** **

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

**WASHINGTON, D. C. 20549**

 

**FORM 10-KSB**

 

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

 

**For thefiscal year ended December 31, 2002**

 

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

 

**MERRILL MERCHANTS BANCSHARES, INC.**

(Name of Small Business Issuer 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 by Section 13 or15(d) of the Exchange Act during the past 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject 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 orinformation statements incorporated by reference in Part III of this Form10-KSB or any amendment to this Form 10-KSB. o

 

Therevenues for the issuer’s fiscal year ended December 31, 2002 are $22,270,000.

 

Statethe aggregate 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, as of a specified date within the last 60 days. On January 31, 2003:$32,966,000.

 

Statethe number of shares outstanding of each of the issuer’s classes of commonequity, as of the latest practicable date. The Company had 3,161,547 sharesoutstanding as of January 31, 2003.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portionsof the definitive proxy statement pursuant to Regulation 14A, which wasdelivered to the Commission for filing on March 4, 2003, and the 2002 AnnualReport to Shareholders for the fiscal year ended December 31, 2002, areincorporated by reference into Part II and III of this report.

 

TransitionalSmall Business Disclosure Format (check one):

Yeso    Noý

 

 

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| **TABLE OF CONTENTS** |
|-----------------------|
|                  |
| **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 |
| **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. | CONTROLS AND  PROCEDURES |
|                  |   |   |
| **SIGNATURES**        |

** **

**Forward Looking Statements**

 

ThisAnnual Report on Form 10-KSB contains certain forward looking statements consistingof estimates with respect to the financial condition, results of operations andbusiness of the Bank and the Company that are subject to various factors whichcould cause actual results to differ materially from these estimates.  These factors include: changes in general,economic and market conditions, or the development of an adverse interest rateenvironment that adversely affects the interest rate spread or other incomeanticipated from the Bank’s or the Company’s operations and investments.  We undertake no obligation to publiclyupdate forward looking statements, whether as a result of new information,future events or otherwise.

 

**Critical Accounting Policies**

Management’s discussion and analysis of the Company’s financialcondition are based on the consolidated financial statements which are preparedin accordance with accounting principles generally accepted in the UnitedStates.  The preparation of suchfinancial statements requires management to make estimates and assumptions thataffect the reported amounts of assets, liabilities, revenues and expenses andrelated disclosure of contingent assets and liabilities.  On an ongoing basis, management evaluatesits estimates, including those related to the allowance for loan losses.  Management bases its estimates on historicalexperience and on various other assumptions that are believed to be reasonableunder the circumstances, the results of which form the basis in makingjudgments about the carrying values of assets that are not readily apparent fromother sources.  Actual results coulddiffer from the amount derived from management’s estimates and assumptionsunder different assumptions or conditions.

 

Management believes the allowance for loan losses is a criticalaccounting policy that requires the most significant estimates and assumptionsused in the preparation of the consolidated financial statements.  The allowance for loan losses is based onmanagement’s evaluation of the level of the allowance required in relation tothe estimated loss exposure in the loan portfolio.  Management believes the allowance for loan losses is asignificant estimate and therefore regularly evaluates it for adequacy bytaking into consideration factors such as prior loan loss experience, thecharacter and size of the loan portfolio, business and economic conditions andmanagement’s estimation of potential losses. The use of different estimates or assumptions could produce differentprovisions for loan losses.  Refer tothe discussion of Allowance for Loan Losses in the Business Section and Notes 5of the Notes to Consolidated Financial Statements for a detailed description ofmanagement’s estimation process and methodology related to the allowance forloan losses.

 

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**PART I**

 

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

 

**General**

 

MerrillMerchants Bancshares, Inc. (the “Company”), a Maine corporation organized inMarch 1992, is a registered bank holding company under the Bank Holding CompanyAct of 1956, as amended (“BHCA”).  TheCompany is also a registered financial holding company under the BHCA. InOctober 1992, the Company became the bank holding company for Merrill MerchantsBank (the “Bank”) and holds 100% of the Bank’s outstanding common stock (the“Bank Stock”).  In January 1999, the Companyestablished Maine Acceptance Corporation (“MAC”), a finance company.  Effective March 29, 2002, MAC was mergedinto the Bank.  The Company, through itsownership of the Bank, is engaged in a general commercial and retail bankingbusiness, along with trust and investment services.  Unless the context otherwise requires, references herein to theCompany shall include the Company, the Bank, and MAC, on a consolidated basis.

 

TheCompany is an entity legally separate and distinct from the Bank.  The Company’s sources of income and cashflow are derived from dividends paid on the Bank Stock, tax benefits receivedby the Company and earnings from amounts deposited by the Company in interestbearing accounts and investments.

 

TheBank was established in 1992 to purchase assets and assume liabilities ofcertain branch banking offices formerly held by a large out of state bank.  Merrill Merchants Bank is headquartered inBangor, Maine, which is located 76 miles north of Augusta, Maine, the statecapital.  Presently, the Bank maintainseleven banking offices (collectively, the “Branch Banks”) in nine areacommunities.  The three Bangor officesprovide city-wide convenience and are complemented by: (i) an office in Brewer,Bangor’s sister city located on the eastern shore of the Penobscot River; (ii)a branch in Orono, home of the University of Maine, the State’s flagshipcampus; (iii) a branch in Pittsfield, a small rural town of 4,000 peoplelocated about 30 miles southwest of Bangor; (iv) a convenience store branch inOrrington which serves as a satellite office to the Brewer Branch; (v) aconvenience store branch in Milford which serves as a satellite office to theOrono 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 18 ATM locations in its primary market area.

 

TheBank conducts a general commercial and retail banking business that includesthe acceptance of deposits from the general public and the application of thosefunds to the origination of a variety of commercial loans, commercial andresidential real estate loans and consumer loans.  As of December 31, 2002, the Company had total assets of $307.3million, loans, net of allowances, of $211.4 million, total deposits of $238.9million and shareholders’ equity of $28.4 million.  The Bank also established a Trust and Investment ServicesDepartment, which has grown since inception in April 1994 to $237.2 million inassets under management as of December 31, 2002.

 

TheBank’s income is derived principally from interest and fees earned inconnection 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”).

 

1

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*Community Banking Strategy*

 

Havingidentified the need for community banking services in its market area, the Bankhas worked to position itself as a service-oriented community bank.  The Bank is staffed by experiencedmanagement personnel, all of whom reside in the area and who know the Bank’scustomers 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 largerfinancial institutions.  The Bank hasfocused on fostering banking relationships with customers which includemultiple financial services that range from basic checking to investmentmanagement accounts.

 

Asa part of this strategy, the Company and the Bank have attracted local businesspeople, who actively promote the Bank in the community, to serve on theirBoards of Directors.  In an effort tobroaden the community’s awareness of the Bank and attract new business, theCompany has also obtained additional investments in and support for the Companyfrom local investors.

 

TheBank is active in small business lending and has earned the designation“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’s affiliationswith third party vendors have enabled the Bank to deliver sophisticatedproducts such as Internet banking, automated telephone banking, and checkimaging while maintaining a local, friendly flavor in its Branch Banks.  This same strategy has been implemented bythe Trust and Investment Services Department which is also serving many clientswho appreciate the personal attention and customer service providedlocally.  The depository custodyservices and investment advisory services provided by the Trust Department aresupported through its affiliation with The Northern Trust Company.

 

*Market Area and Competition*

 

TheBank’s primary market area, Greater Bangor, is at the center of commercialactivity for the northeastern and central region of the State of Maine.  Nearly 100,000 people live in the Bank’sprimary market area.  The Bank is partof a strategic link to Canada, as Bangor is the closest U.S. metropolitan areato 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 largestfields of employment in the metropolitan Bangor region.  Bangor is also a healthcare center forcentral, eastern and northern Maine.  TheCity is a regional financial center and is also serviced by several statewideand regional accounting firms, law firms, insurance companies and security andinvestment firms.  Bangor is also a hubfor government services, with many local, state and federal offices locatedwithin the city.  Bangor is accessibleby multiple 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.

 

Thefinancial services landscape has changed considerably over the past five yearsin the Bank’s primary market area, Greater Bangor.  Two large out-of-state banks have continued to experience localchange as a result of mergers and acquisitions at the regional and nationallevel.  The State’s largest Maine-basedbank, with a strong presence in the local market, has also experiencedconsiderable change as it has acquired greater market share throughacquisitions in-state and out-of-state. A large locally-based bank has expanded its line of financial servicesand 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.

