201 North Palafox Street, Pensacola, Florida 32502
 
4405 Commons Drive East, Destin, Florida 32541
 
16780 Jordan Street ,Chatom,, Alabama 36518

 
1600 College Avenue, Jackson, Alabama 36545

 
158 Commerce Street,McIntosh, Alabama 36553

 
33219 Hwy 43,Thomasville, AL 36784

 
2301 University Blvd, Tuscaloosa, AL 35401


29




Leased
 
Banking Branches
2430 Teaster Lane, #205, Pigeon Forge, Tennessee 37863
 
2000 Lurleen B Wallace Blvd, Northport, AL 35476
 
230 McFarland Circle North, Tuscaloosa, AL 35406
 
103 Ecor Rouge Place, Fairhope, AL 36532
 
2411 Jenks Avenue, Panama City, Florida 32405
Loan Production Office
202 West Crawford Street, Dalton, Georgia 37020
Mortgage Loan Production Offices
243 Southwood Drive, Panama City, Florida 32405
 
28810 Hwy 98, Suite E, Daphne AL 36526
Service Centers
6413 Lee Highway, #107, Chattanooga, Tennessee 37421
 
1732 Newport Highway, Suite 1, Sevierville, Tennessee 37876



ITEM 3. LEGAL PROCEEDINGS
 
As of the end of 2017, neither SmartFinancial nor its subsidiary was involved in any material litigation. SmartBank is periodically involved as a plaintiff or defendant in various legal actions in the ordinary course of its business. Management believes that any claims pending against SmartFinancial or its subsidiary are without merit or that the ultimate liability, if any, resulting from them will not materially affect SmartBank’s financial condition or SmartFinancial’s consolidated financial position.
 
ITEM 4. MINE SAFETY DICLOSURES
 
Not applicable.
 

30




PART II
 
ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
 
On December 31, 2017, SmartFinancial had 11,152,561 shares of common stock outstanding. SmartFinancial’s common stock is listed on NASDAQ under the symbol “SMBK”.
 
There were approximately 673 holders of record of the common stock as of March 1, 2018. This number does not include shareholders with shares in nominee name held by the Depository Trust Company (DTC). As of March 1, 2018 there were approximately 8,130,397 shares held in nominee name by DTC.
 
Dividends and Dividend Restrictions
 
SmartFinancial paid no cash dividends on common stock in 2016 or 2017. In 2016 and 2017, SmartFinancial recognized following dividends on its SBLF Preferred Stock (including dividends recognized by Legacy SmartFinancial): 
Year
Total SBLF Preferred Stock
Dividends
2016
$
1,022,000

2017
$
195,000


We redeemed the SBLF Preferred Stock in full on March 6, 2017.

The payment of dividends is within the discretion of the board of directors, considering SmartFinancial’s expenses, the maintenance of reasonable capital and risk reserves, and appropriate capitalization requirements for state banks.
 
In connection with the merger with Capstone we entered into a loan agreement for a revolving line of credit. Under the terms of the loan agreement, we may not pay dividends on our common stock if we do not satisfy certain financial covenants and capital ratio requirements.


31




Market Prices for Our Common Stock
 
Table 1 presents the high and low closing prices of SmartFinancial’s common stock for the periods indicated, as reported on the Nasdaq Capital Market. Table 1 also presents cash dividends declared on our common stock for the last three fiscal years. The prices reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not represent actual transactions.
 
TABLE 1 
High and Low Common Stock Price for SmartFinancial
 
Cash Dividends
2017
 
Low
 
High
 
Paid Per Share
First Quarter
 
$
17.17

 
$
23.20

 

Second Quarter
 
$
20.35

 
$
26.26

 

Third Quarter
 
$
22.31

 
$
25.95

 

Fourth Quarter
 
$
21.10

 
$
24.98

 

 
 
 
 
 
 
 
2016
 
 

 
 

 
 

First Quarter
 
$
14.75

 
$
18.50

 

Second Quarter
 
$
14.21

 
$
18.75

 

Third Quarter
 
$
14.41

 
$
16.79

 

Fourth Quarter
 
$
16.14

 
$
20.58

 

 
 
 
 
 
 
 

For information relating to compensation plans under which our equity securities are authorized for issuance, see Part III Items 11 and 12.
 
 
ITEM 6. SELECTED FINANCIAL DATA 

This Item is not applicable to smaller reporting companies. 


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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
SmartFinancial, Inc. (the "Company") is a bank holding company whose principal activity is the ownership and management of its wholly-owned subsidiary, SmartBank (the "Bank"). The Company provides a variety of financial services to individuals and corporate customers through its offices in Tennessee, Alabama, Florida, and Georgia. The Company's primary deposit products are interest-bearing demand deposits and certificates of deposit. Its primary lending products are commercial, residential, and consumer loans.
 
