Edgar Filing: SHORE BANCSHARES INC

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the Quarterly Period Ended June 30, 2014

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 0-22345

SHORE BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

	Maryland		52-1974638
	(State or Other Jurisdiction of		(I.R.S. Employer
	Incorporation or Organization)		Identification No.)

	28969 Information Lane, Easton, Maryland		21601
	(Address of Principal Executive Offices)		(Zip Code)

(410) 763-7800

Registrant’s Telephone Number, Including Area Code

N/A

(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 periods that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes R No £

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

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

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

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

APPLICABLE ONLY TO CORPORATE ISSUERS

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 12,614,943 shares of common stock outstanding as of July 31, 2014.

INDEX

	Page

Part I. Financial Information	2

Item 1. Financial Statements	2

Consolidated Balance Sheets - June 30, 2014 (unaudited) and December 31, 2013	2

Consolidated Statements of Operations - For the three and six months ended June 30, 2014 and 2013 (unaudited)	3

Consolidated Statements of Comprehensive Income (Loss) - For the three and six months ended June 30, 2014 and 2013 (unaudited)	4

Consolidated Statements of Changes in Stockholders’ Equity - For the six months ended June 30, 2014 and 2013 (unaudited)	5

Consolidated Statements of Cash Flows - For the six months ended June 30, 2014 and 2013 (unaudited)	6

Notes to Consolidated Financial Statements (unaudited)	7

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	25

Item 3. Quantitative and Qualitative Disclosures about Market Risk	37

Item 4. Controls and Procedures	37

Part II. Other Information	38

Item 1. Legal Proceedings	38

Item 1A. Risk Factors	38

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	38

Item 3. Defaults Upon Senior Securities	38

Item 4. Mine Safety Disclosures	38

Item 5. Other Information	38

Item 6. Exhibits	38

Signatures	38

Exhibit Index	39

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements.

SHORE BANCSHARES, INC.

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share amounts)

	June 30,			December 31,
	2014			2013
	(Unaudited)
ASSETS
Cash and due from banks	$	22,997		$	21,238
Interest-bearing deposits with other banks		69,717			109,384
Federal funds sold		1,656			468
Investment securities:
Available for sale, at fair value		202,826			147,101
Held to maturity, at amortized cost – fair value of $5,076 (2014) and $5,062 (2013)		5,071			5,185

Loans held for sale		-			3,521

Loans		709,659			711,919
Less: allowance for credit losses		(9,076	)		(10,725	)
Loans, net		700,583			701,194

Premises and equipment, net		14,954			15,198
Goodwill		11,931			12,454
Other intangible assets, net		1,397			3,520
Other real estate owned, net		4,201			3,779
Other assets		29,520			31,082
TOTAL ASSETS	$	1,064,853		$	1,054,124

LIABILITIES
Deposits:
Noninterest-bearing	$	173,837		$	172,797
Interest-bearing		739,648			760,671
Total deposits		913,485			933,468

Short-term borrowings		7,801			10,140
Other liabilities		6,074			7,217
TOTAL LIABILITIES		927,360			950,825

STOCKHOLDERS’ EQUITY
Common stock, par value $.01 per share; shares authorized – 35,000,000; shares issued and outstanding – 12,614,943 (2014) and 8,471,289 (2013)		126			85
Additional paid in capital		63,497			32,207
Retained earnings		74,007			71,444
Accumulated other comprehensive loss		(137	)		(437	)
TOTAL STOCKHOLDERS’ EQUITY		137,493			103,299
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	1,064,853		$	1,054,124

See accompanying notes to Consolidated Financial Statements.

SHORE BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

(Dollars in thousands, except per share amounts)

	For the Three Months Ended					For the Six Months Ended
	June 30,					June 30,
	2014		2013			2014		2013

INTEREST INCOME
Interest and fees on loans	$	8,812	$	10,142		$	17,687	$	20,049
Interest and dividends on investment securities:
Taxable		669		568			1,190		1,211
Tax-exempt		3		4			6		9
Interest on federal funds sold		-		1			-		3
Interest on deposits with other banks		39		40			95		90
Total interest income		9,523		10,755			18,978		21,362

INTEREST EXPENSE
Interest on deposits		1,071		1,748			2,198		3,870
Interest on short-term borrowings		5		6			10		14
Total interest expense		1,076		1,754			2,208		3,884

NET INTEREST INCOME		8,447		9,001			16,770		17,478
Provision for credit losses		950		2,700			1,925		4,850

NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES		7,497		6,301			14,845		12,628

NONINTEREST INCOME
Service charges on deposit accounts		602		600			1,160		1,172
Trust and investment fee income		455		393			886		783
Gains on sales of investment securities		-		913			-		913
Insurance agency commissions		2,536		2,633			5,613		5,446
Gain on sale of wholesale insurance subsidiary		114		-			114		-
Loss on termination of cash flow hedge		-		(1,306	)		-		(1,306	)
Other noninterest income		821		729			1,543		1,444
Total noninterest income		4,528		3,962			9,316		8,452

NONINTEREST EXPENSE
Salaries and wages		4,292		4,307			8,606		8,590
Employee benefits		1,020		1,006			2,202		2,140
Occupancy expense		577		612			1,204		1,209
Furniture and equipment expense		243		243			516		493
Data processing		739		706			1,499		1,409
Directors’ fees		132		55			244		176
Amortization of other intangible assets		60		74			134		148
Insurance agency commissions expense		394		458			906		919
FDIC insurance premium expense		377		367			835		733
Write-downs of other real estate owned		101		56			176		728
Other noninterest expenses		1,982		1,875			3,710		3,705
Total noninterest expense		9,917		9,759			20,032		20,250

INCOME BEFORE INCOME TAXES		2,108		504			4,129		830
Income tax expense		803		143			1,566		247

NET INCOME	$	1,305	$	361		$	2,563	$	583

Basic net income per common share	$	0.13	$	0.04		$	0.28	$	0.07
Diluted net income per common share	$	0.13	$	0.04		$	0.28	$	0.07
Dividends paid per common share	$	-	$	-		$	-	$	-

See accompanying notes to Consolidated Financial Statements.

SHORE BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (Unaudited)

(Dollars in thousands)

	For the Three Months Ended June 30,						For the Six Months Ended June 30,
	2014			2013			2014			2013

Net income	$	1,305		$	361		$	2,563		$	583

Other comprehensive income
Securities available for sale:
Unrealized holding gains (losses) on available-for-sale securities		414			(2,560	)		503			(2,800	)
Tax effect		(167	)		1,034			(203	)		1,130
Reclassification of gains recognized in net income		-			(913	)		-			(913	)
Tax effect		-			368			-			368
Net of tax amount		247			(2,071	)		300			(2,215	)

Cash flow hedging activities:
Unrealized holding gains on cash flow hedging activities		-			265			-			681
Tax effect		-			(106	)		-			(274	)
Reclassification of losses recognized in net income		-			1,306			-			1,306
Tax effect		-			(527	)		-			(527	)
Net of tax amount		-			938			-			1,186
Total other comprehensive income (loss)		247			(1,133	)		300			(1,029	)
Comprehensive income (loss)	$	1,552		$	(772	)	$	2,863		$	(446	)

See accompanying notes to Consolidated Financial Statements.

SHORE BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)

For the Six Months Ended June 30, 2014 and 2013

(Dollars in thousands, except per share amounts)

							Accumulated
			Additional				Other			Total
	Common		Paid in		Retained		Comprehensive			Stockholders’
	Stock		Capital		Earnings		Income (Loss)			Equity
Balances, January 1, 2014	$	85	$	32,207	$	71,444	$	(437	)	$	103,299

Net income		-		-		2,563		-			2,563

Unrealized gains on available-for-sale securities, net of taxes		-		-		-		300			300

Issuance of common stock through public offering, net		41		31,241		-		-			31,282

Stock-based compensation		-		49		-		-			49

Balances, June 30, 2014	$	126	$	63,497	$	74,007	$	(137	)	$	137,493

Balances, January 1, 2013	$	85	$	32,155	$	81,078	$	708		$	114,026

Net income		-		-		583		-			583

Unrealized losses on available-for-sale securities, net of taxes		-		-		-		(2,215	)		(2,215	)

Unrealized gains on cash flow hedging activities, net of taxes		-		-		-		1,186			1,186

Stock-based compensation		-		14		-		-			14

Balances, June 30, 2013	$	85	$	32,169	$	81,661	$	(321	)	$	113,594

See accompanying notes to Consolidated Financial Statements.

SHORE BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(Dollars in thousands)

	For the Six Months Ended
	June 30,
	2014			2013
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	2,563		$	583
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for credit losses		1,925			4,850
Depreciation and amortization		1,126			1,246
Discount accretion on debt securities		(25	)		(21	)
Stock-based compensation expense		49			40
Excess tax benefit from stock-based arrangements		-			(26	)
Deferred income tax expense (benefit)		1,241			(1,006	)
Gains on sales of investment securities		-			(913	)
(Gains) losses on sales of other real estate owned		(5	)		183
Write-downs of other real estate owned		176			728
Gain on sale of wholesale insurance subsidiary		(114	)		-
Loss on termination of cash flow hedge		-			1,306
Net changes in:
Accrued interest receivable		(56	)		(55	)
Other assets		(182	)		3,493
Accrued interest payable		(27	)		(53	)
Other liabilities		(1,116	)		(256	)
Net cash provided by operating activities		5,555			10,099

CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from maturities and principal payments of investment securities available for sale		26,815			18,612
Proceeds from sales of investment securities available for sale		-			40,351
Purchases of investment securities available for sale		(82,395	)		(12,048	)
Proceeds from maturities and principal payments of investment securities held to maturity		108			61
Net change in loans		1,157			(4,680	)
Purchases of premises and equipment		(255	)		(203	)
Proceeds from sales of premises and equipment		-			4
Proceeds from sales of other real estate owned		456			2,838
Proceeds from sale of wholesale insurance subsidiary		2,878			-
Return of investment in unconsolidated subsidiary		-			85
Net cash (used in) provided by investing activities		(51,236	)		45,020

CASH FLOWS FROM FINANCING ACTIVITIES:
Net changes in:
Noninterest-bearing deposits		1,041			4,570
Interest-bearing deposits		(21,023	)		(131,736	)
Short-term borrowings		(2,339	)		(3,666	)
Proceeds from issuance of common stock through public offering, net		31,282			-
Excess tax benefit from stock-based arrangements		-			26
Net cash provided by (used in) financing activities		8,961			(130,806	)
Net decrease in cash and cash equivalents		(36,720	)		(75,687	)
Cash and cash equivalents at beginning of period		131,090			200,193
Cash and cash equivalents at end of period	$	94,370		$	124,506

Supplemental cash flows information:
Interest paid	$	2,235		$	3,937
Income taxes paid	$	85		$	157
Transfers from loans to other real estate owned	$	1,049		$	2,456
Transfers from loans held for sale to loans	$	3,521		$	-

See accompanying notes to Consolidated Financial Statements.

Shore Bancshares, Inc.

Notes to Consolidated Financial Statements

For the Three and Six Months Ended June 30, 2014 and 2013

(Unaudited)

Note 1 - Basis of Presentation

The consolidated financial statements include the accounts of Shore Bancshares, Inc. and its subsidiaries with all significant intercompany transactions eliminated. The consolidated financial statements conform to accounting principles generally accepted in the United States of America (“GAAP”) and to prevailing practices within the banking industry. The accompanying interim financial statements are unaudited; however, in the opinion of management all adjustments necessary to present fairly the consolidated financial position at June 30, 2014, the consolidated results of operations and comprehensive income (loss) for the three and six months ended June 30, 2014 and 2013, and changes in stockholders’ equity and cash flows for the six months ended June 30, 2014 and 2013, have been included. All such adjustments are of a normal recurring nature. The amounts as of December 31, 2013 were derived from the 2013 audited financial statements. The results of operations for the three and six months ended June 30, 2014 are not necessarily indicative of the results to be expected for any other interim period or for the full year. This Quarterly Report on Form 10-Q should be read in conjunction with the Annual Report of Shore Bancshares, Inc. on Form 10-K for the year ended December 31, 2013. For purposes of comparability, certain reclassifications have been made to amounts previously reported to conform with the current period presentation.

When used in these notes, the term “the Company” refers to Shore Bancshares, Inc. and, unless the context requires otherwise, its consolidated subsidiaries.

