Filed Pursuant to Rule 424(b)(5)
Registration No. 333-167774

 

MERGER PROPOSAL — YOUR VOTE IS VERY IMPORTANT

 

 

To the Shareholders of Union National Financial Corporation:

 

On April 19, 2010, our board of directors unanimously approved an agreement that provides for our merger with Donegal Financial Services Corporation, or DFSC. The merger agreement, as amended on May 20, 2010, also provides for the merger of Union National Community Bank, or UNCB, which we currently own, with and into Province Bank FSB, or Province, which DFSC currently owns. DFSC is a savings and loan holding company that Donegal Mutual Insurance Company, or DMIC, and Donegal Group Inc., or DGI, jointly own.

 

We are sending this proxy statement/prospectus to you to ask you to vote on the adoption of our merger agreement with DFSC, DMIC, DGI and Donegal Acquisition, Inc., or DAI, and the transactions the merger agreement contemplates.

 

If our shareholders adopt the merger agreement, and we subsequently complete the merger, each outstanding share of our common stock, other than the 248,999 shares DMIC owns and shares as to which the holders perfect dissenters’ rights, will be converted into the right to receive $5.05 in cash and 0.2134 share of Class A common stock of DGI. The merger consideration of $5.05 in cash and 0.2134 share of Class A common stock of DGI is fixed, and will not change if our stock price or the price of DGI Class A common stock changes. On April 19, 2010, the last trading day before we announced the merger, the closing price of our common stock on the OTC Bulletin Board, or OTCBB, was $6.00. Based on the closing price of DGI Class A common stock on the NASDAQ Global Select Market, or NASDAQ, on April 19, 2010, 0.2134 share of DGI Class A common stock and $5.05 in cash represented approximately $8.18 in value for each share of our common stock.

 

Based on the closing price of DGI Class A common stock on July 29 2010, the last practicable trading day before the printing of this proxy statement/prospectus, 0.2134 share of DGI Class A common stock and $5.05 in cash represented approximately $7.56 in value for each share of our common stock.

 

You should obtain current stock price quotations for DGI Class A common stock which trades on NASDAQ under the symbol “DGICA” and our common stock which trades on the OTCBB under the symbol “UNNF.OB.”

 

OUR BOARD OF DIRECTORS HAS UNANIMOUSLY DETERMINED THAT THE MERGER AND THE MERGER AGREEMENT ARE ADVISABLE AND IN THE BEST INTERESTS OF UNNF AND ITS SHAREHOLDERS AND UNANIMOUSLY RECOMMENDS THAT YOU VOTE “FOR” ADOPTION OF THE MERGER AGREEMENT. We cannot complete the merger unless the holders of 80% of our issued and outstanding shares of common stock vote to adopt the merger agreement. Whether or not you plan to attend our special meeting of shareholders, please vote by completing the enclosed proxy card and returning it to us in the enclosed envelope. If you sign, date and return your proxy card without indicating how you want to vote, we will count your proxy as a vote “FOR” adoption of the merger agreement. If you fail to vote, or you do not instruct your broker how to vote any shares you hold in “street name,” it will have the same effect as voting against adoption of the merger agreement. You may also vote by telephone or Internet by following the instructions accompanying the enclosed proxy card.

 

The accompanying proxy statement/prospectus describes our special meeting, the merger agreement, the transactions the merger agreement contemplates, the documents related to the merger and related matters. We recommend that you carefully read this proxy statement/prospectus, including the considerations discussed under “Risk Factors” beginning on page 67 and the appendices to this proxy statement/prospectus, which include the merger agreement.

 

On behalf of our board of directors, I thank you for your prompt attention to this important matter.

 

Sincerely,

 

 

Mark D. Gainer

Chairman, President and Chief Executive Officer

 

August 5, 2010

 

 

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of the DGI Class A common stock to be distributed under this proxy statement/prospectus or determined if this proxy statement/prospectus is accurate or adequate. Any representation to the contrary is a criminal offense.

 

 

Shares of DGI Class A common stock are not savings or deposit accounts or other obligations of any bank or savings association and they are not insured by the Federal Deposit Insurance Corporation or any other governmental agency.

 

 

The date of this proxy statement/prospectus is July 29, 2010, and we are first mailing or otherwise delivering it to our shareholders on or about August 5, 2010.

 

570 Lausch Lane, Suite 300
Lancaster, Pennsylvania 17601

 

NOTICE OF SPECIAL MEETING OF SHAREHOLDERS

TO BE HELD SEPTEMBER 16, 2010

 

WE HEREBY GIVE NOTICE that we will hold a special meeting of our shareholders at 10:00 a.m., prevailing time, on Thursday, September 16, 2010 at Enck’s Banquet and Conference Center, 1461 Lancaster Road, Manheim, PA 17545, for the following purposes, all of which we describe in greater detail in the subsequent pages of this proxy statement/prospectus:

 

(1) to consider and vote upon a proposal to adopt the Agreement and Plan of Merger, dated as of April 19, 2010, and as amended as of May 20, 2010, among Donegal Acquisition Inc., Donegal Financial Services Corporation, Donegal Group Inc., and Donegal Mutual Insurance Company and us, and the consummation of the transactions the merger agreement contemplates as discussed in this proxy statement/prospectus.

 

(2) to consider and vote upon a proposal to approve the adjournment of our special meeting, if necessary, to permit the further solicitation of proxies if sufficient votes have not been cast at the time of our special meeting to adopt the merger agreement; and

 

(3) to transact any other business properly presented for action at our special meeting and any adjournment or postponement of our special meeting.

 

You should read this proxy statement/prospectus in its entirety before you vote. We have included a copy of the merger agreement as Appendix A to this proxy statement/prospectus. Only the holders of our outstanding common stock as of the close of business on July 29, 2010 are entitled to vote at our special meeting and any adjournment or postponement of our special meeting.

 

This notice also constitutes notice of your right to dissent from the merger and, upon compliance with the requirements of Subchapter D of Chapter 15 of the Pennsylvania Business Corporation Law of 1988, or PBCL, to receive the appraised fair value of your shares. We have included a copy of the relevant sections of the PBCL regarding dissenters’ rights as Appendix C to this proxy statement/prospectus.

 

Our board of directors has unanimously approved the merger agreement and recommends that you vote “FOR” adoption of the merger agreement and “FOR” the adjournment of our special meeting.

 

Whether or not you expect to attend our special meeting in person, we urge you to vote. Please sign, date and promptly return the enclosed proxy. We enclose a self-addressed envelope for your convenience; no postage is required if mailed in the United States. If you submit a signed and dated proxy card but do not indicate how you want to vote your shares, the persons named as proxies in the enclosed proxy will vote your shares “FOR” the adoption of the merger agreement and “FOR” the adjournment of our special meeting. Returning your proxy will not prevent you from attending our special meeting and voting in person if you wish to vote in person. You may also vote by telephone or Internet by following the instructions accompanying the proxy card. You may revoke your proxy and vote in person at any time before we vote your proxy.

 

Please do not send any stock certificates at this time. Thank you for your cooperation.

 

By order of our board of directors,

 

 

Mark D. Gainer

Chairman, President and Chief Executive Officer

 

Lancaster, Pennsylvania

August 5, 2010

 

TABLE OF CONTENTS

 

 

APPENDICES:

 

 

In this proxy statement/prospectus, “you” refers to the shareholders of UNNF, “we,” “us,” “our” or “UNNF” refers to Union National Financial Corporation, “UNCB” refers to Union National Community Bank, “DAI” refers to Donegal Acquisition Inc., “DMIC” refers to Donegal Mutual Insurance Company, “DGI” refers to Donegal Group Inc., “DFSC” refers to Donegal Financial Services Corporation, “Province” refers to Province Bank FSB and “the Donegal parties” refers to one or more of DAI, DMIC, DGI, DFSC and Province as the context requires. Also, we refer to the mergers between DAI and UNNF and between UNNF and DFSC as the “merger,” and the agreement and plan of merger dated as of April 19, 2010, and as amended as of May 20, 2010, among the Donegal parties and UNNF as the “merger agreement.”

 

Both UNNF and DGI file annual, quarterly and special reports, proxy statements and other information with the Securities and Exchange Commission, or SEC, under the Securities Exchange Act of 1934 as amended, or the 1934 Act. You may obtain copies of these documents by mail from the public reference room of the SEC at 100 F Street, N.E., Room 1580, Washington, D.C. 20549, at prescribed rates. You may also call the SEC at (800) SEC-0330 for further information on the public reference room. In addition, UNNF’s and DGI’s SEC filings are also available to the public from commercial document retrieval services and at the website the SEC maintains at www.sec.gov.