Mergers and Acquisitions
 
Merger with Capstone Bancshares

On May 22, 2017, the shareholders of the Company approved a merger with Capstone Bancshares, Inc. ("Capstone"), the one bank holding company of Capstone Bank, which became effective November 1, 2017. Capstone shareholders received either stock, cash, or a combination of stock and cash. After the merger, original shareholders of SmartFinancial owned approximately 74 percent of the outstanding common stock of the combined entity on a fully diluted basis while the previous Capstone shareholders owned approximately 26 percent. The assets and liabilities of Capstone as of the effective date of the merger were recorded at their respective estimated fair values and combined with those of SmartFinancial. The excess of the purchase price over the net estimated fair values of the acquired assets and liabilities was allocated to identifiable intangible assets with the remaining excess allocated to goodwill, which was approximately $38 million. As a result of the merger Company assets increased approximately $536 million and liabilities increased approximately $466 million. The merger had a significant impact on all aspects of the Company's financial statements, and as a result, financial results after the merger may not be comparable to financial results prior to the merger.

Purchase of Cleveland, Tennessee branch

On December 8, 2016, the Bank entered into a purchase and assumption agreement with Atlantic Capital Bank, N.A. on a branch in Cleveland, Tennessee. The purchase was completed on May 19, 2017 for a total of $1.2 million in cash. The assets and liabilities as of the effective date of the transaction were recorded at their respective estimated fair values. The excess of the purchase price over the net estimated fair values of the acquired assets and liabilities was allocated to identifiable intangible assets with the remaining excess allocated to goodwill, which was $660 thousand. In the periods following the acquisition, the financial statements include the results attributable to the Cleveland branch purchase beginning on the date of purchase. As a result of the transaction the Company acquired approximately $27 million in assets and assumed $27 million in liabilities.

Merger of Legacy SmartFinancial and Cornerstone Bancshares
 
On August 31, 2015, Legacy SmartFinancial merged with Cornerstone Bancshares, Inc. (“Cornerstone”) ticker symbol “CSBQ,” the one bank holding company of Cornerstone Community Bank. While Cornerstone was the acquiring entity for legal purposes, the merger was accounted for as a reverse merger using the acquisition method of accounting, in accordance with the provisions of FASB ASC 805-10 Business Combinations. Under this guidance, for accounting purposes, Legacy SmartFinancial is considered the acquirer in the merger, and as a result the historical financial statements of the combined entity are the historical financial statements of Legacy SmartFinancial. As a result of the merger Company assets increased approximately $450 million and liabilities increased approximately $421 million. The merger had a significant impact on all aspects of the Company's financial statements, and as a result, financial results after the merger may not be comparable to financial results prior to the merger.
 
Acquisition of Assets and Liabilities of the former Gulf South Private Bank
 
On October 19, 2012, SmartBank assumed all of the deposits and certain other liabilities and acquired certain assets of GulfSouth Private Bank (“GulfSouth”), headquartered in Destin, Florida from the FDIC pursuant to the terms of a Purchase and Assumption Agreement. As a result of the transaction the Company acquired approximately $141 million in assets and assumed $136 million in liabilities.
 
Business Overview
 
The Company’s business model consists of leveraging capital into assets funded by liabilities. As a general rule capital can be leveraged approximately ten times. The primary source of revenue is interest income from earning assets, namely loans and securities. These liabilities used to fund the assets are primarily deposits. The Company seeks to maximize net interest income, the difference between interest received on earning assets and the amount of interest paid on liabilities. Net interest income to

33




average assets is a key ratio that measures the profitability of the earning assets of the company. Noninterest income is the second source of revenue and primarily consists of customer service fees, gains on the sales of securities and loans, and other noninterest income. Noninterest income to average assets is a ratio that reflects our effectiveness in generating these other forms of revenue. The Company incurs noninterest expenses as result of the operations of its business. Primary expenses are those of employees, occupancy and equipment, professional services, and data processing. The Company seeks to minimize the amount of noninterest expense relative to the amount of total assets; noninterest expense to assets is a key ratio that measures the efficiency of the costs incurred to operate the business.

Executive Summary
 
The following is a summary of the Company’s financial highlights and significant events during 2017:
 
Completed two acquisitions during the year which increased assets by approximately $563 million : a branch in Cleveland, Tennessee in the second quarter and Capstone Bancshares along with Capstone Community Bank in the fourth quarter.
Earnings available to common shareholders held steady at $4.8 million, in spite of a $2.4 million after-tax charge to write down the Company's deferred tax assets as a result of the Tax Cuts and Jobs Act of 2017.
Ended 2017 with record high total assets of $1.7 billion, net loans of $1.3 billion, and deposits of $1.4 billion.
Net interest margin, taxable equivalent, increased over 20 basis points in 2017 to 4.30 percent compared to 4.06 percent in 2016.
Efficiency ratio, which is equal to noninterest expense divided by the sum of net interest income and noninterest income, decreased to 76.0 percent in 2017, compared to 76.4 percent in 2016, in spite of $2.4 million in merger expenses during 2017.

