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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

☒			QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2020

or

☐			TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission file number: 001-34292

ORRSTOWN FINANCIAL SERVICES, INC.

(Exact Name of Registrant as Specified in its Charter)

Pennsylvania

23-2530374

(State or Other Jurisdiction of Incorporation or Organization)

(I.R.S. Employer Identification No.)

77 East King Street

P. O. Box 250

Shippensburg

Pennsylvania

17257

(Address of Principal Executive Offices)

(Zip Code)

Registrant’s Telephone Number, Including Area Code:

(717)

532-6114

 

Securities registered pursuant to Section 12(b) of the Act:

Title of each class

Trading symbol(s)

Name of each exchange on which registered

Common Stock, no par value

ORRF

Nasdaq Stock Market

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 whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.

Large accelerated filer

¨

Accelerated filer

☒

Non-accelerated filer

¨

Smaller reporting company

☒

Emerging growth company

☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.

o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act.).    Yes  ☐    No  x

Number of shares outstanding of the registrant’s Common Stock as of July 30, 2020: 11,209,146.

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ORRSTOWN FINANCIAL SERVICES, INC.

INDEX

 

						Page
Part I – FINANCIAL INFORMATION
			Glossary			3
Item 1.			Financial Statements			4
			Consolidated Balance Sheets (Unaudited)			4
			Consolidated Statements of Income (Unaudited)			5
			Consolidated Statements of Comprehensive Income (Unaudited)			6
			Consolidated Statements of Changes in Shareholders’ Equity (Unaudited)			7
			Consolidated Statements of Cash Flows (Unaudited)			9
			Notes to Consolidated Financial Statements (Unaudited)			11
Item 2			Management’s Discussion and Analysis of Financial Condition and Results of Operations			51
Item 3.			Quantitative and Qualitative Disclosures About Market Risk			75
Item 4.			Controls and Procedures			76
PART II – OTHER INFORMATION
Item 1.			Legal Proceedings			77
Item 1A.			Risk Factors			77
Item 2.			Unregistered Sales of Equity Securities and Use of Proceeds			77
Item 3.			Defaults upon Senior Securities			77
Item 4.			Mine Safety Disclosures			77
Item 5.			Other Information			77
Item 6.			Exhibits			78
SIGNATURES									79

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Glossary of Defined Terms

The following terms may be used throughout this Report, including the unaudited condensed consolidated financial statements and related notes.

Term			Definition
ALL			Allowance for loan losses
AFS			Available for sale
AOCI			Accumulated other comprehensive income (loss)
ASC			Accounting Standards Codification
ASU			Accounting Standards Update
Bank			Orrstown Bank, the commercial banking subsidiary of Orrstown Financial Services, Inc.
CDI			Core deposit intangible
CET1			Common Equity Tier 1
CMO			Collateralized mortgage obligation
Company			Orrstown Financial Services, Inc. and subsidiaries (interchangeable with "Orrstown” below)
EPS			Earnings per common share
ERM			Enterprise risk management
Exchange Act			Securities Exchange Act of 1934, as amended
FASB			Financial Accounting Standards Board
FDIC			Federal Deposit Insurance Corporation
FHLB			Federal Home Loan Bank
FRB			Board of Governors of the Federal Reserve System
GAAP			Accounting principles generally accepted in the United States of America
GSE			U.S. government-sponsored enterprise
Hamilton			Hamilton Bancorp, Inc., and its wholly-owned banking subsidiary, Hamilton Bank
IRC			Internal Revenue Code of 1986, as amended
LHFS			Loans held for sale
MBS			Mortgage-backed securities
MPF Program			Mortgage Partnership Finance Program
MSR			Mortgage servicing right
NIM			Net interest margin
OCI			Other comprehensive income
OREO			Other real estate owned
Orrstown			Orrstown Financial Services, Inc. and subsidiaries
OTTI			Other-than-temporary impairment
2011 Plan			2011 Orrstown Financial Services, Inc. Incentive Stock Plan
PCI loans			Purchased credit impaired loans
Repurchase Agreements			Securities sold under agreements to repurchase
ROU			Right of use (leases)
SBA			U.S. Small Business Administration
SEC			Securities and Exchange Commission
Securities Act			Securities Act of 1933, as amended
TDR			Troubled debt restructuring
Wheatland			Wheatland Advisors, Inc., the Registered Investment Advisor subsidiary of Orrstown Financial Services, Inc.
Unless the context otherwise requires, the terms “Orrstown,” “we,” “us,” “our,” and “Company” refer to Orrstown Financial Services, Inc. and its subsidiaries.

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PART I – FINANCIAL INFORMATION

 

Item 1.  Financial Statements

Condensed Consolidated Balance Sheets (Unaudited)

ORRSTOWN FINANCIAL SERVICES, INC.

(Dollars in thousands, except per share amounts)			June 30, 2020						December 31, 2019
Assets
Cash and due from banks			$	26,652					$	25,969
Interest-bearing deposits with banks			25,638						29,994
Cash and cash equivalents			52,290						55,963
Restricted investments in bank stocks			16,256						16,184
Securities available for sale (amortized cost of $488,433 and $491,492 at June 30, 2020 and December 31, 2019, respectively)			483,936						490,885
Loans held for sale, at fair value			13,594						9,364
Loans			2,041,317						1,644,330
Less: Allowance for loan losses			(17,517)						(14,655)
Net loans			2,023,800						1,629,675
Premises and equipment, net			36,976						37,524
Cash surrender value of life insurance			64,411						63,613
Goodwill			18,724						19,925
Other intangible assets, net			6,160						7,180
Accrued interest receivable			8,182						6,040
Other assets			48,467						46,921
Total assets			$	2,772,796					$	2,383,274
Liabilities
Deposits:
Noninterest-bearing			$	436,290					$	249,450
Interest-bearing			1,815,441						1,626,072
Total deposits			2,251,731						1,875,522
Securities sold under agreements to repurchase			23,716						8,269
FHLB advances and other			202,804						209,667
Subordinated notes			31,875						31,847
Other liabilities			37,032						34,720
Total liabilities			2,547,158						2,160,025
Commitments and contingencies
Shareholders’ Equity
Preferred stock, $1.25 par value per share; 500,000 shares authorized; no shares issued or outstanding			—						—
Common stock, no par value—$0.05205 stated value per share 50,000,000 shares authorized; 11,268,429 shares issued and 11,209,146 outstanding at June 30, 2020; 11,220,604 shares issued and 11,199,874 outstanding at December 31, 2019			586						584
Additional paid - in capital			188,226						188,365
Retained earnings			42,862						35,246
Accumulated other comprehensive loss			(5,114)						(480)
Treasury stock— 59,283 and 20,730 shares, at cost at June 30, 2020 and December 31, 2019, respectively			(922)						(466)
Total shareholders’ equity			225,638						223,249
Total liabilities and shareholders’ equity			$	2,772,796					$	2,383,274

The Notes to Unaudited Condensed Consolidated Financial Statements are an integral part of these statements.

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Condensed Consolidated Statements of Income (Unaudited)

ORRSTOWN FINANCIAL SERVICES, INC.

			Three Months Ended																		Six Months Ended
(Dollars in thousands, except per share amounts)			June 30, 2020						June 30, 2019						June 30, 2020						June 30, 2019
Interest income
Loans			$	21,794					$	19,658					$	41,960					$	34,809
Investment securities - taxable			2,795						3,681						6,233						7,173
Investment securities - tax-exempt			420						632						704						1,474
Short-term investments			13						501						92						674
Total interest income			25,022						24,472						48,989						44,130
Interest expense
Deposits			3,310						4,892						7,664						8,607
Securities sold under agreements to repurchase			152						28						184						55
FHLB advances and other			260						538						1,078						1,197
Subordinated notes			502						499						1,003						996
Total interest expense			4,224						5,957						9,929						10,855
Net interest income			20,798						18,515						39,060						33,275
Provision for loan losses			1,900						200						2,825						600
Net interest income after provision for loan losses			18,898						18,315						36,235						32,675
Noninterest income
Service charges on deposit accounts			554						837						1,401						1,590
Interchange income			819						843						1,607						1,579
Other service charges, commissions and fees			165						241						305						390
Swap fees			232						—						432						—
Trust and investment management income			1,696						1,749						3,336						3,507
Brokerage income			599						672						1,318						1,150
Mortgage banking activities			1,609						652						1,941						1,120
Gain on sale of portfolio loans			925						—						2,803						—
Income from life insurance			532						684						1,072						1,026
Investment securities gains (losses)			9						2,064						(31)						2,403
Other income			53						32						83						144
Total noninterest income			7,193						7,774						14,267						12,909
Noninterest expenses
Salaries and employee benefits			10,063						8,922						21,657						17,599
Occupancy			1,122						1,066						2,249						2,067
Furniture and equipment			1,204						1,140						2,366						2,163
Data processing			791						1,058						1,662						1,828
Automated teller and interchange fees			249						238						500						474
Advertising and bank promotions			167						548						956						1,069
FDIC insurance			214						221						261						406
Other professional services			1,021						707						1,737						1,264
Directors' compensation			264						261						465						497
Taxes other than income			449						314						451						620
Intangible asset amortization			404						402						867						610
Merger related and branch consolidation expenses			—						6,860						—						7,505
Insurance claim receivable (recovery) write-off			—						—						(486)						615
Other operating expenses			2,483						1,555						4,050						2,736
Total noninterest expenses			18,431						23,292						36,735						39,453
Income before income tax expense			7,660						2,797						13,767						6,131
Income tax expense			1,301						110						2,340						342
Net income			$	6,359					$	2,687					$	11,427					$	5,789
Per share information:
Basic earnings per share			$	0.58					$	0.26					$	1.04					$	0.59
Diluted earnings per share			0.58						0.26						1.04						0.58
Dividends paid per share			0.17						0.15						0.34						0.30

The Notes to Unaudited Condensed Consolidated Financial Statements are an integral part of these statements.

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Condensed Consolidated Statements of Comprehensive Income (Unaudited)

ORRSTOWN FINANCIAL SERVICES, INC.

 

			Three Months Ended																		Six Months Ended
(Dollars in thousands)			June 30, 2020						June 30, 2019						June 30, 2020						June 30, 2019
Net income			$	6,359					$	2,687					$	11,427					$	5,789
Other comprehensive income, net of tax:
Unrealized (losses) gains on securities available for sale arising during the period			13,367						5,353						(3,921)						10,480
Reclassification adjustment for (gains) losses realized in net income			(9)						(2,064)						31						(2,403)
Net unrealized gains (losses) on securities available for sale			13,358						3,289						(3,890)						8,077
Tax effect			(2,805)						(691)						817						(1,697)
Total other comprehensive income (loss), net of tax and reclassification adjustments on securities available for sale			10,553						2,598						(3,073)						6,380
Unrealized loss on interest rate swaps used in cash flow hedges			(842)						—						(2,101)						—
Reclassification adjustment for losses realized in net income			121						—						125						—
Net unrealized loss on interest rate swaps used in cash flow hedges			(721)						—						(1,976)						—
Tax effect			151						—						415						—
Total other comprehensive loss, net of tax and reclassification adjustments on interest rate swaps			(570)						—						(1,561)						—
Total other comprehensive income (loss), net of tax and reclassification adjustments			9,983						2,598						(4,634)						6,380
Total comprehensive income			$	16,342					$	5,285					$	6,793					$	12,169

The Notes to Unaudited Condensed Consolidated Financial Statements are an integral part of these statements.

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Condensed Consolidated Statements of Changes in Shareholders’ Equity (Unaudited)

ORRSTOWN FINANCIAL SERVICES, INC.

			Three Months Ended June 30, 2020
(Dollars in thousands, except per share amounts)			Common Stock						Additional Paid-In Capital						Retained Earnings						Accumulated Other Comprehensive Income (Loss)						Treasury Stock						Total Shareholders’ Equity
Balance, March 31, 2020			$	586					$	187,843					$	38,408					$	(15,097)					$	(1,170)					$	210,570
Net income			—						—						6,359						—						—						6,359
Total other comprehensive income, net of taxes			—						—						—						9,983						—						9,983
Cash dividends ($0.17 per share)			—						—						(1,905)						—						—						(1,905)
Share-based compensation plans:
250 net common shares forfeited and 12,672 net treasury shares issued, including compensation expense totaling $651			—						383						—						—						248						631
Balance, June 30, 2020			$	586					$	188,226					$	42,862					$	(5,114)					$	(922)					$	225,638
			Six Months Ended June 30, 2020
(Dollars in thousands, except per share amounts)			Common Stock						Additional Paid-In Capital						Retained Earnings						Accumulated Other Comprehensive Loss						Treasury Stock						Total Shareholders’ Equity
Balance, January 1, 2020			$	584					$	188,365					$	35,246					$	(480)					$	(466)					$	223,249
Net income			—						—						11,427						—						—						11,427
Total other comprehensive loss, net of taxes			—						—						—						(4,634)						—						(4,634)
Cash dividends ($0.34 per share)			—						—						(3,811)						—						—						(3,811)
Share-based compensation plans:
47,825 net common shares issued and 38,553 net treasury shares acquired, including compensation expense totaling $1,176			2						(139)						—						—						(456)						(593)
Balance, June 30, 2020			$	586					$	188,226					$	42,862					$	(5,114)					$	(922)					$	225,638

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			Three Months Ended June 30, 2019
(Dollars in thousands, except per share amounts)			Common Stock						Additional Paid-In Capital						Retained Earnings						Accumulated Other Comprehensive Income						Treasury Stock						Total Shareholders’ Equity
Balance, March 31, 2019			$	494					$	151,702					$	26,161					$	810					$	—					$	179,167
Net income			—						—						2,687						—						—						2,687
Total other comprehensive loss, net of taxes			—						—						—						2,598						—						2,598
Cash dividends ($0.15 per share)			—						—						(1,386)						—						—						(1,386)
Issuance of stock (1,765,704 common shares) to acquire Hamilton Bancorp, Inc.			92						36,530						—						—						—						36,622
Share-based compensation plans:
26,480 net common shares forfeited, including compensation expense of $180			(2)						182						—						—						—						180
Balance, June 30, 2019			$	584					$	188,414					$	27,462					$	3,408					$	—					$	219,868
			Six Months Ended June 30, 2019
(Dollars in thousands, except per share amounts)			Common Stock						Additional Paid-In Capital						Retained Earnings						Accumulated Other Comprehensive Income						Treasury Stock						Total Shareholders’ Equity
Balance, January 1, 2019			$	491					$	151,678					$	24,472					$	(2,972)					$	(236)					$	173,433
Net income			—						—						5,789						—						—						5,789
Total other comprehensive income, net of taxes			—						—						—						6,380						—						6,380
Cash dividends ($0.30 per share)			—						—						(2,799)						—						—						(2,799)
Issuance of stock (1,765,704 common shares) to acquire Hamilton Bancorp, Inc.			92						36,530						—						—						—						36,622
Share-based compensation plans:
19,034 net common shares issued and 9,031 net treasury shares acquired, including compensation expense totaling $679			1						206						—						—						236						443
Balance, June 30, 2019			$	584					$	188,414					$	27,462					$	3,408					$	—					$	219,868

The Notes to Unaudited Condensed Consolidated Financial Statements are an integral part of these statements.

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Condensed Consolidated Statements of Cash Flows (Unaudited)

ORRSTOWN FINANCIAL SERVICES, INC.

			Six Months Ended
(Dollars in thousands)			June 30, 2020						June 30, 2019
Cash flows from operating activities
Net income			$	11,427					$	5,789
Adjustments to reconcile net income to net cash provided by operating activities:
Net (discount accretion) premium amortization			(2,020)						2,203
Depreciation and amortization expense			2,707						2,366
Impairment of intangibles			153						—
Provision for loan losses			2,825						600
Share-based compensation			1,176						679
Gain on sales of loans originated for sale			(1,903)						(909)
Mortgage loans originated for sale			(76,417)						(43,471)
Proceeds from sales of loans originated for sale			73,323						40,392
Gain on sale of portfolio loans			(2,803)						—
Net gain on disposal of OREO			(21)						(8)
Net loss on disposal of premises and equipment			1						607
Deferred income taxes			63						263
Investment securities losses (gains)			31						(2,403)
Income from life insurance			(1,072)						(1,026)
(Increase) decrease in accrued interest receivable			(2,142)						730
Increase (decrease) in accrued interest payable and other liabilities			85						(1,147)
Other, net			1,445						1,100
Net cash provided by operating activities			6,858						5,765
Cash flows from investing activities
Proceeds from sales of AFS securities			—						173,836
Maturities, repayments and calls of AFS securities			29,317						15,297
Purchases of AFS securities			(26,691)						(150,386)
Net cash and cash equivalents received from acquisitions			—						29,442
Net (purchases) redemptions of restricted investments in bank stocks			(72)						3,395
Net decrease (increase) in loans			43,961						(8,395)
Proceeds from sales of portfolio loans			22,665						—
Purchases of bank premises and equipment			(464)						(1,489)
Proceeds from disposal of OREO			198						374
Death benefit proceeds from life insurance contracts			—						571
Net cash provided by investing activities			68,914						62,645
Cash flows from financing activities
Net (decrease) increase in deposits			(82,449)						68,525
Net decrease in borrowings with original maturities less than 90 days			(111,152)						(29,696)
Proceeds from FHLB advances and other borrowings			160,284						20,000
Payments on FHLB advances and other borrowings			(40,548)						(96,582)
Subordinated note issuance costs			—						(57)
Dividends paid			(3,811)						(2,799)
Acquisition of treasury stock			(1,170)						—
Treasury shares repurchased for employee taxes associated with restricted stock vesting			(660)						(294)
Proceeds from issuance of employee stock purchase plan shares			61						58
Net cash used in financing activities			(79,445)						(40,845)
Net (decrease) increase in cash and cash equivalents			(3,673)						27,565
Cash and cash equivalents at beginning of period			55,963						88,815
Cash and cash equivalents at end of period			$	52,290					$	116,380

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Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest			$	10,367					$	10,326
Supplemental schedule of noncash investing activities:
OREO acquired in settlement of loans			—						161
Lease liabilities arising from obtaining ROU assets			—						8,115
SBA PPP loans originated			458,606						—

The Notes to Unaudited Condensed Consolidated Financial Statements are an integral part of these statements.

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Notes to Condensed Consolidated Financial Statements (Unaudited)

(All dollar amounts presented in the tables, except per share amounts, are in thousands)

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

See the Glossary of Defined Terms at the beginning of this Report for terms used throughout the unaudited condensed consolidated financial statements and related notes of this Form 10-Q.

Nature of Operations – Orrstown Financial Services, Inc. is a financial holding company that operates Orrstown Bank, a commercial bank with banking and financial advisory offices in Berks, Cumberland, Dauphin, Franklin, Lancaster, Perry and York Counties, Pennsylvania, and in Anne Arundel, Baltimore, Howard and Washington Counties, Maryland, as well as Baltimore City, Maryland and Wheatland Advisors, Inc., a registered investment advisor non-bank subsidiary, headquartered in Lancaster County, Pennsylvania. The Wheatland operations were discontinued effective July 31, 2020. The Company operates in the community banking segment and engages in lending activities, including commercial, residential, commercial mortgages, construction, municipal, and various forms of consumer lending, and deposit services, including checking, savings, time, and money market deposits. The Company also provides fiduciary services, investment advisory, insurance and brokerage services. The Company and the Bank are subject to regulation by certain federal and state agencies and undergo periodic examinations by such regulatory authorities.

Basis of Presentation – The accompanying unaudited condensed consolidated financial statements include the accounts of Orrstown Financial Services, Inc. and its wholly owned subsidiaries, the Bank and Wheatland. The Company has prepared these unaudited condensed consolidated financial statements in accordance with GAAP for interim financial information, SEC rules that permit reduced disclosure for interim periods, and Article 10 of Regulation S-X. In the opinion of management, all adjustments (all of which are of a normal recurring nature) that are necessary for a fair statement are reflected in the unaudited condensed consolidated financial statements. The December 31, 2019 consolidated balance sheet information contained in this Quarterly Report on Form 10-Q was derived from the Company's 2019 audited consolidated financial statements. The unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements, including the notes thereto, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019. Operating results for the three and six months ended June 30, 2020 are not necessarily indicative of the results that may be expected for the year ending December 31, 2020. All significant intercompany transactions and accounts have been eliminated. Certain reclassifications may have been made to prior year amounts to conform with current year classifications.

The Company's management has evaluated all activity of the Company and concluded that subsequent events are properly reflected in the Company's unaudited condensed consolidated financial statements and notes as required by GAAP.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. The effects of the COVID-19 pandemic may negatively impact material estimates. Material estimates that are particularly susceptible to significant change include the determination of the ALL and those used in valuation methodologies in areas with no observable market, such as loans, deposits, borrowings, goodwill, core deposit and other intangible assets, mortgage servicing rights, other assets and liabilities obtained or assumed in business combinations.

Derivatives - FASB ASC 815, Derivatives and Hedging (“ASC 815”), provides the disclosure requirements for derivatives and hedging activities with the intent to provide users of financial statements with an enhanced understanding of: (a) how and why an entity uses derivative instruments, (b) how the entity accounts for derivative instruments and related hedged items, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. Further, qualitative disclosures are required that explain the Company’s objectives and strategies for using derivatives, as well as quantitative disclosures about the fair value of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.

As required by ASC 815, the Company records all derivatives on the balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair

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value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge.

The Company may enter into derivative contracts that are intended to economically hedge certain of its risk, even though hedge accounting does not apply or the Company elects not to apply hedge accounting. The Company's objectives in using interest rate derivatives are to add stability to interest income and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of fixed amounts from a counterparty in exchange for the Company making variable-rate payments over the life of the agreements without exchange of the underlying notional amount. The Company may enter into derivative contracts that are intended to economically hedge certain of its risk, even though hedge accounting does not apply or the Company elects not to apply hedge accounting.

Changes to the fair value of derivatives designated and that qualify as cash flow hedges are recorded in accumulated other comprehensive income and are subsequently reclassified into earnings in the period that the hedged transaction affects earnings. During the six months ended June 30, 2020, such derivatives were used to hedge the variable cash flows associated with overnight borrowings.

Derivatives not designated as hedges are not speculative and result from a service the Company provides to certain customers. The Company executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies. Those interest rate swaps are simultaneously hedged by offsetting derivatives that the Company executes with a third party, such that the Company minimizes its net risk exposure resulting from such transactions. As the interest rate derivatives associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer derivatives and the offsetting derivatives are recognized directly in earnings.

Leases - The Company evaluates its contracts at inception to determine if an arrangement either is a lease or contains one. Operating lease ROU assets are included in other assets and operating lease liabilities in accrued interest payable and other liabilities in the unaudited condensed consolidated balance sheets. The Company had no finance leases at June 30, 2020.

ROU assets represent the right to use an underlying asset for the lease term, and lease liabilities represent an obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. The Company's leases do not provide an implicit rate, so the Company's incremental borrowing rate is used, which approximates its fully collateralized borrowing rate, based on the information available at commencement date in determining the present value of lease payments. The incremental borrowing rate is reevaluated upon lease modification. The operating lease ROU asset also includes any initial direct costs and prepaid lease payments made less any lease incentives. The Company's lease terms may include options to extend or terminate the lease when it is reasonably certain that it will exercise that option.

In accordance with ASU 2016-02, “Leases (Topic 842)” (“ASU 2016-02”), the Company keeps leases with an initial term of 12 months or less off of the balance sheet. The Company recognizes these lease payments in the unaudited condensed consolidated statements of income on a straight-line basis over the lease term. The Company has lease agreements with lease and non-lease components and has elected the practical expedient to account for them as a single lease component.

The Company's operating leases relate primarily to bank branches and office space. Upon the adoption of ASU 2016-02 on January 1, 2019, operating lease liabilities of $10.5 million and related lease assets of $7.5 million were recognized on the unaudited condensed consolidated balance sheets. The difference between the lease assets and lease liabilities primarily consists of deferred rent liabilities reclassified upon adoption to reduce the measurement of the lease assets.

Recent Accounting Pronouncements - ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments ("ASU 2016-13"). The amendments in this update require an organization to measure all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will use forward-looking information to better inform their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. Organizations will continue to use judgment to determine which loss estimation method is appropriate for their circumstances. Additionally, the amendments in this update amend the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. For certain public companies, this update was effective for interim and annual periods beginning after December 15, 2019. The Company delayed the adoption of ASU 2016-13 as noted below.

ASU No. 2019-10, Financial Instruments—Credit Losses (Topic 326), Derivatives and Hedging (Topic 815), and Leases (Topic 842): Effective Dates ("ASU 2019-10"), extended the implementation deadline of ASU 2016-13 for smaller reporting and other companies until the fiscal year and interim periods beginning after December 15, 2022. The Company meets the

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requirements to be considered a smaller reporting company under SEC Regulation S-K and SEC Rule 405, and did not adopt ASU 2016-13 on January 1, 2020. The Company is evaluating the impact of the delay for adoption of ASU 2016-13. The Company is working with a third party vendor solution to assist with the application of ASU 2016-13 and finalizing the loss estimation models to be used. Once management determines which methods will be utilized, a third party will be contracted to perform a model validation prior to adoption. While the Company anticipates the allowance for loan losses will increase under its current assumptions, it expects the impact of adopting ASU 2016-13 will be influenced by the composition, characteristics and quality of its loan and securities portfolios, as well as general economic conditions and forecasts at the adoption date. The other provisions of ASU 2019-10 were not applicable to the Company.