 

This proxy statement/prospectus incorporates by reference important business and financial information and risk factors about DGI from documents that DGI has previously filed with the SEC. We are not required to include, and have not included, these documents as part of this proxy statement/prospectus. See “Incorporation of Certain Documents by Reference” on page 127. You may obtain these documents from DGI at DGI’s address and telephone number listed below without charge upon written or oral request:

 

Donegal Group Inc.
1195 River Road
Marietta, Pennsylvania 17547
Attention: Jeffrey D. Miller
Telephone: (888) 877-0600

 

In order to ensure timely delivery of the documents, you must request the information no later than September 9, 2010.

 

DGI has filed a registration statement on Form S-4 to register with the SEC under the Securities Act of 1933, as amended, or the 1933 Act, relating to 600,000 shares of DGI Class A common stock. DFSC will distribute the 600,000 shares of DGI Class A common stock as merger consideration to our shareholders pursuant to the merger agreement. This proxy statement/prospectus is a part of that registration statement. As SEC rules permit, this proxy statement/prospectus does not contain all of the information included in the registration statement or in the exhibits or schedules to the registration statement. You may read and copy the registration statement, including any amendments, schedules or exhibits, at the addresses listed above. Statements contained in this proxy statement/prospectus are not necessarily complete. In each case, you should refer to the copy of the applicable document or contract filed as an exhibit to the registration statement.

 

DGI Class A common stock trades on the NASDAQ Global Select Market, or NASDAQ, under the symbol “DGICA,” and UNNF common stock trades on the OTC Bulletin Board, or OTCBB, under the symbol “UNNF.OB.”

 

 

 

 

 

 

 

 

 

 

 

SUMMARY

	•	statements of goals, intentions and expectations;
	•	statements regarding business plans, prospects, growth and operating strategies; and
	•	statements regarding estimates of risks and future costs and benefits.

 

The Parties

 

The Donegal Parties (DMIC, DGI, DFSC, DAI and Province) (Page 75)

 

DMIC

 

DGI

 

DFSC

 

DAI

 

Province

 

UNNF (Page 76)

 

Our Special Meeting (Page 72)

 

General (Page 71)

 

When and Where We Will Hold Our Special Meeting (Page 72)

 

The Matters Our Shareholders Will Consider (Page 72)

	•	Proposal 1 — A proposal to adopt the merger agreement;
	•	Proposal 2 — A proposal to grant discretionary authority to adjourn our special meeting if necessary to permit further solicitation of proxies because we have not received sufficient votes at the time of our special meeting to adopt the merger agreement; and
	•	Any other business that properly comes before our special meeting and any adjournment or postponement of our special meeting.

 

Record Date; Shares Outstanding and Entitled to Vote (Page 73)

 

Quorum (Page 73)

 

Shareholder Vote Required (Page 73)

 

Director and Executive Officer Voting (Page 74)

 

Proxies (Page 74)

	•	submitting written notice of revocation to our corporate secretary any time before we conduct the vote at our special meeting;

	•	submitting a properly executed proxy with a later date;

	•	submitting a new proxy by telephone or Internet; or

	•	voting in person at our special meeting.

 

Recommendation of Our Board of Directors (Page 75)

 

Attending Our Special Meeting (Page 75)

 

The Merger

 

Certain Effects of the Merger (Pages 101 to 102)

	•	Each share of our common stock, other than the shares DMIC owns and shares held by holders who perfect dissenters’ rights, will automatically convert into the right to receive, subject to the provisions of the merger agreement:

	•	0.2134 share of DGI Class A common stock; and
	•	$5.05 in cash.

	•	We will cease to exist as a separate legal entity and DFSC and Province will conduct all of our operations. Province will conduct its banking business under a name that DFSC and we will select.

 

Stock Options (Page 102)

 

Opinion of Our Financial Advisor in Connection with the Merger (Pages 85 to 93)

 

Interests of Our Directors and Executive Officers in the Merger (Page 95)

	•	the continued indemnification of our current directors and executive officers under the merger agreement and providing these individuals with directors’ and officers’ insurance;
	•	the agreement of DFSC and Province to honor the existing employment and change of control agreements for eight of our officers, including our executive officers, unless and until such officers individually determine to execute a mutually acceptable employment agreement with DFSC and Province;
	•	the agreement of DFSC and Province to honor Mr. Gainer’s existing employment agreement and amended and restated executive salary continuation agreement, or the salary agreement, unless and until Mr. Gainer, DFSC and Province execute a mutually acceptable employment agreement and a mutually acceptable amended and restated salary agreement;
	•	the appointment of Mark D. Gainer and two other current members of our board of directors to DFSC’s board of directors and their receipt of directors’ fees in connection therewith; and
	•	the appointment of Mark D. Gainer and four other current members of UNCB’s board of directors to the board of directors of Province and their receipt of directors’ fees in connection therewith.

 

Regulatory Approvals Required for the Merger (Page 96)

 

Conditions to the Merger (Page 107)

	•	approval of the merger proposal by the holders of 80% of our outstanding shares of common stock entitled to vote at our special meeting;
	•	subject to certain limited exceptions and except as otherwise previously disclosed to the other party, the representations and warranties of the parties to the merger agreement must be true and correct unless the failure of the representations and warranties to be true and correct would not have and would not reasonably be expected to have, individually or in the aggregate, a material adverse effect on the representing party;
	•	the receipt of all regulatory approvals needed to complete the merger, including the approval of the OTS and the provision of specified notice to the Department, and the absence of the imposition of materially burdensome conditions by the OTS and any other regulatory agencies whose regulatory approval is necessary for the completion of the merger;
	•	the absence of any law, statute, rule, regulation, order, decree or injunction that would effectively prohibit the merger or make completion of the merger illegal;
	•	DGI’s registration statement, of which this proxy statement/prospectus forms a part, shall have become effective and no stop order suspending its effectiveness shall have been issued and the SEC shall not have initiated or threatened any proceedings for that purpose;
	•	UNCB shall not have delinquent loans, as defined in the merger agreement, that exceed $37.5 million as of the end of the month preceding the month in which the closing of the merger is scheduled to occur;
	•	NASDAQ shall have approved for listing the shares of DGI Class A common stock that DFSC will distribute to our shareholders as part of the merger consideration;
	•	DFSC shall have delivered the merger consideration to the exchange agent not later than the day prior to the closing date; and
	•	DFSC and we shall have received all necessary third party consents.

 

Non-Solicitation (Page 106)

 

Litigation Related to the Merger (Page 109)

 

Termination of the Merger Agreement (Page 108)

	•	failure to obtain the necessary regulatory approvals for the merger unless the failure is due to the terminating party’s failure to perform or observe its covenants in the merger agreement;
	•	failure to complete the merger by December 31, 2010, unless the reason for the failure not to consummate the merger by that date is a failure by the terminating party to perform or observe its covenants and agreements in the merger agreement;
	•	the non-terminating party’s breach of a representation, warranty, covenant, agreement or other obligation contained in the merger agreement that would make it impossible to satisfy the closing conditions, provided the terminating party is not then in material breach of any of its representations, warranties, covenants, agreements or other obligations in the merger agreement; or
	•	failure of the holders of 80% of our outstanding common stock to approve the merger proposal, provided we are not in material breach of our obligations to hold our special meeting and our board of directors is not in breach of its covenant to recommend such approval.

	•	breached our obligation not to initiate, solicit or encourage or take any action to facilitate another proposal to acquire us, participate in any discussions or negotiations relating to another proposal to acquire us or, except as permitted by and subject to certain terms of the merger agreement, approve, recommend or enter into any letter of intent, agreement or other commitment relating to another proposal to acquire us;
	•	failed to have our board of directors recommend approval of the merger proposal by our shareholders or our board of directors shall have changed its recommendation, except as permitted by the merger agreement with respect to a proposal to acquire us on terms and conditions superior to those in the merger agreement;
	•	recommended approval of another proposal to acquire us; or
	•	failed to call, give notice of, convene and hold our special meeting.