Analysis of Results of Operations
 
2017 compared to 2016
 
Net income was $5.0 million in 2017, compared to $5.8 million in 2016. Net income available to common shareholders was $4.8 million, or $0.55 per diluted common share, in 2017, compared to $4.8 million, or $0.78 per diluted common share, in 2016. Net interest income to average assets of 3.90 percent in 2017 was up from 3.77 percent in 2016, with the increase as a result of a higher percentage of average earning assets to average interest bearing liabilities as well as higher earning asset yields. Noninterest income to average assets of 0.42 percent was up from 0.41 percent in 2016 as a result of increases in customer service fees, higher gains on the sale of loans and other assets, and higher other noninterest income. Noninterest expense to average assets increased from 3.20 percent in 2016 to 3.29 percent in 2017 primarily due to $2.4 million in merger expenses during 2017. The resulting pretax income to average assets was 1.00 percent in 2017 compared to 0.95 percent in 2016. Finally, in 2017 the effective tax rate was 56.2 percent, which was up substantially from 36.7 percent in 2016 due to a $2.4 million after-tax charge to write down the Company's deferred tax assets as a result of the Tax Cuts and Jobs Act of 2017.
.

2016 compared to 2015
 
Net income was $5.8 million in 2016, which was up substantially from $1.5 million in 2015. Net income available to common shareholders was $4.8 million, or $0.78 per diluted common share, in 2016, an increase from $1.4 million, or $0.32 per diluted common share, in 2015. Net interest income to average assets of 3.77 percent in 2016 was up from 3.66 percent in 2015, with the increase as a result of a higher percentage of average earning assets to average total assets. Noninterest income to average assets of 0.41 percent was up from 0.33 percent in 2015 as a result of increases in customer service fees, higher gains on the sale of securities, gains on the sale of loans and other assets compared to losses in 2015, and higher other noninterest income. Noninterest expense to average assets decreased from 3.39 percent in 2015 to 3.20 percent in 2016 due to realized efficiencies of scale and the absences of merger and conversion related costs. The resulting pretax income to average assets was 0.95 percent in 2016 compared to 0.46 percent in 2015. Finally, in 2016 the effective tax rate was 36.70 percent, which was down substantially from 2015 when taxes were elevated due to merger and acquisition expenses which were nondeductible.

Net Interest Income and Yield Analysis
 
2017 compared to 2016
 
Net interest income, taxable equivalent, improved to $46.4 million in 2017 from $38.3 million in 2016. The increase in net interest income, taxable equivalent, was the result of a significant increase in earning assets primarily from the Capstone merger but also from organic business activity. Average earning assets increased from $944.6 million in 2016 to $1,083.7 million in 2017. Over

34




this period, average loan balances increased by $150.9 million and average securities and interest bearing balances at other financial institutions decreased by $24.0 million. In addition, total average interest-bearing deposits increased by $113.8 million. Net interest income to average assets of 3.90 percent in 2017 was up from 3.77 percent in 2016. Net interest margin, taxable equivalent, was 4.30 percent in 2017, compared to 4.06 percent in 2016. Net interest margin, taxable equivalent, was slightly negatively impacted by an increase in the cost of interest bearing liabilities from 0.56 percent in 2016 to 0.66 percent in 2017. In 2018 we expect net interest income to average assets and net interest margin, taxable equivalent, to experience pressure as there is the potential for pressure to increase deposit rates as short term rates have continued to increase but do anticipate the effect of rate increases will be mitigated on the income side by increases in yields of our floating rate earning assets.

2016 compared to 2015
 
Net interest income, taxable equivalent, improved to $38.3 million in 2016 from $25.0 million in 2015. The increase in net interest income, taxable equivalent, was the result of a significant increase in earning assets primarily from the merger but also from organic business activity. Average earning assets increased from $615.3 million in 2015 to $944.6 million in 2016. Over this period, average loan balances increased by $282.5 million and average securities and interest bearing balances at other financial institutions increased by $54.1 million. In addition, total average interest-bearing deposits increased by $219.0 million. Net interest income to average assets of 3.77 percent in 2016 was up from 3.66 percent in 2015. Net interest margin, taxable equivalent, was 4.06 percent in 2016, compared to 4.07 percent in 2015. Net interest margin, taxable equivalent, was negatively affected by an increase in the cost of interest bearing liabilities from 0.52 percent in 2015 to 0.56 percent in 2016.

35





The following table summarizes the major components of net interest income and the related yields and costs for the periods presented. 
 
 
2017
 
2016
 
2015
(Dollars in thousands)
 
Average
 
 
 
Yield/
 
Average
 
 
 
Yield/
 
Average
 
 
 
Yield/
 
 
Balance
 
Interest *
 
Cost*
 
Balance
 
Interest *
 
Cost*
 
Balance
 
Interest *
 
Cost*
Assets
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Loans (1)
 
$
919,603

 
$
48,834

 
5.31
%
 
$
768,720

 
$
39,779

 
5.17
%
 
$
486,183

 
$
25,739

 
5.29
%
Investment securities (2)
 