In March 2020, the FASB issued ASU No. 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting ("ASU 2020-04). ASU 2020-04 contains optional expedients and exceptions for applying generally accepted accounting principles to contract modifications and hedging relationships, subject to meeting certain criteria, that reference LIBOR or another reference rate expected to be discontinued. The optional expedients apply consistently to all contracts or transactions within the scope of this topic, while the optional expedients for hedging relationships can be elected on an individual basis. The Company has formed a cross-functional working group to lead the transition from LIBOR to a planned adoption of an alternate index. The Company has not yet determined what index will replace LIBOR in its loan agreements. The Company is in the process of implementing fallback language for loans that will mature after 2021. The Company expects to adopt the LIBOR transition relief allowed under this standard, and is currently evaluating the potential impact of this guidance on its financial statements.

NOTE 2.    MERGERS AND ACQUISITIONS

Hamilton Bancorp, Inc.

On May 1, 2019, the Company acquired 100% of the outstanding common shares of Hamilton Bancorp, Inc., and its wholly-owned subsidiary, Hamilton Bank, based in Towson, Maryland. The Company acquired Hamilton to introduce our banking and financial services into the Greater Baltimore area of Maryland.

Pursuant to the merger agreement, the Company issued 1,765,704 shares of its common stock and paid $14.2 million in cash for all outstanding shares of Hamilton stock and options vesting upon acquisition. Based on the Company's closing stock price of $20.74 on April 30, 2019, the consideration paid to acquire Hamilton totaled approximately $50.8 million.

The fair value of assets acquired, excluding goodwill, totaled $494.0 million, including loans totaling $347.1 million. The fair value of liabilities assumed totaled $449.4 million, including deposits totaling $388.2 million. Goodwill represents consideration transferred in excess of the fair value of the net assets acquired. At May 1, 2019, the Company recognized $6.1 million in goodwill associated with the Hamilton acquisition. The goodwill resulting from the acquisition represents the value expected from the expansion of our market in the Greater Baltimore area and the enhancement of our operations through customer synergies and efficiencies, thereby providing enhanced customer service. Goodwill acquired in the Hamilton acquisition is not deductible for tax purposes.

The Hamilton acquisition was accounted for using the acquisition method of accounting and, accordingly, purchased assets, including identifiable intangible assets, and assumed liabilities were recorded at their respective acquisition date fair values. The fair value measurements of assets acquired and liabilities assumed are subject to refinement for up to one year after the closing date of the acquisition as additional information relative to closing date fair values becomes available. The Company finalized the fair values of loans, intangible assets, other assets, income taxes and liabilities associated with Hamilton as of May 1, 2020. Measurement period adjustments made from the date of acquisition through May 1, 2020 are summarized in Note 6 - Goodwill and Other Intangible Assets.

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The following table summarizes the consideration paid for Hamilton and the estimated fair values of the assets acquired and liabilities assumed recognized at the acquisition date:

Fair value of consideration transferred:
Cash						$	14,197
Common stock issued						36,622
Total consideration transferred						$	50,819
Estimated fair values of assets acquired and liabilities assumed:
Cash and cash equivalents						$	43,140
Securities available for sale						60,882
Restricted investments in bank stocks						2,658
Loans						347,143
Premises and equipment						3,749
Core deposit intangible						4,550
Goodwill						6,132
Cash surrender value of life insurance						17,948
Deferred tax asset, net						7,257
ROU lease asset						2,793
Other assets						3,925
Total assets acquired						500,177
Deposits						(388,246)
Borrowings						(51,393)
Other liabilities						(9,719)
Total liabilities assumed						$	(449,358)

The determination of estimated fair values of the acquired loans required the Company to make certain estimates about discount rates, future expected cash flows, market conditions and other future events that are highly subjective in nature. Based on such factors as past due status, nonaccrual status, bankruptcy status, and credit risk ratings, the acquired loans were divided into loans with evidence of credit quality deterioration, which are accounted for under ASC 310-30 (purchased credit impaired), and loans that do not meet this criteria, which are accounted for under ASC 310-20 (purchased non-impaired). Expected cash flows, both principal and interest, were estimated based on key assumptions covering such factors as prepayments, default rates and severity of loss given default. These assumptions were developed using both Hamilton's historical experience and the portfolio characteristics as of the acquisition date, as well as available market research. The fair value estimates for acquired loans were based on the amount and timing of expected principal, interest and other cash flows, including expected prepayments, discounted at prevailing market interest rates applicable to the types of acquired loans, which the Company considered to be level 3 fair value measurements. Deposit liabilities assumed in the Hamilton acquisition were segregated into two categories: time-deposits (i.e., deposit accounts with a stated maturity) and demand deposits, both using level 2 fair value measurements. In determining fair value of time deposits, the Company discounted the contractual cash flows of the deposit accounts using prevailing market interest rates for time deposit accounts of similar type and duration. For demand deposits, the acquisition date outstanding balance of the assumed demand deposit accounts approximates fair value. Acquisition date fair values for securities available for sale were determined using Level 1 or Level 2 inputs consistent with the methods discussed further in Note 13 - Fair Value. The remaining acquisition date fair values represent either Level 2 fair value measurements or Level 3 fair value measurements (premises and equipment and core deposit intangible).

Upon completion of the acquisition, the Company sold the acquired investment portfolio and paid off acquired borrowings at the indicated fair value amounts in conjunction with its asset/liability management strategies.

The Company recognized a core deposit intangible of $4.6 million, which is being amortized using an accelerated method over a 10-year amortization period, consistent with expected future cash flows.

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Loans acquired with Hamilton were measured at fair value at the acquisition date with no carryover of any ALL. Loans were segregated into those loans considered to be performing and those considered PCI. The following table presents performing and PCI loans acquired, by loan class, at May 1, 2019:

			Performing						PCI						Total
Commercial real estate:
Owner-occupied			$	42,148					$	5,894					$	48,042
Non-owner occupied			45,401						770						46,171
Multi-family			10,773						—						10,773
Acquisition and development:
1-4 family residential construction			7,450						—						7,450
Commercial and land development			4,528						—						4,528
Commercial and industrial			32,316						1,914						34,230
Residential mortgage:
First lien			152,657						10,494						163,151
Home-equity - term			4,478						1						4,479
Home equity - lines of credit			13,657						—						13,657
Installment and other loans			14,467						195						14,662
Total loans acquired			$	327,875					$	19,268					$	347,143

The following table presents the fair value adjustments made to the amortized cost basis of loans acquired at May 1, 2019:

Gross amortized cost basis at acquisition			$	362,125
Market rate adjustment			(5,309)
Credit fair value adjustment on non-credit impaired loans			(3,947)
Credit fair value adjustment on PCI loans			(5,726)
Estimated fair value of acquired loans			$	347,143

The market rate adjustment represents the movement in market interest rates, irrespective of credit adjustments, compared to the contractual rates of the acquired loans. The credit fair value adjustment made on non-credit impaired loans represents the changes in credit quality of the underlying borrowers from loan inception to the acquisition date. The credit fair value adjustment on PCI loans is derived in accordance with ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, and represents the portion of the loan balance that has been deemed uncollectible based on our expectations of future cash flows for each respective loan.

The following table provides information about acquired PCI loans at May 1, 2019:

Contractually required principal and interest at acquisition			$	31,599
Nonaccretable difference			(8,834)
Expected cash flows at acquisition			22,765
Accretable yield			(3,497)
Estimated fair value of acquired PCI loans			$	19,268

Unaudited pro forma net income for the Company for the three and six months ended June 30, 2019, would have totaled $6.2 million and $9.7 million, respectively. Revenues would have totaled $27.6 million and $50.9 million, respectively, for the three and six months ended June 30, 2019, had the Hamilton acquisition occurred on January 1, 2019.

In connection with the Mercersburg and Hamilton acquisitions, the Company incurred merger related expenses totaling $6.9 million and $7.5 million for the three and six months ending June 30, 2019, which are included in noninterest expenses.

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The Company did not incur any merger related expenses in connection with the Hamilton acquisition for the three and six months ended June 30, 2020.

NOTE 3. INVESTMENT SECURITIES

At June 30, 2020 and December 31, 2019, all investment securities were classified as AFS. The following table summarizes amortized cost and fair value of investment securities, and the corresponding amounts of gross unrealized gains and losses recognized in AOCI, at June 30, 2020 and December 31, 2019:

			Amortized Cost						Gross Unrealized Gains						Gross Unrealized Losses						Fair Value
June 30, 2020
States and political subdivisions			$	105,122					$	8,156					$	183					$	113,095
GSE residential MBSs			4,519						86						—						4,605
GSE residential CMOs			63,655						3,116						704						66,067
Non-agency CMOs			17,213						97						—						17,310
Private label commercial CMOs			73,388						25						3,677						69,736
Asset-backed			224,181						97						11,510						212,768
Other			355						—						—						355
Totals			$	488,433					$	11,577					$	16,074					$	483,936
December 31, 2019
States and political subdivisions			$	83,607					$	4,288					$	32					$	87,863
GSE residential CMOs			67,928						1,000						774						68,154
Non-agency CMOs			17,210						—						123						17,087
Private label commercial CMOs			86,704						156						231						86,629
Asset-backed			235,406						138						5,029						230,515
Other			637						—						—						637
Totals			$	491,492					$	5,582					$	6,189					$	490,885

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The following table summarizes investment securities with unrealized losses at June 30, 2020 and December 31, 2019, aggregated by major security type and the length of time in a continuous unrealized loss position.

			Less Than 12 Months																														12 Months or More																														Total
			# of Securities						Fair Value						Unrealized Losses						# of Securities						Fair Value						Unrealized Losses						# of Securities						Fair Value						Unrealized Losses
June 30, 2020
States and political subdivisions			1						$	10,032					$	183					—						$	—					$	—					1						$	10,032					$	183
GSE residential CMOs			3						26,496						704						—						—						—						3						26,496						704
Private label commercial CMOs			5						29,410						1,618						8						33,814						2,059						13						63,224						3,677
Asset-backed			9						73,071						2,724						11						133,451						8,786						20						206,522						11,510
Totals			18						$	139,009					$	5,229					19						$	167,265					$	10,845					37						$	306,274					$	16,074
December 31, 2019
States and political subdivisions			1						$	6,173					$	32					—						$	—					$	—					1						$	6,173					$	32
GSE residential CMOs			5						37,158						309						1						11,602						465						6						48,760						774
Non-agency CMOs			1						17,087						123						—						—						—						1						17,087						123
Private label commercial CMOs			6						26,079						67						8						39,726						164						14						65,805						231
Asset-backed			9						92,189						1,145						9						121,399						3,884						18						213,588						5,029
Totals			22						$	178,686					$	1,676					18						$	172,727					$	4,513					40						$	351,413					$	6,189

The Company determines whether unrealized losses are temporary in nature in accordance with FASB ASC 320-10, Investments - Overall, (“FASB ASC 320-10”) and FASB ASC 325-40, Investments – Beneficial Interests in Securitized Financial Assets, when applicable. The evaluation is based upon factors such as the creditworthiness of the underlying borrowers, performance of the underlying collateral, if applicable, and the level of credit support in the security structure. Management also evaluates other factors and circumstances that may be indicative of an OTTI condition. This includes, but is not limited to, an evaluation of the type of security, length of time and extent to which the fair value has been less than cost and near-term prospects of the issuer.

FASB ASC 320-10 requires the Company to assess if an OTTI exists by considering whether the Company has the intent to sell the security or it is more likely than not that it will be required to sell the security before recovery. If either of these situations applies, the guidance requires the Company to record an OTTI charge to earnings on debt securities for the difference between the amortized cost basis of the security and the fair value of the security. If neither of these situations applies, the Company is required to assess whether it is expected to recover the entire amortized cost basis of the security. If the Company is not expected to recover the entire amortized cost basis of the security, the guidance requires the Company to bifurcate the identified OTTI into a credit loss component and a component representing loss related to other factors. A discount rate is applied which equals the effective yield of the security. The difference between the present value of the expected flows and the amortized book value is considered a credit loss, which would be recorded through earnings as an OTTI charge. When a market price is not readily available, the market value of the security is determined using the same expected cash flows; the discount rate is a rate the Company determines from the open market and other sources as appropriate for the security. The difference between the market value and the present value of cash flows expected to be collected is recognized in accumulated other comprehensive loss on the consolidated statements of financial condition.

As of June 30, 2020, the Company had no cumulative OTTI. There were no OTTI charges recognized in earnings as a result of credit losses on investments in the three and six months ended June 30, 2020 and 2019. During the six months ended June 30, 2020, unrealized losses were substantially higher due to market uncertainty brought about by the COVID-19 pandemic. The sudden and desperate need for liquidity from many institutional pools of capital combined with the global economic implications of the COVID-19 pandemic caused significant widening of spreads.

States and Political Subdivisions. The unrealized losses presented in the table above have been caused by a widening of spreads from the time these securities were purchased. Management considers the investment rating, the state of the issuer of the security and other credit support in determining whether the security is OTTI. Because the Company does not intend to sell these securities and it is not more likely than not that the Company will be required to sell them before recovery of their amortized cost basis, which may be maturity, the Company does not consider these securities to be OTTI at June 30, 2020 or December 31, 2019.

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GSE Residential CMOs. The unrealized losses presented in the table above have been caused by a widening of spreads from the time these securities were purchased. The contractual terms of these securities do not permit the issuer to settle the securities at a price less than its par value basis. Because the Company does not intend to sell these securities and it is not more likely than not that the Company will be required to sell them before recovery of their amortized cost basis, which may be maturity, the Company does not consider these securities to be OTTI at June 30, 2020 or December 31, 2019.

Non-agency CMOs. The unrealized losses presented in the table above have been caused by a widening of spreads from the time the securities were purchased. Management considers the investment rating and other credit support in determining whether a security is other-than-temporarily impaired. As of June 30, 2020, management concluded that an OTTI did not exist on any of the aforementioned securities based upon its assessment. Management also concluded that it does not intend to sell nor will it be required to sell the securities, before their recovery, which may be maturity, and management expects to recover the entire amortized cost basis of these securities.

Private Label Commercial CMOs and Asset-backed. The unrealized losses presented in the table above have been caused by a widening of spreads from the time the securities were purchased. Management considers the investment rating and other credit support in determining whether a security is other-than-temporarily impaired. Because the Company does not intend to sell these securities and it is not more likely than not that the Company will be required to sell them before recovery of their amortized cost basis, which may be maturity, the Company does not consider these securities to be OTTI at June 30, 2020 or December 31, 2019.

The following table summarizes the credit ratings and collateral associated with the Company's investment portfolio, excluding equity securities, at June 30, 2020:

Sector			Portfolio Mix			Amortized Book			Fair Value			Credit Enhancement			AAA			AA			A			BBB			NR			Collateral Type
Unsecured ABS			2		%	$	10,003		$	9,694		41		%	6		%	—		%	—		%	—		%	94		%	Unsecured Consumer Debt
Student Loan ABS			3		%	12,624			11,777			26		%	—		%	—		%	—		%	—		%	100		%	Seasoned Student Loans
Federal Family Education Loan ABS			37		%	182,759			172,613			6		%	4		%	74		%	22		%	—		%	—		%	Federal Family Education Loan (1)
PACE Loan ABS			1		%	6,149			6,246			6		%	100		%	—		%	—		%	—		%	—		%	PACE Loans
Non-Agency CMBS			15		%	73,388			69,735			55		%	80		%	7		%	3		%	10		%	—		%	Commercial Real Estate
Non-Agency RMBS			4		%	17,213			17,310			33		%	100		%	—		%	—		%	—		%	—		%	Reverse Mortgages (2)
Municipal - General Obligation			11		%	53,984			58,963						3		%	84		%	12		%	—		%	—		%
Municipal - Revenue			10		%	51,138			54,132						—		%	61		%	19		%	—		%	20		%
SBA ReRemic			3		%	12,647			12,439						—		%	100		%	—		%	—		%	—		%	SBA Guarantee (3)
Agency MBS			14		%	68,174			70,673						—		%	100		%	—		%	—		%	—		%	Residential Mortgages (3)
Bank CDs			—		%	249			249						—		%	—		%	—		%	—		%	100		%	FDIC Insured CD
			100		%	$	488,328		$	483,831					19		%	61		%	12		%	1		%	7		%
(1) 97% guaranteed by U.S. government
(2) Currently 6% credit enhancement; expected credit enhancement is provided above
(3) 100% guaranteed by U.S. government agencies
Note : Ratings in table are the lowest of the six rating agencies (Standard & Poors, Moody's, Morningstar, DBRS, KBRA and Fitch). Standard & Poors rates U.S. government obligations at AA+

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The following table summarizes amortized cost and fair value of investment securities by contractual maturity at June 30, 2020. Expected maturities may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties. Securities not due at a single maturity date are shown separately.

			Amortized Cost						Fair Value
Due in one year or less			$	—					$	—
Due after one year through five years			249						249
Due after five years through ten years			27,182						29,157
Due after ten years			78,046						84,044
CMOs			158,775						157,718
Asset-backed			224,181						212,768
			$	488,433					$	483,936

The following table summarizes proceeds from sales of investment securities and gross gains and gross losses for the three and six months ended June 30, 2020 and 2019:

			Three months ended June 30,																		Six months ended June 30,
			2020						2019						2020						2019
Proceeds from sale of investment securities			$	—					$	114,372					$	—					$	173,836
Gross gains			9						2,109						—						2,628
Gross losses			—						45						31						225

During the three and six months ended June 30, 2020, a gain of $9 thousand and a loss of $31 thousand, respectively, was recorded to adjust an equity security to market value, compared to net investment security gains of $2.1 million and $2.4 million, respectively, for the three and six months ended June 30, 2019 from security sales. There were no sales of investment securities during the three and six months ended June 30, 2020. Investment securities with a fair value of $428.1 million and $158.7 million at June 30, 2020 and December 31, 2019, respectively, were pledged to secure public funds and for other purposes as required or permitted by law.

NOTE 4. LOANS AND ALLOWANCE FOR LOAN LOSSES

The Company’s loan portfolio is grouped into classes to allow management to monitor the performance by the borrower and to monitor the yield on the portfolio. Consistent with ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Loan Losses, the segments are further broken down into classes to allow for differing risk characteristics within a segment.

The risks associated with lending activities differ among the various loan classes and are subject to the impact of changes in interest rates, market conditions of collateral securing the loans, and general economic conditions. All of these factors may adversely impact both the borrower’s ability to repay its loans and associated collateral.

The Company has various types of commercial real estate loans, which have differing levels of credit risk. Owner occupied commercial real estate loans are generally dependent upon the successful operation of the borrower’s business, with the cash flows generated from the business being the primary source of repayment of the loan. If the business suffers a downturn in sales or profitability, the borrower’s ability to repay the loan could be in jeopardy.

Non-owner occupied and multi-family commercial real estate loans and non-owner occupied residential loans present a different credit risk to the Company than owner occupied commercial real estate loans, as the repayment of the loan is dependent upon the borrower’s ability to generate a sufficient level of occupancy to produce rental income that exceeds debt service requirements and operating expenses. Lower occupancy or lease rates may result in a reduction in cash flows, which hinders the ability of the borrower to meet debt service requirements, and may result in lower collateral values. The Company generally recognizes that greater risk is inherent in these credit relationships as compared to owner occupied loans mentioned above.

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Acquisition and development loans consist of 1-4 family residential construction and commercial and land development loans. The risk of loss on these loans is largely dependent on the Company’s ability to assess the property’s value at the completion of the project, which should exceed the property’s construction costs. During the construction phase, a number of factors could potentially negatively impact the collateral value, including cost overruns, delays in completing the project, competition, and real estate market conditions which may change based on the supply of similar properties in the area. In the event the collateral value at the completion of the project is not sufficient to cover the outstanding loan balance, the Company must rely upon other repayment sources, including, if any, the guarantors of the project or other collateral securing the loan.

Commercial and industrial loans include advances to local and regional businesses for general commercial purposes and include permanent and short-term working capital, machinery and equipment financing, and may be either in the form of lines of credit or term loans. Although commercial and industrial loans may be unsecured to our highest-rated borrowers, the majority of these loans are secured by the borrower’s accounts receivable, inventory and machinery and equipment. In a significant number of these loans, the collateral also includes the business real estate or the business owner’s personal real estate or assets. Commercial and industrial loans present credit exposure to the Company, as they are more susceptible to risk of loss during a downturn in the economy as borrowers may have greater difficulty in meeting their debt service requirements and the value of the collateral may decline. The Company attempts to mitigate this risk through its underwriting standards, including evaluating the creditworthiness of the borrower and, to the extent available, credit ratings on the business. Additionally, monitoring of the loans through annual renewals and meetings with the borrowers are typical. However, these procedures cannot eliminate the risk of loss associated with commercial and industrial lending. At June 30, 2020 and December 31, 2019, commercial and industrial loans include $447.2 million and $0, respectively, of loans, net of deferred fees, originated through the U.S. Small Business Administration Paycheck Protection Program ("SBA PPP").

Municipal loans consist of extensions of credit to municipalities and school districts within the Company’s market area. These loans generally present a lower risk than commercial and industrial loans, as they are generally secured by the municipality’s full taxing authority, by revenue obligations, or by its ability to raise assessments on its customers for a specific utility.

The Company originates loans to its retail customers, including fixed-rate and adjustable first lien mortgage loans with the underlying 1-4 family owner occupied residential property securing the loan. The Company’s risk exposure is minimized in these types of loans through the evaluation of the creditworthiness of the borrower, including credit scores and debt-to-income ratios, and underwriting standards which limit the loan-to-value ratio to generally no more than 80% upon loan origination, unless the borrower obtains private mortgage insurance.

Home equity loans, including term loans and lines of credit, present a slightly higher risk to the Company than 1-4 family first liens, as these loans can be first or second liens on 1-4 family owner occupied residential property, but can have loan-to-value ratios of no greater than 90% of the value of the real estate taken as collateral. The creditworthiness of the borrower is considered including credit scores and debt-to-income ratios.

Installment and other loans’ credit risk are mitigated through prudent underwriting standards, including evaluation of the creditworthiness of the borrower through credit scores and debt-to-income ratios and, if secured, the collateral value of the assets. These loans can be unsecured or secured by assets the value of which may depreciate quickly or may fluctuate, and may present a greater risk to the Company than 1-4 family residential loans.

On March 27, 2020, the Coronavirus Aid, Relief and Economic Security (“CARES”) Act was enacted. The CARES Act established the SBA PPP. The SBA PPP is intended to provide economic relief to small businesses nationwide adversely impacted under the COVID-19 Emergency Declaration issued on March 13, 2020. The SBA PPP, which began on April 3, 2020, provides small businesses with funds to cover up to 24 weeks of payroll costs and other expenses, including benefits. It also provides for forgiveness of up to the full principal amount of qualifying loans. The Bank closed and funded almost 2,800 PPP loans for a total loan amount of $459.6 million in the three months ended June 30, 2020. As these loans are 100% guaranteed by the SBA, there is no associated allowance for loan losses at June 30, 2020. These loans resulted in net fee income of $13.2 million to be recognized through net interest income over the life of the loans, which is between two and five years. During the three and six months ended June 30, 2020, the Company recognized $1.9 million of net deferred fees, included in interest income on loans on the condensed consolidated statements of income. In addition, in an effort to assist clients which were negatively impacted by the COVID-19 pandemic, the Bank offered various mitigation options, including a loan payment deferral program. Under this program, most commercial deferrals were for a 90-day period, while most consumer deferrals were for a 180-day period. As of June 30, 2020, the Company processed loan deferrals under this program for commercial and consumer clients with a total loan balance of $218.1 million and $21.2 million, respectively. In accordance with the revised Interagency Statement on Loan Modifications by Financial Institutions Working with Customers Affected by the Coronavirus issued on April 7, 2020, these deferrals are exempt from TDR status as they meet the specified requirements.

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The following table presents the loan portfolio by segment and class, excluding residential mortgage LHFS, at June 30, 2020 and December 31, 2019:

			June 30, 2020						December 31, 2019
Commercial real estate:
Owner occupied			$	164,442					$	170,884
Non-owner occupied			390,980						361,050
Multi-family			111,016						106,893
Non-owner occupied residential			116,531						120,038
Acquisition and development:
1-4 family residential construction			7,966						15,865
Commercial and land development			50,220						41,538
Commercial and industrial (1)			665,312						214,554
Municipal			34,276						47,057
Residential mortgage:
First lien			295,736						336,372
Home equity - term			11,944						14,030
Home equity - lines of credit			160,842						165,314
Installment and other loans			32,052						50,735
Total loans			$	2,041,317					$	1,644,330

⁽¹⁾ This balance includes $447.2 million and $0 of SBA PPP loans, net of deferred fees and costs, at June 30, 2020 and December 31, 2019, respectively.