 

Expenses; Termination Fee (Page 109)

	•	we terminate the merger agreement in order to enter into an agreement relating to an acquisition proposal that has terms superior to those of the merger agreement from the perspective of our shareholders;

	•	DFSC terminates the merger agreement prior to our special meeting because we have breached our obligation not to encourage or solicit acquisition proposals, we have failed to hold our special meeting or our board of directors has not recommended approval of the merger proposal or has changed its recommendation or has recommended approval of another proposal to acquire us or we fail to hold our special meeting;
	•	a third party makes a tender or exchange offer for 25% or more of our common stock and our board of directors fails to send a statement to our shareholders recommending rejection of that offer within 10 days after the making of the offer; or
	•	the occurrence of any of the following events within 18 months after the termination of the merger agreement, provided that a third party makes a proposal to acquire us after April 19, 2010 and does not withdraw its proposal prior to termination of the merger agreement:

	•	we enter into an agreement to merge with or be acquired by that third party;
	•	that third party acquires substantially all of our assets; or
	•	that third party acquires more than 50% of our common stock.

	•	by us because DFSC breached its representations, warranties, covenants, agreements or other obligations in the merger agreement, which breach could reasonably be expected to result in a material adverse effect and which breach cannot be or is not cured, assuming we are also not in material breach of our obligations under the merger agreement, DFSC will pay our out-of-pocket expenses in connection with the merger, including fees and expenses of legal counsel, financial advisors and accountants, up to a maximum of $500,000; and
	•	by DFSC because we breached our representations, warranties, covenants, agreements or other obligations in the merger agreement which breach could reasonably be expected to result in a material adverse effect and which breach cannot be or is not cured, assuming DFSC is also not in material breach of its obligations under the merger agreement, we will pay DFSC’s out-of-pocket expenses in connection with the merger, including fees and expenses of legal counsel, financial advisors and accountants, up to a maximum of $500,000, provided, however, that we do not have to pay DFSC’s expenses if we have paid the break-up fee to DFSC.

 

Material U.S. Federal Income Tax Consequences of the Merger (Pages 110 to 112)

 

Dividends (Page 124)

 

Certain Differences in Rights of Shareholders (Pages 113 to 124)

Comparative Market Prices and Dividends (Page 124)

										Pro Forma Equivalent
		DGI Class A				Our				Value of One Share of
		Common Stock				Common Stock				Our Common Stock
April 19, 2010		$	14.68			$	6.00			$	8.18
July 29, 2010			11.78				7.45				7.56

Dissenters Rights (Page 99)

Recent Developments

Questions and Additional Information (Page 75)

 

SELECTED CONSOLIDATED HISTORICAL FINANCIAL DATA OF DGI

		Three Months
		Ended March 31,								Year Ended December 31,
		2010				2009				2009				2008				2007				2006				2005
		(Dollars in thousands, except per share amounts)
Income Statement Data
Premiums earned		$	91,372			$	88,350			$	355,025			$	346,575			$	310,072			$	301,478			$	294,498
Investment income, net			4,930				5,358				20,631				22,756				22,785				21,320				18,472
Realized investment gains (losses)			22				259				4,480				(2,971	)			2,051				1,830				1,803
Total revenues			97,915				95,502				386,733				372,424				340,618				329,967				319,847
Income before income taxes			276				212				20,677				32,092				52,849				56,622				52,345
Income taxes			41				42				1,847				6,550				14,569				16,408				15,396
Net income			235				170				18,830				25,542				38,280				40,215				36,949
Basic earnings per share — Class A			0.01				0.01				0.76				1.03				1.55				1.65				1.57
Diluted earnings per share — Class A			0.01				0.01				0.76				1.02				1.53				1.60				1.51
Cash dividends per share — Class A			—				—				0.45				0.42				0.36				0.33				0.30
Basic earnings per share — Class B			0.01				0.01				0.68				0.92				1.39				1.48				1.41
Diluted earnings per share — Class B			0.01				0.01				0.68				0.92				1.39				1.48				1.41
Cash dividends per share — Class B			—				—				0.40				0.37				0.31				0.28				0.26
Balance Sheet Data at End of Period
Total investments			657,735				639,618				666,835				632,136				605,870				591,338				547,746
Total assets			936,025				890,379				935,602				880,109				834,096				831,698				781,422
Debt obligations			15,465				15,465				15,465				15,465				30,929				30,929				30,929
Stockholders’ equity			385,428				368,350				385,506				363,584				352,690				320,802				277,896
Book value per share			15.11				14.47				15.12				14.29				13.92				12.70				11.30

 

SELECTED CONSOLIDATED HISTORICAL FINANCIAL DATA OF UNNF

		Three Months
		Ended March 31,								Year Ended December 31,
		2010				2009				2009				2008				2007				2006				2005
		(Dollars in thousands, except per share amounts)
Summary of Operations Data:
Interest income			$  5,522			$	6,049			$	23,758			$	28,173			$	31,373			$	30,290			$	23,978
Interest expense			2,263				3,178				11,286				13,579				16,009				15,626				9,662
Net interest income			3,259				2,871				12,472				14,594				15,634				14,664				14,316
Provision for credit losses			496				313				2,627				1,027				1,237				672				681
Net interest income after provision for credit losses			2,763				2,558				9,845				13,567				14,127				13,992				13,635
Non-interest income			1,180				619				5,375				3,807				6,509				8,262				6,011
Non-interest expense			4,022				4,014				16,737				17,118				20,745				19,711				15,627
(Loss) income before income taxes (benefit)			(79	)			(837	)			(1,517	)			256				(109	)			2,543				4,019
(Benefit from) provision for income taxes			(82	)			(328	)			(802	)			(188	)			(421	)			99				666
Net (loss) income			3				(509	)			(715	)			444				312				2,444				3,353
Preferred stock dividends			18				—				—				—				—				—				—
Net (loss) income available to common shareholders			(15	)			(509	)			(715	)			444				312				2,444				3,353
Per Share Data:
(Loss) earnings per common share			$  (0.01	)		$	(0.19	)		$	(0.26	)		$	0.17			$	0.12			$	0.96			$	1.31
Dividends paid			—				—				—				—				0.28				0.62				0.63
Book value per share at period end			11.11				11.37				10.97				11.32				11.31				11.31				10.84
Average number of shares outstanding basic and diluted (in thousands)			2,742				2,721				2,730				2,643				2,544				2,537				2,556
Statement of Condition Data (at end of period):
Assets			$499,931			$	510,922			$	489,644			$	485,109			$	501,776			$	517,597			$	462,178
Net loans and leases			327,033				351,970				333,416				353,922				360,662				338,043				297,538
Deposits			416,925				407,889				404,765				383,577				376,311				340,075				296,610
Short-term borrowings			—				—				—				—				6,629				10,544				18,305
Long-term debt			30,834				50,334				33,334				50,334				68,816				117,571				105,815
Junior subordinated debentures			17,341				17,341				17,341				17,341				17,341				17,341				11,341
Total stockholders’ equity			31,278				30,929				31,336				30,794				28,800				28,548				27,225
Financial Ratios:			(Annualized	)
Return on average assets			0.00	%			(0.41	)%			(0.14	)%			0.09	%			0.06	%			0.50	%			0.79	%
Return on average equity			0.04				(6.47	)			(2.26	)			1.48				1.07				8.81				12.59
Ratio of average equity to average assets			6.53				6.31				6.29				6.15				6.05				5.67				6.25

 

The following discussion provides management’s analysis of UNNF’S financial condition and results of operations for the three-month periods ended March 31, 2009 and 2010 and for the years ended December 31, 2007, 2008 and 2009. The UNNF financial statements and accompanying notes included elsewhere in this proxy statement/prospectus are an integral part of this discussion and should be read in conjunction with it.

 

Management’s discussion and analysis represents an overview of the financial condition and results of operations, and highlights the significant changes in the financial condition and results of operations, as presented in the accompanying consolidated financial statements for UNNF, a bank holding company, and its wholly owned subsidiary, UNCB. UNNF’s consolidated financial condition and results of operations consist primarily of UNCB’s financial condition and results of operations. UNNF’s trust subsidiaries, Union National Capital Trust I and Union National Capital Trust II, were established for the purpose of issuing $11,000,000 of trust capital securities during 2003 and 2004.

