Merchants Bancshares 10-Q 2016 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

[ X ] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2016

or

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

For the transition period from           to

Commission File Number:

0-11595

Merchants Bancshares, Inc.

(Exact name of registrant as specified in its charter)

Delaware	03-0287342
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification No.)
275 Kennedy Drive, South Burlington, VT	05403
(Address of principal executive offices)	(Zip Code)

802-658-3400

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

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.  [ X ] Yes   [   ] 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).  [X] Yes   [   ] No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a nonaccelerated 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.

Large Accelerated Filer [   ] Accelerated Filer [ X ] Nonaccelerated Filer [   ] Smaller Reporting Company [   ]

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

As of October 24, 2016, there were 6,885,686 shares of the registrant’s common stock, par value $0.01 per share, outstanding.

MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES

FORM 10-Q

TABLE OF CONTENTS

		Page Reference
PART I	FINANCIAL INFORMATION
Item 1	Financial Statements	3
	Consolidated Balance Sheets (Unaudited)	3
	Consolidated Statements of Income (Unaudited)	4
	Consolidated Statements of Comprehensive Income (Unaudited)	5
	Consolidated Statements of Cash Flows (Unaudited)	6
	Notes to Interim Unaudited Consolidated Financial Statements	7
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	35
Item  3	Quantitative and Qualitative Disclosures about Market Risk	51
Item 4	Controls and Procedures	54
PART II	OTHER INFORMATION
Item 1	Legal Proceedings	55
Item 1a	Risk Factors	55
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	56
Item 3	Defaults on Senior Securities	56
Item 4	Mine Safety Disclosure	57
Item 5	Other Information	57
Item 6	Exhibits	58
	Signatures	59

2

MERCHANTS BANCSHARES, INC.

PART I – FINANCIAL INFORMATION

Item 1 – Financial Statements

Merchants Bancshares, Inc.

Consolidated Balance Sheets

(Unaudited)

	September 30,		December 31,
(In thousands except share and per share data)	2016		2015
ASSETS
Cash and due from banks	$	31,166	$	30,605
Interest earning deposits with banks and other short-term investments		47,551		119,578
Total cash and cash equivalents		78,717		150,183
Investments:
Securities available for sale, at fair value (amortized cost of $294,572 and $283,185)		298,973		283,454
Securities held to maturity (fair value of $93,018 and $120,093)		90,672		119,674
Total investments		389,645		403,128
Loans		1,477,285		1,414,280
Less: Allowance for loan losses		12,540		12,040
Net loans		1,464,745		1,402,240
Federal Home Loan Bank stock		4,844		3,797
Bank premises and equipment, net		13,624		15,030
Investment in real estate limited partnerships		5,352		5,687
Bank owned life insurance		10,709		10,551
Core deposit intangible		1,207		1,360
Goodwill		7,011		6,967
Other assets		18,801		22,294
Total assets	$	1,994,655	$	2,021,237
LIABILITIES
Deposits:
Demand (noninterest bearing)	$	632,847	$	631,244
Savings, interest bearing checking and money market accounts		661,962		665,623
Time deposits		209,031		254,572
Total deposits		1,503,840		1,551,439
Short-term borrowings		22,000		—
Securities sold under agreement to repurchase, short-term		276,083		286,639
Other long-term debt		3,673		5,238
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		20,619
Other liabilities		10,153		9,248
Total liabilities		1,836,368		1,873,183
STOCKHOLDERS' EQUITY
Preferred stock
Class A non-voting shares authorized - 200,000, none outstanding		—		—
Class B voting shares authorized - 1,500,000, none outstanding		—		—
Common stock, $.01 par value		72		72
Authorized: 10,000,000 shares; Issued: 7,180,616 at September 30, 2016 and 7,168,869 at December 31, 2015
Outstanding: 6,883,644 at September 30, 2016 and 6,855,294 at December 31, 2015
Capital in excess of par value		55,356		55,063
Retained earnings		112,218		106,219
Treasury stock, at cost: 582,106 shares including 285,134 shares held by the Compensation Plan for Directors and Trustees at September 30, 2016 and 612,935 shares including 299,360 shares held by the Compensation Plan for Directors and Trustees at December 31, 2015		(13,438)		(13,798)
Deferred compensation arrangements: 285,134 shares at September 30, 2016 and 299,360 shares at December 31, 2015		6,352		6,521
Accumulated other comprehensive loss		(2,273)		(6,023)
Total stockholders' equity		158,287		148,054
Total liabilities and stockholders' equity	$	1,994,655	$	2,021,237

See accompanying notes to unaudited consolidated financial statements

3

Merchants Bancshares, Inc.

Consolidated Statements of Income

(Unaudited)

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(In thousands except per share data)	2016		2015		2016		2015
INTEREST AND DIVIDEND INCOME
Interest and fees on loans	$	13,058	$	11,055	$	38,759	$	32,478
Investment income:
Interest and dividends on investment securities		1,818		1,961		5,803		5,784
Interest on interest earning deposits with banks and other short-term investments		54		25		193		157
Total interest and dividend income		14,930		13,041		44,755		38,419
INTEREST EXPENSE
Savings, interest bearing checking and money market accounts		413		354		1,277		1,075
Time deposits		321		318		1,052		975
Short-term borrowings		79		8		110		13
Securities sold under agreement to repurchase, short-term		107		89		319		390
Long-term debt		213		199		637		595
Total interest expense		1,133		968		3,395		3,048
Net interest income		13,797		12,073		41,360		35,371
Provision for credit losses		500		150		905		250
Net interest income after provision for credit losses		13,297		11,923		40,455		35,121
NONINTEREST INCOME
Trust division income		843		886		2,545		2,666
Net debit card income		765		796		2,226		2,301
Overdraft income		667		548		1,975		1,327
Service charges on deposits		427		390		1,266		1,108
Other		429		829		1,264		1,470
Total noninterest income		3,131		3,449		9,276		8,872
NONINTEREST EXPENSE
Compensation and benefits		5,785		5,508		17,549		15,746
Occupancy expense		1,050		1,036		3,214		3,228
Equipment expense		676		726		2,099		2,224
Telephone expense		187		206		577		609
Legal and professional fees		651		414		1,975		1,394
Mobile & internet banking		345		399		1,047		1,195
Core / Item processing		425		450		1,401		1,289
Marketing		196		148		595		437
State franchise  taxes		399		404		1,195		1,094
FDIC insurance		248		218		783		653
Community Bank System, Inc. merger costs		476		—		476		—
NUVO Bank & Trust Company acquisition costs		—		215		61		363
Amortization of core deposit intangible		51		—		153		—
Other		931		867		3,047		2,847
Total noninterest expense		11,420		10,591		34,172		31,079
Income before provision for income taxes		5,008		4,781		15,559		12,914
Provision for income taxes		1,097		925		3,792		2,606
NET INCOME	$	3,911	$	3,856	$	11,767	$	10,308
Basic earnings per common share	$	0.57	$	0.61	$	1.71	$	1.63
Diluted earnings per common share	$	0.57	$	0.61	$	1.71	$	1.62

See accompanying notes to unaudited consolidated financial statements

4

Merchants Bancshares, Inc.

Consolidated Statements of Comprehensive Income

(Unaudited)

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(In thousands)	2016		2015		2016		2015
Net income	$	3,911	$	3,856	$	11,767	$	10,308
Other comprehensive income,  net of tax:
Unrealized  holding (loss) gain on securities available for sale, net of taxes of $(443), $650, $1,445 and $497		(820)		1,215		2,687		933
Accretion of unrealized holding losses of securities transferred from available for sale to held to maturity, net of taxes of $285, $78, $419 and $213		531		144		779		396
Change in net unrealized loss on interest rate swaps, net of taxes of $25, $39, $66 and $50		46		73		122		94
Pension liability adjustment, net of taxes of $5, $36, $87 and $107		12		67		162		201
Other comprehensive (loss) income		(231)		1,499		3,750		1,624
Comprehensive income	$	3,680	$	5,355	$	15,517	$	11,932

See accompanying notes to unaudited consolidated financial statements

5

Merchants Bancshares, Inc.

Consolidated Statements of Cash Flows

(Unaudited)

	Nine Months Ended September 30,
(In thousands)	2016		2015
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	11,767	$	10,308
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for credit losses		905		250
Depreciation and amortization		1,579		1,652
Amortization of investment security premiums and accretion of discounts, net		1,553		939
Amortization of deferred loan costs		507		355
Amortization of core deposit intangible		153		—
Stock based compensation		41		97
Deferred gain on sale of premises		(387)		(387)
Gain on sale of other real estate owned		(20)		—
Equity in losses of real estate limited partnerships, net		1,222		846
Increase in cash surrender value of bank owned life insurance		(158)		(181)
Changes in assets and liabilities:
Net change in interest receivable		464		111
Net change in other assets		1,142		1,247
Net change in interest payable		(37)		(32)
Net change in other liabilities		1,427		841
Net cash provided by operating activities		20,158		16,046
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from maturities of investment securities available for sale		33,283		34,957
Proceeds from maturities of investment securities held to maturity		29,382		14,917
Purchases of investment securities available for sale		(45,403)		(112,892)
Loan originations in excess of principal payments		(63,887)		(76,020)
Purchases of Federal Home Loan Bank stock, net		(1,047)		—
Proceeds from sales of other real estate owned		92		—
Real estate limited partnership investments		(827)		(1,594)
Purchases of bank premises and equipment		(173)		(1,179)
Net cash used in investing activities		(48,580)		(141,811)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net change in deposits		(47,599)		78,701
Net increase in short-term borrowings		22,000		—
Net (decrease) increase in securities sold under agreement to repurchase		(10,556)		9,330
Principal payments on long-term debt		(1,565)		(62)
Cash dividends paid		(5,768)		(5,319)
Proceeds from the exercise of stock warrants		235		—
Increase in deferred compensation arrangements		430		215
Tax benefit from exercise of stock options and distribution of shares in deferred compensation arrangements		(221)		(100)
Net cash (used in) provided by financing activities		(43,044)		82,765
Decrease in cash and cash equivalents		(71,466)		(43,000)
Cash and cash equivalents beginning of period		150,183		154,459
Cash and cash equivalents end of period	$	78,717	$	111,459
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Total interest payments	$	3,432	$	3,079
Total income tax payments		1,122		—
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:
Distribution of stock under deferred compensation arrangements	$	559	$	514
Non-cash exercise of stock options and warrants		161		626
Transfer of loans to other real estate owned		60		—

See accompanying notes to unaudited consolidated financial statements

6

Notes To Interim Unaudited Consolidated Financial Statements  

For additional information, see the Merchants Bancshares, Inc. Annual Report on Form 10-K for the fiscal year ended December 31, 2015, filed with the Securities and Exchange Commission (the “SEC”) on March 14, 2016.

NOTE 1: FINANCIAL STATEMENT PRESENTATION

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of Merchants Bancshares, Inc. (the “Company”), and its wholly-owned subsidiary Merchants Bank (the “Bank,” and collectively with the Company, “Merchants,” “we,” “us,” or “our”). All material intercompany accounts and transactions are eliminated in consolidation. We offer a full range of deposit, loan, cash management, and trust services to meet the financial needs of individual consumers, businesses and municipalities at 31 full-service banking offices throughout the state of Vermont and one full-service banking office in Massachusetts as of September 30, 2016.

Basis of Presentation

The accompanying unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and the instructions to the Quarterly Report on Form 10-Q and Rule 10-01 of Regulation S-X promulgated under the Securities Exchange Act of 1934, as amended. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. All adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of our interim consolidated financial statements as of September 30, 2016 and December 31, 2015 and for the three and nine months ended September 30, 2016 and 2015 have been included. The information was prepared from our unaudited financial statements and the unaudited financial statements of our subsidiaries, Merchants Bank and MBVT Statutory Trust I.  Amounts reported for prior periods are reclassified, where necessary, to be consistent with the current period presentation.

Management’s Use of Estimates in Preparation of Financial Statements

The preparation of financial statements in conformity with U.S. Generally Accepted Accounting Principles (“GAAP”) requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of income and expenses during the reporting periods. The most significant estimates include those used in determining the allowance for credit losses, income taxes, interest income recognition on loans and investments and analysis of other-than-temporary impairment of our investment securities portfolio. Operating results in the future may vary from the amounts derived from Management's estimates and assumptions.

NOTE 2: NEW ACCOUNTING PRONOUNCEMENTS

Accounting Standards Update (“ASU”) 2014-09, “Revenue from Contracts with Customers (Topic 606)” implements a common revenue standard that clarifies the principles for recognizing revenue. The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve that core principle, an entity should apply the following steps: (i) identify the contract(s) with a customer, (ii) identify the performance obligations in the contract, (iii) determine the transaction price, (iv) allocate the transaction price to the performance obligations in the contract and (v) recognize revenue when (or as) the entity satisfies a performance obligation. In July 2015, the Financial Accounting Standards Board (“FASB”) deferred the effective date of the ASU by one year which means ASU 2014-09 will be effective for the Company on January 1, 2018.  In March 2016, FASB issued ASU 2016-08 which amended illustrative examples to clarify how to apply the implementation guidance on principal versus agent considerations. The Company is evaluating the potential impact of ASU 2014-09, and subsequent amendments, on

7

its consolidated financial statements.

In January 2016, the FASB amended existing guidance to improve accounting standards for financial instruments including clarification and simplification of accounting and disclosure requirements and the requirement for public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes. These amendments are effective for public business entities for annual periods and interim periods within those annual periods beginning after December 15, 2017. The Company is evaluating the impact of these amendments on its consolidated financial statements.

In February 2016, the FASB amended existing guidance to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. These amendments are effective for public business entities for annual periods and interim periods within those annual periods beginning after December 15, 2018. The Company is evaluating the impact of these amendments on its consolidated financial statements.

In March 2016, the FASB amended existing guidance to simplify aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. These amendments are effective for public business entities for annual periods and interim periods within those annual periods beginning after December 15, 2016. The Company is evaluating the impact of these amendments on its consolidated financial statements.

In June 2016, the FASB released Accounting Standards Update 2016-13 Financial Instruments – Credit Losses which amended existing guidance to replace current generally accepted accounting principles used to measure a reporting entity’s credit losses.  The main objective of this update is to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. To achieve this objective, the amendments in this update replace the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. These amendments are effective for public business entities for annual periods and interim periods within those annual periods beginning after December 15, 2019. The Company is evaluating the impact of these amendments on its consolidated financial statements.

In August 2016, the FASB released Accounting Standards Update 2016-15 Clarifying Certain Cash Receipts and Cash Payments with the objective of eliminating the diversity in practice related to how certain cash receipts and cash payments are presented and classified in the statement of cash flows.  This update addresses eight specific cash flow issues: (1) debt prepayment or debt extinguishment costs, (2) settlement of zero-coupon debt instruments or other debt instruments with coupon interest rates that are insignificant in relation to the effective interest rate of the borrowing, (3) contingent consideration payments made after a business combination, (4) proceeds from the settlement of insurance claims, (5) proceeds from the settlement of corporate-owned life insurance policies, including bank-owned life insurance policies, (6) distributions received from equity method investees, (7) beneficial interests in securitization transactions and (8) separately identifiable cash flows and application of the predominance principle.  These amendments are effective for public business entities for annual periods and interim periods within those annual periods beginning after December 15, 2017. The Company is evaluating the impact of these amendments on its consolidated financial statements.

NOTE 3: ACQUISITION OF NUVO BANK & TRUST COMPANY

On December 4, 2015, the Company completed the acquisition of NUVO Bank & Trust Company (“NUVO”), Springfield, Massachusetts.  NUVO's banking business operates as a division of Merchants Bank. Total consideration paid by Merchants for NUVO's outstanding stock comprised 517,109 shares of common stock and $5.109 million in cash.  Merchants also paid an aggregate of $878,718 to cash out NUVO stock options and a portion of its common stock warrants and issued replacement warrants to purchase an aggregate of 90,756 shares of Merchants common stock on adjusted terms, consisting of warrants expiring in 2017 to purchase 56,386 shares at an exercise price of $20.69 and warrants expiring in 2018 to purchase 34,370 shares at an exercise price of $41.39 per share.  

8

The acquisition of NUVO expands the Company’s New England footprint beyond Vermont and into the Springfield and greater Western Massachusetts commercial banking market. The Company now has 32 banking locations, including the new office in Springfield, Massachusetts.

The acquisition of NUVO was accounted for using the acquisition method of accounting and, accordingly, assets acquired, liabilities assumed and consideration paid were recorded at their estimated fair values as of the acquisition date. The excess of consideration paid of $7.011 million over the fair value of net assets acquired has been reported as goodwill in the Company’s unaudited consolidated statements of financial condition as of September 30, 2016. Goodwill created in the acquisition is not deductible for income tax purposes. This goodwill consists largely of the synergies and cost savings arising from the combining of the operations of the two companies.

The assets acquired and liabilities assumed in the acquisition of NUVO were recorded at their preliminary estimated fair values based on management’s best estimates using information available at the date of the acquisition and are subject to adjustment.