 

Overthe past decade, due to more liberal interstate banking laws, northeastern andcentral Maine has seen an increase in acquisitions of locally-owned Maine-basedbanks, including Maine-based banks in the Bank’s primary market area, bynon-local entities.  It has been theobservation of the Company’s management that these acquisitions often result incustomer dissatisfaction as the decision-making on loans, marketing, and otheraspects of the acquired banks’ businesses is shifted from local bank managementpossessing independent decision-making power to management operating underpolicies and guidelines from corporate headquarters in other states.  The Company believes that this shift oftenresults in delayed decision-making by management which is not familiar with theneeds of the acquired 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 a bank in theBank’s primary market area with local management having decision-making powerand emphasizing loans to small and medium sized businesses and toindividuals.  The Bank has concentratedon extending business loans to such customers in the Bank’s primary market areaand to extending trust services to clients with accounts of all sizes.  The Bank’s management also makes decisionsbased upon, among other things, the knowledge of the Bank’s employees regardingthe communities and customers in the Bank’s primary market area.  The individuals employed by the Bank, to alarge extent, reside near the Branch Banks and thus are generally familiar withthe Branch Banks’ communities and customers. This is important in local decision-making and allows the Bank torespond to customer questions and concerns on a timely basis and fostersquality customer service.

 

TheTrust and Investment Services Department of the Bank has taken advantage ofopportunities created as the larger banks have altered their personal servicecommitment 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 attorneys as well as investment and employee benefitsprofessionals with trust and banking experience.

 

TheBank has worked and will continue to work to position itself to be competitivein its market area.  The Bank’s abilityto make decisions close to the marketplace, management’s commitment toproviding quality banking products, the caliber of the professional staff, andthe community involvement of the Bank’s employees are all factors affecting theBank’s ability to be competitive.  Ifthe Company and the Bank are unable to compete successfully, however, thebusiness and operations could be adversely affected.

 

*Employees*

 

Asof December 31, 2002, the Company had 107 full-time employees and 16 part-timeemployees.  The employees are notrepresented by a collective bargaining unit.

 

*Lending Activities*

 

TheBank has experienced loan growth since it was established in October 1992.  One of the primary factors contributing tothe growth has been an experienced local lending group.  Many commercial lending relationships havebeen developed by the Bank as a result of long standing business associationsover many years.  Many of the Bank’sofficers have held lending positions with Bangor area banks for in excess oftwenty years.  Management believes thatthese relationships have not only been instrumental in loan growth but also indeveloping quality customers.

 

3

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TheCompany strives to provide a full range of financial products and services tosmall and medium sized businesses and consumers.  The Bank has an established Officer Loan Committee which meetsweekly to review and approve credits and a Director Loan Committee which meetsbi-monthly, or as necessary, to approve credits in excess of $250,000.  The Bank’s loan mix is subject to thediscretion of its Board of Directors and the demands of the localmarketplace.  Management has establishedrelationships with local area legal and accounting professionals to cultivatereferrals.  Asset quality is a toppriority for the Bank and a significant consideration in business developmentefforts.

 

*Commercial and Commercial Real Estate Lending*

 

Loansin this category principally include loans to service, retail, medical,wholesale and light manufacturing businesses. Commercial loans are made based on the management, financial strengthand repayment ability of the borrower. As of December 31, 2002, commercial and commercial real estate loansrepresented the largest class of loans at $125.2 million or 58% of totalloans.  The Bank participates ingovernment guaranteed lending including programs with the Finance Authority ofMaine (FAME) and Rural Development (RD).  The Bank is a leading lender in the State of Maine for the SmallBusiness Administration.

 

TheBank’s commercial real estate loans are ordinarily made at variable rates ofinterest, and amortized up to fifteen years, although some loans are originatedfor shorter terms at fixed rates of interest. A broad range of short-to-medium term commercial loans, bothcollateralized and uncollateralized, are made available to businesses forworking capital (including inventory and receivables), business expansion(including improvements of real estate) and the purchase of equipment andmachinery.  The purpose of a particularloan generally determines its structure. The commercial real estate loans are secured by a variety of properties,including buildings occupied by small-to-medium sized businesses, apartmentcomplexes and non-owner/user office and retail business.

 

TheBank’s commercial loans primarily are underwritten in the Bank’s primary marketarea on the basis of the borrowers’ ability to service such debt fromincome.  Many of these loans involvelines of credit written at variable rates of interest on a demand basis, or forterms not exceeding one year, while others are written on a term basistypically for up to five years, generally at variable rates of interest.  As a general practice, the Bank takes as collaterala security interest in any available real estate, equipment or other chattelalthough 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.

 

Commercialloans generally present a higher level of risk than one-to-four-familyresidences due to the concentration of principal in a limited number of loansand borrowers, the effect of general economic considerations on commercialproperties and the increased difficulty of evaluating and monitoring thesetypes of loans.  In addition, therepayment of loans secured by commercial real estate is typically dependent onthe successful operation of the related business activities.

 

*Residential Mortgage Lending*

 

TheBank endeavors to meet the needs of its individual customers by makingresidential 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, thereal estate normally constitutes the primary collateral.

 

Loansin this category include both portfolio loans which are held by the Bank untilmaturity 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.

 

Asof December 31, 2002, residential loans accounted for a total of $40.4 millionrepresenting 19% of total loans.  TheBank’s secondary market servicing portfolio totaled $95.1 million at December31, 2002.

 

TheBank offers one-year ARMs with rate adjustments tied to the weekly average rateof U.S. Treasury securities adjusted to a constant one-year maturity withspecified 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 of fixed-rateand adjustable-rate loan originations depends in large part on the level ofinterest rates.  As interest rates fall,there is generally a reduced demand for ARMs and, as interest rates rise, thereis generally an increased demand for ARMs.

 

Fixedand adjustable rate mortgage loans collateralized by single family residentialreal estate generally have been originated in amounts of no more than 80% ofappraised value.  However, in someinstances, the Bank may lend in excess of 80% of the value of the propertycollateralizing the loan.  The Bank, inmost cases, requires title, fire and extended casualty insurance to be obtainedby the borrower, and, where required by applicable regulations, floodinsurance.  The Bank maintains its ownerrors and omissions insurance policy to protect against loss in the event offailure of a mortgagor to pay premiums on fire and other hazard insurancepolicies.  Although the contractual loanpayment period for single family residential real estate loans is generally fora 15 to 30 year period, such loans often remain outstanding for significantlyshorter periods than their contractual terms. The Bank charges no penalty for prepayment of mortgage loans.  Mortgage loans originated by the Bankcustomarily include a “due on sale” clause giving the Bank the right to declarea loan immediately due and payable in the event, among other matters, that theborrower sells or otherwise disposes of the real property subject to a mortgage. In general, the Bank enforces due onsale clauses.

 

*Construction Lending*

 

The Companyoriginates construction loans to individuals for the construction of one- tofour-family residences and to businesses for owner-occupancy. Residential andcommercial 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, 2002, construction loans totaled $13.4million representing 6% 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*

 

TheCompany originates home equity loans on a fixed and variable interest ratebasis.  At December 31, 2002, fixed-rateloans totaled $9.0 million and variable-rate loans amounted to $10.9 million.  Fixed-rate loans are for terms of 5 to 15years with monthly amortization required and interest rates ranging from 6.75%to 12.5%.  Interest rates onvariable-rate loans range from prime to 2.0% over the prime interest rate.  These home equity loans are generallysecured by a second mortgage on the principal residential property.

 

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*Consumer Lending*

 

Consumerloans made by the Bank have included home improvement, automobile, boat andrecreational vehicle loans, credit cards and overdraft protectionaccounts.  The Bank’s consumer loanportfolio consists primarily of loans to individuals for various consumerpurposes.  A majority of these loans arefor terms of less than 60 months and although generally collateralized by lienson various personal assets of the borrower may be made uncollateralized.  Consumer loans are made at fixed andvariable interest rates.

 

MaineAcceptance Corporation (MAC), a finance company which opened for business inBangor on March 1, 1999, provides indirect auto and recreational vehicle lending,as well as other types of direct loans, including personal unsecured,recreational vehicle, auto, mobile home and home equity loans.  Effective March 29, 2002, MAC was mergedinto the Bank.

 

Consumerloans are attractive to the Company because they typically have a shorter termand carry higher interest rates than those charged on other types ofloans.  Consumer loans, however, do poseadditional risks of collectibility when compared to traditional types of loansgranted by commercial banks, such as residential mortgage loans.  In many instances, the Company is requiredto rely on the borrower’s ability to repay since the collateral may be ofreduced value at the time of collection. Accordingly, the initial determination of the borrower’s ability to repayis of primary importance in the underwriting of consumer loans.

 

Consumerloans totaled approximately $15.9 million and represented 7% of the Company’sloan portfolio at December 31, 2002. Such loans bear interest at fixed rates ranging from 5% to 17%.

