Heritage Bankshares (HBKS) 10-Q 2011 Q2 Quarterly report

U. S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2011

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

For the transition period fromto              to             

Commission File Number0-11255

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  x    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 2,303,108 shares of the registrant’s common stock were outstanding as of July 31, 2011.

TABLE OF CONTENTS

		Page No.
Part I.       FINANCIAL INFORMATION
Item 1 -	Financial Statements (Unaudited)
Consolidated Balance Sheets June 30, 2011 and December 31, 2010			3
Consolidated Statements of Income Three and Six Months Ended June 30, 2011 and 2010			4
Consolidated Statements of Cash Flows Six Months Ended June 30, 2011 and 2010			5
Notes to Consolidated Financial Statements			6
Item 2 -	Management’s Discussion and Analysis of Financial Condition and Results of Operation		21
Item 3 -	Quantitative and Qualitative Disclosures About Market Risk		24
Item 4 -	Controls and Procedures		25
Part II.      OTHER INFORMATION
Item 1 -	Legal Proceedings		25
Item 2 -	Unregistered Sales of Equity Securities and Use of Proceeds		25
Item 3 -	Defaults Upon Senior Securities		25
Item 4 -	(Removed and Reserved)		25
Item 5 -	Other Information		25
Item 6 -	Exhibits		25
Signatures			26

2

Part I. FINANCIAL INFORMATION

Item 1 - Financial Statements

HERITAGE BANKSHARES, INC.

CONSOLIDATED BALANCE SHEETS

	June  30, 2011 (Unaudited)			December  31, 2010 (Audited)
	(in thousands, except per share data)
ASSETS
Cash and due from banks	$	5,296		$	3,056
Interest-bearing deposits in other banks		15,231			12,923
Federal funds sold		28			401
Total cash and cash equivalents		20,555			16,380
Certificates of deposit in other banks		1,285			2,260
Securities available-for-sale, at fair value		23,443			17,368
Loans, net
Held for investment, net of allowance for loan losses of $2,149 and $2,090, respectively		214,733			214,342
Accrued interest receivable		634			668
Stock in Federal Reserve Bank (“FRB”), at cost		592			587
Stock in Federal Home Loan Bank of Atlanta (“FHLB”), at cost		1,335			1,773
Premises and equipment, net		10,972			11,165
Other real estate owned		263			263
Other assets		2,511			2,282
Total assets	$	276,323		$	267,088
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities
Deposits
Noninterest-bearing	$	87,012		$	85,308
Interest-bearing		148,916			138,794
Total deposits		235,928			224,102
Federal Home Loan Bank Advances		—			—
Other borrowings		935			1,087
Securities sold under agreements to repurchase		2,011			2,378
Accrued interest payable		91			100
Other liabilities		1,916			1,841
Total liabilities		240,881			229,508
Commitments and contingencies		—			—
Stockholders’ equity
Preferred stock, no par value - 1,000,000 shares authorized:
Fixed rate cumulative perpetual preferred stock, Series A, 7,497 shares and 10,103 shares issued and outstanding at June 30, 2011 and December 31, 2010, respectively		7,497			10,103
Fixed rate cumulative perpetual preferred stock, Series B, 303 shares issued and outstanding at both June 30, 2011 and December 31, 2010		303			303
Common stock, $5 par value – 6,000,000 shares authorized; 2,303,108 and 2,307,502 shares issued and outstanding at June 30, 2011 and December 31, 2010, respectively		11,516			11,538
Additional paid-in capital		6,657			6,658
Retained earnings		9,348			8,801
Discount on preferred stock		(153	)		(235	)
Accumulated other comprehensive income, net		274			412
Total stockholders’ equity		35,442			37,580
Total liabilities and stockholders’ equity	$	276,323		$	267,088

See accompanying notes to consolidated financial statements.

3

HERITAGE BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

	Three Months Ended June 30						Six Months Ended June 30
	2011			2010			2011			2010
	(in thousands, except share and per share data)
Interest and dividend income
Loans and fees on loans	$	2,856		$	2,331		$	5,710		$	4,630
Taxable investment securities		173			393			321			794
Dividends on FRB and FHLB stock		12			10			25			19
Interest on federal funds sold		—			—			—			—
Other interest income		23			31			50			66
Total interest income		3,064			2,765			6,106			5,509
Interest expense
Deposits		308			350			614			704
Borrowings		11			33			26			67
Total interest expense		319			383			640			771
Net interest income		2,745			2,382			5,466			4,738
Provision for loan losses		11			159			11			159
Net interest income after provision for loan losses		2,734			2,223			5,455			4,579
Noninterest income
Service charges on deposit accounts		81			115			173			231
Gain on sale of investment securities		87			232			87			486
Late charges and other fees on loans		15			16			32			32
Other		62			72			138			140
Total noninterest income		245			435			430			889
Noninterest expense
Compensation		1,110			1,052			2,193			2,281
Data processing		143			139			288			277
Occupancy		197			183			389			377
Furniture and equipment		151			151			296			301
Taxes and licenses		81			85			166			171
Professional fees		98			68			217			173
FDIC assessment		21			69			100			146
Marketing		40			34			79			65
Hiring and recruiting		40			—			42			34
Telephone		28			24			60			47
(Gain)/Loss on sale or impairment of other assets		1			(3	)		1			30
Other		190			155			342			301
Total noninterest expense		2,100			1,957			4,173			4,203
Income before provision for income taxes		879			701			1,712			1,265
Provision for income taxes		288			250			561			452
Net income		591			451			1,151			813
Preferred stock dividends and accretion of discount		(111	)		(146	)		(310	)		(293	)
Net income available to common stockholders	$	480		$	305		$	841		$	520
Earnings per common share
Basic	$	0.21		$	0.13		$	0.36		$	0.23
Diluted	$	0.21		$	0.13		$	0.36		$	0.23
Dividends per common share	$	0.06		$	0.06		$	0.12		$	0.12
Weighted average common shares outstanding - basic		2,306,348			2,301,386			2,306,925			2,296,593
Effect of dilutive stock options		9,706			4,823			10,147			6,005
Weighted average common shares outstanding - diluted		2,316,054			2,306,209			2,317,072			2,302,598

See accompanying notes to consolidated financial statements.

