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

**WASHINGTON, D. C. 20549**

 

**FORM 10-KSB**

 

**ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE**

**SECURITIES EXCHANGE ACT OF 1934**

 

**For thefiscal year ended December 31, 2001**

 

**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)*                                                   |

 

Check whether the issuer (1)filed all reports required to be filed by Section 13 or 15(d) of the ExchangeAct during the past 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.   Yes  ý    No o

 

Check if there is nodisclosure of delinquent filers in response to Item 405 of Regulation S-B isnot contained in this form, and no disclosure will be contained, to the best ofregistrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-KSB or any amendment tothis Form 10-KSB.  o

 

The revenues for theissuer’s fiscal year ended December 31, 2001 are $22,801,000.

 

State the aggregate marketvalue of the voting and non-voting common equity held by non-affiliatescomputed by reference to the price at which the common equity was sold, as of aspecified date within the last 60 days. On January 31, 2002: $22,105,000.

 

State the number of sharesoutstanding of each of the issuer’s classes of common equity, as of the latestpracticable date. The Company had 2,670,545 shares outstanding as of January31, 2002.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portions of the definitiveproxy statement pursuant to Regulation 14A, which was delivered to theCommission for filing on March 15, 2002, and the 2001 Annual Report toShareholders for the fiscal year ended December 31, 2001, are incorporated byreference into Part II and III of this report.

 

Transitional Small Business Disclosure Format(check one):

Yes  o    No ý

 

 

**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                                                              |
| **SIGNATURES** |     |

 

**ForwardLooking Statements**

 

ThisAnnual Report on Form 10-KSB contains certain forward looking statementsconsisting of estimates with respect to the financial condition, results ofoperations and business of the Bank and the Company that are subject to variousfactors which could cause actual results to differ materially from theseestimates.  These factors include:changes in general, economic and market conditions, or the development of anadverse interest rate environment that adversely affects the interest ratespread or other income anticipated from the Bank’s or the Company’s operationsand investments.  We undertake noobligation to publicly update forward looking statements, whether as a resultof new information, future events or otherwise.

 

**CriticalAccounting Policies**

 

Management’sdiscussion and analysis of the Company’s financial condition are based on theconsolidated financial statements which are prepared in accordance withaccounting principles generally accepted in the United States.  The preparation of such financial statementsrequires management to make estimates and assumptions that affect the reportedamounts of assets, liabilities, revenues and expenses and related disclosure ofcontingent assets and liabilities.  Onan ongoing basis, management evaluates its estimates, including those relatedto the allowance for loan losses. Management bases its estimates on historical experience and on variousother assumptions that are believed to be reasonable under the circumstances,the results of which form the basis in making judgments about the carryingvalues of assets that are not readily apparent from other sources.  Actual results could differ from the amountderived from management’s estimates and assumptions under different assumptionsor conditions.

 

Managementbelieves the allowance for loan losses is a critical accounting policy thatrequires the most significant estimates and assumptions used in the preparationof the consolidated financial statements. The allowance for loan losses is based on management’s evaluation of thelevel of the allowance required in relation to the estimated loss exposure inthe loan portfolio.  Management believesthe allowance for loan losses is a significant estimate and therefore regularlyevaluates it for adequacy by taking into consideration factors such as priorloan loss experience, the character and size of the loan portfolio, businessand economic conditions and management’s estimation of potential losses.  The use of different estimates or assumptionscould produce different provisions for loan losses.  Refer to the discussion of Allowance for Loan Losses in theBusiness Section and Notes 5 of the Notes to Consolidated Financial Statementsfor a detailed description of management’s estimation process and methodologyrelated to the allowance for loan losses.

 

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**PART I**

 

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

 

**General**

 

Merrill Merchants Bancshares, Inc. (the“Company”), a Maine corporation organized in March 1992, is a registered bankholding company under the Bank Holding Company Act of 1956, as amended(“BHCA”).  The Company is also aregistered Financial Holding Company under BHCA. In October 1992, the Companybecame the bank holding company for Merrill Merchants Bank (the “Bank”) andholds 100% of the Bank’s outstanding common stock (the “Bank Stock”).  In January 1999, the Company establishedMaine Acceptance Corporation (“MAC”), a finance company.  The Company, through its ownership of theBank and MAC, is engaged in a general commercial and retail banking business,along with trust and investment services. Unless the context otherwise requires, references herein to the Companyshall 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, interest received fromloans to MAC, tax benefits received by the Company and earnings from amountsdeposited by the Company in interest bearing 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, 2001, the Company had total assets of $278.2million, loans, net of allowances, of $185.1 million, total deposits of $219.3million and shareholders’ equity of $26.0 million.  The Bank also established a Trust and Investment ServicesDepartment, which has grown since inception in April 1994 to $234.8 million inassets under management as of December 31, 2001.

 

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 Bankfrom 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 market.  The Company’saffiliations with third party vendors have enabled the Bank to deliversophisticated products such as Internet banking, automated telephone banking,and check imaging while maintaining a local, friendly flavor in its BranchBanks.  This same strategy has beenimplemented by the Trust and Investment Services Department which is alsoserving many clients who appreciate the personal attention and customer serviceprovided locally.  The depositorycustody services and investment advisory services provided by the TrustDepartment are supported through its affiliation with The Northern TrustCompany.

 

*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. The City is a regional financial center and is also serviced by severalstatewide and regional accounting firms, law firms, insurance companies andsecurity and investment firms.  Bangoris also a hub for government services, with many local, state and federaloffices located within the city.  Bangoris accessible by multiple exits from Interstate 95, a major interstate highwaywhich transits the eastern seaboard of the United States.  Major routes to all regions of the statebisect Bangor from various directions. Bangor International Airport provides domestic and internationalpassenger and cargo service for a significant portion of the state.  The Bank has targeted this same area as itsfocus for possible expansion of the franchise. Any such expansion would occur with carefully selected de novo branchingor taking advantage of opportunities created as the large regional banks consolidateand sell or close branches.

 

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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to the same regulatoryrestrictions as the Company and the Bank. Interstate banking also could intensify competition if out of stateinstitutions increasingly take advantage of recent legislation liberalizinginterstate banking and branching opportunities in Maine.

 

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 are shifted from local bankmanagement possessing independent decision-making power to management operatingunder policies 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 they serve.  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 to individuals.  The Bank has concentrated on extendingbusiness loans to such customers in the Bank’s primary market area and toextending 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 investments 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 benefits professionalswith 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, the businessand operations could be adversely affected.

 

*Employees*

 

Asof December 31, 2001, the Company had 103 full-time employees and 13 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 local marketplace.  Management has established relationshipswith local area legal and accounting professionals to cultivate referrals.  Asset quality is a top priority for the Bankand a significant consideration in business development efforts.