 

*M&M Joint Venture*

 

In1996, the Bank and MSB Leasing, Inc. (a subsidiary of Machias Savings Bank, astate chartered mutual savings bank) formed M&M Consulting LimitedLiability 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 thirty otherfinancial institutions in northern New England access to experienced individualswho are highly trained in loan review, regulatory compliance, training andinternal auditing in a cost-efficient and timely manner.

 

*Lending Activities*

 

Thefollowing table summarizes the composition of the Bank’s loan portfolio by typeof loan at the dates indicated:

 

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

 
|                           |   | **At  December 31,**        |    |
|--------------------------------|--------|-----------------------------|---------|
|                           |   | **2002**                    |    | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                           |   | **Amount**                  |    | **%** |   | **Amount** |   | **%** |   | **Amount** |   | **%** |   | **Amount** |   | **%** |   | **Amount** |   | **%** |   |
|                           |   | **(Dollars  in thousands)** |    |
| Real Estate                    |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial                     |   | $                           | 70,247  |   | 33 | % | $ | 69,209 |   | 37 | % | $ | 59,277 |   | 36 | % | $ | 49,161 |   | 36 | % | $ | 48,896 |   | 38 | % |
| Construction                   |   | 13,379                      |    | 6 | % | 6,678 |   | 4 | % | 4,623 |   | 3 | % | 1,937 |   | 2 | % | 1,833 |   | 1 | % |
| Residential                    |   | 40,362                      |    | 19 | % | 35,040 |   | 19 | % | 26,112 |   | 16 | % | 23,390 |   | 17 | % | 22,279 |   | 18 | % |
| Home equity                    |   | 19,889                      |    | 9 | % | 17,675 |   | 9 | % | 18,830 |   | 11 | % | 18,054 |   | 13 | % | 19,362 |   | 15 | % |
| Total real estate              |   | 143,877                     |    | 67 | % | 128,602 |   | 69 | % | 108,842 |   | 66 | % | 92,542 |   | 68 | % | 92,370 |   | 72 | % |
| Commercial                     |   | 54,920                      |    | 26 | % | 43,533 |   | 23 | % | 42,459 |   | 25 | % | 33,686 |   | 25 | % | 28,322 |   | 22 | % |
| Consumer                       |   | 15,932                      |    | 7 | % | 15,945 |   | 8 | % | 14,622 |   | 9 | % | 9,994 |   | 7 | % | 6,963 |   | 6 | % |
| Total loans                    |   | $                           | 214,729 |   | 100 | % | $ | 188,080 |   | 100 | % | $ | 165,923 |   | 100 | % | $ | 136,222 |   | 100 | % | $ | 127,655 |   | 100 | % |
| Less allowance for loan losses |   | (3,295                      | )       |   |   | (2,986 | ) |   |   | (2,658 | ) |   |   | (2,274 | )  |   |   | (2,023 | )  |   |   |
| Total                          |   | $                           | 211,434 |   |   |   | $ | 185,094 |   |   |   | $ | 163,265 |   |   |   | $ | 133.948 |   |   |   | $ | 125,632 |   |   |   |

 

 

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Thefollowing table sets forth as of December 31, 2002, commercial and constructionloans 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.

 

**Loan Maturity Schedule**

 
|                                                       |   | **At  December 31, 2002**      |       |
|------------------------------------------------------------|--------|--------------------------------|------------|
|                                                       |   | **Due in one  year or less**   |       | **Due after  one year  but before 5 years** |   | **Due after 5  years** |   | **Total** | ** ** |
|                                                       |   | **(Dollars in thousands****)** | ** ** |
| Commercial                                                 |   | $                              | 31,516     |   | $ | 18,146 |   | $ | 5,258 |   | $ | 54,920 |   |
| Construction                                               |   | 13,379                         |       | — |   | — |   | 13,379 |   |
|                                                       |   |                           |       |   |   |   |   |   |   |
| Commercial and construction loans maturing after one year: |   |                           |       |   |   |   |   |   |   |
| Predetermined interest rates                               |   | $                              | 6,722      |   |   |   |   |   |   |   |
| Floating or adjustable interest rates                      |   | 16,682                         |       |   |   |   |   |   |   |
| Total                                                      |   | $                              | 23,404     |   |   |   |   |   |   |   |
|                                                            |        |                                |            |  |  |  |  |  |  |  |  |  |  |

 

The following is a summaryof non-performing assets at the dates indicated:

 

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

 
|                                                                              |   | **At December 31,**         |   |
|-----------------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                              |   | **2002**                    |   | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                                                                              |   | **(Dollars  in thousands)** |   |
| Loans:                                                                            |   |                        |   |   |   |   |   |   |   |   |   |
| Non-accrual loans                                                                 |   | $                           | 432    |   | $ | 432 |   | $ | 421 |   | $ | 266 |   | $ | 148 |   |
| Loans 90 days or more pastdue but still accruing                                  |   | 37                          |   | 75 |   | 104 |   | — |   | 4 |   |
| Restructured loans                                                                |   | 132                         |   | — |   | — |   | — |   | — |   |
| Non-performing loans                                                              |   | 601                         |   | 507 |   | 525 |   | 266 |   | 152 |   |
| OREO and repossessed assets                                                       |   | 165                         |   | 221 |   | 90 |   | 50 |   | 12 |   |
|                                                                              |   |                        |   |   |   |   |   |   |   |   |   |
| Non-performing assets                                                             |   | $                           | 766    |   | $ | 728 |   | $ | 615 |   | $ | 316 |   | $ | 164 |   |
| Non-performing loans as a percentage of total  loans                              |   | 0.28                        | %      | 0.27 | % | 0.32 | % | 0.19 | % | 0.12 | % |
| Non-performing assets as a percentage of total  assets                            |   | 0.25                        | %      | 0.26 | % | 0.25 | % | 0.15 | % | 0.08 | % |
| Non-performing assets as a percentage of total  loans and OREO/repossessed assets |   | 0.36                        | %      | 0.39 | % | 0.37 | % | 0.23 | % | 0.13 | % |

 

AtDecember 31, 2002, loans on non-accrual status totaled $432,000. Interestincome not recognized on non-accrual loans was $36,000 in 2002.  There was no interest income recognized onnon-accrual loans in 2002.

 

7

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*Adversely Classified Assets*

 

TheBank’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.

 

AtDecember 31, 2002, the Bank had $2.7 million of loans that were classified assubstandard and $480,000 classified as doubtful.  This compares to $2.9 million and $203,000 of loans that wereclassified as substandard and doubtful, respectively, at December 31, 2001.  The Bank had no loans which were classifiedas loss at either date.  Totalclassified loans as a percentage of total loans decreased to 1.5% at December31, 2002 from 1.6% at December 31, 2001. Delinquent loans may or may not be adversely classified depending uponmanagement’s judgment with respect to each individual loan.  As of December 31, 2002 and 2001, theportion of loans guaranteed by either the SBA, RD or FAME for each yearamounted to 28% and 16%, respectively, of the total loan balances adverselyclassified.  At December 31, 2002,included in the $3.2 million of loans that were classified as substandard anddoubtful were $2.7 million of performing loans.  This compares to $3.1 million of adversely classified performingloans as of December 31, 2001.  Theseamounts constitute loans that, in the opinion of management, could potentiallymigrate to non-performing or loss status.

 

8

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*Allowance for Loan Losses*

 

Thefollowing table sets forth activity in the Company’s allowance for loan lossesduring the years indicated:

 

