Heritage Bankshares (HBKS) 10-Q 2011 Q3 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 September 30, 2011

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

For the transition period from                      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 2,303,107 shares of the registrant’s common stock were outstanding as of October 31, 2011.

TABLE OF CONTENTS

		Page No.
Part I.FINANCIAL INFORMATION
Item 1 -	Financial Statements (Unaudited)
Consolidated Balance Sheets September 30, 2011 and December 31, 2010			3
Consolidated Statements of Income Three and Nine Months Ended September 30, 2011 and 2010			4
Consolidated Statements of Cash Flows Nine Months Ended September 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		22
Item 3 -	Quantitative and Qualitative Disclosures About Market Risk		26
Item 4 -	Controls and Procedures		26
Part II.OTHER INFORMATION
Item 1 -	Legal Proceedings		26
Item 2 -	Unregistered Sales of Equity Securities and Use of Proceeds		27
Item 3 -	Defaults Upon Senior Securities		27
Item 4 -	(Removed and Reserved)		27
Item 5 -	Other Information		27
Item 6 -	Exhibits		27
Signatures			28

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Part I. FINANCIAL INFORMATION

Item 1 Financial Statements

HERITAGE BANKSHARES, INC.

CONSOLIDATED BALANCE SHEETS

	September 30, 2011 (Unaudited)		December  31, 2010 (Audited)
	(in thousands, except per share data)
ASSETS
Cash and due from banks	$	5,727	$	3,056
Interest-bearing deposits in other banks		19,658		12,923
Federal funds sold		31		401
Total cash and cash equivalents		25,416		16,380
Certificates of deposit in other banks		249		2,260
Securities available-for-sale, at fair value		41,834		17,368
Loans, net
Held for investment, net of allowance for loan losses of $2,153 and $2,090, respectively		214,342		214,342
Accrued interest receivable		717		668
Stock in Federal Reserve Bank (“FRB”), at cost		591		587
Stock in Federal Home Loan Bank of Atlanta (“FHLB”), at cost		1,094		1,773
Premises and equipment, net		11,031		11,165
Other real estate owned		288		263
Other assets		2,255		2,282
Total assets	$	297,817	$	267,088
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities
Deposits
Noninterest-bearing	$	92,326	$	85,308
Interest-bearing		165,270		138,794
Total deposits		257,596		224,102
FHLB advances		—		—
Other borrowings		859		1,087
Securities sold under agreements to repurchase		1,545		2,378
Accrued interest payable		94		100
Other liabilities		1,871		1,841
Total liabilities		261,965		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, 0 shares and 10,103 shares issued and outstanding at September 30, 2011 and December 31, 2010, respectively		—		10,103
Fixed rate cumulative perpetual preferred stock, Series B, 0 shares and 303 shares issued and outstanding at September 30, 2011 and December 31, 2010, respectively		—		303
Senior non-cumulative perpetual preferred stock, Series C, 7,800 shares and 0 shares issued and outstanding at September 30, 2011 and December 31, 2010, respectively		7,800		—
Common stock, $5 par value - 6,000,000 shares authorized; 2,303,107 shares and 2,307,502 shares issued and outstanding at September 30, 2011 and December 31, 2010, respectively		11,516		11,538
Additional paid-in capital		6,681		6,658
Retained earnings		9,455		8,801
Discount on preferred stock		—		(235	)
Accumulated other comprehensive income, net		400		412
Total stockholders’ equity		35,852		37,580
Total liabilities and stockholders’ equity	$	297,817	$	267,088

See accompanying notes to consolidated financial statements.

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HERITAGE BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