143,329

 
2,953

 
2.07
%
 
167,352

 
2,609

 
1.56
%
 
113,281

 
1,877

 
1.66
%
Federal funds and other
 
20,807

 
353

 
1.70
%
 
8,568

 
247

 
2.88
%
 
15,853

 
161

 
1.02
%
Total interest-earning assets
 
1,083,739

 
$
52,140

 
4.82
%
 
944,640

 
$
42,635

 
4.51
%
 
615,317

 
$
27,777

 
4.51
%
Noninterest-earning assets
 
104,850

 
 

 
 

 
67,592

 
 

 
 

 
68,202

 
 

 
 

Total assets
 
$
1,188,589

 
 

 
 

 
$
1,012,232

 
 

 
 

 
$
683,519

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities and Shareholders’ Equity
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

Interest-bearing demand deposits
 
$
166,382

 
$
539

 
0.32
%
 
$
150,649

 
$
286

 
0.19
%
 
$
117,036

 
$
173

 
0.15
%
Money market and savings deposits
 
342,637

 
1,759

 
0.51
%
 
258,092

 
1,172

 
0.45
%
 
161,405

 
656

 
0.41
%
Time deposits
 
329,524

 
3,221

 
0.98
%
 
316,046

 
2,647

 
0.84
%
 
227,317

 
1,797

 
0.79
%
Total interest-bearing deposits
 
838,543

 
5,519

 
0.66
%
 
724,787

 
4,105

 
0.57
%
 
505,758

 
2,626

 
0.52
%
Securities sold under agreement to repurchase
 
19,856

 
61

 
0.31
%
 
21,329

 
65

 
0.30
%
 
11,335

 
30

 
0.26
%
Federal Home Loan Bank advances and other borrowings
 
4,887

 
113

 
2.32
%
 
17,451

 
129

 
0.74
%
 
13,490

 
101

 
0.75
%
Total interest-bearing liabilities
 
863,286

 
5,693

 
0.66
%
 
763,567

 
4,299

 
0.56
%
 
530,583

 
2,757

 
0.52
%
Net interest income, taxable equivalent
 
 
 
$
46,447

 
 

 
 

 
$
38,336

 
 

 
 

 
$
25,020

 
 

Noninterest-bearing deposits
 
172,842

 
 

 
 

 
139,652

 
 

 
 

 
80,794

 
 

 
 

Other liabilities
 
6,657

 
 

 
 

 
5,535

 
 

 
 

 
1,812

 
 

 
 

Total liabilities
 
1,042,785

 
 

 
 

 
908,754

 
 

 
 

 
613,189

 
 

 
 

Shareholders’ equity
 
145,804

 
 

 
 

 
103,478

 
 

 
 

 
70,330

 
 

 
 

Total liabilities and shareholders’ equity
 
$
1,188,589

 
 
 
 
 
$
1,012,232

 
 

 
 

 
$
683,519

 
 

 
 

 
 
 

 
 
 
 

 
 
 
 
 
 
 
 
 
 
 
 
Interest rate spread (3)
 
 

 
 

 
4.16
%
 
 

 
 

 
3.95
%
 
 

 
 

 
3.99
%
Tax equivalent net interest margin (4)
 
 

 
 

 
4.30
%
 
 

 
 

 
4.06
%
 
 

 
 

 
4.07
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Percentage of average interest-earning assets to average interest-bearing liabilities
 
 

 
 

 
125.5
%
 
 

 
 

 
123.7
%
 
 

 
 

 
116.0
%
Percentage of of average equity to average assets
 
 

 
 

 
12.3
%
 
 

 
 

 
10.2
%
 
 

 
 

 
10.3
%
* Taxable equivalent basis
 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
 

 
(1)
Loans include nonaccrual loans. Yields related to loans exempt from income taxes are stated on a taxable-equivalent basis assuming a federal income tax rate of 34.0 percent. The taxable-equivalent adjustment was $28 thousand for 2017, $16 thousand for 2016 and $8 thousand for 2015. Loan fees included in loan income was $2.5 million, $2.6 million, and $1.3 million for 2017, 2016 and 2015, respectively.
(2)
Yields related to investment securities exempt from income taxes are stated on a taxable-equivalent basis assuming a federal income tax rate of 34.0 percent. The taxable-equivalent adjustment was $90 thousand, $55 thousand and $16 thousand for 2017, 2016 and 2015, respectively.
(3)
Net interest spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.
(4)
Net interest margin represents net interest income divided by average interest-earning assets.


