UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 FORM 10-Q Quarterly Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarter ended Commission File No. 0-16761 ----------- March 31, 2003 HIGHLANDS BANKSHARES, INC. West Virginia 55-0650793 - ----------------------------------- -------------------- (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) P. O. Box 929 Petersburg, West Virginia 26847 (304) 257-4111 ---------------------------- (Registrant's Telephone Number, Including Area Code) Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirement for the past 90 days. Yes ..X. No .... Indicate by check mark whether the issuer is an accelerated filer (as defined in Rule 12b-2 of the Act). [ ___ ] The aggregate market value of the 1,323,687 shares of Common Stock of the registrant issued and outstanding held by nonaffiliates on April 30, 2003 was approximately $ 34,217,309 based on the closing sales price of $ 25.85 per share on April 30, 2003. For purposes of this calculation, the term "affiliate" refers to all directors and executive officers of the registrant. State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date. As of April 30, 2003: 1,436,874 shares of Common Stock, $5 Par Value. 1 HIGHLANDS BANKSHARES, INC. INDEX Page PART I FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Statements of Income - Three Months Ended March 31, 2003 and 2002 2 Consolidated Balance Sheets - March 31, 2003 and December 31, 2002 3 Consolidated Statements of Changes in Stockholders' Equity - Three Months Ended March 31, 2003 and 2002 4 Consolidated Statements of Cash Flows - Three Months Ended March 31, 2003 and 2002 5 Notes to Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 9 Item 3. Controls and Procedures 21 PART II OTHER INFORMATION 22 Item 1. Legal Proceedings 22 Item 2. Changes in Securities 22 Item 3. Defaults upon Senior Securities 22 Item 4. Submission of Matters to a Vote of Security Holders 22 Item 5. Other Information 22 Item 6. Exhibit and Reports on Form 8K 22 SIGNATURES 23 Certification of Chief Executive Officer 24 Certification of Executive Officer 25 Certification of Executive Officer 26 Certification of Principal Financial Officer 27 2 Part I Financial Information Item 1. Financial Statements HIGHLANDS BANKSHARES, INC. CONSOLIDATED STATEMENTS OF INCOME (In Thousands of Dollars) Three Months Ended March 31, 2003 2002 -------- -------- Interest Income Interest and fees on loans $ 4,226 $ 4,279 Interest on federal funds sold 59 54 Interest on time deposits 15 33 Interest and dividends on investment securities Taxable 233 319 Nontaxable 43 52 -------- -------- Total Interest Income 4,576 4,737 -------- -------- Interest Expense Interest on time deposits over $100,000 486 580 Interest on other deposits 1,221 1,523 Interest on borrowed money 51 53 -------- -------- Total Interest Expense 1,758 2,156 -------- -------- Net Interest Income 2,818 2,581 Provision for Loan Losses 210 120 -------- -------- Net Interest Income After Loan Losses 2,608 2,461 -------- -------- Noninterest Income Service charges 138 129 Other 205 150 --------- --------- Total Noninterest Income 343 279 --------- --------- Noninterest Expense Salaries and employee benefits 1,085 1,049 Equipment and occupancy expense 285 252 Data processing 145 145 Other 459 434 --------- --------- Total Noninterest Expense 1,974 1,880 --------- --------- Income Before Income Taxes 977 860 Provision for Income Taxes 317 260 --------- --------- Net Income $ 660 $ 600 ========= ========= Per Share Data (1) Net Income $ .46 $ .40 ========= ========= Cash Dividends $ .14 $ .12 ========= ========= Weighted Average Common Shares Outstanding 1,436,874 1,505,694 ========= ========= (1) Prior year's per share figures restated to reflect stock split in form of dividend in third quarter 2002. The accompanying notes are an integral part of these statements. 3 HIGHLANDS BANKSHARES, INC. CONSOLIDATED BALANCE SHEETS (In Thousands of Dollars) March 31, December 31, 2003 2002 -------- -------- ASSETS Cash and due from banks - noninterest bearing $ 7,637 $ 8,226 Time deposits in other banks 6,032 4,500 Federal funds sold 21,405 14,625 Securities held to maturity (note 2) 1,367 1,369 Securities available for sale (note 3) 29,226 23,496 Other investments (note 4) 845 672 Loans, net of unearned interest (note 5) 225,104 225,754 Less allowance for loan losses (note 6) (1,916) (1,793) -------- -------- Net Loans 223,188 223,961 Bank premises and equipment 6,745 6,873 Interest receivable 1,943 1,821 Investments in insurance contracts 5,387 5,338 Other assets 1,413 1,466 ------- ------- Total Assets $305,188 $292,347 ======= ======= LIABILITIES Deposits: Noninterest bearing demand deposits $ 33,849 $ 31,785 Interest bearing Money market and checking 21,328 20,936 Money market savings 17,803 16,996 Savings 30,850 29,503 Time deposits over $100,000 48,569 45,392 All other time deposits 117,165 112,899 ------- ------- Total Deposits 269,564 257,511 Borrowed money 3,900 4,030 Accrued expenses and other liabilities 2,400 1,890 ------- ------- Total Liabilities 275,864 263,431 ------- ------- STOCKHOLDERS' EQUITY Common stock ($5 par value, 3,000,000 shares authorized) 7,184 7,184 Surplus 1,662 1,662 Retained earnings 20,309 19,850 Accumulated other comprehensive income 169 220 ------- ------- Total Stockholders' Equity 29,324 28,916 ------- ------- Total Liabilities and Stockholders' Equity $305,188 $292,347 ======= ======= The accompanying notes are an integral part of these statements. 4 HIGHLANDS BANKSHARES, INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (In Thousands of Dollars) Accumulated Other Common Retained Comprehensive Treasury Stock Surplus Earnings Income Stock Total Balances, December 31, 2002 $7,184 $1,662 $19,850 $220 $28,916 Comprehensive Income Net income 660 660 Net change in unrealized appreciation on investment securities available for sale, net of taxes (51) (51) ------ Total Comprehensive Income 609 Dividends paid (201) (201) ----- ----- ------ ----- ---- ------ Balances, March 31, 2003 $7,184 $1,662 $20,309 $169 $29,324 ====== ====== ======= ==== ===== ====== Accumulated Other Common Retained Comprehensive Treasury Stock Surplus Earnings Income Stock Total Balances, December 31, 2001 $2,734 $1,662 $24,624 $283 (993) $28,310 Comprehensive Income Net income 600 600 Net change in unrealized appreciation on investment securities available for sale, net of taxes (70) (70) ------ Total Comprehensive Income 530 Dividends paid (186) (186) ----- ----- ------ ----- ----- ------ Balances, March 31, 2002 $2,734 $1,662 $25,038 $213 (993) $28,654 ====== ====== ======= ==== ==== ====== The accompanying notes are an integral part of these statements. 5 HIGHLANDS BANKSHARES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In Thousands of Dollars) Three Months Ended March 31, 2003 2002 -------- -------- Cash Flows from Operating Activities: Net income $ 660 $ 600 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 148 132 Income from insurance contracts (49) (43) Net amortization of securities 118 68 Provision for loan losses 210 120 Increase in interest receivable (122) (244) (Increase) decrease in other assets 53 (93) Increase in accrued expenses 510 468 -------- -------- Net Cash Provided by Operating Activities 1,528 1,008 -------- -------- Cash Flows from Investing Activities: Net change in federal funds sold (6,780) 408 Proceeds from maturities of securities available for sale 3,487 2,636 Proceeds from maturities of securities held to maturity 1 1 Purchase of securities available for sale (9,386) (3,063) Proceeds from redemption of other investments (173) Net change in time deposits in other banks (1,532) 911 Net change in loans 562 (4,229) Purchase of property and equipment (18) (89) --------- -------- Net Cash Used in Investing Activities (13,839) (3,425) --------- -------- Cash Flows from Financing Activities: Net increase in deposits 12,053 2,867 Dividends paid in cash (201) (186) Repayment of borrowed money (130) (122) --------- -------- Net Cash Provided by Financing Activities 11,722 2,559 -------- -------- Net Increase (Decrease) in Cash and Cash Equivalents (589) 142 Cash and Cash Equivalents, Beginning of Period 8,226 6,492 -------- -------- Cash and Cash Equivalents, End of Period $ 7,637 $ 6,634 ======== ======== Supplemental Disclosures: Cash Paid For: Income taxes $ $ 5 Interest 1,761 2,424 The accompanying notes are an integral part of these statements. 