**Summary of Loan Loss Experience**

 
|                                                    |   | **Year Ended December 31,** |    |
|---------------------------------------------------------|--------|-----------------------------|---------|
|                                                    |   | **2002**                    |    | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                                                    |   | **(Dollars in  thousands)** |    |
| Total net loans outstanding at the end of year(1)       |   | $                           | 211,434 |   | $ | 185,094 |   | $ | 163,265 |   | $ | 133,948 |   | $ | 125,632 |   |
| Average net loans outstanding during the year(1)        |   | $                           | 198,120 |   | $ | 171,692 |   | $ | 150,553 |   | $ | 127,595 |   | $ | 119,144 |   |
| Allowance for loan losses, beginning of year            |   | $                           | 2,986   |   | $ | 2,658 |   | $ | 2,274 |   | $ | 2,023 |   | $ | 1,717 |   |
| Loans charged off during the period:                    |   |                        |    |   |   |   |   |   |   |   |   |
| Real estate:                                            |   |                        |    |   |   |   |   |   |   |   |   |
| Commercial                                              |   | —                      |    | — |   | — |   | (66 | ) | — |   |
| Residential                                             |   | —                      |    | — |   | — |   | — |   | (20 | ) |
| Home equity                                             |   | —                      |    | (20 | ) | (14 | ) | — |   | (7 | ) |
| Commercial                                              |   | (28                         | )       | (65 | ) | (9 | ) | (10 | ) | (20 | ) |
| Consumer                                                |   | (161                        | )       | (99 | ) | (42 | ) | (49 | ) | (31 | ) |
| Total                                                   |   | (189                        | )       | (184 | ) | (65 | ) | (125 | ) | (78 | ) |
| Recoveries of loans previously charged off:             |   |                        |    |   |   |   |   |   |   |   |   |
| Real estate:                                            |   |                        |    |   |   |   |   |   |   |   |   |
| Commercial                                              |   | —                      |    | — |   | — |   | — |   | — |   |
| Residential                                             |   | 27                          |    | 22 |   | 22 |   | 22 |   | 22 |   |
| Home equity                                             |   | —                      |    | — |   | — |   | — |   | — |   |
| Commercial                                              |   | 5                           |    | 1 |   | 1 |   | 7 |   | — |   |
| Consumer                                                |   | 13                          |    | 15 |   | 3 |   | 2 |   | 2 |   |
| Total                                                   |   | 45                          |    | 38 |   | 26 |   | 31 |   | 24 |   |
| Net loans charged off during the year                   |   | (144                        | )       | (146 | ) | (39 | ) | (94 | ) | (54 | ) |
| Provisions charged to income statement                  |   | 453                         |    | 474 |   | 423 |   | 345 |   | 360 |   |
| Allowance for loan losses, end of year                  |   | $                           | 3,295   |   | $ | 2,986 |   | $ | 2,658 |   | $ | 2,274 |   | $ | 2,023 |   |
| Ratios:                                                 |   |                        |    |   |   |   |   |   |   |   |   |
| Net charge-offs to average loans outstanding            |   | 0.07                        | %       | 0.08 | % | 0.03 | % | 0.07 | % | 0.04 | % |
| Net charge-offs to loans, end of period                 |   | 0.07                        | %       | 0.08 | % | 0.02 | % | 0.07 | % | 0.04 | % |
| Allowance for loan losses to average loans  outstanding |   | 1.64                        | %       | 1.71 | % | 1.74 | % | 1.75 | % | 1.67 | % |
| Allowance for loan losses to loans, end of year         |   | 1.53                        | %       | 1.59 | % | 1.60 | % | 1.67 | % | 1.58 | % |
| Allowance for loan losses to non-performing loans       |   | 548.25                      | %       | 588.95 | % | 506.29 | % | 854.89 | % | 1330.92 | % |

 

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(1)Excludes loans held for sale.

 

The provisionfor loan losses was $453,000 for the twelve month period ended December 31,2002 and $474,000 for the same period ended December 31, 2001. The allowancefor loan losses was $3.3 million at December 31, 2002, which was an increase of$309,000 or 10% over the amount at December 31, 2001.

 

9

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The following table setsforth the breakdown of the allowance for loan losses by loan category for theperiods indicated.  Management believesthat the allowance can be allocated by category only on an approximatebasis.  The allocation of an allowanceto each category is not necessarily indicative of future losses and does notrestrict the use of the allowance to absorb losses in any other category.

 
|                                    |   | **At December 31,**        |        |
|-----------------------------------------|--------|----------------------------|-------------|
|                                    |   | **2002**                   |        | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                                    |   | **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) |   | $                          |  1,881 |   | 58 | % | $ |  1,574 |   | 60 | % | $ |  1,321 |   | 61 | % | $ |  1,111 |   | 61 | % | $ |  999 |   | 60 | % |
| Construction                            |   | 67                         |        | 6 | % | 33 |   | 4 | % | 23 |   | 3 | % | 10 |   | 2 | % | 9 |   | 1 | % |
| Residential                             |   | 361                        |        | 19 | % | 285 |   | 19 | % | 223 |   | 16 | % | 122 |   | 17 | % | 120 |   | 18 | % |
| Home equity                             |   | 248                        |        | 9 | % | 220 |   | 9 | % | 236 |   | 11 | % | 179 |   | 13 | % | 193 |   | 15 | % |
| Consumer                                |   | 460                        |        | 8 | % | 424 |   | 8 | % | 310 |   | 9 | % | 272 |   | 7 | % | 179 |   | 6 | % |
| Off-Balance Sheet                       |   | 278                        |        | — |   | 212 |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Unallocated                             |   | —                     |        | — |   | 238 |   | — |   | 545 |   | — |   | 580 |   | — |   | 523 |   | — |   |
| Total allowance for loan losses         |   | $                          |  3,295 |   | 100 | % | $ |  2,986 |   | 100 | % | $ |  2,658 |   | 100 | % | $ |  2,274 |   | 100 | % | $ |  2,023 |   | 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.

 

TheCompany recognizes that credit losses will be experienced and the risk of losswill vary with, among other things, general economic conditions; the type ofloan being made; the creditworthiness of the borrower over the term of theloan; and in the case of a collateralized loan, the quality of the collateralfor such loan. The allowance for loan losses represents the Company’s estimateof the allowance necessary to provide for probable incurred losses in theportfolio. In making this determination, the Company analyzes the ultimatecollectibility of the loans in its portfolio, incorporating feedback providedby lenders, an independent loan review function, and information provided byexaminations performed by regulatory agencies. The Company makes an evaluationas to the adequacy of the allowance for loan losses on a quarterly basis.  At December 31, 2002, although management ofthe Company believes that the allowance for loan losses is appropriate, futureadjustments may be necessary if economic conditions, real estate values andother factors differ substantially from the current operating environment.

 

Ona quarterly basis, an analysis of the adequacy of the loan loss reserve isreviewed by the Board of Directors.  Theanalysis of the allowance for loan losses is comprised of three components:specific credit allocation, general portfolio allocation, and subjectivedetermined allocation.

 

Thespecific credit allocation is established where management has identifiedsignificant conditions or circumstances related to a credit that managementbelieves indicate the probability that a loss has been incurred.  Specific allowances include a detailedreview of each impaired loan in accordance with Statement of FinancialAccounting Standards (SFAS) No. 114, “Accounting by Creditors for Impairment ofa Loan,” and SFAS No. 118, “Accounting by Creditors for Impairment of aLoan-Income Recognition and Disclosures” and an allocation is made based onthis analysis.  At December 31, 2002,loans totaling $333,000 had specific allowances of $33,000 compared with loanbalances of $439,000 at December 31, 2001 which had specific allowances of$172,000.

 

Thegeneral portfolio allocation is calculated by applying loss factors tooutstanding loans and outstanding commitments based on internal credit ratingof those loans.  Changes in creditratings affect the amount of the general allowance.  Loss factors for credit rated and pooled loans are based onhistorical loss experience and long-term industry benchmarks for lossesadjusted for significant factors that, in management’s judgment, affect thecollectibility of the portfolio as of the evaluation date.  Such factors are derived based upon thecollective wisdom and experience of management, examiners and auditors and areadjusted based on past experience, current economic conditions and trends inthe portfolio.  At December 31, 2002 and2001, the general allowance totaled $3.3 million and $2.6 million,respectively.

 

10

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Theunallocated portion of the allowance for loan losses was eliminated at December31, 2002 and amounted to $238,000 at December 31, 2001.  Management determined that the unallocatedportion of the allowance was not necessary due to consistent credit qualityperformance including past due trends, charge-off history and risk ratingclassifications.

 

Theallowance for loan losses is based on estimates, and ultimate losses will varyfrom current estimates. These estimates are reviewed quarterly, and asadjustments, either positive or negative, become necessary, a correspondingincrease or decrease is made in the provision for loan losses.

 

Becausesome loans may not be repaid in full, an allowance for loan and losses isrecorded. Increases to the allowance are recorded by a provision for loanlosses charged to expense. Estimating the risk of the loss and the amount ofloss 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, generaleconomic conditions, information about specific borrower situations includingtheir financial position and collateral values, and other factors and estimateswhich are subject to change over time. While management may periodicallyallocate portions of the allowance for specific problem loan situations, theentire allowance is available for any loan charge-offs that occur. A loan ischarged off against the allowance by management as a loss when deemeduncollectible, although collection efforts continue and future recoveries mayoccur.

 

*Investment Activities*

 

TheCompany’s investment portfolio serves three important functions: first, itenables the adjustment of the balance sheet’s sensitivity to changes ininterest 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.

 

Thecomposition of the investment portfolio as of December 31, 2002 was 34% U.S.Treasury notes and U.S. Government agencies and corporations, 49%mortgage-backed securities and collateralized mortgage obligations and 17%other securities.  The comparabledistributions for December 31, 2001 were 25% U.S. Treasury notes and U.S.Government agencies and corporations, 54% mortgage-backed securities andcollateralized mortgage obligations and 21% other securities.