	Three Months  Ended September 30						Nine Months  Ended September 30
	2011			2010			2011			2010
	(in thousands, except share and per share data)
Interest and dividend income
Interest income and fees on loans	$	2,833		$	2,710		$	8,543		$	7,340
Interest on taxable investment securities		193			422			514			1,216
Dividends on FRB and FHLB stock		12			11			37			29
Interest on federal funds sold		—			—			—			1
Other interest income		25			32			75			97
Total interest income		3,063			3,175			9,169			8,683
Interest expense
Deposits		309			363			923			1,067
Borrowings		10			57			36			124
Total interest expense		319			420			959			1,191
Net interest income		2,744			2,755			8,210			7,492
Provision for loan losses		33			178			44			337
Net interest income after provision for loan losses		2,711			2,577			8,166			7,155
Noninterest income
Service charges on deposit accounts		87			113			259			344
Gain on sale of investment securities		—			278			87			764
Late charges and other fees on loans		25			39			57			71
Other		85			84			224			225
Total noninterest income		197			514			627			1,404
Noninterest expense
Compensation		1,090			1,078			3,283			3,358
Data processing		148			143			435			419
Occupancy		234			193			622			571
Furniture and equipment		142			141			438			442
Taxes and licenses		86			88			252			259
Professional fees		74			96			292			269
FDIC assessment		37			99			137			246
Marketing		34			31			113			96
Hiring and recruiting		—			—			42			34
Telephone		30			30			90			77
Loss on early extinguishment of debt		—			49			—			49
(Gain)/Loss on sale or impairment of other assets		—			—			1			30
Other		186			149			528			450
Total noninterest expense		2,061			2,097			6,233			6,300
Income before provision for income taxes		847			994			2,560			2,259
Provision for income taxes		299			346			861			799
Net income		548			648			1,699			1,460
Preferred stock dividends and accretion of discount		(252	)		(147	)		(562	)		(439	)
Net income available to common stockholders	$	296		$	501		$	1,137		$	1,021
Earnings per common share
Basic	$	0.13		$	0.22		$	0.49		$	0.44
Diluted	$	0.13		$	0.22		$	0.49		$	0.44
Dividends per common share	$	0.06		$	0.06		$	0.18		$	0.18
Weighted average common shares outstanding - basic		2,303,107			2,307,141			2,305,652			2,300,109
Effect of dilutive stock options		13,441			5,962			11,246			5,991
Weighted average common shares outstanding - diluted		2,316,548			2,313,103			2,316,898			2,306,100

See accompanying notes to consolidated financial statements.

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HERITAGE BANKSHARES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

	Nine Months  Ended September 30,
	2011			2010
	(in thousands)
Cash flows from operating activities:
Net income	$	1,699		$	1,460
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan loss		44			337
Amortization of loan yield adjustments, net		242			266
Depreciation, amortization and accretion, net		451			674
Stock-based compensation		68			106
Deferred compensation		28			31
Exercise of stock options tax benefit		—			31
Net (gains) losses on:
Sale of securities		(87	)		(764	)
Sale, disposal or impairment of property, plant and equipment		—			3
Sale or impairment of other real estate owned		—			30
Increase in bank owned life insurance		(13	)		(13	)
Changes in assets/liabilities, net
(Increase) decrease in interest receivable and other assets		(3	)		201
Increase in interest payable and other liabilities		3			56
Net cash provided by operating activities		2,432			2,418
Cash flows from investing activities:
Proceeds from maturities and principal repayments of securities available for sale		6,487			34,036
Purchases of securities available for sale		(36,921	)		(46,053	)
Proceeds from sales of securities available for sale		6,005			38,361
Net decrease in certificates of deposit at other banks		2,011			1,442
Proceeds from the sale of other real estate owned		—			283
Net increase in loans held for investment		(311	)		(26,673	)
Purchases of Federal Home Loan Bank stock and Federal Reserve Bank stock		(4	)		(439	)
Redemption of Federal Home Loan Bank stock and Federal Reserve Bank stock		679			71
Purchases of premises and equipment		(292	)		(113	)
Net cash provided by/(used for) investing activities		(22,346	)		915
Cash flows from financing activities:
Proceeds from exercise of stock options		—			93
Net increase in deposits		33,494			4,452
Proceeds from Federal Home Loan Bank advances		31,150			101,355
Repayments of Federal Home Loan Bank advances		(31,150	)		(101,355	)
Net increase (decrease) in securities sold under agreements to repurchase		(833	)		411
Repayments of other borrowings		(228	)		—
Proceeds from other borrowings		—			1,160
Proceeds from issuance of preferred stock		7,788			—
Repurchase of preferred stock		(10,406	)		—
Repurchase of common stock		(55	)		—
Cash dividends paid		(810	)		(813	)
Net cash provided by financing activities		28,950			5,303
Increase in cash and cash equivalents		9,036			8,636
Cash and cash equivalents, beginning of period		16,380			22,004
Cash and cash equivalents, end of period	$	25,416		$	30,640
Supplemental disclosure:
Interest paid	$	965		$	1,196
Income taxes paid	$	1,079		$	913
Noncash financing activities:
Transfer of loans to other real estate owned	$	25		$	—

See accompanying notes to consolidated financial statements.

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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.

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The Bank then considers the impact of various bank, industry, economic and other environmental factors and documents, which are further used in the analysis.

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 has 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 have been presented in Note 7 to our Financial Statements below.

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. This amendment has no impact on the Company’s financial statements at September 30, 2011.

