Heritage Bankshares (HBKS) 10-Q 2010 Q1 Quarterly report

U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

x Quarterly Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended March 31, 2010

¨ Transition Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period ended                        

Commission File Number 0-11255

HERITAGE BANKSHARES, INC.

(Exact name of registrant as specified in its charter)

Virginia	54-1234322
(State or other jurisdiction of incorporation or organization)	(IRS Employer Identification Number)

150 Granby Street, Suite 150, Norfolk, Virginia 23510

(Address of principal executive office)

(757) 648-1700

(Issuer’s telephone number)

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 and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

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

Large accelerated filer	¨	Accelerated filer	¨
Non-accelerated filer	¨  (Do not check if a smaller reporting company)	Smaller reporting company	x

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

A total of 2,298,652 shares of the registrant’s common stock were outstanding as of April 30, 2010.

TABLE OF CONTENTS

		Page No.
Part I.	FINANCIAL INFORMATION
Item 1 -	Financial Statements (Unaudited)
	Consolidated Balance Sheets March 31, 2010 and December 31, 2009	3
	Consolidated Statements of Income Three Months Ended March 31, 2010 and 2009	4
	Consolidated Statements of Cash Flows Three Months Ended March 31, 2010 and 2009	5
	Notes to Consolidated Financial Statements	6
Item 2 -	Management’s Discussion and Analysis of Financial Condition and Results of Operation	13
Item 3 -	Quantitative and Qualitative Disclosures About Market Risk	17
Item 4T -	Controls and Procedures	17
Part II.	OTHER INFORMATION
Item 1 -	Legal Proceedings	18
Item 2 -	Unregistered Sales of Equity Securities and Use of Proceeds	18
Item 3 -	Defaults Upon Senior Securities	18
Item 4 -	(Removed and Reserved)	18
Item 5 -	Other Information	18
Item 6 -	Exhibits	18
Signatures		19

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Part I. FINANCIAL INFORMATION

Item 1 - Financial Statements

HERITAGE BANKSHARES, INC.

CONSOLIDATED BALANCE SHEETS

	At March 31, 2010 (Unaudited)			December 31, 2009 (Audited)
	(in thousands, except per share data)
ASSETS
Cash and due from banks	$	4,156		$	4,598
Interest-bearing deposits in other banks		32,920			18,674
Federal funds sold		2,050			2,668
Total cash and cash equivalents		39,126			25,940
Securities available for sale, at fair value		33,882			50,103
Loans, net of allowance for loan losses of $1,750 and $1,773, respectively		178,455			181,544
Accrued interest receivable		600			747
Stock in Federal Reserve Bank, at cost		587			586
Stock in Federal Home Loan Bank of Atlanta, at cost		1,476			1,476
Premises and equipment, net		11,774			11,891
Other real estate owned		160			313
Other assets		2,051			1,954
Total assets	$	268,111		$	274,554
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities
Deposits
Noninterest-bearing	$	78,707		$	76,429
Interest-bearing		140,349			152,707
Total deposits		219,056			229,136
Federal Home Loan Bank Advances		5,000			5,000
Securities sold under agreements to repurchase		5,389			2,016
Accrued interest payable		135			119
Other liabilities		1,726			1,505
Total liabilities		231,306			237,776
Commitments and contingencies		—			—
Stockholders’ equity
Preferred stock, no par value - 1,000,000 shares authorized:
Fixed rate cumulative perpetual preferred stock, Series A, 10,103 shares issued and outstanding at both March 31, 2010 and December 31, 2009		10,103			10,103
Fixed rate cumulative perpetual preferred stock, Series B, 303 shares issued and outstanding at both March 31, 2010 and December 31, 2009		303			303
Common stock, $5 par value – 6,000,000 shares authorized; 2,298,652 and 2,291,352 shares issued and outstanding at March 31, 2010 and December 31, 2009, respectively		11,493			11,457
Additional paid-in capital		6,527			6,473
Retained earnings		7,931			7,854
Discount on preferred stock		(275	)		(289	)
Accumulated other comprehensive income, net		723			877
Total stockholders’ equity		36,805			36,778
Total liabilities and stockholders’ equity	$	268,111		$	274,554

See accompanying notes to financial statements.

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HERITAGE BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

	Three Months Ended March 31
	2010			2009
	(in thousands, except per share data)
Interest and dividend income
Loans and fees on loans	$	2,299		$	2,209
Taxable investment securities		400			566
Dividends on FRB and FHLB stock		9			5
Interest on federal funds sold		—			1
Other interest income		36			10
Total interest income		2,744			2,791
Interest expense
Deposits		355			602
Borrowings		34			39
Total interest expense		389			641
Net interest income		2,355			2,150
Provision for loan losses		—			55
Net interest income after provision for loan losses		2,355			2,095
Noninterest income
Service charges on deposit accounts		117			92
Late charges and other fees on loans		15			12
Gain on sale of investment securities		254			—
Other		68			57
Total noninterest income		454			161
Noninterest expense
Compensation		1,228			1,049
Data processing		137			127
Occupancy		194			219
Furniture and equipment		150			160
Taxes and licenses		86			67
Professional fees		106			127
FDIC assessment		78			80
Recruiting		34			1
Marketing		31			28
Telephone		23			29
Stationery and supplies		15			22
Loss on sale of other real estate owned		33			—
Other		131			150
Total noninterest expense		2,246			2,059
Income before provision for income taxes		563			197
Provision for income taxes		202			46
Net income	$	361		$	151
Preferred stock dividends and accretion of discount		(146	)		—
Net income available to common stockholders	$	215		$	151
Earnings per common share
Basic	$	0.09		$	0.07
Diluted	$	0.09		$	0.07
Dividends per common share	$	0.06		$	0.06
Weighted average shares outstanding - basic		2,291,800			2,279,252
Effect of dilutive stock options		7,187			10,442
Weighted average shares outstanding - assuming dilution		2,298,987			2,289,694

See accompanying notes to financial statements.