Recent Accounting Standards

Accounting Standards Update (“ASU”) 2013-04, “Liabilities (Accounting Standards Codification (“ASC”) Topic 405) - Obligations Resulting from Joint and Several Liability Arrangements for Which the Total Amount of the Obligation Is Fixed at the Reporting Date.” ASU 2013-04 provides guidance for the recognition, measurement and disclosure of obligations resulting from joint and several liability arrangements for which the total amount of the obligation is fixed at the reporting date. This guidance requires an entity to measure the obligation as the sum of the amount the reporting entity agreed to pay on the basis of its arrangement among its co-obligors, and any additional amount the reporting entity expects to pay on behalf of its co-obligors. This guidance also requires an entity to disclose the nature and amount of the obligation as well as other information about those obligations. ASU 2013-04 became effective for the Company on January 1, 2014, and did not have a significant impact on the Company’s financial statements.

ASU 2014-04, “Receivables (ASC Topic 310) – Troubled Debt Restructurings by Creditors, Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure.” ASU 2014-04 clarifies when an in substance repossession or foreclosure occurs which is defined as when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan such that the loan receivable should be derecognized and the real estate property recognized. The ASU requires that the real property be recognized upon obtaining legal title to the real estate collateral, or the borrower voluntarily conveying all interest in the real estate property to the lender to satisfy the loan through a deed in lieu of foreclosure or similar legal agreement. ASU 2014-04 is effective for the Company for interim and annual periods beginning after December 15, 2014 and is not expected to have a significant impact on the Company’s financial statements.

Note 2 – Earnings Per Share

Basic earnings per common share is calculated by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted earnings per common share is calculated by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period, adjusted for the dilutive effect of common stock equivalents (stock-based awards). The following table provides information relating to the calculation of earnings per common share:

	For the Three Months Ended				For the Six Months Ended
	June 30,				June 30,
(In thousands, except per share data)	2014		2013		2014		2013
Net income	$	1,305	$	361	$	2,563	$	583
Weighted average shares outstanding - Basic		10,013		8,461		9,246		8,460
Dilutive effect of common stock equivalents		11		4		12		-
Weighted average shares outstanding - Diluted		10,024		8,465		9,258		8,460
Earnings per common share - Basic	$	0.13	$	0.04	$	0.28	$	0.07
Earnings per common share - Diluted	$	0.13	$	0.04	$	0.28	$	0.07

The increase in the weighted average shares outstanding for the three and six months ended June 30, 2014 when compared to the three and six months ended June 30, 2013 was due to the Company’s public offer and sale of its common stock (the “stock sale”) during the second quarter of 2014. As a result of the stock sale, the Company sold 4,140,000 shares of its common stock for a price of $8.25 per share, which produced net proceeds of $31.2 million.

There were no weighted average common stock equivalents excluded from the calculation of diluted earnings per share for the three and six months ended June 30, 2014, and for the three months ended June 30, 2013. There were 54 thousand weighted average common stock equivalents excluded from the calculation of diluted earnings per share for the six months ended June 30, 2013 because the effect of including them would have been antidilutive.

Note 3 – Investment Securities

The following table provides information on the amortized cost and estimated fair values of investment securities.

			Gross		Gross		Estimated
	Amortized		Unrealized		Unrealized		Fair
(Dollars in thousands)	Cost		Gains		Losses		Value
Available-for-sale securities:
June 30, 2014
U.S. Treasury	$	5,276	$	8	$	-	$	5,284
U.S. Government agencies		57,289		85		243		57,131
Mortgage-backed		139,872		640		720		139,792
Equity		617		2		-		619
Total	$	203,054	$	735	$	963	$	202,826

December 31, 2013
U.S. Treasury	$	5,342	$	1	$	-	$	5,343
U.S. Government agencies		60,754		62		372		60,444
Mortgage-backed		81,130		520		937		80,713
Equity		609		-		8		601
Total	$	147,835	$	583	$	1,317	$	147,101
Held-to-maturity securities:
June 30, 2014
U.S. Government agencies	$	2,889	$	-	$	151	$	2,738
States and political subdivisions		2,182		156		-		2,338
Total	$	5,071	$	156	$	151	$	5,076

December 31, 2013
U.S. Government agencies	$	2,975	$	-	$	222	$	2,753
States and political subdivisions		2,210		99		-		2,309
Total	$	5,185	$	99	$	222	$	5,062

The following tables provide information about gross unrealized losses and fair value by length of time that the individual securities have been in a continuous unrealized loss position at June 30, 2014 and December 31, 2013.

	Less than 12 Months				More than 12 Months				Total
(Dollars in thousands)	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
June 30, 2014
Available-for-sale securities:
U.S. Government agencies	$	19,606	$	30	$	9,963	$	213	$	29,569	$	243
Mortgage-backed		45,133		166		24,006		554		69,139		720
Total	$	64,739	$	196	$	33,969	$	767	$	98,708	$	963

Held-to-maturity securities:
U.S. Government agencies	$	-	$	-	$	2,738	$	151	$	2,738	$	151

	Less than 12 Months				More than 12 Months				Total
(Dollars in thousands)	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
December 31, 2013
Available-for-sale securities:
U.S. Government agencies	$	33,004	$	372	$	-	$	-	$	33,004	$	372
Mortgage-backed		28,694		416		19,121		521		47,815		937
Equity		601		8		-		-		601		8
Total	$	62,299	$	796	$	19,121	$	521	$	81,420	$	1,317

Held-to-maturity securities:
U.S. Government agencies	$	2,753	$	222	$	-	$	-	$	2,753	$	222

All of the securities with unrealized losses in the portfolio have modest duration risk, low credit risk, and minimal losses when compared to total amortized cost. The unrealized losses on debt securities that exist are the result of market changes in interest rates since original purchase. Because the Company does not intend to sell these securities and it is not more likely than not that the Company will be required to sell these securities before recovery of their amortized cost bases, which may be at maturity for debt securities, the Company considers the unrealized losses to be temporary.

The following table provides information on the amortized cost and estimated fair values of investment securities by maturity date at June 30, 2014.

	Available for sale				Held to maturity
	Amortized		Estimated		Amortized		Estimated
(Dollars in thousands)	Cost		Fair Value		Cost		Fair Value
Due in one year or less	$	2,011	$	2,014	$	240	$	241
Due after one year through five years		60,204		60,211		432		448
Due after five years through ten years		9,402		9,458		1,006		1,119
Due after ten years		130,820		130,524		3,393		3,268
		202,437		202,207		5,071		5,076
Equity securities		617		619		-		-
Total	$	203,054	$	202,826	$	5,071	$	5,076

The maturity dates for debt securities are determined using contractual maturity dates.

Note 4 – Loans and Allowance for Credit Losses

The Company makes residential mortgage, commercial and consumer loans to customers primarily in Talbot County, Queen Anne’s County, Kent County, Caroline County and Dorchester County in Maryland and in Kent County, Delaware. The following table provides information about the principal classes of the loan portfolio at June 30, 2014 and December 31, 2013. At December 31, 2013, $3.5 million of nonaccrual construction loans were classified as held for sale. During the first quarter of 2014, these loans held for sale were reclassified to loans.

(Dollars in thousands)	June 30, 2014			December 31, 2013
Construction	$	68,348		$	64,591
Residential real estate		277,184			274,857
Commercial real estate		297,762			304,605
Commercial		56,492			57,195
Consumer		9,873			10,671
Total loans		709,659			711,919
Allowance for credit losses		(9,076	)		(10,725	)
Total loans, net	$	700,583		$	701,194

Loans are stated at their principal amount outstanding net of any deferred fees and costs. Interest income on loans is accrued at the contractual rate based on the principal amount outstanding. Fees charged and costs capitalized for originating loans are being amortized substantially on the interest method over the term of the loan. A loan is placed on nonaccrual (i.e., interest income is no longer accrued) when it is specifically determined to be impaired or when principal or interest is delinquent for 90 days or more, unless the loan is well secured and in the process of collection. Any unpaid interest previously accrued on those loans is reversed from income. Interest payments received on nonaccrual loans are applied as a reduction of the loan principal balance unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.

A loan is considered impaired if it is probable that the Company will not collect all principal and interest payments according to the loan’s contractual terms. An impaired loan may show deficiencies in the borrower’s overall financial condition, payment history, support available from financial guarantors and/or the fair market value of collateral. The impairment of a loan is measured at the present value of expected future cash flows using the loan’s effective interest rate, or at the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. Generally, the Company measures impairment on such loans by reference to the fair value of the collateral. Once the amount of impairment has been determined, the uncollectible portion is charged off. Income on impaired loans is recognized on a cash basis, and payments are first applied against the principal balance outstanding (i.e., placing impaired loans on nonaccrual status). Generally, interest income is not recognized on impaired loans unless the likelihood of further loss is remote. The allowance for credit losses may include specific reserves related to impaired loans. Specific reserves remain until charge offs are made. Impaired loans do not include groups of smaller balance homogenous loans such as residential mortgage and consumer installment loans that are evaluated collectively for impairment. Reserves for probable credit losses related to these loans are based on historical loss ratios and are included in the formula portion of the allowance for credit losses. See additional discussion under the caption “Critical Accounting Policies” in Management’s Discussion and Analysis of Financial Condition and Results of Operations.

A loan is considered a troubled debt restructuring if a borrower is experiencing financial difficulties and a creditor has granted a concession. Concessions may include interest rate reductions or below market interest rates, principal forgiveness, restructuring amortization schedules and other actions intended to minimize potential losses. All loans designated as troubled debt restructurings (“TDRs”) are considered impaired loans and may be on either accrual or nonaccrual status.

The following tables include impairment information relating to loans and the allowance for credit losses as of June 30, 2014 and December 31, 2013.

(Dollars in thousands)	Construction		Residential real estate		Commercial real estate		Commercial		Consumer		Unallocated		Total
June 30, 2014
Loans individually evaluated for impairment	$	11,878	$	19,232	$	9,126	$	317	$	25	$	-	$	40,578
Loans collectively evaluated for impairment		56,470		257,952		288,636		56,175		9,848		-		669,081
Total loans	$	68,348	$	277,184	$	297,762	$	56,492	$	9,873	$	-	$	709,659

Allowance for credit losses allocated to:
Loans individually evaluated for impairment	$	201	$	310	$	24	$	65	$	25	$	-	$	625
Loans collectively evaluated for impairment		2,047		2,044		2,628		793		281		658		8,451
Total allowance for credit losses	$	2,248	$	2,354	$	2,652	$	858	$	306	$	658	$	9,076

(Dollars in thousands)	Construction		Residential real estate		Commercial real estate		Commercial		Consumer		Unallocated		Total
December 31, 2013
Loans individually evaluated for impairment	$	5,569	$	19,748	$	14,462	$	887	$	48	$	-	$	40,714
Loans collectively evaluated for impairment		59,022		255,109		290,143		56,308		10,623		-		671,205
Total loans	$	64,591	$	274,857	$	304,605	$	57,195	$	10,671	$	-	$	711,919

Allowance for credit losses allocated to:
Loans individually evaluated for impairment	$	204	$	285	$	44	$	245	$	5	$	-	$	783
Loans collectively evaluated for impairment		1,756		3,569		2,985		1,021		238		373		9,942
Total allowance for credit losses	$	1,960	$	3,854	$	3,029	$	1,266	$	243	$	373	$	10,725

The following tables provide information on impaired loans and any related allowance by loan class as of June 30, 2014 and December 31, 2013. The difference between the unpaid principal balance and the recorded investment is the amount of partial charge-offs that have been taken.