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

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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 September 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		3,600		13.63		—		—
Outstanding at September 30, 2011		237,800	$	12.61		4.9	$	172
Exercisable at September 30, 2011		211,400	$	12.68		4.8	$	147

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 September 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 nine months ended September 30, 2011. The aggregate intrinsic value of options exercised during the nine months ended September 30, 2010 was $91,686. Cash received from exercises of options during the first nine months of 2010 was $93,050.

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The amount charged against income, before income tax benefit of $1,423, in relation to stock-based payment arrangements was $67,642 for the nine months ended September 30, 2011. The amount charged against income, before income tax benefit of $8,114, in relation to stock-based payment arrangements was $106,038 for the nine months ended September 30, 2010. At September 30, 2011, unrecognized compensation expense, net of estimated forfeitures, related to unvested stock option grants was $38,658 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 September 30, 2011:
2011	$	17
2012		18
2013		4
Total	$	39

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						Nine Months Ended
	September 30, 2011			September 30, 2010			September 30, 2011			September 30, 2010
	(in thousands)
Unrealized holding gains on available-for-sale securities	$	191		$	50		$	69		$	389
Realized gains on sales of available-for-sale securities		—			(278	)		(87	)		(764	)
Tax effect on realized gains		—			94			29			259
Tax effect on unrealized gains		(65	)		(17	)		(23	)		(132	)
Other comprehensive income (loss), net of tax	$	126		$	(151	)	$	(12	)	$	(248	)

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				Nine Months Ended
	September 30, 2011		September 30, 2010		September 30, 2011		September 30, 2010
	(in thousands, except share and per share data)
Net income available to common stockholders (numerator, basic and diluted)	$	296	$	501	$	1,137	$	1,021
Weighted average common shares outstanding (denominator)		2,303,107		2,307,141		2,305,652		2,300,109
Earnings per common share - basic	$	0.13	$	0.22	$	0.49	$	0.44
Effect of dilutive securities
Weighted average common shares outstanding during the period		2,303,107		2,307,141		2,305,652		2,300,109
Effect of dilutive stock options		13,441		5,962		11,246		5,991
Weighted diluted average common shares outstanding (denominator) during the period		2,316,548		2,313,103		2,316,898		2,306,100
Earnings per common share - assuming dilution	$	0.13	$	0.22	$	0.49	$	0.44

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.

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

	At September 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	$	25,385	$	25,385	$	15,979	$	15,979
Federal funds sold		31		31		401		401
Certificates of deposit in other banks		249		249		2,260		2,260
Securities available for sale		41,834		41,834		17,368		17,368
Loans held for investment		214,342		218,671		214,342		217,450
Accrued interest receivable		717		717		668		668
Stock in FRB and FHLB		1,685		1,685		2,360		2,360
Bank-owned life insurance		597		597		584		584
Other financial assets		197		197		148		148
Financial liabilities:
Deposits		257,596		257,872		224,102		224,337
Securities sold under agreements to repurchase		1,545		1,545		2,378		2,378
Other borrowings		859		888		1,087		1,104
Accrued interest payable		94		94		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 by 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 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.

10

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

September 30, 2011 in thousands	Total		Level 1		Level 2		Level 3
Investment in securities available for sale
U.S. Treasury notes	$	2,043	$	—	$	2,043	$	—
U.S. Government agencies		29,060		—		29,060		—
Mortgage-backed securities		10,731		—		10,731		—
Other financial assets		197		—		197		—
Total Assets at Fair Value	$	42,031	$	—	$	42,031	$	—

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

September 30, 2011 in thousands	Total		Level 1		Level 2		Level 3
Impaired loans	$	1,410	$	—	$	1,410	$	—
Other real estate owned		288		—		288		—
Total Assets at Fair Value	$	1,698	$	—	$	1,698	$	—

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	$	—

11

Note 6 – Securities

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
	(in thousands)
At September 30, 2011
Securities available for sale
U.S. Treasury notes	$	2,004	$	39	$	—	$	2,043
U.S. Government agencies		29,000		125		65		29,060
Mortgage-backed securities		10,224		507		—		10,731
Total securities available for sale	$	41,228	$	671	$	65	$	41,834
Total securities(1)	$	41,228	$	671	$	65	$	41,834
	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 September 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 September 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.

