**U.S. SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D. C.  20549**

 

**FORM 10-KSB**

 

**ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OFTHESECURITIES EXCHANGE ACT OF 1934**

 

**For thefiscal year ended December 31, 2003**

 

**Commission File No.: 000-24715**

 

**MERRILLMERCHANTS BANCSHARES, INC.**

(Name of Small BusinessIssuer in its charter)

 

| **Maine**                                                                  |   | **01-0471507**                       |
|----------------------------------------------------------------------------|--------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization)            |   | (I.R.S. Employer Identification No.) |
|                                                                       |   |                                 |
| **201 Main Street, Bangor, Maine 04401**                                   |
| (Address of principal executive offices)                                   |
|                                                                       |
| **(207) 942-4800**                                                         |
| (Issuer’s Telephone Number, Including Area Code)                      |
|                                                                       |
| Securities  registered pursuant to section 12(g) of the Exchange Act: |
|                                                                       |
| **Common Stock, par value $1.00 per share**                                |
| (Title of Class)                                                           |

 

Checkwhether the issuer (1) filed all reports required to be filed bySection 13 or 15(d) of the Exchange Act during the past 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past 90 days.   Yes  ý   No  o

 

Indicateby check mark if disclosure of delinquent filers in response to Item 405 ofRegulation S-B is not contained in this form, and no disclosure will becontained, to the best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-KSB or anyamendment to this Form 10-KSB.  o

 

Therevenues for the issuer’s fiscal year ended December 31, 2003 are$22,394,000.

 

Theaggregate market value of the voting and non-voting common equity held bynon-affiliates computed by reference to the price at which the common equitywas sold on January 31, 2004 was $82,226,339.

 

TheCompany had 3,302,130 shares of common stock outstanding as of January 31,2004.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portionsof the definitive proxy statement pursuant to Regulation 14A, which was filedwith the Commission on March 18, 2004, and the 2003 Annual Report toShareholders for the fiscal year ended December 31, 2003, are incorporatedby reference into Parts II and III of this report.

 

TransitionalSmall Business Disclosure Format (check one):

Yes  o   No  ý

 

 

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**TABLE OFCONTENTS**

 
| PART I    |     |                                                                                                     |   |
|-----------|----------|----------------------------------------------------------------------------------------------------------|--------|
|      | ITEM 1.  | BUSINESS                                                                                                 |   |
|      | ITEM 2.  | DESCRIPTION OF PROPERTY                                                                                  |   |
|      | ITEM 3.  | LEGAL PROCEEDINGS                                                                                        |   |
|      | ITEM 4.  | SUBMISSION OF MATTERS TO A VOTE  OF SECURITY HOLDERS                                                     |   |
| PART II   |     |                                                                                                     |   |
|      | ITEM 5.  | MARKET FOR THE COMPANY’S COMMON  STOCK AND RELATED STOCKHOLDER MATTERS                              |   |
|      | ITEM 6.  | MANAGEMENT’S DISCUSSION AND  ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS              |   |
|      | ITEM 7.  | FINANCIAL STATEMENTS                                                                                     |   |
|      | ITEM 8.  | CHANGES AND DISAGREEMENTS WITH  ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                       |   |
|      | ITEM 8A. | CONTROLS AND PROCEDURES                                                                                  |   |
|      |     |                                                                                                     |   |
| PART  III |     |                                                                                                     |   |
|      | ITEM 9.  | DIRECTORS AND PRINCIPAL OFFICERS  OF THE COMPANY; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT |   |
|      | ITEM 10. | EXECUTIVE COMPENSATION                                                                                   |   |
|      | ITEM 11. | SECURITY OWNERSHIP OF CERTAIN  BENEFICIAL OWNERS AND MANAGEMENT                                          |   |
|      | ITEM 12. | CERTAIN RELATIONSHIPS AND  RELATED TRANSACTIONS                                                          |   |
|      | ITEM 13. | EXHIBITS, LIST AND REPORTS ON  FORM 8-K                                                                  |   |
|      | ITEM 14. | PRINCIPAL ACCOUNTANT FEES AND  SERVICES                                                                  |   |

 

**SIGNATURES**

 

**Forward Looking Statements**

 

ThisAnnual Report on Form 10-KSB contains certain forward looking statementsconsisting of estimates with respect to the financial condition, results ofoperations and business of the Bank and the Company that are subject to variousfactors which could cause actual results to differ materially from theseestimates.  These factors include:changes in general, economic and market conditions, or the development of anadverse interest rate environment that adversely affects the interest ratespread or other income anticipated from the Bank’s or the Company’s operationsand investments.  We undertake no obligationto publicly update forward looking statements, whether as a result of newinformation, future events or otherwise.

 

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**PART I**

 

**ITEM 1.****    ****BUSINESS**

 

**General**

 

Merrill Merchants Bancshares, Inc. (the “Company”), a Maine corporationorganized in March 1992, is a registered bank holding company under theBank Holding Company Act of 1956, as amended (“BHCA”).  The Company is also a registered financialholding company under the BHCA. In October 1992, the Company became thebank holding company for Merrill Merchants Bank (the “Bank”) and holds 100% ofthe Bank’s outstanding common stock (the “Bank Stock”).  In January 1999, the Companyestablished Maine Acceptance Corporation (“MAC”), a finance company and effectiveMarch 29, 2002, MAC was merged into the Bank.  The Company, through its ownership of the Bank, is engaged in ageneral commercial and retail banking business, along with trust and investmentservices.  Unless the context otherwiserequires, references herein to the Company shall include the Company, the Bank,and MAC, on a consolidated basis.

 

The Company is an entity legally separate and distinct from theBank.  The Company’s sources of incomeand cash flow are derived from dividends paid on the Bank Stock, tax benefitsreceived by the Company and earnings from amounts deposited by the Company ininterest bearing accounts and investments.

 

The Bank was established in 1992 to purchase assets and assumeliabilities of certain branch banking offices formerly held by a large out ofstate bank.  Merrill Merchants Bank isheadquartered in Bangor, Maine, which is located 76 miles north of Augusta,Maine, the state capital.  Presently,the Bank maintains eleven banking offices (collectively, the “Branch Banks”) innine area communities.  The three Bangoroffices provide city-wide convenience and are complemented by: (i) an office inBrewer, Bangor’s sister city located on the eastern shore of the PenobscotRiver; (ii) a branch in Orono, home of the University of Maine, the State’sflagship campus; (iii) a branch in Pittsfield, a small rural town of 4,000people located about 30 miles southwest of Bangor; (iv) a convenience storebranch in Orrington which serves as a satellite office to the Brewer Branch;(v) a convenience store branch in Milford which serves as a satellite office tothe Orono Branch; (vi) a branch in Holden, a small town located next to Brewer;(vii) a private banking office located in Waterville; and (viii) a supermarketbranch in Newport, a small town neighboring Pittsfield, approximately 25 milessouthwest of Bangor.  The Newport Branchis located at the juncture of Interstate 95 and Route 2, which is the maintravel route to the winter and summer tourist area of the Moosehead LakeRegion.  In addition to the BranchBanks, the Bank has 17 ATM locations in its primary market area.

 

The Bank conducts a general commercial and retail banking business thatincludes the acceptance of deposits from the general public and the applicationof those funds to the origination of a variety of commercial loans, commercialand residential real estate loans and consumer loans.  As of December 31, 2003, the Company had total assets of$342.2 million, loans, net of allowances, of $242.9 million, total deposits of$258.8 million and shareholders’ equity of $30.6 million.  The Bank also established a Trust andInvestment Services Department, which has grown since inception inApril 1994 to $315.5 million in assets under management as ofDecember 31, 2003.

 

The Bank’s income is derived principally from interest and fees earnedin connection with its lending activities, interest and dividends on investmentsecurities, and service charges and fees on deposit and trust accounts.  Its main expenses are the interest paid ondeposits and operating expenses.  TheBank’s customer deposits are insured, up to the applicable limits, by theFederal Deposit Insurance Corporation (“FDIC”).

 

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*Community Banking Strategy*

 

Having identified the need for community banking services in its marketarea, the Bank has worked to position itself as a service-oriented communitybank.  The Bank is staffed byexperienced management personnel, all of whom reside in the area and who knowthe Bank’s customers and are able to provide personalized service for thesecustomers.  This strategy has beendeliberately developed and implemented at a time when consolidation within theindustry has resulted in an increasing depersonalization among the larger financialinstitutions.  The Bank has focused onfostering banking relationships with customers which include multiple financialservices that range from basic checking to investment management accounts.

 

As a part of this strategy, the Company and the Bank have attractedlocal business people, who actively promote the Bank in the community, to serveon their Boards of Directors.  In aneffort to broaden the community’s awareness of the Bank and attract newbusiness, the Company has also obtained additional investments in and supportfor the Company from local investors.

 

The Bank is active in small business lending and has earned thedesignation “Preferred Lender” by the Small Business Administration (SBA).  The Bank is also active in residentialmortgage lending, and a number of products, including government insured loanprograms, are available to meet the demands of both the consumer and thecommercial markets.  The Company’saffiliations with third party vendors have enabled the Bank to deliversophisticated products such as Internet banking, automated telephone banking,and check imaging while maintaining a local, friendly flavor in its BranchBanks.  This same strategy has beenimplemented by the Trust and Investment Services Department which is alsoserving many clients who appreciate the personal attention and customer serviceprovided locally.  The depositorycustody services and investment advisory services provided by the TrustDepartment are supported through its affiliation with The Northern Trust Company.

 

*Market Area and Competition*

 

The Bank’s primary market area, Greater Bangor, is at the center ofcommercial activity for the northeastern and central region of the State ofMaine.  Nearly 100,000 people live inthe Bank’s primary market area.  TheBank is part of a strategic link to Canada, as Bangor is the closest U.S.metropolitan area to Eastern Quebec and the Canadian Maritime provinces.  Many regional and national companies sitetheir operations in the Bangor area. Services, trades, manufacturing and government are the four largest fieldsof employment in the metropolitan Bangor region.  Bangor is also a healthcare center for central, eastern andnorthern Maine.  The City is a regionalfinancial center and is also serviced by several statewide and regionalaccounting firms, law firms, insurance companies and security and investmentfirms.  Bangor is also a hub forgovernment services, with many local, state and federal offices located withinthe city.  Bangor is accessible bymultiple exits from Interstate 95, a major interstate highway which transitsthe eastern seaboard of the United States. Major routes to all regions of the state bisect Bangor from variousdirections.  Bangor InternationalAirport provides domestic and international passenger and cargo service for asignificant portion of the state.  TheBank has targeted this same area as its focus for possible expansion of thefranchise.  Any such expansion wouldoccur with carefully selected de novo branching or taking advantage ofopportunities created as the large regional banks consolidate and sell or closebranches.

 

The financial services landscape has changed considerably over the pastfive years in the Bank’s primary market area, Greater Bangor.  Two large out-of-state banks have continuedto experience local change as a result of mergers and acquisitions at theregional and national level.  TheState’s largest Maine-based bank, with a strong presence in the local market,has also experienced considerable change as it has acquired greater marketshare through acquisitions in-state and out-of-state.  A large locally-based bank has expanded its line of financialservices and acquired an extensive branch network beyond the local market.  Credit unions have continued to expand theirmembership and the scope of banking services offered.  Non-banking entities such as brokerage houses, mortgage companiesand insurance companies are offering very competitive products.  Many of these entities and institutions haveresources substantially greater than those available to the Bank and are notsubject

 

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tothe same regulatory restrictions as the Company and the Bank.  Interstate banking also could intensifycompetition if out-of-state institutions increasingly take advantage of recentlegislation liberalizing interstate banking and branching opportunities inMaine.