In connection with the acquisition, the consideration paid and the fair value of identifiable assets acquired and liabilities assumed as of the date of acquisition are summarized in the following table:

(In thousands)
Consideration paid:
Common stock issued in exchange for NUVO shares	$	16,889
Cash paid for NUVO shares		5,988
Stock warrants issued		656
Total consideration paid	$	23,533
Assets acquired:
Cash and cash equivalents	$	7,070
Interest bearing time deposits with banks		110
Investments		4,344
Restricted investment in bank stock		376
Loans		149,360
Premises and equipment , net		580
Accrued interest receivable		369
Core deposit intangible		1,377
Deferred tax asset		1,993
Other assets		356
Total assets acquired		165,935
Liabilities assumed:
Deposits		144,482
Federal Home Loan Bank advances		4,001
Accrued interest payable		42
Tax effect of acquisition fair value adjustments		705
Other liabilities		183
Total liabilities assumed		149,413
Net assets acquired	$	16,522
Goodwill	$	7,011

9

The following table details the changes in fair value of the consideration paid and the net assets acquired as of December 4, 2015 from the amounts originally reported in the Company’s Form 10-K for the year ended December 31, 2015:

(In thousands)
Goodwill reported as of December 31, 2015	$	6,967
Effect of adjustments to:
Stock warrants issued		112
Deferred tax asset		(68)
Adjusted goodwill as of September 30, 2016	$	7,011

The changes to goodwill during the nine months ended September 30, 2016 are primarily due to changes in the final market value for assets acquired and consideration paid. In many cases, the fair values of assets acquired and liabilities assumed were determined by estimating the cash flows expected to result from those assets and liabilities and discounting them at appropriate market rates. These changes had no impact on current quarter or previously reported income.

NOTE 4: GOODWILL AND INTANGIBLE ASSETS

The goodwill and intangible balances presented below resulted from the Company’s acquisition of NUVO.  The acquisition of NUVO resulted in goodwill of $7.011 million and core deposit intangible (“CDI”) of $1.377 million.  For further information regarding goodwill and other intangible assets recorded in connection with the acquisition of NUVO, including the effect of adjustments to goodwill, please refer to Note 3.

Goodwill

Goodwill is deemed to have an indefinite life and therefore is not amortized, but is instead subject to impairment tests. There was no impairment for the three and nine months ended September 30, 2016 or the period from the date of the acquisition through December 31, 2015. 

	September 30,		December 31,
(In thousands)	2016		2015
Beginning of period	$	6,967	$	—
Effect of adjustments		44		—
Goodwill		—		6,967
Impairment		—		—
End of period	$	7,011	$	6,967

Other Intangible Assets

Acquired CDI were as follows:

		September 30,		December 31,
(In thousands)		2016		2015
Beginning of period	$	1,360	$	—
Additions		—		1,377
Amortization		153		17
End of period	$	1,207	$	1,360

The CDI recognized in 2015 was related to the acquisition of NUVO. Aggregate amortization expense for the CDI was $51 thousand and $153 thousand for the three and nine months ended September 30, 2016, respectively and $17 thousand for the period from the date of the acquisition through December 31, 2015.

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The estimated amortization expense for each of the next five years:

(In thousands)		Amount
Remainder of 2016	$	51
2017		173
2018		147
2019		126
2020		120
2021		120
Thereafter		470

NOTE 5: INVESTMENT SECURITIES

Investments in securities are classified as available for sale or held to maturity as of September 30, 2016 and December 31, 2015. The amortized cost and fair values of the securities classified as available for sale and held to maturity as of September 30, 2016 are as follows:

			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
(In thousands)	Cost		Gains		Losses		Value
Available for Sale:
U.S. Treasury Obligations	$	25,076	$	257	$	—	$	25,333
U.S. Government Sponsored Enterprises ("U.S. GSEs")		49,030		499		—		49,529
Federal Home Loan Bank ("FHLB") Obligations		62,372		878		(3)		63,247
Residential Real Estate Mortgage-backed Securities ("Agency MBSs")		80,061		2,256		(24)		82,293
Agency Commercial Mortgage Backed Securities ("Agency CMBSs")		24,162		151		(33)		24,280
Agency Collateralized Mortgage Obligations ("Agency CMOs")		53,576		448		(63)		53,961
Asset Backed Securities ("ABSs")		295		35		—		330
Total Available for Sale	$	294,572	$	4,524	$	(123)	$	298,973

			Gross		Gross
	Amortized		Unrecognized		Unrecognized		Fair
	Cost		Gains		Losses		Value
Held to Maturity:
U.S. Agency Obligations	$	18,073	$	830	$	—	$	18,903
Agency CMOs		66,456		1,249		(19)		67,686
Agency MBSs		6,143		286		—		6,429
Total Held to Maturity	$	90,672	$	2,365	$	(19)	$	93,018

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The amortized cost and fair values of the securities classified as available for sale and held to maturity as of December 31, 2015 are as follows:

			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
(In thousands)	Cost		Gains		Losses		Value
Available for Sale:
U.S. Treasury Obligations	$	25,064	$	61	$	(12)	$	25,113
U.S. GSEs		20,895		3		(104)		20,794
FHLB Obligations		51,230		107		(226)		51,111
Agency MBSs		96,073		1,688		(512)		97,249
Agency CMBSs		24,950		—		(397)		24,553
Agency CMOs		64,648		74		(443)		64,279
ABSs		325		30		—		355
Total Available for Sale	$	283,185	$	1,963	$	(1,694)	$	283,454

			Gross		Gross
	Amortized		Unrecognized		Unrecognized		Fair
	Cost		Gains		Losses		Value
Held to Maturity:
U.S. Agency Obligations	$	20,084	$	486	$	—	$	20,570
U.S. GSEs		9,556		166		—		9,722
FHLB Obligations		4,758		76		—		4,834
Agency CMOs		78,249		253		(716)		77,786
Agency MBSs		7,027		154		—		7,181
Total Held to Maturity	$	119,674	$	1,135	$	(716)	$	120,093

The contractual final maturity distribution of the debt securities classified as available for sale as of September 30, 2016, are as follows:

									Securities
			After One		After Five				not due
	Within		But Within		But Within		After Ten		at a Single
(In thousands)	One Year		Five Years		Ten Years		Years		Maturity		Total
Available for Sale (at fair value):
U.S. Treasury Obligations	$	10,120	$	15,213	$	—	$	—	$	N/A	$	25,333
U.S. GSEs		—		49,529		—		—		N/A		49,529
FHLB Obligations		—		57,024		6,223		—		N/A		63,247
Agency MBSs		N/A		N/A		N/A		N/A		82,293		82,293
Agency CMBSs		N/A		N/A		N/A		N/A		24,280		24,280
Agency CMOs		N/A		N/A		N/A		N/A		53,961		53,961
ABSs		N/A		N/A		N/A		N/A		330		330
Total Available for Sale	$	10,120	$	121,766	$	6,223	$	—	$	160,864	$	298,973
Available for Sale (at amortized cost):
U.S. Treasury Obligations	$	10,093	$	14,983	$	—	$	—	$	N/A	$	25,076
U.S. GSEs		—		49,030		—		—		N/A		49,030
FHLB Obligations		—		56,453		5,919		—		N/A		62,372
Agency MBSs		N/A		N/A		N/A		N/A		80,061		80,061
Agency CMBSs		N/A		N/A		N/A		N/A		24,162		24,162
Agency CMOs		N/A		N/A		N/A		N/A		53,576		53,576
ABSs		N/A		N/A		N/A		N/A		295		295
Total Available for Sale	$	10,093	$	120,466	$	5,919	$	—	$	158,094	$	294,572

12

The contractual final maturity distribution of the debt securities classified as held to maturity as of September 30, 2016, are as follows:

									Securities
			After One		After Five				not due
	Within		But Within		But Within		After Ten		at a Single
(In thousands)	One Year		Five Years		Ten Years		Years		Maturity		Total
Held to Maturity (at fair value):
U.S. Agency Obligations	$	—	$	—	$	—	$	18,903	$	N/A	$	18,903
Agency CMOs		N/A		N/A		N/A		N/A		67,686		67,686
Agency MBSs		N/A		N/A		N/A		N/A		6,429		6,429
Total Held to Maturity	$	—	$	—	$	—	$	18,903	$	74,115	$	93,018
Held to Maturity (at amortized cost):
U.S. Agency Obligations	$	—	$	—	$	—	$	18,073	$	N/A	$	18,073
Agency CMOs		N/A		N/A		N/A		N/A		66,456		66,456
Agency MBSs		N/A		N/A		N/A		N/A		6,143		6,143
Total Held to Maturity	$	—	$	—	$	—	$	18,073	$	72,599	$	90,672

Actual maturities will differ from contractual maturities because borrowers may have rights to call or prepay obligations.

For the nine months ended September 30, 2016 and 2015, we did not record any securities gains or losses related to the sale of securities.

Securities with a carrying value of $363.92 million and $335.81million at September 30, 2016 and December 31, 2015, respectively, were pledged to secure public deposits, securities sold under agreements to repurchase, and for other purposes required by law.

Gross unrealized losses on investment securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in continuous unrealized loss position, at September 30, 2016, were as follows:

	Less Than 12 Months					12 Months or More					Total
	Number	Fair				Number	Fair				Number	Fair
(In thousands)	of Issues	Value		Loss		of Issues	Value		Loss		of Issues	Value		Loss
Available for Sale:
FHLB Obligations	1	$	5,997	$	(3)	—	$	—	$	—	1	$	5,997	$	(3)
Agency MBSs	3		8,363		(24)	—		—		—	3		8,363		(24)
Agency CMBSs	1		3,717		(33)	—		—		—	1		3,717		(33)
Agency CMOs	2		7,024		(23)	2		2,426		(40)	4		9,450		(63)
Total Available for Sale	7	$	25,101	$	(83)	2	$	2,426	$	(40)	9	$	27,527	$	(123)
Held to Maturity:
Agency CMOs	—	$	—	$	—	1	$	3,345	$	(19)	—	$	3,345	$	(19)
Total Held to Maturity	—	$	—	$	—	1	$	3,345	$	(19)	—	$	3,345	$	(19)

13

Gross unrealized losses on investment securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in continuous unrealized loss position, at December 31, 2015, were as follows:

	Less Than 12 Months					12 Months or More					Total
	Number	Fair				Number	Fair				Number	Fair
(In thousands)	of Issues	Value		Loss		of Issues	Value		Loss		of Issues	Value		Loss
Available for Sale:
U.S. Treasury Obligations	3	$	15,068	$	(12)	—	$	—	$	—	3	$	15,068	$	(12)
U.S. GSEs	3		14,817		(104)	—		—		—	3		14,817		(104)
FHLB Obligations	8		39,094		(226)	—		—		—	8		39,094		(226)
Agency MBSs	17		60,748		(512)	—		—		—	17		60,748		(512)
Agency CMBSs	5		19,608		(331)	1		4,761		(66)	6		24,369		(397)
Agency CMOs	15		42,235		(283)	3		6,089		(160)	18		48,324		(443)
Total Available for Sale	51	$	191,570	$	(1,468)	4	$	10,850	$	(226)	55	$	202,420	$	(1,694)
Held to Maturity:
Agency CMOs	14	$	51,713	$	(623)	2	$	5,287	$	(93)	16	$	57,000	$	(716)
Total Held to Maturity	14	$	51,713	$	(623)	2	$	5,287	$	(93)	16	$	57,000	$	(716)

There were no securities classified as trading at September 30, 2016 and December 31, 2015.

Unrealized losses on investment securities result from the cost basis of the security being higher than its current fair value. These differences generally occur because of changes in interest rates since the time of purchase, or because the credit quality of the issuer has deteriorated. We perform a quarterly analysis of each security in our portfolio to determine if impairment exists, and if it does, whether that impairment is other-than-temporary.

At September 30, 2016, all of our MBSs and CMOs held were issued by U.S. government-sponsored entities and agencies, primarily the Federal National Mortgage Association (“FNMA”) and Federal Home Loan Mortgage Corporation (“FHLMC”), institutions which the government has affirmed its commitment to support.  Because the decline in fair value is attributable to changes in interest rates and illiquidity, and not credit quality, and because we do not have the intent to sell these securities and it is not likely that we will be required to sell the securities before their anticipated recovery, we do not consider these securities to be other-than-temporarily impaired at September 30, 2016.

Agency MBSs and Agency CMOs consist of pools of residential mortgages which are guaranteed by FNMA, FHLMC, or Government National Mortgage Association (“GNMA”) with various origination dates and maturities.  Agency CMBS consists of bonds backed by commercial real estate which are guaranteed by FNMA and GNMA.

During the first quarter of 2014, we transferred securities with a total amortized cost of $12.63 million, and a corresponding fair value of $12.64 million, from available for sale to held to maturity.  The net unrealized gain, net of taxes, on these securities at the dates of the transfers was $8 thousand. During the third and fourth quarters of 2013, we transferred securities with a total amortized cost of $152.89 million, and a corresponding fair value of $147.45 million, from available for sale to held to maturity. The net unrealized holding loss, net of taxes, on these securities at the dates of the transfers was $3.53 million. The unrealized holding gains and losses at the time of transfer continues to be reported in accumulated other comprehensive income, net of tax and are amortized over the remaining lives of the securities as an adjustment of the yield.  The amortization of the unamortized holding gains and losses reported in accumulated other comprehensive income will offset the effect on interest income of the premium and discount for the transferred securities.  The remaining unamortized balance of the net losses for the securities transferred from available for sale to held to maturity was $2.35 million or $1.52 million, net of tax at September 30, 2016.

14

NOTE 6: SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

The following table presents the contractual maturity of our secured borrowings and class of collateral pledged at September 30, 2016:

	Remaining Contractual Maturity of the Agreements
	Overnight and						Greater Than
(In thousands)	Continuous		Up to 30 Days		30-90 Days		90 Days		Total
Repurchase Agreements:
Available for Sale:
U.S. Treasury Obligations	$	24,388	$	—	$	—	$	—	$	24,388
U.S. GSEs		35,634		—		—		—		35,634
FHLB Obligations		59,753		—		—		—		59,753
Agency MBSs		41,151		—		—		—		41,151
Agency CMBSs		20,298		—		—		—		20,298
Agency CMOs		27,722		—		—		—		27,722
Total Available for Sale	$	208,946	$	—	$	—	$	—	$	208,946
(In thousands)
Held to Maturity:
U.S. Agency Obligations	$	16,602	$	—	$	—	$	—	$	16,602
Agency CMOs		50,535		—		—		—		50,535
Total Held to Maturity	$	67,137	$	—	$	—	$	—	$	67,137

The following table presents the contractual maturity of our secured borrowings and class of collateral pledged at December 31, 2015:

	Remaining Contractual Maturity of the Agreements
	Overnight and						Greater Than
(In thousands)	Continuous		Up to 30 Days		30-90 Days		90 Days		Total
Repurchase Agreements:
Available for Sale:
U.S. Treasury Obligations	$	23,902	$	—	$	—	$	—	$	23,902
U.S. GSEs		21,719		—		—		—		21,719
FHLB Obligations		42,681		—		—		—		42,681
Agency MBSs		49,162		—		—		430		49,592
Agency CMBSs		14,957		—		—		—		14,957
Agency CMOs		33,112		—		—		—		33,112
Total Available for Sale	$	185,533	$	—	$	—	$	430	$	185,963
(In thousands)
Held to Maturity:
U.S. Agency Obligations	$	14,524	$	—	$	—	$	—	$	14,524
Agency CMOs		66,889		—		—		—		66,889
Agency MBSs		19,263		—		—		—		19,263
Total Held to Maturity	$	100,676	$	—	$	—	$	—	$	100,676

15

The fair value of securities pledged to secure repurchase agreements may decline. The Company manages this risk by having a policy to pledge securities valued greater than the gross outstanding balance of repurchase agreements. Securities sold under agreements to repurchase are secured by securities with a carrying value of $276.20 million at September 30, 2016 and $287.27 million at December 31, 2015.

NOTE 7: LOANS AND THE ALLOWANCE FOR CREDIT LOSSES

Loans

The composition of our loan portfolio at September 30, 2016 and December 31, 2015 was as follows:

(In thousands)	September 30, 2016		December 31, 2015
Commercial, financial and agricultural	$	268,530	$	237,451
Municipal loans		112,007		105,421
Real estate loans – residential		450,584		468,443
Real estate loans – commercial		584,392		558,004
Real estate loans – construction		55,210		34,802
Installment loans		6,547		10,115
All other loans		15		44
Total loans	$	1,477,285	$	1,414,280

We primarily originate commercial, commercial real estate, municipal, and residential real estate loans to customers throughout the states of Vermont and Massachusetts. There are no significant industry concentrations in the loan portfolio. Total loans included $1.14 million and $1.20 million of net deferred loan origination costs at September 30, 2016 and December 31, 2015, respectively. The aggregate amount of overdrawn deposit balances classified as loan balances was $267 thousand and $308 thousand at September 30, 2016 and December 31, 2015, respectively.

The following table reflects our loan loss experience and activity in the allowance for loan losses for the three months ended September 30, 2016:

	Commercial,
	financial				Real		Real		Real
	and				estate-		estate-		estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All other		Totals
Allowance for loan losses:
Beginning balance	$	3,198	$	352	$	2,809	$	5,423	$	549	$	89	$	—	$	12,420
Charge-offs		(115)		—		(82)		—		—		(50)		—		(247)
Recoveries		1		—		6		—		—		14		—		21
Provision (credit)		22		251		(70)		84		25		34		—		346
Ending balance	$	3,106	$	603	$	2,663	$	5,507	$	574	$	87	$	—	$	12,540

In addition to the provision for loan losses included above, there was a provision for the reserve for undisbursed lines of $154 thousand included in the provision for credit losses in the consolidated statement of income.