 

11

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

 

**Investment Securities Portfolio Composition**

 
|                                                              |   | **At December 31,**         |   |
|-------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                              |   | **2002**                    |   | **2001** |   | **2000** |   |
|                                                              |   | **(Dollars in  thousands)** |   |
| Securities available for sale(1):                                 |   |                        |   |   |   |   |   |
| U.S. Treasury securities                                          |   | $                           | — |   | $ | 1,030 |   | $ | 7,017 |   |
| U.S. Government agencies and corporations                         |   | 11,750                      |   | 17,376 |   | 16,866 |   |
| Mortgage-backed securities and collateralizedmortgage obligations |   | 33,660                      |   | 38,684 |   | 28,382 |   |
| State and local government debt securities                        |   | 2,925                       |   | 5,254 |   | 2,514 |   |
| Certificates of deposit                                           |   | 4,158                       |   | 4,457 |   | 3,663 |   |
| U.S. Government and agency money marketfunds                      |   | 11,935                      |   | 3,130 |   | — |   |
| Other securities(2)                                               |   | 4,439                       |   | 1,676 |   | 1,244 |   |
|                                                              |   |                        |   |   |   |   |   |
| Total                                                             |   | $                           | 68,867 |   | $ | 71,607 |   | $ | 59,686 |   |

 

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(1)                                  Carried at estimated market value.

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

 

**Maturity Schedule of Securities Available for Sale**

 
|                                                               |   | **At  December 31, 2002  (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                          |   | $                                            | 3,424  |   | 6.27 | % | $ | 8,326 |   | 3.99 | % | $ | — |   | — |   | $ | — |   | — |   | $ | 11,750 |   | 4.65 | % |
| Mortgage-backed securities and collateralized mortgage obligations |   | —                                       |   | — |   | 497 |   | 6.89 | % | 12,780 |   | 4.65 | % | 20,383 |   | 5.22 | % | 33,660 |   | 5.03 | % |
| States and local government debt securities                        |   | 565                                          |   | 4.19 | % | 1,054 |   | 6.54 | % | 1,140 |   | 7.24 | % | 166 |   | 7.18 | % | 2,925 |   | 6.40 | % |
| Certificates of deposit                                            |   | 2,673                                        |   | 2.66 | % | 1,485 |   | 2.64 | % | — |   | — |   | — |   | — |   | 4,158 |   | 2.65 | % |
| U.S. Government and agency money market funds                      |   | 11,935                                       |   | 1.59 | % | — |   | — |   | — |   | — |   | — |   | — |   | 11,935 |   | 1.59 | % |
| Other securities                                                   |   | 4,439                                        |   | 3.37 | % | — |   | — |   | — |   | — |   | — |   | — |   | 4,439 |   | 3.37 | % |
| Total                                                              |   | $                                            | 23,036 |   | 2.81 | % | $ | 11,362 |   | 4.17 | % | $ | 13,920 |   | 4.86 | % | $ | 20,549 |   | 5.24 | % | $ | 68,867 |   | 4.17 | % |

 

----

(1)                                  Yield is adjusted for the effect of tax-exemptsecurities assuming a Federal tax rate of 34%. Yield is calculated using amortized cost.

 

12

----

 

*Deposit Activities*

 

Thefollowing table sets forth the average balances and weighted average rates forthe Bank’s categories of deposits for the periods indicated:

 

**Average Deposit Balances and Rates**

 
|                    |   | **Year Ended December 31,** |    |
|-------------------------|--------|-----------------------------|---------|
|                    |   | **2002**                    |    | **2001** |   | **2000** |   |
|                    |   | **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   |   | $                           | 35,917  |   | — |   | 16 | % | $ | 32,284 |   | — |   | 16 | % | $ | 29,234 |   | — |   | 16 | % |
| Interest checking       |   | 28,628                      |    | 0.65 | % | 13 | % | 26,548 |   | 1.74 | % | 13 | % | 21,170 |   | 2.07 | % | 12 | % |
| Money market            |   | 32,203                      |    | 1.77 | % | 14 | % | 22,665 |   | 3.01 | % | 11 | % | 16,971 |   | 4.51 | % | 9 | % |
| Savings                 |   | 42,428                      |    | 1.41 | % | 19 | % | 37,383 |   | 2.88 | % | 19 | % | 42,037 |   | 3.95 | % | 23 | % |
| Certificates of deposit |   | 87,393                      |    | 4.18 | % | 38 | % | 82,160 |   | 5.52 | % | 41 | % | 74,223 |   | 5.82 | % | 40 | % |
|                    |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total                   |   | $                           | 226,569 |   |   |   | 100 | % | $ | 201,040 |   |   |   | 100 | % | $ | 183,635 |   |   |   | 100 | % |

 

TheBank does not have a concentration of deposits from any one source, the loss ofwhich would have a material adverse effect on the business of the Bank.  Management believes that substantially allthe Bank’s depositors are residents in its primary market area except for $20.8million in brokered deposits at December 31, 2002.

 

Thefollowing table summarizes at December 31, 2002 the Bank’s certificates ofdeposit (CD) of $100,000 or more and brokered CD’s by time remaining untilmaturity:

 
|                                  |   | **December 31, 2002**       |   |
|---------------------------------------|--------|-----------------------------|--------|
|                                  |   | **(Dollars in  thousands)** |   |
| Maturity Period:                      |   |                        |   |
| Less than three months                |   | $                           | 6,402  |   |
| Over three months through six months  |   | 2,117                       |   |
| Over six months through twelve months |   | 4,012                       |   |
| Over twelve months                    |   | 25,112                      |   |
| Total                                 |   | $                           | 37,643 |   |

 

*Short-Term Borrowings*

 

Theborrowings utilized by the Bank primarily have been securities sold underagreements to repurchase. Other short-term borrowings generally include federalfunds purchased, FHLB advances, treasury, tax and loan deposits andinterest-bearing demand notes due to the U.S. Treasury, which are repaid uponnotification by the U.S. Treasury.

 

13

----

 

The following table setsforth certain information regarding securities sold under agreement torepurchase for the dates indicated:

 
|                                                         |   | **At or for the  Year Ended December 31,** |   |
|--------------------------------------------------------------|--------|--------------------------------------------|--------|
|                                                         |   | **2002**                                   |   | **2001** |   | **2000** |   |
|                                                         |   | **(Dollars in thousands)**                 |   |
| Average balances outstanding                                 |   | $                                          | 17,096 |   | $ | 16,453 |   | $ | 13,055 |   |
| Maximum amount outstanding at any month -end during the year |   | $                                          | 19,428 |   | $ | 23,539 |   | $ | 15,930 |   |
| Balance outstanding at end of year                           |   | $                                          | 19,236 |   | $ | 19,138 |   | $ | 14,168 |   |
| Weighted average rate during the year                        |   | 1.40                                       | %      | 3.21 | % | 4.69 | % |
| Weighted average rate at end of year                         |   | 1.07                                       | %      | 1.59 | % | 4.82 | % |

 

**Federal and State Taxation**

 

*General*

 

TheCompany, the Bank and MAC file a consolidated federal income tax return on afiscal year basis.  Consolidated returnshave the effect of eliminating intercompany distributions, including dividendsand inter-company interest income and expense, from the computation ofconsolidated 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.

 

*Federal Income Taxation*

 

Althoughthe Bank’s income tax liability is determined under provisions of the InternalRevenue Code of 1986, as amended (the “Code”), which is applicable to alltaxpayers or corporations, Sections 581 through 597 of the Code applyspecifically to financial institutions.

 

Thetwo primary areas in which the treatment of financial institutions differ fromthe treatment of other corporations under the Code are in the areas of bondgains and losses and bad debt deductions. Bond gains and losses generated from the sale or exchange of portfolioinstruments are generally treated for financial institutions as ordinary gainsand losses as opposed to capital gains and losses for other corporations, asthe Code considers bond portfolios held by banks to be inventory in a trade orbusiness rather than capital assets. Banks are allowed a statutory method for calculating a reserve for baddebt deductions.  Based on the assetsize of the Bank, it is permitted to maintain a bad debt reserve calculated onan experience method, based on charge-offs for the current and preceding fiveyears or a  “grandfathered” base yearreserve, if larger.

 

*State and Local Taxation*

 

TheCompany on a consolidated basis is subject to a separate state franchise tax inlieu of state corporate income tax.  Theamount of the tax is the sum of 1% of Maine net income and $.08 per $1,000 ofMaine assets as defined in Maine law. Maine assets are the corporation’s total end of the year assets asreported on the federal income tax return. Maine net income is the corporation’s net income or loss as reported onthe federal income tax return which is apportioned to Maine under Maine law.