 

*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, 2001, commercial and commercial real estate loansrepresented the largest class of loans at $112.7 million or 60% of totalloans.  The Bank participates ingovernment guaranteed lending including programs with the Finance Authority ofMaine (FAME) and Rural Development (RD).  The Bank originated the second highest number of SBA loans in the Stateof Maine for the past four fiscal years.

 

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 basis typicallyfor up to five years, generally at variable rates of interest.  As a general practice, the Bank takes ascollateral a security interest in any available real estate, equipment or otherchattel although such loans may also be made on an uncollateralized basis.  As additional security for commercial loans,the Bank normally requires the personal guarantee of the principals and mayrequire financial performance covenants.

 

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 in 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 making residentialmortgage loans.  Residential loansinclude the origination of conventional mortgages, residential lot loans andresidential acquisition, development and construction loans for the purchase orconstruction of single-family housing or lots. The Bank offers fixed and adjustable rate mortgages (“ARMs”).  With these loans, the real estate normallyconstitutes 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 

 

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guaranteed programs and hasalso helped coordinate several innovative programs including a partnership withPenquis Community Action Program in their “Own Me” program which assists lowincome women in the purchase of a home, and housing workshops for the hearingimpaired.

 

Asof December 31, 2001, residential loans accounted for a total of $35.0 millionrepresenting 19% of total loans.  TheBank’s secondary market servicing portfolio stands at $79.1 million.

 

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 these mortgagesare adjusted yearly with limitations on upward adjustments of 2% per adjustmentperiod and 6% over the life of the loan. It has been the Bank’s experience that the proportion of fixed-rate andadjustable-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 amortgage.  In general, the Bank enforcesdue on sale clauses.

 

*Residential Construction Lending*

 

TheCompany originates construction loans to individuals for the construction ofone- to four-family residences. Residential construction loans generallyprovide for the payment of interest only during the construction phase, whichis usually between six and twelve months. At the end of the construction phase,the loan converts to a permanent mortgage loan. Construction loans toindividuals are generally made on the same terms as one- to four-familymortgage loans. At December 31, 2001, construction loans totaled $6.7million representing 4% of total loans.

 

Constructionlending generally involves a higher degree of risk than single-family permanentmortgage lending because of the greater potential for disagreements betweenborrowers and builders and the failure of builders to pay subcontractors.Additional risk often exists because of the inherent difficulty in estimatingboth a property’s value 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, 2001, fixed rateloans totaled $9.7 million and variable rate loans amounted to $8.0million.  Fixed rate loans are for termsof 5 to 15 years with monthly amortization required and interest rates rangingfrom 7.5% to 12.5%.  Interest rates onvariable rate loans are 1.5% to 2.0% over the prime interest rate.  These home equity loans are generallysecured by a second mortgage on the principal residential property.

 

5

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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, a finance company which opened for business in Bangoron March 1, 1999, provides indirect auto and recreational vehicle lending, aswell as other types of direct loans, including personal unsecured, recreationalvehicle, auto, mobile home and home equity loans.

 

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 of reducedvalue at the time of collection.  Accordingly,the initial determination of the borrower’s ability to repay is of primaryimportance in the underwriting of consumer loans.

 

Consumerloans totaled approximately $15.9 million (of which $7.2 million were MACloans) and represented 8% of the Company’s loan portfolio at December 31,2001.  Such loans bear interest at fixedrates ranging from 7% to 18%.

 

*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 approximately thirtyother financial institutions in northern New England access to experiencedindividuals who are highly trained in loan review, regulatory compliance,training and internal auditing in a cost-efficient and timely manner.

 

*Lending Activities*

 

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

 

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

 
|                           |   | **At December 31,**         |    |
|--------------------------------|--------|-----------------------------|---------|
|                           |   | **2001**                    |    | **2000** |   | **1999** |   | **1998** |   | **1997** |   |
|                           |   | **Amount**                  |    | **%** |   | **Amount** |   | **%** |   | **Amount** |   | **%** |   | **Amount** |   | **%** |   | **Amount** |   | **%** |   |
|                           |   | **(Dollars  in thousands)** |    |
| Real Estate                    |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial                     |   | $                           | 69,209  |   | 37 | % | $ | 59,277 |   | 36 | % | $ | 49,161 |   | 36 | % | $ | 48,896 |   | 38 | % | $ | 40,984 |   | 34 | % |
| Construction                   |   | 6,678                       |    | 4 | % | 4,623 |   | 3 | % | 1,937 |   | 2 | % | 1,833 |   | 1 | % | 3,012 |   | 3 | % |
| Residential                    |   | 35,040                      |    | 19 | % | 26,112 |   | 16 | % | 23,390 |   | 17 | % | 22,279 |   | 18 | % | 26,638 |   | 22 | % |
| Home equity                    |   | 17,675                      |    | 9 | % | 18,830 |   | 11 | % | 18,054 |   | 13 | % | 19,362 |   | 15 | % | 20,036 |   | 17 | % |
| Total real estate              |   | 128,602                     |    | 69 | % | 108,842 |   | 66 | % | 92,542 |   | 68 | % | 92,370 |   | 72 | % | 90,670 |   | 76 | % |
| Commercial                     |   | 43,533                      |    | 23 | % | 42,459 |   | 25 | % | 33,686 |   | 25 | % | 28,322 |   | 22 | % | 20,757 |   | 18 | % |
| Consumer                       |   | 15,945                      |    | 8 | % | 14,622 |   | 9 | % | 9,994 |   | 7 | % | 6,963 |   | 6 | % | 7,461 |   | 6 | % |
| Total loans                    |   | $                           | 188,080 |   | 100 | % | $ | 165,923 |   | 100 | % | $ | 136,222 |   | 100 | % | $ | 127,655 |   | 100 | % | $ | 118,888 |   | 100 | % |
| Less allowance for loan losses |   | (2,986                      | )       |   |   | (2,658 | ) |   |   | (2,274 | ) |   |   | (2,023 | ) |   |   | (1,717 | ) |   |   |
| Total                          |   | $                           | 185,094 |   |   |   | $ | 163,265 |   |   |   | $ | 133,948 |   |   |   | $ | 125,632 |   |   |   | $ | 117,171 |   |   |   |

 

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Thefollowing table sets forth as of December 31, 2001, 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.