 

Liberal interstate banking laws have resulted in an increase inacquisitions of locally-owned Maine-based banks by non-local entities.  It has been the observation of the Company’smanagement that these acquisitions often result in customer dissatisfaction asthe decision-making on loans, marketing, and other aspects of the acquiredbanks’ businesses is shifted from local bank management possessing independentdecision-making power to management operating under policies and guidelinesfrom corporate headquarters in other states. The Company believes that this shift often results in delayeddecision-making by management which is not familiar with the needs of theacquired bank’s customers or the communities it serves.  Individuals and small businesses areparticularly sensitive to these changes since they may not fit the productparameters established by the larger banks.

 

Thus, the Company believes that there will continue to be a need for abank in the Bank’s primary market area with local management havingdecision-making power and emphasizing loans to small and medium sizedbusinesses and to individuals.  The Bankhas concentrated on extending business loans to such customers in the Bank’sprimary market area and to extending trust services to clients with accounts ofall sizes.  The Bank’s management alsomakes decisions based upon, among other things, the knowledge of the Bank’semployees regarding the communities and customers in the Bank’s primary marketarea.  The individuals employed by theBank, to a large extent, reside near the Branch Banks and thus are generallyfamiliar with the Branch Banks’ communities and customers.  This is important in local decision-makingas it allows the Bank to respond to customer questions and concerns on a timelybasis and fosters quality customer service.

 

The Trust and Investment Services Department of the Bank has takenadvantage of opportunities created as the larger banks have altered their personalservice commitment to clients not meeting established account criteria.  The Bank is able to offer a comprehensivearray of trust and investment services to individuals, businesses, non-profitorganizations and municipalities of varying asset size and to provide thehighest level of personal service.  Thestaff includes an attorney as well as investment and employee benefitsprofessionals with trust and banking experience.

 

The Bank has worked and will continue to work to position itself to becompetitive in its market area.  TheBank’s ability to make decisions close to the marketplace, management’scommitment to providing quality banking products, the caliber of theprofessional staff, and the community involvement of the Bank’s employees areall factors affecting the Bank’s ability to be competitive.  If the Company and the Bank are unable tocompete successfully, however, the business and operations could be adverselyaffected.

 

*Employees*

 

As of December 31, 2003, the Company had 112 full-time employeesand 15 part-time employees.  Theemployees are not represented by a collective bargaining unit.

 

*Lending Activities*

 

The Bank has experienced loan growth since it was established inOctober 1992.  One of the primaryfactors contributing to the growth has been an experienced local lendinggroup.  Many commercial lendingrelationships have been developed by the Bank as a result of long standingbusiness associations over many years. Many of the Bank’s officers have held lending positions with Bangor areabanks for in excess of twenty years. Management believes that these relationships have not only beeninstrumental in loan growth but also in developing quality customers.

 

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The Company strives to provide a full range of financial products andservices to small and medium sized businesses and consumers.  The Bank has an established Officer LoanCommittee which meets weekly to review and approve credits and a Director LoanCommittee which meets bi-monthly, or as necessary, to approve credits in excessof $250,000.  The Bank’s loan mix issubject to the discretion of its Board of Directors and the demands of thelocal marketplace.  Management hasestablished relationships with local area legal and accounting professionals tocultivate referrals.  Asset quality is atop priority for the Bank and a significant consideration in businessdevelopment efforts.

 

*Commercial and Commercial Real Estate Lending*

 

Loans in this category principally include loans to service, retail,medical, construction, wholesale and light manufacturing businesses.  Commercial loans are made based on themanagement, financial strength and repayment ability of the borrower.  As of December 31, 2003, commercial andcommercial real estate loans represented the largest class of loans at $135.8million or 55% of total loans.  The Bankparticipates in government guaranteed lending including programs with theFinance Authority of Maine (FAME) and Rural Development (RD).   The Bank is a leading lender in the Stateof Maine for the Small Business Administration.

 

The Bank’s commercial real estate loans are ordinarily made at variablerates of interest, and amortized up to fifteen years, although some loans areoriginated for shorter terms at fixed rates of interest.  A broad range of short-to-medium termcommercial loans, both collateralized and uncollateralized, are made availableto businesses for working capital (including inventory and receivables), businessexpansion (including improvements of real estate) and the purchase of equipmentand machinery.  The purpose of aparticular loan generally determines its structure.  The commercial real estate loans are secured by a variety ofproperties, including buildings occupied by small-to-medium sized businesses,apartment complexes and non-owner/user office and retail business.

 

The Bank’s commercial loans primarily are underwritten in the Bank’sprimary market area on the basis of the borrowers’ ability to service such debtfrom income.  Many of these loansinvolve lines of credit written at variable rates of interest on a demandbasis, or for terms not exceeding one year, while others are written on a termbasis typically for up to five years, generally at variable rates of interest.  As a general practice, the Bank takes ascollateral a security interest in any available real estate, equipment or otherchattel although such loans may also be made on an uncollateralized basis.  As additional security for commercial loans,the Bank normally requires the personal guarantee of the principals and mayrequire financial performance covenants.

 

Commercial loans generally present a higher level of risk thanone-to-four-family residences due to the concentration of principal in alimited number of loans and borrowers, the effect of general economicconsiderations on commercial properties and the increased difficulty ofevaluating and monitoring these types of loans.  In addition, the repayment of loans secured by commercial realestate is typically dependent on the successful operation of the relatedbusiness activities.

 

*Residential Mortgage Lending*

 

The Bank endeavors to meet the needs of its individual customers bymaking residential mortgage loans. Residential loans include the origination ofconventional mortgages, residential lot loans and residential acquisition,development and construction loans for the purchase or construction ofsingle-family housing or lots. The Bank offers fixed and adjustable ratemortgages (“ARMs”).  With these loans,the real estate normally constitutes the primary collateral.

 

Loans in this category include both portfolio loans which are held bythe Bank until maturity and loans which are sold on the secondary market.  In the case of secondary market loans, allservicing rights are retained by the Bank which maintains the serviceconnection to the customer.  The Bankparticipates in government guaranteed programs and has also helped coordinateseveral innovative programs including a partnership with

 

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PenquisCommunity Action Program in its “Own Me” program which assists low income womenin the purchase of a home, and housing workshops for the hearing impaired.

 

As of December 31, 2003, residential loans accounted for a totalof $55.4 million representing 22% of total loans.  The Bank’s secondary market servicing portfolio totaled $106.9million at December 31, 2003.

 

The Bank offers one-year ARMs with rate adjustments tied to the weeklyaverage rate of U.S. Treasury securities adjusted to a constant one-yearmaturity with specified minimum and maximum interest rate adjustments.  The interest rates on a majority of thesemortgages are adjusted yearly with limitations on upward adjustments of 2% peradjustment period and 6% over the life of the loan.  It has been the Bank’s experience that the proportion offixed-rate and adjustable-rate loan originations depends in large part on thelevel of interest rates.  As interestrates fall, there is generally a reduced demand for ARMs and, as interest ratesrise, there is generally an increased demand for ARMs.

 

Fixed and adjustable rate mortgage loans collateralized by singlefamily residential real estate generally have been originated in amounts of nomore than 80% of appraised value. However, in some instances, the Bank may lend in excess of 80% of thevalue of the property collateralizing the loan.  The Bank, in most cases, requires title, fire and extendedcasualty insurance to be obtained by the borrower, and, where required byapplicable regulations, flood insurance. The Bank maintains its own errors and omissions insurance policy toprotect against loss in the event of failure of a mortgagor to pay premiums onfire and other hazard insurance policies. Although the contractual loan payment period for single familyresidential real estate loans is generally for a 15 to 30 year period, suchloans often remain outstanding for significantly shorter periods than theircontractual terms.  The Bank charges nopenalty for prepayment of mortgage loans. Mortgage loans originated by the Bank customarily include a “due onsale” clause giving the Bank the right to declare a loan immediately due andpayable in the event, among other matters, that the borrower sells or otherwisedisposes of the real property subject to a mortgage.  In general, the Bank enforces due on sale clauses.

 

*Construction Lending*

 

TheCompany originates construction loans to individuals for the construction ofone- to four-family residences and to businesses for owner-occupancy. Residentialand commercial construction loans generally provide for the payment of interestonly during the construction phase, which is usually between six and twelvemonths. At the end of the construction phase, the loan converts to a permanentmortgage loan. At December 31, 2003, construction loans totaled $9.7million representing 4% of total loans.

 

Construction lending generally involves a higher degree of risk thansingle-family permanent mortgage lending or a commercial real estate loanbecause of the greater potential for disagreements between borrowers andbuilders and the failure of builders to pay subcontractors. Additional riskoften exists because of the inherent difficulty in estimating both a property’svalue and the estimated cost of the property.

 

*Home Equity Lending*

 

The Company originates home equity loans on a fixed and variableinterest rate basis.  AtDecember 31, 2003, fixed-rate loans totaled $15.1 million andvariable-rate loans amounted to $13.4 million. Fixed-rate loans are for terms of 5 to 15 years with monthlyamortization required and interest rates ranging from 4.89% to 13.5%.  Interest rates on variable-rate loans rangefrom prime to 2.0% over the prime interest rate.  These home equity loans are generally secured by a secondmortgage on the principal residential property.

 

*Consumer Lending*

 

 Consumer loans made by the Bankhave included home improvement, automobile, boat and recreational vehicleloans, credit cards and overdraft protection accounts.  The Bank’s consumer loan portfolio consists

 

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primarilyof loans to individuals for various consumer purposes.  A majority of these loans are for terms ofless than 60 months and although generally collateralized by liens on variouspersonal assets of the borrower may be made uncollateralized.  Consumer loans are made at fixed andvariable interest rates.

 

Maine Acceptance Corporation (MAC), a finance company which opened forbusiness in Bangor on March 1, 1999, provides indirect auto andrecreational vehicle lending, as well as other types of direct loans, includingpersonal unsecured, recreational vehicle, auto, mobile home and home equityloans.  Effective March 29, 2002,MAC was merged into the Bank.

 

Consumer loans are attractive to the Company because they typicallyhave a shorter term and carry higher interest rates than those charged on othertypes of loans.  Consumer loans,however, do pose additional risks of collectibility when compared totraditional types of loans granted by commercial banks, such as residentialmortgage loans.  In many instances, theCompany is required to rely on the borrower’s ability to repay since thecollateral may be of reduced value at the time of collection.  Accordingly, the initial determination ofthe borrower’s ability to repay is of primary importance in the underwriting ofconsumer loans.

 

Consumer loans totaled approximately $17.3 million and represented 7%of the Company’s loan portfolio at December 31, 2003.  Such loans bear interest at fixed ratesranging from 4.5% to 18%.