 

14

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**SUPERVISION AND REGULATION**

 

Bankholding companies and state banks are extensively regulated under both federaland state law.  These laws andregulations 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**

 

OnNovember 12, 1999, President Clinton signed into law the Gramm-Leach-BlileyFinancial Services Modernization Act of 1999 (the “Act”), federal legislationintended to modernize the financial services industry by establishing acomprehensive framework to permit affiliations among commercial banks,insurance companies, securities firms and other financial service providers.

 

Underthe Act, bank holding companies may elect to be regulated as financial holdingcompanies.  Financial holding companiesmay engage in activities that are financial in nature or incidental orcomplementary to activities which are financial in nature.  Bank holding companies 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

 

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

 

TheCompany filed an election to be treated as a financial holding company with theFederal Reserve Bank of Boston in March 2001. As a result, the Company is currently regulated as a financial holdingcompany. As a financial holding company, the Company may conduct thoseactivities which are considered financial in nature under a new section 4(k) ofthe 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 or securities;

 

•                  Underwriting and sellinginsurance;

 

•                  Providingfinancial, investment, or advisory services;

 

•                  Selling pools of assets;

 

•                  Underwriting,dealing in, or making a market 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, inorder to commence a new activity Merrill Merchants Bank must have received a “satisfactory” on its latestCRA exam.

 

15

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**The USA PATRIOT Act**

 

Inresponse to the events of September 11th, President George W. Bushsigned into law the Uniting and Strengthening America by Providing AppropriateTools Required to Intercept and Obstruct Terrorism Act of 2002, or the USAPATRIOT Act, on October 26, 2002.  TheUSA PATRIOT Act gives the federal government new powers to address terroristthreats through enhanced domestic security measures, expanded surveillancepowers, increased information sharing, and broadened anti-money launderingrequirements.  By way of amendments tothe Bank Secrecy Act, Title III of the USA PATRIOT Act takes measures intendedto encourage information sharing among bank regulatory agencies and lawenforcement bodies.  Further, certainprovisions of Title III impose affirmative obligations on a broad range offinancial institutions, including banks, thrifts, brokers, dealers, creditunions, money transfer agents and parties registered under the CommodityExchange Act.

 

Amongother requirements, Title III of the USA PATRIOT Act imposes the followingrequirements with respect to financial institutions:

 

•                  Pursuant to Section 352, *all* financial institutions must establishanti-money laundering programs that include, at minimum: (i) internal policies,procedures, and controls, (ii) specific designation of an anti-money launderingcompliance officer, (iii) ongoing employee training programs, and (iv) an independentaudit function to test the anti-money laundering program.  Rules promulgated under this Section are dueby April 24, 2002.

 

•                  Section 326 of the Act authorizes theSecretary of the Department of Treasury, in conjunction with other bankregulators, to issue regulations by October 26, 2002 that provide for minimumstandards with respect to customer identification at the time new accounts areopened.

 

•                  Section 312 of the Act requires financialinstitutions that establish, maintain, administer, or manage private bankingaccounts or correspondent accounts in the United States for non-United Statespersons or their representatives (including foreign individuals visiting theUnited States) to establish appropriate, specific, and, where necessary,enhanced due diligence policies, procedures, and controls designed to detectand report money laundering.  Rulespromulgated under this Section are due by April 24, 2002, to be effective byJuly 23, 2002.

 

•                  EffectiveDecember 25, 2002, financial institutions are prohibited from establishing,maintaining, administering or managing correspondent accounts for foreign shellbanks (foreign banks that do not have a physical presence in any country), andwill be subject to certain recordkeeping obligations with respect to correspondentaccounts 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*

 

Asa bank holding company and financial holding company, the Company is subject tothe regulation and supervision of the Federal Reserve under the BHCA.  The Company is also subject to theregulation 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

 

16

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beforeacquiring more than 5% of the voting shares of a Maine financial institution orof any financial institution holding company which directly or indirectlycontrols a Maine financial institution. Under certain circumstances, the Company may be required to obtainFederal Reserve Board approval before redeeming any of its equity securities inan amount in excess 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 and Preferred Stock may be considered an unsafe or unsoundpractice by the Federal Reserve Board.

 

Beforeany “company,” as defined in the BHCA, may acquire “control,” as defined in theBHCA, over the Company, the prior approval of the Federal Reserve Boardgenerally is required.  In addition,before any individual or entity which is not required to seek prior approvalfrom the Federal Reserve Board may acquire control of the Company, prior noticeto the Federal Reserve Board generally is required.  Similarly, notice to and approval by the Maine Superintendent ofthe Bureau of Financial Institutions is required before any “financial institutionholding company,” as defined in the Maine Banking Code, may acquire more than5% of a Maine financial institution or Maine financial institution holdingcompany.

 

TheBank is also subject to continued regular supervision and examination by applicablefederal and state banking agencies.  TheBank is a Maine state-chartered bank that is a member of the Federal ReserveSystem.  The Federal Reserve exercisesprimary supervision over the Bank through periodic examination.  The Bank is also subject to regulation bythe FDIC as well as the Maine Bureau of Financial Institutions.  The FDIC has authority to terminateinsurance for accounts pursuant to procedures established for that purpose.  The Bank must comply with variousrequirements 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.

 

*Payment of Dividends*

 

TheCompany 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.

 

Inaddition to the statutory prohibition against the withdrawal of any portion ofthe Bank’s capital and certain statutory limitations on the payment ofdividends, under Maine law, the Bank may not pay dividends if it is insolventor 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.

 

Thepayment of dividends by any state bank that is a member of the Federal ReserveSystem is affected by the requirement to maintain adequate capital pursuant tothe capital adequacy guidelines issued by the Federal Reserve Board.   The regulations and restrictions ondividends paid by the Bank may limit the Company’s ability to obtain funds fromsuch dividends for its cash needs, including funds for payment of operatingexpenses, and dividends on the Common Stock.

 

If,in the opinion of the applicable federal bank regulatory authority, adepository institution or holding company is engaged in or is about to engagein an unsafe or unsound practice (which, depending on the financial

 

17

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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”), a FDIC-insured depository institution maynot pay any dividend if payment would cause it to become undercapitalized oronce it is undercapitalized.  See“FDICIA.”

 

Thepayment of dividends by the Company and the Bank also may be affected orlimited by other factors, such as the requirement to maintain adequate capitalabove regulatory guidelines.

 

*Transactions With Affiliates and Insiders*

 

TheBank is subject to Section 23A of the Federal Reserve Act, which places limitson the amount of loans or extensions of credit to, or investments in, orcertain other transactions with, affiliates, including the Company.  In addition, limits are placed on the amountof advances to third parties collateralized by the securities or obligations ofaffiliates.  Most of these loans andcertain other transactions must be secured in prescribed amounts.  The Bank is also subject to Section 23B ofthe Federal Reserve Act, which, among other things, prohibits an institutionfrom engaging in transactions with certain affiliates unless the transactionsare on terms substantially the same, or at least as favorable to suchinstitution or its subsidiaries, as those prevailing at the time for comparabletransactions with non-affiliated companies. Regulation W, a comprehensive regulation governing transactions withaffiliates, becomes effective April 1, 2003.

 

*Capital Adequacy*

 

Thefederal banking agencies have adopted risk-based capital guidelines forbanks and bank holding companies.  Theminimum guideline for the ratio of total capital to risk-weighted assets(“Total Risk Based Capital” ratio) for “adequately capitalized” institutions is8%.  The minimum adequate capitalizationguideline for the ratio of Tier 1 Capital to risk-weighted assets (“Tier 1 RiskBased Capital” ratio) is 4%.

 

Inaddition, the federal banking agencies have established minimum leverage ratioguidelines for banks and bank holding companies.  Their guidelines provide for a minimum ratio of Tier 1 Capital toaverage assets, less goodwill and certain other intangible assets (the“Leverage Ratio”), of 3% for banks that meet certain specific criteria and 4%for other institutions.  The Company’sLeverage Ratio at December 31, 2002 was 9.18%. Failure to meet capital guidelines could subject a bank to a variety ofenforcement remedies, including the termination of deposit insurance by theFDIC, and to certain restrictions on its business.  See “FDICIA.”