 

**LoanMaturity Schedule**

 
|         |   | **At December 31, 2001**     |   |
|--------------|--------|------------------------------|--------|
|         |   | **Due in one  year or less** |   | **Due after one year****but before 5 years** |   | **Due after 5  years** |   | **Total** |   |
|         |   | **(Dollars in thousands)**   |   |
| Commercial   |   | $                            | 22,130 |   | $ | 17,126 |   | $ | 4,277 |   | $ | 43,533 |   |
| Construction |   | 6,678                        |   | — |   | — |   | 6,678 |   |
|              |        |                              |        |  |  |  |  |  |  |  |  |  |  |

 

Commercialand construction loans maturing after one year:
| Predetermined interest rates          |   | $      | 8,382  |   |
|---------------------------------------|--------|--------|--------|--------|
| Floating or adjustable interest rates |   | 13,021 |   |
| Total                                 |   | $      | 21,403 |   |

 

                                           The followingis a summary of non–performing assets at the dates indicated:

 

##### **Non-PerformingAssets**

 
|                                                           |   | **At December 31,**         |       |
|----------------------------------------------------------------|--------|-----------------------------|------------|
|                                                           |   | **2001**                    |       | **2000** |   | **1999** |   | **1998** |   | **1997** |   |
|                                                           |   | **(Dollars  in thousands)** | ** ** |
| Loans:                                                         |   |                        | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Non-accrual loans                                              |   | $                           | 432        |   | $ | 421 |   | $ | 266 |   | $ | 148 |   | $ | 181 |   |
| Loans 90 days or  more past due but still accruing             |   | 75                          |       | 104 |   | — |   | 4 |   | 3 |   |
| Restructured  loans                                            |   | —                      |       | — |   | — |   | — |   | — |   |
| Non-performing  loans                                          |   | 507                         |       | 525 |   | 266 |   | 152 |   | 184 |   |
| OREO                                                           |   | 221                         |       | 90 |   | 50 |   | 12 |   | 43 |   |
|                                                           |   |                        |       |   |   |   |   |   |   |   |   |
| Non-performing  assets                                         |   | $                           | 728        |   | $ | 615 |   | $ | 316 |   | $ | 164 |   | $ | 227 |   |
| Non-performing  loans as a percentage of total loans           |   | 0.27                        | %          | 0.32 | % | 0.19 | % | 0.12 | % | 0.15 | % |
| Non-performing  assets as a percentage of total assets         |   | 0.26                        | %          | 0.25 | % | 0.15 | % | 0.08 | % | 0.13 | % |
| Non-performing  assets as a percentage of total loans and OREO |   | 0.39                        | %          | 0.37 | % | 0.23 | % | 0.13 | % | 0.19 | % |

 

AtDecember 31, 2001, loans on non-accrual status totaled $432,000. Interestincome not recognized on non-accrual loans was $30,000 in 2001.  There was no interest income recognized onnon-accrual loans in 2001.

 

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, 2001, the Bank had $2.9 million of loans that were classified assubstandard and $203,000 classified as doubtful.  This compares to $1.9 million and $120,000 of loans that wereclassified as substandard and doubtful, respectively, at December 31,2000.  The Bank had no loans which wereclassified as loss at either date. Total classified loans as a percentage of total loans increased to 1.6%at December 31, 2001 from 1.2% at December 31, 2000.  Delinquent loans may or may not be adversely classified dependingupon management’s judgment with respect to each individual loan.  As of December 31, 2001 and 2000, theportion of loans guaranteed by either the SBA, RD or FAME for each yearamounted to approximately 16% of the total loan balances adverselyclassified.  At December 31, 2001,included in the $3.1 million of loans that were classified as substandard anddoubtful were $2.8 million of performing loans.  This compares to $2.1 million of adversely classified performingloans as of December 31, 2000.  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,** |    |
|--------------------------------------------------------|--------|-----------------------------|---------|
|                                                   |   | **2001**                    |    | **2000** |   | **1999** |   | **1998** |   | **1997** |   |
|                                                   |   | **(Dollars in  thousands)** |    |
| Total net loans outstanding at the end of  year (1)    |   | $                           | 185,094 |   | $ | 163,265 |   | $ | 133,948 |   | $ | 125,632 |   | $ | 117,171 |   |
| Average net loans outstanding during the year (1)      |   | $                           | 171,692 |   | $ | 150,553 |   | $ | 127,595 |   | $ | 119,144 |   | $ | 109,263 |   |
| Allowance for loan losses, beginning of year           |   | $                           | 2,658   |   | $ | 2,274 |   | $ | 2,023 |   | $ | 1,717 |   | $ | 1,450 |   |
| Loans charged off during the period:                   |   |                        |    |   |   |   |   |   |   |   |   |
| Real estate:                                           |   |                        |    |   |   |   |   |   |   |   |   |
| Commercial                                             |   | —                      |    | — |   | (66 | ) | — |   | (6 | ) |
| Residential                                            |   | —                      |    | — |   | — |   | (20 | ) | (16 | ) |
| Home equity                                            |   | (20                         | )       | (14 | ) | — |   | (7 | ) | — |   |
| Commercial                                             |   | (65                         | )       | (9 | ) | (10 | ) | (20 | ) | (23 | ) |
| Consumer                                               |   | (99                         | )       | (42 | ) | (49 | ) | (31 | ) | (55 | ) |
| Total                                                  |   | (184                        | )       | (65 | ) | (125 | ) | (78 | ) | (100 | ) |
| Recoveries of loans previously charged off:            |   |                        |    |   |   |   |   |   |   |   |   |
| Real estate:                                           |   |                        |    |   |   |   |   |   |   |   |   |
| Commercial                                             |   | —                      |    | — |   | — |   | — |   | — |   |
| Residential                                            |   | 22                          |    | 22 |   | 22 |   | 22 |   | 12 |   |
| Home equity                                            |   | —                      |    | — |   | — |   | — |   | — |   |
| Commercial                                             |   | 1                           |    | 1 |   | 7 |   | — |   | — |   |
| Consumer                                               |   | 15                          |    | 3 |   | 2 |   | 2 |   | — |   |
| Total                                                  |   | 38                          |    | 26 |   | 31 |   | 24 |   | 12 |   |
| Net loans charged off during the year                  |   | (146                        | )       | (39 | ) | (94 | ) | (54 | ) | (88 | ) |
| Provisions charged to income statement                 |   | 474                         |    | 423 |   | 345 |   | 360 |   | 355 |   |
| Allowance for loan losses, end of year                 |   | $                           | 2,986   |   | $ | 2,658 |   | $ | 2,274 |   | $ | 2,023 |   | $ | 1,717 |   |
| Ratios:                                                |   |                        |    |   |   |   |   |   |   |   |   |
| Net charge-offs to average loans outstanding           |   | 0.08                        | %       | 0.03 | % | 0.07 | % | 0.04 | % | 0.08 | % |
| Net charge-offs to loans, end of period                |   | 0.08                        | %       | 0.02 | % | 0.07 | % | 0.04 | % | 0.07 | % |
| Allowance for loan losses to average loans outstanding |   | 1.71                        | %       | 1.74 | % | 1.75 | % | 1.67 | % | 1.55 | % |
| Allowance for loan losses to loans, end of year        |   | 1.59                        | %       | 1.60 | % | 1.67 | % | 1.58 | % | 1.44 | % |
| Allowance for loan losses to non-performing loans      |   | 588.95                      | %       | 506.29 | % | 854.89 | % | 1330.92 | % | 933.15 | % |

 

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(1) Excludes loans held forsale.