 

*M&M Joint Venture*

 

In 1996, the Bank and MSB Leasing, Inc. (a subsidiary of MachiasSavings Bank, a state chartered mutual savings bank) formed M&M ConsultingLimited Liability Company (“M&M”), a jointly owned subsidiary.  M&M was established to provide a reviewof various internal bank risk control functions.  M&M, which has a former FDIC examiner as one of itsprincipals, provides the Bank, Machias Savings Bank and over fifty otherfinancial institutions in northern New England access to experiencedindividuals who are highly trained in loan review, regulatory compliance,training and internal auditing in a cost-efficient and timely manner.

 

*Lending Activities*

 

The following table summarizes the composition of the Bank’s loanportfolio by type of loan at the dates indicated:

 

###### **Loan Portfolio Composition**

 
|                           |   | **At  December 31,**   |    |
|--------------------------------|--------|-----------------------------|---------|
|                           |   | **2003**                    |    | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                           |   | **Amount**                  |    | **%** |   | **Amount** |   | **%** |   | **Amount** |   | **%** |   | **Amount** |   | **%** |   | **Amount** |   | **%** |   |
|                           |   | **(Dollars  in thousands)** |    |
| Real Estate                    |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial                     |   | $                           | 80,212  |   | 32 | % | $ | 70,247 |   | 33 | % | $ | 69,209 |   | 37 | % | $ | 59,277 |   | 36 | % | $ | 49,161 |   | 36 | % |
| Construction                   |   | 9,669                       |    | 4 | % | 13,379 |   | 6 | % | 6,678 |   | 4 | % | 4,623 |   | 3 | % | 1,937 |   | 2 | % |
| Residential                    |   | 55,380                      |    | 22 | % | 40,362 |   | 19 | % | 35,040 |   | 19 | % | 26,112 |   | 16 | % | 23,390 |   | 17 | % |
| Home equity                    |   | 28,496                      |    | 12 | % | 19,889 |   | 9 | % | 17,675 |   | 9 | % | 18,830 |   | 11 | % | 18,054 |   | 13 | % |
| Total real estate              |   | 173,757                     |    | 70 | % | 143,877 |   | 67 | % | 128,602 |   | 69 | % | 108,842 |   | 66 | % | 92,542 |   | 68 | % |
| Commercial                     |   | 55,486                      |    | 23 | % | 54,920 |   | 26 | % | 43,533 |   | 23 | % | 42,459 |   | 25 | % | 33,686 |   | 25 | % |
| Consumer                       |   | 17,269                      |    | 7 | % | 15,932 |   | 7 | % | 15,945 |   | 8 | % | 14,622 |   | 9 | % | 9,994 |   | 7 | % |
| Total loans                    |   | $                           | 246,512 |   | 100 | % | $ | 214,729 |   | 100 | % | $ | 188,080 |   | 100 | % | $ | 165,923 |   | 100 | % | $ | 136,222 |   | 100 | % |
| Less allowance for loan losses |   | (3,652                      | )       |   |   | (3,295 | ) |   |   | (2,986 | ) |   |   | (2,658 | ) |   |   | (2,274 | ) |   |   |
| Total                          |   | $                           | 242,860 |   |   |   | $ | 211,434 |   |   |   | $ | 185,094 |   |   |   | $ | 163,265 |   |   |   | $ | 133,948 |   |   |   |
|                                |        |                             |         |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The following table sets forth as of December 31, 2003, commercialand construction loans by scheduled due date for the periods indicated.  Loans maturing after one year are furtherdistinguished between those with predetermined interest rates and loans whichhave floating or adjustable interest rates.

 

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**LoanMaturity Schedule**

 
|                                                        |   | **At  December 31, 2003**     |   |
|-------------------------------------------------------------|--------|------------------------------------|--------|
|                                                        |   | **Due in one********year or less** |   | **Due after  one year****but before 5 years** |   | **Due after 5********years** |   | **Total** |   |
|                                                        |   | **(Dollars  in thousands)**        |   |
| Commercial                                                  |   | $                                  | 31,759 |   | $ | 18,701 |   | $ | 5,026 |   | $ | 55,486 |   |
| Construction                                                |   | 9,669                              |   | — |   | — |   | 9,669 |   |
| Commercial and construction loans maturing after  one year: |   |                               |   |   |   |   |   |   |   |
| Predetermined interest rates                                |   | $                                  | 5,325  |   |   |   |   |   |   |   |
| Floating or adjustable interest rates                       |   | 18,402                             |   |   |   |   |   |   |   |
| Total                                                       |   | $                                  | 23,727 |   |   |   |   |   |   |   |
|                                                             |        |                                    |        |  |  |  |  |  |  |  |  |  |  |

 

The following is a summary of non-performingassets at the dates indicated:

 

##### **Non-Performing Assets**

 
|                                                                              |   | **At  December 31,**   |   |
|-----------------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                              |   | **2003**                    |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                                                              |   | **(Dollars  in thousands)** |   |
| Loans:                                                                            |   |                        |   |   |   |   |   |   |   |   |   |
| Non-accrual loans                                                                 |   | $                           | 598    |   | $ | 432 |   | $ | 432 |   | $ | 421 |   | $ | 266 |   |
| Loans 90 days or more past due but still accruing                                 |   | 8                           |   | 37 |   | 75 |   | 104 |   | — |   |
| Restructured loans                                                                |   | 8                           |   | 132 |   | — |   | — |   | — |   |
| Non-performing loans                                                              |   | 614                         |   | 601 |   | 507 |   | 525 |   | 266 |   |
| OREO and repossessed assets                                                       |   | 3                           |   | 165 |   | 221 |   | 90 |   | 50 |   |
| Non-performing assets                                                             |   | $                           | 617    |   | $ | 766 |   | $ | 728 |   | $ | 615 |   | $ | 316 |   |
| Non-performing loans as a percentage of total  loans                              |   | 0.25                        | %      | 0.28 | % | 0.27 | % | 0.32 | % | 0.19 | % |
| Non-performing assets as a percentage of total  assets                            |   | 0.18                        | %      | 0.25 | % | 0.26 | % | 0.25 | % | 0.15 | % |
| Non-performing assets as a percentage of total  loans and OREO/repossessed assets |   | 0.25                        | %      | 0.36 | % | 0.39 | % | 0.37 | % | 0.23 | % |

 

At December 31, 2003, loans on non-accrual status totaled$598,000. Interest income not recognized on non-accrual loans was $24,000 in2003.  There was no interest incomerecognized on non-accrual loans in 2003.

 

*Adversely Classified Assets*

 

The Bank’s management adversely classifies certain assets as “doubtful”or “loss” based on criteria established under banking regulations.  An asset is considered substandard ifinadequately protected by the current net worth and paying capacity of theobligor or of the collateral pledged, if any. Substandard assets include those characterized by the “distinctpossibility” that the insured institution will sustain “some loss” if existingdeficiencies are not corrected.  Assetsclassified as doubtful have all the weaknesses inherent in those classifiedsubstandard with the added characteristic that the weaknesses present make“collection or liquidation in full,” on the basis of currently existing facts,conditions, and values, “highly questionable and improbable.” Assets classifiedas loss are those considered “uncollectible” and of such little value thattheir continuance as assets without the establishment of a specific lossreserve is not warranted.

 

At December 31, 2003 and 2002, loans classified as substandardamounted to $5.5 million and $2.7 million, respectively, and loans classifiedas doubtful totaled $81,000 and $480,000, respectively.  Performing

 

7

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loansrepresent 95% and 85% of the adversely classified balances as ofDecember 31, 2003 and 2002, respectively. The Bank had no loans which were classified as loss at either date.  Total classified loans as a percentage oftotal loans increased to 2.3% at December 31, 2003 from 1.5% atDecember 31, 2002.  Classifiedloans represent loans that, in the opinion of management, could potentiallymigrate to non-performing or loss status. Delinquent loans may or may not be adversely classified depending uponmanagement’s judgment with respect to each individual loan.  As of December 31, 2003 and 2002, theportion of loans guaranteed by either the SBA, RD or FAME for each yearamounted to 20% and 28%, respectively, of the total loan balances adverselyclassified.

 

*Allowance for Loan Losses*

 

The following table sets forth activity in the Company’s allowance forloan losses during the years indicated:

 

**Summary of Loan Loss Experience**

 
|                                                    |   | **Year Ended  December 31,** |    |
|---------------------------------------------------------|--------|-----------------------------------|---------|
|                                                    |   | **2003**                          |    | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                                    |   | **(Dollars in  thousands)**       |    |
| Total net loans outstanding at the end of year (1)      |   | $                                 | 242,860 |   | $ | 211,434 |   | $ | 185,094 |   | $ | 163,265 |   | $ | 133,948 |   |
| Average net loans outstanding during the year  (1) |   | $                                 | 229,392 |   | $ | 198,120 |   | $ | 171,692 |   | $ | 150,553 |   | $ | 127,595 |   |
| Allowance for loan losses, beginning of year            |   | $                                 | 3,295   |   | $ | 2,986 |   | $ | 2,658 |   | $ | 2,274 |   | $ | 2,023 |   |
| Loans charged off during the period:                    |   |                              |    |   |   |   |   |   |   |   |   |
| Real estate:                                            |   |                              |    |   |   |   |   |   |   |   |   |
| Commercial                                              |   | —                            |    | — |   | — |   | — |   | (66 | ) |
| Residential                                             |   | —                            |    | — |   | — |   | — |   | — |   |
| Home equity                                             |   | —                            |    | — |   | (20 | ) | (14 | ) | — |   |
| Commercial                                              |   | (7                                | )       | (28 | ) | (65 | ) | (9 | ) | (10 | ) |
| Consumer                                                |   | (113                              | )       | (161 | ) | (99 | ) | (42 | ) | (49 | ) |
| Total                                                   |   | (120                              | )       | (189 | ) | (184 | ) | (65 | ) | (125 | ) |
| Recoveries of loans previously charged off:             |   |                              |    |   |   |   |   |   |   |   |   |
| Real estate:                                            |   |                              |    |   |   |   |   |   |   |   |   |
| Commercial                                              |   | —                            |    | — |   | — |   | — |   | — |   |
| Residential                                             |   | —                            |    | 27 |   | 22 |   | 22 |   | 22 |   |
| Home equity                                             |   | —                            |    | — |   | — |   | — |   | — |   |
| Commercial                                              |   | 4                                 |    | 5 |   | 1 |   | 1 |   | 7 |   |
| Consumer                                                |   | 29                                |    | 13 |   | 15 |   | 3 |   | 2 |   |
| Total                                                   |   | 33                                |    | 45 |   | 38 |   | 26 |   | 31 |   |
| Net loans charged off during the year                   |   | (87                               | )       | (144 | ) | (146 | ) | (39 | ) | (94 | ) |
| Provisions charged to income statement                  |   | 444                               |    | 453 |   | 474 |   | 423 |   | 345 |   |
| Allowance for loan losses, end of year                  |   | $                                 | 3,652   |   | $ | 3,295 |   | $ | 2,986 |   | $ | 2,658 |   | $ | 2,274 |   |
| Ratios:                                                 |   |                              |    |   |   |   |   |   |   |   |   |
| Net charge-offs to average loans outstanding            |   | 0.04                              | %       | 0.07 | % | 0.08 | % | 0.03 | % | 0.07 | % |
| Net charge-offs to loans, end of period                 |   | 0.04                              | %       | 0.07 | % | 0.08 | % | 0.02 | % | 0.07 | % |
| Allowance for loan losses to average loans  outstanding |   | 1.57                              | %       | 1.64 | % | 1.71 | % | 1.74 | % | 1.75 | % |
| Allowance for loan losses to loans, end of year         |   | 1.48                              | %       | 1.53 | % | 1.59 | % | 1.60 | % | 1.67 | % |
| Allowance for loan losses to non-performing loans       |   | 594.79                            | %       | 548.25 | % | 588.95 | % | 506.29 | % | 854.89 | % |

 

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(1)Excludes loans held for sale.