4

HERITAGE BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

	Three Months Ended March 31,
	2010			2009
	(in thousands)
Cash flows from operating activities:
Net income	$	361		$	151
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan loss		—			55
Amortization of loan yield adjustments, net		82			104
Depreciation, amortization and accretion, net		199			227
Stock based compensation		36			85
Deferred compensation		10			9
Exercise of stock options tax benefit		13			—
Net (gains) losses on:
Sale of securities		(254	)		—
Sale, disposal or impairment of property, plant and equipment		—			4
Impairment of real estate owned		33			—
Changes in assets/liabilities, net:
Decrease(increase) in interest receivable and other assets		130			(63	)
Increase in interest payable and other liabilities		224			78
Net cash provided by operating activities		834			650
Cash flows from investing activities:
Proceeds from maturities and principal repayments of securities available for sale		9,362			4,294
Purchases of securities available for sale		—			(21,064	)
Proceeds from sales of securities available for sale		6,837			—
Proceeds from sale of other real estate owned		120			—
Net (increase)decrease in loans held for investment		3,007			(319	)
Purchases of FHLB stock and FRB stock		(1	)		(1,738	)
Redemption of FHLB stock and FRB stock		—			866
Purchases of premises and equipment		(37	)		(468	)
Proceeds from sales of premises and equipment		—			5
Net cash provided by (used for) investing activities		19,288			(18,424	)
Cash flows from financing activities:
Proceeds from exercise of stock options		42			—
Net increase(decrease) in deposits		(10,080	)		980
Proceeds from Federal Home Loan Bank advances		34,050			83,550
Repayments of Federal Home Loan Bank advances		(34,050	)		(66,000	)
Net increase in securities sold under agreements to repurchase		3,373			1,670
Net decrease in federal funds purchased		—			(1	)
Cash dividends paid		(271	)		(136	)
Net cash provided by (used for) financing activities		(6,936	)		20,063
Increase in cash and cash equivalents		13,186			2,289
Cash and cash equivalents, beginning of period		25,940			13,418
Cash and cash equivalents, end of period	$	39,126		$	15,707
Supplemental disclosure:
Interest paid	$	372		$	670
Income taxes paid	$	233		$	—

See accompanying notes to financial statements.

5

HERITAGE BANKSHARES, INC.

Notes to Consolidated Financial Statements

Note 1 – Principles of Consolidation and Basis of Presentation

The accompanying unaudited consolidated financial statements include the accounts of Heritage Bankshares, Inc. and its wholly-owned subsidiary, Heritage Bank. All significant intercompany balances and transactions have been eliminated in consolidation.

Heritage Bankshares, Inc. (the “Company”) is a bank holding company incorporated under the laws of the Commonwealth of Virginia in 1983, and serves as the holding company for its wholly-owned subsidiaries. The Company’s only subsidiary, Heritage Bank (the “Bank”), is a state banking corporation engaged in the general commercial and retail banking business. The Bank is a full-service bank conducting a general commercial and consumer banking business with its customers located throughout the Hampton Roads area of Virginia.

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial reporting and with the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. These consolidated financial statements should be read in conjunction with and with reference to the audited consolidated financial statements and accompanying footnotes included in the Company’s annual report on Form 10-K for the year ended December 31, 2009. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Actual results could differ from those estimates. Certain reclassifications have been made to prior year financial statements to conform to current period presentation.

The Company believes its critical accounting policies are those that are particularly sensitive in terms of judgments and the extent to which estimates are used, and such policies include (a) the valuation of the allowance for loan losses and the impairment of loans, (b) the impairment of financial investments and other accounts, (c) the deferral of loan fees and direct loan origination costs, and (d) accounting for income taxes.

Allowance for Loan Losses; Impairment of Loans.The Bank maintains an allowance for loan losses at a level which, in management’s judgment, is adequate to absorb estimated credit losses on existing loans. The amount of the allowance is affected by: (1) loan charge-offs, which decrease the allowance, (2) recoveries on loans previously charged-off, which increase the allowance, and (3) the provision for loan losses charged to income, which increases the allowance.

The Bank analyzes its loan portfolio through ongoing credit review processes and constructs a comprehensive allowance analysis for its loan portfolio at least quarterly. This analysis includes two basic elements: (1) specific allowances for individual loans, and (2) general allowances for loan portfolio segments, which factor in historical loan loss experience and delinquency rates for the Bank and the banking industry and numerous other environmental factors.