 

These financial statements contain forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Actual results and trends of UNNF and UNCB could differ materially from those set forth in such statements due to various risks, uncertainties and other factors. Such risks, uncertainties and other factors that could cause actual results and experience to differ include, but are not limited to, the following:

 

 

When we use words such as “believes”, “expects”, “anticipates”, or similar expressions, we are making forward-looking statements. UNNF undertakes no obligation to publicly revise or update these forward-looking statements to reflect events or circumstances that arise after the date of this report.

 

Readers should carefully review the risk factors described in the Annual Report and other documents that we periodically file with the SEC, including our Form 10-K for the year ended December 31, 2009, our Forms 8-K, and other reports, that we have filed during 2010 with the SEC.

 

We prepare our consolidated financial statements based upon the application of U.S. generally accepted accounting principles, or GAAP. The reporting of our financial condition and results of operations is impacted by the application of accounting policies by management, some of which are particularly sensitive and require significant judgments, estimates and assumptions to be made in matters that are inherently uncertain. These accounting policies, along with the disclosures presented in other financial statement notes and in this financial review, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Management views critical accounting policies to be those which are highly dependent on subjective or complex judgments, estimates and assumptions, and where changes in those estimates and assumptions could have a significant impact on the consolidated financial statements. Management currently views the determination of the allowance for credit losses, the fair value of investment securities and the fair value of other real estate owned to be critical accounting policies.

 

Determination of the Allowance for Credit Losses

 

The provision for credit losses and the level of the allowance for credit losses involve significant estimates by management. In evaluating the adequacy of the allowance for credit losses, management considers the specific collectability of impaired and nonperforming loans, past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect borrowers’ ability to repay (including the timing of future payments), the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions and other relevant qualitative factors. While we use available information to make such evaluations, future adjustments to the allowance for credit losses and the provision for credit losses may be necessary if economic conditions, loan credit quality, or collateral issues differ substantially from the factors and assumptions used in making the evaluation.

 

Fair Value of Investment Securities

 

Investments are carried at fair value with any unrealized gains and losses, considered to be temporary, reported net of tax as an adjustment to stockholders’ equity. In order to determine whether unrealized losses in the fair value of investment securities reflect other-than-temporary impairment, or OTTI, management regularly reviews the entire portfolio of investment securities for possible impairment, analyzing factors including, but not limited to, the underlying creditworthiness of the issuing organization, the length of time for which the fair value of the investment securities may be less than cost, and independent analysts’ opinions about circumstances that could affect the performance of the investment securities. In assessing potential OTTI for debt securities with fair values less than cost, other considerations include (i) whether management intends to sell the security, or (ii) if it is more likely than not that management will be required to sell the security before recovery, or (iii) if management does not expect to recover the entire amortized cost basis. In assessing potential OTTI for equity securities with fair values less than cost, consideration is given to management’s intention and ability to hold the securities until recovery of any unrealized losses. After considering such factors, it is a matter of judgment on the part of management to make the determination of whether or not the decline in market value is other-than-temporary.

Fair Value of Other Real Estate Owned

 

Other Real Estate Owned, or OREO, includes property acquired through foreclosure, deed in-lieu of foreclosure, and an in-substance foreclosure. OREO is held for sale. The carrying value of the property is recorded at the fair value of the property as determined based upon an independent appraisal, less estimated costs to sell at the time of acquisition. Any excess of the loan balance over the carrying value of the property at the time of transfer from loans to OREO is charged to the allowance for credit losses. Subsequent to the transfer to OREO, if the sales price of the property less actual costs to sell is less than the carrying value of the property, the deficiency is charged against income as a loss on sale. Due to changing market conditions, there are inherent uncertainties upon liquidation with respect to determining the fair value of OREO. Therefore, the amount ultimately realized upon liquidation may differ from the carrying value reflected in the accompanying consolidated financial statements.

 

Total assets increased by $10,287,000 or 2% to $499,931,000 at March 31, 2010, from $489,644,000 at December 31, 2009. The increase was primarily the result of strong retail deposit generation, which further strengthened our liquidity position. Total deposits grew by $12,160,000 or 3% to $416,925,000 at March 31, 2010 from $404,765,000 at December 31, 2009.

 

Investment securities were $60,757,000 at March 31, 2010, compared to $60,546,000 at December 31, 2009. All of our investment securities were classified as available for sale at March 31, 2010 and December 31, 2009. Investment securities classified as available for sale are marketable equity securities, and those debt securities that we intend to hold for an undefined period of time, but not necessarily to maturity. In addition to the investment portfolio generating interest income, it serves other primary financial management functions such as a reliable source of liquidity and a tool to manage interest rate risk. In order to support these functions, the entire investment securities portfolio has been designated as being available for sale. Any decision to sell an available-for-sale investment security would be based on various factors, including significant movements in interest rates, changes in maturity mix of assets and liabilities, liquidity needs, regulatory capital considerations, reasonable gain realization, changes in the creditworthiness of the issuing entity, changes in investment strategy and portfolio mix, and other similar factors. Changes in unrealized gains or losses on available-for-sale investment securities, net of taxes, are recorded as other comprehensive (loss) income, a component of stockholders’ equity.

 

Certain types of mortgage-backed and asset-backed securities are purchased to better position the investment securities portfolio for a subsequent increase or decrease in interest rates, as aligned with our interest rate risk position. These investment securities may be purchased at premiums or discounts, with short, mid, or long-term average expected lives or maturities. Overall yields on these investment securities will increase or decrease based on changes in prepayment speeds and subsequent cash flow reinvestments.

 

Investment security purchases and sales generally occur to manage UNCB’s liquidity requirements, pledging requirements, interest rate risk, and to enhance net interest margin and capital management. The investment securities portfolio is evaluated regularly for possible opportunities to increase earnings through potential sales or portfolio repositioning. In the first three months of 2010, proceeds of $16,479,000 were received on sales, and $77,000 was recognized in net gains, while $18,644,000 of investment securities were purchased. Investment securities of $57,793,000 and $57,209,000 were pledged to secure public, trust, and government deposits and for other purposes at March 31, 2010 and December 31, 2009, respectively.

 

In addition to the credit risk present in the loan portfolio, we also have credit risk associated with our investment security holdings. Based on recent national economic trends and other factors, the private issuer mortgage-backed securities and corporate debt securities credit ratings as published by national statistical rating organizations are being monitored closely.

Investment securities consisted of the following at of March 31, 2010 and December 31, 2009, (in thousands):

 

 

Debt securities include mortgage-backed securities, obligations of state and political subdivisions, obligations of U.S. government agencies, structured notes and corporate securities. At March 31, 2010, there were fifteen debt securities with unrealized losses of $153,000 that amounted to 0.4% of their amortized cost, compared to December 31, 2009, when there were twenty-seven debt securities with unrealized losses of $585,000 that amounted to 1.3% of their amortized cost. Management believes that the unrealized losses reflect temporary declines primarily due to changes in interest rates subsequent to the acquisition of specific securities. These temporary declines have been provided for in other comprehensive income (loss). All of the obligations of state and political subdivisions outstanding at December 31, 2009, were sold in 2010, and as a result of positive market movements, no losses were recognized on the sale of these securities.

 

Equity securities held are comprised primarily of common stock holdings in other financial institutions. There were nine and ten equity securities with unrealized losses of $11,000, at both March 31, 2010 and December 31, 2009, respectively. We have the ability and intent to hold these investments for a reasonable period of time sufficient for the fair value of each equity security to increase to our cost. Management does not consider the equity securities to be other-than-temporarily impaired at March 31, 2010.

 

As of March 31, 2010, $12,000 of the fair value of the total investment securities portfolio was measured using Level 1 inputs as defined by fair value measurement and disclosure guidance, $57,848,000 or 95% of the fair value of total investment securities was measured using Level 2 inputs, and $2,897,000 or 5% of the fair value of total investment securities was measured using Level 3 inputs. For additional information, refer to Note 12 — Fair Value Measurement of Assets and Liabilities and Fair Value of Financial Instruments to the consolidated financial statements included elsewhere in this proxy statement/prospectus.

 

The fair value of Level 3 investment securities decreased to $2,897,000 at March 31, 2010, compared to $3,269,000 at December 31, 2009. Of the decrease in value, $272,000 was related to net proceeds received on the sale of an impaired security, $172,000 was related to principal and interest payments received and fully applied to principal, offset by $72,000 of net unrealized gains (with a corresponding after-tax increase to stockholders’ equity of $48,000 recorded as other comprehensive income).