6 HIGHLANDS BANKSHARES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 ACCOUNTING PRINCIPLES: The consolidated financial statements conform to U. S. generally accepted accounting principles and to general industry practices. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial position as of March 31, 2003 and the results of operations for the three month periods ended March 31, 2003 and 2002. The notes included herein should be read in conjunction with the notes to financial statements included in the 2002 annual report to stockholders of Highlands Bankshares, Inc. NOTE 2 SECURITIES HELD TO MATURITY: The amortized cost and market value of securities held to maturity as of March 31, 2003 and December 31, 2002, are as follows (in thousands): 2003 2002 ---- ---- Amortized Market Amortized Market Cost Value Cost Value Mortgage-backed securities $ 2 $ 3 $ 4 $ 4 Obligations of states and political subdivisions 1,365 1,465 1,365 1,447 ------ ------ ----- ------ Total $ 1,367 $ 1,468 $1,369 $ 1,451 ====== ====== ===== ====== NOTE 3 SECURITIES AVAILABLE FOR SALE: The amortized cost and fair value of securities available for sale as of March 31, 2003 and December 31, 2002 are as follows (in thousands): 2003 2002 ---- ---- Amortized Market Amortized Market Cost Value Cost Value US Treasury securities and obligations of US Government corporations and agencies $17,084 $17,186 $8,844 $ 8,961 Mortgage-backed securities 4,735 4,874 5,410 5,582 Obligations of states and political subdivisions 3,493 3,558 4,238 4,350 Other investments 3,531 3,608 4,540 4,603 ------ ------ ----- ------ Total $28,843 $29,226 $23,032 $23,496 ====== ====== ====== ====== 7 HIGHLANDS BANKSHARES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 4 OTHER INVESTMENTS: Other investments totaling $845,000 include investments in the Federal Home Loan Bank and other governmental entities whose transferability is restricted. NOTE 5 LOANS OUTSTANDING: A summary of loans outstanding as of March 31, 2003 and December 31, 2002, is as follows (in thousands): 2003 2002 ---- ---- Commercial $ 46,668 $ 47,089 Real estate - construction 5,339 6,813 - mortgages 124,234 121,558 Consumer installment 48,908 50,351 ------- ------- Total 225,149 225,811 Unearned interest (45) (57) -------- -------- Net loans outstanding $225,104 $225,754 ======= ======= NOTE 6 ALLOWANCE FOR LOAN LOSSES: A summary of transactions in the allowance for loan losses for the three months ended March 31, 2003 and 2002 follows (in thousands): 2003 2002 ---- ---- Balance, beginning of period $ 1,793 $ 1,602 Provisions charged to operating expenses 210 120 Loan recoveries 63 23 Loan charge-offs (150) (122) -------- ------- Balance, end of period $ 1,916 $ 1,623 ======= ======= 8 HIGHLANDS BANKSHARES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 7 INVESTMENT IN INSURANCE CONTRACTS: Investment in insurance contracts consists of single premium insurance contracts which have the dual purposes of providing a rate of return to the Company which approximately equals the Company's average cost of funds and providing life insurance and retirement benefits to employees. The carrying value of these investments was $5,387,000 at March 31, 2003 and $5,338,000 at December 31, 2002. NOTE 8 CAPITAL STOCK TRANSACTIONS: In the second quarter of 2002, the Company repurchased stock from unrelated parties in two separate transactions. Total shares repurchased were 22,940 (68,820 on an after-split basis) at a cost of $1,217,000. In June 2002, the Company approved a stock split effected in the form of a dividend which was distributed September 3, 2002 to shareholders of record as of August 1, 2002. This transaction resulted in an increase of shares outstanding from 478,958 as of June 30, 2002 to 1,436,874 as of September 30, 2002. Earnings per share and dividends per share calculations for prior periods have been adjusted for this stock dividend. The Board of Directors also voted to retire 67,806 shares of treasury stock in the third quarter of 2002. 9 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Critical Accounting Policies The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States ("GAAP"). The financial statements contained within these statements are, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of these transactions would be the same, the timing of events that would impact these transactions could change. The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two basic principles of accounting: (i) SFAS No. 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimable and (ii) SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. Recent Accounting Pronouncements In December 2001, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position ("SOP") no. 01-6, Accounting by Certain Entities (Including Entities with Trade Receivables) That Lend to or Finance the Activities of Others, to reconcile and conform the accounting and financial reporting provisions established by various AICPA industry audit guides. SOP No. 01-6 is effective for annual and interim financial statements issued for fiscal years beginning December 15, 2001 and did not have a material impact on the Company's consolidated financial statements. All other recent accounting pronouncements had no material impact on the Company's consolidated financial statements. Forward Looking Statements This filing may contain certain forward-looking statements (as defined in the Private Securities Litigation Act of 1995), which reflect management's beliefs and expectations based on information currently available. These forward-looking statements are inherently subject to significant risks and uncertainties. These risks and uncertainties can include, but are not limited to, changes in general economic and financial market conditions, the Company's ability to effectively carry out business plans, changes in regulatory or legislative requirements, or changes in competitive conditions. Although Management believes the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially. 10 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Overview The Company's net income was $660,000 in the first quarter of 2003, an increase of 10.00% compared to the first quarter of 2002. Earnings per share were $.46 for the first quarter of 2003 compared to $.40 per share for the same quarter in 2002. The Company's annualized return on average equity was 9.01% in the first quarter of 2003 compared to 8.43% for the first quarter of 2002. Return on average assets was .88% for 2003 and .86% for 2002. Net interest income before provision for loan loss increased 9.18% over the first quarter of 2002. Increasing loan balances required a provision for loan losses $90,000 greater than that taken during the first quarter of 2002. Even with the increase in the loan loss provision, net interest income after the provision for loan losses increased 5.97% from the first quarter of 2002. Taxable equivalent net interest income increased 8.85% over the first quarter of 2002 as an 83 basis point decline in taxable interest income was offset by a 102 basis point decline in interest expense on liabilities. Noninterest income increased 22.94% as trust fees and insurance income increased. Noninterest expenses increased 5.00% as expanded loan and deposit volumes required greater operating expenses and regular annual merit increases caused