The Bank evaluates various loans individually for impairment as required by generally accepted accounting principles related to receivables. An evaluation is based upon either discounted cash flows or collateral evaluations. If the evaluation shows that a particular loan is impaired, then a specific reserve is established, or a charge-off is made, for the amount of any impairment.

For loans without an individual measure of impairment, the Bank makes estimates of losses for groups of loans as required by generally accepted accounting principles related to contingencies. As part of the loan loss reserve methodology, loans are placed into one of four major categories or segments of loans: (1) commercial and industrial loans, (2) consumer loans, (3) 1-4 family residential loans (including home equity loans and lines), and (4) multi-family and other commercial real estate loans. The Bank then considers the impact of various bank, industry, economic and other environmental factors and documents, which are further used in the analysis.

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The Bank’s allowance for loan losses is divided into four distinct portions: (1) Historical – an amount based on the Bank’s actual net charge-offs; (2) Impaired Loans – an amount for specific allocations on significant individual credits as prescribed by generally accepted accounting principles related to receivables; (3) Loan Segments – an amount to adjust the historical allocation for the four loan segments based on environmental factors as provided by guidance for contingencies; and (4) Unallocated – an amount to reflect the imprecision inherent in these calculations.

Impairment of Financial Investments and Other Accounts. Impairment of investment securities, other equity investments and other asset accounts results in a write-down that must be included in net income when the fair value of the asset declines below cost and is other-than-temporary. The fair values of these investments and other assets are subject to change, as they are influenced by market conditions and management decisions.

Deferral of Loan Fees and Direct Loan Origination Costs. Generally accepted accounting principles relating to accounts receivable require that loan fees and direct loan origination costs be deferred and recognized as an adjustment to the loan’s yield. While the amount of fees to be deferred is generally apparent in the origination of a loan, the Company utilizes estimates to determine the amount of deferred direct origination costs, especially payroll costs, that are attributable to the loan origination process. Management’s estimates of the amount of costs associated with successful loan origination activities are reviewed and updated annually.

Accounting for Income Taxes. The determination of the Company’s effective tax rate requires judgment. In the ordinary course of business, there are transactions and calculations for which the ultimate tax outcomes are uncertain. In addition, the Company’s tax returns are subject to audit by various tax authorities. Although we believe that our estimates are reasonable, there can be no assurance that the final tax outcome will not be materially different than that which is reflected in the income tax provision and accrual.

Subsequent Events. In accordance with accounting guidance, the Company evaluated events and transactions for potential recognition or disclosure in these financial statements through the date the financial statements were issued.

Note 2 – Share-Based Compensation

The following table presents a summary of stock option activity to date during 2010:

	Shares	Weighted Average Exercise Price		Weighted Average Remaining Term (Years)	Aggregate Intrinsic Value
					(in thousands)
Outstanding at January 1, 2010	267,000	$	12.02	—		—
Granted	—		—	—		—
Exercised	7,300		5.69	—		—
Forfeited/expired	—		—	—		—
Outstanding at March 31, 2010	259,700	$	12.20	6.0	$	111
Exercisable at March 31, 2010	187,300	$	11.95	5.7	$	96

The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Company’s closing stock price on the last trading day of the quarter and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on March 31, 2010. The amount changes based on the fair market value of the Company’s stock. The Company’s current policy is to issue new shares of common stock to satisfy option exercises.

The aggregate intrinsic value of options exercised during the three months ended March 31, 2010 was $39,121, and cash received from exercises of options during the first three months of 2010 was $41,529. There were no options exercised during the three months ended March 31, 2009.

The amount charged against income, before income tax benefit of $3,000, in relation to the stock-based payment arrangement was $35,894 for the three months ended March 31, 2010. The amount charged against

7

income, before income tax benefit of $51,683, in relation to the stock-based payment arrangement was $85,237 for the three months ended March 31, 2009. At March 31, 2010, unrecognized compensation expense, net of estimated forfeitures, related to unvested stock option grants was $194,520 and is currently expected to be recognized over a weighted average period of 0.9 years as follows:

	Stock-Based Compensation Expense
	(in thousands)
At March 31, 2010:
2010	$	110
2011		70
2012		11
2013		4
Total	$	195

Note 3 – Other Comprehensive Income

The components of the Company’s other comprehensive income and related tax effects are as follows:

	Three Months Ended March 31,
	2010			2009
	(in thousands)
Unrealized holding gains on available-for-sale securities	$	(234	)	$	122
Tax effect		80			(41	)
Net of tax amount	$	(154	)	$	81

Note 4 – Earnings Per Share Reconciliation

The Company’s basic and diluted earnings per common share calculations are presented in the following table:

	Three Months Ended March 31,
	2010		2009
	(in thousands, except share and per share data)
Net income available to common stockholders (numerator, basic and diluted)	$	215	$	151
Weighted average shares outstanding (denominator)		2,291,800		2,279,252
Earnings per common share – basic	$	0.09	$	0.07
Effect of dilutive securities
Weighted average shares outstanding during the period		2,291,800		2,279,252
Effect of dilutive stock options		7,187		10,442
Weighted diluted average shares outstanding (denominator) during the period		2,298,987		2,289,694
Earnings per common share – assuming dilution	$	0.09	$	0.07

Note 5 – Disclosure About Fair Value of Financial Instruments

The following summary presents an estimate of the fair value of the Company’s financial instruments. Because no active market readily exists for a portion of the Company’s financial instruments, fair values of some financial instruments are based on estimates using present value and other valuation techniques. Much of the information used to determine fair value is highly subjective in nature and therefore the results may not be precise. The subjective factors include, among other things, estimates of cash flows, risk characteristics, credit quality and interest rates, all of which are subject to change. Accordingly, the amounts that will actually be realized or paid upon settlement or maturity of the various instruments could be significantly different.