In order to monitor ongoing risk associated with its loan portfolio and specific loans within the segments, management uses an internal grading system. The first several rating categories, representing the lowest risk to the Bank, are combined and given a “Pass” rating. Management generally follows regulatory definitions in assigning criticized ratings to loans, including "Special Mention," "Substandard," "Doubtful" or "Loss." The Special Mention category includes loans that have potential weaknesses that may, if not monitored or corrected, weaken the asset or inadequately protect the Bank's position at some future date. These assets pose elevated risk, but their weakness does not yet justify a more severe, or classified rating. Substandard loans are classified as they have a well-defined weakness, or weaknesses that jeopardize liquidation of the debt. These loans are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Substandard loans include loans that management has determined not to be impaired, as well as loans considered to be impaired. A Doubtful loan has a high probability of total or substantial loss, but because of specific pending events that may strengthen the asset, its classification as Loss is deferred. Loss loans are considered uncollectible, as the borrowers are often in bankruptcy, have suspended debt repayments, or have ceased business operations. Once a loan is classified as Loss, there is little prospect of collecting the loan’s principal or interest and it is charged-off.

The Company has a loan review policy and program which is designed to identify and monitor risk in the lending function. The Management ERM Committee, comprised of executive officers and loan department personnel, is charged with the oversight of overall credit quality and risk exposure of the Company's loan portfolio. This includes the monitoring of the lending activities of all Company personnel with respect to underwriting and processing new loans and the timely follow-up and corrective action for loans showing signs of deterioration in quality. A loan review program provides the Company with an independent review of the commercial loan portfolio on an ongoing basis. Generally, consumer and residential mortgage loans are included in the Pass categories unless a specific action, such as extended delinquencies, bankruptcy, repossession or death of the borrower occurs, which heightens awareness as to a possible credit event.

Internal loan reviews are completed annually on all commercial relationships with a committed loan balance in excess of $500 thousand, which includes confirmation of risk rating by an independent credit officer. In addition, all commercial relationships greater than $500 thousand rated Substandard, Doubtful or Loss are reviewed quarterly and corresponding risk ratings are reaffirmed by the Company's Problem Loan Committee, with subsequent reporting to the Management ERM Committee and the Board of Directors.

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The following table summarizes the Company’s loan portfolio ratings based on its internal risk rating system at June 30, 2020 and December 31, 2019:

			Pass						Special Mention						Non-Impaired Substandard						Impaired - Substandard						Doubtful						PCI Loans						Total
June 30, 2020
Commercial real estate:
Owner occupied			$	144,332					$	7,223					$	4,666					$	3,371					$	—					$	4,850					$	164,442
Non-owner occupied			345,176						45,468						—						—						—						336						390,980
Multi-family			95,478						14,796						662						80						—						—						111,016
Non-owner occupied residential			108,985						4,404						1,357						283						—						1,502						116,531
Acquisition and development:
1-4 family residential construction			7,844						122						—						—						—						—						7,966
Commercial and land development			38,947						9,895						541						837						—						—						50,220
Commercial and industrial			636,604						15,372						9,222						708						—						3,406						665,312
Municipal			30,025						4,251						—						—						—						—						34,276
Residential mortgage:
First lien			287,633						—						—						2,461						—						5,642						295,736
Home equity - term			11,841						—						72						11						—						20						11,944
Home equity - lines of credit			160,036						175						35						596						—						—						160,842
Installment and other loans			31,950						—						—						17						—						85						32,052
			$	1,898,851					$	101,706					$	16,555					$	8,364					$	—					$	15,841					$	2,041,317
December 31, 2019
Commercial real estate:
Owner occupied			$	151,161					$	4,513					$	3,163					$	5,872					$	—					$	6,175					$	170,884
Non-owner occupied			342,753						17,152						—						—						—						1,145						361,050
Multi-family			100,361						4,822						682						345						—						683						106,893
Non-owner occupied residential			111,697						4,534						1,115						235						—						2,457						120,038
Acquisition and development:
1-4 family residential construction			15,865						—						—						—						—						—						15,865
Commercial and land development			39,939						206						1,393						—						—						—						41,538
Commercial and industrial			198,951						1,133						8,899						1,763						—						3,808						214,554
Municipal			42,649						4,408						—						—						—						—						47,057
Residential mortgage:
First lien			323,040						978						—						2,590						—						9,764						336,372
Home equity - term			13,774						74						149						13						—						20						14,030
Home equity - lines of credit			164,469						74						38						733						—						—						165,314
Installment and other loans			50,497						—						—						85						—						153						50,735
			$	1,555,156					$	37,894					$	15,439					$	11,636					$	—					$	24,205					$	1,644,330

For commercial real estate, acquisition and development and commercial and industrial loans, a loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by

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management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Generally, loans that are more than 90 days past due are deemed impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed to determine if the loan should be placed on nonaccrual status. Nonaccrual loans in the commercial and commercial real estate portfolios and any TDRs are, by definition, deemed to be impaired. Impairment is measured on a loan-by-loan basis for commercial, construction and restructured loans by either the present value of the expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent. A loan is collateral dependent if the repayment of the loan is expected to be provided solely by the underlying collateral. For loans that are deemed to be impaired for extended periods of time, periodic updates on fair values are obtained, which may include updated appraisals. Updated fair values are incorporated into the impairment analysis in the next reporting period.

Loan charge-offs, which may include partial charge-offs, are taken on an impaired loan that is collateral dependent if the loan’s carrying balance exceeds its collateral’s appraised value, the loan has been identified as uncollectible, and it is deemed to be a confirmed loss. Typically, impaired loans with a charge-off or partial charge-off will continue to be considered impaired, unless the note is split into two, and management expects the performing note to continue to perform and is adequately secured. The second, or non-performing note, would be charged-off. Generally, an impaired loan with a partial charge-off may continue to have an impairment reserve on it after the partial charge-off, if factors warrant.

At June 30, 2020 and December 31, 2019, nearly all of the Company’s loan impairments were measured based on the estimated fair value of the collateral securing the loan, except for TDRs. By definition, TDRs are considered impaired. All TDR impairment analyses are initially based on discounted cash flows for those loans. For real estate loans, collateral generally consists of commercial real estate, but in the case of commercial and industrial loans, it could also consist of accounts receivable, inventory, equipment or other business assets. Commercial and industrial loans may also have real estate collateral.

Updated appraisals are generally required every 18 months for classified commercial loans in excess of $250 thousand. The “as is" value provided in the appraisal is often used as the fair value of the collateral in determining impairment, unless circumstances, such as subsequent improvements, approvals, or other circumstances, dictate that another value than that provided by the appraiser is more appropriate.

Generally, impaired commercial loans secured by real estate, other than performing TDRs, are measured at fair value using certified real estate appraisals that had been completed within the last 18 months. Appraised values are discounted for estimated costs to sell the property and other selling considerations to arrive at the property’s fair value. In those situations in which it is determined an updated appraisal is not required for loans individually evaluated for impairment, fair values are based on either an existing appraisal or a discounted cash flow analysis as determined by management. The approaches are discussed below:

•Existing appraisal – if the existing appraisal provides a strong loan-to-value ratio (generally 70% or lower) and, after consideration of market conditions and knowledge of the property and area, it is determined by the Credit Administration staff that there has not been a significant deterioration in the collateral value, the existing certified appraised value may be used. Discounts to the appraised value, as deemed appropriate for selling costs, are factored into the fair value.

•Discounted cash flows – in limited cases, discounted cash flows may be used on projects in which the collateral is liquidated to reduce the borrowings outstanding, and is used to validate collateral values derived from other approaches.

Collateral on certain impaired loans is not limited to real estate, and may consist of accounts receivable, inventory, equipment or other business assets. Estimated fair values are determined based on borrowers’ financial statements, inventory ledgers, accounts receivable aging or appraisals from individuals with knowledge in the business. Stated balances are generally discounted for the age of the financial information or the quality of the assets. In determining fair value, liquidation discounts are applied to this collateral based on existing loan evaluation policies.

The Company distinguishes substandard loans on both an impaired and non-impaired basis, as it places less emphasis on a loan’s classification, and increased reliance on whether the loan was performing in accordance with the contractual terms. A substandard classification does not automatically meet the definition of impaired. Loss potential, while existing in the aggregate amount of substandard loans, does not have to exist in individual extensions of credit classified as substandard. As a result, the Company’s methodology includes an evaluation of certain accruing commercial real estate, acquisition and development, and commercial and industrial loans rated substandard to be collectively evaluated for impairment. Although the Company believes

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these loans meet the definition of substandard, they are generally performing and management has concluded that it is likely the Company will be able to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement.

Larger groups of smaller balance homogeneous loans are collectively evaluated for impairment. Generally, the Company does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement due to financial difficulties of the borrower.

The following table, which excludes PCI loans, summarizes impaired loans by segment and class, segregated by those for which a specific allowance was required and those for which a specific allowance was not required at June 30, 2020 and December 31, 2019. The recorded investment in loans excludes accrued interest receivable due to insignificance. Related allowances established generally pertain to those loans in which loan forbearance agreements were in the process of being negotiated or updated appraisals were pending, and any partial charge-off will be recorded when final information is received.

			Impaired Loans with a Specific Allowance																														Impaired Loans with No Specific Allowance
			Recorded Investment (Book Balance)						Unpaid Principal Balance (Legal Balance)						Related Allowance						Recorded Investment (Book Balance)						Unpaid Principal Balance (Legal Balance)
June 30, 2020
Commercial real estate:
Owner-occupied			$	—					$	—					$	—					$	3,371					$	4,124
Non-owner occupied			—						—						—						—						313
Multi-family			—						—						—						80						—
Non-owner occupied residential			—						—						—						283						399
Acquisition and development:
Commercial and land development			—						—						—						837						875
Commercial and industrial			—						—						—						708						1,858
Residential mortgage:
First lien			688						688						35						1,773						3,083
Home equity—term			—						—						—						11						14
Home equity—lines of credit			—						—						—						596						830
Installment and other loans			—						—						—						17						28
			$	688					$	688					$	35					$	7,676					$	11,524
December 31, 2019
Commercial real estate:
Owner-occupied			$	—					$	—					$	—					$	5,872					$	8,086
Multi-family			—						—						—						345						569
Non-owner occupied residential			—						—						—						235						422
Commercial and industrial			—						—						—						1,763						3,361
Residential mortgage:
First lien			425						425						36						2,165						3,164
Home equity—term			—						—						—						13						15
Home equity—lines of credit			—						—						—						733						1,077
Installment and other loans			—						—						—						85						97
			$	425					$	425					$	36					$	11,211					$	16,791

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The following table, which excludes accruing PCI loans, summarizes the average recorded investment in impaired loans and related recognized interest income for the three and six months ended June 30, 2020 and 2019:

			2020																		2019
			Average Impaired Balance						Interest Income Recognized						Average Impaired Balance						Interest Income Recognized
Three Months Ended June 30,
Commercial real estate:
Owner-occupied			$	4,639					$	—					$	1,770					$	1
Non-owner occupied			169						—						—						—
Multi-family			270						—						118						—
Non-owner occupied residential			521						—						282						—
Acquisition and development:
Commercial and land development			837						—						—						—
Commercial and industrial			1,320						—						260						—
Residential mortgage:
First lien			3,177						12						2,512						14
Home equity – term			12						—						13						—
Home equity - lines of credit			704						1						709						1
Installment and other loans			18						—						9						—
			$	11,667					$	13					$	5,673					$	16
Six Months Ended June 30,
Commercial real estate:
Owner occupied			$	5,143					$	1					$	1,819					$	1
Non-owner occupied			96						—						—						—
Multi-family			301						—						122						—
Non-owner occupied residential			396						—						291						—
Acquisition and development:
Commercial and land development			478						—						—						—
Commercial and industrial			1,384						—						269						—
Residential mortgage:
First lien			2,874						24						2,652						29
Home equity - term			12						—						14						—
Home equity - lines of credit			715						1						736						1
Installment and other loans			34						—						8						—
			$	11,433					$	26					$	5,911					$	31

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The following table presents impaired loans that are TDRs, with the recorded investment at June 30, 2020 and December 31, 2019:

			June 30, 2020																		December 31, 2019
			Number of Contracts						Recorded Investment						Number of Contracts						Recorded Investment
Accruing:
Commercial real estate:
Owner occupied			1						$	28					1						$	30
Residential mortgage:
First lien			9						916						9						931
Home equity - lines of credit			1						16						1						18
			11						960						11						979
Nonaccruing:
Commercial real estate:
Owner occupied			1						215						4						1,909
Residential mortgage:
First lien			5						337						5						359
			6						552						9						2,268
			17						$	1,512					20						$	3,247

There were no new TDR's for the three and six months ended June 30, 2020 or 2019.

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Management further monitors the performance and credit quality of the loan portfolio by analyzing the length of time a portfolio is past due, by aggregating loans based on its delinquencies. The following table presents the classes of loan portfolio summarized by aging categories of performing loans and nonaccrual loans at June 30, 2020 and December 31, 2019:

									Days Past Due
			Current						30-59						60-89						90+ (still accruing)						Total Past Due						Non- Accrual						Total Loans
June 30, 2020
Commercial real estate:
Owner occupied			$	155,868					$	113					$	268					$	—					$	381					$	3,343					$	159,592
Non-owner occupied			390,644						—						—						—						—						—						390,644
Multi-family			110,936						—						—						—						—						80						111,016
Non-owner occupied residential			114,303						106						286						51						443						283						115,029
Acquisition and development:
1-4 family residential construction			7,966						—						—						—						—						—						7,966
Commercial and land development			49,356						27						—						—						27						837						50,220
Commercial and industrial			661,099						99						—						—						99						708						661,906
Municipal			34,276						—						—						—						—						—						34,276
Residential mortgage:
First lien			284,370						2,038						1,877						264						4,179						1,545						290,094
Home equity - term			11,826						87						—						—						87						11						11,924
Home equity - lines of credit			159,724						273						265						—						538						580						160,842
Installment and other loans			31,889						42						13						6						61						17						31,967
Subtotal			2,012,257						2,785						2,709						321						5,815						7,404						2,025,476
Loans acquired with credit deterioration:
Commercial real estate:
Owner occupied			4,850						—						—						—						—						—						4,850
Non-owner occupied			336						—						—						—						—						—						336
Non-owner occupied residential			1,270						—						66						166						232						—						1,502
Commercial and industrial			3,382						—						—						24						24						—						3,406
Residential mortgage:
First lien			3,922						1,304						18						398						1,720						—						5,642
Home equity - term			20						—						—						—						—						—						20
Installment and other loans			66						1						18						—						19						—						85
Subtotal			13,846						1,305						102						588						1,995						—						15,841
			$	2,026,103					$	4,090					$	2,811					$	909					$	7,810					$	7,404					$	2,041,317

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									Days Past Due
			Current						30-59						60-89						90+ (still accruing)						Total Past Due						Non- Accrual						Total Loans
December 31, 2019
Commercial real estate:
Owner occupied			$	158,723					$	144					$	—					$	—					$	144					$	5,842					$	164,709
Non-owner occupied			359,425						480						—						—						480						—						359,905
Multi-family			105,865						—						—						—						—						345						106,210
Non-owner occupied residential			116,370						841						66						69						976						235						117,581
Acquisition and development:
1-4 family residential construction			15,587						278						—						—						278						—						15,865
Commercial and land development			40,403						1,135						—						—						1,135						—						41,538
Commercial and industrial			208,668						315						—						—						315						1,763						210,746
Municipal			47,057						—						—						—						—						—						47,057
Residential mortgage:
First lien			314,473						9,092						1,234						150						10,476						1,659						326,608
Home equity - term			13,993						—						4						—						4						13						14,010
Home equity - lines of credit			163,907						417						275						—						692						715						165,314
Installment and other loans			50,224						236						37						—						273						85						50,582
Subtotal			1,594,695						12,938						1,616						219						14,773						10,657						1,620,125
Loans acquired with credit deterioration:
Commercial real estate:
Owner occupied			6,015						—						129						31						160						—						6,175
Non-owner occupied			564						—						—						581						581						—						1,145
Multi-family			683						—						—						—						—						—						683
Non-owner occupied residential			1,710						105						111						531						747						—						2,457
Commercial and industrial			3,792						—						—						16						16						—						3,808
Residential mortgage:
First lien			6,308						1,857						745						854						3,456						—						9,764
Home equity - term			16						4						—						—						4						—						20
Installment and other loans			131						22						—						—						22						—						153
Subtotal			19,219						1,988						985						2,013						4,986						—						24,205
			$	1,613,914					$	14,926					$	2,601					$	2,232					$	19,759					$	10,657					$	1,644,330

The Company maintains its ALL at a level management believes adequate for probable incurred credit losses. The ALL is established and maintained through a provision for loan losses charged to earnings. Quarterly, management assesses the adequacy of the ALL utilizing a defined methodology which considers specific credit evaluation of impaired loans as discussed above, past loan loss historical experience, and qualitative factors. Management believes its approach properly addresses relevant accounting guidance for loans individually identified as impaired and for loans collectively evaluated for impairment, and other bank regulatory guidance.

In connection with its quarterly evaluation of the adequacy of the ALL, management reviews its methodology to determine if it properly addresses the current risk in the loan portfolio. For each loan class, general allowances based on quantitative factors, principally historical loss trends, are provided for loans that are collectively evaluated for impairment. An

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adjustment to historical loss factors may be incorporated for delinquency and other potential risk not elsewhere defined within the ALL methodology.

In addition to this quantitative analysis, adjustments to the ALL requirements are allocated on loans collectively evaluated for impairment based on additional qualitative factors, including:

Nature and Volume of Loans – including loan growth in the current and subsequent quarters based on the Company’s targeted growth and strategic plan, coupled with the types of loans booked based on risk management and credit culture; the number of exceptions to loan policy; and supervisory loan to value exceptions.

Concentrations of Credit and Changes within Credit Concentrations – including the composition of the Company’s overall portfolio makeup and management's evaluation related to concentration risk management and the inherent risk associated with the concentrations identified.

Underwriting Standards and Recovery Practices – including changes to underwriting standards and perceived impact on anticipated losses; trends in the number of exceptions to loan policy; supervisory loan to value exceptions; and administration of loan recovery practices.

Delinquency Trends – including delinquency percentages noted in the portfolio relative to economic conditions; severity of the delinquencies; and whether the ratios are trending upwards or downwards.

Classified Loans Trends – including internal loan ratings of the portfolio; severity of the ratings; whether the loan segment’s ratings show a more favorable or less favorable trend; and underlying market conditions and impact on the collateral values securing the loans.

Experience, Ability and Depth of Management/Lending staff – including the years’ experience of senior and middle management and the lending staff; turnover of the staff; and instances of repeat criticisms of ratings.

Quality of Loan Review – including the years of experience of the loan review staff; in-house versus outsourced provider of review; turnover of staff and the perceived quality of their work in relation to other external information.

National and Local Economic Conditions – including trends in the consumer price index, unemployment rates, the housing price index, housing statistics compared to the prior year, bankruptcy rates, regulatory and legal environment risks and competition. During the three and six months ended June 30, 2020, this factor was increased for the commercial and consumer portfolios to account for the negative economic impact of the COVID-19 pandemic.

COVID-19 – during the three months ended June 30, 2020, a qualitative allocation was implemented associated with the potential impact of the COVID-19 pandemic on the Company's commercial loan portfolio. The factor assumes downgrades of loans with identified hardships resulting from the shutdown driven by the pandemic.

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The following table presents the activity in the ALL for the three and six months ended June 30, 2020 and 2019:

			Commercial																																																						Consumer
			Commercial Real Estate						Acquisition and Development						Commercial and Industrial						Municipal						Total						Residential Mortgage						Installment and Other						Total						Unallocated						Total
Three Months Ended
June 30, 2020
Balance, beginning of period			$	8,420					$	1,033					$	2,647					$	99					$	12,199					$	3,139					$	294					$	3,433					$	171					$	15,803
Provision for loan losses			877						31						590						(24)						1,474						323						102						425						1						1,900
Charge-offs			—						—						(421)						—						(421)						(18)						(14)						(32)						—						(453)
Recoveries			50						5						100						—						155						108						4						112						—						267
Balance, end of period			$	9,347					$	1,069					$	2,916					$	75					$	13,407					$	3,552					$	386					$	3,938					$	172					$	17,517
June 30, 2019
Balance, beginning of period			$	7,025					$	969					$	1,814					$	98					$	9,906					$	3,765					$	217					$	3,982					$	395					$	14,283
Provision for loan losses			(221)						39						325						(4)						139						(32)						40						8						53						200
Charge-offs			—						—						(47)						—						(47)						(25)						(51)						(76)						—						(123)
Recoveries			43						—						28						—						71						26						3						29						—						100
Balance, end of period			$	6,847					$	1,008					$	2,120					$	94					$	10,069					$	3,734					$	209					$	3,943					$	448					$	14,460
Six Months Ended
June 30, 2020
Balance, beginning of period			$	7,634					$	959					$	2,356					$	100					$	11,049					$	3,147					$	319					$	3,466					$	140					$	14,655
Provision for loan losses			1,260						102						912						(25)						2,249						400						144						544						32						2,825
Charge-offs			—						—						(496)						—						(496)						(109)						(86)						(195)						—						(691)
Recoveries			453						8						144						—						605						114						9						123						—						728
Balance, end of period			$	9,347					$	1,069					$	2,916					$	75					$	13,407					$	3,552					$	386					$	3,938					$	172					$	17,517
June 30, 2019
Balance, beginning of period			$	6,876					$	817					$	1,656					$	98					$	9,447					$	3,753					$	244					$	3,997					$	570					$	14,014
Provision for loan losses			(118)						189						484						(4)						551						157						14						171						(122)						600
Charge-offs			(25)						—						(90)						—						(115)						(271)						(71)						(342)						—						(457)
Recoveries			114						2						70						—						186						95						22						117						—						303
Balance, end of period			$	6,847					$	1,008					$	2,120					$	94					$	10,069					$	3,734					$	209					$	3,943					$	448					$	14,460

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The following table summarizes the ending loan balance individually evaluated for impairment based upon loan segment, as well as the related ALL loss allocation for each at June 30, 2020 and December 31, 2019. PCI loans are excluded from loans individually evaluated for impairment.

			Commercial																																																						Consumer
			Commercial Real Estate						Acquisition and Development						Commercial and Industrial						Municipal						Total						Residential Mortgage						Installment and Other						Total						Unallocated						Total
June 30, 2020
Loans allocated by:
Individually evaluated for impairment			$	3,734					$	837					$	708					$	—					$	5,279					$	3,068					$	17					$	3,085					$	—					$	8,364
Collectively evaluated for impairment			779,235						57,349						664,604						34,276						1,535,464						465,454						32,035						497,489						—						2,032,953
			$	782,969					$	58,186					$	665,312					$	34,276					$	1,540,743					$	468,522					$	32,052					$	500,574					$	—					$	2,041,317
ALL allocated by:
Individually evaluated for impairment			$	—					$	—					$	—					$	—					$	—					$	35					$	—					$	35					$	—					$	35
Collectively evaluated for impairment			9,347						1,069						2,916						75						13,407						3,517						386						3,903						172						17,482
			$	9,347					$	1,069					$	2,916					$	75					$	13,407					$	3,552					$	386					$	3,938					$	172					$	17,517
December 31, 2019
Loans allocated by:
Individually evaluated for impairment			$	6,452					$	—					$	1,763					$	—					$	8,215					$	3,336					$	85					$	3,421					$	—					$	11,636
Collectively evaluated for impairment			752,413						57,403						212,791						47,057						1,069,664						512,380						50,650						563,030						—						1,632,694
			$	758,865					$	57,403					$	214,554					$	47,057					$	1,077,879					$	515,716					$	50,735					$	566,451					$	—					$	1,644,330
ALL allocated by:
Individually evaluated for impairment			$	—					$	—					$	—					$	—					$	—					$	36					$	—					$	36					$	—					$	36
Collectively evaluated for impairment			7,634						959						2,356						100						11,049						3,111						319						3,430						140						14,619
			$	7,634					$	959					$	2,356					$	100					$	11,049					$	3,147					$	319					$	3,466					$	140					$	14,655

The following table provides activity for the accretable yield of PCI loans for the three and six months ended June 30, 2020 and 2019:

			Three Months Ended																		Six Months Ended
			June 30, 2020						June 30, 2019						June 30, 2020						June 30, 2019
Accretable yield, beginning of period			$	4,414					$	1,894					$	6,950					$	2,065
Additions (1)			—						3,497						570						3,497
Accretion of income			(1,315)						(1,221)						(1,913)						(1,392)
Reclassifications from nonaccretable difference due to improvement in expected cash flows			1,104						617						1,121						617
Other changes, net (2)			(21)						201						(2,546)						201
Accretable yield, end of period			$	4,182					$	4,988					$	4,182					$	4,988

⁽¹⁾ This amount reflects a measurement period adjustment during the six months ended June 30, 2020 for Hamilton loans that should have been in the PCI pool at the acquisition date.