4

HERITAGE BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

	Six Months Ended June 30,
	2011			2010
	(in thousands)
Cash flows from operating activities:
Net income	$	1,151		$	813
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan loss		11			159
Amortization of loan yield adjustments, net		172			175
Depreciation, amortization and accretion, net		306			400
Stock based compensation		32			70
Deferred compensation		19			21
Exercise of stock options tax benefit		—			26
Net (gains) losses on:
Sale of securities		(87	)		(486	)
Sale, disposal or impairment of property, plant and equipment		—			3
Sale or impairment of other real estate owned		1			30
Increase in bank owned life insurance		(13	)		(13	)
Changes in assets/liabilities, net
Increase in interest receivable and other assets		(111	)		(92	)
Increase in interest payable and other liabilities		48			160
Net cash provided by operating activities		1,529			1,266
Cash flows from investing activities:
Proceeds from maturities and principal repayments of securities available for sale		4,694			18,428
Purchases of securities available for sale		(16,921	)		(46,053	)
Proceeds from sales of securities available for sale		6,005			10,153
Net decrease in certificates of deposit at other banks		975			1,454
Proceeds from the sale of other real estate owned		—			283
Net increase in loans held for investment		(574	)		(14,813	)
Purchases of FHLB stock and FRB stock		(5	)		(60	)
Redemption of FHLB stock		438			—
Purchases of premises and equipment		(90	)		(92	)
Net cash used for investing activities		(5,478	)		(30,700	)
Cash flows from financing activities:
Proceeds from exercise of stock options		—			82
Net increase in deposits		11,826			5,232
Proceeds from FHLB advances		31,150			70,355
Repayments of FHLB advances		(31,150	)		(51,855	)
Net increase(decrease) in securities sold under agreements to repurchase		(367	)		17
Repayments of other borrowings		(152	)		—
Repurchase of preferred stock		(2,606	)		—
Repurchase of common stock		(55	)		—
Cash dividends paid		(522	)		(542	)
Net cash provided by financing activities		8,124			23,289
Increase (decrease) in cash and cash equivalents		4,175			(6,145	)
Cash and cash equivalents, beginning of period		16,380			22,004
Cash and cash equivalents, end of period	$	20,555		$	15,859
Supplemental disclosure:
Interest paid	$	649		$	764
Income taxes paid	$	679		$	488

See accompanying notes to consolidated 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 the Company 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 for 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 unaudited 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, 2010. 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 that, 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. The 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.

6

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 the decline 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.

Recent Accounting Pronouncements

The following is a summary of recent authoritative pronouncements:

In July 2010, the Receivables topic of the Accounting Standards Codification (“ASC”) was amended by Accounting Standards Update (“ASU”) 2010-20 to require expanded disclosures related to a company’s allowance for credit losses and the credit quality of its financing receivables. The amendments require the allowance disclosures to be provided on a disaggregated basis. The Company is required to include these disclosures in its interim and annual financial statements. See Note 7 to our Financial Statements below.

Disclosures about Troubled Debt Restructurings (“TDRs”) required by ASU 2010-20 were deferred by the Financial Accounting Standards Board (“FASB”) in ASU 2011-01 issued in January 2011. In April 2011, the FASB issued ASU 2011-02 to assist creditors with their determination of when a restructuring is a TDR. The determination is based on whether the restructuring constitutes a concession and whether the debtor is experiencing financial difficulties as both events must be present.

Disclosures related to TDRs under ASU 2010-20 will be effective for reporting periods beginning after June 15, 2011.

Also in December 2010, the Business Combinations topic of the ASC was amended to specify that if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. The amendment also requires that the supplemental pro forma disclosures include a description of the nature and amount of any material, nonrecurring pro forma adjustments directly attributable to the business combination included in the reported pro forma revenue and earnings. This amendment is effective for the Company for business combinations for which the acquisition date is on or after January 1, 2011, although early adoption is permitted. This amendment has no impact on the Company’s financial statements at June 30, 2011.

7

In April 2011, the criteria used to determine effective control of transferred assets in the Transfers and Servicing topic of the ASC was amended by ASU 2011-03. The requirement for the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms and the collateral maintenance implementation guidance related to that criterion were removed from the assessment of effective control. The other criteria to assess effective control were not changed. The amendments are effective for the Company beginning January 1, 2012 but are not expected to have a material effect on the Company’s financial statements.

ASU 2011-04 was issued in May 2011 to amend the Fair Value Measurement topic of the ASC by clarifying the application of existing fair value measurement and disclosure requirements and by changing particular principles or requirements for measuring fair value or for disclosing information about fair value measurements. The amendments will be effective for the Company beginning January 1, 2012 but are not expected to have a material effect on the Company’s financial statements.

The Comprehensive Income topic of the ASC was amended in June 2011. The amendment eliminates the option to present other comprehensive income as a part of the statement of changes in stockholders’ equity. The amendment requires consecutive presentation of the statement of net income and other comprehensive income and requires an entity to present reclassification adjustments from other comprehensive income to net income on the face of its financial statements. The amendments will be applicable to the Company on January 1, 2012 and will be applied retrospectively.

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.