an increase in salary and benefit expense. Net Interest Income The Company's net interest margin before provision for loan loss increased from $2,581 during the first quarter of 2002 to $2,818,000 during the first quarter of 2003. The Company's net yield on interest earning assets on a tax equivalent basis was 4.10% in the first quarter of 2003 compared to 4.08% for the first quarter of 2002. Strong loan demand throughout the latter part of 2002 contributed to average loan balances being 8.44% higher when compared to the first quarter of 2002. The average rates earned on loans dropped 75 basis points. Commercial loan rates decreased 63 basis points, rates on real estate loans decreased 58 basis points and rates on consumer lending fell 82 basis points. Balances of federal funds sold increased dramatically over 2002 levels due to a recent slowing of loan demand and increased deposit volume. The increase in federal funds sold is intended to act as a source of funding should maturing, high rate certificates leave the Banks. This increase in balances caused income earned on federal funds sold to increase 9.26% over first quarter 2003 levels. The increase in balances offset a 57 basis point decline in rates. Earnings on interest bearing deposits decreased 136 basis points over 2002 due to a combination of repositioning of time deposits of HBI Life and Highlands Bankshares Trust from external institutions to the Company's subsidiary banks, the general decline of interest rates, and a change in the composition of interest bearing deposits from CDs to interest bearing demand deposit accounts held by the subsidiary banks at the Federal Home Loan Bank. 11 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Net Interest Income (continued) Balances of securities at March 31, 2003 were 23.04% higher than at December 31, 2002 and only 2.07% lower than at March 31, 2002 This was due largely to increased securities purchases late in the quarter. Average balances of securities were 14.02% lower during the first quarter of 2003 than during the same period in 2002. Securities balances have been lower in recent periods because high loan growth during 2002 was funded in part by reductions in securities and because the depressed interest rate environment has significantly decreased opportunities for securities investments which earn an acceptable rate of return vis-a-vis the Company's other opportunities. Management has been reluctant to invest in long term securities because of the expectation that interest rates will begin to rise over the next 12 months. In recent quarters, customers have appeared to be reluctant to commit to long-term, fixed rates on certificates when rates are at historical lows and instead placed their deposits in accounts that are highly liquid and will allow them to respond quickly when rates increase. Although interest rates remain at or near historical lows, in the latter months of 2002 and during the first quarter of 2003, the Company's subsidiary banks nonetheless experienced significant deposit growth as customers now appear to be more rate sensitive when making decisions regarding selection of financial institutions within which to place deposits. Levels of competition for deposits in the Company's service area have caused the Company's subsidiary banks to traditionally pay higher rates on deposits than larger, statewide financial institutions. Although steps have been taken in recent years to reduce this differential and have been moderately successful, the subsidiary banks remain marginally above the competition in rates paid on deposits and these higher rates appear to have drawn deposit customers to the Company's subsidiary banks during recent months. Average balances of interest bearing liabilities during the first quarter of 2003 increased 9.59% from 2002 and total deposit balances at March 31, 2003 were 4.68% higher than at December 31, 2002. Rates paid on deposits during the first quarter of 2003 were 106 basis points lower than during the first quarter of 2002. As higher rate CDs continued to mature, the rates paid on time deposits fell 120 basis points as compared to the same period a year ago. Combined average interest bearing transaction accounts, savings accounts and money market accounts increased 20.77% while rates paid on these accounts fell 35 basis points. The Company borrows from the Federal Home Loan Bank at fixed rates of interest and uses to proceeds to monies to customers on a fixed rate basis. The Company anticipates continuing to use this approach as a mechanism to provide long-term financing to customers and limit market rate risk. In addition, monies were borrowed on a short-term, variable rate basis to fund the renovation and expansion at the Capon Valley Bank. In the third quarter of 2002, this variable rate debt was refinanced on a ten year fixed rate loan at 3.94%. A complete yield analysis is shown as Table I on page 19. Provision for Loan Losses The Company's provision for loan losses was $210,000 for the first quarter of 2003 compared to $120,000 for first quarter of 2002. Net loan charge-offs were $87,000 in 2003 compared to $99,000 in 2002. As loan balances have increased 7.40% since March 31, 2002 a larger provision for loan loss has been necessary to maintain what management feels are acceptable ratios of allowance for loan losses to total loans, even as net charge-offs decreased from the same period a year ago. In addition, the slowing economy and increased delinquencies have required a large allowance for loan losses. 12 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Noninterest Income Noninterest income during the first quarter of 2003 rose 22.94% over the same period a year ago. Service charge income increased 6.98% as deposits continue to grow. Other income increased 36.67% over first quarter 2002 levels and was due primarily to increases in underwriting revenue of HBI Life Insurances company and an increase in trust fees by Highlands Bankshares Trust Company. Noninterest Expenses Overall noninterest expense increased 5.00% in 2003 compared to 2002. Salary and benefit expense increased 1.62% due to annual merit increases and increased pension costs. Occupancy and equipment increased 13.10% due largely to ongoing efforts to upgrade systems. Data processing expense was unchanged from a year ago. Miscellaneous non-interest expenses increased 10.14% as increased costs were seen in postage costs due to expanded operations and the June 2002 postal rate hike, and general increases due to expanding operations. These increases were offset in part by decreases in advertising and marketing expenses, professional and legal fees, and stationery and office supply expense. Loan Portfolio The Company is an active residential mortgage and construction lender and generally extends commercial loans to small and medium sized businesses within its primary service area. The Company's commercial lending activity extends across its primary service areas of Grant, Hardy, Randolph, Mineral,, and northern Pendleton counties in West Virginia, Frederick County in Virginia and portions of western Maryland. The Company's secondary service area includes Hampshire County in West Virginia. Consistent with its focus on providing community-based financial services, the Company does not attempt to diversify its loan portfolio geographically by making significant amounts of loans to borrowers outside of its primary service area. The principal economic risk associated with each of the categories of loans in the Company's portfolio is the creditworthiness of its borrowers. Within each category, such risk is increased or decreased depending on prevailing economic conditions. The risk associated with the real estate mortgage loans and installment loans to individuals varies based upon employment levels, consumer confidence, fluctuations in value of residential real estate and other