⁽²⁾ This balance represents the impact of purchased credit impaired loans sold during the six months ended June 30, 2020.

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NOTE 5. LEASES

A lease provides the lessee the right to control the use of an identified asset for a period of time in exchange for consideration. The Company has primarily entered into operating leases for branches and office space. Most of the Company's leases contain renewal options, which the Company is reasonably certain to exercise. Including renewal options, the Company's leases range from three years to 50 years. Operating lease right-of-use assets and lease liabilities are included in other assets and accrued interest and other liabilities on the Company's unaudited condensed consolidated balance sheets.

The Company uses its incremental borrowing rate to determine the present value of the lease payments, as the rate implicit in the Company's leases is not readily determinable. Lease agreements that contain non-lease components are generally accounted for as a single lease component, while variable costs, such as common area maintenance expenses and property taxes, are expensed as incurred.

The following table presents information related to the Company's operating leases at June 30, 2020 and December 31, 2019:

			June 30, 2020						December 31, 2019
Operating lease ROU assets			$	8,746					$	9,222
Operating lease ROU liabilities			9,265						9,688
Weighted-average remaining lease term (in years)			17.9						17.6
Weighted-average discount rate			4.6		%				4.5		%

The following table presents information related to the Company's operating leases for the three and six months ended June 30, 2020 and 2019:

			Three Months Ended																		Six Months Ended
			June 30, 2020						June 30, 2019						June 30, 2020						June 30, 2019
Cash paid for operating lease liabilities			$	319					$	281					$	637					$	461
Operating lease expense			370						256						750						509

The following table presents expected future maturities of the Company's lease liabilities as of June 30, 2020:

Remainder of 2020			$	642
2021			1,147
2022			727
2023			748
2024			738
Thereafter			10,549
			14,551
Less: imputed interest			5,286
Total lease liabilities			$	9,265

NOTE 6. GOODWILL AND OTHER INTANGIBLE ASSETS

The following table presents changes in goodwill at June 30, 2020 and December 31, 2019:

			June 30, 2020						December 31, 2019
Balance, beginning of year			$	19,925					$	12,592
Acquired goodwill			—						7,029
Adjustments to acquired goodwill (1)			(1,201)						304
Balance, end of period			$	18,724					$	19,925

⁽¹⁾ The Company finalized its purchase accounting adjustments associated with Hamilton as of May 1, 2020.

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Goodwill is not amortized but is reviewed for potential impairment on at least an annual basis, with testing between annual tests if an event occurs or circumstances change that could potentially reduce the fair value of a reporting unit. Due to the severe economic impact of COVID-19, the Company reviewed its goodwill for impairment. It was concluded that no impairment existed at June 30, 2020. Management will continue to evaluate current economic conditions to determine if a triggering event would impact the current valuations for these assets.

The following table presents changes in other intangible assets for the three and six months ended June 30, 2020 and 2019:

			Three Months Ended June 30,																		Six Months Ended June 30,
			2020						2019						2020						2019
Beginning of period			$	6,717					$	3,702					$	7,180					$	3,910
Acquired CDI			—						4,550						—						4,550
Non-compete agreement			—						290						—						290
Amortization Expense			(404)						(402)						(867)						(610)
Impairment			(153)						—						(153)						—
Balance, end of period			$	6,160					$	8,140					$	6,160					$	8,140

During the three and six months ended June 30, 2020, the Company recorded an impairment charge of $153 thousand for the full remaining balance attributable to a customer list intangible asset due to the pending dissolution of Wheatland. No impairment charges were recorded in the three and six months ended June 30, 2019.

The following table presents the components of other identifiable intangible assets at June 30, 2020 and December 31, 2019:

			June 30, 2020																		December 31, 2019
			Gross Amount						Accumulated Amortization						Gross Amount						Accumulated Amortization
Amortized intangible assets:
Core deposit intangibles			$	8,390					$	2,235					$	8,390					$	1,493
Other customer relationship intangibles			174						169						524						338
Non-compete agreement			—						—						290						193
Total			$	8,564					$	2,404					$	9,204					$	2,024

The following table presents future estimated aggregate amortization expense for intangible assets remaining at June 30, 2020:

Remainder of 2020			$	702
2021			1,275
2022			1,105
2023			935
2024			766
Thereafter			1,377
			$	6,160

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NOTE 7. INCOME TAXES

The Company files income tax returns in the U.S. federal jurisdiction, the Commonwealth of Pennsylvania and the State of Maryland. The Company is no longer subject to tax examination by tax authorities for years before 2016.

The following table summarizes income tax expense for the three and six months ended June 30, 2020 and 2019:

			Three months ended June 30,																		Six months ended June 30,
			2020						2019						2020						2019
Current expense			$	427					$	69					$	455					$	90
Deferred expense			874						41						1,885						252
Income tax expense			$	1,301					$	110					$	2,340					$	342

The following table summarizes deferred tax assets and liabilities at June 30, 2020 and December 31, 2019:

(Dollars in thousands)			June 30, 2020						December 31, 2019
Deferred tax assets:
Allowance for loan losses			$	4,056					$	3,418
Deferred compensation			505						415
Retirement and salary continuation plans			2,429						2,357
Share-based compensation			620						631
Off-balance sheet reserves			270						234
Nonaccrual loan interest			740						697
Net unrealized losses on AFS securities			944						127
Purchase accounting adjustments			2,496						4,081
Bonus accrual			257						493
Interest Rate Swaps			441						—
Low-income housing credit carryforward			230						—
Net operating loss carryovers			1,645						1,872
Other			719						672
Total deferred tax assets			15,352						14,997
Deferred tax liabilities:
Depreciation			433						452
Mortgage servicing rights			557						694
Purchase accounting adjustments			1,356						1,599
Other			275						275
Total deferred tax liabilities			2,621						3,020
Net deferred tax asset, included in other assets			$	12,731					$	11,977

At June 30, 2020, the Company had acquired federal and state net operating loss carryforwards of $11.1 million and $6.7 million, respectively, subject to annual loss limitation limits, that expire through 2037. A deferred tax asset is recognized for these carryforwards because the benefit is more likely than not to be realized.

FASB ASC 740, Income Taxes, (“ASC 740”) clarifies the accounting for income taxes by prescribing a minimum probability threshold that a tax position must meet before a financial statement benefit is recognized. The minimum threshold is defined in ASC 740 as a tax position that is more likely than not to be sustained upon examination by the applicable taxing authority, including resolution of any related appeals or litigation processes, based on the technical merits of the position. The tax benefit to be recognized is measured as the largest amount of benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. ASC 740 was applied to all existing tax positions upon initial adoption. There was no liability for uncertain tax positions and no known unrecognized tax benefits at June 30, 2020 or December 31, 2019.

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NOTE 8. SHARE-BASED COMPENSATION PLANS

The Company maintains share-based compensation plans under the shareholder-approved 2011 Plan. The purpose of the share-based compensation plans is to provide officers, employees, and non-employee members of the Board of Directors of the Company with additional incentive to further the success of the Company. At June 30, 2020, 881,920 shares of the common stock of the Company were reserved to be issued and 347,721 shares were available to be issued.

The 2011 Plan incentive awards may consist of grants of incentive stock options, nonqualified stock options, stock appreciation rights, restricted stock, deferred stock units and performance shares. All employees and members of the Board of Directors of the Company and its subsidiaries, are eligible to participate in the 2011 Plan. The 2011 Plan allows for the Compensation Committee of the Board of Directors to determine the type of incentive to be awarded, its term, manner of exercise, vesting and restrictions on shares. Generally, awards are nonqualified under the IRC, unless the awards are deemed to be incentive awards to employees at the Compensation Committee’s discretion.

The table below presents a summary of nonvested restricted shares activity for the six months ended June 30, 2020:

			Shares						Weighted Average Grant Date Fair Value
Nonvested shares, beginning of year			228,758						$	21.90
Granted			111,307						20.24
Forfeited			(4,000)						19.65
Vested			(61,731)						20.52
Nonvested shares, at period end			274,334						$	21.57

The following table presents restricted shares compensation expense, with tax benefit information, and fair value of shares vested, for the three and six months ended June 30, 2020 and 2019:

			Three months ended June 30,																		Six months ended June 30,
			2020						2019						2020						2019
Restricted share award expense			$	654					$	181					$	1,173					$	676
Restricted share award tax benefit			137						38						246						148
Fair value of shares vested			347						—						1,089						444

The unrecognized compensation expense related to the share awards totaled $3.1 million at June 30, 2020 and $2.2 million at December 31, 2019. The unrecognized compensation expense at June 30, 2020 is expected to be recognized over a weighted-average period of 2.0 years.

The following table presents a summary of outstanding stock options activity for the six months ended June 30, 2020:

			Shares						Weighted Average Exercise Price
Outstanding, beginning of year			30,559						$	21.56
Forfeited			(1,000)						21.14
Expired			(2,792)						25.76
Options outstanding and exercisable			26,767						$	21.14

The exercise price of each option equals the market price of the Company’s stock on the grant date. An option’s maximum term is ten years. All options are fully vested upon issuance. The following table presents information pertaining to options outstanding and exercisable at June 30, 2020:

Exercise Price						Number Outstanding						Remaining Contractual Life (Years)						Exercise Price
$21.14						26,767						0.06						$	21.14

Outstanding and exercisable options had an intrinsic value of zero at June 30, 2020 and $41 thousand at December 31, 2019.

The Company maintains an employee stock purchase plan to provide its employees with an opportunity to purchase Company common stock. Eligible employees may purchase shares in an amount that does not exceed 10% of their annual

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salary, at the lower of 95% of the fair market value of the shares on the semi-annual offering date or related purchase date. The purchases occur in March and September of each year. The Company reserved 350,000 shares of its common stock to be issued under the employee stock purchase plan. At June 30, 2020, 164,453 shares were available to be issued.

The following table presents information for the employee stock purchase plan for the three and six months ended June 30, 2020 and 2019:

			Three months ended June 30,																		Six months ended June 30,
			2020						2019						2020						2019
Shares purchased			—						—						3,613						3,004
Weighted average price of shares purchased			$	—					$	—					$	16.91					$	18.96
Compensation expense recognized			—						—						3						3
Tax benefits			—						—						1						1

The Company issues either new shares or treasury shares, depending on market conditions, for award through its share-based compensation plans.

NOTE 9. DERIVATIVE FINANCIAL INSTRUMENTS

The Company is exposed to certain risk arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity, and credit risk primarily by managing the amount, sources, and duration of its assets and liabilities and the use of derivative financial instruments. Specifically, the Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The Company’s derivative financial instruments are used as risk management tools by the Company to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally related to the Company’s borrowings and are not used for trading or speculative purposes.

The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. At June 30, 2020, the Company had two interest rate derivatives designated as hedging instruments with an aggregate notional amount of $100.0 million. The Company had no derivative instruments at December 31, 2019. Such derivatives were used to hedge the variable cash flows associated with the Company's borrowings. At June 30, 2020, the Company had cash collateral of $2.3 million held with the counterparty for these derivatives.

The Company enters into interest rate swaps that allow its commercial loan customers to effectively convert a variable-rate commercial loan agreement to a fixed-rate commercial loan agreement. Under these agreements, the Company enters into a variable-rate loan agreement with a customer in addition to an interest rate swap agreement, which serves to effectively swap the customer’s variable-rate loan into a fixed-rate loan. The Company then enters into a corresponding swap agreement with a third party in order to economically hedge its exposure through the customer agreement. The interest rate swaps with both the customers and third parties are not designated as hedges and are marked through earnings. At June 30, 2020, the Company had two interest rate derivative not designated as a hedging instrument with an aggregate notional amount of $14.2 million. The Company had no such derivative instruments at December 31, 2019.

As a part of its normal residential mortgage operations, the Company will enter into an interest rate lock commitment with a potential borrower. The Company enters into a corresponding commitment to an investor to sell that loan at a specific price

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shortly after origination. In accordance with FASB ASC 820, adjustments are recorded through earnings to account for the net change in fair value of these transactions for the held for sale pipeline.

The following table summarizes the fair value of the Company's derivative instruments at June 30, 2020 and December 31, 2019:

			6/30/2020																														12/31/2019
			Notional Amount						Balance Sheet Location						Fair Value						Notional Amount						Balance Sheet Location						Fair Value
Derivatives designated as hedging instruments:
Interest rate swaps - balance sheet hedge			$	100,000					Other liabilities						$	(1,978)					$	—											$	—
Total derivatives designated as hedging instruments															$	(1,978)																	$	—
Derivatives not designated as hedging instruments:
Interest rate swap - commercial borrower			$	7,100					Other assets						$	234					$	—											$	—
Interest rate swap - counterparty			7,100						Other liabilities						(251)						—												—
Interest rate lock commitments with customers			34,839						Other assets						986						4,408						Other assets						103
Forward sale commitments			13,187						Other liabilities						(54)						8,969						Other assets						1
Total derivatives not designated as hedging instruments															$	915																	$	104

The following tables summarize the effect of the Company's derivative financial instruments on OCI and net income for the three and six months ended June 30, 2020 and 2019:

			Amount of Loss Recognized in OCI on Derivative																		Amount of Loss Recognized in OCI on Derivative
			Three Months Ended June 30,																		Six Months Ended June 30,
			2020						2019						2020						2019
Derivatives in cash flow hedging relationships:
Interest rate products			$	(842)					$	—					$	(2,101)					$	—
Total			$	(842)					$	—					$	(2,101)					$	—

			Amount of Loss Reclassified from Accumulated OCI into Income																		Amount of Loss Reclassified from AOCI into Income																		Location of Loss Recognized from AOCI into Income
			Three Months Ended June 30,																		Six Months Ended June 30,
			2020						2019						2020						2019
Derivatives in cash flow hedging relationships:
Interest rate products			$	(121)					$	—					$	(125)					$	—					Interest expense
Total			$	(121)					$	—					$	(125)					$	—

			Amount of Gain (Loss) Recognized in Income																		Amount of Gain (Loss) Recognized in Income																		Location of Gain (Loss) Recognized in Income
			Three Months Ended June 30,																		Six Months Ended June 30,
			2020						2019						2020						2019
Derivatives not designated as hedging instruments:
Interest rate products			$	(17)					$	—					$	(17)					$	—					Other operating expenses
Interest rate lock commitments with customers			551						—						883						—						Mortgage banking activities
Forward sale commitment			141						—						(197)						—						Mortgage banking activities
Total			$	675					$	—					$	669					$	—

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The following table is a summary of interest rate swap components at June 30, 2020 and December 31, 2019:

			June 30, 2020						December 31, 2019
Weighted average pay rate			0.54		%				—		%
Weighted average receive rate			0.08		%				—		%
Weighted average maturity in years			5.7						—

NOTE 10. SHAREHOLDERS’ EQUITY AND REGULATORY CAPITAL

Banks and bank holding companies are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities and certain off-balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action. Under the Basel Committee on Banking Supervision's capital guidelines for U.S. Banks ("Basel III rules"), an entity must hold a capital conservation buffer above the adequately capitalized risk-based capital ratios. The Company and the Bank have elected not to include net unrealized gain or loss on available for sale securities in computing regulatory capital.

The consolidated asset limit on small bank holding companies is $3.0 billion and a company with assets under that limit is not subject to the FRB consolidated capital rules, but may file reports that include capital amounts and ratios. The Company has elected to file those reports.

Management believes that the Company and the Bank met all capital adequacy requirements to which they are subject at June 30, 2020 and December 31, 2019.

Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required. At June 30, 2020, the most recent regulatory notifications categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank's classification.

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The following table presents capital amounts and ratios at June 30, 2020 and December 31, 2019:

			Actual																		For Capital Adequacy Purposes (includes applicable capital conservation buffer)																		To Be Well Capitalized Under Prompt Corrective Action Provisions
			Amount						Ratio						Amount						Ratio						Amount						Ratio
June 30, 2020
Total risk-based capital:
Orrstown Financial Services, Inc.			$	256,183					14.5		%				$	185,262					10.5		%				n/a						n/a
Orrstown Bank			244,669						13.9		%				185,169						10.5		%				$	176,352					10.0		%
Tier 1 risk-based capital:
Orrstown Financial Services, Inc.			205,582						11.7		%				149,974						8.5		%				n/a						n/a
Orrstown Bank			225,943						12.8		%				149,899						8.5		%				141,081						8.0		%
Tier 1 common equity risk-based capital:
Orrstown Financial Services, Inc.			205,582						11.7		%				123,508						7.0		%				n/a						n/a
Orrstown Bank			225,943						12.8		%				123,446						7.0		%				114,629						6.5		%
Tier 1 leverage capital:
Orrstown Financial Services, Inc.			205,582						7.6		%				107,855						4.0		%				n/a						n/a
Orrstown Bank			225,943						8.4		%				107,901						4.0		%				134,876						5.0		%
December 31, 2019
Total risk-based capital:
Orrstown Financial Services, Inc.			$	244,003					14.1		%				$	182,028					10.5		%				n/a						n/a
Orrstown Bank			231,805						13.4		%				181,948						10.5		%				$	173,284					10.0		%
Tier 1 risk-based capital:
Orrstown Financial Services, Inc.			196,451						11.3		%				147,356						8.5		%				n/a						n/a
Orrstown Bank			216,100						12.5		%				147,291						8.5		%				138,627						8.0		%
Tier 1 common equity risk-based capital:
Orrstown Financial Services, Inc.			196,451						11.3		%				121,352						7.0		%				n/a						n/a
Orrstown Bank			216,100						12.5		%				121,299						7.0		%				112,635						6.5		%
Tier 1 leverage capital:
Orrstown Financial Services, Inc.			196,451						8.6		%				91,782						4.0		%				n/a						n/a
Orrstown Bank			216,100						9.4		%				91,798						4.0		%				114,747						5.0		%

In September 2015, the Board of Directors of the Company authorized a share repurchase program under which the Company may repurchase up to 5% of the Company's outstanding shares of common stock, or approximately 416,000 shares, in accordance with all applicable securities laws and regulations, including Rule 10b-18 of the Exchange Act of 1934, as amended. When and if appropriate, repurchases may be made in open market or privately negotiated transactions, depending on market conditions, regulatory requirements and other corporate considerations, as determined by management. Share repurchases may not occur and may be discontinued at any time. At June 30, 2020, 154,680 shares had been repurchased under the program at a total cost of $2.6 million, or $16.88 per share.

On July 21, 2020, the Board declared a cash dividend of $0.17 per common share, which will be paid on August 10, 2020 to shareholders of record at August 3, 2020.

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NOTE 11. EARNINGS PER SHARE

The following table presents earnings per share for the three and six months ended June 30, 2020 and 2019:

			Three Months Ended June 30,																		Six Months Ended June 30,
			2020						2019						2020						2019
Net income			$	6,359					$	2,687					$	11,427					$	5,789
Weighted average shares outstanding - basic			10,916						10,348						10,937						9,757
Dilutive effect of share-based compensation			77						166						90						166
Weighted average shares outstanding - diluted			10,993						10,514						11,027						9,923
Per share information:
Basic earnings per share			$	0.58					$	0.26					$	1.04					$	0.59
Diluted earnings per share			0.58						0.26						1.04						0.58

Average outstanding stock options and restricted shares totaling 27,667 and 37,232 for the three months ended June 30, 2020 and 2019, respectively, and of 29,113 and 39,108 for the six months ended June 30, 2020 and 2019, respectively, were not included in the computation of earnings per share because the effect was antidilutive, due to the exercise price exceeding the average market price. The dilutive effect of share-based compensation in each period above relates principally to restricted stock awards.

NOTE 12. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contract amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. The following table presents these contractual, or notional, amounts:

			Contractual or Notional Amount
			June 30, 2020						December 31, 2019
Commitments to fund:
Home equity lines of credit			$	215,471					$	205,502
1-4 family residential construction loans			18,836						19,812
Commercial real estate, construction and land development loans			28,505						19,018
Commercial, industrial and other loans			244,489						222,288
Standby letters of credit			10,684						10,588

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s credit-worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the customer. Collateral varies but may include accounts receivable, inventory, equipment, residential real estate, and income-producing commercial properties.

Standby letters of credit and financial guarantees written are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. The Company holds collateral supporting those commitments when deemed necessary by management. The liability, at June 30, 2020 and December 31, 2019, for guarantees under standby letters of credit issued was not material.

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The Company maintains a reserve, based on historical loss experience of the related loan class, for off-balance sheet credit exposures that currently are not funded, in other liabilities on the unaudited condensed consolidated balance sheets. This reserve totaled $1.2 million at June 30, 2020 and $1.0 million at December 31, 2019.

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NOTE 13. FAIR VALUE

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Certain financial instruments and all non-financial instruments are excluded from disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.

The fair value hierarchy distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity's own assumptions about market participant assumptions based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are:

Level 1 – quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access at the measurement date.

Level 2 – significant other observable inputs other than Level 1 prices such as prices for similar assets and liabilities in active markets; quoted prices for identical or similar instruments in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3 – at least one significant unobservable input that reflects a company's own assumptions about the assumptions that market participants would use in pricing an asset or liability.

In instances in which multiple levels of inputs are used to measure fair value, hierarchy classification is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company's assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.

The Company used the following methods and significant assumptions to estimate fair value for instruments measured on a recurring basis:

Where quoted prices are available in an active market, securities are classified within Level 1 of the valuation hierarchy. Level 1 securities include highly liquid government bonds, mortgage products and exchange traded equities. If quoted market prices are not available, securities are classified within Level 2 and fair values are estimated by using pricing models, quoted prices of securities with similar characteristics or discounted cash flow. Level 2 securities include U.S. agency securities, mortgage-backed securities, obligations of states and political subdivisions and certain corporate, asset backed and other securities. In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy. All of the Company’s securities are classified as available for sale.

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The Company had no fair value liabilities measured on a recurring basis at June 30, 2020 and December 31, 2019.

The following table summarizes assets measured at fair value on a recurring basis at June 30, 2020 and December 31, 2019:

			Level 1						Level 2						Level 3						Total Fair Value Measurements
June 30, 2020
Investment securities:
States and political subdivisions			$	—					$	113,095					$	—					$	113,095
GSE residential MBSs			—						4,605						—						4,605
GSE residential CMOs			—						66,067						—						66,067
Nonagency CMOs			—						—						17,309						17,310
Private label commercial CMOs			—						63,211						6,525						69,736
Asset-backed			—						212,768						—						212,768
Other			355						—						—						355
Loans held for sale			—						13,594						—						13,594
Interest rate swaps			—						234						—						234
Interest rate lock commitments on residential mortgages			—						—						986						986
Totals			$	355					$	473,574					$	24,820					$	498,750
December 31, 2019
Investment securities:
States and political subdivisions			$	—					$	87,863					$	—					$	87,863
GSE residential CMOs			—						68,154						—						68,154
Nonagency CMOs			—						—						17,087						17,087
Private label commercial CMOs			—						79,437						7,192						86,629
Asset-backed			—						230,515						—						230,515
Other			637						—						—						637
Loans held for sale			—						9,364						—						9,364
Interest rate lock commitments on residential mortgages			—						—						103						103
Totals			$	637					$	475,333					$	24,382					$	500,352

The Company has CMOs measured at fair value on a recurring basis using significant unobservable inputs (Level 3) at June 30, 2020 and December 31, 2019. The Level 3 valuation is based on a non-executable broker quote, which is considered a significant unobservable input. Such quotes are updated as available and may remain constant for a period of time for certain broker-quoted securities that do not move with the market or that are not interest rate sensitive as a result of their structure or overall attributes.

Effective October 1, 2019, the Company’s residential mortgage loans held for sale were recorded at fair value utilizing Level 2 measurements. This fair value measurement is determined based upon third party quotes obtained on similar loans. For loans held for sale for which the fair value option has been elected, the aggregate fair value exceeded the aggregate principal balance by $407 thousand as of June 30, 2020.

The determination of the fair value of interest rate lock commitments on residential mortgages is based on agreed upon pricing with the respective investor on each loan and includes a pull through percentage. The pull through percentage represents an estimate of loans in the pipeline to be delivered to an investor versus the total loans committed for delivery. Significant changes in this input could result in a significantly higher or lower fair value measurement. As the pull through percentage is a significant unobservable input, this is deemed a Level 3 valuation input. The average pull through percentage, which is based upon historical experience, was 93% as of June 30, 2020. An increase or decrease of 5% in the pull through assumption would result in a positive or negative change of $57 thousand in the fair value of interest rate lock commitments at June 30, 2020.

