SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K FOR ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1998 Commission File Number: 0-22345 Shore Bancshares, Inc. (Exact name of registrant as specified in its charter) Maryland 52-1974638 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 109 North Commerce Street Centreville, Maryland 21617 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including are code: (410) 758-1600 Securities registered under Section 12(b) of the Act: None Securities registered under Section 12(g) of the Act: Common Stock, Par Value $0.01 (Title of Class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes __x__ No ____ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. _____ The aggregate market value of Shore Bancshares, Inc. voting stock held by non-affiliates as of February 22, 1999 was $60,727,755, based on the sales price as of that date. As of February 22, 1999, Shore Bancshares, Inc. had 1,913,516 shares of Common Stock $.01 Par Value outstanding. DOCUMENTS INCORPORATED BY REFERENCE Parts I, II and IV: Portions of the Annual Shareholders Report for the year ended December 31, 1998 (the "Annual Report".) Part III: Portions of the definitive Proxy Statement for the Annual Meeting of Shareholders to be held on April 20, 1999 (the "Proxy Statement".) 1
PART I ITEM I BUSINESS GENERAL Shore Bancshares, Inc. (the "Company"), a Maryland corporation incorporated on March 15, 1996, became a registered bank holding company on July 1, 1996 under the Bank Holding Company Act of 1956, as amended. The Company engages in its business through its sole subsidiary, The Centreville National Bank of Maryland (the "Bank"), a national banking association. The Company acquired the Bank through the merger of the Bank into an interim national banking association formed as a Company subsidiary for the purpose of the merger, pursuant to a Plan of Reorganization and Agreement to Merge (the "Plan") proposed by Bank management and approved by the Bank's stockholders on April 16, 1996. Pursuant to the Plan, each outstanding share of Bank common stock was exchanged for two shares of the Company's common stock. The Bank's charter was not affected by the merger. Currently, the Company has issued and outstanding 1,913,516 shares of common stock, par value $0.01 per share ("Shares"), held by 1,102 holders of record on February 22, 1999. The Company's and the Bank's main office is located at 109 North Commerce Street, Centreville, Queen Anne's County, Maryland. The Bank has five full service branch offices located in Centreville, Chestertown, Stevensville and Hillsboro, Maryland. As of December 31, 1998, the Company had assets of approximately $181.1 million, net loans of approximately $109.8 million, and deposits of $153.3 million. Stockholders' equity has continued to grow over the last five years and has increased $2.6 million (13.3%) over the preceding five years. BANKING PRODUCTS AND SERVICES The Bank has been doing business in Maryland since 1876 and is engaged in both the commercial and consumer banking business. The Bank serves its customers through a network of five banking offices. The Bank provides a wide range of personal banking services designed to meet the needs of local consumers. Among the services provided are checking accounts, savings and time accounts, safe deposit boxes, and installment and other personal loans, especially residential mortgages, as well as home equity loans, automobile and other consumer financing. As a convenience to its customers, the Bank offers Saturday banking hours, drive-thru teller windows, "Direct Dial," a telephone banking service, debit cards, and 24-hour automated teller machines at all of its branch locations. The Bank is also engaged in the financing of commerce and industry by providing credit and deposit services for small to medium sized businesses and for the agricultural community in the Bank's market area. The Bank offers many forms of commercial lending, including lines of credit, revolving credit, term loans, accounts receivable financing, and commercial real estate mortgage lending and other forms of secured financing. A full range of commercial banking services is offered, including the acceptance of checking and savings deposits. Additional types of real estate loans, discount brokerage services, credit cards and related services are also offered through affiliates or correspondent banks. The Bank does not offer trust services and does not engage in municipal trading services. BANK SERVICE CORPORATIONS The Bank owns one-third of the outstanding common stock of two service corporations: The Delmarva Bank Data Processing Center, Inc. and The Eastern Shore Mortgage Corporation, both Maryland corporations. The Eastern Shore Mortgage Corporation, located in Easton, Maryland, was engaged in mortgage banking activities, including the origination of residential mortgage loans and the subsequent sale of the loans to permanent investors but is currently in the process of liquidation. Its primary customers were residents who live on Maryland's Eastern Shore. The Delmarva Bank Data Processing Center, Inc., also located in Easton, Maryland, provides data processing services to banks located in Maryland, Delaware, Virginia and the District of Columbia. 2
SEASONALITY The management of the Bank does not believe that the deposits or the business of the Bank in general are seasonal in nature. The deposits may, however, vary with local and national economic conditions but not enough to have a material effect on planning and policy making. EMPLOYEES As of December 31, 1998, the Company had no employees and the Bank employed 71 individuals, 11 of whom worked part-time. DEPOSITS No material portion of the Bank's deposits has been obtained from an individual or a few individuals (including federal, state and local governments and agencies) the loss of any one or more of which would have a materially adverse effect on the Bank, nor is a material portion of the Bank's loans concentrated within a single industry or group of related industries. On December 31, 1998, the Bank had approximately 14,000 deposit customers representing $153.3 million in deposits. COMMITMENTS As of the end of the last two fiscal years the Bank had the following commitments to lend: <TABLE> <CAPTION> % of % of 12/31/98 Total 12/31/97 Total -------- --------- -------- -------- (in thousands) (in thousands) <S><C> Standby Letters of Credit $1,377 7.33% $1,770 12.59% Commitments