 

Theprovision for loan losses was $474,000 for the twelve month period endedDecember 31, 2001 and $423,000 for the same period ended December 31, 2000. Theallowance for loan losses was $3.0 million at December 31, 2001, which was anincrease of $328,000 or 12% over the amount at December 31, 2000.

 

9

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Thefollowing table sets forth the breakdown of the allowance for loan losses byloan category for the periods indicated. Management believes that the allowance can be allocated by category onlyon an approximate basis.  The allocationof an allowance to each category is not necessarily indicative of future lossesand does not restrict the use of the allowance to absorb losses in any othercategory.

 

|                                      |   | **At December 31,**         |   |
|-------------------------------------------|--------|-----------------------------|--------|
|                                      |   | **2001**                    |   | **2000** |   | **1999** |   | **1998** |   | **1997** |   |   |
|                                      |   | **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 and Commercial Real Estate (1) |   | $                           | 1,574  |   | 60 | % | $ | 1,321 |   | 61 | % | $ | 1,111 |   | 61 | % | $ | 999 |   | 60 | % | $ | 989 |   | 52 | % |   |
| Construction                              |   | 33                          |   | 4 | % | 23 |   | 3 | % | 10 |   | 2 | % | 9 |   | 1 | % | 15 |   | 3 | % |   |
| Residential                               |   | 285                         |   | 19 | % | 223 |   | 16 | % | 122 |   | 17 | % | 120 |   | 18 | % | 134 |   | 22 | % |   |
| Home equity                               |   | 220                         |   | 9 | % | 236 |   | 11 | % | 179 |   | 13 | % | 193 |   | 15 | % | 199 |   | 17 | % |   |
| Consumer                                  |   | 424                         |   | 8 | % | 310 |   | 9 | % | 272 |   | 7 | % | 179 |   | 6 | % | 200 |   | 6 | % |   |
| Off-Balance Sheet                         |   | 212                         |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   |   |
| Unallocated                               |   | 238                         |   | — |   | 545 |   | — |   | 580 |   | — |   | 523 |   | — |   | 180 |   | — |   |   |
| Total allowance for loan losses           |   | $                           | 2,986  |   | 100 | % | $ | 2,658 |   | 100 | % | $ | 2,274 |   | 100 | % | $ | 2,023 |   | 100 | % | $ | 1,717 |   | 100 | % |   |
|                                           |        |                             |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)                                  Commercial andcommercial real estate loans have been combined in allocating the allowance forloan losses as the Company utilizes an internal risk rating system for theseloans on a consolidated basis.

 

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, 2001, although management ofthe Company believes that the allowance for loan losses is adequate, futureadditions may be necessary if economic conditions, real estate values and otherfactors 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, 2001,loans totaling $439,000 had specific allowances of $172,000 compared with loanbalances of $347,000 at December 31, 2000 which had specific allowances of$113,000.

 

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, 2001 and2000, the general allowance totaled $2.6 million and $2.0 million,respectively.

 

10

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The subjective determined allocation represents the unallocated portionof the allowance for loan losses. The unallocated allowance is based uponmanagement’s evaluation of various conditions, the effects of which are notdirectly measured in determining the specific and general allowances.  The evaluation of the inherent lossregarding these conditions involves a higher degree of uncertainty because theyare not identified with specific problem credits or portfolio segments.  The conditions evaluated in connection withthe unallocated allowance include the following conditions that existed as ofthe balance sheet date:

 

•                  then existinggeneral economic and business conditions affect our key lending areas;

•                  credit qualitytrends, including trends in non-performing and past due loans expected toresult from existing conditions;

•                  collateralvalues;

•                  loan volumesand concentrations;

•                  seasoning ofthe loan portfolio;

•                  specificindustry conditions within portfolio segments;

•                  recent lossexperience in particular segments of the portfolio;

•                  duration of thecurrent business cycle;

•                  bank regulatoryexamination results; and

•                  findings of ourinternal credit examiners.

 

Theunallocated portion of the allowance for loan losses decreased to $238,000 atDecember 31, 2001 from $545,000 at December 31, 2000.  The decrease in unallocated reserve was due to allocatingadditional reserves to off-balance sheet credit risk.  Management determined that the unallocated portion of theallowance is necessary due to a number of factors impacting the local economythat have not yet been fully reflected in the financial information provided byborrowers.  These factors include arecovering economy, high energy and medical costs, and depressed conditions incertain natural resource-based industries, such as commercial fishing, timberand agriculture.  While these factorsare not yet identifiable with respect to specific borrowers, the Company hasdetermined an overall increase in the allowance for loan losses to be necessaryto provide for resultant expected losses.

 

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.

 

11

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Thecomposition of the investment portfolio as of December 31, 2001 was 25% U.S.Treasury notes and U.S. Government agencies and corporations, 54%mortgage-backed securities and collateralized mortgage obligations and 21%other securities.  The comparabledistributions for December 31, 2000 were 40% U.S. Treasury notes and U.S.Government agencies and corporations, 48% mortgage-backed securities andcollateralized mortgage obligations and 12% other securities.

 

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

 

**Investment Securities Portfolio Composition**

 
|                                                               |   | **At December 31,**        |       |
|--------------------------------------------------------------------|--------|----------------------------|------------|
|                                                               |   | **2001**                   |       | **2000** |   | **1999** |   |
|                                                               |   | **(Dollars in thousands)** | ** ** |
| Securities held to maturity (1):                                   |   |                       |       |   |   |   |   |
| Mortgage-backed securities and collateralized mortgage obligations |   | $                          | —     |   | $ | — |   | $ | 262 |   |
| Securities available for sale (2):                                 |   |                       |       |   |   |   |   |
| U.S. Treasury securities                                           |   | $                          | 1,030      |   | $ | 7,017 |   | $ | 15,005 |   |
| U.S. Government agencies and corporations                          |   | 17,376                     |       | 16,866 |   | 16,477 |   |
| Mortgage-backed securities and collateralized mortgage obligations |   | 38,684                     |       | 28,382 |   | 21,201 |   |
| State and local government debt securities                         |   | 5,254                      |       | 2,514 |   | 1,620 |   |
| Certificates of deposit                                            |   | 4,457                      |       | 3,663 |   | 2,971 |   |
| U.S. Government and agency money market funds                      |   | 3,130                      |       | — |   | 2,632 |   |
| Other securities (3)                                               |   | 1,676                      |       | 1,244 |   | 1,307 |   |
|                                                               |   |                       |       |   |   |   |   |
| Total                                                              |   | $                          | 71,607     |   | $ | 59,686 |   | $ | 61,213 |   |

 

----

(1)           Carried at amortized cost.

(2)           Carried at estimated market value.

(3)           Includes FHLB stock, Federal Reserve stock, FNMA stock andmarketable equity securities.