	At September 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. Government agencies	$	9,935	$	65	$	—	$	—	$	9,935	$	65
Mortgage-backed securities		—		—		—		—		—		—
Total temporarily impaired securities	$	9,935	$	65	$	—	$	—	$	9,935	$	65

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

12

The amortized cost and fair value of investment securities at September 30, 2011, by contractual maturity, are reflected 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		8,626		8,975
Due after five years through ten years		32,602		32,859
Due after ten years		—		—
Total	$	41,228	$	41,834

There were no sales of securities available for sale in the third quarter of 2011, and gross proceeds from sales of securities available for sale were $6,005,000 for the nine month period ended September 30, 2011. Gross realized gains associated with these sales were $87,000; there have been no gross losses during 2011. Gross proceeds from sales of securities available for sale in the quarter ended September 30, 2010 were $28,208,000, accumulating to $38,361,000 for the nine months ended September 30, 2010. Gross realized gains associated with these sales were $278,000 and $764,000, respectively, for the quarter and nine months ended September 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:

	September 30, 2011			December 31, 2010
	(in thousands)
Commercial	$	35,194		$	37,354
Real estate - commercial		112,576			101,080
Real estate - consumer		52,613			55,694
Real estate - construction		11,522			18,389
Consumer		4,590			3,915
Total loans		216,495			216,432
Allowance for loan losses		(2,153	)		(2,090	)
Loans, net(1)	$	214,342		$	214,342

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

Nonperforming assets at the dates indicated were:

	September 30, 2011		December 31, 2010
	(in thousands)
Nonaccrual loans:
Commercial	$	—	$	—
Real estate - commercial		1,465		—
Real estate - consumer		—		—
Real estate - construction		—		—
Consumer		—		—
Total nonaccrual loans		1,465		—
Accruing loans past due 90 days or more		—		—
Total nonperforming loans		1,465		—

13

	September 30, 2011		December 31, 2010
	(in thousands)
Real estate owned, net		288		263
Total nonperforming assets	$	1,753	$	263

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

	At September 30
	2011		2010
	(in thousands)
Balance, beginning of year	$	2,090	$	1,773
Provision for loan losses		44		337
Loans charged-off
Commercial		1		13
Real estate - commercial		—		—
Real estate - consumer		—		83
Real estate - construction		29		—
Consumer		1		13
Total loans charged-off		31		109
Recoveries
Commercial		2		13
Real estate - commercial		—		—
Real estate - consumer		48		—
Real estate - construction		—		—
Consumer		—		12
Total loans recovered		50		25
Net recoveries/(charge-offs)		19		(84	)
Balance, end of period	$	2,153	$	2,026

The following table presents the aging analysis of the Company’s loan portfolio at September 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	$	—	$	—	$	—	$	—	$	—	$	35,194	$	35,194	$	—
Real estate - commercial		—		—		—		—		1,465		111,111		112,576		—
Real estate - consumer		501		—		—		501		—		52,112		52,613		—
Real estate - construction		—		—		—		—		—		11,522		11,522		—
Consumer		—		—		—		—		—		4,590		4,590		—
Total	$	501	$	—	$	—	$	501	$	1,465	$	214,529	$	216,495	$	—

14

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 September 30, 2011:

	Commercial		Real Estate Commercial		Real Estate Construction		Total
	(in thousands)
Category:
Normal review	$	35,194	$	111,111	$	11,522	$	157,827
Closely monitored		—		—		—		—
In collection		—		1,465		—		1,465
Total	$	35,194	$	112,576	$	11,522	$	159,292

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.

15

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

	Commercial		Real Estate Commercial		Real Estate Construction		Total
	(in thousands)
Grade:
Pass	$	35,181	$	110,407	$	10,198	$	155,786
Substandard		13		2,169		1,324		3,506
Doubtful		—		—		—		—
Loss		—		—		—		—
Total	$	35,194	$	112,576	$	11,522	$	159,292

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.

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

	Consumer Mortgages		Installment and Other Consumer		Total
	(in thousands)
Performing	$	52,613	$	4,590	$	57,203
Nonperforming		—		—		—
Total	$	52,613	$	4,590	$	57,203

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

16

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 September 30, 2011:

		00000000		00000000			00000000		00000000		00000000		00000000		00000000
	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	$	—	$	55	(1)	$	—	$	—	$	—	$	—	$	55
Ending balance:
Collectively evaluated for impairment		308		972			480		101		40		197		2,098
Ending balance:
Loans acquired with deteriorated credit		—		—			—		—		—		—		—
Total Ending Balance	$	308	$	1,027		$	480	$	101	$	40	$	197	$	2,153

		00000000		00000000			00000000		00000000		00000000		00000000		00000000
	Commercial		Real Estate Commercial			Real Estate Consumer		Real Estate Construction		Consumer		Unallocated		Total
	(in thousands)
Total loans:
Ending balance:
Individually evaluated for impairment	$	—	$	1,465	(1)	$	—	$	—	$	—	$	—	$	1,465
Ending balance:
Collectively evaluated for impairment		35,194		111,111			52,613		11,522		4,590		—		215,030
Ending balance:
Loans acquired with deteriorated credit		—		—			—		—		—		—		—
Total Ending Balance	$	35,194	$	112,576		$	52,613	$	11,522	$	4,590	$	—	$	216,495

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

		00000000		00000000		00000000		00000000		00000000		00000000		00000000
	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

		00000000		00000000		00000000		00000000		00000000		00000000		00000000
	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.