 

8

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The provision for loan losses was $444,000 for the twelve month periodended December 31, 2003 and $453,000 for the same period endedDecember 31, 2002. The allowance for loan losses was $3.7 million atDecember 31, 2003, which was an increase of $357,000 or 11% over theamount at December 31, 2002.

 

The following table sets forth the breakdown of the allowance for loanlosses by loan category for the periods indicated.  Management believes that the allowance can be allocated bycategory only on an approximate basis. The allocation of an allowance to each category is not necessarilyindicative of future losses and does not restrict the use of the allowance toabsorb losses in any other category.

 
|                                       |   | **At  December 31,**  |   |
|--------------------------------------------|--------|----------------------------|--------|
|                                       |   | **2003**                   |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                       |   | **Amount**                 |   | **% of  Loans to  Total  Loans** |   | **Amount** |   | **% of  Loans to  Total  Loans** |   | **Amount** |   | **% of  Loans to  Total  Loans** |   | **Amount** |   | **% of  Loans to  Total  Loans** |   | **Amount** |   | **% of  Loans to  Total  Loans** |   |
|                                       |   | **(Dollars in thousands)** |   |
| Commercial  andCommercial  Real Estate (1) |   | $                          | 2,774  |   | 55 | % | $ | 1,881 |   | 58 | % | $ | 1,574 |   | 60 | % | $ | 1,321 |   | 61 | % | $ | 1,111 |   | 61 | % |
| Construction                               |   | 48                         |   | 4 | % | 67 |   | 6 | % | 33 |   | 4 | % | 23 |   | 3 | % | 10 |   | 2 | % |
| Residential                                |   | 181                        |   | 22 | % | 361 |   | 19 | % | 285 |   | 19 | % | 223 |   | 16 | % | 122 |   | 17 | % |
| Home  equity                               |   | 74                         |   | 12 | % | 248 |   | 9 | % | 220 |   | 9 | % | 236 |   | 11 | % | 179 |   | 13 | % |
| Consumer                                   |   | 277                        |   | 7 | % | 460 |   | 8 | % | 424 |   | 8 | % | 310 |   | 9 | % | 272 |   | 7 | % |
| Off-Balance  Sheet                         |   | 125                        |   | — |   | 278 |   | — |   | 212 |   | — |   | — |   | — |   | — |   | — |   |
| Unallocated                                |   | 173                        |   | — |   | — |   | — |   | 238 |   | — |   | 545 |   | — |   | 580 |   | — |   |
| Total  allowance for loan losses           |   | $                          | 3,652  |   | 100 | % | $ | 3,295 |   | 100 | % | $ | 2,986 |   | 100 | % | $ | 2,658 |   | 100 | % | $ | 2,274 |   | 100 | % |
|                                            |        |                            |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)                                  Commercial and commercial real estate loanshave been combined in allocating the allowance for loan losses as the Companyutilizes an internal risk rating system for these loans on a consolidatedbasis.

 

The allowance for loan losses represents the amount available forcredit losses inherent in the Company’s loan portfolio.  Loans are charged off when they are deemeduncollectible, after giving consideration to factors such as the customer’sfinancial condition, underlying collateral and guarantees, as well as generaland industry economic conditions.

 

In general, the Company determines the appropriate overall reserve forloan losses based upon periodic, systematic reviews of its portfolio toidentify inherent losses based on management’s judgment about variousqualitative factors.  These reviewsresult in the identification and quantification of loss factors, which are usedin determining the amount of the allowance for loan losses. The Companyperiodically evaluates prevailing economic and business conditions, industryconcentrations, changes in the size and characteristics of the portfolio andother pertinent factors.  Portions ofthe allowance for loan losses are quantified to cover the estimated lossesinherent in each loan category based on the results of this detailed reviewprocess.

 

Commercial loans are individually reviewed and assigned a credit riskrating from “1” (low risk of loss) to “8” (high risk of loss). For non-impairedloans with a credit risk rating of “1” to “6”, estimated loss factors based onhistorical loss experience (ranging from two to five years) are used tocalculate a loan loss reserve for each credit risk rating classification.  Qualitative adjustments are also made basedupon management’s assessment of prevailing economic conditions, trends in volumesand terms of loans, levels and trends in delinquencies and non-accruals, andthe effect of changes in lending policies. A specific allocation is made for impaired loans, or loans no longeraccruing interest as a result of the deemed uncollectibility of interest due,which are measured at the net present value of future cash flows, discounted atthe loan’s effective interest rate, or at fair market value of collateral ifthe loan is collateral dependent. The combination of these analyses is thebasis for the determination of the commercial loan portion of the allowance forloan losses.

 

Consumer loans, which include residential mortgages, home equity loans,and direct/indirect loans, are generally evaluated as a group based on producttype. The determination of the consumer loan portion of the allowance for loanlosses is based on a five-year average of annual historical losses, adjustedfor the qualitative factors noted above.

 

9

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The results of all analyses are reviewed and discussed by the Board ofDirectors on a quarterly basis.  Anintegral component of the Company’s risk management process is to ensure theproper quantification of the reserve for loan losses based upon an analysis ofrisk characteristics, demonstrated losses, loan segmentations, and otherfactors.  Reserve methodology isreviewed on a periodic basis and modified as appropriate.  Based on this analysis, including theaforementioned assumptions, the Company believes that the allowance for loanlosses is adequate as of December 31, 2003.  The unallocated component of the allowance for loan lossesrepresents management’s view that, given the complexities of the loanportfolio, there are estimable losses that have been incurred within the portfoliobut not yet tied to specific loans. Although management utilizes its best judgment in providing for possiblelosses, there can be no assurance the Bank will not have to increase itsprovision for possible losses in the future due to increases in non-performingassets or otherwise, which would adversely affect the results of operations.

 

Because some loans may not be repaid in full, an allowance for loan andlosses is recorded. Increases to the allowance are recorded by a provision forloan losses charged to expense. Estimating the risk of the loss and the amountof loss on any loan is necessarily subjective. Accordingly, the allowance ismaintained by management at a level considered adequate to cover probablelosses that are currently anticipated based on past loss experience, general economicconditions, information about specific borrower situations including theirfinancial position and collateral values, and other factors and estimates whichare subject to change over time. While management may periodically allocateportions of the allowance for specific problem loan situations, the entireallowance is available for any loan charge-offs that occur. A loan is chargedoff against the allowance by management as a loss when deemed uncollectible,although collection efforts continue and future recoveries may occur.

 

*Investment Activities*

 

The Company’s investment portfolio serves three important functions:first, it enables the adjustment of the balance sheet’s sensitivity to changesin interest rate movements; second, it provides an outlet for investing excessfunds; and third, it provides liquidity. The investment portfolio is structured to maximize the return oninvested funds within conservative risk guidelines.

 

The composition of the investment portfolio as of December 31,2003 was 16% U.S. Treasury notes and U.S. Government agencies and corporations,68% mortgage-backed securities and collateralized mortgage obligations and 16%other securities.  The comparabledistributions for December 31, 2002 were 34% U.S. Treasury notes and U.S.Government agencies and corporations, 49% mortgage-backed securities andcollateralized mortgage obligations and 17% other securities.

 

10

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The following table sets forth the composition of the Company’s investmentportfolio at the dates indicated:

 

**InvestmentSecurities Portfolio Composition**

 
|                                                                |   | **At  December 31,**   |   |
|---------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                |   | **2003**                    |   | **2002** |   | **2001** |   |
|                                                                |   | **(Dollars  in thousands)** |   |
| Securities available for sale (1):                                  |   |                        |   |   |   |   |   |
| U.S. Treasury securities                                            |   | $                           | — |   | $ | — |   | $ | 1,030 |   |
| U.S. Government agencies and corporations                           |   | 12,473                      |   | 11,750 |   | 17,376 |   |
| Mortgage-backed securities and  collateralized mortgage obligations |   | 51,780                      |   | 33,660 |   | 38,684 |   |
| State and local government debt securities                          |   | 2,682                       |   | 2,925 |   | 5,254 |   |
| Certificates of deposit                                             |   | 2,957                       |   | 4,158 |   | 4,457 |   |
| U.S. Government and agency money market  funds                      |   | 2,105                       |   | 11,935 |   | 3,130 |   |
| Other securities (2)                                                |   | 4,143                       |   | 4,439 |   | 1,676 |   |
|                                                                |   |                        |   |   |   |   |   |
| Total                                                               |   | $                           | 76,140 |   | $ | 68,867 |   | $ | 71,607 |   |

 

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(1)                        Carried at estimated market value.

(2)                        Includes FHLB stock, Federal Reserve stock,FNMA stock and marketable equity securities.

 

**MaturitySchedule of Securities Available for Sale**

 
|                                                                |   | **At  December 31, 2003  (At Market Value)** |   |
|---------------------------------------------------------------------|--------|---------------------------------------------------|--------|
|                                                                |   | **One year  or less**                             |   | **Over one  year  through 5 years** |   | **Over 5  years  through 10 years** |   | **Over 10  years** |   | **Total** |   |
|                                                                |   | **Amount**                                        |   | **Weighted  Yield (1)** |   | **Amount** |   | **Weighted  Yield (1)** |   | **Amount** |   | **Weighted  Yield (1)** |   | **Amount** |   | **Weighted  Yield (1)** |   | **Amount** |   | **Weighted  Yield (1)** |   |
|                                                                |   | **(Dollars  in thousands)**                       |   |
| U.S. Government agencies and corporations                           |   | $                                                 | 2,349  |   | 4.54 | % | $ | 10,124 |   | 2.83 | % | $ | — |   | — |   | $ | — |   | — |   | $ | 12,473 |   | 3.17 | % |
| Mortgage-backed securities and collateralized  mortgage obligations |   | —                                            |   | — |   | 2,417 |   | 4.47 | % | 19,823 |   | 3.21 | % | 29,540 |   | 3.09 | % | 51,780 |   | 3.20 | % |
| States and local government debt securities                         |   | 505                                               |   | 1.49 | % | 878 |   | 4.23 | % | 1,141 |   | 5.00 | % | 158 |   | 4.74 | % | 2,682 |   | 4.07 | % |
| Certificates of deposit                                             |   | 2,957                                             |   | 1.80 | % | — |   | — |   | — |   | — |   | — |   | — |   | 2,957 |   | 1.80 | % |
| U.S. Government and agency money market  funds                 |   | 2,105                                             |   | 0.91 | % | — |   | — |   | — |   | — |   | — |   | — |   | 2,105 |   | 0.91 | % |
| Other securities                                                    |   | 4,143                                             |   | 2.60 | % | — |   | — |   | — |   | — |   | — |   | — |   | 4,143 |   | 2.60 | % |
| Total                                                               |   | $                                                 | 12,059 |   | 2.39 | % | $ | 13,419 |   | 3.22 | % | $ | 20,964 |   | 3.31 | % | $ | 29,698 |   | 3.10 | % | $ | 76,140 |   | 3.07 | % |

 

----

(1)                           Yield is calculated using amortized cost.