to Grant Loans 17,402 92.67 12,293 87.41 ------ ----- ------ ------ Total $18,779 100.00% $14,063 100.00% ------ ----- ------ ------ </TABLE> The above commitments are firm. The Bank expects approximately $6,000,000 of the commitments to lend described above to be funded within the current year. COMPETITION The Bank offers many personalized services and attracts customers by being responsive and sensitive to the needs of the community. The Bank relies on goodwill and referrals from satisfied customers as well as traditional media advertising to attract new customers. To enhance a positive image in the community, the Bank supports and participates in many local events. Employees, officers, and Directors represent the Bank on many boards and local civic and charitable organizations. The primary factors in competing for deposits are interest rates, personalized services, the quality and range of financial services, convenience of office locations and office hours. Competition for deposits comes primarily from other commercial banks, savings associations, credit unions, money market funds and other investment alternatives. The primary factors in competing for loans are interest rates, loan origination fees, the quality and range of lending services and personalized services. Competition for loans comes primarily from other commercial banks, savings associations, mortgage banking firms, credit unions and other financial intermediaries. 3
Recent changes in federal banking laws facilitate interstate branching and merger activity among banks. Since September 1995, certain bank holding companies are authorized to acquire banks throughout the United States. In addition, as of June 1, 1997, certain banks are permitted to merge with banks organized under the laws of different states. These changes have resulted in an even greater degree of competition in the banking industry and the Company and the Bank will continue to be brought into competition with institutions with which it does not presently compete. Regional and local banks dominate the banking industry in Centreville, Chestertown, Stevensville, and the Hillsboro areas where the Bank maintains offices. The Bank competes for deposits and loans with these institutions and with credit unions, savings institutions, insurance companies, and mortgage companies, as well as other companies that offer financial services. To attract new business and retain existing customers, the Bank offers a wide range of banking products and services and relies on local promotional activity, personal contact by its officers, staff, and Directors, referrals by current customers, extended banking hours, and personalized service. As of June 30, 1998, the most recent date for which comparative data is available, bank deposits in Queen Anne's County (where the Bank's main office, Centreville branch and Stevensville branch are located), Caroline County, Maryland (where the Bank's Hillsboro branch is located), and Kent County (where the Bank's Kent branch is located) ranked as follows: <TABLE> <CAPTION> % of Queen Anne's County Deposits Total -------- ----- (in thousands) <S><C> The Queenstown Bank of Maryland $131,464 35.39% THE CENTREVILLE NATIONAL BANK OF MARYLAND 116,600 31.39 The Chestertown Bank of Maryland 36,528 9.83 NationsBank, N.A. 33,941 9.14 The First National Bank of Maryland 21,530 5.80 Farmers Bank of Maryland 17,692 4.76 Annapolis National Bank 13,712 3.69 ------ ---- Total $371,467 100.00% -------- ------- SOURCE: FDIC DATA BOOK % of Caroline County Deposits Total -------- ----- (in thousands) The Peoples Bank of Maryland $76,830 30.74% Provident State Bank of Preston 62,440 24.98 The First National Bank of Maryland 38,709 15.49 Farmers Bank of Maryland 25,990 10.40 Atlantic Bank 17,320 6.93 NationsBank, N.A. 15,097 6.04 THE CENTREVILLE NATIONAL BANK OF MARYLAND 13,552 5.42 ------ ---- Total $249,938 100.00% -------- ------- SOURCE: FDIC DATA BOOK </TABLE> 4
<TABLE> <CAPTION> % of Kent County Deposits Total -------- ----- (in thousands) <S><C> The Chestertown Bank of Maryland $103,222 32.60% Peoples Bank of Kent County 100,078 31.60 The Chesapeake Bank and Trust Company 40,636 12.83 Farmers Bank of Maryland 32,704 10.33 Crestar Bank 21,331 6.74 THE CENTREVILLE NATIONAL BANK OF MARYLAND 18,683 5.90 ------ ---- Total $316,654 100.00% -------- ------- SOURCE: FDIC DATA BOOK </TABLE> SUPERVISION AND REGULATION GENERAL. The Company and the Bank are extensively regulated under federal and state law. Generally, these laws and regulations are intended to protect depositors, not stockholders. The following is a summary description of certain provisions of certain laws which affect the regulation of bank holding companies and banks. The discussion is qualified in its entirety by reference to applicable laws and regulations. Changes in such laws and regulations may have a material effect on the business and prospects of the Company and the Bank. FEDERAL BANK HOLDING COMPANY REGULATION AND STRUCTURE. The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended, and as such, it is subject to regulation, supervision, and examination by the Federal Reserve Board ("FRB"). The Company is required to file annual and quarterly reports with the FRB and to provide the FRB with such additional information as the FRB may require. The FRB may conduct examinations of the Company and its subsidiaries. With certain limited exceptions, the Company is required to obtain prior approval from the FRB before acquiring direct or indirect ownership or control of more than 5% of any voting securities or substantially all of the assets of a bank or bank holding company, or before merging or consolidating with another bank holding company. Additionally, with certain exceptions, any person proposing to acquire control through direct or indirect ownership of 25% or more of any voting securities of the Company is required to give 60 days' written notice of the acquisition to the FRB, which may prohibit the transaction, and to publish notice to the public. Generally, a bank holding company may not engage in any activities other than banking, managing or controlling its bank and other authorized subsidiaries, and providing services to these subsidiaries. With prior approval of the FRB, the Company may acquire more than 5% of the assets or outstanding shares of a company engaging in non-bank activities determined by the FRB to be closely related to the business of banking or of managing or controlling