16

The following table reflects our loan loss experience and activity in the allowance for loan losses for the three months ended September 30, 2015:

	Commercial,
	financial				Real		Real		Real
	and				estate-		estate-		estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All other		Totals
Allowance for loan losses:
Beginning balance	$	2,925	$	359	$	3,043	$	5,299	$	477	$	59	$	—	$	12,162
Charge-offs		(11)		—		(29)		—		—		(22)		—		(62)
Recoveries		3		—		7		1		—		8		—		19
Provision (credit)		(84)		272		(62)		(62)		16		11		—		91
Ending balance	$	2,833	$	631	$	2,959	$	5,238	$	493	$	56	$	—	$	12,210

In addition to the provision for loan losses included above, there was a provision for the reserve for undisbursed lines of $59 thousand included in the provision for credit losses in the consolidated statement of income.

The following table reflects our loan loss experience and activity in the allowance for loan losses for the nine months ended September 30, 2016:

	Commercial,
	financial				Real		Real		Real
	and				estate-		estate-		estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All other		Totals
Allowance for loan losses:
Beginning balance	$	2,696	$	590	$	2,882	$	5,386	$	420	$	66	$	—	$	12,040
Charge-offs		(122)		—		(155)		—		—		(128)		—		(405)
Recoveries		5		—		28		4		—		53		—		90
Provision (credit)		527		13		(92)		117		154		96		—		815
Ending balance	$	3,106	$	603	$	2,663	$	5,507	$	574	$	87	$	—	$	12,540

In addition to the provision for loan losses included above, there was a provision for the reserve for undisbursed lines of $90 thousand included in the provision for credit losses in the consolidated statement of income.

The following table reflects our loan loss experience and activity in the allowance for loan losses for the nine months ended September 30, 2015:

	Commercial,
	financial				Real		Real		Real
	and				estate-		estate-		estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All Other		Total
Allowance for loan losses:
Beginning balance	$	2,583	$	623	$	3,038	$	5,209	$	325	$	13	$	42	$	11,833
Charge-offs		(28)		—		(84)		—		—		(65)		—		(177)
Recoveries		31		—		36		2		—		41		—		110
Provision (credit)		247		8		(31)		27		168		67		(42)		444
Ending balance	$	2,833	$	631	$	2,959	$	5,238	$	493	$	56	$	—	$	12,210

The $250 thousand provision for credit losses in the consolidated statement of income consisted of a $444 thousand provision for loan losses included above plus $194 thousand credit for excess reserves from the reserve for undisbursed lines and letters.

17

The following presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment based upon the impairment method at September 30, 2016:

	Commercial,
	financial and				Real estate-		Real estate-		Real estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All other		Totals
Allowance for loan losses:
Ending balance individually evaluated for impairment	$	40	$	—	$	178	$	—	$	—	$	—	$	—	$	218
Ending balance collectively evaluated for impairment		3,066		603		2,485		5,507		574		87		—		12,322
Ending balance acquired with deteriorated credit quality		—		—		—		—		—		—		—		—
Totals	$	3,106	$	603	$	2,663	$	5,507	$	574	$	87	$	—	$	12,540
Financing receivables:
Ending balance individually evaluated for impairment	$	465	$	—	$	927	$	973	$	—	$	—	$	—	$	2,365
Ending balance collectively evaluated for impairment		267,271		112,007		449,657		581,480		55,210		6,547		15		1,472,187
Ending balance acquired with deteriorated credit quality		794		—		—		1,939		—		—		—		2,733
Totals	$	268,530	$	112,007	$	450,584	$	584,392	$	55,210	$	6,547	$	15	$	1,477,285

18

The following presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment based upon impairment method at December 31, 2015:

	Commercial,
	financial and				Real estate-		Real estate-		Real estate-
(In thousands)	agricultural		Municipal		residential		commercial		construction		Installment		All other		Totals
Allowance for loan losses:
Ending balance individually evaluated for impairment	$	—	$	—	$	137	$	—	$	—	$	—	$	—	$	137
Ending balance collectively evaluated for impairment		2,696		590		2,745		5,386		420		66		—		11,903
Ending balance acquired with deteriorated credit quality		—		—		—		—		—		—		—		—
Totals	$	2,696	$	590	$	2,882	$	5,386	$	420	$	66	$	—	$	12,040
Financing receivables:
Ending balance individually evaluated for impairment	$	595	$	—	$	706	$	647	$	—	$	22	$	—	$	1,970
Ending balance collectively evaluated for impairment		235,652		105,421		467,737		555,323		34,802		10,093		44		1,409,072
Ending balance acquired with deteriorated credit quality		1,204		—		—		2,034		—		—		—		3,238
Totals	$	237,451	$	105,421	$	468,443	$	558,004	$	34,802	$	10,115	$	44	$	1,414,280

19

The table below presents the recorded investment of loans segregated by class, with delinquency aging as of September 30, 2016:

	31-60		61-90		91 Days		Total
	Days		Days		or More		Past
(In thousands)	Past Due		Past Due		Past Due		Due		Current			Nonperforming	Total
Commercial, financial and agricultural	$	—	$	562	$	—	$	562	$	266,883	$	1,085	$	268,530
Municipal		—		—		—		—		112,007		—		112,007
Real estate-residential:
First mortgage		171		—		—		171		409,996		813		410,980
Second mortgage		—		—		—		—		39,604		—		39,604
Real estate-commercial:
Owner occupied		—		—		—		—		224,276		1,829		226,105
Non-owner occupied		—		—		—		—		357,778		509		358,287
Real estate-construction:
Residential		—		—		—		—		2,881		—		2,881
Commercial		—		—		—		—		52,329		—		52,329
Installment		92		—		—		92		6,455		—		6,547
Other		—		—		—		—		15		—		15
Total	$	263	$	562	$	—	$	825	$	1,472,224	$	4,236	$	1,477,285

Of the total nonperforming loans in the aging table above, $2.08 million were past due of which $316 thousand were restructured loans, $839 thousand were purchase credit impaired, and $0 were 91 days or more past due and accruing.  In the third quarter of 2016, the Company’s policy was updated to classify accruing troubled debt restructurings (“TDRs”) as performing loans to more accurately represent the characteristics of the loans.  Prior period amounts have been reclassified to be consistent with the current period presentation. Nonperforming loans, as of December 31, 2015, were reduced $210 thousand for accruing TDRs.

The table below presents the recorded investment of loans segregated by class, with delinquency aging as of December 31, 2015:

	31-60		61-90			91 Days		Total
	Days		Days			or More		Past
(In thousands)	Past Due		Past Due			Past Due		Due		Current			Nonperforming	Total
Commercial, financial and agricultural	$	—		$	251	$	—	$	251	$	235,905	$	1,295	$	237,451
Municipal		—			—		—		—		105,421		—		105,421
Real estate-residential:
First mortgage		50			—		—		50		425,645		581		426,276
Second mortgage		—			8		—		8		42,159		—		42,167
Real estate-commercial:
Owner occupied		323			—		—		323		219,080		1,605		221,008
Non-owner occupied		—			—		—		—		336,514		482		336,996
Real estate-construction:
Residential		—			—		—		—		2,422		—		2,422
Commercial		—			—		—		—		32,380		—		32,380
Installment		61			9		—		70		10,023		22		10,115
Other		—			—		—		—		44		—		44
Total	$	434		$	268	$	—	$	702	$	1,409,593	$	3,985	$	1,414,280

Of the total nonperforming loans in the aging table above, $2.65 million were past due of which $472 thousand were restructured loans, $1.05 million were purchase credit impaired and $0 were 91 days or more past due and accruing.

20

Impaired loans by class at September 30, 2016 and for the three and nine months ended September 30, 2016 are as follows:

	Period Ended						Three Months Ended				Nine Months Ended
	September 30, 2016						September 30, 2016				September 30, 2016
			Unpaid					Average	Interest			Average	Interest
	Recorded		Principal		Related			Recorded	Income			Recorded	Income
(In thousands)	Investment		Balance		Allowance			Investment	Recognized			Investment	Recognized
With no related allowance recorded
Commercial, financial and agricultural	$	397	$	401	$	—	$	187	$	1	$	225	$	3
Residential:
First mortgage		372		517		—		286		1		246		4
Second mortgage		—		—		—		—		—		1		—
Commercial Real Estate:
Owner occupied		464		468		—		469		—		497		—
Non-owner occupied		509		530		—		513		—		524		—
Construction:
Residential		—		—		—		—		—		—		—
Commercial		—		—		—		—		—		—		—
Installment		—		—		—		5		—		8		—
With related allowance recorded
Commercial, financial and agricultural		68		70		40		400		—		387		—
Residential:
First mortgage		555		565		178		505		—		451		—
Second mortgage		—		—		—		—		—		—		—
Commercial Real Estate:
Owner occupied		—		—		—		—		—		13		—
Total
Commercial, financial and agricultural		465		471		40		587		1		612		3
Residential		927		1,082		178		791		1		698		4
Commercial Real Estate		973		998		—		982		—		1,034		—
Construction		—		—		—		—		—		—		—
Installment		—		—		—		5		—		8		—
Total	$	2,365	$	2,551	$	218	$	2,365	$	2	$	2,352	$	7

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Impaired loans by class at December 31, 2015 and for the three and nine months ended September 30, 2015 are as follows:

	Period Ended						Three Months Ended				Nine Months Ended
	December 31, 2015						September 30, 2015				September 30, 2015
			Unpaid				Average		Interest		Average		Interest
	Recorded		Principal		Related		Recorded		Income		Recorded		Income
(In thousands)	Investment		Balance		Allowance		Investment		Recognized		Investment		Recognized
With no related allowance recorded
Commercial, financial and agricultural	$	595	$	599	$	—	$	571	$	5	$	303	$	7
Residential:
First mortgage		264		322		—		293		2		200		4
Second mortgage		—		—		—		52		—		70		—
Commercial Real Estate:
Owner occupied		165		165		—		—		—		—		—
Non-owner occupied		482		482		—		—		—		3		—
Installment		22		22		—		—		—		—		—
With related allowance recorded
Commercial, financial and agricultural		—		—		—		—		—		166		—
Residential:
First mortgage		442		442		137		541		—		497		—
Second mortgage		—		—		—		—		—		6		—
Commercial Real Estate:
Owner occupied		—		—		—		—		—		—		—
Installment		—		—		—		—		—		—		—
Total
Commercial, financial and agricultural		595		599		—		571		5		469		7
Residential		706		764		137		886		2		773		4
Commercial Real Estate		647		647		—		—		—		3		—
Installment		22		22		—		—		—		—		—
Total	$	1,970	$	2,032	$	137	$	1,457	$	7	$	1,245	$	11

Residential and commercial loans serviced for others at September 30, 2016 and December 31, 2015 amounted to approximately $23.70 million and $27.87 million, respectively.

Nonperforming loans at September 30, 2016 and December 31, 2015 are as follows:

(In thousands)	September 30, 2016		December 31, 2015
Nonaccrual  loans	$	3,488	$	3,513
Loans greater than 90 days and accruing		—		—
Troubled debt restructurings ("TDRs")		748		472
Total nonperforming loans	$	4,236	$	3,985

There were no loans restructured in the three months ended September 30, 2016. One loan was restructured during the nine months ended September 30, 2016 with a balance of $432 thousand and is considered to be a TDR. This loan was individually evaluated for impairment and it was determined that no reserve was required. One loan with a balance of $88 thousand was restructured during the three months ended September 30, 2015 and was considered to be a TDR.  Loans with a total balance of $559 thousand were restructured during the nine months ended September 30, 2015 and were considered to be TDRs.

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TDRs represent balances where the existing loan was modified involving a concession in rate, term or payment amount due to the distressed financial condition of the borrower. There were three restructured residential mortgages at September 30, 2016 with balances totaling $113 thousand. There were two restructured commercial loans at September 30, 2016 with a balance of $397 thousand.  One commercial real estate loan at September 30, 2016 with a balance of $432 thousand was restructured. Five of the six TDRs at September 30, 2016 continue to pay as agreed according to the modified terms. The one TDR that was delinquent at September 30, 2016 totaled $316 thousand.  Four of the six TDRs totaling $194 thousand are accruing and are considered performing loans.  At September 30, 2016, there were no commitments to lend additional funds to borrowers whose loans have been modified in a troubled debt restructuring. We had no commitments to lend additional funds to borrowers whose loans were in nonaccrual status or to borrowers whose loans were 91 days past due and still accruing at September 30, 2016. Interest income on restructured loans during the three and nine months ended September 30, 2016 and 2015 was insignificant.

Nonaccrual loans by class as of September 30, 2016 and December 31, 2015 are as follows:

(In thousands)	September 30, 2016		December 31, 2015
Commercial, financial and agricultural	$	769	$	823
Real estate - residential:
First mortgage		813		581
Second mortgage		—		—
Real estate - commercial:
Owner occupied		1,829		1,605
Non owner occupied		77		482
Installment		—		22
Total nonaccruing non-TDR loans	$	3,488	$	3,513
Nonaccruing TDR’s
Commercial, financial and agricultural		316		472
Real estate – residential:
First mortgage		—		—
Real estate - commercial:
Non owner occupied		432		—
Total nonaccrual loans including TDRs	$	4,236	$	3,985

Commercial Grading System

We use risk rating definitions for our commercial loan portfolios and certain residential loans which are generally consistent with regulatory and banking industry norms. Loans are assigned a credit quality grade which is based upon management’s on-going assessment of risk based upon an evaluation of the quantitative and qualitative aspects of each credit. This assessment is a dynamic process and risk ratings are adjusted as each borrower’s financial situation changes. This process is designed to provide timely recognition of a borrower’s financial condition and appropriately focus management resources.

Pass rated loans exhibit acceptable risk to the bank in terms of financial capacity to repay their loans as well as possessing acceptable fallback repayment sources, typically collateral and personal guarantees. Pass rated commercial loan relationships with a total exposure of $1 million or greater are subject to a formal annual review process; additionally, management reviews the risk rating at the time of any late payments, overdrafts or other sign of deterioration in the interim.

Loans rated Pass-Watch require more than usual attention and monitoring by the account officer, though not to the extent that a formal remediation plan is warranted. Borrowers can be rated Pass-Watch based upon a weakened capital structure, marginally adequate cash flow and/or collateral coverage or early-stage declining trends in operations or financial condition.

Loans rated Special Mention possess potential weakness that may expose the bank to some risk of loss in the future. These loans require more frequent monitoring and formal reporting to Management.

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Substandard loans reflect well-defined weaknesses in the current repayment capacity, collateral or net worth of the borrower with the possibility of some loss to the bank if these weaknesses are not corrected. Action plans are required for these loans to address the inherent weakness in the credit and are formally reviewed.

Residential real estate and consumer loans

We do not use a grading system for our performing residential real estate and consumer loans. Credit quality for these loans is based on performance and payment status.

Below is a summary of loans by credit quality indicator as of September 30, 2016:

					Pass-		Special		Sub-
(In thousands)	Unrated		Pass		Watch		Mention		Standard		Total
Commercial, financial and agricultural	$	499	$	221,528	$	29,333	$	590	$	16,580	$	268,530
Municipal		79		101,956		9,128		844		—		112,007
Real estate – residential:
First mortgage		402,284		6,311		1,573		—		812		410,980
Second mortgage		39,377		—		227		—		—		39,604
Real estate – commercial:
Owner occupied		228		182,831		27,354		1,845		13,847		226,105
Non-owner occupied		474		314,391		39,898		186		3,338		358,287
Real estate – construction:
Residential		263		2,618		—		—		—		2,881
Commercial		222		46,004		4,412		—		1,691		52,329
Installment		6,547		—		—		—		—		6,547
All other loans		15		—		—		—		—		15
Total	$	449,988	$	875,639	$	111,925	$	3,465	$	36,268	$	1,477,285

Below is a summary of loans by credit quality indicator as of December 31, 2015:

					Pass-		Special		Sub-
(In thousands)	Unrated		Pass		Watch		Mention		Standard		Total
Commercial, financial and agricultural	$	597	$	179,451	$	45,977	$	4,177	$	7,249	$	237,451
Municipal		58		92,011		13,352		—		��		105,421
Real estate – residential:
First mortgage		420,798		4,733		164		—		581		426,276
Second mortgage		42,167		—		—		—		—		42,167
Real estate – commercial:
Owner occupied		296		161,810		41,477		5,959		11,466		221,008
Non-owner occupied		166		290,337		44,485		444		1,564		336,996
Real estate – construction:
Residential		478		1,944		—		—		—		2,422
Commercial		145		27,299		3,136		—		1,800		32,380
Installment		10,093		—		—		—		22		10,115
All other loans		44		—		—		—		—		44
Total	$	474,842	$	757,585	$	148,591	$	10,580	$	22,682	$	1,414,280

The carrying amount of loans purchased with evidence of credit deterioration accounted for under FASB Accounting Standards Codification (“ASC”) 310-30 acquired in the NUVO acquisition totaled $2.73 million and $3.24 million at September 30, 2016 and December 31, 2015, respectively.