Note 2 – Share-Based Compensation

The following table presents a summary of stock option activity for the period of January 1, 2011 through June 30, 2011:

	Shares		Weighted Average Exercise Price		Weighted Average Remaining Term (Years)		Aggregate Intrinsic Value
							(in thousands)
Outstanding at January 1, 2011		241,400	$	12.62		—		—
Granted		—		—		—		—
Exercised		—		—		—		—
Forfeited/expired		2,800		14.06		—		—
Outstanding at June 30, 2011		238,600	$	12.60		5.2	$	258
Exercisable at June 30, 2011		208,200	$	12.59		5.0	$	224

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 June 30, 2011. The amount changes based on the fair market value of the Company’s common stock, as reflected by stock market prices. The Company’s current policy is to issue new shares of common stock to satisfy option exercises.

There were no options exercised during the six months ended June 30, 2011. The aggregate intrinsic value of options exercised during the six months ended June 30, 2010 was $77,574, and cash received from exercises of options during the first six months of 2010 was $82,277.

The amount charged against income, before income tax benefit of $1,244, in relation to the stock-based payment arrangement, was $31,839 for the six months ended June 30, 2011. The amount charged against income, before income tax benefit of $5,199, in relation to the stock-based payment arrangement was $69,750 for the six months ended June 30, 2010. At June 30, 2011, unrecognized compensation expense, net of estimated forfeitures, related to unvested stock option grants was $42,125 and is currently expected to be recognized over a weighted average period of 0.6 years as follows:

	Stock-Based Compensation Expense
	(in thousands)
At June 30, 2011:
2011	$	29
2012		9
2013		4
Total	$	42

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Note 3 – Other Comprehensive Income (Loss)

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

	Three Months Ended						Six Months Ended
	June 30, 2011			June 30, 2010			June 30, 2011			June 30, 2010
	(in thousands)
Unrealized holding gains/(losses) on available-for-sale securities	$	(6	)	$	319		$	(122	)	$	339
Realized gains on sales of available-for-sale securities		(87	)		(232	)		(87	)		(486	)
Tax effect on realized gains		29			79			29			165
Tax effect on unrealized gains/(losses)		2			(109	)		42			(115	)
Other comprehensive income (loss), net of tax	$	(62	)	$	57		$	(138	)	$	(97	)

Note 4 – Earnings Per Common Share Reconciliation

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

	Three Months Ended				Six Months Ended
	June 30, 2011		June 30, 2010		June 30, 2011		June 30, 2010
	(in thousands, except share and per share data)
Net income available to common stockholders (numerator, basic and diluted)	$	480	$	305	$	841	$	520
Weighted average common shares outstanding (denominator)		2,306,348		2,301,386		2,306,925		2,296,593
Earnings per common share-basic	$	0.21	$	0.13	$	0.36	$	0.23
Effect of dilutive securities
Weighted average common shares outstanding during the period		2,306,348		2,301,386		2,306,925		2,296,593
Effect of dilutive stock options		9,706		4,823		10,147		6,005
Weighted diluted average common shares outstanding (denominator) during the period		2,316,054		2,306,209		2,317,072		2,302,598
Earnings per common share – assuming dilution	$	0.21	$	0.13	$	0.36	$	0.23

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.

9

The following table presents the carrying amounts and fair value of the Company’s financial instruments at June 30, 2011 and December 31, 2010:

	At June 30, 2011				At December 31, 2010
	Carrying Amount		Fair Value		Carrying Amount		Fair Value
	(Dollars in Thousands)
Financial assets:
Cash, due from banks and interest-bearing deposits at other banks	$	20,527	$	20,527	$	15,979	$	15,979
Federal funds sold		28		28		401		401
Certificates of deposit in other banks		1,285		1,285		2,260		2,260
Securities available for sale		23,443		23,443		17,368		17,368
Loans held for investment		214,733		217,133		214,342		217,450
Accrued interest receivable		634		634		668		668
Stock in FRB and FHLB		1,927		1,927		2,360		2,360
Bank-owned life insurance		597		597		584		584
Other financial assets		206		206		148		148
Financial liabilities:
Deposits		235,928		236,079		224,102		224,337
Securities sold under agreements to repurchase		2,011		2,011		2,378		2,378
Other borrowings		935		950		1,087		1,104
Accrued interest payable		91		91		100		100

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 is measured 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.

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Loans

The Company does not record loans at fair value on a recurring basis. From time to time, a loan is considered impaired. Loans that 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.

Other Real Estate Owned

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. Once management’s intentions change regarding the utilization of its own property, that property is transferred to other real estate owned at 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.

Other Financial Assets

Other financial assets are recorded at fair value on a recurring basis. Fair value is based on quoted market prices which are considered to be Level 2 inputs.

General

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

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

Assets Recorded at Fair Value on a Recurring Basis

June 30, 2011 in thousands	Total		Level 1		Level 2		Level 3
Investment in securities available for sale
U.S. Treasury notes	$	2,029	$	—	$	2,029	$	—
U.S. Government agencies		8,908		—		8,908		—
Mortgage-backed securities		12,506		—		12,506		—
Other financial assets		206		—		206		—
Total Assets at Fair Value	$	23,649	$	—	$	23,649	$	—
December 31, 2010 in thousands	Total		Level 1		Level 2		Level 3
Investment in securities available for sale
Mortgage-backed securities	$	17,368	$	—	$	17,368	$	—
Other financial assets		148		—		148		—
Total Assets at Fair Value	$	17,516	$	—	$	17,516	$	—

Assets Recorded at Fair Value on a Non-Recurring Basis

June 30, 2011 in thousands	Total		Level 1		Level 2		Level 3
Loans held for investment	$	1,401	$	—	$	1,401	$	—
Other real estate owned		263		—		263		—
Total Assets at Fair Value	$	1,664	$	—	$	1,664	$	—

11

December 31, 2010 in thousands	Total		Level 1		Level 2		Level 3
Other real estate owned	$	263	$	—	$	263	$	—
Total Assets at Fair Value	$	263	$	—	$	263	$	—

Note 6 – Securities

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(in thousands)
At June 30, 2011
Securities available for sale
U.S. Treasury notes	$	2,005	$	24	$	—		$	2,029
U.S. Government agencies		9,000		—		(92	)		8,908
Mortgage-backed securities		12,024		482		—			12,506
Total securities available for sale	$	23,029	$	506	$	(92	)	$	23,443
Total securities(1)	$	23,029	$	506	$	(92	)	$	23,443
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
	(in thousands)
At December 31, 2010
Securities available for sale
Mortgage-backed securities	$	16,744	$	624	$	—		$	17,368
Total securities available for sale	$	16,744	$	624	$	—		$	17,368
Total securities(1)	$	16,744	$	624	$	—		$	17,368

(1) At June 30, 2011 and at December 31, 2010, the Company held no securities classified as held to maturity.