conditions that affect the ability of consumers to repay indebtedness. The risk associated with commercial, financial and agricultural loans varies based upon the strength and activity of the local economies of the Company's market areas. The risk associated with real estate construction loans varies based upon the supply of and demand for the type of real estate under construction. Loans outstanding decreased $650,000 or .29% during the first quarter in 2003. The first quarter of any year is traditionally slow as farming and logging operations are hampered by weather conditions and retail borrowing in the first quarter is put on hold until the spring. Mortgage loan balances increased 2.20% from December 31, 2002 to December 31, 2003. Balances of all other types of loans contracted during the first quarter with real estate construction loans falling 21.64% from December 31, 2002 to March 31, 2003, commercial loans fell ..89% and consumer installment declined 2.87%. Asset Quality and Risk Elements Nonperforming loans include nonaccrual loans, loans 90 days or more past due and restructured loans. Nonaccrual loans are loans on which interest accruals have been suspended or discontinued permanently. Restructured loans are loans on which the original interest rate or repayment terms have been changed due to financial hardship of the borrower. 13 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Asset Quality and Risk Elements (continued) The following table summarizes the company's non-performing loans for the periods ended March 31, 2003 and December 31, 2002. March 31 December 31, (in thousands) 2003 2002 ---- ---- Non-accrual loans $ 734 $ 299 Restructured Loans 655 662 Loans past due 90 days or more and still accruing interest 2,402 1,918 Total $ 3,791 $ 2,879 ======== ======== Balances of non-performing loans increased 31.68% from December 31, 2002 to March 31, 2003 as balances of non accrual loans and delinquent loans increased 145.48% and 25.23% respectively. Restructured loans are comprised of two commercial loans for which it was necessary to refinance in order to recoup timely payment of principal. In neither case were any principal amounts forgiven. Real estate acquired through foreclosure fell from $517,000 at December 31, 2002 to $220,000 at March 31, 2003 following the disposal of several foreclosed properties. All foreclosed property held as of March 31, 2003 was in the Company's primary service area. The Company's practice is to value real estate acquired through foreclosure at the lower of (i) an independent current appraisal or market analysis less anticipated costs of disposal, or (ii) the existing loan balance. The Company is actively marketing all foreclosed real estate and does not anticipate material write-downs in value before disposition. An inherent risk in the lending of money is that the borrower will not be able to repay the loan under the terms of the original agreement. The allowance for loan losses (see subsequent section) provides for this risk and is reviewed periodically for adequacy. This review also considers concentrations of loans in terms of geography, business type or level of risk. While lending is geographically diversified within the service area, the Company does have some concentration of loans in the area of agriculture (primarily poultry farming), timber and related industries. Management recognizes these concentrations and considers them when structuring its loan portfolio. As of March 31, 2003, management is not aware of any significant potential problem loans in which the debtor is currently meeting their obligations as stated in the loan agreement but which may change in future periods. Allowance for Loan Losses Management has analyzed the potential risk of loss on the Company's loan portfolio given the loan balances and the value of the underlying collateral and has recognized losses where appropriate. Nonperforming loans are closely monitored on an ongoing basis as part of the Company's loan review process. Management reviews the loan loss allowance at the end of each quarter. Based primarily on the Company's loan classification system, which classifies problem credits as substandard, doubtful or loss, additional provisions for losses are made monthly. The ratio of the allowance for loan losses to total loans outstanding was .85% at March 31, 2003 compared to .79% at December 31, 2002. The allowance for credit losses of $1,915,521 at March 31, 2003, was up $122,000 from its level at December 31, 2002. 14 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Allowance for Loan Losses (Continued) The allowance for loan losses is an estimate of the losses in the current loan portfolio. The allowance is based on two principles of accounting: (i) SFAS 5, Accounting for Contingencies which requires that losses be accrued when they are probable of occurring and estimatable and (ii) SFAS 114, Accounting by Creditors for Impairment of a Loan, which requires that loans be identified which have characteristics of impairment as individual risks, (e.g. the collateral, present value of cash flows or observable market values are less than the loan balance). Each of Company's banking subsidiaries, Capon Valley Bank and The Grant County Bank, determines its allowance for loan losses independently. Each bank pays particular attention to individual loan performance, collateral values, borrower financial condition and overall national and local economic conditions. The determination of adequate allowance at each bank is done in a three step process. The first step is to identify problem loans above a certain threshold and estimated losses are calculated based on collateral values and projected cash flows. The second step is to identify loans above a certain threshold which are problem loans due to the borrowers' payment history or deteriorating financial condition. Losses in this category are determined based on historical loss rates adjusted for current economic conditions. The final step is to calculate a loss for the remainder of the portfolio using historical loss information for each type of loan classification. The determination of specific allowances and weights is in some part subjective and actual losses may be greater or less than the amount of the allowance. However, management believes that the allowance represents a fair assessment of the losses that exist in the loan portfolio. Both banks classify loans into the following categories: impaired, doubtful, substandard, special mention and other loans past due 90+ days and assign loss rates to each. Within these categories, Real Estate, Installment Loans, Commercial Loans and Lines of Credit are assigned a specific loss rate based on historical losses and management's estimate of losses. The allowance associated with loans classed as impaired is calculated at 100% of the identified impairment. Loans 90 days or more past due and nonaccrual loans are included in one of the five categories above. Credit card balances 90 days or more past due are categorized as substandard and are assigned a loss rate of 50%. Generally, all loans in excess of $250,000 are evaluated individually as well as any loan regardless of size that is classified as loss, doubtful, substandard or special mention. This detailed review identifies each applicable loan for specific impairment and a specific allocation for that impaired amount is set aside as the first element in the calculation. Rates assigned each category may vary over time and between the banks as historical loss rates, loan structure and economic conditions change. The remaining portfolio balances are assigned a loss factor based on the historical net loss after recoveries over the last five years. Loss experience per classification varies significantly based on risk and collateral. Installment and commercial loans generally have higher loss volumes than secured real estate loans. These actual loss experience factors are weighed by the average life of the loan category. Installments have a two to three year carrying life, real estate loans a five to six year life; and commercial loans a three to four year life. The net result creates a low and high range of allocated allowance. The Company's actual allowance balance is compared to this range and adjusted as deemed necessary. 