 

11

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*Deposit Activities*

 

The following table sets forth the average balances and weightedaverage rates for the Bank’s categories of deposits for the periods indicated:

 

**AverageDeposit Balances and Rates**

 
|                    |   | **Year Ended  December 31,** |    |
|-------------------------|--------|-----------------------------------|---------|
|                    |   | **2003**                          |    | **2002** |   | **2001** |   |
|                    |   | **Average  Balance**              |    | **Average  Rate** |   | **% of  Total  Deposits** |   | **Average  Balance** |   | **Average  Rate** |   | **% of  Total  Deposits** |   | **Average  Balance** |   | **Average  Rate** |   | **% of  Total  Deposits** |   |
|                    |   | **(Dollars  in thousands)**       |    |
| Non-interest checking   |   | $                                 | 41,740  |   | — |   | 17 | % | $ | 35,917 |   | — |   | 16 | % | $ | 32,284 |   | — |   | 16 | % |
| Interest checking       |   | 34,188                            |    | 0.28 | % | 14 | % | 28,628 |   | 0.65 | % | 13 | % | 26,548 |   | 1.74 | % | 13 | % |
| Money market            |   | 36,943                            |    | 0.95 | % | 15 | % | 32,203 |   | 1.77 | % | 14 | % | 22,665 |   | 3.01 | % | 11 | % |
| Savings                 |   | 41,241                            |    | 0.58 | % | 17 | % | 42,428 |   | 1.41 | % | 19 | % | 37,383 |   | 2.88 | % | 19 | % |
| Certificates of deposit |   | 91,675                            |    | 3.55 | % | 37 | % | 87,393 |   | 4.18 | % | 38 | % | 82,160 |   | 5.52 | % | 41 | % |
|                    |   |                              |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total                   |   | $                                 | 245,787 |   |   |   | 100 | % | $ | 226,569 |   |   |   | 100 | % | $ | 201,040 |   |   |   | 100 | % |

 

The Bank does not have a concentration of deposits from any one source,the loss of which would have a material adverse effect on the business of theBank.  Management believes thatsubstantially all the Bank’s depositors are residents in its primary marketarea except for $25.9 million in brokered deposits at December 31, 2003.

 

The following table summarizes at December 31, 2003 the Bank’scertificates of deposit (CD) of $100,000 or more and brokered CD’s by timeremaining until maturity:

 

|                                  |   | **December 31,  2003** |   |
|---------------------------------------|--------|-----------------------------|--------|
|                                  |   | **(Dollars  in thousands)** |   |
| Maturity Period:                      |   |                        |   |
| Less than three months                |   | $                           | 6,067  |   |
| Over three months through six months  |   | 1,880                       |   |
| Over six months through twelve months |   | 8,200                       |   |
| Over twelve months                    |   | 25,364                      |   |
| Total                                 |   | $                           | 41,511 |   |

 

**Federal and State Taxation**

 

*General*

 

The Company, the Bank and MAC file a consolidated federal income tax returnon a fiscal year basis.  Consolidatedreturns have the effect of eliminating intercompany distributions, includingdividends and inter-company interest income and expense, from the computationof consolidated taxable income for the taxable year in which the distributionsoccur.  Banks and bank holding companiesare subject to federal income taxes in the same manner as othercorporations.  In accordance with anincome tax sharing agreement, income tax charges or credits will be allocatedto the Company, the Bank and MAC on the basis of their respective taxableincome or loss included in the consolidated income tax return.

 

12

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*Federal Income Taxation*

 

Although the Bank’s income tax liability is determined under provisionsof the Internal Revenue Code of 1986, as amended (the “Code”), which isapplicable to all taxpayers or corporations, Sections 581 through 597 of theCode apply specifically to financial institutions.

 

The two primary areas in which the treatment of financial institutionsdiffer from the treatment of other corporations under the Code are in the areasof bond gains and losses and bad debt deductions.  Bond gains and losses generated from the sale or exchange ofportfolio instruments are generally treated for financial institutions asordinary gains and losses as opposed to capital gains and losses for othercorporations, as the Code considers bond portfolios held by banks to beinventory in a trade or business rather than capital assets.  Banks are allowed a statutory method forcalculating a reserve for bad debt deductions. Based on the asset size of the Bank, it is permitted to maintain a baddebt reserve calculated on an experience method, based on charge-offs for thecurrent and preceding five years or a “grandfathered” base year reserve, iflarger.

 

*State and Local Taxation*

 

The Company on a consolidated basis is subject to a separate statefranchise tax in lieu of state corporate income tax.  The amount of the tax is the sum of 1% of Maine net income and$.08 per $1,000 of Maine assets as defined in Maine law.  Maine assets are the corporation’s total endof the year assets as reported on the federal income tax return.  Maine net income is the corporation’s netincome or loss as reported on the federal income tax return which isapportioned to Maine under Maine law.

 

**SUPERVISIONAND REGULATION**

 

Bank holding companies and state banks are extensively regulated underboth federal and state law.  These lawsand regulations are intended to protect depositors, not shareholders.  To the extent that the following informationdescribes statutory and regulatory provisions, it is qualified in its entiretyby reference to the particular statutory and regulatory provisions.  Any change in the applicable law orregulation may have a material effect on the business and prospects of theCompany and the Bank.

 

**Financial Holding Company Regulation**

 

On November 12, 1999, President Clinton signed into law theGramm-Leach-Bliley Financial Services Modernization Act of 1999 (the “Act”),federal legislation intended to modernize the financial services industry byestablishing a comprehensive framework to permit affiliations among commercialbanks, insurance companies, securities firms and other financial service providers.

 

Under the Act, bank holding companies may elect to be regulated asfinancial holding companies.  Financialholding companies may engage in activities that are financial in nature orincidental or complementary to activities which are financial in nature.  A bank holding company may qualify to becomea financial holding company if:

 

•                  eachof its depository institution subsidiaries is “well capitalized”;

 

•                  eachof its depository institution subsidiaries is “well managed”;

 

•                  eachof its depository institution subsidiaries has at least a “satisfactory”Community Reinvestment Act rating at its most recent examination; and

 

13

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•                  thebank holding company has filed a certification with the Federal Reserve Boardthat it elects to become a financial holding company.

 

The Company filed an election to be treated as a financial holdingcompany with the Federal Reserve Bank of Boston in March 2001.  As a result, the Company is currentlyregulated as a financial holding company. As a financial holding company, theCompany may conduct those activities which are considered financial in natureunder a new section 4(k) of the BHCA. These activities include:

 

•                  Activitiespermissible for bank holding companies prior to the enactment of the Act;

 

•                  Lending,exchanging, transferring, investing for others, or safeguarding money orsecurities;

 

•                  Underwritingand selling insurance;

 

•                  Providing financial, investment, oradvisory services;

 

•                  Sellingpools of assets;

 

•                  Underwriting, dealing in, or making amarket in securities; and

 

•                  Merchantbanking.

 

The FRB also has the power to determine by regulation or orderadditional financial activities which would be permissible for financialholding companies.  In addition, in orderto commence a new activity, Merrill Merchants Bank must have received a“satisfactory” on its latest CRA exam.

 

**The USA PATRIOT Act**

 

In response to the events of September 11th, PresidentGeorge W. Bush signed into law the Uniting and Strengthening America byProviding Appropriate Tools Required to Intercept and Obstruct Terrorism Act of2003, or the USA PATRIOT Act, on October 26, 2001.  The USA PATRIOT Act gives the federalgovernment new powers to address terrorist threats through enhanced domestic securitymeasures, expanded surveillance powers, increased information sharing, andbroadened anti-money laundering requirements. By way of amendments to the Bank Secrecy Act, Title III of the USAPATRIOT Act takes measures intended to encourage information sharing among bankregulatory agencies and law enforcement bodies.  Further, certain provisions of Title III impose affirmativeobligations on a broad range of financial institutions, including banks,thrifts, brokers, dealers, credit unions, money transfer agents and partiesregistered under the Commodity Exchange Act.

 

Among other requirements, Title III of the USA PATRIOT Act imposes thefollowing requirements with respect to financial institutions:

 

•                  Pursuantto Section 352, *all*financial institutions must establish anti-money laundering programs thatinclude, at minimum: (i) internal policies, procedures, and controls, (ii)specific designation of an anti-money laundering compliance officer, (iii)ongoing employee training programs, and (iv) an independent audit function totest the anti-money laundering program.

 

•                  Section 326of the Act authorizes the Secretary of the Department of Treasury, inconjunction with other bank regulators, to issue regulations byOctober 26, 2002 that provide for minimum standards with respect tocustomer identification at the time new accounts are opened.

 

•                  Section 312of the Act requires financial institutions that establish, maintain,administer, or manage private banking accounts or correspondent accounts in theUnited States for non-United States persons or their representatives (includingforeign individuals visiting the United States) to establish appropriate,specific, and, where necessary, enhanced due diligence policies, procedures,and controls designed to detect and report money laundering.  Rules promulgated under thisSection are due by April 24, 2002, to

 

14

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be effective by July 23, 2002.

 

•                  EffectiveDecember 25, 2002, financial institutions are prohibited fromestablishing, maintaining, administering or managing correspondent accounts forforeign shell banks (foreign banks that do not have a physical presence in anycountry), and will be subject to certain recordkeeping obligations with respectto correspondent accounts of foreign banks.

 

•                  Bankregulators are directed to consider a holding company’s effectiveness incombating money laundering when ruling on Federal Reserve Act and Bank MergerAct applications.

 

*General*

 

As a bank holding company and financial holding company, the Company issubject to the regulation and supervision of the Federal Reserve under theBHCA.  The Company is also subject tothe regulation and supervision of the Maine Bureau of Financial Institutions byvirtue of provisions of Maine law which govern financial institution holdingcompanies such as the Company.  Underapplicable federal law, the Company must obtain the approval of the FederalReserve Board before it acquires all or substantially all of the assets of abank or another bank holding company, merges or consolidates with another bankholding company, or acquires direct or indirect ownership or control of anyvoting shares of a bank or bank holding company if, after such acquisition, itwould own or control more than 5% of any class of voting shares of such bank orbank holding company (unless it already owns or controls a majority of suchshares).  Similarly, under applicableMaine law, the Company must obtain the prior approval of the MaineSuperintendent of the Bureau of Financial Institutions before acquiring morethan 5% of the voting shares of a Maine financial institution or of anyfinancial institution holding company which directly or indirectly controls aMaine financial institution.  Undercertain circumstances, the Company may be required to obtain Federal ReserveBoard approval before redeeming any of its equity securities in an amount inexcess of 10% of its net worth in any twelve-month period.  Furthermore, under certain circumstances,any redemptions, dividends, or distributions with respect to the Company’sCommon Stock may be considered an unsafe or unsound practice by the FederalReserve Board.