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NOTE 8: FAIR VALUE OF FINANCIAL INSTRUMENTS

We record certain assets and liabilities at fair value.  Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  Fair value measurements are also utilized to determine the initial value of certain assets and liabilities, to perform impairment assessments, and for disclosure purposes. We use quoted market prices and observable inputs to the maximum extent possible when measuring fair value.  In the absence of quoted market prices, various valuation techniques are utilized to measure fair value.  When possible, observable market data for identical or similar financial instruments are used in the valuation.  When market data is not available, fair value is determined using valuation models that incorporate Management’s estimates of the assumptions a market participant would use in pricing the asset or liability.

The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below:

· Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

· Level 2 - Quoted prices for similar assets or liabilities in active markets, quoted prices in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability.

· Level 3 - Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e. supported by little or no market activity).

A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.

The types of instruments valued based on quoted market prices in active markets include most U.S. government and Agency securities, liquid mortgage products, active listed equities and most money market securities. Such instruments are generally classified within Level 1 or Level 2 of the fair value hierarchy. We do not adjust the quoted price for such instruments.

The types of instruments valued based on quoted prices in markets that are not active, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency include most investment-grade and high-yield corporate bonds, less liquid mortgage products, less liquid Agency securities, less liquid listed equities, state, municipal and provincial obligations, and certain physical commodities. Such instruments are generally classified within Level 2 of the fair value hierarchy.

Level 3 is for positions that are not traded in active markets or are subject to transfer restrictions; valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments are generally based on available market evidence. In the absence of such evidence, Management’s best estimate will be used. Management’s best estimate consists of both internal and external support on certain Level 3 investments. Subsequent to inception, Management only changes Level 3 inputs and assumptions when corroborated by evidence such as transactions in similar instruments, completed or pending third-party transactions in the underlying investment or comparable entities, subsequent rounds of financing, recapitalizations and other transactions across the capital structure, offerings in the equity or debt markets, and changes in financial ratios or cash flows.

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Financial instruments on a recurring basis

The table below presents the balance of financial assets and liabilities at September 30, 2016 measured at fair value on a recurring basis:

			Fair Value Measurements at Reporting Date Using
			Quoted Prices in
			Active Markets for		Significant Other		Significant
			Identical Assets		Observable Inputs		Unobservable Inputs
(In thousands)	Total		(Level 1)		(Level 2)		(Level 3)
Assets
U.S. Treasury Obligations	$	25,333	$	—	$	25,333	$	—
U.S. GSEs		49,529		—		49,529		—
FHLB Obligations		63,247		—		63,247		—
Agency MBSs		82,293		—		82,293		—
Agency CMBSs		24,280		—		24,280		—
Agency CMOs		53,961		—		53,961		—
ABSs		330		—		330		—
Interest rate swap agreements		2,402		—		2,402		—
Total assets	$	301,375	$	—	$	301,375	$	—
Liabilities
Interest rate swap agreements		1,881		—		1,881		—
Total liabilities	$	1,881	$	—	$	1,881	$	—

The table below presents the balance of financial assets and liabilities at December 31, 2015 measured at fair value on a recurring basis:

			Fair Value Measurements at Reporting Date Using
			Quoted Prices in
			Active Markets for		Significant Other		Significant
			Identical Assets		Observable Inputs		Unobservable Inputs
(In thousands)	Total		(Level 1)		(Level 2)		(Level 3)
Assets
U.S. Treasury Obligations	$	25,113	$	—	$	25,113	$	—
U.S. GSEs		20,794		—		20,794		—
FHLB Obligations		51,111		—		51,111		—
Agency MBSs		97,249		—		97,249		—
Agency CMBSs		24,553		—		24,553		—
Agency CMOs		64,279		—		64,279		—
ABSs		355		—		355		—
Interest rate swap agreements		1,084		—		1,084		—
Total assets	$	284,538	$	—	$	284,538	$	—
Liabilities
Interest rate swap agreements		1,004		—		1,004		—
Total liabilities	$	1,004	$	—	$	1,004	$	—

Investment securities are reported at fair value utilizing Level 2 inputs. The prices for these instruments are obtained through an independent pricing service or dealer market participant with whom we have historically transacted both purchases and sales of investment securities. Prices obtained from these sources include market quotations and matrix pricing. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. More information regarding our investment securities can be found in Note 5 to these consolidated financial statements.

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The interest rate swaps are reported at their fair value utilizing Level 2 inputs from third parties. The fair value of our interest rate swaps are determined using prices obtained from a third party advisor.  The fair value measurement of the interest rate swap is determined by netting the discounted future fixed cash payments and the discounted expected variable cash receipts.  The variable cash receipts are based on the expectation of future interest rates derived from observed market interest rate curves.

There were no transfers between Level 1 and Level 2 for the nine months ended September 30, 2016 or September 30, 2015.  There were no Level 3 assets measured at fair value on a recurring basis at September 30, 2016 or December 31, 2015.

Financial instruments on a non-recurring basis

Certain financial assets are also measured at fair value on a non-recurring basis, however they were not material at September 30, 2016 or December 31, 2015. These financial assets include impaired loans and other real estate owned (“OREO”).

Fair value of financial instruments

The fair value of Merchants’ financial instruments as of September 30, 2016 are summarized in the table below:

	Carrying
(In thousands)	Amount		Fair Value		Level 1		Level 2		Level 3
Cash and cash equivalents	$	78,717	$	78,717	$	78,717	$	—	$	—
Securities available for sale		298,973		298,973		—		298,973		—
Securities held to maturity		90,672		93,018		—		93,018		—
FHLB stock		4,844		N/A		N/A		N/A		N/A
Loans, net of allowance for loan losses		1,464,745		1,469,387		—		—		1,469,387
Interest rate swap agreement		2,402		2,402		—		2,402		—
Accrued interest receivable		3,910		3,910		—		1,017		2,893
Total	$	1,944,263	$	1,946,407	$	78,717	$	395,410	$	1,472,280
Deposits	$	1,503,840	$	1,504,161	$	1,294,809	$	209,352	$	—
Short-term borrowings		22,000		22,000		—		22,000		—
Securities sold under agreement to repurchase		276,083		276,027		—		276,027		—
Other long-term debt		3,673		3,704		—		3,704		—
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		15,536		—		15,536		—
Interest rate swap agreement		1,881		1,881		—		1,881		—
Accrued interest payable		115		115		10		105		—
Total	$	1,828,211	$	1,823,424	$	1,294,819	$	528,605	$	—

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The fair value of Merchants’ financial instruments as of December 31, 2015 are summarized in the table below:

	Carrying
(In thousands)	Amount		Fair Value		Level 1		Level 2		Level 3
Cash and cash equivalents	$	150,183	$	150,183	$	150,183	$	—	$	—
Securities available for sale		283,454		283,454		—		283,454		—
Securities held to maturity		119,674		120,093		—		120,093		—
FHLB stock		3,797		N/A		N/A		N/A		N/A
Loans, net of allowance for loan losses		1,402,240		1,397,877		—		—		1,397,877
Interest rate swap agreement		1,084		1,084		—		1,084		—
Accrued interest receivable		4,374		4,374		—		1,085		3,289
Total	$	1,964,806	$	1,957,065	$	150,183	$	405,716	$	1,401,166
Deposits	$	1,551,439	$	1,551,046	$	1,296,867	$	254,179	$	—
Short-term borrowings		—		—		—		—		—
Securities sold under agreement to repurchase		286,639		286,586		—		286,586		—
Other long-term debt		5,238		5,191		—		5,191		—
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		14,975		—		14,975		—
Interest rate swap agreement		1,004		1,004		—		1,004		—
Accrued interest payable		152		152		13		139		—
Total	$	1,865,091	$	1,858,954	$	1,296,880	$	562,074	$	—

The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, accrued interest receivable and accrued interest payable approximate fair value. It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.

The methodologies for other financial assets and financial liabilities are discussed below.

Loans - The fair value for loans is estimated using discounted cash flow analyses, using interest rates and spreads currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously.  The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

Deposits - The fair value of deposits with no stated maturity, which includes demand, savings, interest bearing checking and money market accounts, is equal to the amount payable on demand resulting in a Level 1 classification. The fair value of variable rate, fixed term certificates of deposit also approximates the carrying amount reported in the consolidated balance sheets. The fair value of fixed rate and fixed term certificates of deposit is estimated using a discounted cash flow method which applies interest rates currently being offered for deposits of similar remaining maturities resulting in a Level 2 classification.

Debt - The fair value of debt is estimated using current market rates for borrowings of similar remaining maturity resulting in a Level 2 classification.

Commitments to Extend Credit and Standby Letters of Credit - The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of financial standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties. The fair value of commitments to extend credit and standby letters of credit is not material as of September 30, 2016 and December 31, 2015.

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NOTE 9: EMPLOYEE BENEFIT PLANS

Pension Plan

Prior to January 1995, we maintained a noncontributory defined benefit plan (the “Pension Plan”) covering all eligible employees. During 1995, the Pension Plan was curtailed. Accordingly, all accrued benefits were fully vested and no additional years of service or age will be accrued.

The following tables summarize the components of net periodic benefit cost and other changes in Pension Plan assets and benefit obligations recognized in other comprehensive income for the three and nine months ended September 30, 2016 and 2015:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(In thousands)	2016		2015		2016		2015
Interest cost	$	128	$	112	$	352	$	336
Expected return on plan assets		(241)		(264)		(725)		(791)
Service costs		15		13		44		39
Net loss amortization		95		103		327		308
Net periodic pension cost (benefit)	$	(3)	$	(36)	$	(2)	$	(108)

We have no minimum required contribution for 2016.

Our Pension Investment Policy Statement sets forth the investment objectives and constraints of the Pension Plan. The purpose of the policy is to assist our Retirement Plan Committee in effectively supervising, monitoring, and evaluating the Pension Plan.

NOTE 10: EARNINGS PER SHARE

The following table presents reconciliations of the calculations of basic and diluted earnings per share for the three and nine months ended September 30, 2016 and 2015:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(In thousands except per share data)	2016		2015		2016		2015
Net income	$	3,911	$	3,856	$	11,767	$	10,308
Weighted average common shares outstanding		6,878		6,338		6,866		6,333
Dilutive effect of common stock equivalents		21		11		20		13
Weighted average common and common equivalent shares outstanding		6,899		6,349		6,886		6,346
Basic earnings per common share	$	0.57	$	0.61	$	1.71	$	1.63
Diluted earnings per common share	$	0.57	$	0.61	$	1.71	$	1.62

Basic earnings per common share were computed by dividing net income by the weighted average number of shares of common stock outstanding during the year. Diluted earnings per common share were computed by including potentially dilutive shares on the weighted average share count. Anti-dilutive warrants totaling 34,370 shares have been excluded from the calculation of diluted EPS for the three and nine months ended September 30, 2016, respectively. There were no anti-dilutive shares excluded for the three or nine months ended September 30, 2015.

NOTE 11: STOCK REPURCHASE PROGRAM

We extended our stock buyback program through January 26, 2017. Under the program, which was originally adopted in January 2007, we may repurchase up to 200,000 shares of our common stock on the open market from time to time, and have purchased 143,475 shares at an average price per share of $23.00 since the program's adoption. There were no shares repurchased during the three or nine months ended September 30, 2016.

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NOTE 12: COMMITMENTS AND CONTINGENCIES

Financial Instruments with Off-Balance Sheet Risk

Merchants is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments primarily include commitments to extend credit and financial guarantees. Such instruments involve, to varying degrees, elements of credit and interest rate risk that are not recognized in the accompanying consolidated balance sheets.

Exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and financial guarantees written is represented by the contractual amount of those instruments. We use the same credit policies in making commitments as we do for on-balance sheet instruments.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since a portion of the commitment is expected to expire without being drawn upon, the total commitment amount does not necessarily represent a future cash requirement. We evaluate each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained by us upon extension of credit is based on Management's credit evaluation of the counterparty, and an appropriate amount of real and/or personal property is typically obtained as collateral.

Disclosures are required regarding liability-recognition for the fair value at issuance of certain guarantees. We do not issue any guarantees that would require liability-recognition or disclosure, other than our standby letters of credit. We have issued conditional commitments in the form of standby letters of credit to guarantee payment on behalf of a customer and guarantee the performance of a customer to a third party. Standby letters of credit generally arise in connection with lending relationships. The credit risk involved in issuing these instruments is essentially the same as that involved in extending loans to customers. Contingent obligations under standby letters of credit totaled approximately $7.11 million at September 30, 2016 and $6.30 million at December 31, 2015, respectively, and represent the maximum potential future payments we could be required to make. Typically, these instruments have terms of 12 months or less and expire unused; therefore, the total amounts do not necessarily represent future cash requirements. Each customer is evaluated individually for creditworthiness under the same underwriting standards used for commitments to extend credit and on-balance sheet instruments. Our policies governing loan collateral apply to standby letters of credit at the time of credit extension. Loan-to-value ratios are generally consistent with loan-to-value requirements for other commercial loans secured by similar types of collateral.

We may enter into commitments to sell loans, which involve market and interest rate risk. There were no such commitments at September 30, 2016 or December 31, 2015.

Reserve Balances at the Federal Reserve Bank

At September 30, 2016 and December 31, 2015, amounts at the Federal Reserve Bank included $27.67 million and $30.52 million, respectively, held to satisfy certain reserve requirements of the Federal Reserve Bank.

Legal Proceedings

We have been named as defendants in various legal proceedings arising from our normal business activities. Although the amount of any ultimate liability with respect to such proceedings cannot be determined, in the opinion of Management, based upon input from counsel on the anticipated outcome of such proceedings, any such liability will not have a material effect on our consolidated financial position.

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NOTE 13: ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

The following table presents changes in accumulated other comprehensive income (loss) by component, net of tax for the three and nine months ended September 30, 2016.

	Unrealized		Unrealized Gains
	Gains (Losses)		(Losses) on Securities
	on Securities		Transferred From						Accumulated Other
	Available-For-		Available-For-Sale to				Interest Rate		Comprehensive
(In thousands)	Sale		Held-To-Maturity		Pension Plan		Swaps		Income (Loss)
Beginning Balance June 30, 2016	$	3,673	$	(2,049)	$	(3,587)	$	(79)	$	(2,042)
Other comprehensive (loss) income before reclassifications		(820)		—		(50)		46		(824)
Accretion of unrealized losses of securities transferred from available-for-sale to held-to-maturity recognized in other comprehensive income		—		531		—		—		531
Reclassification adjustments for losses reclassified into income		—		—		62		—		62
Net current period other comprehensive (loss) income		(820)		531		12		46		(231)
Balance September 30, 2016	$	2,853	$	(1,518)	$	(3,575)	$	(33)	$	(2,273)
Beginning Balance December 31, 2015	$	166	$	(2,297)	$	(3,737)	$	(155)	$	(6,023)
Other comprehensive income (loss) before reclassifications		2,687		—		(50)		122		2,759
Accretion of unrealized losses of securities transferred from available-for-sale to held-to-maturity recognized in other comprehensive income		—		779		—		—		779
Reclassification adjustments for losses reclassified into income		—		—		212		—		212
Net current period other comprehensive income		2,687		779		162		122		3,750
Balance September 30, 2016	$	2,853	$	(1,518)	$	(3,575)	$	(33)	$	(2,273)

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The following table presents changes in accumulated other comprehensive income (loss) by component, net of tax for the three and nine months ended September 30, 2015.

	Unrealized		Unrealized Gains
	Gains (Losses)		(Losses) on Securities
	on Securities		Transferred From						Accumulated Other
	Available-For-		Available-For-Sale to				Interest Rate		Comprehensive
(In thousands)	Sale		Held-To-Maturity		Pension Plan		Swaps		Income (Loss)
Beginning Balance June 30, 2015	$	1,200	$	(2,572)	$	(3,261)	$	(290)	$	(4,923)
Other comprehensive income before reclassifications		1,215		—		—		73		1,288
Accretion of unrealized losses of securities transferred from available-for-sale to held-to-maturity recognized in other comprehensive income		—		144		—		—		144
Reclassification adjustments for losses reclassified into income		—		—		67		—		67
Net current period other comprehensive income		1,215		144		67		73		1,499
Balance September 30, 2015	$	2,415	$	(2,428)	$	(3,194)	$	(217)	$	(3,424)
Beginning Balance December 31, 2014	$	1,482	$	(2,824)	$	(3,395)	$	(311)	$	(5,048)
Other comprehensive income before reclassifications		933		—		—		94		1,027
Accretion of unrealized losses of securities transferred from available-for-sale to held-to-maturity recognized in other comprehensive income		—		396		—		—		396
Reclassification adjustments for losses reclassified into income		—		—		201		—		201
Net current period other comprehensive income		933		396		201		94		1,624
Balance September 30, 2015	$	2,415	$	(2,428)	$	(3,194)	$	(217)	$	(3,424)

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Details of the reclassification adjustments in the above table for the three and nine months ended September 30, 2016 and 2015 are presented below:

Details about Accumulated Other	Three Months Ended		Nine Months Ended
Comprehensive Income Components	September 30,		September 30,		Affected Line Item in the Statement
(In thousands)	2016		2016		Where Net Income is Presented
Amortization of defined benefit pension plan
	$	95	$	327	Compensation and benefits expense
		95		327	Total before tax
		(33)		(115)	Provision for income taxes
	$	62	$	212	Net of tax
Total reclassification adjustments	$	62	$	212	Decrease to net income
Details about Accumulated Other	Three Months Ended		Nine Months Ended
Comprehensive Income Components	September 30,		September 30,		Affected Line Item in the Statement
(In thousands)	2015		2015		Where Net Income is Presented
Amortization of defined benefit pension plan
	$	103	$	308	Compensation and benefits expense
		103		308	Total before tax
		(36)		(107)	Provision for income taxes
	$	67	$	201	Net of tax
Total reclassification adjustments	$	67	$	201	Decrease to net income

NOTE 14: DERIVATIVE FINANCIAL INSTRUMENTS

At September 30, 2016 and December 31, 2015, we had an interest rate swap with a notional amount of $10 million that was designated as a cash flow hedge. The swap was used to convert a portion of the floating rate interest on our trust preferred issuance to a fixed rate of interest. Each quarter we assess the effectiveness of the hedging relationships by comparing the changes in cash flows of the derivative hedging instruments with the changes in cash flows of the designated hedged item. There was no ineffective portion recognized in earnings during the three or nine months ended September 30, 2016 or September 30, 2015. The fair values of $51 thousand and $239 thousand was reflected in other liabilities in the accompanying consolidated balance sheets at September 30, 2016 and December 31, 2015, respectively.