8

The following table presents the carrying amounts and fair value of the Company’s financial instruments at March 31, 2010 and December 31, 2009:

	At March 31, 2010				At December 31, 2009
	Carrying Amount		Fair Value		Carrying Amount		Fair Value
	(Dollars in Thousands)
Financial assets:
Cash and due from banks	$	37,076	$	37,076	$	23,272	$	23,272
Federal funds sold		2,050		2,050		2,668		2,668
Securities available for sale		33,882		33,882		50,103		50,103
Loans held for investment, net		178,455		179,096		181,544		182,340
Accrued interest receivable		600		600		746		746
Stock in FRB and FHLB		2,063		2,063		2,062		2,062
Bank-owned life insurance		566		566		553		553
Other real estate owned		160		160		313		313
Other financial assets		24		24		—		—
Financial liabilities:
Deposits		219,056		219,148		229,136		229,214
Federal Home Loan Bank advance		5,000		5,092		5,000		5,053
Securities sold under agreements to repurchase		5,389		5,389		2,016		2,016
Accrued interest payable		135		135		119		119

Fair Value Hierarchy

“Fair Value Measurements and Disclosures” establishes three levels of inputs that may be used to measure fair value:

Level 1: Valuation is based on quoted prices in active markets for identical assets or liabilities.

Level 2: Valuation is based on observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 assets and liabilities include debt securities with quoted prices that are traded less frequently than exchange-traded instruments and derivative contracts whose value is determined using a pricing model with inputs that are observable in the market or can be derived principally from or corroborated by observable market data.

Level 3: Valuation is based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.

Investment Securities Available for Sale

Investment securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions, and other factors such as credit loss assumptions. Level 2 securities include Treasury notes and bills, mortgage-backed securities issued by government sponsored entities, municipal bonds and other securities issued by government sponsored agencies.

Loans

The Company does not record loans at fair value on a recurring basis. From time to time, a loan is considered impaired. Loans which are deemed to be impaired are valued in accordance with guidance related to receivables. The fair value of impaired loans is estimated using one of several methods, including collateral value, liquidation value and discounted cash flows. When the fair value of collateral is based on an observable market price or a current appraised value, the Company records the impaired loan as Level 2. If the fair value of the loan is based on criteria other than observable market prices or current appraised value, the loan is recorded as Level 3.

9

Foreclosed Assets

Foreclosed assets are adjusted to fair value upon transfer of the loans to foreclosed assets. Foreclosed assets are carried at the lower of the carrying value or fair value. Fair value is based upon independent observable market prices or appraised values of the collateral, which the Company considers to be Level 2 inputs.

General

The Company has no liabilities carried at fair value or measured at fair value on a nonrecurring basis.

The Company has no assets or liabilities whose fair values are measured using Level 3 inputs.

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

March 31, 2010
in thousands	Total		Level 1		Level 2		Level 3
Investment in securities available for sale
Mortgage-backed securities	$	33,882	$	—	$	33,882	$	—
Total Assets at Fair Value	$	33,882	$	—	$	33,882	$	—

There were no liabilities recorded at fair value on a recurring basis.

Assets and Liabilities Recorded at Fair Value on a Non-Recurring Basis

March 31, 2010
in thousands	Total		Level 1		Level 2		Level 3
Loans (consumer)	$	14	$	—	$	14	$	—
Other real estate owned	$	160		—	$	160		—
Total Assets at Fair Value	$	174	$	—	$	174	$	—

There were no liabilities recorded at fair value on a non-recurring basis.

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

December 31, 2009
in thousands	Total		Level 1		Level 2		Level 3
Investment in securities available for sale
U.S. government sponsored enterprises	$	4,975	$	—	$	4,975	$	—
Mortgage-backed securities		45,128		—		45,128		—
Total Assets at Fair Value	$	50,103	$	—	$	50,103	$	—

There were no liabilities recorded at fair value on a recurring basis.

Assets and Liabilities Recorded at Fair Value on a Non-Recurring Basis

December 31, 2009
in thousands	Total		Level 1		Level 2		Level 3
Other real estate owned		313		—		313		—
Total Assets at Fair Value	$	313	$	—	$	313	$	—

There were no liabilities recorded at fair value on a non-recurring basis.

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Note 6 – Securities

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	(in thousands)
At March 31, 2010
Securities available for sale
U.S. government sponsored enterprises	$	—	$	—	$	—	$	—
Mortgage-backed securities		32,787		1,095		—		33,882
Total securities available for sale	$	32,787	$	1,095	$	—	$	33,882
Total securities(1)	$	32,787	$	1,095	$	—	$	33,882
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	(in thousands)
At December 31, 2009
Securities available for sale
U.S. government sponsored enterprises	$	5,000	$	—	$	25	$	4,975
Mortgage-backed securities		43,774		1,354		—		45,128
Total securities available for sale	$	48,774	$	1,354	$	25	$	50,103
Total securities(1)	$	48,774	$	1,354	$	25	$	50,103

(1) At March 31, 2010 and at December 31, 2009, the Company held no securities classified as held to maturity.