(Dollars in thousands)	Unpaid principal balance		Recorded investment with no allowance		Recorded investment with an allowance		Related allowance		Quarter-to- date average recorded investment		Year-to-date average recorded investment
June 30, 2014
Impaired nonaccrual loans:
Construction	$	12,263	$	7,780	$	200	$	200	$	8,040	$	8,131
Residential real estate		3,915		2,780		257		125		3,299		4,719
Commercial real estate		5,801		2,927		946		18		5,034		5,098
Commercial		472		196		65		65		598		642
Consumer		30		-		25		25		28		21
Total		22,481		13,683		1,493		433		16,999		18,611

Impaired accruing TDRs:
Construction		3,898		3,809		89		1		2,157		1,749
Residential real estate		16,195		12,761		3,434		185		16,080		16,102
Commercial real estate		5,253		4,480		773		6		7,023		7,509
Commercial		56		56		-		-		59		66
Consumer		-		-		-		-		-		-
Total		25,402		21,106		4,296		192		25,319		25,426

Total impaired loans:
Construction		16,161		11,589		289		201		10,197		9,880
Residential real estate		20,110		15,541		3,691		310		19,379		20,821
Commercial real estate		11,054		7,407		1,719		24		12,057		12,607
Commercial		528		252		65		65		657		708
Consumer		30		-		25		25		28		21
Total	$	47,883	$	34,789	$	5,789	$	625	$	42,318	$	44,037

(Dollars in thousands)	Unpaid principal balance		Recorded investment with no allowance		Recorded investment with an allowance		Related allowance		Quarter-to- date average recorded investment		Year-to-date average recorded investment
December 31, 2013
Impaired nonaccrual loans:
Construction	$	6,787	$	3,709	$	240	$	203	$	5,563	$	7,270
Residential real estate		7,692		3,862		1,304		225		5,094		10,240
Commercial real estate		5,218		4,261		410		38		3,917		7,829
Commercial		1,801		547		245		245		740		619
Consumer		56		43		5		5		49		48
Total		21,554		12,422		2,204		716		15,363		26,006

Impaired accruing TDRs:
Construction		1,620		1,527		93		1		1,759		14,405
Residential real estate		14,582		13,177		1,405		60		15,387		11,101
Commercial real estate		9,791		9,006		785		6		10,201		13,308
Commercial		95		95		-		-		98		105
Consumer		-		-		-		-		-		-
Total		26,088		23,805		2,283		67		27,445		38,919

Total impaired loans:
Construction		8,407		5,236		333		204		7,322		21,675
Residential real estate		22,274		17,039		2,709		285		20,481		21,341
Commercial real estate		15,009		13,267		1,195		44		14,118		21,137
Commercial		1,896		642		245		245		838		724
Consumer		56		43		5		5		49		48
Total	$	47,642	$	36,227	$	4,487	$	783	$	42,808	$	64,925

The following tables provide information on loans that were modified and considered TDRs during the six months ended June 30, 2014 and June 30, 2013.

(Dollars in thousands)	Number of contracts		Premodification outstanding recorded investment		Postmodification outstanding recorded investment		Related allowance
TDRs:
For the six months ended June 30, 2014
Construction		-	$	-	$	-	$	-
Residential real estate		-		-		-		-
Commercial real estate		-		-		-		-
Commercial		-		-		-		-
Consumer		-		-		-		-
Total		-	$	-	$	-	$	-

For the six months ended June 30, 2013
Construction		2	$	123	$	123	$	-
Residential real estate		3		783		798		37
Commercial real estate		1		474		474		-
Commercial		-		-		-		-
Consumer		-		-		-		-
Total		6	$	1,380	$	1,395	$	37

The following tables provide information on TDRs that defaulted during the six months ended June 30, 2014 and June 30, 2013. Generally, a loan is considered in default when principal or interest is past due 90 days or more.

(Dollars in thousands)	Number of contracts		Recorded investment		Related allowance
TDRs that subsequently defaulted (1):
For the six months ended June 30, 2014
Construction		-	$	-	$	-
Residential real estate		-		-		-
Commercial real estate		-		-		-
Commercial		-		-		-
Consumer		-		-		-
Total		-	$	-	$	-

TDRs that subsequently defaulted (2):
For the six months ended June 30, 2013
Construction		-	$	-	$	-
Residential real estate		4		1,563		-
Commercial real estate		1		1,741		74
Commercial		-		-		-
Consumer		-		-		-
Total		5	$	3,304	$	74

(1) These loans were classified as TDRs during 2013.

(2) These loans were classified as TDRs during 2012.

Management uses risk ratings as part of its monitoring of the credit quality in the Company’s loan portfolio. Loans that are identified as special mention, substandard or doubtful are adversely rated. They are assigned higher risk ratings than favorably rated loans in the calculation of the formula portion of the allowance for credit losses.

The following tables provide information on loan risk ratings as of June 30, 2014 and December 31, 2013.

(Dollars in thousands)	Pass/Performing		Special mention		Substandard		Doubtful		Total
June 30, 2014
Construction	$	37,020	$	17,573	$	13,755	$	-	$	68,348
Residential real estate		242,869		23,320		10,995		-		277,184
Commercial real estate		255,486		29,555		12,721		-		297,762
Commercial		52,063		2,768		1,571		90		56,492
Consumer		9,687		161		25		-		9,873
Total	$	597,125	$	73,377	$	39,067	$	90	$	709,659

(Dollars in thousands)	Pass/Performing		Special mention		Substandard		Doubtful		Total
December 31, 2013
Construction	$	39,268	$	15,884	$	9,439	$	-	$	64,591
Residential real estate		235,054		22,638		17,114		51		274,857
Commercial real estate		255,280		30,105		19,210		10		304,605
Commercial		52,032		3,691		972		500		57,195
Consumer		10,451		48		172		-		10,671
Total	$	592,085	$	72,366	$	46,907	$	561	$	711,919

The following tables provide information on the aging of the loan portfolio as of June 30, 2014 and December 31, 2013.

	Accruing
(Dollars in thousands)	Current			30-59 days past due			60-89 days past due			90 days or more past due			Total past due			Nonaccrual			Total
June 30, 2014
Construction	$	60,108		$	106		$	154		$	-		$	260		$	7,980		$	68,348
Residential real estate		271,171			1,526			1,450			-			2,976			3,037			277,184
Commercial real estate		290,697			1,885			1,307			-			3,192			3,873			297,762
Commercial		55,071			1,146			9			5			1,160			261			56,492
Consumer		9,709			40			99			-			139			25			9,873
Total	$	686,756		$	4,703		$	3,019		$	5		$	7,727		$	15,176		$	709,659
Percent of total loans		96.8	%		0.7	%		0.4	%		-	%		1.1	%		2.1	%

	Accruing
(Dollars in thousands)	Current			30-59 days past due			60-89 days past due			90 days or more past due			Total past due			Nonaccrual			Total
December 31, 2013
Construction	$	60,642		$	-		$	-		$	-		$	-		$	3,949		$	64,591
Residential real estate		265,182			2,765			1,724			20			4,509			5,166			274,857
Commercial real estate		299,295			639			-			-			639			4,671			304,605
Commercial		55,576			330			247			250			827			792			57,195
Consumer		10,469			23			131			-			154			48			10,671
Total	$	691,164		$	3,757		$	2,102		$	270		$	6,129		$	14,626		$	711,919
Percent of total loans		97.1	%		0.5	%		0.3	%		-	%		0.8	%		2.1	%

Management evaluates the adequacy of the allowance for credit losses at least quarterly and adjusts the provision for credit losses based on this analysis. The following tables provide a summary of the activity in the allowance for credit losses allocated by loan class for the three months ended June 30, 2014 and 2013. Allocation of a portion of the allowance to one loan class does not preclude its availability to absorb losses in other loan classes.

(Dollars in thousands)	Construction			Residential real estate			Commercial real estate			Commercial			Consumer			Unallocated		Total
For the three months ended June 30, 2014
Allowance for credit losses:
Beginning balance	$	1,997		$	2,086		$	4,584		$	677		$	308		$	417	$	10,069

Charge-offs		(224	)		(315	)		(1,523	)		(95	)		(20	)		-		(2,177	)
Recoveries		1			63			7			157			6			-		234
Net charge-offs		(223	)		(252	)		(1,516	)		62			(14	)		-		(1,943	)

Provision		474			520			(416	)		119			12			241		950
Ending balance	$	2,248		$	2,354		$	2,652		$	858		$	306		$	658	$	9,076

(Dollars in thousands)	Construction			Residential real estate			Commercial real estate			Commercial			Consumer			Unallocated			Total
For the three months ended June 30, 2013
Allowance for credit losses:
Beginning balance	$	4,116		$	4,864		$	4,374		$	1,760		$	330		$	291		$	15,735

Charge-offs		(802	)		(1,096	)		(872	)		(136	)		(13	)		-			(2,919	)
Recoveries		1			59			90			50			7			-			207
Net charge-offs		(801	)		(1,037	)		(782	)		(86	)		(6	)		-			(2,712	)

Provision		1,031			432			1,922			(458	)		(23	)		(204	)		2,700
Ending balance	$	4,346		$	4,259		$	5,514		$	1,216		$	301		$	87		$	15,723

The following tables provide a summary of the activity in the allowance for credit losses allocated by loan class for the six months ended June 30, 2014 and 2013.

(Dollars in thousands)	Construction			Residential real estate			Commercial real estate			Commercial			Consumer			Unallocated		Total
For the six months ended June 30, 2014
Allowance for credit losses:
Beginning balance	$	1,960		$	3,854		$	3,029		$	1,266		$	243		$	373	$	10,725

Charge-offs		(241	)		(987	)		(1,613	)		(937	)		(147	)		-		(3,925	)
Recoveries		11			106			13			207			14			-		351
Net charge-offs		(230	)		(881	)		(1,600	)		(730	)		(133	)		-		(3,574	)

Provision		518			(619	)		1,223			322			196			285		1,925
Ending balance	$	2,248		$	2,354		$	2,652		$	858		$	306		$	658	$	9,076

(Dollars in thousands)	Construction			Residential real estate			Commercial real estate			Commercial			Consumer			Unallocated			Total
For the six months ended June 30, 2013
Allowance for credit losses:
Beginning balance	$	4,387		$	5,194		$	4,134		$	1,682		$	407		$	187		$	15,991

Charge-offs		(1,509	)		(1,889	)		(1,947	)		(223	)		(62	)		-			(5,630	)
Recoveries		2			298			93			102			17			-			512
Net charge-offs		(1,507	)		(1,591	)		(1,854	)		(121	)		(45	)		-			(5,118	)

Provision		1,466			656			3,234			(345	)		(61	)		(100	)		4,850
Ending balance	$	4,346		$	4,259		$	5,514		$	1,216		$	301		$	87		$	15,723

Note 5 – Other Assets

The Company had the following other assets at June 30, 2014 and December 31, 2013.

(Dollars in thousands)	June 30, 2014		December 31, 2013
Nonmarketable investment securities	$	1,586	$	2,058
Accrued interest receivable		2,617		2,561
Deferred income taxes		17,456		19,090
Prepaid expenses		1,253		700
Other assets		6,608		6,673
Total	$	29,520	$	31,082

Note 6 – Other Liabilities

The Company had the following other liabilities at June 30, 2014 and December 31, 2013.

(Dollars in thousands)	June 30, 2014		December 31, 2013
Accrued interest payable	$	198	$	225
Other accounts payable		2,456		3,543
Deferred compensation liability		1,472		1,505
Other liabilities		1,948		1,944
Total	$	6,074	$	7,217

Note 7 - Stock-Based Compensation

As of June 30, 2014, the Company maintained the Shore Bancshares, Inc. 2006 Stock and Incentive Compensation Plan (“2006 Equity Plan”) under which it may issue shares of common stock or grant other equity-based awards. Stock-based awards granted to date generally are time-based, vest in equal installments on each anniversary of the grant date over a three- to five-year period of time, and, in the case of stock options, expire 10 years from the grant date. Stock-based compensation expense is recognized ratably over the requisite service period for all awards, is based on the grant-date fair value and reflects forfeitures as they occur.

The following tables provide information on stock-based compensation expense for the three and six months ended June 30, 2014 and 2013.

	For the Three Months Ended				For the Six Months Ended
	June 30,				June 30,
(Dollars in thousands)	2014		2013		2014		2013
Stock-based compensation expense	$	27	$	18	$	49	$	40
Excess tax benefit related to stock-based compensation		-		-		-		26

	June 30,
(Dollars in thousands)	2014		2013
Unrecognized stock-based compensation expense	$	122	$	130
Weighted average period unrecognized expense is expected to be recognized		1.2 years		1.9 years

The following table summarizes restricted stock award activity for the Company under the 2006 Equity Plan for the six months ended June 30, 2014.

	Number			Weighted Average Grant
	of Shares			Date Fair Value
Nonvested at beginning of period		13,930		$	8.33
Granted		3,654			9.57
Vested		(3,333	)		8.93
Cancelled		-			-
Nonvested at end of period		14,251		$	8.51

The fair value of restricted stock awards that vested during the first six months of 2014 was $30 thousand.

The following table summarizes stock option activity for the Company under the 2006 Equity Plan for the six months ended June 30, 2014.