 

**Maturity Schedule of Securities Available for Sale**

 
|                                                                |   | **At December 31, 2001  (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. Treasury securities                                            |   | $                                           | 1,030  |   | 6.19 | % | $ | — |   | — |   | $ | — |   | — |   | $ | — |   | — |   | $ | 1,030 |   | 6.19 | % |
| U.S. Government agencies and corporations                           |   | 6,643                                       |   | 6.31 | % | 10,733 |   | 5.12 | % | — |   | — |   | — |   | — |   | 17,376 |   | 5.57 | % |
| Mortgaged-backed securities and collateralized mortgage obligations |   | —                                      |   | — |   | 951 |   | 6.72 | % | 8,238 |   | 6.08 | % | 29,495 |   | 5.94 | % | 38,684 |   | 5.99 | % |
| States and local government debt securities                         |   | 3,235                                       |   | 3.57 | % | 690 |   | 7.29 | % | 1,154 |   | 7.54 | % | 175 |   | 7.18 | % | 5,254 |   | 5.05 | % |
| Certificates of deposit                                             |   | 4,457                                       |   | 3.19 | % | — |   | — |   | — |   | — |   | — |   | — |   | 4,457 |   | 3.19 | % |
| U.S. Government and agency money market funds                       |   | 3,130                                       |   | 2.14 | % | — |   | — |   | — |   | — |   | — |   | — |   | 3,130 |   | 2.14 | % |
| Other securities                                                    |   | 1,676                                       |   | 4.72 | % | — |   | — |   | — |   | — |   | — |   | — |   | 1,676 |   | 4.72 | % |
| Total                                                               |   | $                                           | 20,171 |   | 4.08 | % | $ | 12,374 |   | 5.36 | % | $ | 9,392 |   | 6.26 | % | $ | 29,670 |   | 5.95 | % | $ | 71,607 |   | 5.36 | % |

 

----

(1)         Yield is adjusted forthe effect of tax-exempt securities assuming a Federal tax rate of 34%.  Yield is calculated using amortized cost.

 

12

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*DepositActivities*

 

The following table sets forth the averagebalances and weighted average rates for the Bank’s categories of deposits forthe periods indicated:

 

**Average Deposit Balances and Rates**

 
|                    |   | **Year Ended December 31,** |    |
|-------------------------|--------|-----------------------------|---------|
|                    |   | **2001**                    |    | **2000** |   | **1999** |   |
|                    |   | **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   |   | $                           | 32,284  |   | — |   | 16 | % | $ | 29,234 |   | — |   | 16 | % | $ | 26,052 |   | — |   | 16 | % |
| Interest checking       |   | 26,548                      |    | 1.74 | % | 13 | % | 21,170 |   | 2.07 | % | 12 | % | 18,982 |   | 1.75 | % | 12 | % |
| Money market            |   | 22,665                      |    | 3.01 | % | 11 | % | 16,971 |   | 4.51 | % | 9 | % | 9,902 |   | 2.86 | % | 6 | % |
| Savings                 |   | 37,383                      |    | 2.88 | % | 19 | % | 42,037 |   | 3.95 | % | 23 | % | 48,486 |   | 3.82 | % | 30 | % |
| Certificates of deposit |   | 82,160                      |    | 5.52 | % | 41 | % | 74,223 |   | 5.82 | % | 40 | % | 58,757 |   | 5.38 | % | 36 | % |
|                    |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total                   |   | $                           | 201,040 |   |   |   | 100 | % | $ | 183,635 |   |   |   | 100 | % | $ | 162,179 |   |   |   | 100 | % |

 

The Bank does not have a concentration ofdeposits from any one source, the loss of which would have a material adverseeffect on the business of the Bank. Management believes that substantially all the Bank’s depositors areresidents in its primary market area. As of December 31, 2001, the Bank had $6.3 million in brokered deposits.

 

Thefollowing table summarizes at December 31, 2001 the Bank’s certificates ofdeposit of $100,000 or more by time remaining until maturity:

 

|                                  |   | **December 31, 2001**      |   |
|---------------------------------------|--------|----------------------------|--------|
|                                  |   | **(Dollars in thousands)** |   |
| Maturity Period:                      |   |                       |   |
| Less than three months                |   | $                          | 12,535 |   |
| Over three months through six months  |   | 4,268                      |   |
| Over six months through twelve months |   | 2,656                      |   |
| Over twelve months                    |   | 9,950                      |   |
| Total                                 |   | $                          | 29,409 |   |

 

*Short-TermBorrowings*

 

The borrowings utilized bythe Bank primarily have been securities sold under agreements to repurchase.Other short-term borrowings generally include federal funds purchased, FHLBadvances, treasury, tax and loan deposits and interest-bearing demand notes dueto the U.S. Treasury, which are repaid upon notification by the U.S. Treasury.

 

13

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The following table sets forth certain information regarding securitiessold under agreement to repurchase for the dates indicated:

 
|                                                         |   | **At or for the  Year Ended December 31,** |   |
|--------------------------------------------------------------|--------|--------------------------------------------|--------|
|                                                         |   | **2001**                                   |   | **2000** |   | **1999** | ** ** |
|                                                         |   | **(Dollars in thousands)**                 |   |
| Average balances outstanding                                 |   | $                                          | 16,453 |   | $ | 13,055 |   | $ | 13,299 |   |
| Maximum amount outstanding at any month-end during the  year |   | $                                          | 23,539 |   | $ | 15,930 |   | $ | 14,502 |   |
| Balance outstanding at end of year                           |   | $                                          | 19,138 |   | $ | 14,168 |   | $ | 13,791 |   |
| Weighted average rate during the year                        |   | 3.21                                       | %      | 4.69 | % | 3.86 | % |
| Weighted average rate at end of year                         |   | 1.59                                       | %      | 4.82 | % | 4.35 | % |

 

**Federal and State Taxation**

 

*General*

 

The Company, the Bank and MAC file aconsolidated federal income tax return on a fiscal year basis.  Consolidated returns have the effect ofeliminating intercompany distributions, including dividends and inter-companyinterest income and expense, from the computation of consolidated taxableincome for the taxable year in which the distributions occur.  Banks and bank holding companies are subjectto federal income taxes in the same manner as other corporations.  In accordance with an income tax sharingagreement, income tax charges or credits will be allocated to the Company, theBank and MAC on the basis of their respective taxable income or loss includedin the consolidated income tax return.

 

*FederalIncome Taxation*

 

Although the Bank’s income tax liability isdetermined under provisions of the Internal Revenue Code of 1986, as amended(the “Code”), which is applicable to all taxpayers or corporations, Sections581 through 597 of the Code apply specifically to financial institutions.

 

The two primary areas in which the treatmentof financial institutions differ from the treatment of other corporations underthe Code are in the areas of bond gains and losses and bad debt deductions.  Bond gains and losses generated from thesale or exchange of portfolio instruments are generally treated for financialinstitutions as ordinary gains and losses as opposed to capital gains andlosses for other corporations, as the Code considers bond portfolios held bybanks to be inventory in a trade or business rather than capital assets.  Banks are allowed a statutory method forcalculating a reserve for bad debt deductions. Based on the asset size of the Bank, it is permitted to maintain a baddebt reserve calculated on an experience method, based on charge-offs for thecurrent and preceding five years or a “grandfathered” base year reserve, if larger.