 

Before any “company,” as defined in the BHCA, may acquire “control,” asdefined in the BHCA, over the Company, the prior approval of the FederalReserve Board generally is required.  Inaddition, before any individual or entity which is not required to seek priorapproval from the Federal Reserve Board may acquire control of the Company,prior notice to the Federal Reserve Board generally is required.  Similarly, notice to and approval by theMaine Superintendent of the Bureau of Financial Institutions is required beforeany “financial institution holding company,” as defined in the Maine BankingCode, may acquire more than 5% of a Maine financial institution or Mainefinancial institution holding company.

 

The Bank is also subject to continued regular supervision andexamination by applicable federal and state banking agencies.  The Bank is a Maine state-chartered bank thatis a member of the Federal Reserve System. The Federal Reserve exercises primary supervision over the Bank throughperiodic examination.  The Bank is alsosubject to regulation by the FDIC as well as the Maine Bureau of FinancialInstitutions.  The FDIC has authority toterminate insurance for accounts pursuant to procedures established for thatpurpose.  The Bank must comply withvarious requirements and restrictions under federal and state law, includingrequirements to maintain reserves against deposits, restrictions on the typesand amounts of loans that may be granted and the interest that may be chargedthereon and limitations on the types of investments that may be made and thetypes of services that may be offered. Various consumer laws and regulations also affect the operations of theBank.  In addition to the impact ofregulation, commercial banks are affected significantly by the actions of theFederal Reserve Board as it attempts to control the money supply and creditavailability in order to influence the economy.

 

15

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*Payment of Dividends*

 

The Company is a legal entity separate and distinct from the Bank.  The principal source of cash flow of theCompany, including cash flow to pay dividends on its stock, is dividends fromthe Bank.  There are statutory andregulatory limitations on the payment of dividends by the Bank to the Company,as well as by the Company to its shareholders.

 

In addition to the statutory prohibition against the withdrawal of anyportion of the Bank’s capital and certain statutory limitations on the paymentof dividends, under Maine law, the Bank may not pay dividends if it isinsolvent or if the payment of such dividends would render the Bank insolvent.  In addition, Maine law generally requiresthat dividends may be paid only out of either unreserved and unrestrictedearned surplus or out of the unreserved and unrestricted net earnings of thethen current and preceding fiscal years. If the dividends are to be paid only out of net earnings, shareholdersmust be notified of the source of the dividend and of the fact that there wasno earned surplus from which to pay the dividend.

 

The payment of dividends by any state bank that is a member of theFederal Reserve System is affected by the requirement to maintain adequatecapital pursuant to the capital adequacy guidelines issued by the FederalReserve Board.   The regulations andrestrictions on dividends paid by the Bank may limit the Company’s ability toobtain funds from such dividends for its cash needs, including funds forpayment of operating expenses, and dividends on the Common Stock.

 

If, in the opinion of the applicable federal bank regulatory authority,a depository institution or holding company is engaged in or is about to engagein an unsafe or unsound practice (which, depending on the financial conditionof the depository institution or holding company, could include the payment ofdividends), such authority may require, after notice and hearing (except in thecase of an emergency proceeding where there is no notice or hearing), that suchinstitution or holding company cease and desist from such practice.  The federal banking agencies have indicatedthat paying dividends that deplete a depository institution’s or holdingcompany’s capital base to an inadequate level would be such an unsafe andunsound banking practice.  Moreover, theFederal Reserve and the FDIC have issued policy statements which provide thatbank holding companies and insured depository institutions generally shouldonly pay dividends out of current operating earnings.  In addition, under the Federal Deposit Insurance CorporationImprovement Act of 1991 (“FDICIA”), an FDIC-insured depository institution maynot pay any dividend if payment would cause it to become undercapitalized oronce it is undercapitalized.  See“FDICIA.”

 

The payment of dividends by the Company and the Bank also may beaffected or limited by other factors, such as the requirement to maintainadequate capital above regulatory guidelines.

 

*Transactions With Affiliates and Insiders*

 

The Bank is subject to Section 23A of the Federal Reserve Act,which places limits on the amount of loans or extensions of credit to, orinvestments in, or certain other transactions with, affiliates, including theCompany.  In addition, limits are placedon the amount of advances to third parties collateralized by the securities orobligations of affiliates.  Most ofthese loans and certain other transactions must be secured in prescribedamounts.  The Bank is also subject toSection 23B of the Federal Reserve Act, which, among other things,prohibits an institution from engaging in transactions with certain affiliatesunless the transactions are on terms substantially the same, or at least as favorableto such institution or its subsidiaries, as those prevailing at the time forcomparable transactions with non-affiliated companies.

 

16

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Effective April 1, 2003, the FederalReserve Board, or FRB, rescinded its interpretations of Sections 23A and 23B ofthe FRA and replaced these interpretations with Regulation W.  In addition, Regulation W makes variouschanges to existing law regarding Sections 23A and 23B, including expanding thedefinition of what constitutes an affiliate subject to Sections 23A and 23B andexempting certain subsidiaries of state-chartered banks from the restrictionsof Sections 23A and 23B.

 

Under Regulation W, all transactions enteredinto on or before December 12, 2002, which either became subject toSections 23A and 23B solely because of Regulation W, and all transactionscovered by Sections 23A and 23B, the treatment of which will change solelybecause of Regulation W, became subject to Regulation W on July 1, 2003.   All other covered affiliate transactionsbecome subject to Regulation W on April 1, 2003.  The Federal Reserve Board expects each depository institutionthat is subject to Sections 23A and 23B to implement policies and procedures toensure compliance with Regulation W.  Wedo not expect that the changes made by Regulation W will have a materialadverse effect on our business.

 

The Bank’s authority to extend credit to itsdirectors, executive officers and 10% shareholders, as well as to entitiescontrolled by such persons, is currently governed by the requirements ofSections 22(g) and 22(h) of the FRA and Regulation O of the Federal ReserveBoard.  Among other things, theseprovisions require that extensions of credit to insiders (a) be made on termsthat are substantially the same as, and follow credit underwriting proceduresthat are not less stringent than, those prevailing for comparable transactionswith unaffiliated persons and that do not involve more that the normal risk ofrepayment or present other unfavorable features and (b) not exceed certainlimitations on the amount of credit extended to such persons, individually andin the aggregate, which limits are based, in part, on the amount of the Bank’scapital.  The regulations allow smalldiscounts on fees on residential mortgages for directors, officers andemployees.  In addition, extensions forcredit in excess of certain limits must be approved by the Bank’s Board ofDirectors.

 

Section 402 of the Sarbanes-Oxley Act of2002 prohibits the extension of personal loans to directors and executiveofficers of issuers (as defined in Sarbanes-Oxley).  The prohibition, however, does not apply to mortgages advanced byan insured depository institution, such as the Bank, that are subject to theinsider lending restrictions of Section 22(h) of the Federal Reserve Act.

 

*Capital Adequacy*

 

The federal banking agencies have adopted risk-based capital guidelinesfor banks and bank holding companies. The minimum guideline for the ratio of total capital to risk-weightedassets (“Total Risk Based Capital” ratio) for “adequately capitalized”institutions is 8%.  The minimumadequate capitalization guideline for the ratio of Tier 1 Capital torisk-weighted assets (“Tier 1 Risk Based Capital” ratio) is 4%.

 

In addition, the federal banking agencies have established minimumleverage ratio guidelines for banks and bank holding companies.  Their guidelines provide for a minimum ratioof Tier 1 Capital to average assets, less goodwill and certain other intangibleassets (the “Leverage Ratio”), of 3% for banks that meet certain specificcriteria and 4% for other institutions. The Company’s Leverage Ratio at December 31, 2003 was 9.18%.  Failure to meet capital guidelines couldsubject a bank to a variety of enforcement remedies, including the terminationof deposit insurance by the FDIC, and to certain restrictions on itsbusiness.  See “FDICIA.”

 

The following table sets forth capital ratios required by the FederalReserve to be maintained by the Company in order for the Company to beadequately capitalized, and the Company’s actual ratios of capital to totalregulatory or risk-weighted assets, as applicable, at December 31, 2003.

 
|                     |   | **Company  Regulatory  Minimum** |   | **Company** |   | **Bank** |   |
|--------------------------|--------|----------------------------------|--------|-------------|--------|----------|--------|
| Tier 1 capital           |   | 4.00                             | %      | 12.85       | %      | 11.40    | %      |
| Total risk-based capital |   | 8.00                             | %      | 14.10       | %      | 12.65    | %      |

 

17

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*FDICIA*

 

FDICIA requires the federal banking regulators to take “promptcorrective action” in respect of FDIC -insured depository institutions that donot meet minimum capital requirements. FDICIA established five capital tiers: “well capitalized,” “adequatelycapitalized,” “undercapitalized,” “significantly undercapitalized” and“critically undercapitalized.” An FDIC-insured depository institution is wellcapitalized if it maintains a Leverage Ratio of at least 5%, a risk adjustedTier 1 Capital Ratio of at least 6% and a Total Capital Ratio of at least 10%and is not subject to a directive, order or written agreement to meet andmaintain specific capital levels.  Aninsured depository****institution isdefined to be adequately****capitalizedif it meets all of its minimum capital requirements as described above.  In addition, an insured depositoryinstitution will be considered undercapitalized if it fails to meet any minimumrequired measure, significantly undercapitalized if it is significantly belowany such measure and critically undercapitalized if it fails to maintain alevel of tangible equity equal to not less than 2% of total assets.  An insured depository institution may bedeemed to be in a capitalization category that is lower than is indicated byits actual capital position if it receives an unsatisfactory examinationrating.

 

The capital-based prompt corrective action provisions of FDICIA andtheir implementing regulations apply to FDIC-insured depository institutionsand are not directly applicable to holding companies which control suchinstitutions.  However, the FederalReserve Board has indicated that, in regulating bank holding companies, it willtake appropriate action at the holding company level based on an assessment ofthe effectiveness of supervisory actions imposed upon subsidiary depositoryinstitutions pursuant to such provisions and regulations.

 

FDICIA generally prohibits an FDIC-insured depository institution frommaking any capital distribution (including payment of dividends) or paying anymanagement fee to its holding company if the depository institution wouldthereafter be undercapitalized.

 

The Company and the Bank, at December 31, 2003 and 2002, were“well capitalized” under the criteria discussed above.

 

*FDIC Insurance Premiums*

 

The Bank is required to pay semiannual FDIC deposit insuranceassessments.  Each financial institutionis assigned to one of three capital groups – well capitalized, adequately capitalizedor undercapitalized — and further assigned to one of three subgroups within acapital group, on the basis of supervisory evaluations by the institution’sprimary federal and, if applicable, state supervisors and other informationrelevant to the institution’s financial condition and the risk posed to theFDIC deposit insurance fund.  The actualassessment rate applicable to a particular institution (and any applicablerefund) will, therefore, depend in part upon the risk assessment classificationso assigned to the institution by the FDIC. The FDIC is authorized by federal law to raise insurance premiums incertain circumstances.  Any increase inpremiums would have an adverse effect on the Bank and the Company’searnings.  Under the FDIC, insurance ofdeposits may be terminated by the FDIC upon a finding that the institution hasengaged in unsafe and unsound practices, is in an unsafe or unsound conditionto continue operations or has violated any applicable law, regulation, rule,order or condition imposed by a federal bank regulatory agency.