			Weighted
	Number		Average
	of Shares		Exercise Price
Outstanding at beginning of period		40,662	$	6.64
Granted		-		-
Exercised		-		-
Expired/Cancelled		-		-
Outstanding at end of period		40,662	$	6.64

Exercisable at end of period		20,331	$	6.64

At the end of the second quarter of 2014, the aggregate intrinsic value of the options outstanding under the 2006 Equity Plan was $96 thousand based on the $9.01 market value per share of the company’s common stock at June 30, 2014. Similarly, the aggregate intrinsic value of the options exercisable was $48 thousand at June 30, 2014. Since there were no options exercised during the first six months of 2014 or 2013, there was no intrinsic value associated with stock options exercised and no cash received on exercise of options. At June 30, 2014, the weighted average remaining contract life of options outstanding was 7.7 years.

Note 8 – Accumulated Other Comprehensive Income

The Company records unrealized holding gains (losses), net of tax, on investment securities available for sale and on cash flow hedging activities as accumulated other comprehensive income (loss), a separate component of stockholders’ equity. The following table provides information on the changes in the components of accumulated other comprehensive income (loss) for the six months ended June 30, 2014 and 2013.

(Dollars in thousands)	Accumulated net unrealized holding gains (losses) on available for sale securities			Accumulated net unrealized holding gains (losses) on cash flow hedging activities			Total accumulated other comprehensive income (loss)
Balance, December 31, 2013	$	(437	)	$	-		$	(437	)
Other comprehensive income		300			-			300
Balance, June 30, 2014	$	(137	)	$	-		$	(137	)

Balance, December 31, 2012	$	1,894		$	(1,186	)	$	708
Other comprehensive (loss) income		(1,670	)		407			(1,263	)
Reclassification of (gains) losses recognized		(545	)		779			234
Balance, June 30, 2013	$	(321	)	$	-		$	(321	)

Note 9 – Fair Value Measurements

Accounting guidance under GAAP defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. This accounting guidance also establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities. Securities available for sale are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis, such as impaired loans, loans held for sale and other real estate owned (foreclosed assets). These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Under fair value accounting guidance, assets and liabilities are grouped at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine their fair values. These hierarchy levels are:

Level 1 inputs – Unadjusted quoted prices in active markets for identical assets or liabilities that the entity has the ability to access at the measurement date.

Level 2 inputs – Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3 inputs – Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

Below is a discussion on the Company’s assets measured at fair value on a recurring basis.

Investment Securities Available for Sale

Fair value measurement for investment securities available for sale is based on quoted prices from an independent pricing service. The fair value measurements consider observable data that may include present value of future cash flows, prepayment assumptions, credit loss assumptions and other factors. The Company classifies its investments in U.S. Treasury securities as Level 1 in the fair value hierarchy, and it classifies its investments in U.S. Government agencies securities and mortgage-backed securities issued or guaranteed by U.S. Government sponsored entities as Level 2.

The tables below present the recorded amount of assets measured at fair value on a recurring basis at June 30, 2014 and December 31, 2013. No assets were transferred from one hierarchy level to another during the first six months of 2014 or 2013.

					Significant
					Other		Significant
			Quoted		Observable		Unobservable
			Prices		Inputs		Inputs
(Dollars in thousands)	Fair Value		(Level 1)		(Level 2)		(Level 3)
June 30, 2014
Securities available for sale:
U.S. Treasury	$	5,284	$	5,284	$	-	$	-
U.S. Government agencies		57,131		-		57,131		-
Mortgage-backed		139,792		-		139,792		-
Equity		619		-		619		-
Total	$	202,826	$	5,284	$	197,542	$	-

					Significant
					Other		Significant
			Quoted		Observable		Unobservable
			Prices		Inputs		Inputs
(Dollars in thousands)	Fair Value		(Level 1)		(Level 2)		(Level 3)
December 31, 2013
Securities available for sale:
U.S. Treasury	$	5,343	$	5,343	$	-	$	-
U.S. Government agencies		60,444		-		60,444		-
Mortgage-backed		80,713		-		80,713		-
Equity		601		-		601		-
Total	$	147,101	$	5,343	$	141,758	$	-

Below is a discussion on the Company’s assets measured at fair value on a nonrecurring basis.

Loans

The Company does not record loans at fair value on a recurring basis; however, from time to time, a loan is considered impaired and a valuation allowance may be established if there are losses associated with the loan. Loans are considered impaired if it is probable that payment of interest and principal will not be made in accordance with contractual terms. The fair value of impaired loans can be estimated using one of several methods, including the collateral value, market value of similar debt, liquidation value and discounted cash flows. At June 30, 2014 and December 31, 2013, substantially all impaired loans were evaluated based on the fair value of the collateral and were classified as Level 2 in the fair value hierarchy.

Loans held for sale

Loans held for sale are adjusted for fair value upon transfer of loans to loans held for sale. Subsequently, loans held for sale are carried at the lower of carrying value or fair value. Fair value is based on independent market prices, appraised value of the collateral or management’s estimation of the value of the collateral. At June 30, 2014, the Company had no loans held for sale. At December 31, 2013, loans held for sale were classified as Level 2 in the fair value hierarchy.

Other Real Estate and Other Assets Owned (Foreclosed Assets)

Foreclosed assets are adjusted for fair value upon transfer of loans to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value. Fair value is based on independent market prices, appraised value of the collateral or management’s estimation of the value of the collateral. At June 30, 2014 and December 31, 2013, foreclosed assets were classified as Level 2 in the fair value hierarchy.

The tables below present the recorded amount of assets measured at fair value on a nonrecurring basis at June 30, 2014 and December 31, 2013. No assets were transferred from one hierarchy level to another during the first six months of 2014 or 2013.

					Significant
					Other		Significant
			Quoted		Observable		Unobservable
			Prices		Inputs		Inputs
(Dollars in thousands)	Fair Value		(Level 1)		(Level 2)		(Level 3)
June 30, 2014
Impaired loans
Construction	$	11,677	$	-	$	11,677	$	-
Residential real estate		18,922		-		18,922		-
Commercial real estate		9,102		-		9,102		-
Commercial		252		-		252		-
Consumer		-		-		-		-
Total impaired loans		39,953		-		39,953		-
Loans held for sale		-		-		-		-
Other real estate owned		4,201		-		4,201		-
Total assets measured at fair value on a nonrecurring basis	$	44,154	$	-	$	44,154	$	-

					Significant
					Other		Significant
			Quoted		Observable		Unobservable
			Prices		Inputs		Inputs
(Dollars in thousands)	Fair Value		(Level 1)		(Level 2)		(Level 3)
December 31, 2013
Impaired loans
Construction	$	5,365	$	-	$	5,365	$	-
Residential real estate		19,463		-		19,463		-
Commercial real estate		14,418		-		14,418		-
Commercial		642		-		642		-
Consumer		43		-		43		-
Total impaired loans		39,931		-		39,931		-
Loans held for sale		3,521		-		3,521		-
Other real estate owned		3,779		-		3,779		-
Total assets measured at fair value on a nonrecurring basis	$	47,231	$	-	$	47,231	$	-

The following information relates to the estimated fair values of financial assets and liabilities that are reported in the Company’s consolidated balance sheets at their carrying amounts. The discussion below describes the methods and assumptions used to estimate the fair value of each class of financial asset and liability for which it is practicable to estimate that value.

Cash and Cash Equivalents

Cash equivalents include interest-bearing deposits with other banks and federal funds sold. For these short-term instruments, the carrying amount is a reasonable estimate of fair value.

Investment Securities Held to Maturity

For all investments in debt securities, fair values are based on quoted prices. If a quoted price is not available, then fair value is estimated using quoted prices for similar securities.

Loans

The fair values of categories of fixed rate loans, such as commercial loans, residential real estate, and other consumer loans, are estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Other loans, including variable rate loans, are adjusted for differences in loan characteristics.

Financial Liabilities

The fair values of demand deposits, savings accounts, and certain money market deposits are the amounts payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. These estimates do not take into consideration the value of core deposit intangibles. Generally, the carrying amount of short-term borrowings is a reasonable estimate of fair value. The fair values of securities sold under agreements to repurchase (included in short-term borrowings) and long-term debt are estimated using the rates offered for similar borrowings.

Commitments to Extend Credit and Standby Letters of Credit

The majority of the Company’s commitments to grant loans and standby letters of credit are written to carry current market interest rates if converted to loans. In general, commitments to extend credit and letters of credit are not assignable by the Company or the borrower, so they generally have value only to the Company and the borrower. Therefore, it is impractical to assign any value to these commitments.

The following table provides information on the estimated fair values of the Company’s financial assets and liabilities that are reported in the balance sheets at their carrying amounts. The financial assets and liabilities have been segregated by their classification level in the fair value hierarchy.

	June 30, 2014				December 31, 2013
			Estimated				Estimated
	Carrying		Fair		Carrying		Fair
(Dollars in thousands)	Amount		Value		Amount		Value
Financial assets
Level 1 inputs
Cash and cash equivalents	$	94,370	$	94,370	$	131,090	$	131,090

Level 2 inputs
Investment securities held to maturity	$	5,071	$	5,076	$	5,185	$	5,062
Loans, net		700,583		719,929		701,194		721,688

Financial liabilities
Level 2 inputs
Deposits	$	913,485	$	914,011	$	933,468	$	934,943
Short-term borrowings		7,801		7,801		10,140		10,140

Note 10 – Financial Instruments with Off-Balance Sheet Risk

In the normal course of business, to meet the financial needs of its customers, the Company’s bank subsidiaries are parties to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. 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. Letters of credit are conditional commitments issued by the Company’s bank subsidiaries to guarantee the performance of a customer to a third party. Letters of credit and other commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Because many of the letters of credit and commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements.

The following table provides information on commitments outstanding at June 30, 2014 and December 31, 2013.

(Dollars in thousands)	June 30, 2014		December 31, 2013
Commitments to extend credit	$	132,486	$	116,596
Letters of credit		8,280		10,477
Total	$	140,766	$	127,073

Note 11 – Segment Reporting

The Company operates two primary business segments: Community Banking and Insurance Products and Services. Through the Community Banking business, the Company provides services to consumers and small businesses on the Eastern Shore of Maryland and Delaware through its 18-branch network. Community banking activities include small business services, retail brokerage, trust services and consumer banking products and services. Loan products available to consumers include mortgage, home equity, automobile, marine, and installment loans, credit cards and other secured and unsecured personal lines of credit. Small business lending includes commercial mortgages, real estate development loans, equipment and operating loans, as well as secured and unsecured lines of credit, credit cards, accounts receivable financing arrangements, and merchant card services.

Through the Insurance Products and Services business, the Company provides a full range of insurance products and services to businesses and consumers in the Company’s market areas. Products include property and casualty, life, marine, individual health and long-term care insurance. Pension and profit sharing plans and retirement plans for executives and employees are available to suit the needs of individual businesses.

The following table includes selected financial information by business segments for the first six months of 2014 and 2013.

	Community			Insurance Products			Parent			Consolidated
(Dollars in thousands)	Banking			and Services			Company			Total
2014
Interest income	$	18,978		$	-		$	-		$	18,978
Interest expense		(2,208	)		-			-			(2,208	)
Provision for credit losses		(1,925	)		-			-			(1,925	)
Noninterest income		3,174			6,142			-			9,316
Noninterest expense		(11,132	)		(5,038	)		(3,862	)		(20,032	)
Net intersegment (expense) income		(3,356	)		(360	)		3,716			-
Income (loss) before taxes		3,531			744			(146	)		4,129
Income tax (expense) benefit		(1,339	)		(282	)		55			(1,566	)
Net income (loss)	$	2,192		$	462		$	(91	)	$	2,563

Total assets	$	1,050,124		$	10,493		$	4,236		$	1,064,853

2013
Interest income	$	21,331		$	31		$	-		$	21,362
Interest expense		(3,884	)		-			-			(3,884	)
Provision for credit losses		(4,850	)		-			-			(4,850	)
Noninterest income		2,619			5,841			(8	)		8,452
Noninterest expense		(11,672	)		(5,031	)		(3,547	)		(20,250	)
Net intersegment (expense) income		(2,588	)		(358	)		2,946			-
Income (loss) before taxes		956			483			(609	)		830
Income tax (expense) benefit		(284	)		(144	)		181			(247	)
Net income (loss)	$	672		$	339		$	(428	)	$	583

Total assets	$	1,035,452		$	15,924		$	2,901		$	1,054,277

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

Unless the context clearly suggests otherwise, references to “the Company”, “we”, “our”, and “us” in the remainder of this report are to Shore Bancshares, Inc. and its consolidated subsidiaries.