36




Rate and Volume Analysis
 
Net interest income, taxable equivalent, increased by $8.1 million between the years ended December 31, 2017 and 2016 and by $6.3 million between the years ended December 31, 2016 and 2015. The following is an analysis of the changes in net interest income comparing the changes attributable to rates and those attributable to volumes (in thousands): 

 
 
2017 Compared to 2016
Increase (decrease) due to
 
2016 Compared to 2015
Increase (decrease) due to
 
 
Rate
 
Days
 
Volume
 
Net
 
Rate
 
Days
 
Volume
 
Net
Interest-earning assets:
 
 

 
 
 
 

 
 

 
 

 
 
 
 

 
 

Loans (1)
 
$
1,342

 
(109
)
 
$
7,822

 
$
9,055

 
$
(976
)
 
70

 
$
14,946

 
$
14,040

Investment securities (2)
 
727

 
(7
)
 
(376
)
 
344

 
(171
)
 
5

 
898

 
732

Federal funds and other
 
(246
)
 
(1
)
 
353

 
106

 
160

 

 
(74
)
 
86

Total interest-earning assets
 
1,823

 
(117
)
 
7,799

 
9,505

 
(987
)
 
75

 
15,770

 
14,858

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing demand deposits
 
224

 
(1
)
 
30

 
253

 
63

 

 
50

 
113

Money market and savings deposits
 
209

 
(3
)
 
381

 
587

 
118

 
2

 
396

 
516

Time deposits
 
467

 
(7
)
 
114

 
574

 
144

 
5

 
701

 
850

Total interest-bearing deposits
 
900

 
(11
)
 
525

 
1,414

 
325

 
7

 
1,147

 
1,479

Securities sold under agreement to repurchase
 

 

 
(4
)
 
(4
)
 
9

 

 
26

 
35

Federal Home Loan Bank advances and other
borrowings
 
77

 

 
(93
)
 
(16
)
 
(2
)
 

 
30

 
28

Total interest-bearing liabilities
 
977

 
(11
)
 
428

 
1,394

 
332

 
7

 
1,203

 
1,542

Net interest income
 
$
846

 
(106
)
 
$
7,371

 
$
8,111

 
$
(1,319
)
 
68

 
$
14,567

 
$
13,316


(1)
Loans include nonaccrual loans. Yields related to loans exempt from income taxes are stated on a taxable-equivalent basis assuming a federal income tax rate of 34.0 percent. The taxable-equivalent adjustment was $28 thousand for 2017, $16 thousand for 2016 and $8 thousand for 2015.
(2)
Yields related to investment securities exempt from income taxes are stated on a taxable-equivalent basis assuming a federal income tax rate of 34.0 percent. The taxable-equivalent adjustment was $90 thousand, $55 thousand and $16 thousand for 2017, 2016 and 2015, respectively.

Changes in net interest income are attributed to either changes in average balances (volume change), changes in average rates (rate change) for earning assets and sources of funds on which interest is received or paid, or changes within the number of days in the two periods compared.  Volume change is calculated as change in volume times the previous rate while rate change is change in rate times the previous volume.  The change attributed to rates and volumes (change in rate times change in volume) is considered above as a change in volume.


37




Non Interest Income
 
The following table provides a summary of noninterest income for the periods presented. 
 
 
Year ended December 31,
(Dollars in thousands)
 
2017
 
2016
 
2015
Service charges and fees on deposit accounts
 
$
1,374

 
$
1,128

 
$
913

Gain on sale of  securities
 
144

 
199

 
52

Gain (loss) on sale of loans and other assets
 
1,276

 
948

 
(112
)
(Loss) gain on sale of foreclosed assets
 
(48
)
 
191

 
266

Other noninterest income
 
2,234

 
1,717

 
1,124

Total noninterest income
 
$
4,979

 
$
4,183

 
$
2,243

 
2017 compared to 2016
 
Noninterest income totaled $5.0 million in 2017, which was an increase from $4.2 million in 2016. Noninterest income to average assets of 0.42 percent was up from 0.41 percent in 2016. Primary drivers of the increase were gains on the sale of loans and other assets and higher other noninterest income. In 2017, there were gains of $1.3 million on the sale of mortgage loans, SBA loans and other assets compared to $0.9 million in 2016. In 2017 there were losses of $48 thousand on the sale of foreclosed assets, compared to a gain of $191 thousand in 2016. Other noninterest income of $2.2 million in 2017 was up from $1.7 million in 2016 primarily due to higher income from company owned life insurance and higher interchange income. In 2018, we expect noninterest income to average assets to increase as a result of increased loan sales from the mortgage unit, higher service charges on deposit accounts, and higher other noninterest income.
 
2016 compared to 2015
 
Noninterest income totaled $4.2 million in 2016, which was an increase from $2.2 million in 2015. Noninterest income to average assets of 0.41 percent was up from 0.33 percent in 2015. Primary drivers of the increase were higher gains on the sale of securities, gains on the sale of loans and other assets compared to losses in 2015, and higher other noninterest income. In 2016, there were gains of $948 thousand on the sale of mortgage loans, SBA loans and other assets compared to a loss of $112 thousand in 2015 due to the loss on the sale of a bank owned property. In 2016 there were gains of $191 thousand on the sale of foreclosed assets, down from a gain of $266 thousand in 2015. Other noninterest income of $1.7 million in 2016 was up from $1.1 million in 2015 primarily due to increased revenue as a result of the merger.


Noninterest Expense
 
The following table provides a summary of noninterest expense for the periods presented. 
 