The following tables show gross unrealized losses and fair value on investment securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at March 31, 2010 and at December 31, 2009. The current year unrealized losses on investment securities, if any, are a result of changes in interest rates during the period. All unrealized losses on investment securities are considered by management to be temporary given the credit ratings on these investment securities and the short duration of the unrealized loss.

At March 31, 2010

Less Than 12 Months

12 Months or More

Total

(in thousands)

Fair Value

Unrealized Losses

Fair Value

Unrealized Losses

Fair Value

Unrealized Losses

U.S. government sponsored enterprises

$

—

$

—

$

—

$

—

$

—

$

—

Mortgage-backed securities

—

—

—

—

—

—

Total temporarily impaired securities

$

—

$

—

$

—

$

—

$

—

$

—

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	At December 31, 2009
	Less Than 12 Months				12 Months or More				Total
	(in thousands)
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
U.S. government sponsored enterprises	$	4,975	$	25	$	—	$	—	$	4,975	$	25
Mortgage-backed securities		—		—		—		—		—		—
Total temporarily impaired securities	$	4,975	$	25	$	—	$	—	$	4,975	$	25

The amortized cost and fair value of investment securities at March 31, 2010, by contractual maturity, are shown below. Actual maturities will differ from contractual maturities because some securities may be called or prepaid prior to their contractual maturity:

	Securities Available for Sale				Securities Held to Maturity (1)
	(in thousands)
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
Due in one year or less	$	468	$	472	$	—	$	—
Due after one year through five years		17,236		17,596		—		—
Due after five years through ten years		10,463		11,054		—		—
Due after ten years		4,620		4,760		—		—
Total	$	32,787	$	33,882	$	—	$	—

(1) At March 31, 2010, the Company held no securities classified as held to maturity.

Note 7 – Prior Period Adjustments to FDIC Assessment Expense

The unaudited financial statements and accompanying information contained in this Form 10-Q reflect the impact of corrections to FDIC assessment expense related to prior periods. Specifically, as a result of such corrections to prior-period FDIC assessment expense, retained earnings at March 31, 2009 decreased by $77,438 compared to the originally-reported amount. Further, net income for the three months ended March 31, 2009 decreased by $30,048, from $181,000, as originally reported, to $151,000 (earnings decreased from $0.08 per diluted share to $0.07 per diluted share after the correction). Corrections were made in accordance with the guidance in SEC Staff Accounting Bulletin No. 108.

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

As used in this quarterly report on Form 10-Q, the “Company,” “we,” “our” and “us” refer to Heritage Bankshares, Inc. and its subsidiaries, unless the context requires otherwise.

Forward-Looking Statements

Statements contained in this quarterly report on Form 10-Q that are not historical facts are forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. Such forward-looking statements may be identified by the use of such words as “may,” “will,” “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated” and “potential”, among others, though these words are not the exclusive means of identifying such forward-looking statements. These forward-looking statements relate to, among other things, expectations regarding the business environment in which we operate, projections of future performance and perceived opportunities in the market, and they are based on management’s current beliefs, assumptions and expectations. Such forward-looking statements are subject to risks and uncertainties which could cause actual results to differ materially from the expectations of future results, performance or financial condition we express or imply in any forward-looking statements. For a detailed discussion of the factors that might cause such a difference, see Item 1A, “Risk Factors,” in our Annual Report on Form 10-K for the year ended December 31, 2009, filed March 26, 2010.

Factors that might affect forward-looking statements include, among other things:

• the demand for our products and services;

• actions taken by our competitors;

• changes in prevailing interest rates;

• changes in delinquencies and defaults by our borrowers;

• changes in loan quality and performance;

• changes in FDIC insurance assessments;

• legislative or regulatory changes or actions that affect our business;

• our ability to achieve financial goals and strategic plans;

• our participation in the TARP Capital Purchase Program;

• litigation; and

• credit and other risks of lending activities.

As a result, we cannot assure you that our future results of operations, financial condition or other matters will be consistent with those expressed or implied in any forward-looking statements. You should not place undue reliance on these forward-looking statements, as they all are based only on information available at this time, and we assume no obligation to update any of these statements.

Financial Condition of the Company at March 31, 2010

Total Assets. The Company’s total assets decreased by $2.0 million, or 0.7%, from $270.1 million at March 31, 2009 to $268.1 million at March 31, 2010. The decrease in assets resulted primarily from a $4.4 million, or 5.7%, decrease in liquid assets, comprised of cash and cash equivalents and investment securities available for sale, which was partially offset by an increase of $1.8 million, or 1.0%, in the ending balance of loans held for investment. Total assets decreased by $6.5 million or 2.3% from $274.6 million at December 31, 2009, attributable to a decrease in both liquid assets and loan balances.