 

*Interstate Banking*

 

The acquisition by the Company of more than 5% of the outstandingvoting securities or substantially all of the assets of a bank located outsideof the State of Maine is regulated by the BHCA.  Such acquisition is also subject to the law of the state in whichthe bank to be acquired is located. Under certain circumstances, the Company might not be permitted to acquirean interest in another bank located outside Maine.  Further, any company attempting to acquire control of the Companyor the Bank also may be subject to certain limitations on interstatebanking.  Even assuming that the law ofthe state in which the bank is located permits acquisition, the

 

18

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MaineBanking Code requires prior approval of the Superintendent of the Bureau ofFinancial Institutions for certain acquisitions of more than 5% of a financialinstitution having operations conducted outside of Maine.

 

The status of interstate banking legislation adopted by individualstates has been in a constant state of change in recent years.  While federal law has substantiallyliberalized interstate banking, a number of states have adopted some form oflegislation which limits interstate banking by bank holding companies.

 

*Interstate Act*

 

Subject to certain conditions and exceptions, the Riegle-NealInterstate Banking and Branching Efficiency Act of 1994 (“Interstate Act”) (i)permits bank holding company acquisitions of banks of a minimum age of up tofive years as established by state law in any state, (ii) permits mergers ofnational and state banks across state lines unless the state has opted out ofthe interstate bank merger provisions, (iii) permits branching de novo bynational and state banks into other states and (iv) permits certain interstatebank agency activities one year after enactment.  Subject to certain limitations, Maine law permits out of statefinancial institutions, federal associations and national banks to establish denovo branches or to acquire branches in Maine.

 

*Community Reinvestment Act*

 

The Community Reinvestment Act requires that, in connection withexaminations of financial institutions within their jurisdiction, the FederalReserve, the FDIC, the Office of the Comptroller of the Currency and the Officeof Thrift Supervision evaluate the record of such financial institutions inmeeting the credit needs of their local communities, including low and moderateincome neighborhoods, consistent with the safe and sound operation of thoseinstitutions.  These factors are alsoconsidered in evaluating mergers, acquisitions and applications to open abranch or facility.

 

*Federal Securities Law*

 

The common stock of the Company is registered with the SEC underSection 12(g) of the Securities Exchange Act of 1934, as amended (the“Exchange Act”).  Accordingly, theCompany is subject to the information, proxy solicitation, insider tradingrestrictions and other requirements of the Exchange Act.

 

*Sarbanes-Oxley Act*

 

OnJuly 30, 2002, President George W. Bush signed into law the Sarbanes-OxleyAct of 2002.  The Sarbanes-Oxley Actimplements a broad range of corporate governance and accounting measures forpublic companies designed to promote honesty and transparency in corporateAmerica and better protect investors from the type of corporate wrongdoing thatoccurred in Enron, WorldCom and similar companies.  The Sarbanes-Oxley Act’s principal legislation includes:

 

•                                          the creation of an independent accountingoversight board;

 

•                                          auditor independence provisions whichrestrict non-audit services that accountants may provide to their auditclients;

 

•                                          additional corporate governance andresponsibility measures, including the requirement that the chief executiveofficer and chief financial officer certify financial statements;

 

•                                          the forfeiture of bonuses or otherincentive-based compensation and profits from the sale of an issuer’ssecurities by directors and senior officers in the twelve month periodfollowing initial publication of any financial statements that later requirerestatement;

 

19

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•                                          an increase in the oversight of, andenhancement of certain requirements relating to, audit committees of publiccompanies and how they interact with the company’s independent auditors.

 

•                                          a requirement that audit committee membersmust be independent and are absolutely barred from accepting consulting,advisory or other compensatory fees from the issuer;

 

•                                          a requirement that companies disclose whetherat least one member of the committee is an “audit committee financial expert”and if not, why not;

 

•                                          expanded disclosure requirements forcorporate insiders, including accelerated reporting of stock transactions byinsiders and a prohibition on insider trading during pension blackout periods;

 

•                                          a prohibition on personal loans to directorsand officers, except certain loans made by insured financial institutions;

 

•                                          disclosure of a code of ethics and filing ofa Form 8-K for a change or waiver of such code;

 

•                                          mandatory disclosure by analysts of potentialconflicts of interest; and

 

•                                          a range of enhanced penalties for fraud andother violations.

 

Although management anticipates that the Company will incur additionalexpense in complying with the provisions of the Sarbanes-Oxley Act and theresulting regulations, management does not expect that such compliance willhave a material impact on Company results of operations or financial condition.

 

*Other Regulations*

 

Interest and certain other charges collected or contracted for by banksare subject to state usury laws and certain federal laws concerning interestrates.  The Bank’s loan operations arealso subject to certain federal laws applicable to credit transactions, such asthe federal Truth-In-Lending Act governing disclosures of credit terms toconsumer borrowers, the Home Mortgage Disclosure Act of 1975 requiringfinancial institutions to provide information to enable the public and publicofficials to determine whether a financial institution is fulfilling itsobligation to help meet the housing needs of the community it serves, the EqualCredit Opportunity Act prohibiting discrimination on the basis of race, creedor other prohibited factors in extending credit, the Fair Credit Reporting Actof 1978 governing the use and provision of information to credit reportingagencies, the Fair Debt Collection Act governing the manner in which consumerdebts may be collected by collection agencies and the rules and regulations ofthe various federal agencies charged with the responsibility of implementingsuch federal laws.  The depositoperations of the Bank also are subject to the Right to Financial Privacy Act,which imposes a duty to maintain confidentiality of consumer financial recordsand prescribes procedures for complying with administrative subpoenas offinancial records, and the Electronic Funds Transfer Act and Regulation Eissued by the Federal Reserve Board to implement that act, which governautomatic deposits to and withdrawals from deposit accounts and customers’rights and liabilities arising from the use of automated teller machines andother electronic banking services.

 

20

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**ITEM 2.****                                                    ****DESCRIPTION OF PROPERTY**

 

The Company’s headquarters and the Bank’s main branch are located at201 Main Street, Bangor, Maine, in a two-story building owned by the Bank.  The building contains approximately 17,000square feet.  As of December 31,2003, the Company’s properties and leasehold improvements had an aggregate netbook value of $2.6 million.

 
| **Location**                                            |   | **Ownership** |   | **Year  Opened** |   | **Lease or  License  Expiration (1)** |   |
|---------------------------------------------------------|--------|---------------|--------|------------------|--------|---------------------------------------|--------|
| **Corporate Headquarters of the  Bank and the Company** |   | Owned         |   | 1992             |   | —                                |   |
| 201 Main Street                                         |   |          |   |             |   |                                  |   |
| Bangor, Maine  04401                               |   |          |   |             |   |                                  |   |
|                                                    |   |          |   |             |   |                                  |   |
| **Branch Offices:**                                     |   |          |   |             |   |                                  |   |
| 992 Union Street                                        |   | Leased        |   | 1997             |   | 2017                                  |   |
| Bangor, Maine  04401                               |   |          |   |             |   |                                  |   |
|                                                    |   |          |   |             |   |                                  |   |
| 992 Union Street, Suite 1A                              |   | Leased        |   | 1998             |   | 2004                                  |   |
| Bangor, Maine  04401                               |   |          |   |             |   |                                  |   |
|                                                    |   |          |   |             |   |                                  |   |
| 920 Stillwater Avenue                                   |   | Leased        |   | 1994             |   | 2014                                  |   |
| Bangor, Maine  04401                               |   |          |   |             |   |                                  |   |
|                                                    |   |          |   |             |   |                                  |   |
| 366 Wilson Street                                       |   | Leased        |   | 1995             |   | 2015                                  |   |
| Brewer, Maine  04412                               |   |          |   |             |   |                                  |   |
|                                                    |   |          |   |             |   |                                  |   |
| 69 Main Street                                          |   | Leased        |   | 1992             |   | 2007                                  |   |
| Orono, Maine  04473                                |   |          |   |             |   |                                  |   |
|                                                    |   |          |   |             |   |                                  |   |
| 27 Main Street                                          |   | Owned         |   | 1992             |   | —                                |   |
| Pittsfield, Maine  04967                           |   |          |   |             |   |                                  |   |
|                                                    |   |          |   |             |   |                                  |   |
| 1007 Main Road                                          |   | Owned         |   | 2002             |   | —                                |   |
| Holden, Maine  04492                               |   |          |   |             |   |                                  |   |
|                                                    |   |          |   |             |   |                                  |   |
| 58 Elm Street                                           |   | Leased        |   | 2003             |   | 2004                                  |   |
| Waterville, Maine  04901                           |   |          |   |             |   |                                  |   |
|                                                    |   |          |   |             |   |                                  |   |
| **Supermarket Office:**                                 |   |          |   |             |   |                                  |   |
| Newport Plaza                                           |   | Leased        |   | 1997             |   | 2007                                  |   |
| 44 Moosehead Trail                                      |   |          |   |             |   |                                  |   |
| Newport, Maine  04953                              |   |          |   |             |   |                                  |   |
|                                                    |   |          |   |             |   |                                  |   |
| **Convenience Store  Offices:**                         |   |          |   |             |   |                                  |   |
| 191 River Road                                          |   | Leased        |   | 1999             |   | 2019                                  |   |
| Orrington, Maine  04474                            |   |          |   |             |   |                                  |   |
|                                                    |   |          |   |             |   |                                  |   |
| 2 Main Street                                           |   | Leased        |   | 2002             |   | 2020                                  |   |
| Milford, Maine  04461                              |   |          |   |             |   |                                  |   |
|                                                    |   |          |   |             |   |                                  |   |
| **Operations:**                                         |   |          |   |             |   |                                  |   |
| 359 Perry Road                                          |   | Leased        |   | 1996             |   | 2016                                  |   |
| Bangor, Maine  04401                               |   |          |   |             |   |                                  |   |

 

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(1)              Lease expiration dates assume all optionsto extend lease term are exercised.

 

21

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**ITEM 3.****                                                    ****LEGAL PROCEEDINGS**

 

Althoughthe Bank and the Company, from time to time, are involved in routine litigationincidental to the business, there are no material legal proceedings to whichthe Bank or the Company are a party or to which any of its property is subject,or, to the Company’s knowledge, any such proceedings that any governmentalauthority is contemplating, as of the date of this Form 10-KSB for the fiscalyear ended December 31, 2003.

 

**ITEM 4.****                                                    ****SUBMISSION OF MATTERS TO AVOTE OF SECURITY HOLDERS**

 

None.

 

**PART II**

 

**ITEM 5.****                                                    ****MARKET FOR THE COMPANY’SCOMMON STOCK AND RELATED STOCKHOLDER MATTERS**

 

Thefollowing information included in the Merrill Merchants Bancshares, Inc. 2003Annual Report to Stockholders (the “Annual Report”) is incorporated herein byreference: “Market for Common Stock” on page 13 of the Annual Report.

 

**ITEM 6.****                                                  ****MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

Thefollowing information included in the Annual Report is incorporated herein byreference: “Selected Financial Highlights” on page 1 and “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” onpages 5 through 13 of the Annual Report.

 

**ITEM 7.****                                                    ****FINANCIAL STATEMENTS**

 

Thefollowing information included in the Annual Report is incorporated herein byreference to the Company’s consolidated financial statements and related noteson pages 14 through 32 of the Annual Report.