banks. The FRB provides expedited procedures for expansion into approved categories of non-bank activities. Subsidiary banks of a bank holding company are subject to certain quantitative and qualitative restrictions on extensions of credit to the bank holding company or its subsidiaries, on investments in their securities and on the use of their securities as collateral for loans to any borrower. These regulations and restrictions may limit the Company's ability to obtain funds from the Bank for its cash needs, including funds for the payment of dividends, interest and operating expenses. Further, subject to certain exceptions, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. For example, the Bank may not generally require a customer to obtain other services from itself or the Company, and may not require that a customer promise not to obtain other services from a competitor as a condition to and extension of credit to the customer. Under FRB policy, a bank holding company is expected to act as a source of financial strength to its subsidiary banks and to make capital injections into a troubled subsidiary bank, and the FRB may charge the bank holding company with engaging in unsafe and unsound practices for failure to commit resources to a subsidiary bank when required. A required capital injection may be called for at a time when the holding company does not have the resources to provide it. In addition, 5
depository institutions insured by the Federal Deposit Insurance Corporation ("FDIC") can be held liable for any losses incurred by, or reasonably anticipated to be incurred by, the FDIC in connection with the default of, or assistance provided to, a commonly controlled FDIC-insured depository institution. Accordingly, in the event that any insured subsidiary of the Company causes a loss to the FDIC, other insured subsidiaries of the Company could be required to compensate the FDIC by reimbursing it for the estimated amount of such loss. Such cross guaranty liabilities generally are superior in priority to the obligations of the depository institution to its stockholders due solely to their status as stockholders and obligations to other affiliates. FEDERAL BANK REGULATION. The Company's banking subsidiary is a federally-chartered national bank regulated by the Office of Comptroller of the Currency ("OCC"). The OCC may prohibit the institutions over which it has supervisory authority from engaging in activities or investments that the agency believes constitutes unsafe or unsound banking practices. Federal banking regulators have extensive enforcement authority over the institutions they regulate to prohibit or correct activities which violate law, regulation or a regulatory agreement or which are deemed to constitute unsafe or unsound practices. Enforcement actions may include the appointment of a conservator or receiver, the issuance of a cease and desist order, the termination of deposit insurance, the imposition of civil money penalties on the institution, its directors, officers, employees and institution-affiliated parties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the removal of or restrictions on directors, officers, employees and institution-affiliated parties, and the enforcement of any such mechanisms through restraining orders or other court actions. The Bank is subject to certain restrictions on extensions of credit to executive officers, directors, principal stockholders or any related interest of such persons which generally require that such credit extensions be made on substantially the same terms as are available to third persons dealing with the Bank and not involve more than the normal risk of repayment. Other laws tie the maximum amount which may be loaned to any one customer and its related interests to capital levels. Under the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), each federal banking agency is required to prescribe, by regulation, non-capital safety and soundness standards for institutions under its authority. The federal banking agencies, including the OCC, have adopted standards covering internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, and compensation, fees and benefits. An institution which fails to meet those standards may be required by the agency to develop a plan acceptable to the agency, specifying the steps that the institution will take to meet the standards. Failure to submit or implement such a plan may subject the institution to regulatory sanctions. The Company, on behalf of the Bank, believes that it meets substantially all standards which have been adopted. FDICIA also imposed new capital standards on insured depository institutions. See "Capital Requirements." Before establishing new branch offices, the Bank must meet certain minimum capital stock and surplus requirements and the Bank must obtain OCC approval. DEPOSIT INSURANCE. As a FDIC member institution, the Bank's deposits are insured to a maximum of $100,000 per depositor through the Bank Insurance Fund ("BIF"), administered by the FDIC, and each institution is required to pay semi-annual deposit insurance premium assessments to the FDIC. The BIF assessment rates have a range of 0 cents to 27 cents for every $100 in assessable deposits. The federal Economic Growth and Regulatory Paperwork Reduction Act of 1996 (the "1996 Act"), included provisions that, among other things, recapitalized the Savings Association Insurance Fund ("SAIF") through a special assessment on savings association deposits and bank deposits that had been acquired from savings associations. As a result of the April 1997 merger of Kent Savings and Loan Association, F.A. into the Bank, approximately $21.8 million of the Bank's deposits are assessed at SAIF rates. The SAIF assessment rates are determined quarterly and the SAIF is also administered by the FDIC. CAPITAL REQUIREMENTS. The federal banking regulators have adopted certain risk-based capital guidelines to assist in the assessment of the capital adequacy of a banking organization's operations for both transactions reported on the balance sheet as assets and transactions, such as letters of credit, and recourse arrangements, which are recorded as off balance sheet items. Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain U.S. Treasury securities, to 100% for assets with relatively high credit risk, such as business loans. 6