Forward-Looking Information

Portions of this Quarterly Report on Form 10-Q contain forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995. Statements that are not historical in nature, including statements that include the words “anticipate”, “estimate”, “should”, “expect”, “believe”, “intend”, and similar expressions, are expressions about our confidence, policies, and strategies, the adequacy of capital levels, and liquidity and are not guarantees of future performance. Such forward-looking statements involve certain risks and uncertainties, including economic conditions, competition in the geographic and business areas in which we operate, inflation, fluctuations in interest rates, legislation, and governmental regulation. These risks and uncertainties are described in detail in the section of the periodic reports that Shore Bancshares, Inc. files with the Securities and Exchange Commission (the “SEC”) entitled “Risk Factors” (see Item 1A of Part II of this report and Item 1A of Part I of the Annual Report of Shore Bancshares, Inc. on Form 10-K for the year ended December 31, 2013). Actual results may differ materially from such forward-looking statements, and we assume no obligation to update forward-looking statements at any time except as required by law.

Introduction

The following discussion and analysis is intended as a review of significant factors affecting the Company’s financial condition and results of operations for the periods indicated. This discussion and analysis should be read in conjunction with the unaudited consolidated financial statements and related notes presented elsewhere in this report, as well as the audited consolidated financial statements and related notes included in the Annual Report of Shore Bancshares, Inc. on Form 10-K for the year ended December 31, 2013.

Shore Bancshares, Inc. is the largest independent financial holding company headquartered on the Eastern Shore of Maryland. It is the parent company of The Talbot Bank of Easton, Maryland located in Easton, Maryland (“Talbot Bank”) and CNB located in Centreville, Maryland (together with Talbot Bank, the “Banks”). The Banks operate 18 full service branches in Kent County, Queen Anne’s County, Talbot County, Caroline County and Dorchester County in Maryland and Kent County, Delaware. The Company engages in the insurance business through three insurance producer firms, The Avon-Dixon Agency, LLC, Elliott Wilson Insurance, LLC and Jack Martin Associates, Inc.; and an insurance premium finance company, Mubell Finance, LLC (all of the foregoing are collectively referred to as the “Insurance Subsidiaries”). Each of these entities is a wholly-owned subsidiary of Shore Bancshares, Inc. The Company engages in the trust services business through the trust department at CNB under the trade name Wye Financial & Trust. The Company owned a wholesale insurance company, Tri-State General Insurance Agency, LTD (“TSGIA”), until it was sold on June 6, 2014.

The shares of common stock of Shore Bancshares, Inc. are listed on the NASDAQ Global Select Market under the symbol “SHBI”.

Shore Bancshares, Inc. maintains an Internet site at www.shorebancshares.com on which it makes available free of charge its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to the foregoing as soon as reasonably practicable after these reports are electronically filed with, or furnished to, the SEC.

Regulatory Enforcement Actions

Talbot Bank entered into a Stipulation and Consent to the Issuance of a Consent Order (the “Consent Agreement”) with the Federal Deposit Insurance Corporation (the “FDIC”), a Stipulation and Consent to the Issuance of a Consent Order (the “Maryland Consent Agreement” and together with the Consent Agreement, the “Consent Agreements”) with the Maryland Commissioner of Financial Regulation (the “Commissioner”) and an Acknowledgement of Adoption of the Order by the Commissioner (the “Acknowledgement”). The FDIC and the Commissioner issued the related Consent Order (the “Order”), effective May 24, 2013. The description of the material terms of the Consent Agreements, the Order and the Acknowledgement, along with Talbot Bank’s progress with the requirements of such documents, are set forth below.

Management. Talbot Bank is required to have and retain experienced, qualified management, and to assess management’s ability to (1) comply with the requirements of the Order; (2) operate Talbot Bank in a safe and sound manner; (3) comply with all applicable laws, rules and regulations; and (4) restore all aspects of Talbot Bank to a safe and sound condition, including capital adequacy, asset quality, and management effectiveness. Talbot Bank has implemented certain changes to comply with the Order, which include expanding its credit administration and loan workout units with the addition of experienced new staff members, in an effort to accelerate the resolution of Talbot Bank’s credit issues and position Talbot Bank for future growth. Additionally, Talbot Bank is conducting an internal and external search for a chief financial officer.

Board Participation. Talbot Bank’s board of directors is required to increase its participation in the affairs of Talbot Bank, assuming full responsibility for the approval of sound policies and objectives and for the supervision of all Talbot Bank activities, including comprehensive, documented meetings to be held no less frequently than monthly. The board of directors must also develop a program to monitor Talbot Bank’s compliance with the Order. Talbot Bank has completed a plan to increase the participation of its board of directors which includes increasing the frequency of board meetings from monthly to biweekly and establishing a risk management committee of the board which is responsible for monitoring Talbot Bank’s compliance with the Order.

Loss Charge-Offs. The Order requires that Talbot Bank eliminate from its books, by charge-off or collection, all assets or portions of assets classified “Loss” by the FDIC or the Commissioner. Talbot Bank has eliminated from its books all such classified assets.

Classified Assets Reduction. Within 60 days of the effective date of the Order, Talbot Bank was required to submit a Classified Asset Plan to the FDIC and the Commissioner to reduce the risk position in each asset in excess of $750,000 which was classified “Substandard” and “Doubtful” by the FDIC or the Commissioner. Talbot Bank revised its existing Classified Asset Plan to address the terms of the Order and submitted the updated plan to the FDIC and the Commissioner in accordance with the Order.

Allowance for Loan and Lease Losses. Within 60 days of the effective date of the Order, the board of directors was required to review the adequacy of the allowance for loan and lease losses (the “ALLL”), establish a policy for determining the adequacy of the ALLL and submit such ALLL policy to the FDIC and the Commissioner. Talbot Bank amended its ALLL policy to comply with the terms of the Order and submitted the updated policy to the FDIC and the Commissioner in accordance with the Order.

Loan Policy. Within 60 days from the effective date of the Order, Talbot Bank was required to (i) review its loan policies and procedures (“Loan Policy”) for adequacy, (ii) make all appropriate revisions to the Loan Policy to address the lending deficiencies identified by the FDIC, and (iii) submit the Loan Policy to the FDIC and the Commissioner. Talbot Bank completed its review of and made the required revisions to the Loan Policy. The updated Loan Policy was submitted to the FDIC and the Commissioner in accordance with the terms of the Order.

Loan Review Program. Within 30 days from the effective date of the Order, the Board was required to establish a program of independent loan review that provides for a periodic review of Talbot Bank’s loan portfolio and the identification and categorization of problem credits (the “Loan Review Program”) and submit the Loan Review Program to the FDIC and the Commissioner. Talbot Bank enhanced its existing Loan Review Program and submitted it to the FDIC and the Commissioner in accordance with the terms of the Order.

Capital Requirements. Within 90 days from the effective date of the Order, Talbot Bank was required to meet and maintain the following minimum capital levels, after establishing an appropriate ALLL, (i) a leverage ratio (the ratio of Tier 1 capital to total assets) of at least 8%, and (ii) a total risk-based capital ratio (the ratio of qualifying total capital to risk-weighted assets) of at least 12%. As of June 30, 2014, the leverage ratio and total risk-based capital ratio were 8.97% and 13.30%, respectively, for Talbot Bank, which exceeded the Order’s minimum capital requirements.

Profit and Budget Plan. Within 60 days from the effective date of the Order and within 30 days of each calendar year-end thereafter, Talbot Bank was and will be required to submit a profit and budget plan to the FDIC and the Commissioner consisting of goals and strategies, consistent with sound banking practices, and taking into account Talbot Bank’s other plans, policies or other actions required by the Order. In accordance with the Order, Talbot Bank developed a profit and budget plan which was submitted to the FDIC and the Commissioner within 60 days from the effective date of the Order and one which was submitted within 30 days of the end of 2013.

Dividend Restriction. While the Order is in effect, Talbot Bank cannot declare or pay dividends or fees to the Company without the prior written consent of the FDIC and the Commissioner. Talbot Bank is in compliance with this provision of the Order.

Brokered Deposits. The Order provides that Talbot Bank may not accept, renew, or rollover any brokered deposits unless it is in compliance with the requirements of the FDIC regulations governing brokered deposits. Talbot Bank is in compliance with this provision of the Order.

Oversight Committee. Within 30 days from the effective date of the Order, Talbot Bank was required to establish a board committee to monitor and coordinate compliance with the Order. Talbot Bank has established a board committee to comply with this provision of the Order.

Progress Reports. Within 45 days from the end of each calendar quarter following the effective date of the Order, Talbot Bank must furnish the FDIC and the Commissioner with progress reports detailing the form, manner and results of any actions taken to secure compliance with the Order. Talbot Bank has and will continue to submit progress reports to comply with this provision of the Order.

The Order will remain in effect until modified or terminated by the FDIC and the Commissioner.

Critical Accounting Policies

Our financial statements are prepared in accordance with GAAP. The financial information contained within the financial statements is, 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. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has determined that the accounting policies with respect to the allowance for credit losses, goodwill and other intangible assets, deferred tax assets, and fair value are critical accounting policies. These policies are considered critical because they relate to accounting areas that require the most subjective or complex judgments, and, as such, could be most subject to revision as new information becomes available.

Allowance for Credit Losses

The allowance for credit 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) Topic 450, “Contingencies”, of the Financial Accounting Standards Board’s Accounting Standards Codification (“ASC”), which requires that losses be accrued when they are probable of occurring and estimable; and (ii) ASC Topic 310, “Receivables”, which requires that losses be accrued based on the differences between the loan balance and the value of collateral, present value of future cash flows or values that are observable in the secondary market. Management uses many factors to estimate the inherent loss that may be present in our loan portfolio, including economic conditions and trends, the value and adequacy of collateral, the volume and mix of the loan portfolio, and our internal loan processes. Actual losses could differ significantly from management’s estimates. In addition, GAAP itself may change from one previously acceptable method to another. Although the economics of transactions would be the same, the timing of events that would impact the transactions could change.

Three basic components comprise our allowance for credit losses: (i) the specific allowance; (ii) the formula allowance; and (iii) the unallocated allowance. Each component is determined based on estimates that can and do change when the actual events occur. The specific allowance is established against impaired loans (i.e., nonaccrual loans and TDRs) based on our assessment of the losses that may be associated with the individual loans. The specific allowance remains until charge-offs are made. An impaired loan may show deficiencies in the borrower’s overall financial condition, payment history, support available from financial guarantors and/or the fair market value of collateral. The formula allowance is used to estimate the loss on internally risk-rated loans, exclusive of those identified as impaired. Loans are grouped by type (construction, residential real estate, commercial real estate, commercial or consumer). Each loan type is assigned allowance factors based on management’s estimate of the risk, complexity and size of individual loans within a particular category. Loans identified as special mention, substandard, and doubtful are adversely rated. These loans are assigned higher allowance factors than favorably rated loans due to management’s concerns regarding collectability or management’s knowledge of particular elements regarding the borrower. The unallocated allowance captures losses that have impacted the portfolio but have yet to be recognized in either the specific or formula allowance.

Management has significant discretion in making the adjustments inherent in the determination of the provision and allowance for credit losses, including in connection with the valuation of collateral, the estimation of a borrower’s prospects of repayment, and the establishment of the allowance factors in the formula allowance and unallocated allowance components of the allowance. The establishment of allowance factors is a continuing exercise, based on management’s ongoing assessment of the totality of all factors, including, but not limited to, delinquencies, loss history, trends in volume and terms of loans, effects of changes in lending policy, the experience and depth of management, national and local economic trends, concentrations of credit, the quality of the loan review system and the effect of external factors such as competition and regulatory requirements, and their impact on the portfolio. Allowance factors may change from period to period, resulting in an increase or decrease in the amount of the provision or allowance, based on the same volume and classification of loans. Changes in allowance factors will have a direct impact on the amount of the provision, and a corresponding effect on net income. Errors in management’s perception and assessment of these factors and their impact on the portfolio could result in the allowance not being adequate to cover losses in the portfolio, and may result in additional provisions or charge-offs.