18

The following table reflects the average daily recorded investment in impaired loans as of September 30, 2011 and interest income recognized on those loans for the nine month period ending September 30, 2011:

	Recorded Investment		Unpaid Principal 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		—		—		—		19		—
Consumer		—		—		—		—		—
Total	$	—	$	—	$	—	$	19	$	—
With an allowance recorded:
Commercial	$	—	$	—	$	—	$	—	$	—
Real estate - commercial		1,465		1,466		55		480		—
Real estate - consumer		—		—		—		—		—
Real estate - construction		—		—		—		—		—
Consumer		—		—		—		—		—
Total	$	1,465	$	1,466	$	55	$	480	$	—
Total
Commercial	$	—	$	—	$	—	$	—	$	—
Real estate - commercial		1,465		1,466		55		480		—
Real estate - consumer		—		—		—		—		—
Real estate - construction		—		—		—		19		—
Consumer		—		—		—		—		—
Total	$	1,465	$	1,466	$	55	$	499	$	—

The following table 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

19

The following table presents troubled loans that were restructured during the three and nine month periods ended September 30, 2011 and the types of concessions granted.

Three months ended September 30, 2011

Nine months ended September 30, 2011

Number of loans

Pre- modification Outstanding Recorded Investment

Post- modification Outstanding Recorded Investment

Number of loans

Pre- modification Outstanding Recorded Investment

Post- modification Outstanding Recorded Investment

Below market interest rate:

Commercial

—

$

—

$

—

—

$

—

$

—

Real estate - commercial

—

—

—

—

—

—

Real estate - consumer

—

—

—

—

—

—

Real estate - construction

—

—

—

—

—

—

Consumer

—

—

—

—

—

—

Total

—

$

—

$

—

—

$

—

$

—

Extended payment terms:

Commercial

—

$

—

$

—

—

$

—

$

—

Real estate - commercial

—

—

—

—

—

—

Real estate - consumer

—

—

—

—

—

—

Real estate - construction

—

—

—

—

—

—

Consumer

—

—

—

—

—

—

Total

—

$

—

$

—

—

$

—

$

—

Forgiveness of principal:

Commercial

—

$

—

$

—

—

$

—

$

—

Real estate - commercial

—

—

—

—

—

—

Real estate - consumer

—

—

—

—

—

—

Real estate - construction

—

—

—

—

—

—

Consumer

—

—

—

—

—

—

Total

—

$

—

$

—

—

$

—

$

—

Total

—

$

—

$

—

—

$

—

$

—

During the three and nine month periods ended September 30, 2011, no loans that had been restructured during the prior twelve months went into default.

	Three months ended September 30, 2011				Nine months ended September 30, 2011
	Number of loans		Recorded Investment		Number of loans		Recorded Investment
Troubled Debt Restructurings that Subsequently Defaulted:
Commercial		—	$	—		—	$	—
Real estate - commercial		—		—		—		—
Real estate - consumer		—		—		—		—
Real estate - construction		—		—		—		—
Consumer		—		—		—		—
Total		—	$	—		—	$	—

At the time of restructuring, loans that are considered troubled are evaluated for impairment allowances based on collateral value, expected cash flows and/or financial strength of the borrower. Any such loan deemed impaired is assigned a specific allowance in the calculation of allowance for loan losses. If there are subsequent payment defaults on troubled debt restructured loans, additional evaluations are conducted to determine impairment levels.

Note 8 – TARP Program Repayment and Participation in Small Business Loan 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.

20

On August 11, 2011, the Company completed a $7.8 million investment transaction under the Small Business Lending Fund program (the “SBLF Program”). The SBLF Program is a voluntary program authorized under the Small Business Jobs Act of 2010 which 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 by providing capital to qualified community banks at favorable rates.

Simultaneously with its closing of the SBLF Program transaction, the Company used the SBLF Program investment proceeds to redeem (repay) the full remaining balance of $7.8 million of shares of TARP Program preferred stock held by the Treasury, thereby satisfying its remaining financial obligations under and otherwise ending its participation in the TARP Program.