15 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Allowance for Loan Losses (Continued) The adequacy of the allowance for loan losses is computed quarterly and the allowance adjusted prior to the issuance of the quarterly financial statements. All loan losses charged to the allowance are approved by the boards of directors of each bank at their regular meetings. The allowance is reviewed for adequacy after considering historical loss rates, current economic conditions (both locally and nationally) and any known credit problems that have not been considered under the above formula. The Company believes that its allowance must be viewed in its entirety and, therefore, is available for potential credit losses in its entire portfolio, including loans, credit-related commitments and other financial instruments. In the opinion of management, the allowance, when taken as a whole, is adequate to absorb reasonably estimated credit losses inherent in the Company's portfolio. Management continues to monitor the economic health of the poultry industry. The Company has direct loans to poultry growers and the industry is a large employer in the Company's trade area.. Loan requests for poultry house loans or expansion continue to be presented for approval. In the fall of 2002, Perdue Farms, Inc. ceased operations at it's Petersburg processing plant. At present, this facility sits idle. In part because of this closure, the unemployment rate in Grant County has grown from 6.7% in October of 2002 to 12.50% in March of 2003, the last month for which data are available. The March unemployment rate for Grant County is down from 15.00% in February. While management believes that this closure has contributed to the slow-down in loan growth, the overall impact of the closure on the Company has been minimized by the Company's geographic diversity as the other counties in the Company's primary service area maintain healthy economies and that the impact of this closure on loan defaults will not be material. An analysis of the loan loss allowance is set forth in the following table (in thousands): Quarter Ended March 31, 2003 2002 Balance, beginning of period $ 1,793 $ 1,602 Net charge-offs (recoveries) Charge-offs (150) (122) Recoveries 63 23 ------ ------ Total net charge-offs * (87) (99) Provision for credit losses 210 120 ------ ------ Balance, End of Period $ 1,916 $ 1,623 ====== ====== * Components of net charge-offs: Real estate $ (8) $ (8) Commercial (5) (16) Consumer (74) (75) ------- ------ Total $ (87) $ (99) ======= ====== 16 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Allowance for Loan Losses (Continued) The Company believes that its allowance must be viewed in its entirety and, therefore, is available for potential credit losses in its entire portfolio, including loans, credit-related commitments and other financial instruments. In the opinion of management, the allowance, when taken as a whole, is adequate to absorb reasonably estimated credit losses inherent in the Company's portfolio. During the course of routine examination of the Company's two subsidiary banks, The Grant County Bank and Capon Valley Bank, under the normal examination cycle by regulatory agencies, examiners have identified certain supervisory issues. Results of these regulatory examinations are not published or publicly available. Requirements of regulatory agencies in regards to certain calculated amounts such as the allowance for loan losses may at times differ from GAAP requirements. One of the regulatory agencies which exerts supervisory control on the Company's subsidiary banks has indicated that a requirement for an increased allowance for loan losses will be directed to Capon Valley Bank. Management of the Bank does not agree with the regulator's conclusions and is in the process of appealing those conclusions. The Company believes that the allowance for loan losses shown in these statements is adequate to cover potential losses in the current loan portfolio using guidance set forth in SFAS Nos. 5 and 114. As such, the current methodology for calculating the allowance for loan loss will be continued until such time as GAAP requirements change. If one or more of the regulatory agencies require materially differing amounts of allowance for loan losses than that which would be calculated under GAAP requirements, the subsidiary bank to which this requirement might apply will calculate its allowance for loan losses for regulatory filings based on the regulatory guidance, while the Company will continue to report its results based on generally accepted accounting principles as promulgated by the FASB, the SEC and other accounting authorities. The following table shows the allocation of loans in the loan portfolio and the corresponding amounts of the allowance allocated by loan types as of March 31, 2003 and December 31, 2002: March 31, 2003 December 31, 2002 -------------- ----------------- Loan Allowance Percentage Percentage of Allowance Percentage Percentage of Type Allocation of Allowance Total Loans Allocation of Allowance Total Loans Commercial $ 593 31% 21% $ 543 30% 21% Mortgage 541 28% 57% 504 28% 57% Consumer 686 36% 22% 652 37% 22% Unallocated 96 5% % 94 5% % ----- --- ---- ----- --- --- Totals $1,916 100% 100% $1,793 100% 100% ===== === ==== ===== === === 17 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Securities The Company's securities portfolio serves several purposes. Portions of the portfolio secure certain public and trust deposits while the remaining portions are held as investments or used to assist the Company in liquidity and asset liability management. Total securities and other investments at March 31, 2003 were $30,593,000 compared to $24,865,000 at December 31, 2002. This is an increase of 23.04%. Total securities and other investments as a percentage of total assets were 10.30% at March 31, 2003 compared to 8.74% at December 31, 2002. During 2002, loan demand outstripped deposit growth, and the Company funded loan growth through reductions in balances of fed funds sold and securities. As a result, securities balances dropped dramatically during 2002. In the first quarter of 2003, as loan demand slowed and deposit balances increased, the Company took steps to increase it's security portfolio to former levels. As interest rates remain low, the Company has been reluctant to purchase securities with long term maturities. The securities portfolio consists of three components, specifically, securities held to maturity, securities available for sale and other investments. Securities are classified as held to maturity when management has the intent and the Company has the ability at the time of purchase to hold the securities to maturity. Held to maturity securities are carried at cost, adjusted for amortization of premiums and accretion of discounts. Securities to be held for indefinite periods of time are classified as available for sale and accounted for at market value. Securities available for sale include securities that may be sold in response to changes in market interest rates, changes in the security's prepayment risk, increases in loan demand, general liquidity needs and other similar factors. Other investments include restricted securities whose ownership is required for participation in certain governmental programs. The Company's recent purchases of all securities have generally been limited to securities of high credit quality with short to medium term maturities. Changes in the market values of