We have interest rate swaps with a notional amount of $45.1 million with certain commercial customers.  In order to minimize our risk, these customer derivatives (pay floating/receive fixed swaps) have been offset with essentially matching interest rate swaps with our counterparty totaling $45.1 million (pay fixed/receive floating swaps). At September 30, 2016, the weighted average receive rate of these interest rate swaps was 2.24%, the weighted average pay rate was 3.64% and the weighted average maturity was 9.4 years.  The fair values of $1.83 million and $1.83 million were reflected in other assets and other liabilities, respectively, in the accompanying consolidated balance sheets at September 30, 2016. At December 31, 2015, the weighted average receive rate of these interest rate swaps was 2.13%, the weighted average pay rate was 3.60% and the weighted average maturity was 10.2 years.  The fair values of $765 thousand and $765 thousand were reflected in other assets and other liabilities, respectively, in the accompanying consolidated balance sheets at

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December 31, 2015. Hedge accounting has not been applied for these derivatives.  Since the terms of the swaps with our customer and the other financial institution offset each other, with the only difference being counterparty credit risk, changes in the fair value of the underlying derivative contracts are not materially different and do not significantly impact our results of operations.

We have interest rate swaps with notional amounts totaling $8.4 million at September 30, 2016, and $9.8 million at December 31, 2015, that were designated as fair value hedges of certain fixed rate loans with municipalities. At September 30, 2016, the weighted average receive rate of these interest rate swaps was 1.87%, the weighted average pay rate was 3.27% and the weighted average maturity was 15.8 years. The fair value of $572 thousand at September 30, 2016, was reflected as a reduction to loans and an increase to other assets. At December 31, 2015 the weighted average receive rate of these interest rate swaps was 1.78%, the weighted average pay rate was 3.25% and the weighted average maturity was 16.6 years. The fair value of $319 thousand at December 31, 2015, was reflected as a reduction to loans and an increase to other assets. The ineffective portion of the interest swaps was immaterial and as such, amounts are not recognized in earnings.

We assessed our counterparty risk at September 30, 2016 and determined any credit risk inherent in our derivative contracts was insignificant. Information about the fair value of derivative financial instruments can be found in Note 8 to these consolidated financial statements.

NOTE 15: SUBSEQUENT EVENTS

On October 22, 2016, the Company entered into a definitive merger agreement to be acquired by Community Bank System, Inc. for approximately $304 million in Community Bank System, Inc. stock and cash.  The merger is subject to the approval by the stockholders of Merchants Bancshares, Inc. and regulatory authorities and is expected to be completed during the second quarter of 2017.

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

Forward-Looking Statements

Certain statements contained in this Quarterly Report on Form 10-Q that are not historical facts may constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are intended to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve risks and uncertainties. These statements, which are based on certain assumptions and describe our future plans, strategies and expectations, can generally be identified by the use of the words “may,” “will,” “should,” “could,” “would,” “plan,” “potential,” “estimate,” “project,” “believe,” “intend,” “anticipate,” “expect,” “target” and similar expressions. These statements include, among others, statements regarding our intent, belief or expectations with respect to economic conditions, trends affecting our financial condition or results of operations, and our exposure to market, interest rate and credit risk. 

Forward-looking statements are based on the current assumptions and beliefs of Management and are only expectations of future results. Our actual results could differ materially from those projected in the forward-looking statements as a result of, among other factors, difficulties in achieving cost savings in connection with the acquisition of NUVO Bank & Trust Company (“NUVO”) or in achieving such cost savings within the expected timeframe; adverse conditions in the capital and debt markets; changes in interest rates; competitive pressures from other financial institutions and non-bank entities; weakness in general economic conditions on a national basis or in the local markets in which we operate, including changes which adversely affect borrowers’ ability to service and repay our loans; changes in the value of securities and other assets; changes in loan default and charge-off rates; the adequacy of loan loss reserves; reductions in deposit levels necessitating increased borrowing to fund loans and investments; changes in government regulation; failure to obtain the approval of our stockholders in connection with our proposed merger with Community Bank System, Inc.(“Community”);  the timing to consummate the proposed merger;  the risk that a condition to closing of the proposed merger may not be satisfied; the risk that a regulatory approval that may be required for the proposed merger is not obtained or is obtained subject to conditions that are not anticipated; the parties’ ability to achieve the synergies and value creation contemplated by the proposed merger; the parties’ ability to successfully integrate operations in the proposed merger; the effect of the announcement of the proposed merger on our ability to maintain relationships with our key partners, customers and employees, and on our operating results and business generally; and changes in assumptions used in making such forward-looking statements, as well as the other risks and uncertainties detailed in our Annual Report on Form 10-K and in this Quarterly Report on Form 10-Q. Forward-looking statements speak only as of the date on which they are made. We do not undertake any obligation to update any forward-looking statement to reflect circumstances or events that occur after the date the forward-looking statement is made.

Use of Non-GAAP Financial Measures

Certain information in Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains financial information determined by methods other than in accordance with accounting principles generally accepted in the United States of America (“GAAP”).  We use these “non-GAAP” measures in our analysis of our performance and believe that these non-GAAP financial measures provide a greater understanding of ongoing operations and enhance comparability of results with prior periods as well as demonstrating the effects of significant gains and charges in the current period. We believe that a meaningful analysis of our financial performance requires an understanding of the factors underlying that performance. We believe that investors may use these non-GAAP financial measures to analyze financial performance without the impact of unusual items that may obscure trends in our underlying performance. These disclosures should not be viewed as a substitute for operating results determined in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies.

In several places net interest income is presented on a fully taxable equivalent basis. Specifically included in interest income is tax-exempt interest income from certain tax-exempt loans. An amount equal to the tax benefit derived from this tax exempt income is added back to the interest income total, to produce net interest income on a fully taxable equivalent basis. We believe the disclosure of taxable equivalent net interest income information improves the clarity of financial analysis, and is particularly useful to investors in understanding and evaluating the changes and trends in our results of operations. Other financial institutions commonly present net interest income on a taxable equivalent basis. This

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adjustment is considered helpful in the comparison of one financial institution’s net interest income to that of another, as each will have a different proportion of taxable exempt interest from its earning assets. Moreover, net interest income is a component of a second financial measure commonly used by financial institutions, net interest margin, which is the ratio of net interest income to average earning assets. A reconciliation of taxable equivalent financial information to our consolidated financial statements prepared in accordance with GAAP appears at the bottom of the table entitled “Distribution of Assets, Liabilities and Stockholders’ Equity; Interest Rates and Net Interest Margin” on page 39. 

The tangible capital ratio is the ratio of tangible stockholders’ equity (total stockholders’ equity less goodwill and CDI related to the NUVO acquisition) divided by tangible assets (total assets less goodwill and CDI related to the NUVO acquisition). Tangible book value per share is calculated by dividing tangible stockholders’ equity by period end shares outstanding. A reconciliation of the tangible capital ratio and tangible book value per share can be found below.

Additionally, in several places adjusted financial measures are presented. Adjusted noninterest expense excludes non-recurring expenses not considered integral to the Company’s normal operations. Specifically excluded in adjusted noninterest expense are NUVO acquisition costs, Community Bank System, Inc. merger costs and severance and retirement costs. Adjusted net income is GAAP net income adjusted for these non-recurring elements of noninterest expense. These adjustments are considered helpful in the comparison of quarterly noninterest expense and net income. Reconciliations of adjusted net income and adjusted noninterest expense to our consolidated financial statements prepared in accordance with GAAP appear below and are titled “Adjusted Net Income non-GAAP Reconciliation” and “Adjusted Noninterest Expense Non-GAAP Reconciliation,” respectively.

A 35.0% tax rate was used in both 2016 and 2015.

Tangible Book Value Non-GAAP Reconciliation

	Period Ended
	September 30,			December 31,
(In thousands except share and per share data)	2016			2015
Total assets	$	1,994,655		$	2,021,237
Core deposit intangible		1,207			1,360
Goodwill		7,011			6,967
Tangible assets	$	1,986,437		$	2,012,910
Total stockholders' equity		158,287			148,054
Core deposit intangible		1,207			1,360
Goodwill		7,011			6,967
Tangible stockholders' equity	$	150,069		$	139,727
Period end shares outstanding		6,883,644			6,855,294
Tangible book value per share	$	21.80		$	20.38
Tangible capital ratio		7.55	%		6.94	%

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Adjusted Net Income Non-GAAP Reconciliation

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(In thousands)	2016		2015		2016		2015
Community Bank System, Inc. merger related expenses	$	476	$	—	$	476	$	—
NUVO Bank & Trust Company acquisition related expenses		—		215		61		363
Severance and retirement costs		9		342		186		407
Tax effect		106		110		152		154
Adjustments, net of tax	$	379	$	447	$	571	$	616
GAAP net income as reported		3,911		3,856		11,767		10,308
Adjusted net income	$	4,290	$	4,303	$	12,338	$	10,924

Adjusted Noninterest Expense Non-GAAP Reconciliation

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(In thousands)	2016		2015		2016		2015
Noninterest expense	$	11,420	$	10,591	$	34,172	$	31,079
Less:
Community Bank System, Inc. merger related expenses		476		—		476		—
NUVO Bank & Trust Company acquisition related expenses		—		215		61		363
Severance and retirement costs		9		342		186		407
Adjusted noninterest expense	$	10,935	$	10,034	$	33,449	$	30,309

General

The following discussion and analysis of financial condition as of September 30, 2016 and December 31, 2015 and results of operations of Merchants and its subsidiaries for the three and nine months ended September 30, 2016 and 2015 should be read in conjunction with the consolidated financial statements and notes thereto and selected statistical information appearing elsewhere in this Quarterly Report on Form 10-Q. The financial condition and results of operations of Merchants essentially reflect the operations of its principal subsidiary, Merchants Bank.

RESULTS OF OPERATIONS

Overview

We realized net income of $3.91 million, or $0.57 per diluted share, for the third quarter of 2016 compared to net income $3.86 million in net income, or $0.61 per diluted share, in the third quarter of 2015. For the nine months ended September 30, 2016, net income was $11.77 million, or $1.71 per diluted share, compared to net income of $10.31 million, or $1.62 per diluted share, for the same period in 2015. Excluding NUVO acquisition costs, Community Bank System, Inc. merger costs and severance and retirement related expenses, net of tax, adjusted net income would have been $4.29 million and $12.34 million, or $0.62 and $1.79 per diluted share, for the three and nine months ended September 30, 2016, respectively compared to adjusted net income of $4.30 million and $10.92 million and $0.68 and $1.72 per diluted share for the same periods in 2015. Refer to Adjusted Net Income Non-GAAP table on page 37.

The return on average assets was 0.80% for the three and nine months ended September 30, 2016, compared to 0.88% and 0.79% for the same periods in 2015. The return on average stockholders’ equity was 9.91% and 10.20% for the three and nine months ended September 30, 2016, respectively, compared to 11.93% and 10.75% for the same periods in 2015.

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Stockholders equity ended the quarter at $158.29 million. The book value per share at September 30, 2016 was $22.99 per share, an increase of $1.40 per share from $21.59 at December 31, 2015.  The tangible book value per share at September 30, 2016 was $21.80 per share, an increase of $1.42 per share from $20.38 at December 31, 2015. At September 30, 2016, our common Tier 1 equity ratio was 12.78%. At September 30, 2016, the leverage capital ratio increased to 8.84% from 8.77%, the total risk-based capital ratio decreased slightly to 15.59% from 15.77% and the non-GAAP tangible capital ratio increased to 7.55% from 6.94%, at December 31, 2015. See page 36 for our non-GAAP tangible book value calculation.

· Net interest income: Net interest income was $13.80 million and $41.36 million for the three and nine months ended September 30, 2016, respectively, compared to $12.07 million and $35.37 million for the same periods in 2015. Net interest income on a fully-taxable basis was $14.39 million and $43.02 million for the three and nine months ended September 30, 2016, respectively, compared to $12.60 million and $36.91 million for the same periods in 2015.

· Provision for Credit Losses: The Company recorded a $500 thousand and $905 thousand provision for credit losses for the three and nine months ended September 30, 2016, compared to a $150 thousand and $250 thousand provision for credit losses for the three and nine months ended September 30, 2015. 

· Noninterest income: Noninterest income for the three and nine months ended September 30, 2016 was $3.13 million and $9.28 million, respectively, a decrease of $318 thousand and an increase $404 thousand for the same periods in 2015.

· Noninterest expense: Noninterest expense was $11.42 million and $34.17 million three and nine months ended September 30, 2016, an increase of $829 thousand and $3.09 million from the same periods in 2015.  Excluding NUVO acquisition costs, Community Bank System, Inc. merger costs and severance and retirement costs, adjusted noninterest expense was $10.94 million and $33.45 million for the three and nine months ended September 30, 2016, respectively, compared to $10.03 million and $30.31 million for the same periods in 2015. Refer to the “Adjusted Noninterest Expense Non-GAAP Reconciliation” on page 37 for additional information.

· Loans: Loans were $1.48 billion for the third quarter of 2016, an increase of $63.01 million from December 31, 2015. Average loans totaled $1.45 billion and $1.43 billion for the three and nine months ended September 30, 2016, respectively compared to average loans of $1.25 billion and $1.22 billion for the three and nine months ended September 30, 2015, respectively.

· Investments: The investment portfolio, which includes FHLB stock, ended the quarter at $394.49 million, a decrease of $12.44 million from December 31, 2015.

· Deposits: Total deposits were $1.50 billion at September 30, 2016, a decrease of $47.60 million from December 31, 2015. Average deposits totaled $1.50 billion and $1.51 billion for the three and nine months ended September 30, 2016, respectively compared to average deposits of $1.40 billion and $1.36 billion for the three and nine months ended September 30, 2015, respectively.

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Net Interest Income

As shown on the following tables, our fully taxable equivalent (“FTE”) net interest income was $14.39 million and $43.02 million for the three and nine months ended September 30, 2016, respectively compared to $12.60 million and $36.91 million for the three and nine months ended September 30, 2015, respectively.Our fully taxable equivalent net interest margin increased 7 and 10 basis points to 3.03% and 3.05% for the three and nine months ended September 30, 2016, respectively from 2.96% and 2.95% for the same periods in 2015. The increase in the net interest margin from the same period in 2015 was driven by higher loan yields and changes in the loan mix.

The following tables present an analysis of net interest income and interest income earned and interest expense charged for each major component of interest earning assets and interest bearing liabilities. Yields/rates are computed on a FTE basis, using a 35% rate. Nonaccrual loans are included in the average loan balance outstanding.