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Liquid Assets.Cash and cash equivalents and investment securities available for sale were $73.0 million at March 31, 2010, compared to $77.4 million at March 31, 2009, a decrease of $4.4 million. Cash and cash equivalents increased by $23.4 million, from $15.7 million at March 31, 2009 to $39.1 million at March 31, 2010. This increase is largely attributable to receipt of TARP funds of $10.1 million in September 2009 and to the amortization, prepayment, and sale of investment securities (investment securities available for sale decreased by $27.8 million, from $61.7 million to $33.9 million, over the comparable quarters), offset by the elimination of overnight FHLB borrowings. The net increase in cash has been maintained on a short term basis in interest-bearing deposits in other banks in anticipation of loan growth. Liquid assets decreased by $3.0 million, or 4.0%, at March 31, 2010, compared to $76.0 million at December 31, 2009.

Loans. Loans held for investment, net, were $178.5 million at March 31, 2010, which represents an increase of $1.8 million, or 1.0%, from the loan balance of $176.7 million at March 31, 2009. Compared to the balances at December 31, 2009 of $181.5 million, net loan balances decreased by $3.1 million, or 1.7%, at March 31, 2010.

Asset Quality. The Company’s total nonperforming assets increased to $312,000, or 0.12% of assets, at March 31, 2010, compared to $202,000, or 0.07% of assets, at March 31, 2009, attributable to an increase in the balance of nonaccrual loans. Nonperforming assets at December 31, 2009 were $314,000, or 0.11% of assets.

Deposits. At March 31, 2010, increases in noninterest-bearing deposits of $19.7 million more than offset decreases in interest-bearing deposits of $17.4 million compared to March 31, 2009, for a net increase in total deposits of $2.3 million, or 1.1%, from $216.8 million at March 31, 2009 to $219.1 million at March 31, 2010. Core deposits, which are comprised of noninterest-bearing, money market, NOW and savings deposits, increased by $4.4 million, or 2.7%, from $163.3 million at March 31, 2009 to $167.7 million at March 31, 2010. Certificates of deposit decreased by $2.1 million between the comparable three-month periods. Total deposits at March 31, 2010 decreased by $10.1 million, or 4.4%, from $229.1 million at December 31, 2009 attributable to a $19.6 million decrease in core deposits, partially offset by a $9.5 million increase in certificates of deposit balance. This decrease in core deposits during the first quarter of 2010 represented our normal seasonal shifts in deposit balances and the departure of funds temporarily on deposit at the Bank.

Average total deposits increased by $1.2 million, or 0.6%, from $216.1 million during the three months ended March 31, 2009 to $217.3 million during the three months ended March 31, 2010. Average core deposits increased by $6.1 million between the comparable quarters, partially offset by a $4.9 million decrease in certificates of deposit. In addition, the mix of noninterest-bearing deposits to total deposits increased from 26.6% to 32.7% between the first quarters of 2009 and 2010, thereby contributing to the improvement in our net interest spread and net interest margin of 28 basis points and 22 basis points, respectively.

Borrowed Funds. Borrowed funds decreased by $15.1 million, from $25.5 million at March 31, 2009 to $10.4 million at March 31, 2010. Increases in liquid assets between March 31, 2009 and March 31, 2010 were utilized to reduce FHLB overnight advances to zero, leaving only a $5.0 million FHLB medium term advance and $5.4 million in securities sold under agreements to repurchase with deposit clients of the Bank. By comparison, at March 31, 2009, borrowed funds were comprised of $17.6 million in FHLB overnight advances, $5.0 million in a medium term FHLB advance, and $2.9 million in securities sold under agreements to repurchase. Borrowed funds at March 31, 2010 increased $3.4 million when compared to the balance at December 31, 2009 attributable to an increase in securities sold under agreements to repurchase.

Capital. Stockholders’ equity increased by $10.8 million, or 41.5%, from $26.0 million at March 31, 2009 to $36.8 million at March 31, 2010. Stockholders’ equity increased primarily as a result of an infusion of $10.1 million in TARP funding and a $478,000 increase in retained earnings related to 2009 earnings. Stockholders’ equity remained unchanged from $36.8 million at December 31, 2009.

The tables below set forth, for the periods indicated, information with respect to the Company’s nonperforming assets and allowance for loan losses.

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Nonperforming assets at the dates indicated were:

	At March 31,
	2010		2009
	(in thousands)
Nonaccrual loans	$	152	$	16
Accruing loans past due 90 days or more		—		8
Total nonperforming loans		152		24
Restructured loans		—		—
Other real estate owned, net		160		178
Total nonperforming assets	$	312	$	202

The following presents a summary of activity in the allowance for loan losses account for the applicable periods:

	At March 31,
	2010			2009
	(in thousands)
Balance, beginning of period	$	1,773		$	1,652
Provision for loan losses		—			55
Loans charged-off		(24	)		(8	)
Recoveries		1			10
Balance, end of period	$	1,750		$	1,709

Comparison of Operating Results for the Three Months Ended March 31, 2010 and 2009

Overview. The Company’s pretax income was $563,000 for the first quarter of 2010, compared to a pretax income of $197,000 for the first quarter of 2009, an increase of $366,000. Compared to the first quarter of 2009, net interest income increased by $205,000, provision for loan losses decreased by $55,000, noninterest income increased by $293,000, and noninterest expense increased by $187,000.