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The following provides details of the Level 3 fair value measurement activity for the periods ended June 30, 2020 and 2019:

CMOs:

			Three Months Ended June 30,																		Six Months Ended June 30,
			2020						2019						2020						2019
Balance, beginning of period			$	23,250					$	—					$	24,279					$	—
Unrealized gain (loss) included in OCI			532						—						(429)						—
Principal payments and other			52						—						(16)						—
Balance, end of period			$	23,834					$	—					$	23,834					$	—

Interest rate lock commitments on residential mortgages:

			Three Months Ended June 30,																		Six Months Ended June 30,
			2020						2019						2020						2019
Balance, beginning of period			$	435					$	—					$	103					$	—
Total gains, realized/unrealized:
Included in earnings			551						—						883						—
Balance, end of period			$	986					$	—					$	986					$	—

Certain financial assets are measured at fair value on a nonrecurring basis. Adjustments to the fair value of these assets usually results from the application of lower of cost or market accounting or write-downs of individual assets. The Company used the following methods and significant assumptions to estimate fair value for these financial assets.

Impaired Loans

Loans are designated as impaired when, in the judgment of management and based on current information and events, it is probable that all amounts due, according to the contractual terms of the loan agreement, will not be collected. The measurement of loss associated with impaired loans for all loan classes can be based on either the observable market price of the loan, the fair value of the collateral, or discounted cash flows using a market rate of interest for performing TDRs. For collateral-dependent loans, fair value is measured based on the value of the collateral securing the loan, less estimated costs to sell. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The value of the real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of the Company using observable market data (Level 2). However, if the collateral is a house or building in the process of construction, or if management adjusts the appraisal value, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal, if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivable collateral are based on financial statement balances or aging reports (Level 3). Impaired loans with an allocation to the ALL are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the unaudited condensed consolidated statements of income.

Any changes in the fair value of impaired loans still held were not material for the three and six months ended June 30, 2020 and 2019:

Foreclosed Real Estate

OREO property acquired through foreclosure is initially recorded at the fair value of the property at the transfer date less estimated selling cost. Subsequently, OREO is carried at the lower of its carrying value or the fair value less estimated selling cost. Fair value is usually determined based upon an independent third-party appraisal of the property or occasionally upon a recent sales offer. There were no charges recorded to the value of OREO at the lower of cost or fair value on properties held during the three and six months ended June 30, 2020 and 2019. There were no changes in the fair value of OREO for properties, still held at June 30, that were charged to real estate expenses for the three and six months ended June 30, 2020 and 2019.

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Mortgage Servicing Rights

The MSR fair value is estimated to be equal to its carrying value, unless the quarterly valuation model calculates the present value of the estimated net servicing income is less than its carrying value, in which case an impairment charge is taken. At June 30, 2020 and December 31, 2019, an impairment reserve of $890 thousand and $70 thousand, respectively, existed on the mortgage servicing right portfolio. For the three months ended June 30, 2020 and 2019, impairment charges of $317 thousand and $0 were included, respectively, in mortgage banking activities on the unaudited condensed consolidated statements of income. For the six months ended June 30, 2020 and 2019, impairment charges of $820 thousand and $0 were included, respectively, in mortgage banking activities on the unaudited condensed consolidated statements of income. The impairment charges resulted from rapidly declining market rates caused by the COVID-19 pandemic.

The following table summarizes assets measured at fair value on a nonrecurring basis at June 30, 2020 and December 31, 2019:

			Level 1						Level 2						Level 3						Total Fair Value Measurements
June 30, 2020
Impaired Loans
Commercial real estate:
Owner occupied			$	—					$	—					$	892					$	892
Multi-family			—						—						80						80
Non-owner occupied residential			—						—						42						42
Commercial and industrial			—						—						211						211
Residential mortgage:
First lien			—						—						885						885
Home equity - lines of credit			—						—						179						179
Installment and other loans			—						—						7						7
Total impaired loans			$	—					$	—					$	2,296					$	2,296
Mortgage servicing rights			$	—					$	—					$	2,501					$	2,501
December 31, 2019
Impaired Loans
Commercial real estate:
Owner occupied			$	—					$	—					$	938					$	938
Multi-family			—						—						96						96
Non-owner occupied residential			—						—						103						103
Commercial and industrial			—						—						11						11
Residential mortgage:
First lien			—						—						641						641
Home equity - lines of credit			—						—						400						400
Installment and other loans			—						—						7						7
Total impaired loans			$	—					$	—					$	2,196					$	2,196
Mortgage servicing rights			$	—					$	—					$	3,119					$	3,119

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The following table presents additional qualitative information about assets measured on a nonrecurring basis and for which the Company has utilized Level 3 inputs to determine fair value:

Fair Value Estimate

Valuation Techniques

Unobservable Input

Range

June 30, 2020

Impaired loans

$

2,296

Appraisal of collateral

Management adjustments on appraisals for property type and recent activity

0% - 20% discount

- Management adjustments for liquidation expenses

6%- 33% discount

Mortgage servicing rights

$

2,501

Discounted cash flows

Weighted average CPR

15.16%

- Weighted average discount rate

9.59%

December 31, 2019

Impaired loans

$

2,196

Appraisal of collateral

Management adjustments on appraisals for property type and recent activity

0% - 20% discount

- Management adjustments for liquidation expenses

6% - 33% discount

Mortgage servicing rights

$

3,119

Discounted cash flows

Weighted average CPR

11.63%

- Weighted average discount rate

9.54%

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Fair values of financial instruments

The following table presents carrying amounts and estimated fair values of the Company’s financial instruments at June 30, 2020 and December 31, 2019:

			Carrying Amount						Fair Value						Level 1						Level 2						Level 3
June 30, 2020
Financial Assets
Cash and due from banks			$	26,652					$	26,652					$	26,652					$	—					$	—
Interest-bearing deposits with banks			25,638						25,638						25,638						—						—
Restricted investments in bank stocks			16,256						n/a						n/a						n/a						n/a
Investment securities			483,936						483,936						—						460,102						23,834
Loans held for sale			13,594						13,594						—						13,594						—
Loans, net of allowance for loan losses			2,023,800						2,007,374						—						—						2,007,374
Interest rate lock commitments on residential mortgages			986						986						—						—						986
Interest rate swaps			234						234						—						234						—
Accrued interest receivable			8,182						8,182						—						1,750						6,432
Financial Liabilities
Deposits			2,251,731						2,255,147						—						2,255,147						—
Securities sold under agreements to repurchase			23,716						23,716						—						23,716						—
FHLB Advances			202,804						203,100						—						203,100						—
Subordinated notes			31,875						32,436						—						32,436						—
Interest rate swaps			2,227						2,227						—						2,227						—
Accrued interest payable			441						441						—						441						—
December 31, 2019
Financial Assets
Cash and due from banks			$	25,969					$	25,969					$	25,969					$	—					$	—
Interest-bearing deposits with banks			30,493						30,493						30,493						—						—
Restricted investments in bank stocks			16,184						n/a						n/a						n/a						n/a
Investment securities			490,386						490,386						—						466,107						24,279
Loans held for sale			9,364						9,364						—						9,364						—
Loans, net of allowance for loan losses			1,629,675						1,652,788						—						—						1,652,788
Interest rate lock commitments on residential mortgages			103						103						—						—						103
Accrued interest receivable			6,040						6,040						—						1,863						4,177
Financial Liabilities
Deposits			1,875,522						1,876,555						—						1,876,555						—
Securities sold under agreements to repurchase			8,269						8,269						—						8,269						—
FHLB Advances			209,667						210,005						—						210,005						—
Subordinated notes			31,847						33,953						—						33,953						—
Accrued interest payable			879						879						—						879						—

The methods used to estimate the fair value of financial instruments at June 30, 2020 did not necessarily represent an exit price. In accordance with the Company's adoption of ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, the methods utilized to measure the fair value of financial instruments at June 30, 2020 represents an approximation of exit price; however, an actual exit price may differ.

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NOTE 14. CONTINGENCIES

The nature of the Company’s business generates a certain amount of litigation involving matters arising out of the ordinary course of business. Except as described below, in the opinion of management, there are no legal proceedings that might have a material effect on the results of operations, liquidity, or the financial position of the Company at this time.

On March 5, 2019, Paul Parshall, a purported individual stockholder of Hamilton, filed, on behalf of himself and all of Hamilton’s stockholders other than the named defendants and their affiliates (the “Purported Class”), a derivative and putative class action complaint in the Circuit Court for Baltimore City, Maryland, captioned Paul Parshall v. Carol Coughlin et. al., naming each Hamilton director, Orrstown, and Hamilton as defendants (the “Action”). The Action alleged, among other things, that Hamilton’s directors breached their fiduciary duties to the Purported Class in connection with the merger, and that the Proxy Statement/Prospectus omitted certain material information regarding the merger. Orrstown was alleged to have aided and abetted the Hamilton directors’ alleged breaches of their fiduciary duties. The Action sought, among other remedies, to enjoin the merger or, in the event the merger was completed, rescission of the merger or rescissory damages; unspecified damages; and costs of the lawsuit, including attorneys’ and experts’ fees. A settlement was reached on the Action in March 2020 which resulted in a payment by the Company of $135 thousand in mootness fees to the defendants in April 2020.

On May 25, 2012, SEPTA filed a putative class action complaint in the U.S. District Court for the Middle District of Pennsylvania against the Company, the Bank and certain current and former directors and executive officers (collectively, the “Orrstown Defendants”). The complaint alleges, among other things, that (i) in connection with the Company’s Registration Statement on Form S-3 dated February 23, 2010 and its Prospectus Supplement dated March 23, 2010, and (ii) during the purported class period of March 24, 2010 through October 27, 2011, the Company issued materially false and misleading statements regarding the Company’s lending practices and financial results, including misleading statements concerning the stringent nature of the Bank’s credit practices and underwriting standards, the quality of its loan portfolio, and the intended use of the proceeds from the Company’s March 2010 public offering of common stock. The complaint asserts claims under Sections 11, 12(a) and 15 of the Securities Act of 1933, Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, and seeks class certification, unspecified money damages, interest, costs, fees and equitable or injunctive relief. Under the Private Securities Litigation Reform Act of 1995 (“PSLRA”), motions for appointment of Lead Plaintiff in this case were due by July 24, 2012. SEPTA was the sole movant and the Court appointed SEPTA Lead Plaintiff on August 20, 2012.

Pursuant to the PSLRA and the Court’s September 27, 2012 Order, SEPTA was given until October 26, 2012 to file an amended complaint and the Orrstown Defendants until December 7, 2012 to file a motion to dismiss the amended complaint. SEPTA’s opposition to the Orrstown Defendants’ motion to dismiss was originally due January 11, 2013. Under the PSLRA, discovery and all other proceedings in the case were stayed pending the Court’s ruling on the motion to dismiss. The September 27, 2012 Order specified that if the motion to dismiss were denied, the Court would schedule a conference to address discovery and the filing of a motion for class certification. On October 26, 2012, SEPTA filed an unopposed motion for enlargement of time to file its amended complaint in order to permit the parties and new defendants to be named in the amended complaint time to discuss plaintiff’s claims and defendants’ defenses. On October 26, 2012, the Court granted SEPTA’s motion, mooting its September 27, 2012 scheduling Order, and requiring SEPTA to file its amended complaint on or before January 16, 2013 or otherwise advise the Court of circumstances that require a further enlargement of time. On January 14, 2013, the Court granted SEPTA’s second unopposed motion for enlargement of time to file an amended complaint on or before March 22, 2013.

On March 4, 2013, SEPTA filed an amended complaint. The amended complaint expanded the list of defendants in the action to include the Company’s former independent registered public accounting firm, Smith Elliott Kearns & Company, LLC (“SEK”), and the underwriters of the Company’s March 2010 public offering of common stock. In addition, among other things, the amended complaint extends the purported 1934 Exchange Act class period from March 15, 2010 through April 5, 2012. Pursuant to the Court’s March 28, 2013 Second Scheduling Order, on May 28, 2013, all defendants filed their motions to dismiss the amended complaint, and on July 22, 2013, SEPTA filed its “omnibus” opposition to all of the defendants’ motions to dismiss. On August 23, 2013, all defendants filed reply briefs in further support of their motions to dismiss. On December 5, 2013, the Court ordered oral argument on the Orrstown Defendants’ motion to dismiss the amended complaint to be heard on February 7, 2014. Oral argument on the pending motions to dismiss SEPTA’s amended complaint was held on April 29, 2014.

The Second Scheduling Order stayed all discovery in the case pending the outcome of the motions to dismiss, and informed the parties that, if required, a telephonic conference to address discovery and the filing of SEPTA’s motion for class certification would be scheduled after the Court’s ruling on the motions to dismiss.

On April 10, 2015, pursuant to Court order, all parties filed supplemental briefs addressing the impact of the U.S. Supreme Court’s March 24, 2015 decision in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund on defendants’ motions to dismiss the amended complaint.

On June 22, 2015, in a 96-page Memorandum, the Court dismissed without prejudice SEPTA’s amended complaint against all defendants, finding that SEPTA failed to state a claim under either the Securities Act of 1933, as amended, or the

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Securities Exchange Act of 1934, as amended. The Court ordered that, within 30 days, SEPTA either seek leave to amend its amended complaint, accompanied by the proposed amendment, or file a notice of its intention to stand on the amended complaint.

On July 22, 2015, SEPTA filed a motion for leave to amend under Local Rule 15.1, and attached a copy of its proposed second amended complaint to its motion. Many of the allegations of the proposed second amended complaint are essentially the same or similar to the allegations of the dismissed amended complaint. The proposed second amended complaint also alleges that the Orrstown Defendants did not publicly disclose certain alleged failures of internal controls over loan underwriting, risk management, and financial reporting during the period 2009 to 2012, in violation of the federal securities laws. On February 8, 2016, the Court granted SEPTA’s motion for leave to amend and SEPTA filed its second amended complaint that same day.

On February 25, 2016, the Court issued a scheduling Order directing: all defendants to file any motions to dismiss by March 18, 2016; SEPTA to file an omnibus opposition to defendants’ motions to dismiss by April 8, 2016; and all defendants to file reply briefs in support of their motions to dismiss by April 22, 2016. Defendants timely filed their motions to dismiss the second amended complaint and the parties filed their briefs in accordance with the Court-ordered schedule, above. The February 25, 2016 Order stays all discovery and other deadlines in the case (including the filing of SEPTA’s motion for class certification) pending the outcome of the motions to dismiss.

The allegations of SEPTA’s second amended complaint disclosed the existence of a confidential, non-public, fact-finding inquiry regarding the Company being conducted by the SEC. As disclosed in the Company’s Form 8-K filed on September 27, 2016, on that date the Company entered into a settlement agreement with the SEC resolving the investigation of accounting and related matters at the Company for the periods ended June 30, 2010 to December 31, 2011. As part of the settlement of the SEC’s administrative proceedings and pursuant to the cease-and-desist order, without admitting or denying the SEC’s findings, the Company, its Chief Executive Officer, its former Chief Financial Officer, its former Executive Vice President and Chief Credit Officer, and its Chief Accounting Officer, agreed to pay civil money penalties to the SEC. The Company agreed to pay a civil money penalty of $1.0 million. The Company had previously established a reserve for that amount which was expensed in the second fiscal quarter of 2016. In the settlement agreement with the SEC, the Company also agreed to cease and desist from committing or causing any violations and any future violations of Securities Act Sections 17(a)(2) and 17(a)(3) and Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B), and Rules 12b-20, 13a-1 and 13a-13 promulgated thereunder.

On September 27, 2016, the Orrstown Defendants filed with the Court a Notice of Subsequent Event in Further Support of their Motion to Dismiss the Second Amended Complaint, regarding the settlement with the SEC. The Notice attached a copy of the SEC’s cease-and-desist order and briefly described what the Company believed were the most salient terms of the neither-admit-nor-deny settlement. On September 29, 2016, SEPTA filed a Response to the Notice, in which SEPTA argued that the settlement with the SEC did not support dismissal of the second amended complaint.

On December 7, 2016, the Court issued an Order and Memorandum granting in part and denying in part defendants’ motions to dismiss SEPTA’s second amended complaint. The Court granted the motions to dismiss the Securities Act claims against all defendants, and granted the motions to dismiss the Exchange Act Section 10(b) and Rule 10b-5 claims against all defendants except Orrstown Financial Services, Inc., Orrstown Bank, Thomas R. Quinn, Jr., Bradley S. Everly, and Jeffrey W. Embly. The Court also denied the motions to dismiss the Exchange Act Section 20(a) claims against Quinn, Everly, and Embly.

On January 31, 2017, the Court entered a Case Management Order establishing the schedule for the litigation and, on August 15, 2017, it entered a revised Order that, among other things, set the following deadlines: all fact discovery closed on March 1, 2018, and SEPTA’s motion for class certification was due the same day; expert merits discovery closed May 30, 2018; summary judgment motions were due by June 26, 2018; the mandatory pretrial and settlement conference was set for December 11, 2018; and trial was scheduled to begin on January 7, 2019.

On December 15, 2017, the Orrstown Defendants and SEPTA exchanged expert reports in opposition to and in support of class certification, respectively. On January 15, 2018, the parties exchanged expert rebuttal reports. SEPTA’s motion for class certification was due March 1, 2018, with the Orrstown Defendants’ opposition due April 2, 2018, and SEPTA’s reply due April 23, 2018.

On February 9, 2018, SEPTA filed a Status Report and Request for a Telephonic Status Conference asking the Court to convene a conference to discuss the status of discovery in the case and possible revisions to the case schedule. On February 12, 2018, the Orrstown Defendants filed their status report to provide the Court with a summary of document discovery in the case to date. On February 27, 2018, SEPTA filed an unopposed motion for a continuance of the existing case deadlines pending a status conference with the Court or the issuance of a revised case schedule. On February 28, 2018, the Court issued an Order continuing all case management deadlines until further order of the Court.

On March 27, 2018, the Court held a telephonic status conference with the parties to discuss outstanding discovery issues and case deadlines. On May 2, 2018, the parties filed a joint status report. On May 10, 2018, the Court held a follow-up

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telephonic status conference at which the parties reported on the progress of discovery to date. Party and non-party document discovery in the case has continued. To date, SEPTA has taken a few non-party depositions.

On August 9, 2018, SEPTA filed a motion to compel the production of Confidential Supervisory Information (CSI) of non-parties the Board of Governors of the Federal Reserve System (FRB) and the Pennsylvania Department of Banking and Securities, in the possession of Orrstown and third parties. On August 23, 2018, the Orrstown Defendants filed a response to the motion to compel. On August 30, 2018, the FRB filed an unopposed motion to intervene in the Action for the purpose of opposing SEPTA’s motion to compel, and on September 27, 2018, the FRB filed its brief in opposition to SEPTA’s motion. On October 11, 2018, SEPTA filed its reply brief in support of its motion to compel. On February 12, 2019, the Court denied SEPTA’s motion to compel the production of CSI on the ground that SEPTA had failed to exhaust its administrative remedies.

On April 11, 2019, SEPTA filed a motion for leave to file a third amended complaint. The proposed third amended complaint seeks to reassert the Securities Act claims that the Court dismissed as to all defendants on December 7, 2016, when the Court granted in part and denied in part defendants’ motions to dismiss SEPTA’s second amended complaint. The proposed third amended complaint also seeks to reassert the Exchange Act claims against those defendants that the Court dismissed from the case on December 7, 2016. Defendants’ briefs in opposition to SEPTA’s motion for leave to file a third amended complaint were filed on April 25, 2019. SEPTA filed a reply brief in further support of its motion for leave to file a third amended complaint on May 9, 2019.

On June 13, 2019, Orrstown filed a motion for protective order to stay discovery pending resolution of SEPTA’s motion for leave to file a third amended complaint. On June 19, 2019, former defendants SEK and the underwriters of the Company’s March 2010 public offering joined in Orrstown’s motion for protective order. On June 25, 2019, SEPTA filed its opposition to Orrstown’s motion. On July 9, 2019, Orrstown filed a reply brief in further support of its motion. On July 17, 2019, the Court entered an Order partially granting Orrstown’s motion for protective order, ruling that all deposition discovery in the case is stayed pending a decision on SEPTA’s motion for leave to file a third amended complaint.

On February 14, 2020, the Court issued an Order and Memorandum granting SEPTA’s motion for leave to file a third amended complaint. The third amended complaint is now the operative complaint. It reinstates the Orrstown Defendants, as well as SEK and the underwriter defendants, previously dismissed from the case on December 7, 2016. The third amended complaint also revives the previously-dismissed 1933 Securities Act claim against the Orrstown Defendants, SEK, and the underwriter defendants. Under the Court-ordered briefing schedule, defendants filed their motions to dismiss the third amended complaint on April 24, 2020. SEPTA’s opposition was filed on July 8, 2020, and defendants’ reply briefs are due on August 12, 2020.

On February 24, 2020, the Orrstown Defendants, and the underwriter defendants and SEK, separately filed motions under 28 U.S.C. § 1292(b) asking the District Court to certify its February 14, 2020 Order for interlocutory appeal to the Third Circuit Court of Appeals. The District Court granted those motions on July 17, 2020, and defendants filed their Petition for Permission to Appeal with the Third Circuit on July 27, 2020. SEPTA’s opposition to the Petition is due by August 6, 2020.

The Company believes that the allegations of SEPTA’s third amended complaint are without merit and intends to defend itself vigorously against those claims. It is not possible at this time to estimate reasonably possible losses, or even a range of reasonably possible losses, in connection with the litigation.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis is intended to assist readers in understanding the consolidated financial condition and results of operations of Orrstown and should be read in conjunction with the preceding unaudited condensed consolidated financial statements and notes thereto included in this Quarterly Report on Form 10-Q, as well as with the audited consolidated financial statements and notes thereto for the year ended December 31, 2019, included in our Annual Report on Form 10-K. Throughout this discussion, the yield on earning assets is stated on a fully taxable-equivalent basis and balances represent average daily balances unless otherwise stated. Certain prior period amounts presented in this discussion and analysis have been reclassified to conform to current period classifications.

Overview

The Company, headquartered in Shippensburg, Pennsylvania, is a one-bank holding company that has elected status as a financial holding company. The consolidated financial information presented herein reflects the Company and its wholly-owned subsidiaries, the Bank and Wheatland. At June 30, 2020, the Company had total assets of $2.8 billion, total liabilities of $2.5 billion and total shareholders’ equity of $225.6 million.

Caution About Forward-Looking Statements

Certain statements appearing herein, which are not historical in nature, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In addition, we may make other written and oral communications, from time to time, that contain such statements. Such forward-looking statements refer to a future period or periods, reflecting our current beliefs as to likely future developments, and use words like “may,” “will,” “expect,” “estimate,” “anticipate” or similar terms. Forward-looking statements are statements that include projections, predictions, expectations, or beliefs about events or results or otherwise are not statements of historical facts, including, but not limited to, statements related to new business development, new loan opportunities, growth in the balance sheet and fee based revenue lines of business, merger and acquisition activity, reducing risk assets, and mitigating losses in the future. Actual results and trends could differ materially from those set forth in such statements and there can be no assurances that we will achieve the desired level of new business development and new loans, growth in the balance sheet and fee based revenue lines of business, successful merger and acquisition activity, continue to reduce risk assets or mitigate losses in the future. In addition to risks and uncertainties related to the COVID-19 pandemic and resulting governmental and societal responses, factors that could cause actual results to differ from those expressed or implied by the forward-looking statements include, but are not limited to, the following: ineffectiveness of the Company’s business strategy due to changes in current or future market conditions; the effects of competition, including industry consolidation and development of competing financial products and services; difficulty integrating the Company's strategic acquisitions; the inability to fully achieve expected savings, efficiencies or synergies from mergers and acquisitions, or taking longer than estimated for such savings, efficiencies and synergies to be realized; changes in laws and regulations; interest rate movements; changes in credit quality; inability to raise capital, if necessary, under favorable conditions; volatility in the securities markets; deteriorating economic conditions; expenses associated with pending litigation and legal proceedings; the failure of the SBA to honor its guarantee of loans issued under the SBA PPP; and other risks and uncertainties, including those detailed in our Annual Report on Form 10-K for the year ended December 31, 2019, and our Quarterly Reports on Form 10-Q under the sections titled “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in other filings made with the SEC. The statements are valid only as of the date hereof and we disclaim any obligation to update this information.

Economic Climate and Market Conditions

The pace of U.S. economic growth weakened substantially late in the first quarter of 2020 and into the second quarter of 2020 as over 30 million people in the U.S filed for unemployment since mid-March 2020. Early in 2020, a novel coronavirus (“COVID-19”) emerged and spread, first in China and then around the globe. The fast spread of the virus and the fear that resulted combined to create a high level of uncertainty about the near and intermediate future economic outlook. Because of this uncertainty, markets were pricing in a wide range of potential outcomes by buying sovereign government bonds, especially U.S. Treasuries, and selling stocks and bonds not issued by sovereign governments. The COVID-19 pandemic has adversely affected, and is likely to continue to adversely affect, economic activity globally, nationally and locally. Actions taken around the world to help mitigate the spread of COVID-19 include restrictions on travel, quarantines in certain areas, and forced closures for certain types of public places and businesses, as well as shelter-in-place orders by many states.