The following table shows 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 June 30, 2011. Current year unrealized losses on investment securities, if any, are a result of changes in interest rates during the periods. Unrealized losses on investment securities, if any, are considered by management to be temporary given the credit ratings on these investment securities and the short duration of any unrealized loss due to credit quality.

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	At June 30, 2011
	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. Treasury notes	$	—	$	—		$	—	$	—	$	—	$	—
U.S. Government agencies		8,908		(92	)		—		—		8,908		(92	)
Mortgage-backed securities		—		—			—		—		—		—
Total temporarily impaired securities	$	8,908	$	(92	)	$	—	$	—	$	8,908	$	(92	)

There were no investment securities with unrealized losses at December 31, 2010.

The amortized cost and fair value of investment securities at June 30, 2011, 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
	(in thousands)
	Amortized Cost		Fair Value
Due in one year or less	$	—	$	—
Due after one year through five years		9,918		10,196
Due after five years through ten years		13,111		13,247
Due after ten years		—		—
Total	$	23,029	$	23,443

Gross proceeds from sales of securities available for sale were $6,005,391 for both the three and six month periods ended June 30, 2011. Gross realized gains associated with these sales were $87,345; there were no gross losses during 2011. Gross proceeds from sales of securities available for sale in the quarter ended June 30, 2010 were $3,317,029, accumulating to $10,153,437 for the six months ended June 30, 2010. Gross realized gains associated with these sales were $232,224 and $486,319, respectively, for the quarter and six months ended June 30, 2010. Gains and losses on the sale of investment securities are recorded as of the trade date and are determined using the specific identification method.

Note 7 – Loans held for investment, net

Loans at the dates indicated consisted of the following:

	June 30, 2011			December 31, 2010
	(in thousands)
Commercial	$	35,449		$	37,354
Real estate – commercial		108,116			101,080
Real estate – consumer		53,949			55,694
Real estate - construction		14,072			18,389
Consumer		5,296			3,915
Total loans		216,882			216,432
Allowance for loan losses		(2,149	)		(2,090	)
Loans, net(1)	$	214,733		$	214,342

⁽¹⁾ Loans amounts are presented net of unearned fees and costs for June 30, 2011 and December 31, 2010.

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Nonperforming assets at the dates indicated were:

	June 30, 2011		December 31, 2010
	(in thousands)
Nonaccrual loans:
Commercial	$	—	$	—
Real estate - commercial		1,469		—
Real estate - consumer		—		—
Real estate - construction		—		—
Consumer		—		—
Total nonaccrual loans		1,469		—
Accruing loans past due 90 days or more		—		—
Total nonperforming loans		1,469		—
Real estate owned, net		263		263
Total nonperforming assets	$	1,732	$	263

A summary of the activity in the allowance for loan losses account for the periods indicated is as follows:

	At June 30
	2011			2010
	(in thousands)
Balance, beginning of year	$	2,090		$	1,773
Provision for loan losses		11			159
Loans charged-off
Commercial		(1	)		(13	)
Real estate – commercial		—			—
Real estate – consumer		—			—
Real estate – construction		—			—
Consumer		(1	)		(11	)
Total loans charged-off		(2	)		(24	)
Recoveries
Commercial		2			12
Real estate – commercial		—			—
Real estate – consumer		48			—
Real estate – construction		—			—
Consumer		—			12
Total loans recovered		50			24
Net recoveries		48			—
Balance, end of period	$	2,149		$	1,932

14

The following table presents the aging analysis of the Company’s loan portfolio at June 30, 2011:

	30-59 Days Past  Due		60-89 Days Past  Due		90 days or more Past  Due		Total Past Due		Nonaccrual Loans		Current		Total Loans Outstanding		Loans 90 days past due and accruing
	(in thousands)
Commercial	$	—	$	—	$	—	$	—	$	—	$	35,449	$	35,449	$	—
Real estate – commercial		—		—		—		—		1,469		106,647		108,116		—
Real estate – consumer		504		—		—		504		—		53,445		53,949		—
Real estate – construction		—		—		—		—		—		14,072		14,072		—
Consumer		—		—		—		—		—		5,296		5,296		—
Total	$	504	$	—	$	—	$	504	$	1,469	$	214,909	$	216,882	$	—

The following table presents the aging analysis of the Company’s loan portfolio at December 31, 2010:

	30-59 Days Past  Due		60-89 Days Past  Due		90 days or more Past  Due		Total Past Due		Nonaccrual Loans		Current		Total Loans Outstanding		Loans 90 days past due and accruing
	(in thousands)
Commercial	$	—	$	—	$	—	$	—	$	—	$	37,354	$	37,354	$	—
Real estate – commercial		—		—		—		—		—		101,080		101,080		—
Real estate – consumer		131		—		—		131		—		55,563		55,694		—
Real estate – construction		—		—		—		—		—		18,389		18,389		—
Consumer		—		—		—		—		—		3,915		3,915		—
Total	$	131	$	—	$	—	$	131	$	—	$	216,301	$	216,432	$	—

The Bank utilizes an internal system based on payment history as its primary credit indicator on its commercial and commercial real estate loan portfolios. Loans that consistently meet an established historical payment schedule are not given further scrutiny other than that given in the ordinary course of business. Any loan that misses its normal payment date falls into a category of heightened scrutiny to determine whether a potential weakness exists. Based upon the collection and analysis of certain data, if there is a determination that no weakness exists, the loan will be given no further heightened scrutiny. If, however, current financial information indicates a potential weakness, aggressive investigation will begin into collateral values and borrower ability to pay to determine loss potential to the Bank. If loss potential is small, the loan is placed into a category of continued monitoring. If loss potential is high, the process of collateral realization may begin.