 

In order to determine whether unrealized losses in the fair value of investment securities are OTTI, management regularly reviews the entire portfolio of investment securities for possible impairment, analyzing factors including but not limited to the underlying creditworthiness of the issuing organization, the length of time for which the fair value of the investment securities has been less than cost, and independent analysts’ opinions about circumstances that could affect the performance of the investment securities. In assessing potential OTTI for debt securities, other considerations include (i) whether management intends to sell the security, or (ii) if it is more likely than not that management will be required to sell the security before recovery, or (iii) if management does not expect to recover the entire amortized cost basis. In assessing potential OTTI for equity securities, consideration is given to management’s intention and ability to hold the securities until recovery of any unrealized losses.

 

As of March 31, 2010, our recorded investment balances include three securities with previously recorded impairments. The fair value of these impaired investments was $2,897,000 at March 31, 2010, compared to an original amortized cost of $6,950,000. All principal and interest payments received on impaired investment securities are fully applied to principal.

 

Accounting Standards Codification, or ASC, Topic 320, “Investments — Debt and Equity Securities” provides a list of factors that a reporting entity should evaluate to determine whether there has been a

significant decrease in the volume and level of activity for the asset or liability in relation to normal market activity for the asset or liability. When the reporting entity concludes there has been a significant decrease in the volume and level of activity for the asset or liability, further analysis of the information from that market is needed and significant adjustments to the related prices may be necessary to estimate fair value in accordance with fair value measurement and disclosure guidance. Further, fair value measurement and disclosure guidance clarifies that when there has been a significant decrease in the volume and level of activity for the asset or liability, some transactions may not be orderly, and we must evaluate the weight of evidence to determine whether the transactions are orderly. The guidance provides a list of circumstances that may indicate that a transaction is not orderly. A transaction price that is not associated with an orderly transaction is given little, if any, weight when estimating fair value.

 

As discussed more thoroughly in Note 12 — Fair Value of Assets and Liabilities and Fair Value of Financial Instruments to the consolidated financial statements included elsewhere in this proxy statement/prospectus, the fair value of these investment securities was determined by calculating the net present value of the expected future cash flows of each security, with qualitative risk-adjusted discounting for potential credit risks and nonperformance in the underlying issuers, and market sector illiquidity concerns. In accordance with ASC Topic 820, when an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable. Management’s judgment was that, as of March 31, 2010 and December 31, 2009, the facts and circumstances indicated significant illiquidity and an inactive market for these types of investments when other relevant observable inputs were not available; therefore, expected cash flows were used as a reasonable basis in determining the fair value of the corporate investment securities.

 

During 2009, four of UNCB’s five private issuer securities were downgraded to below investment grade (one private issuer mortgage-backed security was downgraded to below investment grade in 2008). Accordingly, UNCB recorded $1,504,000 of other-than-temporary impairment charges in 2009 including (i) $859,000 related to three corporate securities supported primarily by obligations from other financial industry entities, and (ii) $645,000 related to two private issuer mortgage-backed securities not guaranteed by the U.S. government. During 2008, we recorded $1,290,000 of other-than-temporary investment impairment charges related to two securities, including the private-issuer security that was downgraded to below-investment-grade in 2008, and a corporate security. Management determined that, due to severe illiquidity and distress in the financial markets, the unrealized declines in the value of these investments were other-than-temporary and credit related, requiring the write-down and related impairment charge to earnings. For the securities with impairment charges recorded, interest income payments received subsequent to impairment are fully applied to principal further reducing the amortized cost of these investments.

 

During 2009, one of the previously impaired corporate securities (USCap Funding V) was fully impaired, completely written-off and declared as a worthless asset for tax purposes. This impaired corporate security had a cumulative credit related OTTI of $936,000 at December 31, 2009. During 2010, another one of the previously impaired corporate securities (InCaps Funding II Senior Note) was sold for $277,000, leaving UNCB with a total of three impaired investment securities remaining at March 31, 2010. At the time of the sale, the InCaps Funding II Senior Note security had $631,000 of previously recorded impairments and an adjusted amortized cost of $272,000, which resulted in a $5,000 gain that was recorded on the sale.

 

Management determined that further impairments as of March 31, 2010 were not warranted on the three remaining impaired investment securities based upon the following considerations:

 

 

 

Loans and leases at March 31, 2010 were $333,028,000 compared to $339,274,000 at December 31, 2009. Outstanding loans decreased by $6,246,000 from December 31, 2009 to March 31, 2010, primarily due to reduced loan demand from creditworthy borrowers and the impact of certain loans at December 31, 2009, that subsequently involved collateral foreclosure and were classified as OREO at March 31, 2010, in the Consolidated Statements of Financial Condition (for additional information, refer to the discussion on “Non-Performing Assets” on page 21). We continue to focus lending on creditworthy consumers and businesses, with necessary consideration given to increased credit risks posed by the weak economy and the housing market. The economy and housing market, and increased unemployment, could affect some of UNCB’s borrowers, and may result in increased nonperforming loans and credit losses.

 

At March 31, 2010, UNCB had $68,708,000 of loans specifically pledged to the Federal Home Loan Bank of Pittsburgh, or FHLB, for providing collateral on FHLB long-term debt, compared to $72,287,000 of pledged loans at December 31, 2009.

 

In accordance with GAAP, the allowance for credit losses is maintained at a level believed by management to be adequate to absorb estimated probable loan and lease principal losses. The allowance for credit losses is established through provisions charged against net interest income. The uncollectible principal portion of impaired loans and leases is charged against the allowance for credit losses, and subsequent principal recoveries are credited to the allowance for credit losses.

 

Management’s evaluation of the adequacy of the allowance is based on UNCB’s past loan and lease loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay (including the timing of future payments), the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions and other relevant qualitative factors. This evaluation is inherently subjective as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans and leases that may be susceptible to significant change.

 

The allowance for credit losses is evaluated based on an assessment of the losses inherent in the loan and lease portfolio. This assessment results in an allowance that consists of specific, general and unallocated components. The specific component relates to loans and leases that are classified as impaired. For such loans and leases, an allowance is established when (i) the discounted cash flows, or (ii) collateral value, or (iii) observable market price of the impaired loan or lease is lower than the carrying value. The general component covers all other loans and leases, including criticized loans that are not impaired, and is based on historical loss experience adjusted for relevant qualitative factors. Separate qualitative adjustments are made for higher-risk criticized loans that are not impaired. An unallocated component is maintained to cover uncertainties that could affect our estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the loan and lease portfolio.

 

UNCB continues to monitor closely the loan portfolio, and the underlying borrower financial performance and collateral values, identifying credit concerns and risks, including those resulting from the uncertain and weakened economy. Future adjustments may be necessary to the allowance for credit losses, and consequently the provision for credit losses, if economic conditions or loan credit quality differ substantially from the assumptions management used in the evaluation of the level of the allowance compared to the balance of outstanding loans and leases.

The allowance for credit losses was $5,995,000 at March 31, 2010, compared to $5,858,000 at December 31, 2009. A provision for credit losses of $496,000 was made for the three months ended March 31, 2010, compared to $313,000 for the same period in 2009. The provision for credit losses for the three months ended March 31, 2010, was significantly higher than the provision for credit losses for the three months ended March 31, 2009 (for additional information, refer to the related discussion on “Provision for Credit Losses” on page 25) given the increased credit risks in the loan portfolio, including those resulting from the current weak economy and real estate market. With the higher provision exceeding net loan charge-offs of $359,000 as well as the decrease to the loan and lease portfolio in the first quarter of 2010, the allowance for credit losses increased to 1.80% of loans at March 31, 2010 compared to 1.73% of loans at December 31, 2009. Management believes, based on information then currently available, that the allowance for credit losses as of March 31, 2010, was adequate to meet probable credit losses at that date.

 

The following table summarizes the changes in the allowance for credit losses for the three months ended March 31, 2010 and 2009 (dollars in thousands):

 

 

Impaired Loans

 

Other than as described herein, management does not believe there are any significant trends, events or uncertainties that are reasonably expected to have a material impact on our loan and lease portfolio to affect future results of operations, liquidity or capital resources. However, based on known information, management believes that the effects of current and past economic conditions and other unfavorable business conditions may impact certain borrowers’ abilities to comply with their repayment terms and therefore may have an adverse effect on future results of operations, liquidity, or capital resources. Management continues to closely monitor economic and business conditions and the impact on borrowers’ financial strength. For certain loans and leases, management has determined that it is probable that all principal and interest payments due according to the contractual terms of the loan agreements will not be collected. These loans are considered to be impaired as defined by GAAP.