Distribution of Assets, Liabilities and Stockholders' Equity; Interest Rates and Net Interest Margin

	Three Months Ended
	September 30, 2016						September 30, 2015
			Interest						Interest
	Average		Income/		Average		Average		Income/		Average
(In thousands, fully taxable equivalent)	Balance		Expense		Rate		Balance		Expense		Rate
ASSETS:
Loans, including fees on loans	$	1,451,612	$	13,647	3.74	%	$	1,245,861	$	11,583	3.69	%
Investments		385,644		1,818	1.89	%		395,560		1,961	1.98	%
Interest-earning deposits with banks and other short-term investments		40,879		54	0.53	%		52,795		25	0.19	%
Total interest earning assets		1,878,135		15,519	3.29	%		1,694,216		13,569	3.19	%
Allowance for loan losses		(12,468)						(12,223)
Cash and due from banks		30,221						26,049
Bank premises and equipment, net		13,889						15,142
Bank owned life insurance		10,680						10,456
Other assets		37,325						26,103
Total assets	$	1,957,782					$	1,759,743
LIABILITIES AND STOCKHOLDERS' EQUITY:
Interest-bearing deposits:
Savings, interest bearing checking and money market accounts	$	662,250	$	413	0.25	%	$	613,337	$	354	0.23	%
Time deposits		213,853		321	0.60	%		195,044		318	0.65	%
Total interest bearing deposits		876,103		734	0.33	%		808,381		672	0.33	%
Short-term borrowings		63,130		79	0.50	%		9,649		8	0.33	%
Securities sold under agreements to repurchase, short-term		206,181		107	0.21	%		195,410		89	0.18	%
Other long-term debt		3,680		12	1.22	%		2,265		12	2.01	%
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		201	3.88	%		20,619		187	3.63	%
Total borrowed funds		293,610		399	0.54	%		227,943		296	0.52	%
Total interest bearing liabilities	$	1,169,713	$	1,133	0.39	%	$	1,036,324	$	968	0.37	%
Noninterest bearing deposits		620,142						586,773
Other liabilities		10,131						7,388
Stockholders' equity		157,796						129,258
Total liabilities and stockholders' equity	$	1,957,782					$	1,759,743
Net interest earning assets	$	708,422					$	657,892
Net interest income (fully taxable equivalent)			$	14,386					$	12,601
Tax equivalent adjustment				(589)						(528)
Net interest income			$	13,797					$	12,073
Net interest rate spread					2.90	%					2.82	%
Net interest margin					3.03	%					2.96	%

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	Nine Months Ended
	September 30, 2016						September 30, 2015
			Interest						Interest
	Average		Income/		Average		Average		Income/		Average
(In thousands, fully taxable equivalent)	Balance		Expense		Rate		Balance		Expense		Rate
ASSETS:
Loans, including fees on loans	$	1,432,167	$	40,421	3.77	%	$	1,218,067	$	34,013	3.73	%
Investments		397,146		5,803	1.95	%		379,030		5,784	2.04	%
Interest-earning deposits with banks and other short-term investments		50,695		193	0.51	%		73,630		157	0.28	%
Total interest earning assets		1,880,008		46,417	3.30	%		1,670,727		39,954	3.20	%
Allowance for loan losses		(12,264)						(12,065)
Cash and due from banks		29,324						25,066
Bank premises and equipment, net		14,358						15,362
Bank owned life insurance		10,626						10,395
Other assets		37,344						27,038
Total assets	$	1,959,396					$	1,736,523
LIABILITIES AND STOCKHOLDERS' EQUITY:
Interest-bearing deposits:
Savings, interest bearing checking and money market accounts	$	666,433	$	1,277	0.26	%	$	577,006	$	1,075	0.25	%
Time deposits		225,442		1,052	0.62	%		201,601		975	0.65	%
Total interest bearing deposits		891,875		2,329	0.35	%		778,607		2,050	0.35	%
Short-term borrowings		29,469		110	0.50	%		5,285		13	0.33	%
Securities sold under agreements to repurchase, short-term		233,934		319	0.18	%		212,859		390	0.24	%
Other long-term debt		4,234		43	1.34	%		2,286		35	2.03	%
Junior subordinated debentures issued to unconsolidated subsidiary trust		20,619		594	3.85	%		20,619		560	3.63	%
Total borrowed funds		288,256		1,066	0.49	%		241,049		998	0.55	%
Total interest bearing liabilities	$	1,180,131	$	3,395	0.38	%	$	1,019,656	$	3,048	0.40	%
Noninterest bearing deposits		615,401						581,351
Other liabilities		10,042						7,640
Stockholders' equity		153,822						127,876
Total liabilities and stockholders' equity	$	1,959,396					$	1,736,523
Net interest earning assets	$	699,877					$	651,071
Net interest income (fully taxable equivalent)			$	43,022					$	36,906
Tax equivalent adjustment				(1,662)						(1,535)
Net interest income			$	41,360					$	35,371
Net interest rate spread					2.92	%					2.80	%
Net interest margin					3.05	%					2.95	%

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The following table presents the extent to which changes in interest rates and changes in the volume of earning assets and interest bearing liabilities have affected interest income and interest expense during the periods indicated. Information is presented in each category with respect to: (i) changes attributable to changes in volume (changes in volume multiplied by prior rate), (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume) and (iii) changes in volume/rate (change in volume multiplied by change in rate).

Analysis of Changes in Fully Taxable Equivalent Net Interest Income

	Three Months Ended						Due to
	September 30,				Increase						Volume/
(In thousands)	2016		2015		(Decrease)		Volume		Rate		Rate
Fully taxable equivalent interest income:
Loans, including fees on loans	$	13,647	$	11,583	$	2,064	$	1,908	$	158	$	(2)
Investments		1,818		1,961		(143)		(49)		(94)		—
Federal funds sold, securities sold under agreements to repurchase and interest bearing deposits with banks		54		25		29		(6)		45		(10)
Total interest income		15,519		13,569		1,950		1,853		109		(12)
Less interest expense:
Savings, interest bearing checking and money market accounts		413		354		59		28		28		3
Time deposits		321		318		3		31		(26)		(2)
Federal funds purchased and Federal Home Loan Bank short-term borrowings		79		8		71		44		4		23
Securities sold under agreements to repurchase, short-term		107		89		18		5		13		—
Other long-term debt		12		12		—		7		(4)		(3)
Junior subordinated debentures issued to unconsolidated subsidiary trust		201		187		14		—		13		1
Total interest expense		1,133		968		165		115		28		22
Net interest income	$	14,386	$	12,601	$	1,785	$	1,738	$	81	$	(34)

	Nine Months Ended						Due to
	September 30,				Increase						Volume/
(In thousands)	2016		2015		(Decrease)		Volume		Rate		Rate
Fully taxable equivalent interest income:
Loans, including fees on loans	$	40,421	$	34,013	$	6,408	$	2,007	$	123	$	4,278
Investments		5,803		5,784		19		93		(88)		14
Federal funds sold, securities sold under agreements to repurchase and interest bearing deposits with banks		193		157		36		(16)		42		10
Total interest income		46,417		39,954		6,463		2,084		77		4,302
Less interest expense:
Savings, interest bearing checking and money market accounts		1,277		1,075		202		56		9		137
Time deposits		1,052		975		77		39		(14)		52
Federal funds purchased and Federal Home Loan Bank short-term borrowings		110		13		97		20		2		75
Securities sold under agreements to repurchase, short-term		319		390		(71)		13		(31)		(53)
Other long-term debt		43		35		8		10		(4)		2
Junior subordinated debentures issued to unconsolidated subsidiary trust		594		560		34		—		11		23
Total interest expense		3,395		3,048		347		138		(27)		236
Net interest income	$	43,022	$	36,906	$	6,116	$	1,946	$	104	$	4,066

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Allowance for Loan Losses

The allowance for loan losses at September 30, 2016 was $12.54 million, or 0.85% of total loans and 296% of nonperforming loans, compared to $12.04 million, or 0.85% of total loans and 302% of nonperforming loans at December 31, 2015, respectively.  We recorded a $500 thousand and $905 thousand provision for credit losses for the three and nine months ended September 30, 2016, compared to a $150 thousand and a $250 thousand provision for credit losses for the three and nine months ended September 30, 2015.  The primary factor for the provision in the third quarter of 2016 was to support growth in loan balances including the seasonal increase in municipal loans. Performing loans past due 31-90 days were 0.06% of total loans at September 30, 2016 compared to 0.05% at December 31, 2015.  Nonperforming loans as a percent of total loans were 0.29% at September 30, 2016 compared to 0.28% at December 31, 2015.  Accruing substandard loans increased to 2.17% of total loans at September 30, 2016 compared to 1.32% at December 31, 2015.  Net charge-offs for the nine months ended September 30, 2016 totaled $315 thousand. All of these factors are taken into consideration during Management’s quarterly review of the allowance for loan losses. For a more detailed discussion of our allowance for loan loss and nonperforming assets, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Credit Quality and Allowance for Credit Losses” below.

NONINTEREST INCOME AND EXPENSES

Noninterest Income

Noninterest income for the three and nine months ended September 30, 2016 was $3.13 million and $9.28 million, respectively, a decrease of $318 thousand and an increase of $404 thousand for the same periods in 2015. The decline from the third quarter in 2015 was primarily due to non-recurring miscellaneous income of $440 thousand recognized in the prior period.

Noninterest Expense

Noninterest expense was $11.42 million and $34.17 million three and nine months ended September 30, 2016, an increase of $829 thousand and $3.09 million from the same periods in 2015.  Excluding NUVO acquisition costs, Community Bank System, Inc. merger costs and severance and retirement costs, adjusted noninterest expense was $10.94 million and $33.45 million for the three and nine months ended September 30, 2016, respectively, an increase of $901 thousand and $3.14 million for the same periods in 2015. The increase on an adjusted basis for the three and nine months ended September 30, 2016 is primarily due to the acquisition of NUVO in December 2015.

Income Taxes

Merchants Bancshares’ effective tax rate was 21.9% and 24.4% for the three and nine months ended September 30, 2016, respectively, compared to 19.3% and 20.2% for the three and nine months ended September 30, 2015, respectively.  The increase is mainly due to changes in business mix composition.

BALANCE SHEET ANALYSIS

Our total assets were $1.99 billion at September 30, 2016, a decrease of $26.58 million from December 31, 2015.  Average earning assets increased to $1.88 billion for the three and nine months ended September 30, 2016, from $1.69 and $1.67 billion for the three and nine months ended September 30, 2015, respectively, mainly due to the NUVO acquisition.

Loans

Average loans for the three months ended September 30, 2016 were $1.45 billion, a $24.65 million, or 1.73%, increase over average loans on a linked quarter basis and an increase of $205.75 million, or 16.51% over the same period in 2015. Loans at September 30, 2016 were $1.48 billion, a $63.01 million increase from $1.41 billion at December 31, 2015. The increase in loan balances from December 31, 2015 is mainly driven by growth in total commercial and commercial real estate loans. 

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The composition of our loan portfolio is shown in the following table:

(In thousands)	September 30, 2016		June 30, 2016		December 31, 2015		September 30, 2015
Commercial, financial and agricultural	$	268,530	$	260,167	$	237,451	$	207,067
Municipal loans		112,007		60,590		105,421		108,423
Residential		450,584		456,132		468,443		448,632
Commercial Real Estate		584,392		560,056		558,004		450,673
Construction		55,210		50,788		34,802		40,748
Installment loans		6,547		7,629		10,115		2,370
All other loans		15		31		44		19
Total loans	$	1,477,285	$	1,395,393	$	1,414,280	$	1,257,932

Totals above are shown net of deferred loans fees of $1.14 million, $1.14 million, $1.20 million, and $802 thousand for September 30, 2016, June 30, 2016, December 31, 2015, and September 30, 2015, respectively.

Investments

The investment portfolio is used to generate interest income, and to manage liquidity and interest rate sensitivity. The average investment portfolio, including FHLB stock, for the third quarter of 2016 was $385.64 million, a decrease of $9.92 million from the average balance for the third quarter of 2015. The ending balance in the investment portfolio, including FHLB stock, at September 30, 2016 was $394.49 million, compared to $406.93 million at December 31, 2015. The book balance of the portfolio at September 30, 2016 includes a $4.40 million net unrealized gain on the available for sale portion of the investment portfolio, compared to a net unrealized gain of $269 thousand at December 31, 2015.

The composition of our investment portfolio as of September 30, 2016, including both available for sale and held to maturity securities, consisted of the following: 

	Amortized		Fair
(In thousands)	Cost		Value
Available for Sale:
U.S. Treasury Obligations	$	25,076	$	25,333
U.S. Government Sponsored Enterprises ("U.S. GSEs")		49,030		49,529
Federal Home Loan Bank ("FHLB") Obligations		62,372		63,247
Residential Real Estate Mortgage-backed Securities ("Agency MBSs")		80,061		82,293
Agency Commercial Mortgage Backed Securities ("Agency CMBSs")		24,162		24,280
Agency Collateralized Mortgage Obligations ("Agency CMOs")		53,576		53,961
Asset Backed Securities ("ABSs")		295		330
Total Available for Sale	$	294,572	$	298,973
Held to Maturity:
U.S. Agency Obligations	$	18,073	$	18,903
Agency CMOs		66,456		67,686
Agency MBSs		6,143		6,429
Total Held to Maturity		90,672		93,018
Total Securities	$	385,244	$	391,991

Agency MBSs and Agency CMOs consist of pools of residential mortgages which are guaranteed by the FNMA, FHLMC, or GNMA with various origination dates and maturities.  Agency CMBS consists of bonds backed by commercial real estate which are guaranteed by FNMA and GNMA. 

We do not intend to sell the investment securities that are in an unrealized loss position, and it is unlikely that we will be required to sell the investment securities before recovery of their amortized cost basis. 

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As a member of the Federal Home Loan Bank (“FHLB”) of Boston, we are required to invest in stock of the FHLB in an amount determined based on our borrowings from the FHLB.  Our investment in FHLB stock totaled $4.84 million at September 30, 2016 compared to $3.80 million at December 31, 2015. The FHLB continues to be classified as “adequately capitalized” by its primary regulator. Based on current available information, we have concluded that our investment in FHLB stock is not impaired.  We will continue to monitor our investment in FHLB stock. 

Deposits and Other Liabilities

Our total deposit balance was $1.50 billion at September 30, 2016, a decrease of $47.60 million from December 31, 2015. Our average deposit balance increased by $101.09 million to $1.50 billion for the three months ended September 30, 2016 from $1.40 billion from the same period in 2015. The average deposit balance increased by $147.32 million to $1.51 billion for the nine months ended September 30, 2016 from $1.36 billion from the same period in 2015.

Securities sold under agreement to repurchase, which represent collateralized customer accounts, were $276.08 million at September 30, 2016, an increase of $8.29 million from $267.79 million at September 30, 2015, due to an increase in municipal customers. The average securities sold under agreement to repurchase balance increased to $206.18 million for the three months ended September 30, 2016 from $195.41 million from the same period in 2015 due to the acquisition of NUVO. The average securities sold under agreement to repurchase balance increased to $233.93 million for the nine months ended September 30, 2016 from $212.86 million from the same period in 2015.

CREDIT QUALITY AND ALLOWANCE FOR CREDIT LOSSES

Recent statistics on the United States economy show continued improvement in the labor market and a Real GDP increase at an annual rate of 1.1% in the second quarter of 2016.  Nationwide unemployment rates have remained flat at 5.0% at September 30, 2016 and December 31, 2015.  

In Vermont, seasonally-adjusted statewide unemployment rates continue to decline and are tied for the 5th lowest unemployment rate in the country in July 2016.  The Massachusetts seasonally-adjusted statewide unemployment rate was slightly lower than the national average and is ranked as the 14th lowest unemployment rate in the country as of July 2016.

Credit quality

Credit quality is a major strategic focus and strength of our company.  Although we actively manage current nonperforming and classified loans, there is no assurance that we will not have increased levels of problem assets in the future.  The composition of the nonperforming pool is dynamic with accounts moving in and out of this category over time.

The following table summarizes our nonperforming loans (“NPL”) and nonperforming assets (“NPA”) as of the dates indicated.

(In thousands)	September 30, 2016		June 30, 2016		December 31, 2015		September 30, 2015
Nonaccrual loans	$	3,488	$	3,659	$	3,513	$	713
Loans past due greater than 90 days and accruing		—		—		—		—
Troubled debt restructurings (“TDR”)		748		830		472		51
Total nonperforming loans		4,236		4,489		3,985		764
OREO		—		60		12		—
Total nonperforming assets	$	4,236	$	4,549	$	3,997	$	764

Nonperforming loans at September 30, 2016 were $4.24 million, including $2.53 million in nonperforming loans acquired from NUVO.  Of the $4.24 million in nonperforming loans in the table above there were $3.43 million in commercial and commercial real estate loans and $813 thousand in residential mortgages.  Nonperforming loans, as of June 30, 2016, December 31, 2015, September 30, 2015 were adjusted $200 thousand, $210 thousand, and $640 thousand, respectively for accruing TDRs reflecting the Company’s policy update classifying these loans as performing loans.

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Our analysis indicates any additional loss exposure on current non-accruing loans is minimal based on a combination of estimated collateral value and a specific allocation of reserve, where needed. 

TDRs represent balances where the existing loan was modified involving a concession in rate, term or payment amount due to the distressed financial condition of the borrower. There were three restructured residential mortgages at September 30, 2016 with balances totaling $113 thousand. There were two restructured commercial loans and one commercial real estate loan at September 30, 2016 with balances of $397 thousand and $432 thousand, respectively.  At September 30, 2016, five TDRs continue to pay as agreed according to the modified terms and are considered well-secured. One TDR is not paying as agreed according to the terms and is not considered well-secured.

Excluded from the nonperforming balances discussed above are loans that are 31 to 90 days past due, which are not necessarily considered classified or impaired.  Accruing loans 31 to 90 days past due as a percentage of total loans as of the periods indicated are presented in the following table:

Period Ended	31-90 Days
September 30, 2016	0.06	%
June 30, 2016	0.06	%
March 31, 2016	0.28	%
December 31, 2015	0.05	%
September 30, 2015	0.01	%

Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days. If a loan or a portion of a loan is internally classified as impaired or is partially charged-off, the loan is generally classified as nonaccrual. Loans that are on a current payment status or past due less than 91 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt. Income accruals are suspended on all non-accruing loans, and all previously accrued and uncollected interest is charged against current income. 

Loans may be returned to accrual status when there is a sustained period of repayment performance (generally a minimum of six months) by the borrower, in accordance with the contractual terms of the loans and all principal and interest amounts contractually due, including arrearages, are reasonably assured of repayment within an acceptable period of time.

While a loan is classified as nonaccrual and the future collectability of the recorded loan balance is uncertain, any payments received are generally applied to reduce the principal balance. When the future collectability of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan has been partially charged-off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Interest collections in excess of that amount are recorded as a reduction of principal.