 

Thefollowing table sets forth capital ratios required by the Federal Reserve to bemaintained by the Company in order for the Company to be adequatelycapitalized, and the Company’s actual ratios of capital to total regulatory orrisk-weighted assets, as applicable, at December 31, 2002.

 
|                     |   | **Company Regulatory  Minimum** |   | **Company** |   | **Bank** |   |
|--------------------------|--------|---------------------------------|--------|-------------|--------|----------|--------|
| Tier 1 capital           |   | 4.00                            | %      | 13.10       | %      | 10.55    | %      |
| Total risk-based capital |   | 8.00                            | %      | 14.35       | %      | 11.80    | %      |

 

*FDICIA*

 

TheFDICIA requires the federal banking regulators to take “prompt correctiveaction” in respect of FDIC ­insured depository institutions that do not meetminimum capital requirements.  The FDICIAestablished

 

18

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fivecapital tiers: “well capitalized,” “adequately capitalized,”“undercapitalized,” “significantly undercapitalized” and “criticallyundercapitalized.” An FDIC-insured depository institution is well capitalizedif it maintains a Leverage Ratio of at least 5%, a risk adjusted Tier 1 CapitalRatio of at least 6% and a Total Capital Ratio of at least 10% and is notsubject to a directive, order or written agreement to meet and maintain specificcapital levels.  An insured depository****institution is defined to be adequately****capitalized if it meets all of its minimumcapital requirements as described above. In addition, an insured depository institution will be consideredundercapitalized if it fails to meet any minimum required measure,significantly undercapitalized if it is significantly below any such measureand critically undercapitalized if it fails to maintain a level of tangibleequity equal to not less than 2% of total assets.  An insured depository institution may be deemed to be in acapitalization category that is lower than is indicated by its actual capitalposition if it receives an unsatisfactory examination rating.

 

Thecapital-based prompt corrective action provisions of FDICIA and theirimplementing regulations apply to FDIC-insured depository institutionsand are not directly applicable to holding companies which control suchinstitution.  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.

 

FDICIAgenerally prohibits an FDIC-insured depository institution from making anycapital distribution (including payment of dividends) or paying any managementfee to its holding company if the depository institution would thereafter beundercapitalized.

 

TheCompany and the Bank, at December 31, 2002 and 2001, were “well capitalized”under the criteria discussed above.

 

*FDIC Insurance Premiums*

 

TheBank is required to pay semiannual FDIC deposit insurance assessments.  Each financial institution is assigned toone of three capital groups -- well capitalized, adequatelycapitalized or undercapitalized -- and further assigned to one ofthree subgroups within a capital group, on the basis of supervisory evaluationsby the institution’s primary federal and, if applicable, state supervisors andother information relevant to the institution’s financial condition and therisk posed to the FDIC deposit insurance fund. The actual assessment rate applicable to a particular institution (andany applicable refund) will, therefore, depend in part upon the risk assessmentclassification so assigned to the institution by the FDIC.  The FDIC is authorized by federal law toraise insurance premiums in certain circumstances.  Any increase in premiums would have an adverse effect on the Bankand the Company’s earnings.  Under theFDIA, insurance of deposits may be terminated by the FDIC upon a finding thatthe institution has engaged in unsafe and unsound practices, is in an unsafe orunsound condition to continue operations or has violated any applicable law,regulation, rule, order or condition imposed by a federal bank regulatoryagency.

 

*Interstate Banking*

 

Theacquisition by the Company of more than 5% of the outstanding voting securitiesor substantially all of the assets of a bank located outside of the State ofMaine is regulated by the BHCA.  Suchacquisition is also subject to the law of the state in which the bank to beacquired is located.  Under certaincircumstances, the Company might not be permitted to acquire an interest inanother bank located outside Maine. Further, any company attempting to acquire control of the Company or theBank also may be subject to certain limitations on interstate banking.  Even assuming that the law of the state inwhich the bank is located permits acquisition, the Maine Banking Code requiresprior approval of the Superintendent of the Bureau of Financial Institutionsfor certain acquisitions of more than 5% of a financial institution havingoperations conducted outside of Maine.

 

Thestatus of interstate banking legislation adopted by individual states has beenin a constant state of

 

19

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change in recent years.  Whilefederal law has substantially liberalized interstate banking, a number ofstates have adopted some form of legislation which limits interstate banking bybank 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 registeredwith the SEC under Section 12(g) of the Securities Exchange Act of 1934, asamended (the “Exchange Act”). Accordingly, the Company is subject to the information, proxysolicitation, insider trading restrictions and other requirements of theExchange Act.

 

*Sarbanes-Oxley Act*

 

On July 30,2002, President George W. Bush signed into law the Sarbanes-Oxley Act of2002.  The Sarbanes-Oxley Act implementsa broad range of corporate governance and accounting measures for publiccompanies designed to promote honesty and transparency in corporate America andbetter protect investors from the type of corporate wrongdoing that occurred inEnron, WorldCom and similar companies. The Sarbanes-Oxley Act’s principal legislation includes:

 

•                                          thecreation of an independent accounting oversight 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;

 

•                                          an increase the oversight of, and enhancementof certain requirements relating to audit committees of public companies andhow they interact with the company’s independent auditors.

 

20

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•                                          requirement that audit committee members mustbe independent and are absolutely barred from accepting consulting, advisory orother compensatory fees from the issuer;

 

•                                          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  oninsider  trading during pension blackoutperiods;

 

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

 

•                                          disclosure of a code of ethics and filing aForm 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 we anticipate that we will incur additional expense incomplying with the provisions of the Sarbanes-Oxley Act and the resultingregulations, management does not expect that such compliance will have amaterial impact on our 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.

 

21

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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, 2002,the Company’s properties and leasehold improvements had an aggregate net bookvalue 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         |   | 2001             |   | —                               |
| Holden, Maine04492                                      |   |          |   |             |   |                                 |
|                                                    |   |          |   |             |   |                                 |
| 58 Elm  Street                                          |   | Leased        |   | 2002             |   | 2003                                 |
| 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        |   | 2001             |   | 2020                                 |
| Milford,  Maine  04461                             |   |          |   |             |   |                                 |
|                                                    |   |          |   |             |   |                                 |
| **Operations:**                                         |   | Leased        |   | 1996             |   | 2016                                 |
| 359 Perry  Road                                         |   |          |   |             |   |                                 |
| Bangor,  Maine 04401                                    |   |          |   |             |   |                                 |

 

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(1)  Lease expiration datesassume all options to extend lease term are exercised.

 

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

 

Although the Bank and the Company, from time to time, are involved invarious legal proceedings in the normal course of business, there are nomaterial legal proceedings to which the Bank or the Company, its directors orits officers is a party or to which any of its property is subject as of thedate of this Form 10-KSB for the fiscal year ended December 31, 2002.

 

22

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**ITEM 4.**** ****SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

None.

 

**PART II**

 

**ITEM5. ****                                              ****MARKET FOR THE COMPANY’S COMMON STOCK AND RELATED**

**STOCKHOLDER  MATTERS**

 

The following information included in the Merrill Merchants Bancshares,Inc. 2002 Annual Report to Stockholders (the “Annual Report”) is incorporatedherein by reference: “Market for Common Stock” on page 13 of the Annual Report.

 

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

 

The following information included in the Annual Report is incorporatedherein by reference: “Selected Financial Highlights” on page 1 and“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” on pages 6 through 13 of the Annual Report.

 

**ITEM7. ****                                              ****FINANCIAL STATEMENTS**

 

The following information included in the Annual Report is incorporatedherein by reference: “Audited Financial Statements and Notes to ConsolidatedFinancial Statements”****on pages 14through 31 of the Annual Report.

 

**ITEM8. ****                                              ****CHANGES AND DISAGREEMENTSWITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

None.

** **

**PART III**

 

**ITEM9. ****                                              ****DIRECTORS AND PRINCIPALOFFICERS OF THE COMPANY; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT**

 

The following information included in the Company’s 2003 ProxyStatement for the 2003 Annual Meeting of Shareholders (“Proxy Statement”) isincorporated herein by reference: “Election of Directors of Merrill MerchantsBancshares, Inc.,”  “ExecutiveOfficers,” and “Section 16(a) Beneficial Ownership Reporting Compliance” onpages 6, 14 and 19 of the Proxy Statement.

 

**ITEM10. ****                                       ****EXECUTIVE COMPENSATION**

 

The following information included in the Proxy Statement isincorporated herein by reference: “Remuneration of Directors and Officers,” and“Interests in Certain Transactions” on pages 13 through 18 of the ProxyStatement.

 

**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 ProxyStatement.

 

23

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The following table sets forth the aggregate information for theCompany’s equity compensation plans in effect at December 31, 2002.

 
|                                                        |   | **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)  |   | 279,333                                                                                                                                    |   | $ | 7.32 |   | 8,445 |   |
| Equity compensation plans not approved by security  holders |   | 0                                                                                                                                          |   | N/A |   | 0 |   |
| Total                                                       |   | 279,333                                                                                                                                    |   | $ | 7.32 |   | 8,445 |   |

 

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(1)       Consists of the 1993 Plan.  Adescription of the plan and additional information is included in the AnnualReport on page 21 and page 28.  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.

 

**ITEM12. ****                                       ****CERTAIN RELATIONSHIPS ANDRELATED TRANSACTIONS**

 

The following information included in the Proxy Statement isincorporated herein by reference:“Interests in Certain Transactions” on page 18of the Proxy Statement.