 

The balance of loans and leases that were considered to be impaired under GAAP was $6,174,000 and $8,715,000, which consisted of eight and ten separate loan and lease relationships to unrelated borrowers, at March 31, 2010 and December 31, 2009, respectively. At March 31, 2010, three of the relationships represented 84% of the total impaired loans and leases of $6,174,000. The decrease in impaired loans and leases from December 31, 2009 to March 31, 2010, primarily resulted from several loans, with a related allowance, that were foreclosed on and transferred into other real estate owned at March 31, 2010 (for additional information, refer to the discussion on “Non-Performing Assets” on page 21). Management continues to diligently monitor and evaluate the impaired loan portfolio, and identify new credit concerns and collectability risks, including those resulting from the current uncertain and weakened economy. The measure

of impairment is based primarily on the fair value of collateral securing these loans, which is primarily real estate and equipment.

 

Impaired Loans With a Related Allowance

 

We had $3,498,000 and $5,916,000 of impaired loans and leases with a related allowance for credit losses at March 31, 2010 and December 31, 2009, respectively. These consisted of four and five separate loan and lease relationships to unrelated borrowers, with a related allowance for credit losses of $1,199,000 and $1,458,000 at March 31, 2010 and December 31, 2009, respectively. This group of impaired loans and leases has a related allowance due to the probability of the borrower not being able to continue to make principal and interest payments due under the contractual terms of the loan or lease. These loans and leases appear to have insufficient collateral and UNNF’s principal may be at risk; as a result, a related allowance is necessary to cover future probable losses.

 

Impaired Loans without a Related Allowance

 

We had $2,676,000 and $2,799,000 of impaired loans and leases without a related allowance at March 31, 2010 and December 31, 2009, respectively. These consisted of four and five separate loan and lease relationships at March 31, 2010 and December 31, 2009, respectively. This group of impaired loans and leases is considered impaired due to the likelihood of the borrower not being able to continue to make principal and interest payments due under the contractual terms of the loan or lease. However, these loans and leases appear to have sufficient collateral and our principal does not appear to be at risk of probable principal losses; as a result, our management believes a related allowance is not necessary.

 

Substandard Loans and Leases

 

Under UNCB’s current internal risk rating system, loans and leases with a rating of “substandard” that were performing, and not determined to be impaired, amounted to $30,885,000 and $32,410,000 at March 31, 2010 and December 31, 2009, respectively. Despite these credits not being impaired, management believes these substandard credits reflect increased risks to the loan portfolio, including risks resulting from the current weak economy and real estate markets. Management considered such increased risks in determining the provision for credit losses (refer to the related discussion on “Provision for Credit Losses” on page 25). Management continues to closely monitor the loan portfolio, and the underlying borrower financial performance and collateral values, identifying credit concerns and risks, including those resulting from the current weak economy. Management considers both impaired and these substandard loans to be potential problem loans, and believes that the current persisting and weakened economic conditions may result in additional loans being classified or nonperforming in future periods.

 

Nonperforming Assets

 

Nonperforming assets consist of nonperforming loans and leases, OREO, and repossessed assets. The following table provides a summary of nonperforming assets at March 31, 2010 and December 31, 2009 (dollars in thousands):

 

 

Nonperforming loans and leases consist of loans and leases that are nonaccruing, and those that are 90 days or more past due. Nonaccruing loans and leases are no longer accruing interest income because of apparent financial difficulties of the borrower. Interest received on nonaccruing loans and leases is recorded as income only after the past due principal is brought current and deemed collectible in full. Total nonperforming loans and leases decreased to $6,491,000, or 1.9%, of gross loans and leases at March 31, 2010, compared to $8,540,000, or 2.5% of gross loans and leases, at December 31, 2009. The decrease in nonperforming loans and leases primarily resulted from several loans being foreclosed on in 2010 and are reported as OREO in the Consolidated Statements of Financial Condition at March 31, 2010. Historically, the percentage of nonperforming loans to gross loans for the five year-end periods ended December 31, 2009, was an average of 1.2%.

 

OREO includes assets acquired through foreclosure, deed in-lieu of foreclosure, and loans identified as in-substance foreclosures. A loan is classified as an in-substance foreclosure when effective control of the collateral has been taken prior to completion of formal foreclosure proceedings. OREO is held for sale and is recorded at fair value less estimated costs to sell. Costs to maintain OREO and subsequent gains and losses attributable to OREO liquidation are included in the Consolidated Statements of Operations in other income and other expense as realized. No depreciation or amortization expense is recognized. OREO was $8,170,000 and $5,383,000 at March 31, 2010 and December 31, 2009, respectively. The increase was primarily the result of foreclosing on two commercial mortgages in 2010. At March 31, 2010, $7,375,000, or 90% of the total OREO balance, consisted of two commercial properties in Lancaster, Pennsylvania. The remaining $795,000, or 10% of the total OREO balance, was comprised of five smaller commercial and residential properties.

 

Repossessed assets consist of (i) vehicles and other equipment acquired from lessees, who defaulted on their contractual lease obligation, and (ii) mobile homes where UNCB does not own the underlying real estate. Repossessed assets were $190,000 and $436,000 at March 31, 2010 and December 31, 2009, respectively. The decrease resulted primarily from the write-down of certain repossessed leased assets to fair market value, which amounted to $144,000.

 

Stockholders’ equity increased by $392,000 to $31,728,000 at March 31, 2010, compared to $31,336,000 at December 31, 2009. The increase in stockholders’ equity was primarily the result of other comprehensive income during the period, proceeds received through the Dividend Reinvestment Plan, or DRIP, and increases

to retained earnings resulting from year-to-date net income, which was offset by scheduled dividends paid to preferred stockholders.

 

Our regulatory capital position at March 31, 2010 exceeded the current regulatory required minimums as disclosed below.

 

Regulatory Capital

 

Bank regulatory authorities in the United States issue risk-based capital standards. These capital standards relate a bank’s capital to the risk profile of its assets and provide the basis by which all banks are evaluated in terms of its capital adequacy. We and UNCB are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet the minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on our consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, We and UNCB must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

 

Quantitative measures established by regulation to ensure capital adequacy require UNCB and us to maintain minimum amounts and ratios of Tier 1 capital to average assets and of total capital (as defined in the regulations) to risk-weighted assets.

 

As of March 31, 2010 and December 31, 2009, we and UNCB exceeded the current regulatory requirements to be considered a quantitatively “well capitalized” financial institution, i.e. a leverage ratio exceeding 5%, Tier 1 risk-based capital exceeding 6%, and total risk-based capital exceeding 10%.

 

In addition to the above regulatory capital standards, effective September 30, 2009, the OCC established individual minimum capital requirements for UNCB. For additional information, refer to Note 9 — Enforcement Actions with Bank Regulatory Agencies to the consolidated financial statements included elsewhere in this proxy statement/prospectus. The specific capital requirements established for UNCB were 8% for Tier 1 capital to average total assets, 9.5% for Tier 1 capital to risk-based assets, and 12% for total capital to risk-based assets. At March 31, 2010, UNCB’s measure of Tier I capital to average Total assets was 8.34%, Tier 1 capital to risk-based assets of 10.00% and total capital to risk-based assets of 12.72%. At March 31, 2010, all three ratios exceeded the respective individual minimum capital requirements established by the OCC.

UNNF and UNCB’s regulatory capital levels as of March 31, 2010 and December 31, 2009 were as follows (dollars in thousands):

 

 

 

 

Included in Tier 1 regulatory capital of UNNF is $10,507,000 of trust capital securities issued through our UNCT I and UNCT II subsidiaries. The balance of these trust capital securities, $493,000, is included in our Tier 2 regulatory capital. In addition, included in Tier 2 regulatory capital of UNCB and UNNF is $6,000,000 of junior subordinated debentures issued by UNCB. These securities would become callable if the FRB makes a determination that trust capital securities can no longer be considered in regulatory capital.

 

Regulatory capital requirements may be increased in the future. We will closely monitor and evaluate its capital position as the regulatory capital environment changes, and if regulatory capital requirements are changed.