 
Year ended December 31,
(Dollars in thousands)
 
2017
 
2016
 
2015
Salaries and employee benefits
 
$
20,743

 
$
17,715

 
$
11,831

Net occupancy and equipment expense
 
4,271

 
3,996

 
2,682

Depository insurance
 
466

 
606

 
488

Foreclosed assets
 
84

 
236

 
290

Advertising
 
638

 
616

 
453

Data processing
 
1,875

 
1,893

 
1,197

Professional services
 
2,085

 
2,123

 
2,454

Amortization of other intangible assets
 
346

 
305

 
233

Service contracts
 
1,398

 
1,154

 
751

Merger expenses
 
2,417

 

 
1,155

Other operating expenses
 
4,758

 
3,856

 
1,632

Total noninterest expense
 
$
39,082

 
$
32,500

 
$
23,166


2017 compared to 2016

38




 
Noninterest expense totaled $39.1 million in 2017 compared to $32.5 million in 2016. Noninterest expense to average assets increased from 3.20 percent in 2016 to 3.29 percent in 2017. Salaries and employee benefits, occupancy and equipment, and other noninterest expense categories in 2017 were all higher as a result of two full months of post-merger expenses. In 2017 noninterest expense was also elevated by $2.4 million of merger expenses, compared to none in 2016. In 2018, we expect noninterest expense to average assets to decrease as a result of assets growing faster than core operating expenses and a reduction in merger expenses.
 
2016 compared to 2015
 
Noninterest expense totaled $32.5 million in 2016 compared to $23.2 million in 2015. Noninterest expense to average assets decreased from 3.39 percent in 2015 to 3.20 percent in 2016. Salaries and employee benefits, occupancy and equipment, data processing, and other noninterest expense categories in 2016 were all higher as a result of twelve full months of post-merger expense compared to four months in 2015. In 2016, the reduction of professional services was due the absence of merger expenses.

Taxes
 
2017 compared to 2016

In 2017, income tax expense totaled $6.4 million compared to $3.4 million in 2016. Income taxes to average assets were 0.54 percent compared to 0.33 percent in the prior year. Taxes in the current year were elevated due to a $2.4 million after-tax charge to reduce the value of the Company's deferred tax assets as a result of the tax law signed in December which resulted in an effective tax rate of 56.2 percent in 2017 compared to 36.7 percent in 2016. In 2018, we expect our effective tax rate to be in the range of 26 percent.
 
2016 compared to 2015

In 2016, income tax expense totaled $3.4 million compared to $1.6 million in 2015. Income taxes to average assets were 0.33 percent compared to 0.24 percent in the prior year. The effective tax rate of about 37 percent in 2016 was down from about 52 percent in 2015 which had approximately $0.3 million of nondeductible merger and acquisition expenses.
 
Loan Portfolio Composition
 
The Company had total net loans outstanding, including organic and purchased loans, of approximately $1,317.4 million at December 31, 2017 and $808.3 million at December 31, 2016. Loans secured by real estate, consisting of commercial or residential property, are the principal component of our loan portfolio. We do not generally originate traditional long-term residential mortgages for our portfolio but we do originate and hold traditional second mortgage residential real estate loans, adjustable rate mortgages and home equity lines of credit. Even if the principal purpose of the loan is not to finance real estate, when reasonable, we attempt to obtain a security interest in the real estate in addition to any other available collateral to increase the likelihood of ultimate repayment or collection of the loan.
 
Organic Loans
 
Our net organic loans increased $181.9 million, or 29.7 percent to $793.8 million at December 31, 2017, from December 31, 2016, as we continue to originate well-underwritten loans. Our goal of streamlining the credit process has improved our efficiency and is a competitive advantage in many of our markets. In addition, continued training and recruiting of experienced loan officers has provided us with the opportunity to close larger and more complex deals than we historically have. Finally, the overall business environment continues to rebound from recessionary conditions. Organic loans include loans which were originally purchased non-credit impaired loans but have been renewed.
 
Purchased Loans
 
Purchased non-credit impaired loans of $490.9 million at December 31, 2017 were up $321.7 million from December 31, 2016 as a result of the Capstone acquisition. Also during 2017, our purchased credit impaired (“PCI”) loans increased by $5.6 million to $32.8 million at December 31, 2017. The activity within the purchased credit impaired loans will be impacted by how quickly these loans are resolved and/or our future acquisition activity. Prior to the GulfSouth transaction in 2012 the Company had no purchased loans. 

The following tables summarize the composition of our loan portfolio for the periods presented (dollars in thousands): 

39




 
 
2017
 
 
Organic
Loans
 
Purchased
Non-Credit
Impaired
Loans
 
Purchased
Credit
Impaired
Loans
 
Total
Amount
 
% of
Gross
Total
Commercial real estate-mortgage
 
$
387,313

 
$
237,772

 
$
17,903

 
$
642,988

 
48.6
%
Consumer real estate-mortgage
 
173,988

 
112,019

 
7,450

 
293,457

 
22.2
%
Construction and land development
 
97,116

 
33,173

 
5,120

 
135,409

 
10.2
%
Commercial and industrial
 
135,271

 
101,958

 
858

 
238,087

 
18.0
%
Consumer and other
 
5,925

 
5,929

 
1,463

 
13,317

 
1.0
%
Total gross loans receivable, net of deferred fees
 
799,612

 
490,852

 
32,794

 
1,323,258

 
100.0
%
Allowance for loan and lease losses
 
(5,844
)
 