Preliminary real GDP for the second quarter of 2020 resulted in a record decline of 32.9%. This is a substantial decrease from negative 5.0% for the first quarter of 2020. The decline in second quarter GDP reflected the response to COVID-19, as shelter-in-place orders issued in March and April were partially lifted in some areas of the country in May and June, and government pandemic assistance payments were distributed to households and businesses. This led to shifts in economic activity, as businesses remained closed or operated remotely and consumers and businesses significantly reduced or redirected their spending. Actions taken to mitigate the spread of COVID-19 have had and are expected to continue to have an adverse

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impact on the economies and financial markets of many countries, including the geographical area in which the Company operates.

Due to the COVID-19 pandemic, market interest rates have declined significantly, with the 10-year Treasury bond falling below 1.00% on March 3, 2020 for the first time and it was at 0.66% on June 30, 2020. On March 3, 2020, in reaction to the increase in uncertainty, the Federal Reserve cut the Fed Funds rates by 50 basis points between regularly scheduled meetings to a target range of 1.00% to 1.25%. On March 11, 2020, the World Health Organization declared COVID-19 a global pandemic. On March 13, 2020, a national emergency was declared by President Trump under the National Emergencies Act. On March 15, 2020, the Federal Reserve responded by again reducing the Fed Funds rate, this time by 100 basis points, to 0% to 0.25%. These reductions in interest rates and other effects of the COVID-19 pandemic may adversely affect the Company's financial condition and results of operations in future periods. It is unknown how long the adverse conditions associated with the COVID-19 pandemic will last and what the complete financial effect will be to the Company. It is reasonably foreseeable that estimates made in the financial statements could be materially and adversely impacted in the near term as a result of these conditions, including expected credit losses on loans and the fair value of financial instruments that are carried at fair value.

Critical Accounting Estimates

The Company’s accounting and reporting policies are in accordance with GAAP and follow accounting and reporting guidelines prescribed by bank regulatory authorities and general practices within the financial services industry in which it operates. Our financial position and results of operations are affected by management's application of accounting policies, including estimates, and assumptions and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the balance sheet date and through the date the financial statements are filed with the SEC. Different assumptions in the application of these policies could result in material changes in the consolidated financial position and/or consolidated results of operations and related disclosures. The more critical accounting estimates include accounting for credit losses and valuation methodologies. Accordingly, these critical accounting estimates are discussed in detail in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year ended December 31, 2019. Significant accounting policies and any changes in accounting principles and effects of new accounting pronouncements are discussed in Note 1, Summary of Significant Accounting Policies, to the Consolidated Financial Statements under Part II, Item 8, "Financial Statements and Supplementary Data," in our Annual Report on Form 10-K for the year ended December 31, 2019. Additional disclosures regarding the effects of new accounting pronouncements are included in this report in Note 1, Summary of Significant Accounting Policies, to the unaudited condensed consolidated financial statements under Part I, Item 1, "Financial Information."

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RESULTS OF OPERATIONS

Three months ended June 30, 2020 compared with three months ended June 30, 2019

Summary

Net income totaled $6.4 million for the three months ended June 30, 2020 compared with net income of $2.7 million for the same period in 2019. Diluted EPS for the three months ended June 30, 2020 totaled $0.58, compared with $0.26 for the three months ended June 30, 2019. Net interest income positively influenced results of operations, and totaled $20.8 million for the three months ended June 30, 2020, a $2.3 million increase compared with 2019. Noninterest income, excluding investment securities gains, totaled $7.2 million for the three months ended June 30, 2020 compared with $5.7 million in 2019. Investment securities gains totaled $9 thousand in the three months ended June 30, 2020, compared with net gains of $2.1 million for the same period in 2019. Noninterest expenses totaled $18.4 million and $23.3 million for the three months ended June 30, 2020 and 2019, respectively.

The comparability of operating results for 2020 with 2019 has generally been impacted by the Hamilton acquisition completed on May 1, 2019 and the SBA PPP loans originated in the three months ended June 30, 2020.

Net Interest Income

Net interest income increased by $2.3 million, from $18.5 million to $20.8 million, for the three months ended June 30, 2020 compared with the three months ended June 30, 2019. Interest income on loans increased by $2.1 million, from $19.7 million to $21.8 million, securities interest income decreased $1.1 million, from $4.3 million to $3.2 million, and total interest expense decreased $1.7 million from $6.0 million to $4.2 million, in comparing the three months ended June 30, 2020 with the three months ended June 30, 2019.

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The following table presents net interest income, net interest spread and net interest margin for the three months ended June 30, 2020 and 2019 on a taxable-equivalent basis:

			Three Months Ended June 30, 2020																														Three Months Ended June 30, 2019
			Average Balance						Taxable- Equivalent Interest						Taxable- Equivalent Rate						Average Balance						Taxable- Equivalent Interest						Taxable- Equivalent Rate
Assets
Federal funds sold & interest-bearing bank balances			$	27,949					$	13					0.18		%				$	84,344					$	501					2.38		%
Securities (1)			493,847						3,327						2.71						497,302						4,481						3.61
Loans (1)(2)(3)			1,988,114						21,912						4.43						1,497,445						19,782						5.30
Total interest-earning assets			2,509,910						25,252						4.05						2,079,091						24,764						4.78
Other assets			200,684																		175,566
Total			$	2,710,594																	$	2,254,657
Liabilities and Shareholders’ Equity
Interest-bearing demand deposits			$	1,154,434					1,259						0.44						$	922,612					2,062						0.90
Savings deposits			160,738						63						0.16						153,235						89						0.23
Time deposits			462,664						1,988						1.73						568,488						2,741						1.93
Securities sold under agreements to repurchase			21,582						24						0.45						8,847						29						1.31
FHLB Advances and other			175,336						388						0.89						97,908						537						2.20
Subordinated notes			31,867						502						6.33						31,819						499						6.28
Total interest-bearing liabilities			2,006,621						4,224						0.85						1,782,909						5,957						1.34
Noninterest-bearing demand deposits			452,253																		235,046
Other			36,511																		31,692
Total Liabilities			2,495,385																		2,049,647
Shareholders’ Equity			215,209																		205,010
Total			$	2,710,594																	$	2,254,657
Taxable-equivalent net interest income /net interest spread									21,028						3.20		%										18,807						3.44		%
Taxable-equivalent net interest margin															3.37		%																3.63		%
Taxable-equivalent adjustment									(230)																		(292)
Net interest income									$	20,798																	$	18,515

NOTES TO ANALYSIS OF NET INTEREST INCOME:
(1)			Yields and interest income on tax-exempt assets have been computed on a taxable-equivalent basis assuming a 21% tax rate.
(2)			Average balances include nonaccrual loans.
(3)			Interest income on loans includes prepayment and late fees.

For the three months ended June 30, 2020, taxable-equivalent basis net interest income increased by $2.2 million compared with the three months ended June 30, 2019. The increase reflected an increase of $430.8 million in average interest-earning assets partially offset by an increase of $223.7 million in average interest-bearing liabilities from the three months ended June 30, 2019 to the three months ended June 30, 2020. These balances increased due to the SBA PPP loans originated in the three months ended June 30, 2020.

Taxable-equivalent interest income earned on loans increased by $2.1 million year-over-year. The $490.7 million increase in average loan balance year-over-year primarily reflects average loans originated through the SBA PPP of $354.3 million during the three months ended June 30, 2020. The three months ended June 30, 2020 also reflects an extra month of loans from the Hamilton acquisition as compared to the same prior year period. For the three months ended June 30, 2020, interest income on loans includes $1.9 million of deferred fees recognized associated with the SBA PPP loans. A total of $13.2 million in net

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deferred fees were recorded for these loans to be recognized over the life of the loans, which is between two and five years. The yield on loans was 4.43% for the three months ended June 30, 2020 as compared to 5.30% for the three months ended June 30, 2019. This decline reflects a reduction in market interest rates on variable rate loans in the portfolio as well as a lower yield on the SBA PPP loans, which contributed to 13 basis points of the decline. Accretion of purchase accounting adjustments were $1.3 million for the three months ended June 30, 2020 as compared to $1.2 million for the three months ended June 30, 2019. The three months ended June 30, 2020 and 2019 included $278 thousand and $530 thousand, respectively, of accelerated accretion related to the payoff of purchased credit impaired loans.

Taxable-equivalent securities interest income decreased by $1.2 million year-over-year, with the taxable equivalent yield decreasing from 3.61% for the three months ended June 30, 2019 to 2.71% for the three months ended June 30, 2020. The 90 basis point decrease in taxable-equivalent yield on securities reflected the decreased interest rate environment between years and certain repositioning within the portfolio under the Company's asset/liability management strategies. The impact of the interest rate decline was partially offset by a decrease of $3.5 million in the average balance of securities from the three months ended June 30, 2019 to the three months ended June 30, 2020. As the Bank continues to execute its plan to grow relationship loans, it will work to reduce its investment portfolio to fund some of this loan growth through investment repayments.

Interest expense on interest-bearing liabilities decreased by $1.7 million year-over-year due to a decline of 49 basis points in the cost of interest-bearing liabilities. The impact of a significant decline in market interest rates was partially offset by the average balance of interest-bearing deposits increasing by $133.5 million and the average balance of total borrowings increasing by $90.2 million. The increase in these balances was due primarily to the SBA PPP loans originated during the three months ended June 30, 2020. During the three months ended June 30, 2020, the Company obtained funding through the Federal Reserve’s Paycheck Protection Program Liquidity Facility ("PPPLF") with an average balance of $3.2 million during the three months ended June 30, 2020. The balance of deposits and borrowings associated with the SBA PPP loans are expected to decline significantly into the first quarter of 2021 as the funds are drawn by the borrowers and the loans are forgiven by the SBA.

Provision for Loan Losses

Asset quality trends continue to be solid with a low level of charge-offs and nonperforming loans. The provision for loan losses totaled $1.9 million for the three months ended June 30, 2020 compared with $200 thousand for the same period in 2019. The provision recorded in the three months ended June 30, 2020 was driven by an increase in qualitative factor assumptions as a result of the COVID-19 pandemic. Due to continuing uncertainty in the external environment, management increased the qualitative factors for certain commercial loan segments in the Bank’s allowance for loan loss analysis in the three months ended June 30, 2020. Net charge-offs in the three months ended June 30, 2020 totaled $186 thousand, as compared to $23 thousand in the comparable prior year period. Nonperforming loans were 0.36% of gross loans at June 30, 2020, compared with 0.65% of gross loans at December 31, 2019. Nonperforming loans decreased by $3.3 million from December 31, 2019 to June 30, 2020 due primarily to a measurement period adjustment for the transfer of a $2.6 million loan from the Hamilton acquisition into the PCI pool during the three months ended March 31, 2020.

Additional information is included in the "Credit Risk Management" section herein.

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Noninterest Income

The following table compares noninterest income for the three months ended June 30, 2020 and 2019:

			Three Months Ended June 30,																		$ Change						% Change
			2020						2019						2020-2019						2020-2019
Service charges on deposit accounts			$	554					$	837					$	(283)					(34)		%
Interchange income			819						843						(24)						(3)		%
Other service charges, commissions and fees			165						241						(76)						(32)		%
Swap fees			232						—						232						—		%
Trust and investment management income			1,696						1,749						(53)						(3)		%
Brokerage income			599						672						(73)						(11)		%
Mortgage banking activities			1,609						652						957						147		%
Gain on sale of portfolio loans			925						—						925						—		%
Income from life insurance			532						684						(152)						(22)		%
Other income			53						32						21						66		%
Subtotal before securities gains (losses)			7,184						5,710						1,474						26		%
Investment securities gains (losses)			9						2,064						(2,055)						(100)		%
Total noninterest income			$	7,193					$	7,774					$	(581)					(7)		%

The following factors contributed to the more significant changes in noninterest income between the three months ended June 30, 2020 and 2019:

•Service charges on deposit accounts decreased by $283 thousand due primarily to waivers of ATM fees in response to the COVID-19 pandemic and reductions in overdraft charges from lower deposit account usage during the three months ended June 30, 2020 due to the pandemic.

•In the three months ended June 30, 2020, the Company recognized income of $232 thousand in swap fees for an interest rate swap arrangement directly entered into with one commercial borrower.

•Mortgage banking income increased by $957 thousand. Refinance activity was strong in the three months ended June 30, 2020 due to the decrease in interest rates, and the gain on sale margin increased. Mortgage loans sold in the three months ended June 30, 2020 totaled $49.5 million compared with $24.6 million in the three months ended June 30, 2019. In addition, there was an increase of $551 thousand in the fair value of interest rate lock commitments in the three months ended June 30, 2020 as compared to $0 for the three months ended June 30, 2019. The Company began recognizing this income in the fourth quarter of 2019. During the three months ended June 30, 2020, the Company recorded an MSR impairment charge of $319 thousand driven by significant market interest rate reductions caused by the COVID-19 pandemic, partially offsetting the mortgage gains.

•During the three months ended June 30, 2020, the Bank recorded $925 thousand in gains due to the sale of $1.7 million of classified loans.

•During the three months ended June 30, 2020, the Company recorded a net investment securities gain of $9 thousand due to the change in the value of an equity security. There were no investment sales during this period. The Company recognized net investment securities gains of $2.1 million in 2019 as opportunities became available to reposition part of the investment portfolio under asset/liability management strategies or to improve responsiveness of the portfolio to interest rate conditions, while also considering funding requirements of anticipated lending activity.

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Noninterest Expenses

The following table compares noninterest expenses for the three months ended June 30, 2020 and 2019:

			Three Months Ended June 30,																		$ Change						% Change
			2020						2019						2020-2019						2020-2019
Salaries and employee benefits			$	10,063					$	8,922					$	1,141					12.8		%
Occupancy			1,122						1,066						56						5.3		%
Furniture and equipment			1,204						1,140						64						5.6		%
Data processing			791						1,058						(267)						(25.2)		%
Automated teller machine and interchange fees			249						238						11						4.6		%
Advertising and bank promotions			167						548						(381)						(69.5)		%
FDIC insurance			214						221						(7)						(3.2)		%
Other professional services			1,021						707						314						44.4		%
Directors' compensation			264						261						3						1.1		%
Taxes other than income			449						314						135						43.0		%
Intangible asset amortization			404						402						2						0.5		%
Merger related and branch consolidation expenses			0						6,860						(6,860)						(100.0)		%
Other operating expenses			2,483						1,555						928						59.7		%
Total noninterest expenses			$	18,431					$	23,292					$	(4,861)					(20.9)		%

The following factors contributed to the more significant changes in noninterest expenses between the three months ended June 30, 2020 and 2019:

•The increase in salaries and employee benefits principally reflected employees added in the Hamilton acquisition and prior year additions to the Bank’s commercial lending team. In addition, the increase included the impact of our overall expansion efforts and incremental expense for additional share-based compensation awards granted in 2020, net of the benefit of forfeitures.

•There was a decline in data processing expense of $267 thousand as the completion of the Hamilton integration in the second half of 2019 resulted in reduced costs in 2020.

•Advertising and bank promotions decreased by $381 thousand due primarily to targeted campaigns in the prior year which did not recur in 2020 as well as reduced marketing efforts in 2020 due to the COVID-19 pandemic.

•Other professional services increased by $314 thousand due to legal costs incurred in the three months ended June 30, 2020 in connection with the SEPTA litigation.

•The Company incurred merger related expenses of $6.9 million in the three months ended June 30, 2019, principally due to data processing contract termination costs, employee contract termination costs and legal and consulting fees for the Hamilton acquisition.

•Other operating expenses increased by $928 thousand due primarily to a reduction of $544 thousand in the fair value of a property held for sale, an increase of $172 thousand in the reserve for unfunded commitments due to increased qualitative factors and an impairment charge of $152 thousand on a customer list intangible asset due to the discontinuance of Wheatland, effective July 31, 2020, during the three months ended June 30, 2020.

•Other line items within noninterest expenses showed fluctuations between 2020 and 2019 attributable to normal business operations and the impact of acquisitions.

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Income Tax Expense

Income tax expense totaled $1.3 million, an effective tax rate of 17.0%, for the three months ended June 30, 2020, compared with $110 thousand, an effective tax rate of 3.9%, for the three months ended June 30, 2019. The Company’s effective tax rate is less than the 21% federal statutory rate, principally due to tax-free income, which includes interest income on tax-free loans and securities and income from life insurance policies, federal income tax credits, and the impact of non-tax deductible expenses, including merger related expenses. The Company recorded a tax benefit of $334 thousand in the second quarter of 2019, related to an increase in its deferred state income tax asset for the effect of the state tax rate change resulting from the Hamilton acquisition. This tax benefit had the effect of lowering the effective tax rate for the second quarter of 2019 by approximately 12%. The remaining difference in the effective tax rate from the three months ended June 30, 2019 to the three months ended June 30, 2020 was due to an increase in estimated earnings before income taxes.

Six months ended June 30, 2020 compared with six months ended June 30, 2019

Summary

Net income totaled $11.4 million for the six months ended June 30, 2020 compared with net income of $5.8 million for the same period in 2019. Diluted earnings per share for the six months ended June 30, 2020 totaled $1.04, compared with $0.58 for the six months ended June 30, 2019. Net interest income positively influenced results of operations, and totaled $39.1 million for the six months ended June 30, 2020, a $5.8 million increase compared with 2019. Noninterest income, excluding investment securities gains, totaled $14.3 million for the six months ended June 30, 2020 compared with $10.5 million in 2019. Investment securities losses totaled $31 thousand in the six months ended June 30, 2020, compared with net gains of $2.4 million for the same period in 2019. Noninterest expenses totaled $36.7 million and $39.5 million for the six months ended June 30, 2020 and 2019, respectively.

The comparability of operating results for 2020 with 2019 have generally been impacted by the Hamilton acquisition completed on May 1, 2019 and the SBA PPP loans originated in the six months ended June 30, 2020.

Net Interest Income

Net interest income increased by $5.8 million, from $33.3 million to $39.1 million, for the six months ended June 30, 2020 compared with the six months ended June 30, 2019. Interest income on loans increased by $7.2 million, from $34.8 million to $42.0 million, securities interest income decreased $1.7 million, from $8.6 million to $6.9 million, and total interest expense decreased $926 thousand from $10.9 million to $9.9 million, in comparing the six months ended June 30, 2020 with the six months ended June 30, 2019.

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The following table presents net interest income, net interest spread and net interest margin for the six months ended June 30, 2020 and 2019 on a taxable-equivalent basis:

			Six Months Ended June 30, 2020																														Six Months Ended June 30, 2019
			Average Balance						Taxable- Equivalent Interest						Taxable- Equivalent Rate						Average Balance						Taxable- Equivalent Interest						Taxable- Equivalent Rate
Assets
Federal funds sold & interest-bearing bank balances			$	25,409					$	92					0.73		%				$	56,879					$	674					2.39		%
Securities (1)			497,418						7,124						2.88						498,522						9,039						3.66
Loans (1)(2)(3)			1,820,830						42,199						4.66						1,378,213						35,054						5.13
Total interest-earning assets			2,343,657						49,415						4.24						1,933,614						44,767						4.67
Other assets			194,543																		156,786
Total			$	2,538,200																	$	2,090,400
Liabilities and Shareholders’ Equity
Interest-bearing demand deposits			$	1,063,460					3,161						0.60						$	884,065					3,911						0.89
Savings deposits			155,966						127						0.16						137,606						142						0.21
Time deposits			483,014						4,376						1.82						482,525						4,554						1.90
Securities sold under agreements to repurchase			15,499						52						0.67						8,755						57						1.31
FHLB Advances and other			181,372						1,210						1.34						109,658						1,195						2.20
Subordinated notes			31,860						1,003						6.29						31,852						996						6.30
Total interest-bearing liabilities			1,931,171						9,929						1.03						1,654,461						10,855						1.32
Noninterest-bearing demand deposits			351,208																		218,796
Other			35,139																		27,523
Total Liabilities			2,317,518																		1,900,780
Shareholders’ Equity			220,682																		189,620
Total			$	2,538,200																	$	2,090,400
Taxable-equivalent net interest income /net interest spread									39,486						3.21		%										33,912						3.35		%
Taxable-equivalent net interest margin															3.39		%																3.54		%
Taxable-equivalent adjustment									(426)																		(637)
Net interest income									$	39,060																	$	33,275

NOTES TO ANALYSIS OF NET INTEREST INCOME:
(1)			Yields and interest income on tax-exempt assets have been computed on a taxable-equivalent basis assuming a 21% tax rate.
(2)			Average balances include nonaccrual loans.
(3)			Interest income on loans includes prepayment and late fees.

For the six months ended June 30, 2020, taxable-equivalent basis net interest income increased by $5.6 million compared with the six months ended June 30, 2019. The increase reflected an increase of $410.0 million in average interest-earning assets partially offset by an increase of $276.7 million in average interest-bearing liabilities from the six months ended June 30, 2019 to the six months ended June 30, 2020. These balances increased primarily due to the SBA PPP loans originated in the six months ended June 30, 2020 as well as loans acquired from Hamilton on May 1, 2019.

Taxable-equivalent interest income earned on loans increased by $7.1 million year-over-year. The $442.6 million increase in average loan balance year-over-year reflects four extra months of Hamilton loans in the six months ended June 30, 2020 as compared to the same prior year period. In addition, SBA PPP loans averaged $177.3 million during the six months ended June 30, 2020. There was an offsetting decrease in residential mortgage loans during the period due to significant refinance activity resulting from the low interest rate environment. For the six months ended June 30, 2020, interest income on loans includes $1.9 million of deferred fees recognized associated with the SBA PPP loans. A total of $13.2 million in net deferred fees were

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recorded for these loans to be recognized over the life of the loans, which is between two and five years. The yield on loans was 4.66% for the six months ended June 30, 2020 as compared to 5.13% for the six months ended June 30, 2019. This decline reflects a reduction in market interest rates on variable rate loans in the portfolio, as well as a lower yield on the SBA PPP loans, which contributed to 13 basis points of the decline. Accretion of purchase accounting adjustments was $1.9 million for the six months ended June 30, 2020 as compared to $1.4 million for the six months ended June 30, 2019. The six months ended June 30, 2020 and 2019 included $743 thousand and $639 thousand, respectively, of accelerated accretion related to the payoff purchased credit impaired loans.

Taxable-equivalent securities interest income decreased by $1.9 million year-over-year, with the taxable equivalent yield decreasing from 3.66% for the six months ended June 30, 2019 to 2.88% for the six months ended June 30, 2020. The 78 basis point decrease in taxable-equivalent yield on securities reflected the decreased interest rate environment between years and certain repositioning within the portfolio under the Company's asset/liability management strategies. The impact of the interest rate decline was partially offset by a decrease of $1.1 million in the average balance of securities from the six months ended June 30, 2019 to the six months ended June 30, 2020. As the Bank continues to execute its plan to grow relationship loans, it will work to reduce its investment portfolio to fund some of this loan growth through investment repayments.

Interest expense on deposits and borrowings decreased by $926 thousand year-over-year, with the average balance of interest-bearing deposits increasing by $198.2 million and the average balance of total borrowings increasing by $78.5 million. The increase in these balances was due primarily to the SBA PPP loans originated during the six months ended June 30, 2020. During the six months ended June 30, 2020, the Company obtained funding through the PPPLF with an average balance of $1.6 million during the six months ended June 30, 2020. The balance of deposits and borrowings associated with the SBA PPP loans are expected to decline significantly into the first quarter of 2021 as the funds are drawn by the borrowers and the loans are forgiven by the SBA.

Provision for Loan Losses

Asset quality trends continue to be solid with a low level of charge-offs and nonperforming loans. The provision for loan losses totaled $2.8 million for the six months ended June 30, 2020 compared with $600 thousand for the same period in 2019. The provision recorded in the six months ended June 30, 2020 was driven by an increase in qualitative factor assumptions as a result of the COVID-19 pandemic. Net recoveries in the six months ended June 30, 2020 totaled $37 thousand, as compared to net charge-offs of $154 thousand in the comparable prior year period. Nonperforming loans were 0.36% of gross loans at June 30, 2020, compared with 0.65% of gross loans at December 31, 2019. Nonperforming loans decreased by $3.3 million from December 31, 2019 to June 30, 2020 due primarily to a measurement period adjustment for the transfer of a $2.6 million loan from the Hamilton acquisition into the PCI pool during the six months ended June 30, 2020.

Additional information is included in the "Credit Risk Management" section herein.