 

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

 

(a)                                  The following financial statements includedin the 2002 Annual Report are incorporated herein by reference:

 

Consolidated Statements of Financial Condition —  December 31, 2002 and 2001;

Consolidated Statements of Income — Years Ended December 31, 2002 and2001;

Consolidated Statements of Changes in Shareholders Equity — December31, 2002 and 2001;

Consolidated Statements of Cash Flows — Years Ended December 31, 2002and 2001; and

Notes to Consolidated Financial Statements — Years Ended December 31,2002 and 2001.

 

(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.*             |

 

24

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| 10.5   |   | Form of Life Insurance  Endorsement Method Split Dollar Plan Agreement.*      |
|--------|--------|-------------------------------------------------------------------------------|
|   |   |                                                                          |
| 10.6   |   | Form of Unfunded Deferred  Compensation 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.*                            |
|   |   |                                                                          |
| 13     |   | Annual Report to  Shareholders for the Year Ended December 31, 2002.          |
|   |   |                                                                          |
| 21     |   | Subsidiaries of the  Registrant                                               |
|   |   |                                                                          |
| 23     |   | Consent of Berry Dunn  McNeil & Parker.                                   |
|   |   |                                                                          |
| 99.1   |   | 2003 Proxy Statement.  (previously filed on March 4, 2003).                   |
|   |   |                                                                          |
| 99.2   |   | CEO Certification pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002. |
|   |   |                                                                          |
| 99.3   |   | CFO Certification pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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* Incorporated by reference to the Company’s Registration Statement onForm SB-2 (File No. 333-56197), and any amendments thereto filed with theSecurities and Exchange Commission.

 

** Incorporated by reference to the Company’s Form 10-KSB for the yearended December 31, 2001.

 

(c)                                  Reports on Form 8-K.

 

None.

 

**ITEM14. ****                                       ****CONTROLS AND PROCEDURES**

 

During the 90-day period prior to the filing date of this report,management, including the Company’s President and Chief Executive Officer, andExecutive Vice President and Treasurer, evaluated the effectiveness of thedesign and operation of the Company’s disclosure controls and procedures.  Based upon and as of the date of thatevaluation, the President and Chief Executive Officer and Executive VicePresident and Treasurer concluded that the disclosure controls and procedureswere effective, in all material respects, to ensure that information requiredto be disclosed in the reports the Company files and submits under the ExchangeAct is recorded, processed, summarized and reported as and when required.

 

There have been no significant changes in the Company’s internalcontrols or in other factors  whichcould significantly affect internal controls subsequent to the date the Companycarried out its evaluation.  There wereno significant deficiencies or material weaknesses identified in the evaluationand therefore, no corrective actions were taken.

 

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**SIGNATURES**

 

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

 

**MERRILL MERCHANTS BANCSHARES, INC.**

 
| By:    | /s/ Edwin N. Clift                       |   |
|--------|------------------------------------------|--------|
|   | *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 21, 2003 |
| Edwin N. Clift                              |   | Executive Officer (Principal  executive officer) |   |           |
|                                        |   |                                             |   |           |
|  /s/ Deborah A. Jordan                 |   | Treasurer (Principal  financial officer)         |   | March 21, 2003 |
| Deborah A. Jordan                           |   |                                             |   |           |
|                                        |   |                                             |   |           |
|  /s/ William C. Bullock, Jr.           |   | Chairman of the Board                            |   | March 21, 2003 |
| William C. Bullock, Jr.                     |   |                                             |   |           |
|                                        |   |                                             |   |           |
|  /s/ Joseph H. Cyr                     |   | Director                                         |   | March 21, 2003 |
| Joseph H. Cyr                               |   |                                             |   |           |
|                                        |   |                                             |   |           |
|  /s/ Perry B. Hansen                   |   | Director                                         |   | March 21, 2003 |
| Perry B. Hansen                             |   |                                             |   |           |
|                                        |   |                                             |   |           |
|  /s/ Robert E. Knowles                 |   | Director                                         |   | March 21, 2003 |
| Robert E. Knowles                           |   |                                             |   |           |
|                                        |   |                                             |   |           |
|  /s/ Frederick A. Oldenburg, Jr., M.D. |   | Director                                         |   | March 21, 2003 |
| Frederick A. Oldenburg,  Jr., M.D.          |   |                                             |   |           |
|                                        |   |                                             |   |           |
|  /s/ Lloyd D. Robinson                 |   | Director                                         |   | March 21, 2003 |
| Lloyd D. Robinson                           |   |                                             |   |           |
|                                        |   |                                             |   |           |
|  /s/ Dennis L. Shubert, M.D., Ph.D.    |   | Director                                         |   | March 21, 2003 |
| Dennis L. Shubert, M.D.,  Ph.D.             |   |                                             |   |           |
|                                        |   |                                             |   |           |
|  /s/ Susan B. Singer                   |   | Director                                         |   | March 21, 2003 |
| Susan B. Singer                             |   |                                             |   |           |

 

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**CERTIFICATIONS**

 

I, Edwin N. Clift, certifythat:

1.                                       I have reviewed this annual report on Form10-KSB of Merrill Merchants Bancshares, Inc.;

2.                                       Based on my knowledge, this annual reportdoes not contain any untrue statement of a material fact or omit to state amaterial fact necessary to make the statements made, in light of thecircumstances under which such statements were made, not misleading withrespect to the period covered by this annual report; and

3.                                       Based on my knowledge, the financialstatements, and other financial information included in this annual report,fairly present in all material respects the financial condition, results ofoperations and cash flows of the registrant as of, and for, the periodspresented in this annual report.

4.                                       The registrant’s other certifying officersand I are responsible for establishing and maintaining disclosure controls andprocedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for theregistrant and have:

(a)                                  Designed such disclosure controls andprocedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this annual report isbeing prepared;

(b)                                 Evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this annual report (the “Evaluation Date”); and

(c)                                  Presented in this annual report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

5.                                       The registrant’s other certifying officersand I have disclosed, based on our most recent evaluation, to the registrant’sauditors and the audit committee of the registrant’s board of directors (orpersons performing the equivalent function):

(a)                                  All significant deficiencies in the design oroperation of internal controls which could adversely affect the registrant’sability to record, process, summarize and report financial data and haveidentified for the registrant’s auditors any material weaknesses in internalcontrols; and

(b)                                 Any fraud, whether or not material, thatinvolves management or other employees who have a significant role in theregistrant’s internal controls; and

6.                                       The registrant’s other certifying officersand I have indicated in this annual report whether or not there were significantchanges in internal controls or in other factors that could significantlyaffect internal controls subsequent to the date of our most recent evaluation,including any corrective actions with regard to significant deficiencies andmaterial weaknesses.

 
| Date:  March 21, 2003 |   | /s/ Edwin N. Clift                     |
|----------------------------|--------|----------------------------------------|
|                       |   | Edwin N. Clift                         |
|                       |   | President and Chief  Executive Officer |

 

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I, Deborah A. Jordan,certify that:

1.                                       I have reviewed this annual report on Form10-KSB of Merrill Merchants Bancshares, Inc.;

2.                                       Based on my knowledge, this annual reportdoes not contain any untrue statement of a material fact or omit to state amaterial fact necessary to make the statements made, in light of thecircumstances under which such statements were made, not misleading withrespect to the period covered by this annual report; and

3.                                       Based on my knowledge, the financialstatements, and other financial information included in this annual report,fairly present in all material respects the financial condition, results ofoperations and cash flows of the registrant as of, and for, the periodspresented in this annual report.

4.                                       The registrant’s other certifying officersand I are responsible for establishing and maintaining disclosure controls andprocedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for theregistrant and have:

(a)                                  Designed such disclosure controls andprocedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this annual report isbeing prepared;

(b)                                 Evaluated the effectiveness of theregistrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this annual report (the “Evaluation Date”); and

(c)                                  Presented in this annual report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date;

5.                                       The registrant’s other certifying officersand I have disclosed, based on our most recent evaluation, to the registrant’sauditors and the audit committee of the registrant’s board of directors (orpersons performing the equivalent function):

(a)                                  All significant deficiencies in the design oroperation of internal controls which could adversely affect the registrant’sability to record, process, summarize and report financial data and haveidentified for the registrant’s auditors any material weaknesses in internalcontrols; and

(b)                                 Any fraud, whether or not material, thatinvolves management or other employees who have a significant role in theregistrant’s internal controls; and

6.                                       The registrant’s other certifying officersand I have indicated in this annual report whether or not there weresignificant changes in internal controls or in other factors that couldsignificantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 
| Date:  March 21, 2003 |   | /s/ Deborah A. Jordan                   |
|----------------------------|--------|-----------------------------------------|
|                       |   | Deborah A. Jordan                       |
|                       |   | Executive Vice President  and Treasurer |

 

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