 

*State andLocal Taxation*

 

The Company on a consolidated basis issubject to a separate state franchise tax in lieu of state corporate incometax.  The amount of the tax is the sumof 1% of Maine net income and $.08 per $1,000 of Maine assets as defined inMaine law.  Maine assets are thecorporation’s total end of the year assets as reported on the federal incometax return.  Maine net income is thecorporation’s net income or loss as reported on the federal income tax returnwhich is apportioned to Maine under Maine law.

 

14

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**SUPERVISION AND REGULATION**

 

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

 

**FinancialHolding Company Regulation**

 

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

 

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

 

•                  each of its depository institution subsidiaries is“well capitalized”;

 

•                  each of its depository institution subsidiaries is“well managed”;

 

•                  each of its depository institution subsidiaries has at least a“satisfactory” Community Reinvestment Act rating at its most recentexamination; and

 

•                  the bank holding company has filed acertification with the Federal Reserve Board that it elects to become afinancial holding company.

 

The Company filed an election to be treated as a financial holdingcompany with the Federal Reserve Bank of Boston in March 2000.  As a result, the Company is currentlyregulated as a financial holding company. As a financial holding company, theCompany may conduct those activities which are considered financial in natureunder a new section 4(k) of the BHCA. These activities include:

 

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

 

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

 

•                  Underwriting and selling insurance;

 

•                  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 powerto determine by regulation or order additional financial activities which wouldbe permissible for financial holding companies.  In addition, in order to commence a new activity  Merrill Merchants Bank must have received a“satisfactory” on its latest CRA exam.

 

15

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**The USA PATRIOT Act**

 

In response to the events ofSeptember 11th, President George W. Bush signed into law the Unitingand Strengthening America by Providing Appropriate Tools Required to Interceptand Obstruct Terrorism Act of 2001, or the USA PATRIOT Act, on October 26,2001.  The USA PATRIOT Act gives thefederal government new powers to address terrorist threats through enhanceddomestic security measures, expanded surveillance powers, increased informationsharing, and broadened anti-money laundering requirements.  By way of amendments to the Bank SecrecyAct, Title III of the USA PATRIOT Act takes measures intended to encourageinformation sharing among bank regulatory agencies and law enforcementbodies.  Further, certain provisions ofTitle III impose affirmative obligations on a broad range of financialinstitutions, including banks, thrifts, brokers, dealers, credit unions, moneytransfer agents and parties registered under the Commodity Exchange Act.

 

Among other requirements,Title III of the USA PATRIOT Act imposes the following requirements withrespect 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) anindependent audit 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.

 

•                  Effective December 25, 2001, financialinstitutions are prohibited from establishing, maintaining, administering ormanaging correspondent accounts for foreign shell banks (foreign banks that donot have a physical presence in any country), and will be subject to certainrecordkeeping obligations with respect to correspondent accounts of foreignbanks.

 

•                  Bank regulators are directed to considera holding company’s effectiveness in combating money laundering when ruling onFederal Reserve Act and Bank Merger Act applications.

 

*General*

 

As a bank holding company and financial holding company, the Company issubject to the regulation and supervision of the Federal Reserve under theBHCA.  The Company is also subject tothe regulation and supervision of the Maine Bureau of Banking by virtue ofprovisions of Maine law which govern financial institution holding companiessuch as the Company.  Under applicablefederal law, the Company must obtain the approval of the Federal Reserve Boardbefore it acquires all or substantially all of the assets of a bank or anotherbank holding company, merges or consolidates with another bank holding company,or acquires direct or indirect ownership or control of any voting shares of abank or bank holding company if, after such acquisition, it would own orcontrol more than 5% of any class of voting shares of such bank or bank holdingcompany (unless it already owns or controls a majority of such shares).  Similarly, under applicable Maine law, theCompany must obtain the prior approval of the Maine Superintendent of theBureau of Banking before acquiring more than 5%

 

16

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ofthe voting shares of a Maine financial institution or of any financialinstitution holding company which directly or indirectly controls a Mainefinancial institution.  Under certaincircumstances, the Company may be required to obtain Federal Reserve Boardapproval before redeeming any of its equity securities in an amount in excessof 10% of its net worth in any twelve-month period.  Furthermore, under certain circumstances, any redemptions,dividends, or distributions with respect to the Company’s Common Stock and PreferredStock may be considered an unsafe or unsound practice by the Federal ReserveBoard.

 

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

 

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

 

*Payment of Dividends*

 

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

 

In addition to the statutory prohibition against the withdrawal of anyportion of the Bank’s capital and certain statutory limitations on the paymentof dividends, under Maine law the Bank may not pay dividends if it 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.

 

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

 

If, in the opinion of the applicable federal bank regulatory authority,a depository institution or holding company is engaged in or is about to engagein an unsafe or unsound practice (which, depending on the financial conditionof the depository institution or holding company, could include the payment ofdividends), such authority may require, after notice and hearing (except in thecase of an emergency proceeding where there is no

 

17

----

 

noticeor hearing), that such institution or holding company cease and desist fromsuch practice.  The federal bankingagencies have indicated that paying dividends that deplete a depositoryinstitution’s or holding company’s capital base to an inadequate level would besuch an unsafe and unsound banking practice. Moreover, the Federal Reserve and the FDIC have issued policy statementswhich provide that bank holding companies and insured depository institutionsgenerally should only pay dividends out of current operating earnings.  In addition, under the Federal DepositInsurance Corporation Improvement Act of 1991 (“FDICIA”), a FDIC-insureddepository institution may not pay any dividend if payment would cause it tobecome undercapitalized or once it is undercapitalized.  See “FDICIA.”

 

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

 

*Transactions With Affiliates and Insiders*

 

The Bank is subject to Section 23A of the Federal Reserve Act, whichplaces limits on the amount of loans or extensions of credit to, or investmentsin, or certain 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.

 

*Capital Adequacy*

 

The federal banking agencies have adopted risk-based capital guidelinesfor banks and bank holding companies. The minimum guideline for the ratio of total capital to risk-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%.

 

In addition, the federal banking agencies have established minimumleverage ratio guidelines for banks and bank holding companies.  Their guidelines provide for a minimum ratioof Tier 1 Capital to average assets, less goodwill and certain other intangibleassets (the “Leverage Ratio”), of 3% for banks that meet certain specificcriteria and 4% for other institutions. The Company’s Leverage Ratio at December 31, 2001 was 9.04%.  Failure to meet capital guidelines couldsubject a bank to a variety of enforcement remedies, including the terminationof deposit insurance by the FDIC, and to certain restrictions on itsbusiness.  See “FDICIA.”