Noninterest Income

The following table compares noninterest income for the six months ended June 30, 2020 and 2019:

			Six Months Ended June 30,																		$ Change						% Change
			2020						2019						2020-2019						2020-2019
Service charges on deposit accounts			$	1,401					$	1,590					$	(189)					(12)		%
Interchange income			1,607						1,579						28						2		%
Other service charges, commissions and fees			305						390						(85)						(22)		%
Swap fees			432						—						432						—		%
Trust and investment management income			3,336						3,507						(171)						(5)		%
Brokerage income			1,318						1,150						168						15		%
Mortgage banking activities			1,941						1,120						821						73		%
Gain on sale of portfolio loans			2,803						—						2,803						—		%
Income from life insurance			1,072						1,026						46						4		%
Other income			83						144						(61)						(42)		%
Subtotal before securities (losses) gains			14,298						10,506						3,792						36		%
Investment securities (losses) gains			(31)						2,403						(2,434)						(101)		%
Total noninterest income			$	14,267					$	12,909					$	1,358					11		%

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The following factors contributed to the more significant changes in noninterest income between the six months ended June 30, 2020 and 2019:

•Service charges on deposit accounts decreased due primarily to waivers of ATM fees in response to the COVID-19 pandemic and reductions in overdraft charges from lower deposit account usage during the six months ended June 30, 2020 due to the pandemic.

•In the six months ended June 30, 2020, the Company recognized income of $432 thousand for swap fees. This includes referral fees under a program in which it refers qualified commercial borrowers to a third party, which enters into an interest rate swap agreement with the borrower. The program began in the third quarter of 2019. The rate swap provides the borrower with the economic equivalent of a fixed-rate loan while allowing the Company to receive a variable rate of interest. During the three months ended June 30, 2020, the Company also earned fees on an interest rate swap arrangement entered into directly with one commercial borrower.

•Mortgage banking income increased by $821 thousand. Refinance activity was strong in the three months ended June 30, 2020 due to the decrease in interest rates, and the gain on sale margin increased. Loans sold in the six months ended June 30, 2020 totaled $71.8 million compared with $39.8 million in the six months ended June 30, 2019. In addition, there was an increase of $863 thousand in the fair value of interest rate lock commitments in the six months ended June 30, 2020 as compared to $0 for the six months ended June 30, 2019. The Company began recognizing this income in the fourth quarter of 2019. During the six months ended June 30, 2020, the Company recorded MSR impairment charges totaling $820 thousand driven by significant market interest rate reductions caused by the COVID-19 pandemic, partially offsetting the mortgage gains.

•During the six months ended June 30, 2020, the Bank recorded $2.8 million in gains due to the sale of $10.9 million of classified loans for net gains of $2.5 million, and the sale of an $11.0 million portfolio of recreational vehicle loans for a gain of $314 thousand.

During the six months ended June 30, 2020, the Company recorded a net investment securities loss of $31 thousand due to the decrease in the value of an equity security. The Company recognized net investment securities gains of $2.4 million in 2019 as opportunities became available to reposition part of the investment portfolio under asset/liability management strategies or to improve responsiveness of the portfolio to interest rate conditions, while also considering funding requirements of anticipated lending activity.

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Noninterest Expenses

The following table compares noninterest expenses for the six months ended June 30, 2020 and 2019:

			Six Months Ended June 30,																		$ Change						% Change
			2020						2019						2020-2019						2020-2019
Salaries and employee benefits			$	21,657					$	17,599					$	4,058					23.1		%
Occupancy			2,249						2,067						182						8.8		%
Furniture and equipment			2,366						2,163						203						9.4		%
Data processing			1,662						1,828						(166)						(9.1)		%
Automated teller machine and interchange fees			500						474						26						5.5		%
Advertising and bank promotions			956						1,069						(113)						(10.6)		%
FDIC insurance			261						406						(145)						(35.7)		%
Other professional services			1,737						1,264						473						37.4		%
Directors' compensation			465						497						(32)						(6.4)		%
Taxes other than income			451						620						(169)						(27.3)		%
Intangible asset amortization			867						610						257						42.1		%
Merger related and branch consolidation expenses			—						7,505						(7,505)						(100.0)		%
Insurance claim receivable (recovery) write off			(486)						615						(1,101)						(179.0)		%
Other operating expenses			4,050						2,736						1,314						48.0		%
Total noninterest expenses			$	36,735					$	39,453					$	(2,718)					(6.9)		%

The following factors contributed to the more significant changes in noninterest expenses between the six months ended June 30, 2020 and 2019:

•Expanded operations with the addition of employees and branches from the Hamilton acquisition in May 2019.

•The increase in salaries and employee benefits principally reflected employees added in the Hamilton acquisition and prior year additions to the Bank’s commercial lending team. In addition, the increase included the impact of our overall expansion efforts, annual merit increases, and incremental expense for additional share-based compensation awards granted in 2020, net of the benefit of forfeitures.

•Occupancy, furniture and equipment costs reflected the Hamilton branches acquired, partially offset by the impact of the consolidation of five branches in the first quarter of 2020.

•Advertising and bank promotions decreased by $113 thousand due primarily to due primarily to targeted campaigns in the prior year which did not recur in 2020 as well as reduced marketing efforts in 2020 due to the COVID-19 pandemic.

•The decrease in FDIC insurance expense reflects credits received in the first quarter of 2020 that offset the Bank's fourth quarter 2019 FDIC assessment. The FDIC's assessment regulations provide that, for banks with consolidated total assets under $10 billion, after the reserve ratio reaches 1.38% (and provided that it remains at least 1.38%), the FDIC will automatically apply credits to reduce regular deposit insurance assessments up to the full amount of their assessments or the full amount of their credits, whichever is less. The reserve ratio reached 1.40% on June 30, 2019. Therefore, credits were first applied during the third quarter of 2019. The final credit was applied as of the March 31, 2020 payment as the reserve ratio was sufficiently maintained.

•Other professional services increased by $473 thousand due to legal costs incurred in the six months ended June 30, 2020 in connection with the SEPTA litigation.

•Taxes other than income decreased by $169 thousand as increased contributions to the Pennsylvania Educational Improvement Tax Credit program resulted in a reduction in the Bank’s Pennsylvania bank shares tax expense during the six months ended June 30, 2020.

•Intangible asset amortization increased principally due to amortization of core deposit intangibles recorded in the Hamilton acquisition.

•The Company incurred merger related expenses in the six months ended June 30, 2019 for data processing contract termination costs, employee contract termination costs and legal and consulting fees for the Hamilton acquisition. The Company also incurred system conversion expenses for the Mercersburg acquisition in the first quarter of 2019.

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•In the six months ended June 30, 2019, the Company incurred a $615 thousand expense to write off an insurance claim receivable from a 2018 cyber security incident. During the six months ended June 30, 2020, $486 thousand of this expense was recovered through refunds received from the insurance company.

•Other operating expenses increased by $1.3 million due primarily to a reduction of $544 thousand in the fair value of a property held for sale, an increase of $172 thousand in the reserve for unfunded commitments due to increased qualitative factors and an impairment charge of $152 thousand on a customer list intangible asset due to the discontinuance of Wheatland, effective July 31, 2020, during the six months ended June 30, 2020.

•Other line items within noninterest expenses showed fluctuations between 2020 and 2019 attributable to normal business operations and the impact of acquisitions.

Income Tax Expense

Income tax expense totaled $2.3 million, an effective tax rate of 17.0%, for the six months ended June 30, 2020, compared with $342 thousand, an effective tax rate of 5.6%, for the six months ended June 30, 2019. The Company’s effective tax rate is less than the 21% federal statutory rate, principally due to tax-free income, which includes interest income on tax-free loans and securities and income from life insurance policies, federal income tax credits, and the impact of non-tax deductible expenses, including merger related expenses. The Company recorded a tax benefit of $185 thousand during the six months ended June 30, 2019, related to a favorable tax law clarification concerning the treatment of life insurance assets of an acquired entity. In the prior year period, the Company also recorded a tax benefit of $334 thousand related to an increase in its deferred state income tax asset for the effect of the state tax rate change resulting from the Hamilton acquisition. These tax benefits had the effect of lowering the effective tax rate for the six months ended June 30, 2019 by approximately 8.4%. The remaining difference in the effective tax rate from the six months ended June 30, 2019 to the six months ended June 30, 2020 was due to an increase in estimated earnings before income taxes.

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FINANCIAL CONDITION

Management devotes substantial time to overseeing the investment of funds in loans and securities and the formulation of policies directed toward the profitability and management of the risks associated with these investments.

Investment Securities

The Company utilizes investment securities to manage interest rate risk, to enhance income through interest and dividend income, to provide liquidity and to provide collateral for certain deposits and borrowings. At June 30, 2020, investment securities totaled $483.9 million, a decrease of $6.9 million, from the $490.9 million balance at December 31, 2019. The balance of investment securities included net unrealized losses of $4.5 million at June 30, 2020 as compared to net unrealized losses of $607 thousand at December 31, 2019. This decline was driven by the significant reduction in market rates in the six months ended June 30, 2020, resulting from market uncertainty related to the COVID-19 pandemic.

In the six months ended June 30, 2020, the Company realized net losses totaling $31 thousand due to a market value adjustment to an equity security, compared to net investment security gains of $2.4 million for the six months ended June 30, 2019.

Loan Portfolio

The Company offers a variety of products to meet the credit needs of its borrowers, principally commercial real estate loans, commercial and industrial loans, and retail loans consisting of loans secured by residential properties, and to a lesser extent, installment loans. No loans are extended to non-domestic borrowers or governments.

The risks associated with lending activities differ among loan classes and are subject to the impact of changes in interest rates, market conditions of collateral securing the loans and general economic conditions. Any of these factors may adversely impact a borrower’s ability to repay loans, and also impact the associated collateral. See Note 4, Loans and Allowance for Loan Losses, to the unaudited condensed consolidated financial statements under Part I, Item 1, "Financial Information," for a description of the Company’s loan classes and differing levels of associated credit risk.

The following table presents the loan portfolio, excluding residential LHFS, by segment and class at June 30, 2020 and December 31, 2019:

			June 30, 2020						December 31, 2019
Commercial real estate:
Owner occupied			$	164,442					$	170,884
Non-owner occupied			390,980						361,050
Multi-family			111,016						106,893
Non-owner occupied residential			116,531						120,038
Acquisition and development:
1-4 family residential construction			7,966						15,865
Commercial and land development			50,220						41,538
Commercial and industrial (1)			665,312						214,554
Municipal			34,276						47,057
Residential mortgage:
First lien			295,736						336,372
Home equity - term			11,944						14,030
Home equity - lines of credit			160,842						165,314
Installment and other loans			32,052						50,735
			$	2,041,317					$	1,644,330

⁽¹⁾ This balance includes $447.2 million and $0 of SBA PPP loans at June 30, 2020 and December 31, 2019, respectively.

Total loans grew by $397.0 million from December 31, 2019 to June 30, 2020. This increase is due primarily to the origination of SBA PPP loans during the six months ended June 30, 2020. These loans, net of deferred fees, totaled $447.2 million at June 30, 2020. This increase was partially offset by a reduction in residential mortgage loans due to significant refinancing activity. In addition, the Company sold $10.9 million in classified loans and $11.0 million of acquired recreational vehicle loans during the six months ended June 30, 2020.

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Asset Quality

Risk Elements

The Company’s loan portfolio is subject to varying degrees of credit risk. Credit risk is managed through our underwriting standards, on-going credit reviews, and monitoring of asset quality measures. Additionally, loan portfolio diversification, which limits exposure to a single industry or borrower, and collateral requirements also mitigate our risk of credit loss.

The loan portfolio consists principally of loans to borrowers in south central Pennsylvania and the greater Baltimore, Maryland region. As the majority of loans are concentrated in these geographic regions, a substantial portion of the borrowers' ability to honor their obligations may be affected by the level of economic activity in the market areas.

Nonperforming assets include nonaccrual loans and foreclosed real estate. In addition, restructured loans still accruing and loans past due 90 days or more and still accruing are also deemed to be risk assets. For all loan classes, generally the accrual of interest income ceases when principal or interest is past due 90 days or more and collateral is inadequate to cover principal and interest or immediately if, in the opinion of management, full collection is unlikely. Interest will continue to accrue on loans past due 90 days or more if the collateral is adequate to cover principal and interest, and the loan is in the process of collection. Interest accrued, but not collected, as of the date of placement on nonaccrual status, is generally reversed and charged against interest income, unless fully collateralized. Subsequent payments received are either applied to the outstanding principal balance or recorded as interest income, depending on management’s assessment of the ultimate collectability of principal. Loans are returned to accrual status, for all loan classes, when all the principal and interest amounts contractually due are brought current, the loans have performed in accordance with the contractual terms of the note for a reasonable period of time, generally six months, and the ultimate collectability of the total contractual principal and interest is reasonably assured. Past due status is based on contract terms of the loan.

Loans, the terms of which are modified, are classified as TDRs if a concession was granted for legal or economic reasons related to a borrower’s financial difficulties. Concessions granted under a TDR typically involve a temporary deferral of scheduled loan payments, an extension of a loan’s stated maturity date, temporary reduction in interest rates, or below market rates. If a modification occurs while the loan is on accruing status, it will continue to accrue interest under the modified terms. Nonaccrual TDRs are restored to accrual status if scheduled principal and interest payments, under the modified terms, are current for six months after modification, and the borrower continues to demonstrate its ability to meet the modified terms. TDRs are evaluated individually for impairment if they have been restructured during the most recent calendar year, or if they are not performing according to their modified terms.

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The following table presents the Company’s risk elements, including the aggregate balances of nonaccrual loans, restructured loans still accruing, loans past due 90 days or more, and OREO as of June 30, 2020 and December 31, 2019. Relevant asset quality ratios are also presented.

			June 30, 2020						December 31, 2019
Nonaccrual loans			$	7,404					$	10,657
OREO			17						197
Total nonperforming assets			7,421						10,854
Restructured loans still accruing			960						979
Loans past due 90 days or more and still accruing			909						2,232
Total nonperforming and other risk assets			$	9,290					$	14,065
Loans 30-89 days past due			$	6,901					$	17,527
Asset quality ratios:
Total nonperforming loans to total loans			0.36		%				0.65		%
Total nonperforming assets to total assets			0.27		%				0.46		%
Total nonperforming assets to total loans and OREO			0.36		%				0.66		%
Total risk assets to total loans and OREO			0.46		%				0.86		%
Total risk assets to total assets			0.34		%				0.59		%
ALL to total loans			0.86		%				0.89		%
ALL to nonperforming loans			236.59		%				137.52		%
ALL to nonperforming loans and restructured loans still accruing			209.43		%				125.95		%

Total nonperforming and other risk assets decreased by $4.8 million, or 33.9%, from December 31, 2019 to June 30, 2020. The principal driver for this decrease is a measurement period adjustment for the transfer of a $2.6 million loan from the Hamilton acquisition into the PCI pool during the six months ended June 30, 2020.

The following table presents detail of impaired loans at June 30, 2020 and December 31, 2019:

			June 30, 2020																														December 31, 2019
			Nonaccrual Loans						Restructured Loans Still Accruing						Total						Nonaccrual Loans						Restructured Loans Still Accruing						Total
Commercial real estate:
Owner occupied			$	3,343					$	28					$	3,371					$	5,842					$	30					$	5,872
Multi-family			80						—						80						345						—						345
Non-owner occupied residential			283						—						283						235						—						235
Acquisition and development:
Commercial and land development			837						—						837						—						—						—
Commercial and industrial			708						—						708						1,763						—						1,763
Residential mortgage:
First lien			1,545						916						2,461						1,659						931						2,590
Home equity - term			11						—						11						13						—						13
Home equity - lines of credit			580						16						596						715						18						733
Installment and other loans			17						—						17						85						—						85
			$	7,404					$	960					$	8,364					$	10,657					$	979					$	11,636

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The following table presents our exposure to borrowers with impaired loans, partial charge-offs taken to date and specific reserves established on the borrowing relationships at June 30, 2020 and December 31, 2019. Of the relationships deemed to be impaired at June 30, 2020, one had a recorded balance in excess of $1.0 million, and 66, or 42.8%, of total impaired loans, had recorded balances of less than $250 thousand.

			# of Relationships						Recorded Investment						Partial Charge-offs to Date						Specific Reserves
June 30, 2020
Relationships greater than $1,000,000			1						$	2,765					$	—					$	—
Relationships greater than $500,000 but less than $1,000,000			1						706						17						—
Relationships greater than $250,000 but less than $500,000			4						1,314						242						—
Relationships less than $250,000			66						3,579						496						35
			72						$	8,364					$	755					$	35
December 31, 2019
Relationships greater than $1,000,000			2						$	5,218					$	—					$	—
Relationships greater than $500,000 but less than $1,000,000			2						1,516						17						—
Relationships greater than $250,000 but less than $500,000			3						980						—						—
Relationships less than $250,000			68						3,922						781						36
			75						$	11,636					$	798					$	36

The Company takes partial charge-offs on collateral-dependent loans when carrying value exceeds estimated fair value, as determined by the most recent appraisal adjusted for current (within the quarter) conditions, less costs to dispose. Impairment reserves remain in place if updated appraisals are pending, and represent management’s estimate of potential loss.

Internal loan reviews are completed annually on all commercial relationships with a committed loan balance in excess of $500 thousand, which includes confirmation of risk rating by an independent credit officer. Credit Administration also reviews loans in excess of $1.0 million. In addition, all relationships greater than $250 thousand rated Substandard, Doubtful or Loss are reviewed and corresponding risk ratings are reaffirmed by the Bank's Problem Loan Committee, with subsequent reporting to the Management ERM Committee.

In its individual loan impairment analysis, the Company determines the extent of any full or partial charge-offs that may be required, or any reserves that may be needed. The determination of the Company’s charge-offs or impairment reserve include an evaluation of the outstanding loan balance and the related collateral securing the credit. Through a combination of collateral securing the loans and partial charge-offs taken to date, the Company believes that it has adequately provided for the potential losses that it may incur on these relationships at June 30, 2020. However, over time, additional information may result in increased reserve allocations or, alternatively, it may be deemed that the reserve allocations exceed those that are needed.

In an effort to assist clients which were negatively impacted by the COVID-19 pandemic, the Bank offered various mitigation options, including a loan payment deferral program. Under this program, most commercial deferrals were for a 90-day period, while most consumer deferrals were for a 180-day period. As of June 30, 2020, the Company processed loan deferrals under this program for commercial and consumer clients with a total loan balance of $218.1 million and $21.2 million, respectively. Deferred interest associated with these loans totaled $1.5 million for the three months ended June 30, 2020. In accordance with the revised Interagency Statement on Loan Modifications by Financial Institutions Working with Customers Affected by the Coronavirus issued on April 7, 2020, these deferrals are exempt from TDR status as they meet the specified requirements. Below is a summary of select loan concentrations and the deferrals within those categories at June 30, 2020.

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									As a Percentage of
Category			Outstanding Balance						Total Loans						Risk-based Capital						COVID-19 Deferrals as a Percentage of Category
Office			$	163,408					8.0		%				66.8		%				12.0		%
Multifamily residential			111,279						5.5						45.5						32.7
Strip Center / Retail			51,328						2.5						21.0						23.1
Commercial Construction			50,220						2.5						20.5						4.2
Hotel / Motels			53,881						2.6						22.0						68.3
Warehouses			46,774						2.3						19.1						3.6
Restaurants & Bars			48,293						2.4						19.7						37.8
Storage Units			25,151						1.2						10.3						40.6
Residential Construction			7,966						0.4						3.3						13.0

The Company’s OREO balance of $17 thousand at June 30, 2020 consisted of one residential property and the balance at December 31, 2019 consisted of two commercial and one residential properties. All OREO properties are carried at the lower of cost or fair value, less costs to dispose.

Credit Risk Management

Allowance for Loan Losses

The Company maintains the ALL at a level deemed adequate by management for probable incurred credit losses. The ALL is established and maintained through a provision for loan losses charged to earnings. Quarterly, management assesses the adequacy of the ALL using a defined methodology which considers specific credit evaluation of impaired loans, past loan loss historical experience and qualitative factors. Management addresses the requirements for loans individually identified as impaired, loans collectively evaluated for impairment, and other bank regulatory guidance in its assessment.

The ALL is evaluated based on review of the collectability of loans in light of historical experience; the nature and volume of the loan portfolio; adverse situations that may affect a borrower’s ability to repay; estimated value of any underlying collateral; and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. A description of the methodology for establishing the allowance and provision for loan losses and related procedures in establishing the appropriate level of reserve is included in Note 4, Loans and Allowance for Loan Losses, to the unaudited condensed consolidated financial statements under Part I, Item 1, "Financial Information."

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The following table summarizes the Company’s internal risk ratings at June 30, 2020 and December 31, 2019:

			Pass						Special Mention						Non-Impaired Substandard						Impaired - Substandard						Doubtful						PCI Loans						Total
June 30, 2020
Commercial real estate:
Owner occupied			$	144,332					$	7,223					$	4,666					$	3,371					$	—					$	4,850					$	164,442
Non-owner occupied			345,176						45,468						—						—						—						336						390,980
Multi-family			95,478						14,796						662						80						—						—						111,016
Non-owner occupied residential			108,985						4,404						1,357						283						—						1,502						116,531
Acquisition and development:
1-4 family residential construction			7,844						122						—						—						—						—						7,966
Commercial and land development			38,947						9,895						541						837						—						—						50,220
Commercial and industrial			636,604						15,372						9,222						708						—						3,406						665,312
Municipal			30,025						4,251						—						—						—						—						34,276
Residential mortgage:
First lien			287,633						—						—						2,461						—						5,642						295,736
Home equity - term			11,841						—						72						11						—						20						11,944
Home equity - lines of credit			160,036						175						35						596						—						—						160,842
Installment and other loans			31,950						—						—						17						—						85						32,052
			$	1,898,851					$	101,706					$	16,555					$	8,364					$	—					$	15,841					$	2,041,317
December 31, 2019
Commercial real estate:
Owner occupied			$	151,161					$	4,513					$	3,163					$	5,872					$	—					$	6,175					$	170,884
Non-owner occupied			342,753						17,152						—						—						—						1,145						361,050
Multi-family			100,361						4,822						682						345						—						683						106,893
Non-owner occupied residential			111,697						4,534						1,115						235						—						2,457						120,038
Acquisition and development:
1-4 family residential construction			15,865						—						—						—						—						—						15,865
Commercial and land development			39,939						206						1,393						—						—						—						41,538
Commercial and industrial			198,951						1,133						8,899						1,763						—						3,808						214,554
Municipal			42,649						4,408						—						—						—						—						47,057
Residential mortgage:
First lien			323,040						978						—						2,590						—						9,764						336,372
Home equity - term			13,774						74						149						13						—						20						14,030
Home equity - lines of credit			164,469						74						38						733						—						—						165,314
Installment and other loans			50,497						—						—						85						—						153						50,735
			$	1,555,156					$	37,894					$	15,439					$	11,636					$	—					$	24,205					$	1,644,330

Potential problem loans are defined as performing loans which have characteristics that cause management concern over the ability of the borrower to perform under present loan repayment terms and which may result in the reporting of these loans as nonperforming loans in the future. Generally, management feels that Substandard loans that are currently performing and not considered impaired result in some doubt as to the borrower’s ability to continue to perform under the terms of the loan, and

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represent potential problem loans. Additionally, the Special Mention classification is intended to be a temporary classification reflective of loans that have potential weaknesses that may, if not monitored or corrected, weaken the asset or inadequately protect the Company’s position at some future date. Special Mention loans represent an elevated risk, but their weakness does not yet justify a more severe, or classified, rating. These loans require inquiry by lenders on the cause of the potential weakness and, once analyzed, the loan classification may be downgraded to Substandard or, alternatively, could be upgraded to Pass. Special Mention loans increased by $63.8 million from December 31, 2019 to June 30, 2020 due to commercial loan downgrades, primarily in the hospitality industry, as a result of the significant economic impact of the COVID-19 pandemic.