Goodwill and Other Intangible Assets

Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired. Other intangible assets represent purchased assets that also lack physical substance but can be distinguished from goodwill because of contractual or other legal rights or because the asset is capable of being sold or exchanged either on its own or in combination with a related contract, asset or liability. Goodwill and other intangible assets are required to be recorded at fair value. Determining fair value is subjective, requiring the use of estimates, assumptions and management judgment. Goodwill and other intangible assets with indefinite lives are tested at least annually for impairment, usually during the third quarter, or on an interim basis if circumstances dictate. Intangible assets that have finite lives are amortized over their estimated useful lives and also are subject to impairment testing. Impairment testing requires that the fair value of each of the Company’s reporting units be compared to the carrying amount of its net assets, including goodwill. The Company’s reporting units were identified based on an analysis of each of its individual operating segments (i.e., the Banks and Insurance Subsidiaries). If the fair value of a reporting unit is less than book value, an expense may be required to write down the related goodwill or purchased intangibles to record an impairment loss.

Goodwill and other intangible assets at June 30, 2014 decreased $2.6 million from the end of 2013 mainly due to the sale of the Company’s wholesale insurance subsidiary, TSGIA, on June 6, 2014.

Deferred Tax Assets

Deferred tax assets and liabilities are determined by applying the applicable federal and state income tax rates to cumulative temporary differences. These temporary differences represent differences between financial statement carrying amounts and the corresponding tax bases of certain assets and liabilities. Deferred taxes result from such temporary differences. A valuation allowance, if needed, reduces deferred tax assets to the amount most likely to be realized, which is based on estimates of future taxable income, recoverable taxes paid in prior years and expected results of tax planning strategies.

Fair Value

The Company measures certain financial assets and liabilities at fair value. Investment securities are significant financial assets measured at fair value on a recurring basis. Impaired loans and other real estate owned are significant financial assets measured at fair value on a nonrecurring basis. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. In determining fair value, the Company is required to maximize the use of observable inputs and minimize the use of unobservable inputs, reducing subjectivity.

OVERVIEW

The Company reported net income of $1.305 million for the second quarter of 2014, or diluted income per common share of $0.13, compared to net income of $361 thousand, or diluted income per common share of $0.04, for the second quarter of 2013. For the first quarter of 2014, the Company reported net income of $1.258 million, or diluted income per common share of $0.15. When comparing the second quarter of 2014 to the second quarter of 2013, the primary reasons for the improved results were a $1.8 million decline in the provision for credit losses and an increase in noninterest income of $566 thousand, which were partially offset by a decline in net interest income of $554 thousand and an increase in noninterest expense of $158 thousand. When comparing the second quarter of 2014 to the first quarter of 2014, the primary reasons for the higher net income were a decrease in noninterest expense of $198 thousand and an increase in net interest income of $124 thousand, which were mainly offset by a decrease in noninterest income of $260 thousand.

For the first six months of 2014, the Company reported net income of $2.6 million, or diluted income per common share of $0.28, compared to net income of $583 thousand, or diluted income per common share of $0.07, for the first six months of 2013. Earnings improved due to a decline in the provision for credit losses of $2.9 million, an increase in noninterest income of $864 thousand and a decline in noninterest expense of $218 thousand, which were partially offset by a decline in net interest income of $708 thousand.

Basic and diluted earnings per share for the second quarter of 2014 and the first half of 2014 were impacted by the increase in weighted average shares due to the Company’s public offer and sale of its common stock, which is discussed below. Weighted average shares increased to 10.0 million for the second quarter of 2014 from 8.5 million for both the second quarter of 2013 and the first quarter of 2014. Similarly, weighted average shares increased to 9.3 million for the first half of 2014 from 8.5 million for the first half of 2013.

During the second quarter of 2014, the Company sold 4,140,000 shares of its common stock for a price of $8.25 per share (the “stock sale”). The Company received $31.2 million in net proceeds after deducting certain direct costs related to the stock sale, primarily underwriting discounts and commissions. The Company contributed $20.0 million of the net proceeds to its wholly-owned subsidiary, Talbot Bank, to satisfy regulatory capital requirements, and intends to use the remaining net proceeds for general corporate purposes.

Much of the improvement in the second quarter of 2014 when compared to the second quarter of 2013, and the first half of 2014 when compared to the first half of 2013 was due to lower credit-related expenses as a result of the execution of an agreement to sell loans and other real estate owned (the “Asset Sale”) by Talbot Bank, which was recorded in the third quarter and completed during the fourth quarter of 2013. Per the agreement, assets included in the Asset Sale had an aggregate book value of $45.0 million, which consisted of nonaccrual loans ($11.1 million), accruing TDRs ($30.4 million), adversely classified performing loans ($1.8 million) and other real estate owned ($1.7 million). Subsequently, $3.5 million in loans included in the agreement were not sold. These loans were reclassified from loans held for sale at December 31, 2013 to loans at March 31, 2014. With the Asset Sale, the Company has refocused its efforts on healthy loan originations and overall business development, however, the slowly improving local economy is delaying any substantial progress.

RESULTS OF OPERATIONS

Net Interest Income

Tax-equivalent net interest income is net interest income adjusted for the tax-favored status of income from certain loans and investments. As shown in the table below, tax-equivalent net interest income was $8.5 million for the second quarter of 2014 and $9.0 million for the second quarter of 2013. Tax-equivalent net interest income was $8.3 million for the first quarter of 2014. The decrease in net interest income for the second quarter of 2014 when compared to the second quarter of 2013 was primarily due to lower volumes of and yields earned on average loans, partially offset by lower volumes of and rates paid on average time deposits, and money market and savings deposits. The increase in net interest income for the second quarter of 2014 when compared to the first quarter of 2014 was primarily due to higher volumes of and yields earned on average investment securities and lower volumes of and rates paid on average time deposits. Net interest margin is tax-equivalent net interest income (annualized) divided by average earning assets. Our net interest margin was 3.49% for the second quarter of 2014, compared to 3.60% for the second quarter of 2013 and 3.50% for the first quarter of 2014. The lower net interest margin for the second quarter of 2014 when compared to the second quarter of 2013 and the first quarter of 2014 was mainly due to a decline in loan yields as a result of refinancing activity.

On a tax-equivalent basis, interest income declined $1.2 million, or 11.5%, for the second quarter of 2014 when compared to the second quarter of 2013. The decrease in interest income was due to a 3.2% decline in average balances of earning assets (i.e., loans, investment securities, federal funds sold and interest-bearing deposits with other banks) combined with a 37 basis point decrease in yields earned on average earning assets. Loan activity had the largest impact on the decline in interest income primarily due to the Asset Sale, loan charge-offs and decreased loan demand. For the second quarter of 2014, average loans decreased 9.8% and the yield earned on loans declined from 5.19% to 5.00% when compared to the second quarter of 2013, which reduced interest income by $1.3 million. Other earning assets impacting the change in interest income included taxable investment securities, which increased $42.5 million and, although the related yield declined 16 basis points, improved interest income $101 thousand. The balance of taxable investment securities increased due to purchases that were partly funded by the proceeds from the stock sale, while the yield on taxable investment securities decreased because reinvestment rates on investment securities purchased were lower than yields on investment securities that matured or were sold from the end of the second quarter of 2013 to the end of the second quarter of 2014. Although the average balances of the remaining components of average earning assets increased $1.7 million, the yields earned declined 3 basis points, which in aggregate decreased interest income $3 thousand. Tax-equivalent interest income increased $66 thousand, or less than 1.0%, when compared to the first quarter of 2014 mainly due to higher volumes of and yields earned on average investment securities, which were partially offset by lower yields on loans.

Interest expense decreased $678 thousand, or 38.7%, when comparing the second quarter of 2014 to the second quarter of 2013. The decrease in interest expense was due to a 31 basis point decline in rates paid on interest-bearing liabilities (i.e., deposits and borrowings) and a 5.5% decline in average balances of interest-bearing liabilities. Changes in the rates and balances related to time deposits, and money market and savings deposits had the largest impact on interest expense. For the three months ended June 30, 2014, the rates paid on time deposits (i.e., certificates of deposit $100,000 or more and other time deposits) decreased 24 basis points and the average balances of these deposits decreased $46.1 million, or 11.5%, when compared to the same period last year, which reduced interest expense $366 thousand. The decrease in average time deposits reflected a reduction in the Company’s liquidity needs and the lower rates reflected current market conditions. Additionally, the rates paid on money market and savings deposits decreased 55 basis points and the average balances of these deposits decreased $4.3 million, or 1.9%, which reduced interest expense $310 thousand. The lower rates paid on money market and savings deposits were mainly due to terminating the interest rate caps associated with the deposits from the Promontory Insured Network Deposits Program (“IND Program”) while the decrease in balances was primarily due to the decline in deposits associated with the IND Program, which the Company fully exited in June 2013. When comparing the second quarter of 2014 to the first quarter of 2014, interest expense decreased $56 thousand, or 4.9%. The decline was primarily due to lower interest rates paid on and average balances of time deposits.

The following table presents the distribution of the average consolidated balance sheets, interest income/expense, and annualized yields earned and rates paid for the three months ended June 30, 2014 and 2013.

	For the Three Months Ended								For the Three Months Ended
	June 30, 2014								June 30, 2013
	Average			Income(1)/		Yield/			Average			Income(1)/		Yield/
(Dollars in thousands)	Balance			Expense		Rate			Balance			Expense		Rate
Earning assets
Loans (2), (3)	$	708,718		$	8,833		5.00	%	$	785,442		$	10,166		5.19	%
Investment securities:
Taxable		183,128			669		1.46			140,614			568		1.62
Tax-exempt		431			4		4.23			579			7		4.81
Federal funds sold		1,476			-		0.05			2,992			1		0.10
Interest-bearing deposits		79,223			39		0.20			75,847			40		0.21
Total earning assets		972,976			9,545		3.93	%		1,005,474			10,782		4.30	%
Cash and due from banks		20,376								22,510
Other assets		64,915								66,967
Allowance for credit losses		(9,675	)							(17,099	)
Total assets	$	1,048,592							$	1,077,852

Interest-bearing liabilities
Demand deposits	$	171,004			60		0.14	%	$	162,589			61		0.15	%
Money market and savings deposits (4)		220,850			66		0.12			225,117			376		0.67
Certificates of deposit $100,000 or more		171,830			477		1.11			203,641			670		1.32
Other time deposits		183,336			468		1.02			197,644			641		1.30
Interest-bearing deposits		747,020			1,071		0.58			788,991			1,748		0.89
Short-term borrowings		8,633			5		0.22			10,752			6		0.24
Total interest-bearing liabilities		755,653			1,076		0.57	%		799,743			1,754		0.88	%
Noninterest-bearing deposits		168,221								154,586
Other liabilities		7,629								9,315
Stockholders’ equity		117,089								114,208
Total liabilities and stockholders’ equity	$	1,048,592							$	1,077,852

Net interest spread				$	8,469		3.36	%				$	9,028		3.42	%
Net interest margin							3.49	%							3.60	%

Tax-equivalent adjustment
Loans				$	21							$	24
Investment securities					1								3
Total				$	22							$	27

(1)

All amounts are reported on a tax-equivalent basis computed using the statutory federal income tax rate of 34.0%, exclusive of the alternative minimum tax rate and nondeductible interest expense.

(2)

Average loan balances include nonaccrual loans.

(3)

Interest income on loans includes amortized loan fees, net of costs, and all are included in the yield calculations.

(4)

Interest on money market and savings deposits for the three months ended June 30, 2013 included an adjustment to expense related to interest rate caps and the hedged deposits from the IND Program associated with them. This adjustment increased interest expense $279 thousand for the three months ended June 30, 2013. Interest expense for the three months ended June 30, 2014 did not reflect this adjustment because the interest rate caps were terminated in June of 2013.

Tax-equivalent net interest income for the six months ended June 30, 2014 was $16.8 million, as seen in the table below. This represented a decrease of $716 thousand, or 4.1%, when compared to the same period last year. The decrease was mainly due to lower volumes of and yields earned on average loans, partially offset by lower volumes of and rates paid on time deposits, and money market and savings deposits. Rates paid on deposits declined enough to improve the net interest margin to 3.50% for the first half of 2014 from the 3.45% for the first half of 2013.