A banking organization's risk-based capital ratios are obtained by dividing its qualifying capital by its total risk adjusted assets. The regulators measure risk-adjusted assets, which include off balance sheet items, against both total qualifying capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and Tier 1 capital. "Tier 1," or core capital, includes common equity, perpetual preferred stock (excluding auction rate issues) and minority interest in equity accounts of consolidated subsidiaries, less goodwill and other intangibles, subject to certain exceptions. "Tier 2," or supplementary capital, includes, among other things, limited-life preferred stock, hybrid capital instruments, mandatory convertible securities, qualifying subordinated debt, and the allowance for loan and lease losses, subject to certain limitations and less required deductions. The inclusion of elements of Tier 2 capital is subject to certain other requirements and limitations of the federal banking agencies. Banks and bank holding companies subject to the risk-based capital guidelines are required to maintain a ratio of Tier 1 capital to risk-weighted assets of at least 4% and a ratio of total capital to risk-weighted assets of at least 8%. The appropriate regulatory authority may set higher capital requirements when particular circumstances warrant. Institutions which meet or exceed a Tier 1 ratio of 6% and a total capital ratio of 10% are considered well capitalized. As of December 31, 1998, the Bank's ratio of Tier 1 to risk-weighted assets stood at 19.95% and its ratio of total capital to risk-weighted assets stood at 21.20%. In addition to risk-based capital, banks and bank holding companies are required to maintain a minimum amount of Tier 1 capital to total assets, referred to as the leverage capital ratio, of at least 3% or 5% to be considered well capitalized. As of December 31, 1998, the Bank's leverage capital ratio was 11.04%. In August, 1995 and May, 1996, the federal banking agencies adopted final regulations specifying that the agencies will include, in their evaluations of a bank's capital adequacy, an assessment of the Bank's interest rate risk ("IRR") exposure. The standards for measuring the adequacy and effectiveness of a banking organization's interest rate risk management includes a measurement of board of director and senior management oversight, and a determination of whether a banking organization's procedures for comprehensive risk management are appropriate to the circumstances of the specific banking organization. The Bank has internal IRR models that are used to measure and monitor IRR. Additionally, the regulatory agencies have been assessing IRR on an informal basis for several years. For these reasons, the Company does not expect the addition of IRR evaluation to the agencies' capital guidelines to result in significant changes in capital requirements for the Bank. Failure to meet applicable capital guidelines could subject a banking organization to a variety of enforcement actions, including limitations on its ability to pay dividends, the issuance by the applicable regulatory authority of a capital directive to increase capital and, in the case of depository institutions, the termination of deposit insurance by the FDIC, as well as to the measures described under "--Federal Deposit Insurance Corporation Improvement Act of 1991" below, as applicable to undercapitalized institutions. In addition, future changes in regulations or practices could further reduce the amount of capital recognized for purposes of capital adequacy. Such a change could affect the ability of the Bank to grow and could restrict the amount of profits, if any, available for the payment of dividends to the Company. FEDERAL DEPOSIT INSURANCE CORPORATION IMPROVEMENT ACT OF 1991. In December, 1991, Congress enacted the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), which substantially revised the bank regulatory and funding provisions of the Federal Deposit Insurance Act and made significant revisions to several other federal banking statutes. FDICIA provides for, among other things, (i) publicly available annual financial condition and management reports for financial institutions, including audits by independent accountants, (ii) the establishment of uniform accounting standards by federal banking agencies, (iii) the establishment of a "prompt corrective action" system of regulatory supervision and intervention, based on capitalization levels, with more scrutiny and restrictions placed on depository institutions with lower levels of capital, (iv) additional grounds for the appointment of a conservator or receiver, and (v) restrictions or prohibitions on accepting brokered deposits, except for institutions which significantly exceed minimum capital requirements. FDICIA also provides for increased funding of the FDIC insurance funds and the implementation of risked-based premiums. See "Deposit Insurance." A central feature of FDICIA is the requirement that the federal banking agencies take "prompt corrective action" with respect to depository institutions that do not meet minimum capital requirements. Pursuant to FDICIA, the federal bank regulatory authorities have adopted regulations setting forth a five-tiered system for measuring the capital adequacy of the depository institutions that they supervise. Under these regulations, a depository institution is classified in one of the following capital categories: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." The Bank is currently classified as "well-capitalized." An institution may be deemed by the regulators to be in a capitalization category that is lower than is indicated by its actual capital position if, among other things, it receives an unsatisfactory examination rating with respect to asset quality, management, earnings or liquidity. 7