The following table is a summary of credit quality indicators related to the Bank’s commercial, commercial real estate, and construction real estate loans at June 30, 2011:

	Commercial		Real Estate Commercial		Real Estate Construction		Total
	(in thousands)
Category:
Normal review	$	35,449	$	106,647	$	14,016	$	156,112
Closely monitored		—		1,469		56		1,525
In collection		—		—		—		—
Total	$	35,449	$	108,116	$	14,072	$	157,637

15

The following table is a summary of credit quality indicators related to the Bank’s commercial, commercial real estate, and construction real estate loans at December 31, 2010:

	Commercial		Real Estate Commercial		Real Estate Construction		Total
	(in thousands)
Category:
Normal review	$	37,354	$	99,602	$	18,389	$	155,345
Closely monitored		—		1,478		—		1,478
In collection		—		—		—		—
Total	$	37,354	$	101,080	$	18,389	$	156,823

For regulatory purposes, the Bank utilizes an internal credit classification system to manage the credit quality of its commercial and real estate loan portfolios. Loans classified as “substandard” have well-defined weaknesses and typically have experienced a degradation in either the current value of the pledged collateral or of the paying capacity of the borrower; these loans carry a distinct possibility that the Bank could sustain some loss unless the weakness is corrected. Loans classified as “doubtful” have uncorrected weaknesses that have a high possibility of loss; a loan may reside in this classification temporarily until a currently unquantifiable expected loss can be determined with a greater degree of accuracy. Any loan classified in the “loss” risk class is considered uncollectible and is to be charged-off within 30 days or less.

The following table presents a summary of commercial, commercial real estate, and construction real estate loans classified by this internal credit classification at June 30, 2011:

	Commercial		Real Estate Commercial		Real Estate Construction		Total
	(in thousands)
Grade:
Pass	$	35,430	$	106,070	$	12,664	$	154,164
Substandard		19		2,046		1,408		3,473
Doubtful		—		—		—		—
Loss		—		—		—		—
Total	$	35,449	$	108,116	$	14,072	$	157,637

The following table presents a summary of commercial, commercial real estate, and construction real estate loans classified by this internal credit classification at December 31, 2010:

	Commercial		Real Estate Commercial		Real Estate Construction		Total
	(in thousands)
Grade:
Pass	$	37,346	$	98,715	$	16,789	$	152,850
Substandard		8		2,365		1,600		3,973
Doubtful		—		—		—		—
Loss		—		—		—		—
Total	$	37,354	$	101,080	$	18,389	$	156,823

The Bank utilizes delinquency status in its evaluation of credit exposure for consumer loans, which include both revolving and closed-end mortgages as well as installment and personal loans. Consumer loans are considered to be nonperforming when severely delinquent, defined as 90 days or more past due.

16

The following table represents the credit risk profile for the consumer portfolio at June 30, 2011:

	Consumer Mortgages		Installment and Other Consumer		Total
	(in thousands)
Performing	$	53,949	$	5,296	$	59,245
Nonperforming		—		—		—
Total	$	53,949	$	5,296	$	59,245

The following table represents the credit risk profile for the consumer portfolio at December 31, 2010:

	Consumer Mortgages		Installment and Other Consumer		Total
	(in thousands)
Performing	$	55,694	$	3,915	$	59,609
Nonperforming		—		—		—
Total	$	55,694	$	3,915	$	59,609

The following tables present an allocation of the Company’s allowance for loan losses and the respective loans evaluated based on its allowance methodology at June 30, 2011:

	Commercial		Real Estate Commercial			Real Estate Consumer		Real Estate Construction			Consumer		Unallocated		Total
	(in thousands)
Allowance for loan losses:
Ending balance:
Individually evaluated for impairment	$	—	$	68	(1)	$	—	$	1	(2)	$	—	$	—	$	69
Ending balance:
Collectively evaluated for impairment		310		933			490		123			46		178		2,080
Ending balance:
Loans acquired with deteriorated credit		—		—			—		—			—		—		—
Total Ending Balance	$	310	$	1,001		$	490	$	124		$	46	$	178	$	2,149
	Commercial		Real Estate Commercial			Real Estate Consumer		Real Estate Construction			Consumer		Unallocated		Total
	(in thousands)
Total loans:
Ending balance:
Individually evaluated for impairment	$	—	$	1,469	(1)	$	—	$	56	(2)	$	—	$	—	$	1,525
Ending balance:
Collectively evaluated for impairment		35,449		106,647			53,949		14,016			5,296		—		215,357
Ending balance:
Loans acquired with deteriorated credit		—		—			—		—			—		—		—
Total Ending Balance	$	35,449	$	108,116		$	53,949	$	14,072		$	5,296	$	—	$	216,882

(1) Certain loans were evaluated for impairment at June 30, 2011. Based on this evaluation process, it was determined that a specific allowance was required.

(2) Certain loans were evaluated for impairment at June 30, 2011. Based on this evaluation process, it was determined that no impairment was required.