 
(16
)
 
(5,860
)
 
 

Total loans, net
 
$
793,768

 
$
490,852

 
$
32,778

 
$
1,317,398

 
 

 
 
 
2016
 
 
Organic
Loans
 
Purchased
Non-Credit
Impaired
Loans
 
Purchased
Credit
Impaired
Loans
 
Total
Amount
 
% of
Gross
Total
Commercial real estate-mortgage
 
$
297,689

 
$
102,576

 
$
14,943

 
$
415,208

 
51.0
%
Consumer real estate-mortgage
 
135,923

 
42,875

 
9,004

 
187,802

 
23.1
%
Construction and land development
 
108,390

 
7,801

 
1,678

 
117,869

 
14.5
%
Commercial and industrial
 
68,235

 
15,219

 
1,568

 
85,022

 
10.5
%
Consumer and other
 
6,786

 
689

 

 
7,475

 
0.9
%
Total gross loans receivable, net of deferred fees
 
617,023

 
169,160

 
27,193

 
813,376

 
100.0
%
Allowance for loan and lease losses
 
(5,105
)
 

 

 
(5,105
)
 
 

Total loans, net
 
$
611,918

 
$
169,160

 
$
27,193

 
$
808,271

 
 

 
 
 
2015
 
 
Organic
Loans
 
Purchased
Non-Credit
Impaired
Loans
 
Purchased
Credit
Impaired
Loans
 
Total
Amount
 
% of
Gross
Total
Commercial real estate-mortgage
 
$
229,203

 
$
120,524

 
$
20,050

 
$
369,777

 
50.8
%
Consumer real estate-mortgage
 
95,233

 
53,697

 
12,764

 
161,694

 
22.2
%
Construction and land development
 
73,028

 
29,755

 
2,695

 
105,478

 
14.5
%
Commercial and industrial
 
53,761

 
28,422

 
2,768

 
84,951

 
11.7
%
Consumer and other
 
4,692

 
1,123

 

 
5,815

 
0.8
%
Total gross loans receivable, net of deferred fees
 
455,917

 
233,521

 
38,277

 
727,715

 
100.0
%
Allowance for loan and lease losses
 
(4,354
)
 

 

 
(4,354
)
 
 

Total loans, net
 
$
451,563

 
$
233,521

 
$
38,277

 
$
723,361

 
 

 

40




 
 
2014
 
 
Organic Loans
 
Purchased Non-Credit Impaired Loans
 
Purchased Credit Impaired Loans
 
Total Amount
 
% of
Gross
Total
Commercial real estate-mortgage
 
$
186,444

 
$
3,905

 
$
3,102

 
$
193,451

 
53.2
%
Consumer real estate-mortgage
 
75,066

 
1,968

 
4,380

 
81,414

 
22.4
%
Construction and land development
 
52,421

 
48

 
36

 
52,505

 
14.5
%
Commercial and industrial
 
33,716

 

 
3

 
33,719

 
9.3
%
Consumer and other
 
2,314

 

 

 
2,314

 
0.6
%
Total gross loans receivable, net of deferred fees
 
349,961

 
5,921

 
7,521

 
363,403

 
100.0
%
Allowance for loan and lease losses
 
(3,880
)
 

 

 
(3,880
)
 
 

Total loans, net
 
$
346,081

 
$
5,921

 
$
7,521

 
$
359,523

 
 

  
 
 
2013
 
 
Organic Loans
 
Purchased Non-Credit Impaired Loans
 
Purchased Credit Impaired Loans
 
Total Amount
 
% of
Gross
Total
Commercial real estate-mortgage
 
$
150,849

 
$
4,448

 
$
3,969

 
$
159,266

 
50.6
%
Consumer real estate-mortgage
 
69,588

 
6,966

 
5,276

 
81,830

 
26.0
%
Construction and land development
 
35,111

 
1,087

 
489

 
36,687

 
11.6
%
Commercial and industrial
 
33,763

 
28

 
15

 
33,806

 
10.7
%
Consumer and other
 
2,916

 
347

 
227

 
3,490

 
1.1
%
Total gross loans receivable, net of deferred fees
 
292,227

 
12,876

 
9,976

 
315,079

 
100.0
%
Allowance for loan and lease losses
 
(3,755
)
 

 
(381
)
 
(4,136
)
 
 

Total loans, net
 
$
288,472

 
$
12,876

 
$
9,595

 
$
310,943

 
 


Loan Portfolio Maturities
 
The following table sets forth the maturity distribution of our loans, including the interest rate sensitivity for loans maturing after one year. 
 