 

*Holding Company Structure and Support of the Bank*

 

Because the Company is the parent holding company of the Bank, itsright to participate in the assets of any subsidiary upon the Bank’sliquidation or reorganization will be subject to the prior claims of thesubsidiary’s creditors (including depositors in the case of bank subsidiaries)except to the extent that the Company may itself be a creditor with recognizedclaims against the subsidiary.

 

Under the Federal Deposit Insurance Act (the “FDIA”), a depositoryinstitution insured by the FDIC can be held liable for any loss incurred by, orreasonably expected to be incurred by the FDIC in connection with (i) thedefault of a commonly-controlled FDIC-insured depository institution or (ii)any assistance provided by the FDIC to any commonly-controlled FDIC-insureddepository institution “in danger of default.” “Default” is defined generallyas the appointment of a conservator or receiver and “in danger of default” isdefined generally as the existence of certain conditions indicating that adefault is likely to occur in the absence of regulatory assistance.  The FDIC’s claim for damages is superior toclaims of depositors, secured creditors and holders of subordinated debt (otherthan affiliates) of the commonly controlled insured depositoryinstitution.  The Bank is 

 

18

----

 

subjectto these cross-guarantee provisions.

 

The following table sets forth capital ratios required by the FederalReserve to be maintained by the Company in order for the Company to beadequately capitalized, and the Company’s actual ratios of capital to totalregulatory or risk-weighted assets, as applicable, at December 31, 2001.

 
|                     |   | **Company Regulatory********Minimum** |   | **Company** |   | **Bank** |   |
|--------------------------|--------|---------------------------------------|--------|-------------|--------|----------|--------|
|                     |   |                                  |   |        |
| Tier 1 capital           |   | 4.00                                  | %      | 13.69       | %      | 10.71    | %      |
| Total risk-based capital |   | 8.00                                  | %      | 15.11       | %      | 11.97    | %      |

* *

*FDICIA*

 

The FDICIA requires the federal banking regulators to take “promptcorrective action” in respect of FDIC insured depository institutions that donot meet minimum capital requirements. The FDICIA established five capital tiers: “well capitalized,”“adequately capitalized,” “undercapitalized,” “significantly undercapitalized”and “critically undercapitalized.” An FDIC-insured depository institution iswell capitalized if it maintains a Leverage Ratio of at least 5%, a riskadjusted Tier 1 Capital Ratio of at least 6% and a Total Capital Ratio of at least10% and is not subject to a directive, order or written agreement to meet andmaintain specific capital levels.  Aninsured depository****institution isdefined to be adequately****capitalizedif it meets all of its minimum capital requirements as described above.  In addition, an insured depositoryinstitution will be considered undercapitalized if it fails to meet any minimumrequired measure, significantly undercapitalized if it is significantly belowany such measure and critically undercapitalized if it fails to maintain alevel of tangible equity equal to not less than 2% of total assets.  An insured depository institution may bedeemed to be in a capitalization category that is lower than is indicated byits actual capital position if it receives an unsatisfactory examinationrating.

 

The capital-based prompt corrective action provisions of FDICIA andtheir implementing regulations apply to FDIC-insured depository institutionsand are not directly applicable to holding companies which control 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.

 

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

 

Undercapitalized depository institutions are subject to restrictions onborrowing from the Federal Reserve.  Inaddition, undercapitalized depository institutions are subject to growth limitationsand are required to submit capital restoration plans.  A depository institution’s holding company must guarantee thecapital plan, up to an amount equal to the lesser of 5% of the depositoryinstitution’s assets at the time it becomes undercapitalized or the amount ofthe capital deficiency when the institution fails to comply with the plan.  The federal banking agencies may not accepta capital plan without determining, among other things, that the plan is basedon realistic assumptions and is likely to succeed in restoring the depositoryinstitution’s capital.  If a depositoryinstitution fails to submit an acceptable plan, it is treated as if it issignificantly undercapitalized.

 

Significantly undercapitalized depository institutions may be subjectto a number of requirements and restrictions, including orders to sellsufficient voting stock to become adequately capitalized, requirements toreduce total assets and cessation of receipt of deposits from correspondentbanks.  Critically undercapitalizeddepository institutions are subject to appointment of a receiver orconservator.

 

The Company and the Bank, at December 31, 2001 and 2000, were “wellcapitalized” under the criteria discussed above.

 

19

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*FDIC Insurance Premiums*

 

The Bank is required to pay semiannual FDIC deposit insuranceassessments.  Each financial institutionis assigned to one of three capital groups –– well capitalized,adequately capitalized or undercapitalized –– and further assignedto one of three subgroups within a capital group, on the basis of supervisoryevaluations by the institution’s primary federal and, if applicable, statesupervisors and other information relevant to the institution’s financialcondition and the risk posed to the FDIC deposit insurance fund.  The actual assessment rate applicable to aparticular institution (and any applicable refund) will, therefore, depend inpart upon the risk assessment classification so assigned to the institution bythe FDIC.  The FDIC is authorized byfederal law to raise insurance premiums in certain circumstances.  Any increase in premiums would have anadverse effect on the Bank and the Company’s earnings.  Under the FDIA, insurance of deposits may beterminated by the FDIC upon a finding that the institution has engaged inunsafe and unsound practices, is in an unsafe or unsound condition to continueoperations or has violated any applicable law, regulation, rule, order orcondition imposed by a federal bank regulatory agency.

 

*Interstate Banking*

 

The acquisition by the Company of more than 5% of the outstandingvoting securities or substantially all of the assets of a bank located outsideof the State of Maine is regulated by the BHCA.  Such acquisition is also subject to the law of the state in whichthe bank to be acquired is located. Under certain circumstances, the Company might not be permitted toacquire an interest in another bank located outside Maine.  Further, any company attempting to acquirecontrol of the Company or the Bank also may be subject to certain limitationson interstate banking.  Even assumingthat the law of the state in which the bank is located permits acquisition, theMaine Banking Code requires prior approval of the Superintendent of the Bureauof Banking for certain acquisitions of more than 5% of a financial institutionhaving operations conducted outside of Maine.

 

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

 

*Interstate Act*

 

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

 

*Community Reinvestment Act*

 

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

 

20

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*Federal Securities Law*

 

The common stock of theCompany is registered with the SEC under Section 12(g) of the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”).  Accordingly, the Company is subject to theinformation, proxy solicitation, insider trading restrictions and otherrequirements of the Exchange Act.