17

The following tables present an allocation of the Company’s allowance for loan losses and the respective loans evaluated based on its allowance methodology at December 31, 2010:

	Commercial		Real Estate Commercial		Real Estate Consumer		Real Estate Construction		Consumer		Unallocated		Total
	(in thousands)
Allowance for loan losses:
Ending balance:
Individually evaluated for impairment(1)	$	—	$	13	$	—	$	—	$	—	$	—	$	13
Ending balance:
Collectively evaluated for impairment		327		872		508		162		34		174		2,077
Ending balance:
Loans acquired with deteriorated credit		—		—		—		—		—		—		—
Total Ending Balance	$	327	$	885	$	508	$	162	$	34	$	174	$	2,090
	Commercial		Real Estate Commercial		Real Estate Consumer		Real Estate Construction		Consumer		Unallocated		Total
	(in thousands)
Total loans:
Ending balance:
Individually evaluated for impairment(1)	$	—	$	1,478	$	—	$	—	$	—	$	—	$	1,478
Ending balance:
Collectively evaluated for impairment		37,354		99,602		55,694		18,389		3,915		—		214,954
Ending balance:
Loans acquired with deteriorated credit		—		—		—		—		—		—		—
Total Ending Balance	$	37,354	$	101,080	$	55,694	$	18,389	$	3,915	$	—	$	216,432

(1) Certain loans were evaluated for impairment at December 31, 2010. Based on this evaluation process, it was determined that no impairment was required.

The following table reflects the average daily recorded investment in impaired loans during the quarter ended June 30, 2011 and interest income recognized on those loans:

	Recorded Investment		Unpaid Balance		Related Allowance		Average Daily Recorded Investment		Interest Income Recognized
	(in thousands)
With no allowance recorded:
Commercial	$	—	$	—	$	—	$	—	$	—
Real estate - commercial		—		—		—		—		—
Real estate - consumer		—		—		—		—		—
Real estate - construction		—		—		—		—		—
Consumer		—		—		—		—		—
Total	$	—	$	—	$	—	$	—	$	—
With an allowance recorded:
Commercial	$	—	$	—	$	—	$	—	$	—
Real estate - commercial		1,469		1,471		68		8		—
Real estate - consumer		—		—		—		—		—
Real estate - construction		—		—		—		—		—
Consumer		—		—		—		—		—
Total	$	1,469	$	1,471	$	68	$	8	$	—
Total
Commercial	$	—	$	—	$	—	$	—	$	—
Real estate - commercial		1,469		1,471		68		8		—
Real estate - consumer		—		—		—		—		—
Real estate - construction		—		—		—		—		—
Consumer		—		—		—		—		—
Total	$	1,469	$	1,471	$	68	$	8	$	—

18

The following is a summary of information pertaining to impaired loans at December 31, 2010:

	Recorded Investment		Unpaid Balance		Related Allowance		Average Daily Recorded Investment		Interest Income Recognized
	(in thousands)
With no allowance recorded:
Commercial	$	—	$	—	$	—	$	44	$	2
Real estate - commercial		—		—		—		—		—
Real estate - consumer		—		—		—		—		—
Real estate - construction		—		—		—		—		—
Consumer		—		—		—		9		1
Total	$	—	$	—	$	—	$	53	$	3
With an allowance recorded:
Commercial	$	—	$	—	$	—	$	—	$	—
Real estate - commercial		—		—		—		—		—
Real estate - consumer		—		—		—		—		—
Real estate - construction		—		—		—		—		—
Consumer		—		—		—		—		—
Total	$	—	$	—	$	—	$	—	$	—
Total
Commercial	$	—	$	—	$	—	$	44	$	2
Real estate - commercial		—		—		—		—		—
Real estate - consumer		—		—		—		—		—
Real estate - construction		—		—		—		—		—
Consumer		—		—		—		9		1
Total	$	—	$	—	$	—	$	53	$	3

Note 8 –TARP Program Repayment and Participation in Small Business Lending Fund Program

In March 2011, consistent with its strategic plan and with the approval of the U.S. Treasury, the Company repaid $2.6 million, or 25%, of its outstanding preferred stock issued in September 2009 in connection with the Company’s participation in the TARP Capital Purchase Program (the “TARP Program”), with a resulting decrease in net income available to common shareholders of $57,000 from the accelerated accretion of a portion of the discount on its outstanding TARP Program preferred stock.

As previously announced, the Company has received preliminary approval from the U.S. Treasury for a $7.8 million investment under the Small Business Lending Fund program (the “SBLF Program”). The SBLF Program was

19

authorized under the Small Business Jobs Act of 2010, and established a $30 billion fund from which the Treasury can make capital investments in eligible institutions; the capital investments, in turn, are designed to increase the availability of credit for small businesses and promote economic growth nationwide. The Company’s participation in the SBLF Program is subject to the Treasury’s due diligence review and other customary closing conditions, including execution and delivery of applicable investment documents, but the Company currently expects that the SBLF investment transaction will close in mid-August.

If the SBLF Program transaction is consummated as expected, the Company’s outstanding investment under the TARP Program would be simultaneously repaid in full with the SBLF Program investment proceeds, and all outstanding TARP Program preferred stock would be redeemed and replaced with preferred stock issued to the Treasury under the SBLF Program.

For the initial 2.5 years after the SBLF Program investment, the dividend rate payable on the SBLF Program preferred stock would fluctuate between 1% and 5% per year to reflect changes in the Bank’s level of “qualified small business lending” as compared to an initial baseline level. Following this initial period and continuing through 4.5 years after the SBLF Program investment, the dividend rate would be fixed at between 1% and 7% based on the Bank’s qualified small business lending at that time, as compared to the baseline; however, the dividend rate would increase to 7% only if the Bank’s rate of small business lending had stayed the same or decreased relative to the initial baseline.

Again assuming completion of the SBLF Program investment, based on the Bank’s current levels of small business lending, we expect that the SBLF Program preferred stock would carry a 5% dividend rate during the third quarter of 2011, but the rate would decrease to 1% for the fourth quarter of 2011 because of recent increases in qualified loans. Any such rate reduction would have a very positive effect on the Company’s net income available to common stockholders. Future preferred stock dividend rates will be determined quarterly and depend on the Bank’s level of qualified business lending.