 

Restrictions

 

Banking regulations limit the amount of investments, loans, extensions of credit and advances UNCB can make to us at any time to 10% of UNCB’s total regulatory capital. At March 31, 2010, this limitation amounted to approximately $5,214,000. These regulations also require any such investment, loan, extension of credit or advance to be secured by securities having a market value in excess of the amount thereof.

 

UNCB is subject to certain restrictions in connection with the payment of dividends. National banking laws require the approval of the OCC if the total of all dividends declared by a national bank in any calendar year exceeds the net profits of UNCB for that year (as defined) combined with UNCB’s retained net operating results for the preceding two calendar years. Under this formula, UNCB’s retained net operating results for the preceding two calendar years was ($189,000). As a result, in 2010, UNCB may declare dividends to UNNF in

an amount equal to the net profits of UNCB in 2010 less $189,000, up to the date of any such dividend declaration. UNCB’s net income for the three months ended March 31, 2010 was $94,000, restricting UNCB from declaring or making any dividend payment to us at March 31, 2010.

 

On January 28, 2010, we entered into an informal Memorandum of Understanding, or MOU, with the Federal Reserve Bank of Philadelphia, or the Philadelphia FRB. The MOU, which is not a “written agreement” for purposes of Section 8 of the Federal Deposit Insurance Act, requires, among other things, us to seek prior approval by the Philadelphia FRB before we (i) declare or pay dividends to shareholders, (ii) distribute interest, principal or other sums on UNCT I and UNCT II junior subordinated debentures, and (iii) incur, increase or guarantee any additional debt. Subsequent to March 31, 2010, the Philadelphia FRB did approve the quarterly interest payments for the second quarter of 2010 on the UNCT I and UNCT II junior subordinated debentures and the preferred stock dividend payments.

 

Overview

 

We reported a net loss available to common stockholders of ($15,000) or a basic and diluted loss per share of ($0.01) for the first quarter of 2010, compared to a net loss available to common stockholders of ($509,000) or a basic and diluted loss per share of ($0.19) for the same period in 2009. The year-over-year first quarter results improved primarily due to an increased net interest margin for the first quarter of 2010, compared to the same period in 2009, and the first quarter of 2010 not having any impairment charges on investment securities similar to those that occurred in the first quarter 2009.

 

Our net interest income as adjusted for tax-exempt financial instruments increased $363,000, or 12%, to $3,296,000 for the first quarter of 2010, compared to $2,933,000 for the same period in 2009. The cost of interest-bearing deposits decreased to 1.92% for the first quarter of 2010, compared to 2.65% for same period in 2009, which significantly improved the taxable-equivalent net interest margin percentage to 2.96% for the first quarter of 2010, compared to 2.58% for same period in 2009.

 

The operating results for the first quarter of 2009 reflected $839,000 in other-than-temporary investment impairment charges related to three pooled trust preferred debt securities that were downgraded to below-investment-grade in 2009. These other-than-temporary investment impairment charges were offset by $411,000 of realized net gains on the sale of investment securities during the first quarter of 2009, resulting in $428,000 of net investment losses. For the first quarter of 2010, gains of $77,000 were realized on the sale of investment securities and UNCB incurred no additional other-than-temporary impairment charges.

 

The discussion that follows further explains the changes in the components of the operating results when comparing the three months ended March 31, 2010 to the same period in 2009.

 

Net Interest Income

 

Net interest income, our primary source of revenue, is the amount by which interest income on loans and investments exceeds interest incurred on deposits and borrowings. The amount of net interest income is affected by changes in interest rates and by changes in the volume and mix of interest-sensitive assets and liabilities. Net interest income and corresponding yields are presented in the discussion and analysis below on a taxable-equivalent basis. Income from tax-exempt assets, primarily loans to or securities issued by state and local governments, is adjusted by an amount equivalent to the federal income taxes which would have been paid if the income received on these assets was taxable at the statutory rate of 34%.

 

Although the effective interest rate impact on earning assets and funding sources can be reasonably estimated at current interest rate levels, the options selected by customers, and the future mix of the loan, investment and deposit products in UNCB’s portfolios, may significantly change the estimates used in the simulation models. In addition, our net interest income may be impacted by further interest rate actions of the FRB and movements in the London Interbank Offered Rate, or LIBOR, upon which certain variable rate loans are priced.

Net interest income as adjusted for tax-exempt financial instruments was $3,296,000 for the three months ended March 31, 2010, compared to $2,933,000 for the same period in 2009. The yield on interest-earning assets decreased by 39 basis points to 4.99% for the first quarter of 2010, compared to 5.38% for the same period in 2009. The interest rate paid on average interest-bearing liabilities decreased by 80 basis points to 2.27% for the first quarter of 2010, compared to 3.07% for the same period in 2009. The decrease in the interest rate paid on average interest-bearing liabilities more than offset the decrease in the yield on interest-earning assets, which resulted in a higher net interest margin for the first quarter of 2010, compared to the same period in 2009. The taxable-equivalent net interest margin percentage for the first quarter of 2010 was 2.96%, compared to 2.58% for the same period in 2009.

 

Interest and fees on loans and leases on a taxable-equivalent basis decreased by $385,000, or 7%, to $5,047,000 for the three months ended March 31, 2010, compared to $5,432,000 for the same period in 2009. The average yield decreased by 14 basis points to 6.05% for the first quarter of 2010, compared to 6.19% for the same period in 2009. The variable rate structure of many of UNNF’s loans reduced the overall yield due to the persistent low market interest rates. The average balance of loans and leases decreased by $17,777,000 for the first quarter of 2010, compared to the same period in 2009 due to reduced loan demand from creditworthy borrowers, the impact of nearly $10 million of loan participations sold for capital and risk management purposes in the third quarter of 2009, and the impact of approximately $8 million of loans that were foreclosed on and transferred to OREO since December 2009. The decrease in interest and fees on loans and leases primarily resulted from the decrease in loans outstanding.

 

Interest and dividends earned on investment securities on a taxable-equivalent basis decreased by $191,000, or 30%, to $438,000 for the three months ended March 31, 2010, compared to $629,000 for the same period in 2009. The decrease in interest and dividends earned on investment securities primarily resulted from a decrease in the average balance of investment securities, which decreased by $10,638,000 for the first quarter of 2010, compared to the same period in 2009. A lack of income from impaired and non-accruing investments, and reduced yields on re-invested proceeds from investment maturities and sales, also contributed to lower investment interest income for the first quarter of 2010. As a result, the average yield decreased by 66 basis points to 3.12% for the first quarter of 2010, compared to 3.78% for the same period in 2009.

 

Interest expense on deposits decreased by $621,000, or 27%, to $1,681,000 for the three months ended March 31, 2010, compared to $2,302,000 for the same period in 2009. The decrease in interest expense on deposits was primarily driven by a decrease of 73 basis points in average rate paid on deposits. The average rate paid on deposits was 1.92% for the first quarter of 2010, compared to 2.65% for the same period in 2009.

 

Interest expense on long-term debt decreased by $252,000, or 39%, to $393,000 for the three months ended March 31, 2010, compared to $645,000 for the same period in 2009. We continued to take measures to reduce our cost of borrowings, prepaying $2,500,000 and $17,000,000 of higher-cost long-term debt in the first quarter of 2010 and for the full year of 2009, respectively, which resulted in a $18,917,000 decrease in the average balance of long-term debt for the first quarter of 2010, compared to the same period in 2009.

 

Provision for Credit Losses

 

The provision for credit losses is an expense charged against net interest income to provide for estimated losses attributable to uncollectible loans and leases. The provision is based on management’s analysis of the adequacy of the allowance for credit losses. The provision for credit losses was $496,000 for the three months ended March 31, 2010, compared to $313,000 for the same period in 2009. The increased provision was the result of increased credit risk related to the loan portfolio at March 31, 2010, compared to March 31, 2009 (refer to the related discussions on the “Allowance for Credit Losses” on page 18 and “Substandard Loans and Leases” on page 20). Management continues to closely monitor the loan portfolio and the adequacy of the allowance for credit loss reserve considering underlying borrower financial performance and collateral values, and increasing credit risks. Future adjustments may be necessary to the provision for credit losses, and consequently the allowance for credit losses, if economic conditions or loan credit quality differ substantially from the assumptions we used in making our evaluation of the level of the allowance for credit losses compared to the balance of outstanding loans and leases.