securities available for sale, net of the deferred tax effect, are reflected as changes in accumulated other comprehensive income. As of March 31, 2003, the market value of the securities available for sale exceeded their cost by $383,000. ($241,000 after tax effect). Deposits The Company's main source of funds is customer deposits received from individuals, governmental entities, and businesses located within the Company's service area. Deposit accounts include demand deposits, savings, money market and certificates of deposit. Total deposits increased 4.68% between December 31, 2002 and March 31, 2003. The cost of funds for the first quarter of 2003 was 2.93% compared to 3.98% for the same quarter in 2002 as the effects of declining interest rates offset the increase in deposit balances. Time deposits continue to make up the bulk of deposit balances as time deposits equaled 61.48% of total deposits at March 31, 2003 and 61.47% of total deposits at December 31, 2002. Capital The Company seeks to maintain a strong capital base to expand facilities, promote public confidence, support current operations and grow at a manageable level. As of March 31, 2003, the Company's total risk based capital ratio was 14.26% which is above the regulatory minimum of 8.0%. The leverage ratio of total capital to total assets was 9.57% at March 31, 2003 which is in line with the Company's peer group. 18 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Liquidity Liquidity is the ability to meet present and future financial obligations through either the sale or maturity of existing assets or the acquisition of additional funds through liability management. Liquid assets include cash, interest bearing deposits with banks, federal funds sold, investments and loans maturing within one year. The Company's ability to obtain deposits and purchase funds at favorable rates determines its liability liquidity. As a result of the Company's management of liquid assets and the ability to generate liquidity through liability funding, management believes that the Company maintains overall liquidity sufficient to satisfy its depositors' requirements and meet its customers' credit needs. Additional sources of liquidity available to the Company include, but are not limited to, loan repayments, the ability to obtain deposits through the adjustment of interest rates and the purchasing of federal funds. To further meet its liquidity needs, the Company also maintains lines of credit with correspondent financial institutions and the Federal Reserve Bank of Richmond. Both subsidiary banks have lines of credit with the Federal Home Loan Bank of Pittsburgh although utilization has been limited. In the past, growths in deposits and proceeds from the maturity of investment securities have been sufficient to fund the net increase in loans. Interest Rate Sensitivity In conjunction with maintaining a satisfactory level of liquidity, management must also control the degree of interest rate risk assumed on the balance sheet. Managing this risk involves regular monitoring of the interest sensitive assets relative to interest sensitive liabilities over specific time intervals. At March 31, 2003 the Company had a negative gap position through the first 90 days, with this negative gap position shifting to a positive gap position with 12 months. With the largest amount of interest sensitive assets and liabilities repricing within three years, the Company monitors these areas very closely. Early withdrawal of deposits, prepayments of loans and loan delinquencies are some of the factors that could affect actual versus expected cash flows. In addition, changes in rates on interest sensitive assets and liabilities may not be equal, which could result in a change in net interest margin. While the Company does not match each of its interest sensitive assets against specific interest sensitive liabilities, it does review its positions regularly and takes necessary actions to correct when necessary. Securities and Exchange Commission Web Site The Securities and Exchange Commission maintains a Web site that contains reports, proxy and information statements and other information regarding registrants that file electronically with the Commission, including Highlands Bankshares, Inc., and the address is (http://www.sec.gov). 19 TABLE I HIGHLANDS BANKSHARES, INC. NET INTEREST MARGIN ANALYSIS (Dollar Amounts in Thousands) Three Months Ended Three Months Ended March 31, 2003 March 31, 2002 -------------------- -------------------- Average Income/ Average Income/ Balance2 Expense Rates Balance2 Expense Rates Interest Income Loans Commercial $ 14,666 $ 296 8.07% $ 10,802 $ 235 8.70% Consumer 53,583 1,413 10.55 55,203 1,569 11.37 Real estate 155,213 2,517 6.49 140,058 2,475 7.07 ------- ------ ----- ------- ----- ------ Total Loans 223,462 4,226 7.56 206,063 4,279 8.31 Federal funds sold 21,576 59 1.09 13,012 54 1.66 Interest bearing deposits 5,406 15 1.11 5,348 33 2.47 Investments Taxable 22,567 233 4.14 26,408 319 4.83 Tax exempt 1 4,525 67 5.92 5,101 82 6.43 ------- ------ ----- ------ ----- ------ Total Earning Assets 1 277,536 4,600 6.63 255,932 4,767 7.46 ------- ------ ----- ------- ----- ------ Interest Expense Interest bearing demand deposits 21,398 49 .92 17,611 48 1.09 Savings and money market 46,679 126 1.08 38,760 147 1.52 Time deposits 164,768 1,532 3.72 155,243 1,908 4.92 Other borrowed money 3,961 51 5.15 4,467 53 4.75 ------- ------ ----- ------ ----- ------ Total Interest Bearing Liabilities $236,806 1,758 2.97 $216,081 2,156 3.99 ======= ------ ----- ======= ----- ------ Net Interest Margin $ 2,842 $2,611 ====== ===== Net Yield on Interest Earning Assets 1 4.10% 4.08% ====== ====== 1 Yields are on a taxable equivalent basis. 2 Includes loans in nonaccrual status. 20 TABLE II HIGHLANDS BANKSHARES, INC. INTEREST RATE SENSITIVITY ANALYSIS MARCH 31, 2003 (In Thousands of Dollars) More than 5 Years 1 - 90 91 - 365 1 to 3 3 to 5or Without Days Days Years Years Maturity Total EARNING ASSETS Loans $38,252 $103,727 $54,556 $15,814 $12,756 $225,105 Fed funds sold 21,405 21,405 Securities 6,571 9,899 9,565 2,956 2,447 31,438 Time deposits in other banks 6,032 6,032 ----- ------ ------ ------ ------ ------- Total 72,260 113,626 64,121 18,770 15,203 283,980 ------ ------- ------ ------ ------ ------- INTEREST BEARING LIABILITIES Transaction accounts 21,328 21,328 Money market savings 17,803 17,803 Savings accounts 30,850 30,850 Time deposits more than $100,000 10,156 19,090 10,058 9,265 48,569 Time deposits less than $100,000 18,289 57,133 27,644 14,099 117,165 Other borrowed money 134 299 985 752 1,730 3,900 ----- ------ ------ ------ ------ ------- Total 98,560 76,522 38,687 24,116 1,730 239,615 ------ ------ ------ ------ ------ ------- Rate sensitivity GAP (26,300) 37,104 25,434 (5,346) 13,473 44,365 Cumulative GAP (26,300) 10,804 36,238 30,892 44,365 Ratio of cumulative interest sensitive assets to cumulative interest sensitive liabilities 73.32% 106.17% 116.95% 112.99% 118.52% Assumes all transaction, money market and savings deposit accounts reprice within 90 days. 21 Item 3. Controls and Procedures Evaluation of Disclosure Controls and Procedures As a result of the enactment of the Sarbanes-Oxley Act of 2002, issuers such as Highlands Bankshares, Inc. that file periodic reports under the Securities Exchange Act of 1934 (the "Act") are now required to include in those reports certain information concerning the issuer's controls and procedures for complying with the disclosure requirements of the federal securities laws. Under rules adopted by the Securities and Exchange Commission effective August 29, 2002, these disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports it files or submits under the Act, is communicated to the issuer's management, including its principal executive officer or officers and principal financial officer or officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. We have established our disclosure controls and procedures to ensure that material information related to Highlands Bankshares, Inc. is made known to our principal executive officers and principal finance officer on a regular basis, in particular during the periods in which our quarterly and annual reports are being prepared. These disclosure controls and procedures consist principally of communications between and among the President and the Finance Officer, and the other executive officers of Highlands Bankshares, Inc. and its subsidiaries to identify any new transactions, events, trends, contingencies or other matters that may be material to the Company's operations. As required, we will evaluate the effectiveness of these disclosure controls and procedures on a quarterly basis, and most recently did so as of April 30, 2003, a date within 90 days prior to the filing of this quarterly report. Based on this evaluation, the management of Highlands Bankshares, Inc., including the Finance Officer, concluded that such disclosure controls and procedures were operating effectively as designed as of the date of such evaluation. Changes in Internal Controls During the period reported upon, there were no significant changes in the internal controls of Highlands Bankshares, Inc. pertaining to its financial reporting and control of its assets or in other factors that could significantly affect these controls. 22 Part II Other Information Item 1. Legal Proceedings - Not Applicable Item 2. Changes in Securities - Not Applicable Item 3. Defaults Upon Senior Securities - Not Applicable Item 4. Submission of Matters to a Vote of Security Holders - Not Applicable Item 5. Other Information - Not Applicable Item 6. Exhibits and Reports on 8-K - (a) Exhibits 3 (i) Articles of Incorporation of Highlands Bankshares, Inc. are incorporated by reference to Appendix C to Highlands Bankshares, Inc.'s Form S-4 filed October 20, 1986; amended on December 8, 1997 and incorporated in 1997 Form 10-KSB. 3 (ii) Bylaws of Highlands Bankshares, Inc. as amended January 14, 2003 are attached. 99.1 Statement of Chief Executive Officer and Financial Officer Pursuant to 18 U.S.C.ss.1350. (b) Reports on Form 8-K filed during the three months ended March 31, 2003. None 23 Signature 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. HIGHLANDS BANKSHARES, INC. /s/ LESLIE A. BARR --------------------------------- Leslie A. Barr President /s/ R. ALAN MILLER --------------------------------- R. Alan Miller Finance Officer Date: May 14, 2003 --------------- 24 CERTIFICATION OF CHIEF EXECUTIVE OFFICER Pursuant to section 302 of the Sarbanes-Oxley Act of 2002 Chapter 63, Title 18 USC Section 1350 (A) and (B) I, Leslie A. Barr, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Highlands Bankshares, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 ------------------ /s/ LESLIE A. BARR ------------------ Leslie A. Barr President 25 CERTIFICATION OF EXECUTIVE OFFICER Pursuant to section 302 of the Sarbanes-Oxley Act of 2002 Chapter 63, Title 18 USC Section 1350 (A) and (B) I, Clarence E. Porter, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Highlands Bankshares, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 ----------------- /s/ CLARENCE E. PORTER ---------------------- Clarence E. Porter Treasurer 26 CERTIFICATION OF EXECUTIVE OFFICER Pursuant to section 302 of the Sarbanes-Oxley Act of 2002 Chapter 63, Title 18 USC Section 1350 (A) and (B) I, Alan L. Brill, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Highlands Bankshares, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 ------------------ /s/ ALAN L. BRILL ----------------- Alan L. Brill Secretary 27 CERTIFICATION OF CHIEF FINANCIAL OFFICER Pursuant to section 302 of the Sarbanes-Oxley Act of 2002 Chapter 63, Title 18 USC Section 1350 (A) and (B) I, R. Alan Miller, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Highlands Bankshares, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 ------------------ /s/ R. ALAN MILLER ------------------ R. Alan Miller Finance Officer 28 Exhibit 99.1 Statement of Chief Executive Officer and Financial Officer Pursuant to 18 U.S.C.ss.1350 The undersigned, as the Chief Executive Officer and Chief Financial Officer, respectively, of Highlands Bankshares Inc., certify that the Quarterly Report on Form 10-Q for the period ended March 31, 2003, which accompanies this certification fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934 and the information contained in the periodic report fairly presents, in all material respects, the financial condition and results of operations of Highlands Bankshares Inc. at the dates and for the periods indicated. The foregoing certification is made pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. ss. 1350) and no purchaser or seller of securities or any other person shall be entitled to rely upon the foregoing certification for any purpose. The undersigned expressly disclaim any obligation to update the foregoing certification except as required by law. /s/ LESLIE A. BARR ------------------------- Leslie A. Barr Chief Executive Officer /s/ R. ALAN MILLER ------------------------- R. Alan Miller Finance Officer Date: May 14, 2003 ----------------- 29 Exhibit 3 (ii) BYLAWS OF HIGHLANDS BANKSHARES, INC. Article I Stockholders Section 1. PLACE OF MEETINGS. All meetings of the stockholders shall be held at the principal office of the corporation at 3 North Main Street, in the City of Petersburg, County of Grant, State of West Virginia, 26847, or at such other place as may be designated in writing by the President. Section 2: VOTING. Stockholders shall be entitled to vote at meetings, in person or by proxy, appointed by instrument in writing and subscribed by the stockholder or by his duly authorized attorney, and shall be entitled to one vote for each share of stock registered in his name on the books of the corporation. Section 3. QUORUM. Any number of stockholders holding together a majority of the stock issued and outstanding, who shall be present in person or represented by proxy at any meeting duly called, shall constitute a quorum for the transaction of business. Section 4. ADJOURNMENT OF MEETINGS. If less than a quorum shall be in attendance, the meeting shall be adjourned from time to time by a majority vote of the stockholders present or represented until a quorum shall attend. Any meeting, at which a quorum is present, may also be adjourned in like manner for such time or upon such call as may be determined by vote. At any adjourned meeting, at which a quorum shall attend, any business may be transacted which might have been transacted if the meeting had been held as originally called. Section 5. ANNUAL ELECTION OF DIRECTORS. The annual meeting of the stockholders for the election of directors and the transaction of other business, shall be held at the office of the corporation at 3 North Main Street, in the City of Petersburg, County of Grant, State of West Virginia, or at such other place as may be designated by the President, on the second Tuesday of May of each year after 2003. Section 6. SPECIAL MEETINGS - HOW CALLED. Special meetings of the stockholders may be called by the President, and shall be called upon a request in writing stating the purposes thereof delivered to the President and signed by a majority of the directors or by twenty-five percent in interest of the stockholders, or by resolution and call of the directors. Section 7. NOTICE OF STOCKHOLDERS' MEETINGS. Written notice stating the place and time of the meeting and the general nature of the business to be transacted shall be given by the Secretary to each stockholder at his last known post office address at least ten days before the meeting and five days before the meeting in the case of a special meeting. At any annual or other meeting of the stockholders, action may be taken upon any subject which might be acted upon at a special meeting called for the purpose, when, in the last mentioned case, in the notice of such annual or other meeting, the purpose to consider and act upon a special object is stated. Section 8. CONSENTS. Any and all notices herein required, including the time and place of the meeting and the nature of the business to be transacted, may be waived by written instrument executed by all the stockholders. Further, any action by the stockholders of the corporation may be taken without a meeting by the unanimous written consent of all of the stockholders. 