Upon consummation of an SBLF Program investment and simultaneous repayment of the Company’s existing TARP Program investment, the Company plans to accelerate the accretion of its TARP Program preferred stock discount, which was $153,000 as of June 30, 2011, thereby reducing net income available to common stockholders by that amount in the third quarter of 2011, but eliminating any future accretion of the TARP Program preferred stock discount. All conditions and stipulations attached to the TARP Program preferred stock would be eliminated.

20

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 that 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, 2010, filed March 28, 2011.

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, including new regulations imposed by the Dodd-Frank Act;

• our ability to achieve financial goals and strategic plans;

• 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 June 30, 2011

Total Assets. The Company’s total assets decreased by $22.5 million, or 7.5%, from $298.8 million at June 30, 2010 to $276.3 million at June 30, 2011. The decrease in assets resulted primarily from a $39.9 million, or 49.9%, decrease in securities and cash in other banks, partially offset by $18.7 million, or 9.5%, increase in loans held for investment, net. Compared to December 31, 2010 total assets increased by $9.2 million, or 3.5%, mainly from increases in securities and cash in other banks.

Investments.Investment securities available for sale were $23.4 million at June 30, 2011 compared to $67.8 million at June 30, 2010, a decrease of $44.4 million, or 65.4%. Certificates of deposit, interest-bearing deposits in other banks, and federal funds sold increased by a total of $4.5 million from $12.1 million at June 30,

21

2010 to $16.6 million at June 30, 2011. The proceeds from net decreases in the total of investment securities, bank deposits, and federal funds sold were primarily used to fund new loans and repay outstanding borrowings. Compared to December 31, 2010, increases in cash and cash equivalents and securities were $10.3 million, generated by increases in deposits.

Loans. Loans held for investment, net, were $214.7 million at June 30, 2011, an increase of $18.7 million, or 9.5%, from the loan balance of $196.0 million at June 30, 2010. At December 31, 2010 loans held for investment, net were $214.3 million.

Asset Quality. Nonperforming assets were $1,732,000, or 0.63% of assets, at June 30, 2011, compared to no nonperforming assets at June 30, 2010. In addition to a bank branch site that we no longer plan to utilize, a total of $1.5 million in loans to one borrower were placed in nonaccrual status during the second quarter. These nonaccrual loans are secured by a multi-purpose, owner-occupied office building located in Hampton Roads, and the Bank has obtained an appraisal of the building that reflects current market conditions to assist the Bank in its determination of the appropriate carrying value for the loans. The only nonperforming asset at December 31, 2010 was the bank branch site that will not be utilized of $263,000.

Deposits. Total deposits at June 30, 2011 were $235.9 million compared to $234.4 million at June 30, 2010, an increase of $1.6 million, or 0.7%. Core deposits, which are comprised of noninterest-bearing, money market, NOW and savings deposits, increased by $3.2 million, or 1.7%, from $184.2 million at June 30, 2010 to $187.4 million at June 30, 2011. Compared to $224.1 million at December 31, 2010, deposits increased by $11.8 million, almost entirely from increases in core deposits.

Average total deposits increased by $11.4 million, or 5.2%, from $220.4 million for the six month period ended June 30, 2010 to $231.8 million for the six month period ended June 30, 2011. Average core deposits increased by $12.2 million over the comparable six-month periods. In addition, the mix of average noninterest-bearing deposits to average total deposits increased from 34.4% in the first six months of 2010 to 36.3% in the first six months of 2011, a factor that contributes to the improvement in our net interest margin.

Borrowed Funds. Borrowed funds decreased by $22.6 million, from $25.5 million at June 30, 2010 to $2.9 million at June 30, 2011. This reduction related primarily to a decrease of $23.5 million in Federal Home Loan Bank advances. Borrowed funds at December 31, 2010 were $3.5 million and consisted entirely of securities sold under agreements to repurchase and other borrowings.

Capital. Stockholders’ equity decreased by $1.7 million, or 4.5%, from $37.1 million at June 30, 2010 to $35.4 million at June 30, 2011. In March 2011, consistent with our strategic plan and with the approval of the U.S. Treasury, the Company redeemed 2,606 shares of Series A Preferred Stock, resulting in a decrease of $2.6 million in the outstanding balance of our TARP preferred stock. This decrease in stockholders’ equity was partially offset by an increase in retained earnings of $1.3 million between June 30, 2010 and June 30, 2011. At December 31, 2010 stockholders’ equity was $37.6 million.

Comparison of Operating Results for the Three Months Ended June 30, 2011 and 2010

Overview. The Company’s pretax income was $879,000 for the second quarter of 2011, compared to pretax income of $701,000 for the second quarter of 2010, an increase of $178,000. This increase resulted from a $363,000 increase in net interest income and a $148,000 decrease in provision for loan losses, partially offset by a decrease in noninterest income of $190,000 and a $143,000 increase in noninterest expense.

Net Interest Income. The Company’s net interest income before provision for loan losses increased by $363,000 to $2.7 million in the second quarter of 2011, compared to $2.4 million in the second quarter of 2010. This increase was primarily attributable to a $35.7 million increase in the average balance of our loan portfolio from $180.0 million in the second quarter of 2010 to $215.7 million in the second quarter of 2011. Our interest rate spread increased 58 basis points from 3.38% in the second quarter of 2010 to 3.96% in the second quarter of 2011, and our net interest margin increased 51 basis points from 3.78% in the second quarter of 2010 to 4.29% in the second quarter of 2011.

Provision for Loan Losses. A provision for loan losses of $11,000 was recorded for the second quarter of 2011, compared to a provision of $159,000 for the second quarter 2010, a decrease of $148,000.