A loan remains in non-accruing status until the factors which suggest doubtful collectability no longer exist, the loan is liquidated, or when the loan is determined to be uncollectible, and is charged off against the allowance for loan losses.  In those cases where a non-accruing loan is secured by real estate, we can, and may, initiate foreclosure proceedings.  The result of such action will either be to cause repayment of the loan with the proceeds of a foreclosure sale or to give us possession of the collateral in order to manage a future resale of the real estate.  Foreclosed property is recorded at the lower of its cost or estimated fair value, less any estimated costs to sell and is actively marketed.  Any cost in excess of the estimated fair value on the transfer date is charged to the allowance for loan losses, while further declines in market values are recorded as OREO expense in the consolidated statements of income. Nonperforming loans, which primarily consist of non-accruing residential mortgage, commercial, commercial real estate loans and non-accruing TDRs totaled $4.24 million and $4.00 million at September 30, 2016 and December 31, 2015, respectively.  At September 30, 2016, $623 thousand of nonperforming loans had specific reserve allocations totaling $218 thousand. 

Substandard loans at September 30, 2016 totaled $36.27 million, of which $32.11 million in loans continue to accrue interest.  Loans identified as substandard have well-defined weaknesses that, if not addressed, could result in a loss.  These accruing substandard loans have generally continued to pay promptly and Management conducts regularly scheduled

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comprehensive reviews of the borrowers’ financial condition, payment performance, accrual status and collateral.  These reviews also ensure that these troubled accounts are properly administered with a focus on loss mitigation and that any potential loss exposures are appropriately quantified, and reserved for. The findings of this review process are a key component in assessing the adequacy of our loan loss reserve.

Accruing substandard loans at September 30, 2016 reflect a $13.41 million increase in balances since December 31, 2015. At September 30, 2016, accruing substandard loans related to owner-occupied commercial real estate totaled $13.71 million, investor commercial real estate loans totaled $1.92 million, residential investment real estate loans totaled $910 thousand, residential mortgage loans total $74 thousand and $15.50 million in substandard loans are outstanding to corporate borrowers in a variety of different industries. Seventeen borrowers in a variety of industries account for 93% of the total accruing substandard loans.

To date, with very few exceptions, payments due from accruing substandard borrowers have been made as agreed and Management’s ongoing evaluation of these borrowers’ financial condition and collateral indicates a reasonable certainty that these exposures are adequately secured. 

Management monitors asset quality closely and continuously performs detailed and extensive reviews on larger credits and problematic credits identified on the watched asset list, nonperforming asset listings and internal credit rating reports.  In addition to frequent financial analysis and review of well-rated and adversely graded loans, Management incorporates active monitoring of key credit and non-credit risks for each customer, assessing risk through the daily reviews of overdrafts, delinquencies and usage of electronic banking products and tracking for timely receipt of all required financial statements.

Allowance for Credit Losses

The allowance for credit losses is made up of two components: the allowance for loan losses (“ALL”) and the reserve for undisbursed lines and standby letters of credit.  The reserves are based on Management's estimate of the amount required to reflect the probable incurred losses in the loan portfolio, based on circumstances and conditions known at each reporting date. We review the adequacy of the reserves quarterly. Factors considered in evaluating the adequacy of the reserves include previous loss experience, the size and composition of the portfolio, risk rating composition, current economic and real estate market conditions and their effect on the borrowers, the performance of individual loans in relation to contractual terms, estimated fair values of properties that secure impaired loans and utilization rates of lines of credit.

The adequacy of the reserves are determined using a consistent, systematic methodology, consisting of a review of both specific reserves for loans identified as impaired and general reserves for the various loan portfolio classifications.  When a loan is impaired, we determine its impairment loss by comparing the excess, if any, of the loan’s carrying amount over (1) the present value of expected future cash flows discounted at the loan’s original effective interest rate, (2) the observable market price of the impaired loan, or (3) the fair value of the collateral securing a collateral-dependent loan.  When a loan is deemed to have an impairment loss, the loan is either charged down to its estimated net realizable value, or a specific reserve is established as part of the overall allowance for loan losses if Management needs more time to evaluate all of the facts and circumstances relevant to that particular loan.

The general allowance for loan losses is a percentage-based reflection of historical loss experience adjusted for qualitative factors and assigns a required allocation by loan classification based on a fixed percentage of all outstanding loan balances. The general allowance for loan losses employs a risk-rating model that grades loans based on their general characteristics of credit quality and relative risk. Appropriate reserve levels are estimated based on Management’s judgments regarding the historical loss experience, current economic trends, trends in the portfolio mix, volume and trends in delinquencies and non-accrual loans.

Losses are charged against the ALL when Management believes that the collectability of principal is doubtful. To the extent Management determines the level of anticipated losses in the portfolio increased or diminished, the ALL is adjusted through current earnings. Management believes that the reserves are maintained at an adequate level, in light of historical and current factors, to reflect the level of credit risk in the loan portfolio. Loan loss experience and nonperforming asset data are presented and discussed in relation to their impact on the adequacy of the ALL.

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The following table reflects our loan loss experience and activity in the allowance for loan losses for the periods indicated:

	Three Months			Nine Months			Twelve Months			Nine Months
	Ended			Ended			Ended			Ended
(In thousands)	September 30, 2016			September 30, 2016			December 31, 2015			September 30, 2015
Average loans during the period	$	1,451,612		$	1,432,167		$	1,240,386		$	1,218,067
Allowance beginning of the period		12,420			12,040			11,833			11,833
Charge-offs:
Commercial, financial & agricultural		(115)			(122)			(29)			(28)
Residential		(82)			(155)			(112)			(84)
Commercial Real Estate		—			—			—			—
Installment, Other		(50)			(128)			(108)			(65)
Total charge-offs		(247)			(405)			(249)			(177)
Recoveries:
Commercial, financial & agricultural		1			5			34			31
Residential		6			28			52			36
Commercial Real Estate		—			4			2			2
Construction		—			—			—			—
Installment, Other		14			53			52			41
Total recoveries		21			90			140			110
Net charge-offs		(226)			(315)			(109)			(67)
Provision for loan losses		346			815			316			444
Allowance end of period	$	12,540		$	12,540		$	12,040		$	12,210
Ratio of net charge-offs to average loans outstanding		(0.06)	%		(0.03)	%		(0.01)	%		(0.01)	%
Components:
Provision for allowance for loan losses	$	346		$	815		$	316		$	444
Provision for reserve for undisbursed lines and letters of credit		154			90			(66)			(194)
Provision for credit losses	$	500		$	905		$	250		$	250

The following table reflects our nonperforming asset and coverage ratios as of the dates indicated:

	September 30, 2016		June 30, 2016		December 31, 2015		September 30, 2015
NPL to total loans	0.29	%	0.32	%	0.28	%	0.06	%
NPA to total assets	0.21	%	0.24	%	0.20	%	0.04	%
Allowance for loan losses to total loans	0.85	%	0.89	%	0.85	%	0.97	%
Allowance for loan losses to NPL	296	%	277	%	302	%	1600	%

We will continue to take all appropriate measures to restore nonperforming assets to performing status or otherwise liquidate these assets in an orderly fashion so as to maximize their value. There can be no assurances that we will be able to complete the disposition of nonperforming assets without incurring further losses.

Loan Portfolio Monitoring

Our Board of Directors grants loan officers the authority to originate loans on our behalf, subject to certain limitations. The Board of Directors also establishes restrictions regarding the types of loans that may be granted and the distribution of loan types within our portfolio, and sets loan authority limits for lenders. These authorized lending limits are reviewed at least annually and are based upon the lender's knowledge and experience. Loan requests that exceed a lender's authority require the signature of our Senior Lender, the Senior Credit Officer, and/or our President. With the exception of certain municipal loans, all extensions of credit of $5 million or greater to any one borrower, or related party interest, are reviewed

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and approved by the Loan Committee of Merchants Bank’s Board of Directors. Short-term Revenue Anticipation and Tax Anticipation extensions of credit of $8 million or greater to a municipality are reviewed and approved by the Loan Committee of Merchants Bank’s Board of Directors.

The Loan Committee and the credit department regularly monitor our loan portfolio. The entire loan portfolio, as well as individual loans, is reviewed for loan performance, compliance with internal policy requirements and banking regulations, creditworthiness, and strength of documentation. We monitor loan concentrations by individual borrowers, industries and loan types. As part of the annual credit policy review process, targets are set by loan type for the total portfolio. Credit risk ratings assessing inherent risk in individual loans are assigned to commercial loans at origination and are reviewed by lenders and Management on a periodic basis according to total exposure and risk rating. These internal reviews assess the adequacy of all aspects of credit administration, additionally; we maintain an on-going active monitoring process of loan performance during the year.  We have also hired external loan review firms to assist in monitoring the commercial, municipal, construction and residential loan portfolios. The commercial loan review firm reviews a minimum threshold of our commercial loan portfolio each year. These comprehensive reviews assessed the accuracy of our risk rating system as well as the effectiveness of credit administration in managing overall credit risks.

All loan officers are required to service their loan portfolios and account relationships. Loan officers, a commercial workout officer, or collection personnel take remedial actions to assure full and timely payment of loan balances as necessary, with the supervision of the Senior Lender and the Senior Credit Officer.

Liquidity and Capital Resource Management

General

Liquid assets are maintained at levels considered adequate to meet our liquidity needs.  Liquidity is adjusted as appropriate to meet asset and liability management objectives. Liquidity is monitored by the Asset and Liability Committee (“ALCO”) of Merchants Bank’s Board of Directors, based upon Merchants Bank’s policies. Our primary sources of liquidity are deposits, amortization and prepayment of loans, maturities of investment securities and other short-term investments, periodic principal repayments on mortgage-backed and other amortizing securities, advances from the FHLB, and earnings and funds provided from operations. While scheduled principal repayments on loans are a relatively predictable source of funds, deposit flows and loan prepayments are greatly influenced by market interest rates, economic conditions, and rates offered by our competition. Interest rates on deposits are priced to maintain a desired level of total deposits.

As of September 30, 2016, we could borrow up to $55 million in overnight funds through unsecured borrowing lines established with correspondent banks.  In addition, we have established both overnight and longer term lines of credit with the FHLB. These borrowings are secured by residential mortgage loans. At September 30, 2016, we pledged loans with a carrying value of $361.73 million which carries a $256.26 million borrowing capacity at the FHLB, less borrowings and letters of credit of $44.75 million, resulting in quarter-end capacity of $211.51 million. At December 31, 2015, we pledged loans with a carrying value of $369.78 million which carried a $262.96 million borrowing capacity at the FHLB, less borrowings and letters of credit of $15.25 million, resulting in year-end capacity of $246.92 million. We also have the ability to borrow through the use of repurchase agreements, collateralized by our investments, with certain approved counterparties. Our investment portfolio, which is managed by the ALCO, had a carrying amount of $389.65 million at September 30, 2016, of which $363.92 million was pledged.  The portfolio is a reliable source of cash flow for us. We closely monitor our short term cash position.  Any excess funds are either left on deposit at the Federal Reserve Bank, or are in a fully insured account with one of our correspondent banks.

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Presented below are our short-term borrowings during the periods indicated:

	Three Months Ended			Nine Months Ended
(Dollars in thousands)	September 30, 2016			September 30, 2016
FHLB and other short-term borrowings
Amount outstanding at end of period	$	22,000		$	22,000
Maximum during the period amount outstanding		110,000			110,000
Average amount outstanding		63,130			29,469
Weighted average-rate during the period		0.50	%		0.50	%
Weighted average rate at period end		0.43	%		0.43	%
Securities sold under agreement to repurchase, short-term
Amount outstanding at end of period	$	276,083		$	276,083
Maximum during the period amount outstanding		295,344			295,344
Average amount outstanding		206,181			233,934
Weighted average-rate during the period		0.21	%		0.18	%
Weighted average rate at period end		0.20	%		0.20	%

Commitments and Off-Balance Sheet Risk

We are a party to financial instruments with off‑balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments primarily include commitments to extend credit and financial guarantees. Contingent obligations under standby letters of credit totaled approximately $7.11 million and $6.30 million at September 30, 2016 and December 31, 2015, respectively, and represent the maximum potential future payments we could be required to make.  Typically, these instruments have terms of 12 months or less and expire unused: therefore, the total amounts do not necessarily represent future cash requirements.  The fair value of our standby letters of credit at September 30, 2016 and December 31, 2015 was insignificant. 

Capital Resources

We are subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on our financial statements. Under capital adequacy guidelines, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. It is the policy of the Board of Governors of the Federal Reserve System (the “FRB”) that banks and bank holding companies, respectively, should pay dividends only out of current earnings and only if, after paying such dividends, the bank or bank holding company would remain adequately capitalized. The FRB has the authority to prohibit a bank holding company, such as us, from paying dividends if it deems such payment to be an unsafe or unsound practice. The FDIC has the authority to use its enforcement powers to prohibit a bank from paying dividends if, in its opinion, the payment of dividends would constitute an unsafe or unsound practice. Federal law also prohibits the payment of dividends by a bank that will result in the bank failing to meet its applicable capital requirements on a pro forma basis.  We are also subject to the regulatory framework for prompt corrective action that requires us to meet specific capital guidelines to be considered well capitalized. Our capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

Quantitative measures established by regulation to ensure capital adequacy require us to maintain minimum ratios of common equity, total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average assets. Management believes, as of September 30, 2016, that Merchants met all capital adequacy requirements to which it is subject.

Under rules effective January 1, 2015, a bank holding company, such as Merchants Bancshares, is considered well capitalized if the bank holding company (i) has a total risk based capital ratio of at least 10%, (ii) has a Tier 1 risk-based capital ratio of at least 8%, and (iii) is not subject to any written agreement order, capital directive or prompt corrective action directive to meet and maintain a specific capital level for any capital measure. In addition, the FDIC has amended its prompt corrective action rules to reflect the new capital rules. Under the FDIC’s revised rules, which became effective January 1, 2015, an FDIC supervised institution, such as Merchants Bank is considered well capitalized if it (i) has a total

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risk-based capital ratio of 10.0% or greater; (ii) a Tier 1 risk-based capital ratio of 8.0% or greater; (iii) a common Tier 1 equity ratio of at least 6.5% or greater, (iv) a leverage capital ratio of 5.0% or greater; and (iv) is not subject to any written agreement, order, capital directive, or prompt corrective action directive to meet and maintain a specific capital level for any capital measure.  The final rule also requires unrealized gains and losses on certain “available-for-sale” securities holdings to be included for purposes of calculating regulatory capital requirements unless a one-time opt-out is exercised.  Merchants elected to opt-out of this regulatory capital provision.  By opting out of the provision, Merchants retains what is known as the accumulated other comprehensive income filter.  The final rule limits a banking organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a “capital conservation buffer” in addition to the amount necessary to meet its minimum risk-based capital requirements.  The phase-in period for the “capital conservation buffer” requirement began January 1, 2016 with a requirement to be 0.625% above the minimum risk-based capital requirements.  When fully phased in on January 1, 2019, banks must maintain a “capital conservation buffer” of 2.50%.

As of September 30, 2016, the most recent notification from the FDIC categorized Merchants Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that Management believes have changed Merchants Bank’s category.

The following table summarizes Merchants’ and Merchants Bank’s capital ratios in comparison to the regulatory requirements:

									To Be Well-
									Capitalized Under				Fully Phased-in,
	Actual				For Capital				Prompt Corrective				with Capital
	September 30, 2016				Adequacy Purposes				Action Provisions				Conservation Buffers
(In thousands)	Amount		Percent		Amount		Percent		Amount		Percent		Amount		Percent
Merchants Bancshares, Inc.:
Leverage capital	$	172,303	8.84	%	$	78,002	4.00	%		N/A	N/A			N/A	N/A
Tier 1 risk-based capital		172,303	14.46	%		71,508	6.00	%		N/A	N/A		$	101,302	8.50	%
Total risk-based capital		185,848	15.59	%		95,343	8.00	%		N/A	N/A			125,138	10.50	%
Common Tier 1 equity		152,303	12.78	%		53,631	4.50	%		N/A	N/A			83,425	7.00	%
Merchants Bank:
Leverage capital	$	169,821	8.69	%	$	78,141	4.00	%	$	97,676	5.00	%		N/A	N/A
Tier 1 risk-based capital		169,821	14.17	%		71,905	6.00	%		95,873	8.00	%	$	101,866	8.50	%
Total risk-based capital		183,365	15.30	%		95,873	8.00	%		119,842	10.00	%		125,834	10.50	%
Common Tier 1 equity		169,821	14.17	%		53,929	4.50	%		77,897	6.50	%		83,889	7.00	%

Capital amounts for Merchants Bancshares, Inc. include $20.62 million in trust preferred securities issued in December 2004. These hybrid securities qualify as Tier 2 capital up to certain regulatory limits.

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Item 3 – Quantitative and Qualitative Disclosures about Market Risk

Risk Management

General

Our Management and Board of Directors are committed to sound risk management practices throughout the organization. We have developed and implemented a risk management monitoring program. Risks associated with our business activities and products are identified and measured as to probability of occurrence and impact on us (low, moderate, or high), and the control or other activities in place to manage those risks are identified and assessed. Periodically, department-level and senior managers re-evaluate and report on the risk management processes for which they are responsible. This documented program provides us with a comprehensive framework for monitoring our risk profile from a macro perspective. It also serves as a tool for assessing internal controls over financial reporting as required under the Federal Deposit Insurance Act and the Sarbanes-Oxley Act of 2002.