FDICIA generally prohibits a depository institution from making any capital distribution (including payment of a cash dividend) or paying any management fees to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to growth limitations and are required to submit capital restoration plans. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. Significantly undercapitalized depository institutions may be subject to a number of other requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and stop accepting deposits from correspondent banks. Critically undercapitalized institutions are subject to the appointment of a receiver or conservator, generally within 90 days of the date such institution is determined to be critically undercapitalized. FDICIA provides the federal banking agencies with significantly expanded powers to take enforcement action against institutions which fail to comply with capital or other standards. Such action may include the termination of deposit insurance by the FDIC or the appointment of a receiver or conservator for the institution. FDICIA also limits the circumstances under which the FDIC is permitted to provide financial assistance to an insured institution before appointment of a conservator or receiver. INTERSTATE BANKING LEGISLATION. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 was enacted into law on September 29, 1994. The law provides that, among other things, substantially all state law barriers to the acquisition of banks by out-of-state bank holding companies were eliminated effective on September 29, 1995. The law also permits interstate branching by banks effective as of June 1, 1997, subject to the ability of states to opt-out completely or to set an earlier effective date. Maryland generally established an earlier effective date of September 29, 1995. MONETARY POLICY. The earnings of a bank holding company are affected by the policies of regulatory authorities, including the FRB, in connection with the FRB's regulation of the money supply. Various methods employed by the FRB are open market operations in United States Government securities, changes in the discount rate on member bank borrowing and changes in reserve requirements against member bank deposits. These methods used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may also affect interest rates charged on loans or paid on deposits. The money policies of the FRB have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. RISK FACTORS REGULATORY RISKS. The banking industry is subject to many laws and regulations. Regulations protect depositors, not stockholders. The Office of the Comptroller of the Currency and the Board of Governors of the Federal Reserve System regulate the Company and the Bank. Regulations and laws increase the Company's operating expenses, affect the Company's earnings, and may put the Company at a disadvantage with less regulated competitors, such as finance companies, mortgage banking companies, credit unions, and leasing companies. EXPOSURE TO LOCAL ECONOMIC CONDITIONS. Most of the loans made by the Bank are made to local borrowers. A decline in local economic conditions would affect the Company's earnings. CREDIT RISKS AND INADEQUACY OF LOAN LOSS RESERVE. When borrowers default and do not repay the loans made to them by the Bank, the Company loses money. Experience shows that some borrowers either will not pay on time or will not pay at all. In these cases, the Bank will cancel, or "write off," the defaulted loan or loans. A "write off" reduces the Company's assets and affects the Company's earnings. The Company anticipates losses by reserving what it believes to be an adequate cushion so that it does not have to take a large loss at any one time. However, actual loan losses cannot be predicted, and the Company's loan loss reserve may not be sufficient. INTEREST RATE RISK. The Company's earnings depend greatly on its net interest income, the difference between the interest earned on loans and investments and the interest paid on deposits. If the interest rate paid on deposits is high and the interest rate earned on loans and investments is low, net interest income is small and the Company earns less. Because interest rates are influenced by competition, the Company cannot completely control its net interest income. RISKS ASSOCIATED WITH REAL ESTATE LENDING. The Bank makes real estate secured loans. Real estate loans are in greater demand when interest rates are low and economic conditions are good. Even when economic conditions are good and interest rates are low, these conditions may not continue. The Company may lose money if the borrower does not pay a real estate loan. If real estate values decrease, then the Company may lose more money when borrowers default. NO ASSURANCE OF GROWTH. The Company's ability to increase assets and earnings depends upon many factors, including competition for deposits and loans, the Company's branch and office locations, avoidance of credit losses, and hiring and training of personnel. Some of these factors are beyond the Company's control. 8
COMPETITION. Other banks and non-banks, including savings and loan associations, credit unions, insurance companies, leasing companies, small loan companies, finance companies, and mortgage companies, compete with the Company. Some of the Company's competitors offer services and products that the Company does not offer. Larger banks and non-bank lenders can make larger loans and service larger customers. Law changes now permit interstate banks, which may increase competition. Increased competition may decrease the Company's earnings. NO ASSURANCE OF CASH OR STOCK DIVIDENDS. Whether dividends may be paid to stockholders depends on the Company's earnings, its capital needs, law and regulations, and other factors. The Company's payment of dividends in the past does not mean that the Company will be able to pay dividends in the future. STOCK NOT INSURED. Investments in the shares of the Company's common stock are not deposits that are insured against loss by the government. RISK INVOLVED IN ACQUISITIONS. Part of the Company's growth may come from buying other banks and companies. A newly purchased bank or company may not be profitable after the Company buys it and may lose money, particularly at first. The new bank or company may bring with it unexpected liabilities or bad loans, bad employee relations, or the new bank or company may lose customers. RISK OF CLAIMS. Customers may sue the Company for losses due to the Company's alleged breach of fiduciary duties, errors and omissions of employees, officers and agents, incomplete documentation, the Company's failure to comply with applicable laws and regulations, or many other reasons. Also, employees of the Company conduct all of the Company's business. The employees may knowingly or unknowingly violate laws and regulations. Company management may not be aware of any violations until after their occurrence. This lack of knowledge will not insulate the Company from liability. Claims and legal actions may result in legal expenses and liabilities that may reduce the Company's profitability and hurt its financial condition. DEVELOPMENTS IN TECHNOLOGY. Financial services