In the SBLF Program transaction, the Company issued to the Secretary of the Treasury 7,800 shares of a newly-created series of preferred stock. For the initial 2.5 years after the SBLF Program investment, the dividend rate payable on the SBLF Program preferred stock will 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 will be fixed at between 1% and 7% based on the Bank’s qualified small business lending at that time, as compared to the initial baseline; however, the dividend rate increases to 7% only if the Bank’s rate of small business lending stays the same or decreases relative to the baseline.

Based on the Bank’s initial level of small business lending compared to the baseline, the SBLF Program preferred stock carried a 5% dividend rate during the third quarter of 2011. However, due to recent increases in qualified loans, the Company currently expects that the dividend rate will decrease to 1% for the fourth quarter of 2011. Any such rate reduction would have a positive effect on the Company’s net income available to common stockholders. As noted above, subsequent dividend rates on the SBLF Program preferred stock will depend on the Bank’s level of qualified small business lending.

In light of consummation of the SBLF Program investment transaction and simultaneous repayment of its remaining TARP Program investment, the Company has accelerated 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.

21

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 with the Securities and Exchange Commission on 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;

• our participation in the Small Business Lending Fund 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 September 30, 2011

Total Assets. The Company’s total assets increased by $16.4 million, or 5.8%, from $281.4 million at September 30, 2010 to $297.8 million at September 30, 2011. The increase in assets resulted primarily from a $10.4 million, or 18.3%, increase in our aggregate cash, securities available for sale, interest-bearing deposits in other banks and federal funds sold and a $6.7 million, or 3.2%, increase in the balance of our loan portfolio. As compared to December 31, 2010, total assets increased by $30.7 million, or 11.5% at September 30, 2011, driven primarily by increases in cash and cash equivalents and investment securities available for sale.

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Investments.Investments in certain securities available for sale late in the third quarter increased our portfolio by $17.9 million, or 75.0%, to $41.8 million at September 30, 2011 compared to $23.9 million at September 30, 2010. Certificates of deposit, interest-bearing deposits in other banks, and federal funds sold decreased by a total of $9.2 million from $29.1 million at September 30, 2010 to $19.9 million at September 30, 2011. Compared to December 31, 2010 securities available for sale and other interest-earning assets (excluding loans) increased by $28.2 million from $35.3 million to $63.5 million at September 30, 2011 primarily as a result of a $33.5 million increase in deposit balances.

Loans. Loans held for investment, net, were $214.3 million at September 30, 2011, an increase of $6.7 million, or 3.2%, from the loan balance of $207.6 million at September 30, 2010. Loans held for investment were unchanged at September 30, 2011 compared to December 31, 2010.

Asset Quality. Nonperforming assets were $1,753,000, or 0.59% of assets, at September 30, 2011, compared to $60,000 of nonperforming assets at September 30, 2010. In addition to a bank branch site that we no longer plan to utilize, we obtained an additional property during the third quarter through foreclosure proceedings against one borrower. 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. At December 31, 2010, nonperforming assets contained only a bank branch site that will not be utilized.

Deposits. Total deposits at September 30, 2011 were $257.6 million compared to $233.6 million at September 30, 2010, an increase of $24.0 million, or 10.3%. Core deposits, which are comprised of noninterest-bearing, money market, NOW and savings deposits, increased by $24.0 million, or 13.0%, from $184.2 million at September 30, 2010 to $208.2 million at September 30, 2011. Total deposits increased by $33.5 million, or 14.9%, compared to $224.1 million at December 31, 2010, attributable almost entirely to core deposits.

Average total deposits increased by $9.2 million, or 4.0%, from $228.2 million for the nine month period ended September 30, 2010 to $237.4 million for the nine month period ended September 30, 2011. Average core deposits increased by $9.3 million over the comparable nine-month periods. In addition, the mix of average noninterest-bearing deposits to average total deposits increased from 33.9% in the first nine months of 2010 to 36.3% in the first nine months of 2011, a factor that contributes to the improvement in our net interest margin.

Borrowed Funds. Borrowed funds decreased by $6.2 million, from $8.6 million at September 30, 2010 to $2.4 million at September 30, 2011. During the third quarter of 2010, the company repaid a $10.0 million, 2.40% fixed rate, medium term advance from the Atlanta Federal Home Loan Bank, incurring a $49,000 loss on extinguishment of debt. Compared to $3.5 million at December 31, 2010, borrowed funds decreased by $1.1 million at September 30, 2011.