Net Interest Income. The Company’s net interest income before provision for loan losses increased by $205,000 to $2.4 million in the first quarter of 2010 compared to $2.2 million in the first quarter of 2009. This increase in net interest income was primarily attributable to a decrease in average interest-bearing liabilities of $15.3 million, augmented by an increase in average interest-earning assets of $8.1 million, between the first quarter of 2009 and the first quarter of 2010; these quarter over quarter changes resulted in a net interest spread increase of 28 basis points, from 3.19% for the three months ended March 31, 2009 to 3.47% for the three months ended March 31, 2010.

Additionally, net interest margin increased by 22 basis points, from 3.63% in the first quarter of 2009 to 3.85% in the first quarter of 2010. This increase was driven primarily by a $12.3 million decrease in average interest-bearing deposits, augmented by a $13.6 million increase in average non-interest bearing deposits.

Provision for Loan Losses. There was no provision for loan losses in the first quarter of 2010, compared to a provision of $55,000 in the first quarter of 2009. In the first quarter of 2010 there were net charge-offs of $23,000, compared to net recoveries of $2,000 in the first quarter of 2009. The balance of nonperforming loans at March 31, 2010 was $152,000, of which $99,000 has now been collected during the month of April.

Noninterest Income. Total noninterest income increased by $293,000, from $161,000 in the first quarter of 2009 to $454,000 in the first quarter of 2010, largely attributable to a $254,000 gain on the sale of investment securities. These securities were sold in anticipation of loan growth.

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Noninterest Expense. Total noninterest expense increased by $187,000, from $2.0 million in the first quarter of 2009 to $2.2 million in the first quarter of 2010. This increase in noninterest expense was driven primarily by a $179,000 increase in compensation expense.

A number of factors have contributed to the increase in compensation expense. The first quarter of 2010 includes $72,000 of expense related primarily to annual salary increases. Further, the portion of compensation expense that we are required to defer under generally accepted accounting principles was $34,000 less than the first quarter of last year. Finally, accruals for vacation earned but not taken increased by $96,000, mostly as a result of overall salary increases. Offsetting these increases to some extent was a $49,000 decrease in expense for stock based compensation, as a result of non-recurring expenses from the repricing of certain options held by executive officers that was completed in the first quarter of 2009.

Income Taxes. The Company’s income tax expense for the first quarter of 2010 was $202,000, which represented an effective tax rate of 35.9%, compared to income tax expense of $46,000 for the first quarter of 2009, which represented an effective tax rate of 23.3%. The lower effective tax rate for the first quarter of 2009 was primarily attributable to a $48,000 tax benefit resulting from an increase in nonqualified stock options related to certain stock options that were repriced in the first quarter of 2009.

Commitments

We are a party to financial instruments with off-balance sheet credit risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit in the form of loans or loans approved but not yet funded, standby letters of credit, and commitments to sell loans. These instruments involve, to varying degrees, elements of risk which have not been recognized in our consolidated balance sheets.

Loan commitments are agreements to extend credit to a customer so long as there are no violations of the applicable contract terms prior to the funding. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee by the customer. Because certain of the commitments are expected to be withdrawn or expire unused, the total commitment amount does not necessarily represent future cash requirements. Standby letters of credit are written unconditional commitments to guarantee the performance of a Bank customer to a third party.

We use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments. Unless otherwise noted, we require collateral or other security to support financial instruments with credit risk.

The following table reflects our other loan commitments outstanding at the dates indicated:

	At March  31, 2010		At March 31, 2009
	(in thousands)
Commitments to extend credit	$	37,335	$	42,941
Standby letters of credit		1,495		1,031
Commitments to sell loans		—		205
	$	38,830	$	44,177

Liquidity

Liquidity refers to the availability of sufficient funds to meet the needs of depositors, borrowers, creditors and investors and to fund operations. Our primary sources of funds are customer deposits, cash and cash equivalents, investment securities available for sale, loan repayments and borrowings. These funds are used to make loans, purchase investment securities, meet depositor withdrawals and fund operations. At March 31, 2010, cash and cash equivalents were $39.1 million, an increase of $13.2 million from $25.9 million at December 31, 2009.

In addition, we maintain a liquid available-for-sale investment securities portfolio. At March 31, 2010, the balance of our available-for-sale investment portfolio was $33.9 million, compared to a $50.1 million balance at December 31, 2009. We also are able to obtain funds through approved borrowing lines with the Federal Home Loan Bank of Atlanta and another financial institution. Management believes our existing liquidity sources are sufficient to satisfy the Company’s operational requirements and obligations. We maintain a high level of liquidity due to a concentration in some customer deposits, which can fluctuate significantly as depositor needs change.

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Capital Resources

The Company’s capital is reflected in its stockholders’ equity, which was $36.8 million at March 31, 2010, essentially unchanged from December 31, 2009. At March 31, 2010, the Company and the Bank were considered “well-capitalized” as defined by the Federal Reserve Bank. We monitor the current and projected capital levels of the Bank and the Company and will consider additional sources of capital, through the issuance of stock, debt or otherwise, as needs arise.

Recent Accounting Pronouncements

The following is a summary of recent authoritative pronouncements:

In January 2010, fair value guidance was amended to require disclosures for significant amounts transferred in and out of Levels 1 and 2 and the reasons for such transfers and to require that gross amounts of purchases, sales, issuances and settlements be provided in the Level 3 reconciliation. The new disclosures are effective for the Company for the current quarter and have been reflected in Note 5, “Disclosure About Fair Value of our Financial Investments”, to our unaudited consolidated financial statements.