use technology, including telecommunications, data processing, computers, automation, Internet-based banking, debit cards, and "smart" cards. Technology changes rapidly. The Company's ability to compete successfully with other banks and non-banks may depend on whether it can exploit technological changes. The Company may not be able to exploit technological changes and expensive new technology may not make the Company more profitable. YEAR 2000. The "Year 2000 Issue" describes the problems that may result from the improper processing of dates and date-sensitive calculations beginning in the Year 2000. Many existing computer programs use only two digits to identify the year in the date field of a program. These programs could experience serious malfunctions when the last two digits of the year change to "00" as a result of identifying a year designated "00" as the Year 1900 rather than the Year 2000. A system failure or other disruptions of operations could occur if the Company's computer programs and other equipment identify a year designated "00" as the Year 1900 rather than the Year 2000. The Company cannot be certain that its computer programs and other equipment, and the computer programs and other equipment of its customers, vendors, suppliers and even the government will be Year 2000 compliant. Any systems failure, disruption, or other losses could affect the Company's earnings. MARKET FOR COMMON STOCK. The Company's shares of common stock are not listed on any exchange, and there is currently no organized trading market. Prices for the Company's common stock may not be the actual value or the trading price in a liquid trading market. ANTI-TAKEOVER EFFECTS OF CERTAIN CHARTER AND BYLAW PROVISIONS. The Company's Articles of Incorporation and Bylaws divide the Company's Board of Directors into three classes and each class serves for a staggered three-year term. No director may be removed except for cause and then only by a vote of at least two-thirds of the total eligible stockholder votes. In addition, Maryland law contains anti-takeover provisions that apply to the Company. These provisions may discourage or make it more difficult for another company to buy the Company or may reduce the market price of the Company's common stock. 9
STATISTICAL INFORMATION: The following supplementary information required under Guide 3 for the respective periods and at the indicated respective dates is set forth on the pages indicated below. The information should be read in conjunction with the related Consolidated Financial Statements and Notes thereto for the year ended December 31, 1998. Table of Contents: Page Investment Securities Portfolio Analysis 10 Summary of Loan Portfolio 11 Maturities of Loan Portfolio 11 Risk Elements of Loan Portfolio 11 Analysis of the Allowance for Credit Losses 12 Allocation of the Allowance for Credit Losses 12 Maturity of Time Certificates of Deposit $100,000 or More 13 Summary of Significant Ratios 13 Other statistical information required in this Item 1 is incorporated by reference from the information appearing in the Company's Annual Report to Stockholders as follows: <TABLE> <CAPTION> Disclosure Required by Guide 3 Reference to the 1998 Annual Report - ------------------------------ ----------------------------------- <S><C> (I) Distribution of Assets, Liabilities, and Stockholders' Average Balances, Yields and Rates (page 40) Equity: Interest Rates and Interest Differential Rate and Volume Variance Analysis (page 41) (II) Investment Portfolio Notes to Financial Statements - Investment Securities (pages 23 and 24) (III) Loan Portfolio Management's Discussion and Analysis of Financial Condition and Results of Operations "Loan Portfolio" (page 9) (V) Deposits Average Balances, Yields and Rates (page 40) Rate and Volume Variance Analysis (page 41) (VI) Return on Equity and Assets Selected Financial Data (page 1) </TABLE> Investment Securities Portfolio Analysis December 31, 1998 (In Thousands) <TABLE> <CAPTION> AVAILABLE FOR SALE ================================================================================ U.S. Treasury U.S. Govt. Agencies Amortized Avg.T.E. Amortized Avg.T.E. Description & Term Cost Yield Cost Yield - ------------------ ====================================== =============================== <S><C> 0 - 3 Months $1,000 6.35% $0 N/A 3 - 6 Months 500 7.05 0 N/A 6 - 12 Months 0 N/A 0 N/A 1 - 3 Years 3,485 6.55 4,524 6.04% 3 - 4 Years 0 N/A 5,000 6.33 4 - 5 Years 0 N/A 2,500 6.46 5 - 10 Years 0 N/A 4,076 6.86 10 - 30 Years 0 N/A 114 7.67 ====================================== =============================== Total $4,985 6.56% $16,214 7.38% ====================================== =============================== HELD TO MATURITY ================================================================================ U.S. Govt. Agencies Municipals Amortized Avg.T.E. Amortized Avg.T.E. Description & Term Cost Yield Cost Yield - ------------------ =========================================== ==================================== 0 - 3 Months $0 N/A $765 6.78% 3 - 6 Months 0 N/A 290 9.73 6 - 12 Months 0 N/A 567 8.19 1 - 3 Years 2,496 6.28% 494 6.99 3 - 4 Years 4,497 6.62 0 N/A 4 - 5 Years 2,495 6.50 343 6.80 5 - 10 Years 5,014 7.38 3,914 7.11 10 - 30 Years 0 N/A 0 N/A ==================================== ===================================== Total $14,502 6.23% $6,373 7.26% ==================================== ===================================== </TABLE> <TABLE> <CAPTION> ======================== AVAILABLE FOR SALE ============== ===================== Securities Mutual Fund Other Securities Amortized Avg.T.E. Book Avg.T.E. Total Description & Term Cost Yield Value Yield Value - ------------------ ============ ========== ============================ ==================== <S><C> 0 - 3 Months $0 N/A $0 N/A $1,000 3 - 6 Months 0 N/A 0 N/A 500 6 - 12 Months 0 N/A 0 N/A 0 1 - 3 Years 0 N/A 0 N/A 8,009 3 - 4 Years 0 N/A 0 N/A 5,000 4 - 5 Years 0 N/A 0 N/A 2,500 5 - 10 Years 0 N/A 0 N/A 4,076 10 - 30 Years 1,010 6.79% 1,068 7.02% 2,192 ========== ========== ============================ ==================== Total $1,010 6.79% $1,068 7.02% $23,277 ========== ========== ============================ ==================== Municipals - In State Amortized Avg.T.E. HELD TO MATURITY Cost Yield Total Description & Term Value - ------------------ ============================================= =========== $300 7.58% $1,065 0 - 3 Months 0 N/A 290 3 - 6 Months 0 N/A 567 6 - 12 Months 793 7.07 3,783 1 - 3 Years 917 7.66 5,414 3 - 4 Years 599 7.20 3,437 4 - 5 Years 270 9.78 9,198 5 - 10 Years 161 6.59 161 10 - 30 Years ============================================= =========== Total $3,040 7.54% $23,915 ============================================= =========== </TABLE> The above yields have been adjusted to reflect a tax equivalent basis assuming a federal tax rate of 34% and a state tax rate of 7%. Tax equivalent yields have been weighted by settled par amount and are calculated using amortized cost. 10