Capital. Stockholders’ equity decreased by $1.5 million, or 4.2%, from $37.4 million at September 30, 2010 to $35.9 million at September 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. During the third quarter of 2011, the Company sold to the U. S. Treasury $7.8 million of non-cumulative preferred stock in connection with our participation in the SBLF program. The Company used the proceeds from this transaction to redeem the balance of our outstanding TARP preferred stock of $7.8 million. The resulting $2.4 million reduction in stockholders’ equity from the decrease in the balance of preferred stock was partially offset by an increase in retained earnings of $1.0 million between September 30, 2010 and September 30, 2011. Stockholders’ equity decreased by $1.7 million, from $37.6 million at December 31, 2010 attributable to the same variables as described above.

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

Overview. The Company’s pretax income was $847,000 for the third quarter of 2011, compared to pretax income of $994,000 for the third quarter of 2010, a decrease of $147,000. This decrease resulted primarily from $278,000 in gains on sales of securities occurring in the third quarter of 2010 that did not recur in the third quarter of 2011, partially offset by a $145,000 decrease in provision for loan losses.

Net Interest Income. The Company’s net interest income before provision for loan losses remained virtually unchanged comparing the third quarters of 2011 and 2010. Our average loan portfolio increased by $13.8 million from $200.5 million in the third quarter of 2010 to $214.3 million in the third quarter of 2011, while our average investment in securities available for sale and other interest-earning assets (excluding loans) decreased by $27.6 million for a net reduction in interest-earning assets of $13.8 million. Average interest-bearing liabilities

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decreased by $22.5 million from the third quarter of 2010 to $160.6 million in the third quarter of 2011, resulting primarily from reductions in average interest bearing deposits of $5.6 million and borrowings of $16.9 million. Our interest rate spread increased 21 basis points from 3.52% in the third quarter of 2010 to 3.73% in the third quarter of 2011. Our net interest margin increased 21 basis points from 3.84% in the third quarter of 2010 to 4.05% in the third quarter of 2011, due to the increase in interest rate spread as well as an increase of $10.4 million in average noninterest-bearing deposits.

Provision for Loan Losses. A provision for loan losses of $33,000 was recorded for the third quarter of 2011, compared to a provision of $178,000 for the third quarter 2010, a decrease of $145,000. The provision for loan losses in the third quarter at 2010 related primarily to increases in loans outstanding.

Noninterest Income. Total noninterest income decreased by $317,000, from $514,000 in the third quarter of 2010 to $197,000 in the third quarter of 2011, with this reduction primarily attributable to $278,000 in gains on sale of investment securities in the third quarter of 2010 that did not recur in the third quarter of 2011.

Noninterest Expense. Total noninterest expense remained stable, reflecting a small decrease of $36,000 from $2.097 million for the third quarter of 2010 to $2.061 million for the third quarter of 2011. During the third quarter of 2011, additional expenses for rent, supplies, and other expenses of $38,000 were incurred to open the new Greenbrier branch and compensation expense included a $21,000 cumulative adjustment for prior periods for stock option forfeiture estimates. These increases were more than offset by decreases in the FDIC assessment and professional fees of $62,000 and $22,000, respectively. In addition, there was a loss of $49,000 on the early extinguishment of debt in the third quarter of 2010 that did not recur in 2011.

Income Taxes. The Company’s income tax expense for the third quarter of 2011 was $299,000, reflecting an effective tax rate of 35.3%, compared to income tax expense of $346,000 for the third quarter of 2010, reflecting an effective tax rate of 34.9%. This increase in effective tax rate is primarily attributable to the impact on tax from the nondeductible cumulative adjustment for stock option forfeitures and to adjustments to tax estimated expense from prior periods based on actual taxes paid.

Net Income Available to Common Stockholders. Because of the refinancing of our outstanding TARP preferred stock with SBLF preferred stock, the remaining unaccreted discount associated with the TARP preferred stock was expensed during the third quarter of 2011, reducing net income available to shareholders by $153,000. After the impact of this accelerated accretion of the discount on our preferred stock and our preferred stock dividends, net income available to common stockholders was $296,000 for the third quarter of 2011, compared to $501,000 for the third quarter of 2010, a decrease of $205,000.

Comparison of Operating Results for the Nine Months Ended September 30, 2011 and 2010

Overview. The Company’s pretax income was $2.56 million for the first nine months of 2011, compared to pretax income of $2.26 million for the first nine months of 2010, an increase of $301,000. This increase resulted from a $718,000 increase in net interest income, a $293,000 decrease in provision for loan losses, and a decrease in noninterest expense of $67,000, the total of which was partially offset by a $677,000 decrease in gains on sales of securities from $764,000 in 2010 to $87,000 in 2011.