Guidance related to subsequent events was amended in February 2010 to remove the requirement for an SEC filer to disclose the date through which subsequent events were evaluated. The amendments were effective upon issuance and had no significant impact on the Company’s financial statements.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

Item 3 Quantitative and Qualitative Disclosures About Market Risk

The Company is a smaller reporting company and thus is not required to provide the information required by this Item 3.

Item 4T Controls and Procedures

The Company is required to maintain disclosure controls and procedures that are designed to provide reasonable assurance that information required to be disclosed in reports filed under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), such as this quarterly report on Form 10-Q, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission, and that such information is accumulated and communicated to Company management, including its principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, the Company recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

We conducted an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of March 31, 2010. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have determined that our disclosure controls and procedures with respect to financial reporting were effective as of March 31, 2010 to ensure that material information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported as and when required.

Changes in Internal Control Over Financial Reporting

The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. This system is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States.

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There were no changes in the Company’s internal control over financial reporting in the quarter ended March 31, 2010 that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

Part II. OTHER INFORMATION

Item 1 Legal Proceedings

The Company is a party to routine litigation incidental to our business, none of which is considered likely to have a material effect on the Company.

Item 2 Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3 Defaults Upon Senior Securities

None

Item 4 (Removed and Reserved)

Item 5 Other Information

None

Item 6 Exhibits

See Index to Exhibits

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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.

	HERITAGE BANKSHARES, INC.
	(Registrant)
May 13, 2010	/s/ Michael S. Ives
	Michael S. Ives,
	President & Chief Executive Officer (Principal Executive Officer)
May 13, 2010	/s/ John O. Guthrie
	John O. Guthrie,
	Chief Financial Officer (Principal Financial and Accounting Officer)

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Index to Exhibits

3.1	Amended and Restated Articles of Incorporation of Heritage Bankshares, Inc. (Incorporated herein by reference to the Company’s Form 10-Q filed on August 11, 2009.)
3.2	Articles of Amendment to the Articles of Incorporation of Heritage Bankshares, Inc. Establishing the Terms of the Preferred Shares. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.)
3.3	Amendment to Bylaws of Heritage Bankshares, Inc. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.)
4.1	Form of Certificate for the Series A Preferred Stock. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.)
4.2	Form of Certificate for the Series B Preferred Stock. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.)
4.3	Warrant to Purchase up to 303.00303 shares of Series B Preferred Stock, dated September 25, 2009. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.)
10.8	Amended and Restated Bylaws of Heritage Bankshares, Inc. (Incorporated herein by reference to the Company’s Form 8-K filed on May 3, 2005.)
10.11	Amendment to Bylaws of Heritage Bankshares, Inc. (Incorporated herein by reference to the Company’s Form 8-K filed on August 1, 2006.)
*10.16	Heritage 2006 Equity Incentive Plan (As Amended and Restated Effective January 28, 2009). (Incorporated herein by reference to the Company’s Form S-8 filed on July 27, 2009.)
10.22	Letter Agreement, dated September 25, 2009, including Securities Purchase Agreement – Standard Terms, incorporated by reference therein, between Heritage Bankshares, Inc. and the United States Department of the Treasury. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.)
10.23	Side Letter, dated September 25, 2009, between Heritage Bankshares, Inc. and the United States Department of the Treasury. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.)
10.24	ARRA Agreement, dated September 25, 2009, between Heritage Bankshares, Inc. and the United States Department of the Treasury. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.)
*10.25	Form of Waiver. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.)
*10.26	Form of Amendment to Employment Agreement. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.)
*10.27	Amendment to Employment Agreement of Michael S. Ives dated September 23, 2009. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.)
*10.28	Supplemental Executive Retirement Plan between the Company and Michael S. Ives dated September 23, 2009. (Incorporated herein by reference to the Company’s Form 8-K filed on September 25, 2009.)
*10.29	Elective Deferred Compensation Agreement with Michael S. Ives. (Incorporated herein by reference to the Company’s Form 8-K filed on February 2, 2010.)

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*10.30	Deferred Compensation Plan Trust. (Incorporated herein by reference to the Company’s Form 8-K filed on February 2, 2010.)
*10.31	Amendment to Employment Agreement of Michael S. Ives dated December 22, 2009. (Incorporated herein by reference to the Company’s Form 10-K filed on March 26, 2010.)
*10.32	Amendment to Employment Agreement of John O. Guthrie dated December 21, 2009. (Incorporated herein by reference to the Company’s Form 10-K filed on March 26, 2010.)
*10.33	Amendment to Employment Agreement of Sharon Curling Lessard dated December 21, 2009. (Incorporated herein by reference to the Company’s Form 10-K filed on March 26, 2010.)
*10.34	Amendment to Employment Agreement of Leigh C. Keogh dated December 21, 2009. (Incorporated herein by reference to the Company’s Form 10-K filed on March 26, 2010.)
31.1	Certification of principal executive officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.**
31.2	Certification of principal financial officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.**
32.1	Certification of principal executive officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.**
32.2	Certification of principal financial officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.**

* Indicates management contract or compensatory plan or arrangement.

** Filed herewith.

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