On a tax-equivalent basis, interest income was $19.0 million for the first six months of 2014, a decrease of $2.4 million, or 11.2%, when compared to the first six months of 2013, mainly due to the impact of loan activity. For the first six months of 2014, average loans declined 9.7% and the related yield declined 12 basis points when compared to the same period in 2013.

Interest expense was $2.2 million for the six months ended June 30, 2014, a decrease of $1.7 million, or 43.2%, when compared to the same period last year. Average interest-bearing liabilities decreased $60.0 million, or 7.3%, while rates paid declined 37 basis points to 0.58% primarily due to time deposit, and money market and savings deposit activity. For the first six months of 2014, the average balance of time deposits decreased $48.9 million, or 11.9%, when compared to the same period last year, and the average rate paid on these deposits declined 28 basis points, which reduced interest expense $836 thousand. For the six months ended June 30, 2014, the average balance of money market and savings deposits decreased $13.0 million, or 5.5%, when compared to the same period last year, and the average rate paid on these deposits declined 70 basis points, which reduced interest expense $826 thousand. As with the quarterly results, the decrease in average time deposits reflected a reduction in the Company’s liquidity needs while the lower rates reflected current market conditions, and the decrease in money market and savings deposits was primarily due to the decline in deposits associated with the IND Program while the lower rates paid on these deposits were mainly due to terminating the interest rate caps associated with these deposits.

The following table presents the distribution of the average consolidated balance sheets, interest income/expense, and annualized yields earned and rates paid for the six months ended June 30, 2014 and 2013.

	For the Six Months Ended								For the Six Months Ended
	June 30, 2014								June 30, 2013
	Average			Income(1)/		Yield/			Average			Income(1)/		Yield/
(Dollars in thousands)	Balance			Expense		Rate			Balance			Expense		Rate
Earning assets
Loans (2), (3)	$	708,216		$	17,730		5.05	%	$	784,604		$	20,098		5.17	%
Loans held for sale		1,206			-		-			-			-		-
Investment securities:
Taxable		169,203			1,190		1.42			143,380			1,211		1.70
Tax-exempt		432			9		4.24			580			14		4.83
Federal funds sold		1,591			-		0.05			5,573			3		0.11
Interest-bearing deposits		89,010			95		0.22			90,869			90		0.20
Total earning assets		969,658			19,024		3.96	%		1,025,006			21,416		4.21	%
Cash and due from banks		21,536								23,731
Other assets		65,555								68,070
Allowance for credit losses		(10,158	)							(16,849	)
Total assets	$	1,046,591							$	1,099,958

Interest-bearing liabilities
Demand deposits	$	172,395			122		0.14	%	$	168,120			132		0.16	%
Money market and savings deposits (4)		221,610			133		0.12			234,597			959		0.82
Certificates of deposit $100,000 or more		175,292			977		1.12			209,929			1,410		1.35
Other time deposits		185,137			966		1.05			199,399			1,369		1.38
Interest-bearing deposits		754,434			2,198		0.59			812,045			3,870		0.96
Short-term borrowings		8,987			10		0.22			11,366			14		0.25
Total interest-bearing liabilities		763,421			2,208		0.58	%		823,411			3,884		0.95	%
Noninterest-bearing deposits		164,926								153,285
Other liabilities		7,433								9,033
Stockholders’ equity		110,811								114,229
Total liabilities and stockholders’ equity	$	1,046,591							$	1,099,958

Net interest spread				$	16,816		3.38	%				$	17,532		3.26	%
Net interest margin							3.50	%							3.45	%

Tax-equivalent adjustment
Loans				$	43							$	49
Investment securities					3								5
Total				$	46							$	54

(1)

All amounts are reported on a tax-equivalent basis computed using the statutory federal income tax rate of 34.0%, exclusive of the alternative minimum tax rate and nondeductible interest expense.

(2)

Average loan balances include nonaccrual loans.

(3)

Interest income on loans includes amortized loan fees, net of costs, and all are included in the yield calculations.

(4)

Interest on money market and savings deposits for the six months ended June 30, 2013 included an adjustment to expense related to interest rate caps and the hedged deposits from the IND Program associated with them. This adjustment increased interest expense $695 thousand for the six months ended June 30, 2013. Interest expense for the six months ended June 30, 2014 did not reflect this adjustment because the interest rate caps were terminated in June of 2013.

Noninterest Income

Total noninterest income for the second quarter of 2014 increased $566 thousand, or 14.3%, when compared to the second quarter of 2013. Included in total noninterest income for the second quarter of 2013 was a $1.3 million loss incurred to terminate the interest rate caps. This loss was substantially offset by $913 thousand in gains on sales of investment securities. These transactions, along with smaller losses on sales of other real estate owned ($119 thousand) and a gain on the TSGIA sale ($114 thousand), were the primary reasons for the increase in noninterest income for the second quarter of 2014 when compared to the second quarter of 2013. When compared to the first quarter of 2014, noninterest income declined $260 thousand, or 5.4%, for the second quarter of 2014. The decrease from the first quarter of 2014 was primarily due to a decline in insurance agency commissions ($541 thousand) that was partially offset by the gain on the TSGIA sale and an increase in other noninterest income ($99 thousand). Insurance agency commissions for the second quarter of 2014 were lower when compared to the first quarter of 2014 due to the fact that contingency commission payments are typically received in the first quarter of the year. Included in other noninterest income for the second quarter of 2014 was $77 thousand more in income from an insurance investment than in the first quarter of 2014.

Total noninterest income for the six months ended June 30, 2014 increased $864 thousand, or 10.2%, when compared to the same period in 2013. Included in total noninterest income for the first half of 2013 were the $1.3 million loss incurred to terminate the interest rate caps and the $913 thousand in gains on sales of investment securities discussed above. In addition, the growth of insurance agency commissions and investment fee income of $167 thousand and $103 thousand, respectively, and the gain on the TSGIA sale improved noninterest income in the first half of 2014 when compared to the first half of 2013.

Noninterest Expense

Total noninterest expense for the second quarter of 2014 increased $158 thousand, or 1.6%, when compared to the second quarter of 2013 and declined $198 thousand, or 2.0%, when compared to the first quarter of 2014. The increase in total noninterest expense from the second quarter of 2013 was primarily due to higher loan collection costs included in other noninterest expense. The decrease from the first quarter of 2014 was primarily due to a decline in almost all expense categories, $212 thousand of which was due to approximately one less month of expenses for TSGIA as a result of its sale in early June 2014. This decline was somewhat offset by an increase in other noninterest expenses, which included higher collection expense for loans.

Total noninterest expense for the six months ended June 30, 2014 declined $218 thousand, or 1.1%, when compared to the same period in 2013. The decrease was primarily due to lower write-downs of other real estate owned of $552 thousand, or 75.8%, which was partially offset by higher expenses in almost all other expense categories, which aggregated $334 thousand, or 1.7%.

Income Taxes

For the second quarter of 2014 and 2013, the Company reported income tax expense of $803 thousand and $143 thousand, respectively, while the effective tax rate was 38.1% and 28.4%, respectively. For the first six months of 2014 and 2013, the Company reported income tax expense of $1.6 million and $247 thousand, respectively, while the effective tax rate was 37.9% and 29.8%, respectively. The lower tax rates for the second quarter and first six months of 2013 when compared to the same periods in 2014 were due to the impact of the tax benefits of the Company’s affiliates with pretax losses which partially offset the tax expense of the affiliates with pretax income.

ANALYSIS OF FINANCIAL CONDITION

Loans

Loans, including loans held for sale, totaled $709.7 million at June 30, 2014 and $715.4 million at December 31, 2013, a decline of $5.8 million, or less than 1.0%. At December 31, 2013, $3.5 million of nonaccrual construction loans were classified as held for sale and were reclassified to loans during the first quarter of 2014. Commercial real estate loans reflected the largest decline ($6.8 million) from the end of 2013 primarily due to net loan repayments and charge offs. Fewer high-quality loan opportunities due to the slowly improving local economy continue to impede overall loan growth. The decline in commercial real estate loans was partially offset by an increase in residential real estate loans ($2.3 million). Loans included deferred costs, net of deferred fees, of $322 thousand at June 30, 2014 and $341 thousand at December 31, 2013. We do not engage in foreign or subprime lending activities. See Note 4, “Loans and Allowance for Credit Losses”, in the Notes to Consolidated Financial Statements and below under the caption “Allowance for Credit Losses” for additional information.

Our loan portfolio has a commercial real estate loan concentration, which is defined as a combination of construction and commercial real estate loans. Construction loans were $68.3 million , or 9.6% of total loans, at June 30, 2014, similar to the $68.1 million, or 9.5% of total loans, including loans held for sale, at December 31, 2013. Commercial real estate loans were $297.8 million, or 41.9% of total loans, at June 30, 2014, compared to $304.6 million, or 42.6% of total loans, including loans held for sale, at December 31, 2013.

Allowance for Credit Losses

We have established an allowance for credit losses, which is increased by provisions charged against earnings and recoveries of previously charged-off debts and is decreased by current period charge-offs of uncollectible debts. Management evaluates the adequacy of the allowance for credit losses at least quarterly and adjusts the provision for credit losses based on this analysis. The evaluation of the adequacy of the allowance for credit losses is based primarily on a risk rating system of individual loans, as well as on a collective evaluation of smaller balance homogenous loans, each grouped by loan type. Each loan type is assigned allowance factors based on criteria such as past credit loss experience, local economic and industry trends, and other measures which may impact collectibility. Please refer to the discussion above under the caption “Critical Accounting Policies” for an overview of the underlying methodology management employs to maintain the allowance.

The provision for credit losses was $950 thousand for the second quarter of 2014, $2.7 million for the second quarter of 2013 and $975 thousand for the first quarter of 2014. The lower level of provision for credit losses when comparing the second quarter of 2014 to the second quarter of 2013 was primarily due to decreases in loan charge-offs and nonaccrual loans. The lower level of provision for credit losses when comparing the second quarter of 2014 to the first quarter of 2014 was primarily due to declines in nonaccrual loans. The provision for credit losses for the first six months of 2014 declined to $1.9 million from $4.9 million for the first six months of 2013.

Net charge-offs were $1.9 million for the second quarter of 2014 and $2.7 million for the second quarter of 2013, as shown in the following table. Net charge-offs were $1.6 million for the first quarter of 2014. Net charge-offs were $3.6 million and $5.1 million for the first six months of 2014 and 2013, respectively. Management remains focused on its efforts to dispose of problem loans and to charge off nonperforming assets as rapidly as possible, to enable the Company to continue to improve its overall credit quality and reduce problem loans. The allowance for credit losses as a percentage of average loans was 1.28% for the second quarter of 2014, lower than the 2.00% for the second quarter of 2013 and 1.42% for the first quarter of 2014, which reflects improved credit quality in the loan portfolio. Management believes that the provision for credit losses and the resulting allowance were adequate to provide for probable losses inherent in our loan portfolio at June 30, 2014.

The following table presents a summary of the activity in the allowance for credit losses for the three and six months ended June 30, 2014 and 2013.

	For the Three Months Ended						For the Six Months Ended
	June 30,						June 30,
(Dollars in thousands)	2014			2013			2014			2013
Allowance balance – beginning of period	$	10,069		$	15,735		$	10,725		$	15,991
Charge-offs:
Construction		(224	)		(802	)		(241	)		(1,509	)
Residential real estate		(315	)		(1,096	)		(987	)		(1,889	)
Commercial real estate		(1,523	)		(872	)		(1,613	)		(1,947	)
Commercial		(95	)		(136	)		(937	)		(223	)
Consumer		(20	)		(13	)		(147	)		(62	)
Totals		(2,177	)		(2,919	)		(3,925	)		(5,630	)
Recoveries:
Construction		1			1			11			2
Residential real estate		63			59			106			298
Commercial real estate		7			90			13			93
Commercial		157			50			207			102
Consumer		6			7			14			17
Totals		234			207			351			512
Net charge-offs		(1,943	)		(2,712	)		(3,574	)		(5,118	)
Provision for credit losses		950			2,700			1,925			4,850
Allowance balance – end of period	$	9,076		$	15,723		$	9,076		$	15,723

Average loans outstanding during the period	$	708,718		$	785,442		$	708,216		$	784,604
Net charge-offs (annualized) as a percentage of average loans outstanding during the period		1.10	%		1.38	%		1.02	%		1.32	%
Allowance for credit losses at period end as a percentage of average loans		1.28	%		2.00	%		1.28	%		2.00	%

Nonperforming Assets and Accruing TDRs

As shown in the following table, nonperforming assets decreased to $19.4 million at June 30, 2014 from $22.2 million at December 31, 2013, primarily due to a $3.0 million decline in nonaccrual loans, including nonaccrual loans held for sale. In addition, accruing TDRs declined $686 thousand to $25.4 million at June 30, 2014 from $26.1 million at December 31, 2013. The ratio of nonaccrual loans to total assets improved to 1.43% at June 30, 2014 from 1.72% at December 31, 2013. In addition, the ratio of accruing TDRs to total assets improved to 2.39% at June 30, 2014 from 2.47% at December 31, 2013.