Net Interest Income. The Company’s net interest income before provision for loan losses increased by $718,000 to $8.2 million in the first nine months of 2011, compared to $7.5 million in the first nine months of 2010. Interest income in the first nine months of 2011 grew significantly, primarily due to a change in the mix in our average interest-earning assets from securities into loans. We reduced the average balance of securities available for sale and other interest-earning assets (excluding loans) from $74.9 million in the first nine months of 2010 to $47.1 million in the first nine months of 2011. At the same time we increased our average loan portfolio by $28.5 million compared to the first nine months of 2010. Our interest rate spread increased 42 basis points from 3.46% in the first nine months of 2010 to 3.88% in the first nine months of 2011, and our net interest margin increased 39 basis points from 3.83% in the first nine months of 2010 to 4.22% in the first nine months of 2011.

Provision for Loan Losses. A provision for loan losses of $44,000 was recorded for the first nine months of 2011, compared to a provision of $337,000 for the first nine months 2010, which related primarily to the substantial increase in the outstanding balance of our loan portfolio during 2010.

Noninterest Income. Total noninterest income decreased by $777,000, from $1.4 million in the first nine months of 2010 to $627,000 in the first nine months of 2011. The primary factor in this decrease was $764,000 of gains on the sales of investment securities in the first nine months of 2010, compared to a gain of only $87,000 in the first nine months of 2011.

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Noninterest Expense. Total noninterest expense decreased by $67,000 from $6.30 million in the first nine months of 2010 to $6.23 million in the first nine months of 2011. Decreases in compensation expense, FDIC assessment, and loss on early extinguishment of debt of $75,000, $109,000, and $49,000, respectively, were partially offset by increases in occupancy and other expenses of $51,000 and $78,000, respectively.

Income Taxes. The Company’s income tax expense for the first nine months of 2011 was $861,000, reflecting an effective tax rate of 33.6%, compared to income tax expense of $799,000 for the first nine months of 2010, reflecting an effective tax rate of 35.4%. 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. 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 the corresponding discount on our outstanding TARP preferred stock. During the third quarter of 2011, we redeemed our remaining TARP preferred stock with the proceeds of $7.8 million of non-cumulative preferred stock issued in connection with our participation in the SBLF program, expensing the remaining net discount, and reducing income available to common shareholders by a total of $153,000 in the third quarter of 2011. Even after the impact of preferred stock dividends and accelerated accretion of the entire discount on our TARP preferred stock, net income available to common stockholders was $1.137 million for the first nine months of 2011, compared to $1.021 million for the first nine months of 2010, an increase of $116,000.

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 September  30, 2011		At September  30, 2010
	(in thousands)
Commitments to extend credit	$	31,524	$	35,713
Standby letters of credit		76		221
	$	31,600	$	35,934

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 September 30, 2011, cash and cash equivalents and certificates of deposit in other banks were $25.7 million, an increase of $7.0 million from $18.7 million at December 31, 2010.

In addition, we maintain a liquid available-for-sale investment securities portfolio. At September 30, 2011, the balance of our unpledged available-for-sale investment portfolio was $40.3 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

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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 $35.9 million at September 30, 2011, compared to $37.6 million at December 31, 2010, a decrease of $1.7 million. This decrease is primarily attributable to the $2.6 million partial redemption of our outstanding TARP Series A Preferred Stock in March of this year, followed by participation in the SBLF program which was consummated in August of this year, the proceeds from which were used to redeem the entire remaining balance of our TARP Series A and Series B Preferred Stock, as described above, partially offset by an increase in retained earnings. At September 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.

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 September 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 September 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 September 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.

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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)
November 10, 2011	/s/ Michael S. Ives
	Michael S. Ives,
	President & Chief Executive Officer
	(Principal Executive Officer)
November 10, 2011	/s/ John O. Guthrie
	John O. Guthrie,
	Chief Financial Officer
	(Principal Financial and Accounting Officer)

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Index to Exhibits

Exhibit No.	Description
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 SBLF Preferred Shares. (Incorporated herein by reference to the Company’s Form 8-K filed on August 11, 2011.)
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.)
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	Securities Purchase Agreement, dated August 11, 2011, between Heritage Bankshares, Inc. and the Secretary of the Treasury. (Incorporated herein by reference to the Company’s Form 8-K filed on August 11, 2011.)
10.23	Repurchase Document, dated August 11, 2011, 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 August 11, 2011.)
*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.)
*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.

** Indicates filed herewith.

# Indicates 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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