Non-Interest Income

 

Non-interest income increased by $561,000, or 91%, to $1,180,000 for the three months ended March 31, 2010, compared to $619,000 for the same period in 2009. Increases (decreases) in the components of non-interest income when comparing the three months ended March 31, 2010 to the same period in 2009, are as follows (in thousands):

 

 

A significant portion of the $561,000 increase in non-interest income was related to investment securities activities. The operating results for the first quarter of 2009 reflected $839,000 in other-than-temporary investment impairment charges related to three pooled trust preferred debt securities that were downgraded to below-investment-grade in 2009. These other-than-temporary investment impairment charges were offset by $411,000 of realized net gains on the sale of investment securities during the first quarter of 2009, resulting in $428,000 of net investment losses. For the first quarter of 2010, gains of $77,000 were realized on the sale of investment securities and UNCB incurred no additional other-than-temporary impairment charges.

 

Non-Interest Expense

 

Non-interest expense was $4,022,000 for the three months ended March 31, 2010, compared to $4,014,000 for the same period in 2009. Increases (decreases) in the components of non-interest expense when comparing the three months ended March 31, 2010, to the same period in 2009, are as follows (in thousands):

 

The discussion that follows explains the significant changes in the components of non-interest expense when comparing the three months ended March 31, 2010 to the same period in 2009.

 

Salaries, wages and employee benefits decreased by $148,000 for the three months ended March 31, 2010, compared to the same period in 2009. The decrease was related to positions that were eliminated in the first quarter of 2009, savings in health care costs due to UNCB’s beneficial participation in a healthcare consortium and savings from the suspension of our 401-K match which began during the second quarter of 2009 and remained suspended through March 31, 2010.

 

Due to recent changes in deposit premium assessments by the FDIC, FDIC insurance assessments amounted to $228,000 for the three months ended March 31, 2010, representing a $108,000 or 90% increase over the three months ended March 31, 2009. The increase in FDIC insurance premiums was primarily the result of increased base assessment rates, as determined by the FDIC.

 

The increase in other expense was primarily the result of several repossessed assets being written-down by $144,000 to fair market value. These repossessed assets consisted of vehicles acquired from lessees, who defaulted on their contractual lease obligations, and the write-downs reflect recent significant market devaluations for the types of assets held as repossessed by UNCB. In addition, during the three months ended March 31, 2010, UNCB prepaid $2,500,000 of FHLB advances to further de-leverage UNCB and reduce current and future borrowing costs. In conjunction with the prepayments, UNCB incurred $89,000 of prepayment penalties, which also contributed to the increase in other expense for the three months ended March 31, 2010. UNCB did not prepay any FHLB advances in the first quarter of 2009, and therefore, did not incur any prepayment penalties for the three months ended March 31, 2009.

 

An income tax benefit of $82,000 and $328,000 was recorded for the three months ended March 31, 2010 and 2009, respectively. For both of these periods, the benefit resulted from tax-exempt earnings as well as from a pre-tax loss. Generally, our effective tax rate is below the statutory rate due to tax-exempt earnings on loans, investments, and bank-owned life insurance, and the impact of tax credits. The realization of deferred tax assets is dependent upon future earnings. Management anticipates that future earnings will be adequate to fully utilize deferred tax assets.

 

Our objective is to maintain adequate liquidity to meet funding needs at a reasonable cost and to provide contingency plans to meet unanticipated funding needs or a loss of funding sources, while minimizing interest rate risk. Adequate liquidity provides resources for credit needs of borrowers, for depositor withdrawals and for funding corporate operations. Sources of liquidity are as follows:

 

 

Management believes that UNCB’s core deposits remain fairly stable. Liquidity and funds management is governed by policies and measured on a daily basis, with supplementary weekly and monthly analyses. These measurements indicate that liquidity generally remains stable and exceeds our minimum defined levels of adequacy. Other than the trends of continued competitive pressures and volatile interest rates, there are no known demands, commitments, events or uncertainties that will result in, or that are reasonably likely to result in, liquidity increasing or decreasing in any material way.

 

In the normal course of business, we are party to financial instruments with off-balance sheet risk to meet the financing needs of our customers. These financial instruments include commitments to extend credit and standby letters of credit. Total commitments to extend credit amounted to $106,597,000 at March 31, 2010 compared to $110,791,000 at December 31, 2009. Total standby letters of credit amounted to $5,725,000 at March 31, 2010 compared to $6,199,000 at December 31, 2009.

 

In addition, in the normal course of business operations, we routinely enter into contracts for services. These contracts may require payment for services to be provided in the future and may also contain penalty clauses for the early termination of the contracts. In January 2007, the contract with our core data processor was renegotiated, resulting in a new maturity date of November 2013. Any early termination will require the payment of a substantial penalty. For the three months ended March 31, 2010, there has been no material change in contracts for services since this contract was renegotiated.

 

From time to time, various types of federal and state legislation have been proposed that could result in additional regulation of, and restrictions on, our and UNCB’s business. As a consequence of the extensive regulation of commercial banking activities in the United States, our and UNCB’s business is particularly susceptible to being affected by federal and state legislation and regulations that may increase the cost of doing business. Also, we are susceptible to changes in tax law that may increase the cost of doing business or impact our ability to realize the value of deferred tax assets. Further, our business is affected by the state of the financial services industry in general. Please refer to Note 9 — Enforcement Actions with Bank Regulatory Agencies to the consolidated financial statements included elsewhere in this proxy statement/prospectus for a discussion on specific regulatory matters impacting us.

 

Management’s discussion and analysis represents an overview of the financial condition and results of operations, and highlights the significant changes in the financial condition and results of operations, as presented in our accompanying consolidated financial statements. Our consolidated financial condition and results of operations consist primarily of UNCB’s financial condition and results of operations. We established our trust subsidiaries, UNNF Capital Trust I, or UNCT I, and UNNF Capital Trust II, or UNCT II, for the purpose of issuing $11.0 million of trust capital securities during 2003 and 2004. Refer to Note 16 — Residential Mortgage Business Venture to the consolidated financial statements included elsewhere in this proxy statement/prospectus for information about our former subsidiaries Home Team Financial, LLC and TA of Lancaster, LLC.

 

Total assets increased by $4,535,000 or 1% to $489,644,000 at December 31, 2009 from $485,109,000 at December 31, 2008. The increase was primarily the result of strong retail deposit generation, which further strengthened UNNF’s liquidity position. The proceeds received from the deposit growth were used to pay down high cost long-term debt and to purchase short-term investments. Total deposits grew by $21,188,000 or 6% to $404,765,000 at December 31, 2009 from $383,577,000 at December 31, 2008.

 

Investment Securities

 

Investment securities were $60,546,000 at December 31, 2009 compared to $64,289,000 at December 31, 2008. All of our investment securities were classified as available for sale at December 31, 2009 and 2008. Investment securities classified as available for sale are marketable equity securities, and those debt securities that we intend to hold for an undefined period of time, but not necessarily to maturity. In addition to the investment portfolio generating interest income, it serves other primary financial management functions such

as an ultimate source of liquidity and a tool to manage interest rate risk. In order to support these functions, the entire investment securities portfolio has been designated as being available for sale. Any decision to sell an available-for-sale investment security would be based on various factors, including significant movements in interest rates, changes in maturity mix of assets and liabilities, liquidity needs, regulatory capital considerations, changes in the creditworthiness of the issuing entity, changes in investment strategy and portfolio mix, and other similar factors. Changes in unrealized gains or losses on available-for-sale investment securities, net of taxes, are recorded as other comprehensive (loss) income, a component of stockholders’ equity.

 

At December 31, 2009, there were no significant concentrations of investments (greater than 10% of stockholders’ equity) in any individual investment security issue. The investment securities portfolio included $53,394,000 or 88% of U.S. agency mortgage-backed securities at December 31, 2009.

 

The following is a summary of available-for-sale investment securities recorded at fair value as of December 31, 2009, 2008 and 2007 (in thousands):

 

 

The following table presents the stated maturities of investment securities at fair value and the weighted-average yields as of December 31, 2009. Yields are shown on a taxable-equivalent basis, assuming a 34% federal income tax rate (dollars in thousands).

 

 

 

 

The realized rate of return on average investment securities, including net investment securities gains (losses) and OTTI charges was 3.39% and 3.12% for the years ended December 31, 2009 and 2008,

respectively. The following table presents the realized rate of return on average investment securities by investment category for the years ended December 31, 2009 and 2008 (dollars in thousands).