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Noninterest Income. Total noninterest income decreased by $190,000, from $435,000 in the second quarter of 2010 to $245,000 in the second quarter of 2011, primarily attributable to a $145,000 reduction in gain on sale of investment securities, from $232,000 in the second quarter of 2010 to $87,000 in the second quarter of 2011.

Noninterest Expense. Total noninterest expense increased by $143,000 from $1.96 million in the second quarter of 2010 to $2.10 million in the second quarter of 2011. Additional expenses in compensation, hiring/recruiting fees and professional fees of $58,000, $40,000, and $30,000, respectively, were the primary contributors to this increase. A decrease in our FDIC assessment of $48,000 in the second quarter of 2011 compared to the second quarter of 2010 reflected changes in the insurance rate calculations adopted by the FDIC, but was offset by increases in other expenses.

Income Taxes. The Company’s income tax expense for the second quarter of 2011 was $288,000, reflecting an effective tax rate of 32.8%, compared to income tax expense of $250,000 for the second quarter of 2010, reflecting an effective tax rate of 35.6%. This reduction in effective tax rate is primarily attributable to an increase in tax-exempt interest income from certain loans.

Net Income Available to Common Stockholders. After the impact of dividends and accretion of the discount on our outstanding TARP preferred stock, net income available to common stockholders was $480,000 for the second quarter of 2011, compared to $305,000 for the second quarter of 2010, an increase of $175,000.

Comparison of Operating Results for the Six Months Ended June 30, 2011 and 2010

Overview. The Company’s pretax income was $1,712,000 for the first six months of 2011, compared to pretax income of $1,265,000 for the first six months of 2010, an increase of $447,000. This increase resulted from a $728,000 increase in net interest income and a $148,000 decrease in provision for loan losses, partially offset by a decrease in noninterest income of $459,000. Noninterest expense remained relatively stable between the two six month periods.

Net Interest Income. The Company’s net interest income before provision for loan losses increased by $728,000 to $5.47 million in the first six months of 2011, compared to $4.74 million in the first six months of 2010. Interest income in the first half of 2011 grew significantly, primarily due to a $36.0 million increase in our average loan portfolio compared to the first half of 2010. Our interest rate spread increased 55 basis points from 3.42% in the first half of 2010 to 3.97% in the first half of 2011, and our net interest margin increased 49 basis points from 3.82% in the first half of 2010 to 4.31% in the first half of 2011.

Provision for Loan Losses. A provision for loan losses of $11,000 was recorded for the first six months of 2011, compared to a provision of $159,000 for the first six months 2010.

Noninterest Income. Total noninterest income decreased by $459,000, from $889,000 in the first half of 2010 to $430,000 in the first half of 2011. The primary factor in this decrease was a $486,000 gain on the sale of investment securities in the first half of 2010, compared to a gain of only $87,000 in the first half of 2011.

Noninterest Expense. Total noninterest expense remained stable, reflecting a small decrease of $30,000 from $4.20 million in the first half of 2010 to $4.17 million in the first half of 2011. Decreases in compensation expense and our FDIC assessment of $88,000 and $46,000, respectively, were mostly offset by increases in professional fees and other expenses of $44,000 and $41,000, respectively.

Income Taxes. The Company’s income tax expense for the first half of 2011 was $561,000, reflecting an effective tax rate of 32.8%, compared to income tax expense of $452,000 for the first half of 2010, reflecting an effective tax rate of 35.8%. This reduction in effective tax rate was primarily attributable to an increase in tax-exempt interest income from certain loans.

Net Income Available to Common Stockholders. After the impact of dividends and accelerated accretion of the discount on our outstanding TARP preferred stock, net income available to common stockholders was $841,000 for the first half of 2011, compared to $520,000 for the first half of 2010. The Company repaid $2.6 million, or 25%, of its outstanding TARP preferred stock in March 2011, with a resulting decrease in net income available to common shareholders of $57,000 from the accelerated accretion of a portion of the discount on our outstanding TARP preferred stock.

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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 June  30, 2011		At June 30, 2010
	(in thousands)
Commitments to extend credit	$	34,959	$	35,942
Standby letters of credit		76		1,046
	$	35,035	$	36,988

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, certificates of deposit in other banks, unpledged 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 June 30, 2011, cash and cash equivalents and certificates of deposit at other banks were $21.8 million, an increase of $3.2 million from $18.6 million at December 31, 2010.

In addition, we maintain a liquid available-for-sale investment securities portfolio. At June 30, 2011, the balance of our unpledged available-for-sale investment portfolio was $21.4 million, compared to a $15.0 million balance at December 31, 2010. We also are able to obtain funds through approved borrowing lines with the Federal Home Loan Bank of Atlanta and other financial institutions. 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.

Capital Resources

The Company’s capital is reflected in its stockholders’ equity, which was $35.4 million at June 30, 2011, compared to $37.6 million at December 31, 2010, a decrease of $2.2 million. This decrease is primarily attributable to the $2.6 million partial redemption of our outstanding Series A Preferred Stock, described above, partially offset by an increase in retained earnings. At June 30, 2011, 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.

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.

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Item 4 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 June 30, 2011. 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 June 30, 2011 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.

There were no changes in the Company’s internal control over financial reporting in the quarter ended June 30, 2011 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)
August 9, 2011	/s/ Michael S. Ives
	Michael S. Ives,
	President & Chief Executive Officer
	(Principal Executive Officer)
August 9, 2011	/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.)
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.**
101	Interactive Data File#

* Indicates management contract or compensatory plan or arrangement.

** Filed herewith.

# Furnished herewith. In accordance with Rule 406T of Regulation S-T, the information in these exhibits shall not be deemed to be “filed” for purposes of Section 18 of the Exchange Act, or otherwise subject to liability under that section, and shall not be incorporated by reference into any registration statement or other document filed under the Securities Act of 1933, as amended, except as expressly set forth by specific reference in such filing.

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