The Company continues to focus on the resolution of its nonperforming and problem loans. The efforts to accomplish this goal include frequently contacting borrowers until the delinquency is cured or until an acceptable payment plan has been agreed upon; obtaining updated appraisals; provisioning for credit losses; charging off loans; transferring loans to other real estate owned; aggressively marketing other real estate owned; and selling loans. The reduction of nonperforming and problem loans is and will continue to be a high priority for the Company.

The following table summarizes our nonperforming assets and accruing TDRs at June 30, 2014 and December 31, 2013.

	June 30,			December 31,
(Dollars in thousands)	2014			2013
Nonperforming assets
Nonaccrual loans excluding nonaccrual loans held for sale
Construction	$	7,980		$	3,949
Residential real estate		3,037			5,166
Commercial real estate		3,873			4,671
Commercial		261			792
Consumer		25			48
Total nonaccrual loans excluding nonaccrual loans held for sale		15,176			14,626
Loans 90 days or more past due and still accruing
Construction		-			-
Residential real estate		-			20
Commercial real estate		-			-
Commercial		-			250
Consumer		5			-
Total loans 90 days or more past due and still accruing		5			270
Other real estate owned		4,201			3,779
Total nonperforming assets excluding nonaccrual loans held for sale		19,382			18,675
Nonaccrual loans held for sale		-			3,521
Total nonperforming assets including nonaccrual loans held for sale	$	19,382		$	22,196

Accruing TDRs
Construction	$	3,898		$	1,620
Residential real estate		16,195			14,582
Commercial real estate		5,253			9,791
Commercial		56			95
Consumer		-			-
Total accruing TDRs	$	25,402		$	26,088

Total nonperforming assets and accruing TDRs excluding nonaccrual loans held for sale	$	44,784		$	44,763
Nonaccrual loans held for sale		-			3,521
Total nonperforming assets and accruing TDRs including nonaccrual loans held for sale	$	44,784		$	48,284

As a percent of total loans (1):
Nonaccrual loans		2.14	%		2.54	%
Accruing TDRs		3.58	%		3.65	%
Nonaccrual loans and accruing TDRs		5.72	%		6.19	%

As a percent of total loans and other real estate owned (1):
Nonperforming assets		2.72	%		3.09	%
Nonperforming assets and accruing TDRs		6.27	%		6.72	%

As a percent of total assets:
Nonaccrual loans		1.43	%		1.72	%
Nonperforming assets		1.82	%		2.11	%
Accruing TDRs		2.39	%		2.47	%
Nonperforming assets and accruing TDRs		4.21	%		4.58	%

(1)

The calculations for December 31, 2013 include loans held for sale that were reclassified to loans during the first quarter of 2014.

Investment Securities

The investment portfolio is comprised of securities that are either available for sale or held to maturity. Investment securities available for sale are stated at estimated fair value based on quoted prices. They represent securities which may be sold as part of the asset/liability management strategy or in response to changing interest rates. Net unrealized holding gains and losses on these securities are reported net of related income taxes as accumulated other comprehensive income, a separate component of stockholders’ equity. Investment securities in the held to maturity category are stated at cost adjusted for amortization of premiums and accretion of discounts. We have the intent and current ability to hold such securities until maturity. At June 30, 2014, 98% of the portfolio was classified as available for sale and 2% as held to maturity, similar to the 97% and 3%, respectively, at December 31, 2013. With the exception of municipal securities, our general practice is to classify all newly-purchased securities as available for sale. See Note 3, “Investment Securities”, in the Notes to Consolidated Financial Statements for additional details on the composition of our investment portfolio.

Investment securities totaled $207.9 million at June 30, 2014, a $55.6 million, or 36.5%, increase since December 31, 2013. The increase was mainly in mortgage-backed securities due to purchases that were partly funded by the proceeds from the stock sale. At the end of June 2014, 68.9% of the securities available for sale were mortgage-backed, 28.2% were U.S. Government agencies and 2.6% were U.S. Treasuries, compared to 54.9%, 41.1% and 3.6%, respectively, at year-end 2013. Our investments in mortgage-backed securities are issued or guaranteed by U.S. Government agencies or government-sponsored agencies.

Deposits

Total deposits at June 30, 2014 were $913.5 million, a $20.0 million, or 2.1%, decrease when compared to the level at December 31, 2013. The decrease in total deposits was mainly due to a decline in time ($23.4 million) and interest-bearing demand deposits ($8.9 million), which was partially offset by an increase in money market and savings deposits ($11.3 million).

Short-Term Borrowings

Short-term borrowings at June 30, 2014 and December 31, 2013 were $7.8 million and $10.1 million, respectively. Short-term borrowings generally consist of securities sold under agreements to repurchase, which are issued in conjunction with cash management services for commercial depositors, overnight borrowings from correspondent banks and short-term advances from the Federal Home Loan Bank (the “FHLB”). Short-term advances are defined as those with original maturities of one year or less. At June 30, 2014 and December 31, 2013, short-term borrowings included only repurchase agreements.

Liquidity and Capital Resources

We derive liquidity through increased customer deposits, maturities in the investment portfolio, loan repayments and income from earning assets. As seen in the Consolidated Statements of Cash Flows in the Financial Statements, the net decrease in cash was $36.7 million for the first half of 2014 compared to a net decrease in cash of $75.7 million for the first half of 2013. The decline in cash in 2014 was mainly due to the purchase of investment securities that were partly funded by the proceeds from the stock sale. The decline in cash in 2013 was primarily due to a reduction in money market deposit accounts as a result of fully exiting the IND Program in June 2013.

To the extent that deposits are not adequate to fund customer loan demand, liquidity needs can be met in the short-term funds markets through arrangements with correspondent banks. The Banks had $15.5 million in federal funds lines of credit and a reverse repurchase agreement available on a short-term basis from correspondent banks at June 30, 2014 and December 31, 2013. The Banks are also members of the FHLB, which provides another source of liquidity. Through the FHLB, the Banks had credit availability of approximately $53.8 million and $46.9 million at June 30, 2014 and December 31, 2013, respectively. These lines of credit are paid for monthly on a fee basis of 0.09%. CNB has pledged, under a blanket lien, all qualifying residential loans under borrowing agreements with the FHLB, whereas Talbot Bank is required to provide specific loans and cash or investment securities as collateral due to its current credit rating with the FHLB. Management is not aware of any demands, commitments, events or uncertainties that are likely to materially affect our future ability to maintain liquidity at satisfactory levels.

Total stockholders’ equity increased $34.2 million to $137.5 million at June 30, 2014 when compared to December 31, 2013 primarily due to the proceeds from the stock sale. Due to the success of the stock sale, total stockholders’ equity to total assets increased to 12.91% at June 30, 2014 from 9.80% at December 31, 2013, providing additional capital strength to the Company and its subsidiaries.

Bank regulatory agencies have adopted various capital standards for financial institutions, including risk-based capital standards. The primary objectives of the risk-based capital framework are to provide a more consistent system for comparing capital positions of financial institutions and to take into account the different risks among financial institutions’ assets and off-balance sheet items. Risk-based capital standards have been supplemented with requirements for a minimum Tier 1 capital to average assets ratio (leverage ratio). The minimum ratios for capital adequacy purposes are 4.00%, 4.00% and 8.00% for the Tier 1 leverage, Tier 1 risk-based capital and total risk-based capital ratios, respectively. To be categorized as well capitalized, a bank must maintain minimum ratios of 5.00%, 6.00% and 10.00% for its Tier 1 leverage, Tier 1 risk-based capital and total risk-based capital ratios, respectively. The Company contributed $20.0 million of the net proceeds of the stock sale to Talbot Bank to satisfy regulatory capital requirements.

The following tables present the capital ratios for Shore Bancshares, Inc., Talbot Bank and CNB as of June 30, 2014 and December 31, 2013.

	Tier 1			Tier 1			Total
	leverage			risk-based			risk-based
June 30, 2014	ratio			capital ratio			capital ratio
Company		10.65	%		14.81	%		16.04	%
Talbot Bank		8.97	%		12.05	%		13.30	%
CNB		9.28	%		13.72	%		14.97	%

	Tier 1			Tier 1			Total
	leverage			risk-based			risk-based
December 31, 2013	ratio			capital ratio			capital ratio
Company		7.03	%		10.09	%		11.34	%
Talbot Bank		4.98	%		6.92	%		8.17	%
CNB		9.16	%		13.82	%		15.07	%

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

Our primary market risk is interest rate fluctuation and management has procedures in place to evaluate and mitigate this risk. This risk and these procedures are discussed in Item 7 of Part II of the Annual Report of Shore Bancshares, Inc. on Form 10-K for the year ended December 31, 2013 under the caption “Market Risk Management and Interest Sensitivity”. Management believes that there have been no material changes in our market risks, the procedures used to evaluate and mitigate these risks, or our actual and simulated sensitivity positions since December 31, 2013.

Item 4. Controls and Procedures.

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports that Shore Bancshares, Inc. files under the Securities Exchange Act of 1934 with the SEC, such as this Quarterly Report, is recorded, processed, summarized and reported within the time periods specified in those rules and forms, and that such information is accumulated and communicated to management, including Shore Bancshares, Inc.’s principal executive officer (“CEO”) and its principal accounting officer (“PAO”), as appropriate, to allow for timely decisions regarding required disclosure. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.

An evaluation of the effectiveness of these disclosure controls as of June 30, 2014 was carried out under the supervision and with the participation of management, including the CEO and the PAO. Based on that evaluation, the Company’s management, including the CEO and the PAO, has concluded that our disclosure controls and procedures are, in fact, effective at the reasonable assurance level at June 30, 2014.

There was no change in our internal control over financial reporting during the second quarter of 2014 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II – OTHER INFORMATION

Item 1. Legal Proceedings

From time to time the Company may become involved in legal proceedings. At the present time, there are no proceedings which the Company believes will have a material adverse impact on the financial condition or earnings of the Company.

Item 1A. Risk Factors

The risks and uncertainties to which our financial condition and operations are subject are discussed in detail in Item 1A of Part I of the Annual Report of Shore Bancshares, Inc. on Form 10-K for the year ended December 31, 2013. Management does not believe that any material changes in our risk factors have occurred since they were last disclosed.

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

None

Item 3. Defaults Upon Senior Securities

None

Item 4. Mine Safety Disclosures

Not Applicable

Item 5. Other Information

None

Item 6. Exhibits.

The exhibits filed or furnished with this quarterly report are shown on the Exhibit List that follows the signatures to this report, which list is incorporated herein by reference.

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.

	SHORE BANCSHARES, INC.

Date: August 14, 2014	By:	/s/ Lloyd L. Beatty, Jr.
		Lloyd L. Beatty, Jr.
		President & Chief Executive Officer
		(Principal Executive Officer)

Date: August 14, 2014	By:	/s/ George S. Rapp
		George S. Rapp
		Vice President & Chief Financial Officer
		(Principal Accounting Officer)

EXHIBIT INDEX

Exhibit
Number		Description

10.1		Stipulation and Consent to the Issuance of a Consent Order with the FDIC¹

10.2		Stipulation and Consent to the Issuance of a Consent Order with the Maryland Commissioner of Financial Regulation¹

10.3		Consent Order issued by the Federal Deposit Insurance Corporation¹

10.4		Acknowledgement of Adoption of the Order by the Maryland Commissioner of Financial Regulation¹

31.1		Certifications of the Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act (filed herewith).

31.2		Certifications of the Principal Accounting Officer pursuant to Section 302 of the Sarbanes-Oxley Act (filed herewith).

32		Certification pursuant to Section 906 of the Sarbanes-Oxley Act (furnished herewith).

101		Interactive Data File

1 Incorporated by reference from the Company’s Current Report on Form 8-K dated May 24, 2013.