Summary of Loan Portfolio (In Thousands) <TABLE> <CAPTION> Loans Outstanding as of December 31, ------------------------------------ 1998 1997 ---- ---- Amount Amount ------ ------ <S><C> Real Estate: Construction and land development $4,488 $2,946 Commercial 14,459 12,973 Residential 76,483 78,273 Commercial 8,448 8,353 Consumer installment 7,318 6,622 ----- ----- TOTAL $111,196 $109,167 ======== ======== </TABLE> Maturities of Loan Portfolio December 31, 1998 (In Thousands) <TABLE> <CAPTION> Maturing Maturing After One Maturing Within But Within After Five One Year Five Years Years Total ------------------------------------------------------------ <S><C> Real estate - Construction and land development $ 4,370 $ 118 $ - $ 4,488 Commercial 4,096 3,157 1,195 8,448 ----------------------------------------------------------- TOTAL $ 8,466 $ 3,275 $ 1,195 $ 12,936 ============================================================ </TABLE> Classified by Sensitivities of Loans to Changes in Interest Rates <TABLE> <S><C> Real estate - Construction and land development Fixed - Interest Rate Loans $ 2,555 $ 118 $ - $ 2,673 Adjustable - Interest Rate Loans 1,815 - - 1,815 ==================================================================== TOTAL $ 4,370 $ 118 $ - $ 4,488 ==================================================================== Commercial Fixed - Interest Rate Loans $ 2,041 $ 2,432 $ 1,022 $ 5,495 Adjustable - Interest Rate Loans 2,055 725 173 2,953 ==================================================================== TOTAL $ 4,096 $ 3,157 $ 1,195 $ 8,448 ==================================================================== </TABLE> Risk Elements of Loan Portfolio (In Thousands) <TABLE> <CAPTION> December 31, 1998 1997 ---- ---- <S><C> Non-accrual loans $55 $199 Accruing loans past due 90 Days or more 765 251 Restructured loans 872 209 Information with respect to non-accrual loans and restructured loans at December 31, 1998: Interest income that would have been recorded under original terms 74 Interest income recorded during the period 72 </TABLE> At December 31, 1998 the Company had $2.8 million in loans on the watch list for which payments were current, but the borrowers have the potential for experiencing financial difficulties. These loans are subject to on going management attention and their classifications are reviewed regularly. 11
Analysis of the Allowance for Credit Losses (In Thousands) <TABLE> <CAPTION> For the Years Ended December 31, 1998 1997 ---- ---- <S><C> Balance at beginning of period $1,404 $1,503 Charge-offs: Real Estate: Construction and land development 0 0 Commercial 0 0 Residential 14 22 Commercial 0 37 Consumer installment 90 99 -- -- 104 158 --- --- Recoveries: Real Estate: Construction and land development 0 0 Commercial 0 0 Residential 0 0 Commercial 26 4 Consumer installment 23 40 -- -- 49 44 -- -- Net charge-offs (recoveries) 55 114 Provision for credit losses 0 0 Allowance acquired 0 15 - -- Balance at end of period $1,349 $1,503 ====== ====== Average daily balance of loans $108,180 $103,742 Ratio of net charge-offs to average loans outstanding 0.05% 0.11% </TABLE> Allocation of the Allowance for Credit Losses (In Thousands) <TABLE> <CAPTION> Percent of loans Percent of loans December 31, in each category December 31, in each category 1998 to total loans 1997 to total loans ------------------------------------------------------------------------------------ <S><C> Real Estate: Construction and land development $56 4.04% $38 2.70% Commercial 578 13.00% 518 11.88% Residential 46 68.78% 47 71.70% Commercial 180 7.60% 194 7.65% Consumer 148 6.58% 112 6.07% Unallocated 341 N/A 495 N/A ------------------------------------------------------------------------------------ TOTAL $1,349 100.00% $1,404 100.00% ==================================================================================== </TABLE> 12
Maturity of Time Certificates of Deposit $100,000 or More (In Thousands) <TABLE> <CAPTION> December 31, December 31, 1998 1997 ---- ---- <S><C> Three months or less $1,192 $2,360 Three months through six months 1,810 2,245 Six months through twelve months 3,839 3,368 Over twelve months 8,516 5,501 ----- ----- TOTAL $15,357 $13,474 ======= ======= </TABLE> Summary of Significant Ratios <TABLE> <CAPTION> 1998 1997 ---- ---- <S><C> Return on average total assets 1.25% 1.43% Return on average total equity 9.52% 10.40% Dividend payout ratio 45.54% 41.28% Total average equity to total average assets ratio 13.17% 13.75% </TABLE> ITEM 2 PROPERTIES The Bank owns real property at the location of its main office at 109 North Commerce Street, Centreville, Maryland 21617, and at its four branch locations at 2609 Centreville Road, Centreville, Maryland 21617 ("Route 213 South Branch Office"), 408 Thompson Creek Road, Stevensville, Maryland 21666 ("Stevensville Branch Office"), at 21913 Shore Highway, Hillsboro, Maryland 21614 ("Hillsboro Branch Office") and 305 East High Street, Chestertown, Maryland ("Kent Branch Office".) There are no encumbrances on any of these properties. The Company owns no real property. ITEM 3 LEGAL PROCEEDINGS There are no material pending legal proceedings other than ordinary routine litigation incidental to the business to which the Company, the Bank, or its subsidiaries is a party or of which any of their properties is subject. Management is not aware of any material proceedings to which any Director, officer, or affiliate of the Company, any person holding beneficially in excess of five (5) percent of the Company's shares of common stock, or any associate of any such Director, officer, or securing holder is a party. ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted during the fourth quarter of 1998 to a vote of security holders, through the solicitation of proxies. PART II ITEM 5 MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS The sections entitled "Market Price of and Dividends on Registrant's Common Equity and Related Stockholder Matters" and "Market Information" on page 39 of the Annual Report is incorporated by reference herein. For information regarding regulatory restrictions on the Bank's and, therefore, the Company's payment of dividends, see Note 16 "Regulatory Matters" on page 35 of the Annual Report, which is incorporated by reference herein. ITEM 6 SELECTED FINANCIAL DATA The table entitled "Selected Financial Data" on page 1 of the Annual Report is incorporated by reference herein. Reference is also made to the information described in Part I, Item 1 of this Form 10K under the heading "Statistical Information." 13
ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Pages 5 through 15 of the Annual Report are incorporated by reference herein. ITEM 7A QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK For information regarding the market risk of the Company's financial instruments, see "Management Discussion and Analysis of Financial Condition and Results of Operations - Market Risk Management" on page 11 of the Annual Report and incorporated by reference herein. The Company's principal market risk exposure is to interest rates. ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Pages 16 through 38 of the Annual Report are incorporated by reference herein. ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE The Board of Directors of the Company, upon recommendation of the Bank's Audit/Compliance Committee, proposed and recommended the election of Stegman & Company as independent certified public accountants to make an examination of the accounts of the Company and the Bank for the year ending December 31, 1998. Stegman and Company served as the Company's and the Bank's independent public auditor for 1996 and 1997. There were no disagreements with Stegman and Company on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedures. PART III ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Incorporated by reference in the section entitled "Election of Directors" on pages 2 - 4 and section entitled "Executive Officers" on page 7 in the Proxy Statement as filed with the Securities and Exchange Commission March 24, 1999. ITEM 11 EXECUTIVE COMPENSATION Incorporated by reference in the sections entitled "Executive Compensation" on pages 7-8, "Bank's Board of Directors' Executive Compensation Committee Report" on pages 6-7, "Performance Graph" on page 8 and the discussion regarding director compensation on pages 5-6, in the Proxy Statement as filed with the Securities and Exchange Commission March 24, 1999. 14
ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference in the section entitled "Beneficial Ownership of Common Stock" on pages 1 and 2 in the Proxy Statement as filed with the Securities and Exchange Commission March 24, 1999. ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated by reference in the section entitled "Election of Directors" on page 2 in the Proxy Statement as filed with the Securities and Exchange Commission March 24, 1999. PART IV ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1), (2) Financial Statements The following consolidated financial statements included in the Annual Report to Shareholders for the year ended December 31, 1998, are incorporated herein by reference in Item 8 of this Report. The following financial statements are filed as a part of this report: Consolidated Balance Sheets at December 31, 1998 and 1997 Consolidated Statements of Income for the years ended December 31, 1998, 1997 and 1996 Consolidated Statements of Cash Flows for the years ended December 31, 1998, 1997 and 1996 Consolidated Statements of Stockholders' Equity for the years ended December 31, 1998, 1997 and 1996 Notes to the Consolidated Financial Statements Independent Auditors' Report All financial statement schedules have been omitted as the required information is either inapplicable or included in the consolidated financial statements or related notes. (a) (3) Exhibits required to be filed by Item 601 of Regulation S-K EXHIBIT INDEX (3) Charter and Bylaws (3.1) Articles of Amendment and Restatement of the Company are incorporated by reference from the Company's June 30, 1998 Form 10-Q, filed with the Commission on August 13, 1998. 15
(3.2) Bylaws of the Company as amended and restated are incorporated by reference from the Company's June 30, 1998 Form 10-Q, filed with the Commission on August 13, 1998. (10.1) 1998 Employee Stock Purchase Plan is incorporated by reference from the Company's Registration Statement on Form S-8 filed with the Commission on September 25, 1998 (Registration No. 333-64317). (10.2) 1998 Stock Option Plan is incorporated by reference from the Company's Registration Statement on Form S-8 filed with the Commission on September 25, 1998 (Registration No. 333-64319). (13) 1998 Annual Report filed herewith. (21) List of Subsidiaries is incorporated by reference from the Company's Form 10, filed with the Commission on April 3, 1997, and Form 10/A, filed with the Commission on May 30, 1997 (Registration No. 0-22523) (23) Consent of Independent Auditors filed herewith. (27) Financial Data Schedule is filed electronically herewith via EDGAR. (b) Reports on Form 8-K None (c) Exhibits to Item 601 to Regulation S-K See the Exhibits described in Item 14(a)(3) above. 16
SIGNATURES Pursuant to the requirements in Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf on March 17, 1998 by the undersigned, thereunto duly authorized. SHORE BANCSHARES, INC. /s/ Daniel T. Cannon ____________________ Daniel T. Cannon President /s/ Carol I. Brownawell _______________________ Carol I. Brownawell Treasurer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 16, 1999. /s/ J. Robert Barton Director ___________________________ J. Robert Barton /s/ Paul M. Bowman Director ___________________________ Paul M. Bowman /s/ David C. Bryan Director ___________________________ David C. Bryan /s/ Daniel T. Cannon Director ___________________________ Daniel T. Cannon Director ___________________________ B. Vance Carmean, Jr. /s/ Mark M. Freestate Director ___________________________ Mark M. Freestate /s/ Thomas K. Helfenbien Director ___________________________ Thomas K. Helfenbein /s/ Neil R. LeCompte Director ___________________________ Neil R. LeCompte Director ___________________________ Susanne K. Nuttle /s/ Jerry F. Pierson Director ___________________________ Jerry F. Pierson /s/ Wm. Maurice Sanger Director ___________________________ Wm. Maurice Sanger Director ___________________________ Walter E. Schmidt 17