 
 
 
 
 
 
 
 
 
Rate Structure for Loans
 
 
 
 
 
 
 
 
Maturing Over One Year
 
 
One Year
or Less
 
One through
Five Years
 
Over Five
Years
 
Total
 
Fixed
Rate
 
Floating
Rate
Commercial real estate-mortgage
 
$
173,603

 
$
259,406

 
$
209,979

 
$
642,988

 
$
332,438

 
$
136,947

Consumer real estate-mortgage
 
118,400

 
92,019

 
83,038

 
293,457

 
106,902

 
68,155

Construction and land development
 
63,082

 
34,891

 
37,436

 
135,409

 
42,898

 
29,429

Commercial and industrial
 
105,431

 
88,665

 
43,991

 
238,087

 
122,698

 
9,958

Consumer and other
 
6,481

 
6,170

 
666

 
13,317

 
5,416

 
1,420

Total Loans
 
$
466,997

 
$
481,151

 
$
375,111

 
$
1,323,258

 
$
610,352

 
$
245,909

 
Nonaccrual, Past Due, and Restructured Loans
 
Loans are considered past due when the contractual amounts due with respect to principal and interest are not received within 30 days of the contractual due date. Loans are generally classified as nonaccrual if they are past due for a period of 90 days or more, unless such loans are well secured and in the process of collection. If a loan or a portion of a loan is classified as doubtful or as partially charged off, the loan is generally classified as nonaccrual. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and interest is in doubt. Loans may be returned to accrual status when all principal and interest amounts contractually due are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment performance of interest and principal by the borrower in accordance with the contractual terms.

41





PCI loans with common risk characteristics are grouped in pools at acquisition. These loans are evaluated for accrual status at the pool level rather than the individual loan level and performance is based on our ability to reasonably estimate the amount and timing of future cash flows rather than a borrower's ability to repay contractual loan amounts. Since we are able to reasonably estimate the amount and timing of future cash flows on the Company's PCI loan pools, none of these loans have been identified as nonaccrual. However, PCI loans included in pools are identified as nonperforming if they are past due 90 days or more at acquisition or become 90 days or more past due after acquisition. The past due status is determined based on the contractual terms of the individual loans.
 
While a loan is classified as nonaccrual and the future collectability of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to the principal outstanding, except in the case of loans with scheduled amortizations where the payment is generally applied to the oldest payment due. When the future collectability of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan had been partially charged off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered.
 
Assets acquired as a result of foreclosure are recorded at estimated fair value in foreclosed assets. Any excess of cost over estimated fair value at the time of foreclosure is charged to the allowance for loan losses. Valuations are periodically performed on these properties, and any subsequent write-downs are charged to earnings. Routine maintenance and other holding costs are included in noninterest expense.
 
Loans, excluding pooled PCI loans, are classified as troubled debt restructurings (“TDR”) by the Company when certain modifications are made to the loan terms and concessions are granted to the borrowers due to financial difficulty experienced by those borrowers. The Company grants concessions by (1) reduction of the stated interest rate for the remaining original life of the debt or (2) extension of the maturity date at a stated interest rate lower than the current market rate for new debt with similar risk. The Company does not generally grant concessions through forgiveness of principal or accrued interest. The Company’s policy with respect to accrual of interest on loans restructured in a TDR follows relevant supervisory guidance. That is, if a borrower has demonstrated performance under the previous loan terms and shows capacity to perform under the restructured loan terms, continued accrual of interest at the restructured interest rate is likely. If a borrower was materially delinquent on payments prior to the restructuring but shows the capacity to meet the restructured loan terms, the loan will likely continue as nonaccrual until there is demonstrated performance under new terms. Lastly, if the borrower does not perform under the restructured terms, the loan is placed on non-accrual status. The Company closely monitors these loans and ceases accruing interest on them if we believe that the borrowers may not continue performing based on the restructured note terms.
 
PCI loans that were classified as TDRs prior to acquisition are not classified as TDRs by the Company after the acquisition date. Subsequent modification of a PCI loan accounted for in a pool that would otherwise meet the definition of a TDR is not reported, or accounted for, as a TDR since pooled PCI loans are excluded from the scope of TDR accounting. A PCI loan not accounted for in a pool would be reported, and accounted for, as a TDR if modified in a manner that meets the definition of a TDR after the acquisition date. 

Nonperforming loans as a percentage of gross loans, net of deferred fees, was 0.25 percent as of December 31, 2017, compared to 0.26 percent as of December 31, 2016. Total nonperforming assets as a percentage of total assets as of December 31, 2017 totaled 0.38 percent compared to 0.42 percent as of December 31, 2016. Acquired PCI loans that are included in loan pools are reclassified at acquisition to accrual status and thus are not included as nonperforming assets unless they are 90 days or greater past due. In 2017, there was $64 thousand in interest income recognized on nonaccrual and restructured loans compared to the $151 thousand in gross interest income that would have been recognized if the loans had been current in accordance with their original terms.
 
The following table summarizes the Company's nonperforming assets as of December 31 for the periods presented. 
(Dollars in thousands)
 
2017
 
2016
 
2015
 
2014
 
2013
Nonaccrual loans
 
$
1,764

 
$
1,415

 
$
2,252

 
$
5,067

 
$