30 ARTICLE II Directors Section 1. FIRST MEETING. The newly elected directors may hold their first meeting for the purpose of organization and the transaction of business, if a quorum be present, immediately after the annual meeting of the stockholders, at such time and place as may be fixed by consent in writing of a quorum of all the directors. Section 2. ELECTION OF OFFICERS. At such meeting the directors shall elect a President, and at their option a Chairman, and one or more Vice-Presidents from their number, and shall also elect a Secretary and a Treasurer with such assistants as may be desirable, who need not be directors. Unless sooner removed, such officers shall hold offices until the next annual election of officers and until their successors are elected and shall qualify. In case such officers shall not be elected at such first meeting, they may be chosen at any subsequent meeting called for the purpose. Section 3. REGULAR MEETING. Regular meetings of the directors may be held without notice on the second Tuesday of every month at The Capon Valley Bank Branch Office, in the City of Moorefield, County of Hardy, State of West Virginia, or elsewhere as designated by the President. Section 4. SPECIAL MEETINGS - HOW CALLED - NOTICE. Special meetings of directors may be called by the President, and shall be called by the Secretary on the written request of any two directors. Three days notice to each director shall be required. This notice may be waived by written consent of all the directors. Section 5. QUORUM. A majority of the directors shall constitute a quorum for the transaction of business. Section 6. PLACE OF MEETING. The directors may hold their meeting at any office or offices of the corporation, or at any other place as they may from time to time by resolution determine. Section 7. GENERAL POWER OF DIRECTORS. The board of directors shall have the management of the business of the corporation and subject to the restrictions imposed by law, by the Articles of Incorporation or by the bylaws, may exercise all the powers of the corporation. Section 8. CONSENTS. Any and all notices herein required, including the time and place of the meeting and the nature of the business to be transacted, may be waived by written instrument executed by all the directors. Further, any action by the directors of the corporation may be taken without a meeting by the unanimous written consent of all of the directors. Section 9. NUMBER The board of directors shall consist of not less than ten nor more than fifteen directors, with the exact number within such minimum and maximum to be fixed by the board of directors or the stockholders. 31 ARTICLE III Officers Section 1. The officers of the corporation shall be a President, at the option of the directors, a Chairman and one or more Vice Presidents, a Secretary and a Treasurer. One person may hold the office of Secretary and Treasurer. Section 2. PRESIDENT. The president shall preside at all meetings of the directors and stockholders when present, and shall have power to call said meetings of stockholders and directors for any purpose or purposes, make and sign contracts in the name and on behalf of the corporation, subject to the approval of the directors shall have general management and control of the business and affairs of the corporation. Section 3. VICE PRESIDENT. The First Vice President, if one be selected by the board of directors, shall be vested with all the powers and shall perform all the duties of the President in the absence or disability of the latter, unless and until the directors shall otherwise determine. He shall have such power to perform such other duties as shall be prescribed by the directors. There may be additional Vice Presidents without executive power. Section 4. SECRETARY. The Secretary shall give or cause to be given notice of all meetings of stockholders and directors and all other notices required by law or by these bylaws. He shall record the proceedings of the meetings of the stockholders and of the directors in a book to be kept for that purpose and shall perform such other duties as may be assigned to him by the directors or the President. He shall sign the stock certificates of the corporation along with the President, and he shall keep a register of the addresses of each stockholder as furnished to him from time to time over the signature of the stockholder as required by law, and shall make the proper changes in such register, retaining and filing his authority for all such entries. Section 5. TREASURER. The Treasurer shall have the custody of all funds, securities and evidences of indebtedness. He shall receive and give or cause to be given all acquaintances for monies paid in on account of the corporation. He shall pay out of the funds of the corporation and keep full and accurate books of account; whenever required by the President or the directors, shall render a financial statement; and shall perform such other duties as may be prescribed by the President or directors. ARTICLE IV Resignations, Filling of Vacancies, Removal of Directors Section 1. RESIGNATIONS. Any director, member of a committee, or other offices, may resign at any time. Such resignations shall be made in writing and the acceptance of the resignation shall not be necessary to make it effective. Section 2. FILLING OF VACANCIES. If the office of any director becomes vacant, the directors in office, except as otherwise provided by law, may appoint any qualified person to fill such vacancy, who shall hold office until the next annual meeting of stockholders. Section 3. REMOVAL. The holders of at least eighty percent (80%) of the outstanding capital stock shall have the power at any regular or special meeting to remove any or all of the board of directors and may elect their successors. 32 ARTICLE V Capital Stock Section 1. ISSUE OF CERTIFICATES OF STOCK. The President shall cause to be issued to each stockholder, one or more certificates under the seal of the corporation, signed by the President and Secretary, certifying the number of shares owned by the stockholder. Section 2. TRANSFER OF SHARES. The shares of stock of the corporation shall be transferable only upon its books by the holders thereof in person or by their duly authorized attorneys. Section 3. DIVIDENDS. The directors may declare dividends from unreserved and unrestricted earned surplus when they deem expedient. Before declaring any dividends there may be retained out of the accumulated profits such sum or sums as the directors in their discretion think proper for their working capital or as a reserve fund to meet contingencies, or for equalizing dividends or for such other purposes as the directors shall think conductive to the interest of the corporation. ARTICLE VI Bylaws Section 1. BYLAWS. The stockholders by the affirmative vote of the holders of a majority of the stock issued and outstanding or the directors by the affirmative vote of a majority thereof may at any meeting, provided the substance of the proposed amendments shall have been stated in the notice of the meeting, amend or alter the bylaws. Bylaws made by the directors may be altered or repealed by the stockholders. ARTICLE VII Fiscal Year Section 1. FISCAL YEAR. The fiscal year of this corporation shall end on December 31 of each year.