 

**ITEM 8.****                                                  ****CHANGES AND DISAGREEMENTSWITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

None.

 

**ITEM 8A.****                                           ****CONTROLS AND PROCEDURES**

 

Management, including the Company’s President and Chief ExecutiveOfficer and Chief Financial Officer, has evaluated the effectiveness of theCompany’s disclosure controls and procedures (as defined in Exchange Act Rules13a-15(f) and 15d-15(e)) as of the end of the period covered by this report.  Based upon that evaluation,the President and Chief Executive Officer and Chief Financial Officerconcluded that the disclosure controls and procedures were effective, in allmaterial respects, to ensure that information required to be disclosed in thereports the Company files and submits under the Exchange Act is recorded,processed, summarized and reported as and when required.

 

There have been no changes in the Company’sinternal control over financial reporting identified in connection with theevaluation that occurred during the Company’s last fiscal quarter that havematerially affected, or that are reasonably likely to materially affect, theCompany’s internal control over financial reporting.

 

22

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**PART III**

 

**ITEM 9.****                                                  ****DIRECTORS AND PRINCIPALOFFICERS OF THE COMPANY; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT**

 

The following information included in the Company’s 2004 ProxyStatement for the 2004 Annual Meeting of Shareholders (“Proxy Statement”) isincorporated herein by reference: “Voting Securities,” “Election of Directorsof Merrill Merchants Bancshares, Inc.,” “Audit Committee,” “ExecutiveOfficers,” and “Section 16(a) Beneficial Ownership Reporting Compliance”on pages 4, 6, 13, 16 and 21 of the Proxy Statement.

 

The Company has adopted a Code of BusinessConduct and Ethics, which applies to the Company’s principal executive officer,principal financial officer, principal accounting officer or controller orperson performing similar functions for the Company.  Our Code of Business Conduct and Ethics meets the requirements ofa “code of ethics” as defined by Item 406 of Regulation S-B and is filed asExhibit 14 to this annual report on Form 10-KSB.

 

**ITEM 10.****                                             ****EXECUTIVE COMPENSATION**

 

The following information included in the Proxy Statement isincorporated herein by reference: “Remuneration of Directors and Officers,”“Employment Agreements,” and “Interests in Certain Transactions” on pages 15through 21 of the Proxy Statement.

 

**ITEM 11.****                                             ****SECURITY OWNERSHIP OFCERTAIN BENEFICIAL OWNERS AND MANAGEMENT**

 

The following information included in the Proxy Statement isincorporated herein by reference:

“Voting Securities” on page 4 of the Proxy Statement.

 

The following table sets forth the aggregate information for theCompany’s equity compensation plans in effect at December 31, 2003.

 
|                                                        |   | **Equity  Compensation Plan Information**                                                                                                  |   |
|-------------------------------------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------|--------|
| **Plan category**                                           |   | **Number of securities to  be issued upon exercise  of outstanding options,  warrants and rights** |   | **Weighted Average  exercise price of  outstanding options,  warrants and rights** |   | **Number of securities remaining  available for future issuance  under equity compensation plan  (excluding securities referenced  in column (a)** |   |
|                                                        |   | **(a)**                                                                                                                                    |   | **(b)** |   | **(c)** |   |
| Equity compensation plans approved by security  holders (1) |   | 75,107                                                                                                                                     |   | $ | 12.60 |   | 0 |   |
| Equity compensation plans not approved by security  holders |   | 0                                                                                                                                          |   | N/A |   | 0 |   |
| Total                                                       |   | 75,107                                                                                                                                     |   | $ | 12.60 |   | 0 |   |

 

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(1)          Consists of the 1993 Plan.  Adescription of the plan and additional information is included in the AnnualReport on page 22 and page 29.  Thenumber of shares available for future issuance is subject to adjustment for anyrecapitalization of common stock, such as a stock dividend, stock split orreverse split of common stock.

 

**ITEM 12.****                                             ****CERTAIN RELATIONSHIPS ANDRELATED TRANSACTIONS**

 

The following information included in the Proxy Statement isincorporated herein by reference: “Interests in Certain Transactions” on page21 of the Proxy Statement.

 

23

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**ITEM 13.****                                             ****EXHIBITS, LIST AND REPORTSON FORM 8-K**

 

(a)                                  The following financial statements includedin the 2003 Annual Report are incorporated herein by reference:

 

Consolidated Statements of Financial Condition —  December 31, 2003 and 2002;

Consolidated Statements of Income — Years Ended December 31, 2003and 2002;

Consolidated Statements of Changes in Shareholders’ Equity — YearsEnded December 31, 2003 and 2002;

Consolidated Statements of Cash Flows — Years Ended December 31,2003 and 2002; and

Notes to Consolidated Financial Statements — December 31, 2003 and2002.

 

(b)                                 Exhibits.                                                   The following exhibits are either filed aspart of this report or are incorporated herein by reference:

 
| 3.1    |   | Articles  of Incorporation of Merrill Merchants Bancshares, Inc.*                                                                    |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                 |
| 3.2    |   | By-laws  of Merrill Merchants Bancshares, Inc.*                                                                                      |
|   |   |                                                                                                                                 |
| 4      |   | Specimen  Stock Certificate of Merrill Merchants Bancshares, Inc.*                                                                   |
|   |   |                                                                                                                                 |
| 10.1   |   | Operating  Agreement between the Company and M&M Consulting Limited Liability Company.*                                          |
|   |   |                                                                                                                                 |
| 10.2   |   | Services  Agreements between the Company and M&M Consulting Limited Liability  Company.*                                         |
|   |   |                                                                                                                                 |
| 10.3   |   | Employment  Agreement with William C. Bullock, Jr. **                                                                                |
|   |   |                                                                                                                                 |
| 10.4   |   | Financial  Services Agreement with Financial Institutions Service Corporation.*                                                      |
|   |   |                                                                                                                                 |
| 10.5   |   | Form  of Life Insurance Endorsement Method Split Dollar Plan Agreement.*                                                             |
|   |   |                                                                                                                                 |
| 10.7   |   | Form  of Executive Supplemental Retirement Plan.*                                                                                    |
|   |   |                                                                                                                                 |
| 10.8   |   | Form  of Mandatory Convertible Debentures.*                                                                                          |
|   |   |                                                                                                                                 |
| 10.9   |   | Correspondent  Trust Services Agreement with Northern Trust Company.*                                                                |
|   |   |                                                                                                                                 |
| 10.10  |   | Stock  Option Plan, as amended.*                                                                                                     |
|   |   |                                                                                                                                 |
| 10.11  |   | Form  of Stock Option Agreement.*                                                                                                    |
|   |   |                                                                                                                                 |
| 10.12  |   | 1998  Directors’ Deferred Compensation Plan.*                                                                                   |
|   |   |                                                                                                                                 |
| 10.13  |   | Employment  Agreement between the Company and Edwin N. Clift.                                                                        |
|   |   |                                                                                                                                 |
| 10.14  |   | Employment  Agreement between the Company and William P. Lucy.                                                                       |
|   |   |                                                                                                                                 |
| 10.15  |   | Employment  Agreement between the Company and Deborah A. Jordan.                                                                     |
|   |   |                                                                                                                                 |
| 13     |   | Annual  Report to Shareholders for the Year Ended December 31, 2003.                                                            |
|   |   |                                                                                                                                 |
| 14     |   | Code  of Ethics                                                                                                                      |
|   |   |                                                                                                                                 |
| 21     |   | Subsidiaries  of the Registrant                                                                                                      |
|   |   |                                                                                                                                 |
| 23     |   | Consent  of Berry, Dunn, McNeil & Parker.                                                                                        |
|   |   |                                                                                                                                 |
| 31.1   |   | Certifications  pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934.                                                   |
|   |   |                                                                                                                                 |
| 32.1   |   | Certifications  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002. |

 

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| *  |   | Incorporated  by reference to the Company’s Registration Statement on Form SB-2 (File No.  333-56197), and any amendments thereto filed with the Securities and Exchange  Commission. |
|----|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** |   | Incorporated  by reference to the Company’s Form 10-KSB for the year ended  December 31, 2001.                                                                                   |

 

24

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(c)                                  Reports on Form 8-K.

 

None.

 

**ITEM 14.****                                          ****PRINCIPAL ACCOUNTANT FEESAND SERVICES**

 

The following information in the ProxyStatement is herein incorporated by reference: “Ratification of Appointment ofIndependent Public Accountants” on page 10 of the Proxy Statement.

 

25

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**SIGNATURES**

 

In accordance with Section 13 or 15(d) of the Exchange Act, theregistrant caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 

**MERRILL MERCHANTS BANCSHARES, INC.**

 
| By:    |                                    | /s/  Edwin N. Clift |   | March 18, 2004 |   |
|--------|-----------------------------------------|---------------------|--------|---------------------|--------|
|   | *President and Chief Executive Officer* |                |

 

In accordance with the Exchange Act, this report has been signed belowby the following persons on behalf of the registrant and in the capacities andon the dates indicated.

 
| **Name**                               |   | **Title**                                |   | **Date**            |
|----------------------------------------|--------|------------------------------------------|--------|---------------------|
|                                   |   |                                     |   |                |
| /s/  Edwin N. Clift                    |   | Director,  President and Chief           |   | March 18, 2004 |
| Edwin  N. Clift                        |   | Executive  Officer (Principal            |   |                |
|                                   |   | executive  officer)                      |   |                |
|                                   |   |                                     |   |                |
| /s/  Deborah A. Jordan                 |   | Treasurer  (Principal financial officer) |   | March 18, 2004 |
| Deborah  A. Jordan                     |   |                                     |   |                |
|                                   |   |                                     |   |                |
| /s/  William C. Bullock, Jr.           |   | Chairman  of the Board                   |   | March 18, 2004 |
| William  C. Bullock, Jr.               |   |                                     |   |                |
|                                   |   |                                     |   |                |
| /s/  Joseph H. Cyr                     |   | Director                                 |   | March 18, 2004 |
| Joseph  H. Cyr                         |   |                                     |   |                |
|                                   |   |                                     |   |                |
| /s/  Perry B. Hansen                   |   | Director                                 |   | March 18, 2004 |
| Perry  B. Hansen                       |   |                                     |   |                |
|                                   |   |                                     |   |                |
| /s/  Robert E. Knowles                 |   | Director                                 |   | March 18, 2004 |
| Robert  E. Knowles                     |   |                                     |   |                |
|                                   |   |                                     |   |                |
| /s/  Frederick A. Oldenburg, Jr., M.D. |   | Director                                 |   | March 18, 2004 |
| Frederick  A. Oldenburg, Jr., M.D.     |   |                                     |   |                |
|                                   |   |                                     |   |                |
| /s/  Lloyd D. Robinson                 |   | Director                                 |   | March 18, 2004 |
| Lloyd  D. Robinson                     |   |                                     |   |                |
|                                   |   |                                     |   |                |
| /s/  Dennis L. Shubert, M.D., Ph.D.    |   | Director                                 |   | March 18, 2004 |
| Dennis  L. Shubert, M.D., Ph.D.        |   |                                     |   |                |
|                                   |   |                                     |   |                |
| /s/  Susan B. Singer                   |   | Director                                 |   | March 18, 2004 |
| Susan  B. Singer                       |   |                                     |   |                |

 

26

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