The following table summarizes activity in the ALL for the six months ended June 30, 2020 and 2019:

			Commercial																																																						Consumer
			Commercial Real Estate						Acquisition and Development						Commercial and Industrial						Municipal						Total						Residential Mortgage						Installment and Other						Total						Unallocated						Total
Three Months Ended
June 30, 2020
Balance, beginning of period			$	8,420					$	1,033					$	2,647					$	99					$	12,199					$	3,139					$	294					$	3,433					$	171					$	15,803
Provision for loan losses			877						31						590						(24)						1,474						323						102						425						1						1,900
Charge-offs			—						—						(421)						—						(421)						(18)						(14)						(32)						—						(453)
Recoveries			50						5						100						—						155						108						4						112						—						267
Balance, end of period			$	9,347					$	1,069					$	2,916					$	75					$	13,407					$	3,552					$	386					$	3,938					$	172					$	17,517
June 30, 2019
Balance, beginning of period			$	7,025					$	969					$	1,814					$	98					$	9,906					$	3,765					$	217					$	3,982					$	395					$	14,283
Provision for loan losses			(221)						39						325						(4)						139						(32)						40						8						53						200
Charge-offs			—						—						(47)						—						(47)						(25)						(51)						(76)						—						(123)
Recoveries			43						—						28						—						71						26						3						29						—						100
Balance, end of period			$	6,847					$	1,008					$	2,120					$	94					$	10,069					$	3,734					$	209					$	3,943					$	448					$	14,460
Six Months Ended
June 30, 2020
Balance, beginning of period			$	7,634					$	959					$	2,356					$	100					$	11,049					$	3,147					$	319					$	3,466					$	140					$	14,655
Provision for loan losses			1,260						102						912						(25)						2,249						400						144						544						32						2,825
Charge-offs			—						—						(496)						—						(496)						(109)						(86)						(195)						—						(691)
Recoveries			453						8						144						—						605						114						9						123						—						728
Balance, end of period			$	9,347					$	1,069					$	2,916					$	75					$	13,407					$	3,552					$	386					$	3,938					$	172					$	17,517
June 30, 2019
Balance, beginning of period			$	6,876					$	817					$	1,656					$	98					$	9,447					$	3,753					$	244					$	3,997					$	570					$	14,014
Provision for loan losses			(118)						189						484						(4)						551						157						14						171						(122)						600
Charge-offs			(25)						—						(90)						—						(115)						(271)						(71)						(342)						—						(457)
Recoveries			114						2						70						—						186						95						22						117						—						303
Balance, end of period			$	6,847					$	1,008					$	2,120					$	94					$	10,069					$	3,734					$	209					$	3,943					$	448					$	14,460

The ALL at June 30, 2020, increased by $2.9 million from December 31, 2019, reflecting the $2.8 million provision for loan losses during the six months ended June 30, 2020. The provision for loan losses increased in the six months ended June 30, 2020 as a result of qualitative factor adjustments for the impact of the COVID-19 pandemic on the Bank’s loan portfolio and commercial loan downgrades. Net charge-offs totaled $186 thousand and $37 thousand for the three and six months ended June 30, 2020, respectively, compared with net charge-offs of $23 thousand and $154 thousand, respectively, for the same periods in 2019. Classified loans totaled $24.9 million at June 30, 2020, or 1.2% of total loans outstanding, and decreased from $27.1 million at December 31, 2019, or 1.6% of loans outstanding. The asset quality ratios previously noted are indicative of the continued benefit the Company has received from favorable historical charge-off statistics and generally stable economic and market conditions for the last few years, even while the loan portfolio has been growing. Recent loan growth trends, as well as concerns regarding the COVID-19 pandemic, contributed to management's determination that an increased provision for loan losses was required to maintain an adequate ALL, with an ALL to total loans ratio of 0.86% at June 30, 2020 as compared to 0.89% at December 31, 2019. Excluding SBA loans, which are 100% guaranteed, the ALL to total loans was 1.1% at June 30, 2020. The ALL plus purchase accounting marks to unguaranteed loans was 1.8% at June 30, 2020 and 2.0% at December 31, 2019.

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Despite generally favorable historical charge-off data, the impact of the COVID-19 pandemic on economic conditions may result in the need for additional provisions for loan losses in future quarters.

The following table summarizes the ending loan balances individually or collectively evaluated for impairment based on loan type, as well as the ALL allocation for each, at June 30, 2020 and December 31, 2019, including PCI loans:

			Commercial																																																						Consumer
			Commercial Real Estate						Acquisition and Development						Commercial and Industrial						Municipal						Total						Residential Mortgage						Installment and Other						Total						Unallocated						Total
June 30, 2020
Loans allocated by:
Individually evaluated for impairment			$	3,734					$	837					$	708					$	—					$	5,279					$	3,068					$	17					$	3,085					$	—					$	8,364
Collectively evaluated for impairment			779,235						57,349						664,604						34,276						1,535,464						465,454						32,035						497,489						—						2,032,953
			$	782,969					$	58,186					$	665,312					$	34,276					$	1,540,743					$	468,522					$	32,052					$	500,574					$	—					$	2,041,317
ALL allocated by:
Individually evaluated for impairment			$	—					$	—					$	—					$	—					$	—					$	35					$	—					$	35					$	—					$	35
Collectively evaluated for impairment			9,347						1,069						2,916						75						13,407						3,517						386						3,903						172						17,482
			$	9,347					$	1,069					$	2,916					$	75					$	13,407					$	3,552					$	386					$	3,938					$	172					$	17,517
December 31, 2019
Loans allocated by:
Individually evaluated for impairment			$	6,452					$	—					$	1,763					$	—					$	8,215					$	3,336					$	85					$	3,421					$	—					$	11,636
Collectively evaluated for impairment			752,413						57,403						212,791						47,057						1,069,664						512,380						50,650						563,030						—						1,632,694
			$	758,865					$	57,403					$	214,554					$	47,057					$	1,077,879					$	515,716					$	50,735					$	566,451					$	—					$	1,644,330
ALL allocated by:
Individually evaluated for impairment			$	—					$	—					$	—					$	—					$	—					$	36					$	—					$	36					$	—					$	36
Collectively evaluated for impairment			7,634						959						2,356						100						11,049						3,111						319						3,430						140						14,619
			$	7,634					$	959					$	2,356					$	100					$	11,049					$	3,147					$	319					$	3,466					$	140					$	14,655

In addition to the specific reserve allocations on impaired loans noted previously, 15 loans, with aggregate outstanding principal balances of $1.7 million, have had cumulative partial charge-offs to the ALL totaling $755 thousand at June 30, 2020. As updated appraisals are received on collateral-dependent loans, partial charge-offs are taken to the extent the loans’ principal balance exceeds their fair value.

Management believes the allocation of the ALL between the various loan classes adequately reflects the probable incurred credit losses in each portfolio and is based on the methodology outlined in Note 4, Loans and Allowance for Loan Losses, to the Consolidated Financial Statements under Part I, Item 1, "Financial Information." Management re-evaluates and makes enhancements to its reserve methodology to better reflect the risks inherent in the different segments of the portfolio, particularly in light of increased charge-offs, with noticeable differences between the different loan classes. Management believes these enhancements to the ALL methodology improve the accuracy of quantifying probable incurred credit losses inherent in the portfolio. Management charges actual loan losses to the reserve and bases the provision for loan losses on its overall analysis.

The unallocated portion of the ALL reflects estimated inherent losses within the portfolio that have not been detected, as well as the risk of error in the specific and general reserve allocation, other potential exposure in the loan portfolio, variances in management’s assessment of national and local economic conditions and other factors management believes appropriate at the time. The unallocated portion of the ALL totaled $172 thousand, or 1.0% of the ALL balance, at June 30, 2020 compared with $140 thousand, or 1.0% of the ALL balance at December 31, 2019. The Company monitors the unallocated portion of the ALL

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and, by policy, has determined it should not exceed 6% of the total reserve. Future negative provisions for loan losses may result if the unallocated portion was to increase, and management determined the reserves were not required for the anticipated risk in the portfolio.

Management believes the Company’s ALL is adequate based on currently available information. Future adjustments to the ALL and enhancements to the methodology may be necessary due to changes in economic conditions, regulatory guidance, or management’s assumptions as to future delinquencies or loss rates.

Deposits

Deposits totaled $2.3 billion at June 30, 2020, an increase of $376.2 million, or 20.1%, from $1.9 billion at December 31, 2019.

Noninterest-bearing deposits increased by $186.8 million, or 74.9%, from December 31, 2019 to June 30, 2020. Interest-bearing deposits totaled $1.8 billion at June 30, 2020, an increase of $189.4 million, or 11.6% from the $1.6 billion balance at December 31, 2019.

The Company continues to increase both noninterest-bearing and interest-bearing deposit relationships from its enhanced treasury management offerings as it increases its commercial relationships. Deposit growth in the first six months of 2020 was principally due to clients seeking a safe haven for their deposits during the COVID-19 pandemic and the high usage of checking accounts for SBA PPP loan funds. As the SBA PPP clients utilize their borrowings to fund operations, the associated deposits are expected to decline.

Shareholders' Equity, Capital Adequacy and Regulatory Matters

Capital management in a regulated financial services industry must properly balance return on equity to its shareholders while maintaining sufficient levels of capital and related risk-based regulatory capital ratios to satisfy statutory regulatory requirements. The Company’s capital management strategies have been developed to provide attractive rates of returns to its shareholders, while maintaining a “well capitalized” position of regulatory strength.

Shareholders’ equity totaled $225.6 million at June 30, 2020, an increase of $2.4 million, or 1.1%, from $223.2 million at December 31, 2019. The increase was primarily attributable to net income totaling $11.4 million for the six months ended June 30, 2020. This increase was partially offset by an increase in accumulated other comprehensive loss from changes in net unrealized gains and losses in securities available for sale, net of tax, which fell by $3.1 million from December 31, 2019 to June 30, 2020 due to declining interest rates and market uncertainty resulting from the COVID-19 pandemic. Accumulated other comprehensive loss also included $1.6 million in losses on cash flow hedges, net of tax, during the six months ended June 30, 2020. In addition, there were dividends paid on common stock totaling $3.8 million during the six months ended June 30, 2020.

The Company routinely evaluates its capital levels in light of its risk profile to assess its capital needs. The Company and the Bank are subject to various regulatory capital requirements administered by federal and state banking agencies. The consolidated asset limit on small bank holding companies is $3.0 billion and a company with assets under that limit is not subject to the FRB consolidated capital rules, but may file reports that include capital amounts and ratios. The Company has elected to file those reports.

At June 30, 2020 and December 31, 2019, the Bank was considered well capitalized under applicable banking regulations. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific guidelines that involve quantitative measures of assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. Prompt corrective action provisions are not applicable to bank holding companies, including financial holding companies.

Note 10, Shareholders' Equity and Regulatory Capital, to the Notes to Unaudited Condensed Consolidated Financial Statements under Part I, Item 1, "Financial Information," includes a table presenting capital amounts and ratios for the Company and the Bank at June 30, 2020 and December 31, 2019.

In addition to the minimum capital ratio requirement and minimum capital ratio to be well capitalized presented in the referenced table in Note 10, the Bank must maintain a capital conservation buffer as more fully described in the Company's Annual Report on Form 10-K for the year ended December 31, 2019, Item 1 - Business, under the topic Basel III Capital Rules. At June 30, 2020, the Bank's capital conservation buffer, based on the most restrictive Total Capital to risk weighted assets capital ratio, was 5.9%, which is greater than the 2.5% requirement.

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Liquidity

The primary function of asset/liability management is to ensure adequate liquidity and manage the Company’s sensitivity to changing interest rates. Liquidity management involves the ability to meet the cash flow requirements of customers who may be either depositors wanting to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. Our primary sources of funds consist of deposit inflows, loan repayments, maturities and sales of investment securities, the sale of mortgage loans and borrowings from the FHLB of Pittsburgh. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition. The maximum borrowing capacity from the FHLB is $843.0 million at June 30, 2020.

We regularly adjust our investments in liquid assets based upon our assessment of expected loan demand, expected deposit flows, yields available on interest-earning deposits and securities and the objectives of our asset/liability management policy. Unencumbered investment securities totaled $55.7 million at June 30, 2020. At June 30, 2020, the Company has $211.4 million of investment securities pledged at the FRB Discount Window, with no associated borrowings outstanding.

The Company applied for and received access to the PPPLF, a liquidity facility created by the Federal Reserve for the pledging of PPP loans, to further expand its already robust access to off balance sheet liquidity. Borrowings through the PPPLF facility totaled $33.7 million at June 30, 2020, with SBA PPP loans of the same amount pledged as collateral. The remaining availability to the Company under this facility is $424.9 million at June 30, 2020.

Mergers and Acquisitions

See Note 2, Mergers and Acquisitions, to the Consolidated Financial Statements under Part I, Item 1, "Financial Statements" in this Form 10-Q.

Supplemental Reporting of Non-GAAP Measures

As a result of acquisitions, the Company had intangible assets consisting of goodwill and core deposit and other intangible assets totaling $24.9 million and $27.1 million at June 30, 2020 and December 31, 2019, respectively.

Management believes providing certain “non-GAAP” financial information will assist investors in their understanding of the effect of acquisition activity on reported results, particularly to overcome comparability issues related to the influence of intangibles (principally goodwill) created in acquisitions.

Tangible book value per share and net interest margin excluding the impact of purchase accounting, as used by the Company in this supplemental reporting presentation, are determined by methods other than in accordance with GAAP. While we believe this information is a useful supplement to GAAP based measures presented in this Form 10-Q, readers are cautioned that this non-GAAP disclosure has limitations as an analytical tool, should not be viewed as a substitute for financial measures determined in accordance with GAAP, and should not be considered in isolation or as a substitute for analysis of our results and financial condition as reported under GAAP, nor are such measures necessarily comparable to non-GAAP performance measures that may be presented by other companies. This supplemental presentation should not be construed as an inference that our future results will be unaffected by similar adjustments to be determined in accordance with GAAP.

The following table presents the computation of each non-GAAP based measure shown together with its most directly comparable GAAP based measure.

						June 30, 2020						December 31, 2019
Tangible Book Value per Common Share
Shareholders' equity						$	225,638					$	223,249
Less: Goodwill						18,724						19,925
Other intangible assets						6,160						7,180
Related tax effect						(1,294)						(1,508)
Tangible common equity (non-GAAP)						$	202,048					$	197,652
Common shares outstanding						11,209						11,200
Book value per share (most directly comparable GAAP based measure)						$	20.13					$	19.93
Intangible assets per share						2.10						2.28
Tangible book value per share (non-GAAP)						$	18.03					$	17.65

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			Three Months Ended June 30,
									2020																		2019
Taxable-Equivalent Net Interest Margin (excluding the effect of purchase accounting)
Taxable-equivalent net interest income/margin, as reported									$	21,028					3.37		%				$	18,807					3.63		%
Effect of purchase accounting:
Loans			Income						(1,603)						(0.27)		%				(1,385)						(0.29)		%
Time deposits			Expenses						24						0.00		%				24						(0.01)		%
Purchase accounting effect on taxable-equivalent income/ margin									(1,627)						(0.27)		%				(1,409)						(0.30)		%
Taxable-equivalent net interest income/margin (excluding the effect of purchase accounting) (non-GAAP)									$	19,401					3.10		%				$	17,398					3.33		%
			Six Months Ended June 30,
									2020																		2019
Taxable-Equivalent Net Interest Margin (excluding the effect of purchase accounting)
Taxable-equivalent net interest income/margin, as reported									$	39,486					3.39		%				$	33,912					3.54		%
Effect of purchase accounting:
Loans			Income						(2,502)						(0.23)		%				(1,638)						(0.22)		%
Time deposits			Expenses						52						0.00		%				14						0.00		%
Purchase accounting effect on taxable-equivalent income/ margin									(2,554)						(0.23)		%				(1,652)						(0.22)		%
Taxable-equivalent net interest income/margin (excluding the effect of purchase accounting) (non-GAAP)									$	36,932					3.16		%				$	32,260					3.32		%

			June 30, 2020
Allowance to unguaranteed loans
Allowance for loan losses			$	17,517
Gross loans			$	2,041,317
less: SBA guaranteed loans			(460,365)
Unguaranteed loans			$	1,580,952
Allowance to unguaranteed loans			1.11		%

			June 30, 2020						December 31, 2019
Allowance plus purchase accounting marks to unguaranteed loans:
Allowance for loan losses			$	17,517					$	14,655
Purchase accounting marks			11,025						18,160
Allowance plus purchase accounting marks			28,542						32,815
Gross loans			2,041,317						1,644,330
less: SBA guaranteed loans			(460,365)						(1,559)
Unguaranteed loans			$	1,580,952					$	1,642,771
Allowance plus purchase accounting marks to unguaranteed loans:			1.8		%				2.0		%

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

Market risk comprises exposure to interest rate risk, foreign currency exchange rate risk, commodity price risk, and other relevant market rate or price risks. In the banking industry, a major risk exposure is changing interest rates. The primary objective of monitoring our interest rate sensitivity, or risk, is to provide management the tools necessary to manage the balance sheet to minimize adverse changes in net interest income as a result of changes in the direction and level of interest rates. Federal Reserve Board monetary control efforts, the effects of deregulation, economic uncertainty and legislative changes have been significant factors affecting the task of managing interest rate sensitivity positions in recent years.

Interest Rate Risk

Interest rate risk is the exposure to fluctuations in the Company’s future earnings (earnings at risk) and value (value at risk) resulting from changes in interest rates. This exposure results from differences between the amounts of interest-earning assets and interest-bearing liabilities that reprice within a specified time period as a result of scheduled maturities, scheduled and unscheduled repayments, the propensity of borrowers and depositors to react to changes in their economic interests, and loan contractual interest rate changes.

We attempt to manage the level of repricing and maturity mismatch through our asset/liability management process so that fluctuations in net interest income are maintained within policy limits across a range of market conditions, while satisfying liquidity and capital requirements. Management recognizes that a certain amount of interest rate risk is inherent, appropriate and necessary to ensure the Company’s profitability. Thus, the goal of interest rate risk management is to evaluate the amount of reward for taking risk and adjusting both the size and composition of the balance sheet relative to the level of reward available for taking risk.

Management endeavors to control the exposure to changes in interest rates by understanding, reviewing and making decisions based on its risk position. The Company primarily uses its securities portfolio, FHLB advances, interest rate swaps and brokered deposits to manage its interest rate risk position. Additionally, pricing, promotion and product development activities are directed in an effort to emphasize the loan and deposit term or repricing characteristics that best meet current interest rate risk objectives.

We use simulation analysis to assess earnings at risk and net present value analysis to assess value at risk. These methods allow management to regularly monitor both the direction and magnitude of our interest rate risk exposure. These analyses require numerous assumptions including, but not limited to, changes in balance sheet mix, prepayment rates on loans and securities, cash flows and repricing of all financial instruments, changes in volumes and pricing, future shapes of the yield curve, relationship of market interest rates to each other (basis risk), credit spread and deposit sensitivity. Assumptions are based on management’s best estimates but may not accurately reflect actual results under certain changes in interest rate due to the timing, magnitude and frequency of rate changes and changes in market conditions and management strategies, among other factors. However, the analyses are useful in quantifying risk and providing a relative gauge of our interest rate risk position over time.

Our asset/liability committee operates under management policies, approved by the Board of Directors, which define guidelines and limits on the level of risk. The committee meets regularly and reviews our interest rate risk position and monitors various liquidity ratios to ensure a satisfactory liquidity position. By utilizing our analyses, we can determine changes that may need to be made to the asset and liability mixes to mitigate the change in net interest income under various interest rate scenarios. Management continually evaluates the condition of the economy, the pattern of market interest rates and other economic data to inform the committee on the selection of investment securities. Regulatory authorities also monitor our interest rate risk position along with other liquidity ratios.

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Net Interest Income Sensitivity

Simulation analysis evaluates the effect of upward and downward changes in market interest rates on future net interest income. The analysis involves changing the interest rates used in determining net interest income over the next twelve months. The resulting percentage change in net interest income in various rate scenarios is an indication of our short-term interest rate risk. The analysis assumes recent pricing trends in new loan and deposit volumes will continue while balances remain constant. Additional assumptions are applied to modify pricing under the various rate scenarios.

The simulation analysis results are presented in the Net Interest Income table below. At June 30, 2020 and December 31, 2019, results indicated the Company would be better positioned over the subsequent 12 months in a moderately declining rate environment than it would be if interest rates increased. This is due to a shift in the mix of assets to more floating rate loans, a shift in the mix of liabilities to fewer certificates of deposit, and the steep decline in interest rates.

Economic Value

Net present value analysis provides information on the risk inherent in the balance sheet that might not be taken into account in the simulation analysis due to the short time horizon used in that analysis. The net present value of the balance sheet incorporates the discounted present value of expected asset cash flows minus the discounted present value of expected liability cash flows. The analysis involves changing the interest rates used in determining the expected cash flows and in discounting the cash flows. The resulting percentage change in net present value in various rate scenarios is an indication of the longer term repricing risk and options embedded in the balance sheet.

At June 30, 2020, similar to at December 31, 2019, these results indicated the Company would be better positioned in a rising interest rate environment than it would be if interest rates decreased. As a result of the low interest rates at June 30, 2020, the impact of increased rates on the economic value of the balance sheet would be substantial. To improve the comparability across periods, the Company follows best practices and maintains the size and mix of the period end balance sheet; thus, the results do not reflect actions management may take to improve results.

Net Interest Income																														Economic Value
						% Change in Net Interest Income																								% Change in Market Value
Change in Market Interest Rates (basis points)						June 30, 2020						December 31, 2019						Change in Market Interest Rates (basis points)						June 30, 2020						December 31, 2019
(100)						0.1		%				(0.5)		%				(100)						(128.5)		%				(21.7)		%
100						(0.4)		%				(1.3)		%				100						119.0		%				10.9		%
200						(1.3)		%				(3.8)		%				200						191.3		%				15.1		%
300						(4.3)		%				(8.1)		%				300						233.0		%				15.0		%

Item 4. Controls and Procedures

Based on the evaluation required by Securities Exchange Act Rules 13a-15(b) and 15d-15(b), the Company's management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of our disclosure controls and procedures, as defined in Securities Exchange Act Rules 13a-15(e) and 15d-15(e), at June 30, 2020.  Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at June 30, 2020.  There have been no changes in internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting during the six months ended June 30, 2020.

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PART II – OTHER INFORMATION

Item 1 – Legal Proceedings

Information regarding legal proceedings is included in Note 14, Contingencies, to the Consolidated Financial Statements under Part I, Item 1, "Financial Statements" and incorporated herein by reference.

Item 1A – Risk Factors

Except as noted below, there have been no material changes from the risk factors as disclosed in our Annual Report on Form 10-K for the year ended December 31, 2019 and our Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2020.

Interest rate volatility stemming from COVID-19 could negatively affect our net interest income, lending activities, deposits and profitability.

Our net interest income, lending activities, deposits and profitability could be negatively affected by volatility in interest rates caused by uncertainties stemming from COVID-19. In March 2020, the Federal Reserve lowered the target range for the federal funds rate to a range from 0 to 0.25 percent, citing concerns about the impact of COVID-19 on markets and stress in the energy sector. A prolonged period of extremely volatile and unstable market conditions would likely increase our funding costs and negatively affect market risk mitigation strategies. Higher income volatility from changes in interest rates and spreads to benchmark indices could cause a loss of future net interest income and a decrease in current fair market values of our assets. Fluctuations in interest rates will impact both the level of income and expense recorded on most of our assets and liabilities and the market value of all interest-earning assets and interest-bearing liabilities, which in turn could have a material adverse effect on our net income, operating results, or financial condition.

Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds

In September 2015, the Board of Directors of the Company authorized a share repurchase program under which the Company may repurchase up to 5% of the Company's outstanding shares of common stock, or approximately 416,000 shares, in accordance with all applicable securities laws and regulations, including Rule 10b-18 of the Exchange Act. When and if appropriate, repurchases may be made in open market or privately negotiated transactions, depending on market conditions, regulatory requirements and other corporate considerations, as determined by management. Share repurchases may not occur and may be discontinued at any time. At June 30, 2020, 154,680 shares had been repurchased under the program at a total cost of $2.6 million, or $16.88 per share. The maximum number of shares that may yet be purchased under the plan is 261,320 at June 30, 2020.  

Item 3 – Defaults Upon Senior Securities

Not applicable.

Item 4 – Mine Safety Disclosures

Not applicable.

Item 5 – Other Information

None.

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Item 6 – Exhibits

2.1(a)						Agreement and Plan of Merger, dated May 31, 2018, by and between Orrstown Financial Services, Inc. and Mercersburg Financial Corporation, incorporated by reference to Exhibit 2.1 of the Registrant's Form 8-K filed June 1, 2018.
2.1(b)						Agreement and Plan of Merger, dated October 23, 2018, by and between Orrstown Financial Services, Inc. and Hamilton Bancorp, Inc., incorporated by reference to Exhibit 2.1 of the Registrant's Form 8-K filed October 24, 2018.
3.1						Articles of Incorporation as amended, incorporated by reference to Exhibit 3.1 of the Registrant’s Report on Form 8-K filed on January 29, 2010.
3.2						By-laws as amended, incorporated by reference to Exhibit 3.2 to the Registrant’s Report on Form 8-K filed January 30, 2018.
4.1						Specimen Common Stock Certificate, incorporated by reference to the Registrant’s Registration Statement on Form S-3 filed February 8, 2010 (File No. 333-164780).
31.1						Rule 13a – 14(a)/15d-14(a) Certification (Principal Executive Officer)
31.2						Rule 13a – 14(a)/15d-14(a) Certifications (Principal Financial Officer)
32.1						Section 1350 Certifications (Principal Executive Officer)
32.2						Section 1350 Certifications (Principal Financial Officer)
101.LAB						XBRL Taxonomy Extension Label Linkbase
101.PRE						XBRL Taxonomy Extension Presentation Linkbase
101.INS						XBRL Instance Document
101.SCH						XBRL Taxonomy Extension Schema
101.CAL						XBRL Taxonomy Extension Calculation Linkbase
101.DEF						XBRL Taxonomy Extension Definition Linkbase

All other exhibits for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

			/s/ Thomas R. Quinn, Jr.
			Thomas R. Quinn, Jr.
			President and Chief Executive Officer
			(Principal Executive Officer)
			/s/ Thomas R. Brugger
			Thomas R. Brugger
			Executive Vice President and Chief Financial Officer
			(Principal Financial Officer)
			Date: August 7, 2020

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