Effective May 26, 2016, the Bank Board of Directors established the Enterprise Risk Management Committee.  The Enterprise Risk Management Committee assists the Board in oversight of the Bank’s enterprise-wide risk management framework and associated policies and practices, risk profile and risk appetite and tolerance, and regulatory compliance program.    

Market Risk

Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates or prices such as interest rates, foreign currency exchange rates, commodity prices, and equity prices. Our primary market risk exposure is interest rate risk. An important component of our asset and liability management process is the ongoing monitoring and management of this risk, which is governed by established policies that are reviewed and approved annually by our Board of Directors. Our Investment Policy details the types of securities that may be purchased, and establishes portfolio limits and maturity limits for the various sectors. The Investment Policy also establishes specific investment quality limits. Our Board of Directors has established a Board-level Asset/Liability Committee (“ALCO”), which delegates responsibility for carrying out the asset/liability management policies to the Management-level Asset/Liability Committee (the “Management ALCO”). The Management ALCO, chaired by the Chief Financial Officer and composed of members of senior management, develops guidelines and strategies impacting our asset and liability management related activities based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends. The Management ALCO manages the investment portfolio. As the portfolio has grown, the Management ALCO has used portfolio diversification as a way to mitigate the risk of being too heavily invested in any single asset class. We continued to work to maximize net interest income while mitigating risk during the year through further repositioning of the investment portfolio, selective sales of specific securities, as well as carefully monitoring the overall duration and average life of the portfolio, and monitoring individual securities, among other strategies.

Liquidity Risk

Our liquidity is measured by our ability to raise cash when needed at a reasonable cost.  We must be capable of meeting expected and unexpected obligations to customers at any time.  Given the uncertain nature of customer demands as well as the need to maximize earnings, we must have available reasonably priced sources of funds, on- and off-balance sheet, which can be accessed quickly in time of need.  As discussed above under Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resource Management,” we have several sources of readily available funds, including the ability to borrow using our investment portfolio as collateral.  We also monitor our liquidity on a quarterly basis in compliance with our Liquidity Contingency Plan. Our liquidity monitoring process identifies early liquidity stress triggers, and also allows us to model worst case liquidity scenarios, and various responses to those scenarios.

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Interest Rate Risk

Interest rate risk is the exposure to a movement in interest rates, which, as described above, affects our net interest income. Asset and liability management is governed by policies reviewed and approved annually by Merchants Bank’s Board of Directors. The ALCO meets frequently to review and develop asset/liability management strategies and tactics.

The ALCO is responsible for evaluating and managing the interest rate risk which arises naturally from imbalances in repricing, maturity and cash flow characteristics of our assets and liabilities. Techniques used by the ALCO take into consideration the cash flow and repricing attributes of balance sheet and off-balance sheet items and their relation to possible changes in interest rates. The ALCO manages interest rate exposure by using a combination of on-balance sheet and off-balance sheet strategies.  On-balance sheet strategies generally consist of management of the duration, rate sensitivity and average lives of our various investments, and by extending or shortening maturities of borrowed funds, as well as carefully managing and monitoring the pricing and average lives of loans and the pricing and maturity of deposits. We also use off-balance sheet strategies, such as interest rate swaps and interest rate caps and floors, to help minimize our exposure to changes in interest rates.  By using derivative financial instruments to hedge exposures to changes in interest rates we are exposed to credit risk and market risk.  Credit risk is the failure of the counterparty to perform under the terms of the derivative contract.  When the fair value of a derivative contract is positive, the counterparty owes us, creating credit risk.  We minimize credit risk in derivative instruments by entering into transactions only with high-quality counterparties.  The market risk associated with interest-rate contracts is managed by establishing and monitoring parameters that limit the types and degree of market risk that may be undertaken.

The ALCO is responsible for ensuring that our Board of Directors receives accurate information regarding our interest rate risk position at least quarterly. The investment advisory firm and ALCO consultant meet collectively with the board and Management-level ALCOs on a quarterly basis. During these meetings the ALCO consultant reviews our current position and discusses future strategies, as well as reviewing the result of rate shocks of our balance sheet and a variety of other analyses.  The investment advisor reports on the overall performance of the portfolio and performs modeling of the cash flow, effective duration, and yield characteristics of the portfolio under various interest rate scenarios; and also reviews and provides detail on individual holdings in the portfolio. 

The ALCO consultant’s most recent review was as of September 30, 2016. The consultant ran a base simulation assuming no changes in rates as well as a 200 basis point rising and, because rates continue to be very low, a 100 basis point falling interest rate scenario that assumes a parallel and pro rata shift of the yield curve over a one-year period, and no growth assumptions.  Additionally, the consultant ran a 400 basis point rising simulation that assumed a parallel shift of the curve over 24 months, a 500 basis point rising simulation which assumed the curve flattened over a 24 month time frame, and a 500 basis point rising simulation which assumed the increase in rates was delayed by two years. A summary of the results is as follows:

Current/Flat Rates: Net interest income levels are projected to trend downward throughout the simulation. The sustained low rate environment causes continued margin pressures as assets continue to reprice, and are replaced at lower rates than the existing portfolio, while funding costs are at or near their floors.

Falling Rates: If rates fall 100 basis points our net interest income is projected to trend downward through the simulation. Margins and income decline as asset yields continue to reprice lower with no relief on the funding side. 

Rising Rates:  Net interest income is projected to increase throughout the simulation given a rise in rates regardless of the shape of the yield curve because our interest rate risk position is structurally asset sensitive due to our strong core funding position which supports a shorter term asset base. If rates remain at current low levels for another two years, the benefit of rising rates is muted because the starting point for asset yields will be lower. 

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We have established a target range for the change in net interest income in year one of zero to 7.5%. The net interest income simulation as of September 30, 2016 showed that the change in net interest income for the next 12 months from our expected or “most likely” forecast was as follows:

	Percent Change in Net
Rate Change	Interest Income
Up 200 basis points	2.20	%
Down 100 basis points	(2.80)	%

The change in net interest income in the second year of the simulation shows a more pronounced downward trend in the flat and down 100 basis points scenarios, the projected change is (2.3)% and (13.7)%, respectively, while the up 200 basis points simulation produces an increase of 8.1%.  The degree to which this exposure materializes will depend, in part, on our ability to manage our balance sheet as interest rates rise or fall.

Actual results may differ materially from those projected. The analysis assumes a static balance sheet. All rate changes are ramped over a 12 month time horizon based upon a parallel yield curve shift. In the down 100 basis points scenario, Federal funds and Treasury yields are floored at 0.01% while Prime is floored at 3.00%.  All other market rates (e.g. LIBOR, FHLB) are floored at 0.25% to reflect credit spreads. The model used to perform the balance sheet simulation assumes a parallel shift of the yield curve over 12 months and reprices every interest-bearing asset and liability on our balance sheet. The model incorporates product specific loan prepayment assumptions and uses contractual repricing dates for variable rate loan products and contractual maturities for fixed rate products. The model uses product-specific assumptions for deposits which are subject to repricing based on current market conditions. The model uses the Yield Book, Inc. system to analyze the investment portfolio which produces bond specific cash flows forecasts for each rate scenario tested in the analysis.  The analysis details bond maturity, amortization, repricing characteristics, and optionality.  The cash flow forecasts take into consideration assumptions for absolute rate movements, the period over which rates are assumed to shift and assumed changes in the shape of the yield curve. The model also assumes that the rate at which residential mortgage related assets prepay will vary as rates rise and fall, based on prepayment estimates derived from Applied Financial Technologies.

The preceding sensitivity analysis does not represent our forecast and should not be relied upon as being indicative of expected operating results.  These estimates are based upon numerous assumptions including without limitation: the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, deposit run-off rates, pricing decisions on loans and deposits and reinvestment/replacement of asset and liability cash flows, among others. While assumptions are developed based upon current economic and local market conditions, we cannot make any assurances as to the predictive nature of these assumptions including how customer preferences or competitor influences might change. As market conditions vary from those assumed in the sensitivity analysis, actual results will likely differ due to: the varying impact of changes in the balances and mix of loans and deposits differing from those assumed, the impact of possible off balance sheet hedging strategies, and other internal/external variables. Furthermore, the sensitivity analysis does not reflect all actions that the ALCO might take in responding to or anticipating changes in interest rates.

The most significant ongoing factor affecting market risk exposure of net interest income during the quarter ended September 30, 2016 was the sustained low interest rate environment.  Net interest income exposure is also significantly affected by the shape and level of the U.S. Government securities and interest rate swap yield curves, and changes in the size and composition of the loan, investment and deposit portfolios.

Credit Risk

The Board of Directors reviews and approves our loan policy on an annual basis. Among other things, the loan policy establishes restrictions regarding the types of loans that may be granted, and the distribution of loan types within our portfolio. Our loan portfolio is continuously monitored for performance, creditworthiness and strength of documentation through the use of a variety of management reports and the assistance of an external loan review firm.  Credit ratings are assigned to commercial loans and are routinely reviewed. Loan officers, under the supervision of the Senior Lender and Senior Credit Officer, take remedial actions to assure full and timely payment of loan balances when necessary.  Our policy is to discontinue the accrual of interest on loans when scheduled payments become contractually past due 91 or more days

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and the ultimate collectability of principal or interest become doubtful.  In certain instances the accrual of interest is discontinued prior to 91 days past due if Management determines that the borrower will not be able to continue making timely payments.

Item 4 – Controls and Procedures

Our principal executive officer, interim principal financial officer, and other members of our senior management have evaluated our disclosure controls and procedures as of the end of the period covered by this quarterly report. Based on this evaluation, our principal executive officer and interim principal financial officer have concluded that the disclosure controls and procedures effectively ensure that information required to be disclosed in our filings and submissions with the SEC under the Securities Exchange Act of 1934, as amended, is accumulated and communicated to our management (including the principal executive officer and interim principal financial officer), and is recorded, processed, summarized and reported within the time periods specified by the SEC. In addition, we have reviewed our internal control over financial reporting and there have been no changes in our internal control over financial reporting during the quarter ended September 30, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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MERCHANTS BANCSHARES, INC.

PART II – OTHER INFORMATION

Item 1 – Legal Proceedings

We are involved in various legal proceedings arising from our normal business activities. In the opinion of Management, based upon input from counsel on the anticipated outcome of such proceedings, final disposition of these proceedings will not have a material adverse effect on our consolidated financial position.

Item 1a – Risk Factors

In addition to the other information set forth in this report, please read the factors discussed in Part I – Item 1A, "Risk Factors" in our Annual Report on Form 10-K for the fiscal year ended December 31, 2015 filed with the SEC on March 14, 2016, which could materially adversely affect our business, financial condition and operating results. These risks are not the only ones facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and operating results.

Risks Related to the Merger

If our merger with Community Bank System, Inc. is not completed, we will have incurred substantial expenses without our stockholders realizing the expected benefits.

On October 22, 2016, we entered into an Agreement and Plan of Merger with Community Bank System, Inc., or “Community,” pursuant to which we will merge with and into Community, with Community as the surviving corporation. Completion of the merger is subject to closing conditions including, but not limited to, various regulatory approvals and the approval of our stockholders. We currently expect that the merger will be completed in the second quarter of 2017. It is possible, however, that factors outside of our control could require the parties to complete the merger at a later time, or not to complete the merger at all. In the event that the merger is not consummated for any reason, we will be subject to many risks, including the costs related to the merger, such as legal, accounting and advisory fees, which must be paid even if the merger is not completed, and, potentially, the payment of a termination fee under certain circumstances. If the merger is not consummated, the market price of our common stock could decline. We also could be subject to litigation related to any failure to complete the merger or related to any enforcement proceeding commenced against us to perform our obligations under the merger agreement.

Our stockholders will receive a fixed consideration of cash and/or Community common stock for each share of our common stock, regardless of any changes in the market value of our common stock or Community common stock before the completion of the merger.

Upon completion of the merger, each share of our common stock will be converted into the right to receive a fix ratio of cash and/or shares of Community common stock. There will be no adjustment to the exchange ratio (except for (i) adjustments to reflect the effect of any stock split, reverse stock split, stock dividend, recapitalization, reclassification or other similar transaction with respect to our common stock or (ii) any adjustment for proration in accordance with the merger agreement to maintain an overall 70% stock consideration and 30% cash consideration ratio), and we do not have a right to terminate the merger agreement based upon changes in the market price of Community common stock, subject to the limited exception described below. Accordingly, the dollar value of Community common stock that our stockholders will receive upon completion of the merger will depend upon the market value of Community common stock at the time of completion of the merger, which may be lower or higher than the closing price of Community common stock on the last full trading day preceding public announcement that Community and we entered into the merger agreement, the last full trading day prior to the date that our proxy statement is delivered to our stockholders, or the date of the stockholder meeting. The market values of Community’s common stock and our common stock have varied since Community and we entered into the merger agreement and will continue to vary in the future due to changes in the business, operations or prospects of Community and us, market assessments of the merger, regulatory considerations, market and economic considerations, and other factors, most of which are beyond our control.

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If, on the date on which all regulatory approvals for the merger have been received, the average closing price of Community common stock for the 20-trading period ending three days prior to such date is less than $35.78, and since the date of the merger agreement the percentage decrease in the market price of the Community common stock is more than 20% greater than any percentage decrease in the average market price of a prescribed index, we may elect to terminate the merger agreement. If we provide notice of our intent to terminate, Community will have the option of paying additional consideration, as specified in the merger agreement, in order to proceed with the merger.

We will be subject to business uncertainties and contractual restrictions while the merger is pending.

Uncertainty about the effect of the merger on employees, suppliers and customers may have an adverse effect on us. These uncertainties may impair our ability to attract, retain and motivate key personnel until the merger is completed, and could cause customers, suppliers and others who deal with us to seek to change existing business relationships with us. Our employee retention and recruitment may be particularly challenging prior to the effective time of the merger, as employees and prospective employees may experience uncertainty about their future roles with the combined company.

The pursuit of the merger and the preparation for the integration may place a significant burden on management and internal resources. Any significant diversion of management attention away from ongoing business and any difficulties encountered in the transition and integration process could affect our financial results. In addition, the merger agreement generally requires that we operate in the usual, regular and ordinary course of business and restricts us from taking certain actions prior to the effective time of the merger or termination of the merger agreement without Community’s consent in writing. These restrictions may prevent us from pursuing attractive business opportunities that may arise prior to the completion of the merger.

Regulatory approvals may not be received, may take longer than expected or impose conditions that are not presently anticipated.

Before the merger may be completed, certain approvals or consents must be obtained from the various bank regulatory and other authorities in the United States. There can be no assurance as to whether regulatory approval will be received or the timing of the approvals. Community is not obligated to complete the merger if the regulatory approvals received in connection with the completion of the merger include any conditions or restrictions that would constitute a “Material Adverse Effect” as defined in the merger agreement. There can be no assurance that regulatory approvals will not include such conditions or restrictions and such conditions or restrictions could have the effect of delaying completion of the merger.

The termination fee and the restrictions on solicitation contained in the merger agreement may discourage other companies from trying to acquire us.

Until the completion of the merger, we are prohibited from soliciting, initiating, encouraging, or with some exceptions, considering any inquiries or proposals that may lead to a proposal or offer for a merger or other business combination transaction with any person other than Community. In addition, we have agreed to pay a termination fee of $10.7 million to Community in specified circumstances. These provisions could discourage other companies from trying to acquire us even though those other companies might be willing to offer greater value to our stockholders than Community has offered in the merger. The payment of the termination fee also could have a material adverse effect on our results of operations.

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

None.

Item 3 – Defaults on Senior Securities

None.

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Item 4 – Mine Safety Disclosure

Not applicable.

Item 5 – Other Information

None.

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PART IV

Item 6 – Exhibits

The following exhibits are either filed or attached as part of this report, or are incorporated herein by reference:

Exhibit	Description
2.1	Agreement and Plan of Merger, dated as of October 22, 2016, by and between Community Bank System, Inc. and Merchants Bancshares, Inc. (Incorporated by reference to Exhibit 2.1 to Merchants Bancshares, Inc.’s Current Report on Form 8-K filed on October 24, 2016).
3.1	Amendment to the Amended and Restated Bylaws of Merchants Bancshares, Inc., adopted on October 22, 2016 (Incorporated by reference to Exhibit 3.1 to Merchants Bancshares, Inc.’s Current Report on Form 8-K filed on October 24, 2016).
10.2	Employment Agreement by and between Merchants, Merchants Bank and Robert Ripley, entered into on October 3, 2016+*
31.1	Certification of Chief Executive Officer Pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as amended*
31.2	Certification of Chief Financial Officer Pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as amended*
32.1	Certification of Chief 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 Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002**
101	The following materials from Merchants Bancshares, Inc.’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2016 formatted in XBRL: (i) Consolidated Balance Sheets at September 30, 2016 and December 31, 2015; (ii) Consolidated Statements of Income for the three and nine months ended September 30, 2016 and 2015; (iii) Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2016 and 2015; (iv) Consolidated Statements of Cash Flows for the nine months ended September 30, 2016 and 2015; and (v) Notes to Interim Unaudited Consolidated Financial Statements.*

+     Management contract or compensatory plan or agreement

*     Filed herewith

**   Furnished herewith

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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.

Merchants Bancshares, Inc.

/s/ Geoffrey R. Hesslink

Geoffrey R. Hesslink

President and Chief Executive Officer

/s/ Eric A. Segal

Eric A. Segal

Interim Principal Financial Officer,

Principal Accounting Officer and Treasurer

November 7, 2016

Date

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