 

*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****.               DESCRIPTIONOF PROPERTY**

 

The Company’s headquarters and the Bank’s main branch are located at 201Main Street, Bangor, Maine, in a two-story building owned by the Bank.  The building contains approximately 17,000square feet.  As of December 31, 2001,the Company’s properties and leasehold improvements had an aggregate net bookvalue of $2.7 million.

 
| **Location**                                                                                       |   | **Ownership** |   | **Year  Opened** |   | **Lease or  License   Expiration********(1)** |
|----------------------------------------------------------------------------------------------------|--------|---------------|--------|------------------|--------|-----------------------------------------------|
| **Corporate Headquarters of the   Bank and the Company**201 Main Street  Bangor, Maine  04401 |   | Owned         |   | 1992             |   | —                                        |
|                                                                                               |   |          |   |             |   |                                          |
| **Branch Offices:**992 Union Street  Bangor, Maine 04401                                           |   | Leased        |   | 1997             |   | 2017                                          |
|                                                                                               |   |          |   |             |   |                                          |
| 992 Union Street, Suite 1A  Bangor, Maine  04401                                              |   | Leased        |   | 1998             |   | 2002                                          |
|                                                                                               |   |          |   |             |   |                                          |
| 920 Stillwater Avenue  Bangor, Maine  04401                                                   |   | Leased        |   | 1994             |   | 2014                                          |
|                                                                                               |   |          |   |             |   |                                          |
| 366 Wilson Street  Brewer, Maine  04412                                                       |   | Leased        |   | 1995             |   | 2015                                          |
|                                                                                               |   |          |   |             |   |                                          |
| 69 Main Street  Orono, Maine  04473                                                           |   | Leased        |   | 1992             |   | 2007                                          |
|                                                                                               |   |          |   |             |   |                                          |
| 27 Main Street  Pittsfield, Maine 04967                                                            |   | Owned         |   | 1992             |   | —                                        |
|                                                                                               |   |          |   |             |   |                                          |
| 1007 Main Road  Holden, Maine  04492                                                          |   | Owned         |   | 2000             |   | —                                        |
|                                                                                               |   |          |   |             |   |                                          |
| 58 Elm Street  Waterville, Maine  04901                                                       |   | Leased        |   | 2001             |   | 2003                                          |
|                                                                                               |   |          |   |             |   |                                          |
| **Supermarket Office:**Newport Plaza 44   Moosehead Trail   Newport, Maine 04953                   |   | Leased        |   | 1997             |   | 2007                                          |
|                                                                                               |   |          |   |             |   |                                          |
| **Convenience  Store Offices:**191 River Road  Orrington, Maine  04474                        |   | Leased        |   | 1999             |   | 2019                                          |
|                                                                                               |   |          |   |             |   |                                          |
| 2 Main Street  Milford, Maine  04461                                                          |   | Leased        |   | 2000             |   | 2020                                          |

 

----

(1) Lease expiration dates assume all options to extend lease term areexercised.

 

**ITEM 3.****               LEGALPROCEEDINGS**

 

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, 2001.

 

22

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

 

None.

 

**PART II**

 

**ITEM 5.****               MARKET FOR THE COMPANY’S COMMON STOCKAND RELATED STOCKHOLDER  MATTERS**

 

The following information included in the Merrill Merchants Bancshares,Inc. 2001 Annual Report to Stockholders (the “Annual Report”) is incorporatedherein by reference: “Market for Common Stock” on page 11 of the Annual Report.

 

**ITEM 6.****                                             ****MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF**

**                              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 5 through 11 of the Annual Report.

 

**ITEM 7.****               FINANCIALSTATEMENTS**

 

The following information included in the Annual Report is incorporatedherein by reference: “Audited Financial Statements and Notes to ConsolidatedFinancial Statements”****on pages 12through 30 of the Annual Report.

 

**ITEM 8.****               CHANGES AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING**

**                             ANDFINANCIAL DISCLOSURE**

 

None.

**PART III**

 

**ITEM 9.****                                            ****DIRECTORS AND PRINCIPAL OFFICERS OF THE COMPANY; COMPLIANCE**

**                             WITHSECTION 16(a) OF THE EXCHANGE ACT**

 

The following information included in the Company’s 2001 ProxyStatement for the 2002 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.

 

**ITEM 10.**** ****          ****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 OF CERTAINBENEFICIAL OWNERS AND**

**                             MANAGEMENT**

 

The following information included in the Proxy Statement isincorporated herein by reference: “Voting Securities” on page 4 of the Proxy Statement.

 

23

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**ITEM 12.****             CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

 

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 REPORTS ON FORM 8-K**

 

(a)           The following financial statementsincluded in the 2001 Annual Report are incorporated herein by reference:

 

ConsolidatedStatements of Financial Condition — December 31, 2001 and 2000;

Consolidated Statements of Income — Years Ended December 31, 2001 and2000;

ConsolidatedStatements of Changes in Shareholders Equity — December 31, 2001 and 2000;

ConsolidatedStatements of Cash Flows — Years Ended December 31, 2001 and 2000; and

Notesto Consolidated Financial Statements — Years Ended December 31, 2001 and 2000.

 

(b)           Exhibits.           The following exhibits are eitherfiled as part of this report or are incorporated herein by reference:

 
| 3.1    |   | Articles of Incorporation of Merrill Merchants Bancshares, Inc.*                            |
|--------|--------|---------------------------------------------------------------------------------------------|
|   |   |                                                                                        |
| 3.2    |   | By-laws of Merrill Merchants Bancshares, Inc.*                                              |
|   |   |                                                                                        |
| 4      |   | Specimen Stock Certificate of Merrill Merchants Bancshares, Inc.*                           |
|   |   |                                                                                        |
| 10.1   |   | Operating Agreement between the Company and M&M Consulting Limited  Liability Company.* |
|   |   |                                                                                        |
| 10.2   |   | Services Agreements between the Company and M&M Consulting  Limited Liability Company.* |
|   |   |                                                                                        |
| 10.3   |   | Employment Agreement with William C. Bullock, Jr. **                                        |
|   |   |                                                                                        |
| 10.4   |   | Financial Services Agreement with Financial Institutions Service  Corporation.*             |
|   |   |                                                                                        |
| 10.5   |   | Form of Life Insurance Endorsement Method Split Dollar Plan  Agreement.*                    |
|   |   |                                                                                        |
| 10.6   |   | 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, 2001.                         |
|   |   |                                                                                        |
| 21     |   | Subsidiaries of the Registrant.***                                                          |
|   |   |                                                                                        |
| 23     |   | Consent of Berry Dunn McNeil & Parker.                                                  |
|   |   |                                                                                        |
| 99     |   | 2002 Proxy Statement. (previously filed on March 15, 2002).                                 |

 

----

*Incorporatedby reference to the Company’s Registration Statement on Form SB-2 (File No.333-56197), and any amendments thereto filed with the Securities and ExchangeCommission.

 

**Incorporated by reference to the Company’s Form 10-KSB for the year endedDecember 31, 2000.

 

***Incorporated by reference to the Company’s Form 10-KSB for the year endedDecember 31, 1999.

 

(c)           Reports on Form 8-K.

 

None.

 

24

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**SIGNATURES**

 

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

 

**MERRILL MERCHANTS BANCSHARES, INC.**

 
| By:    |   /s/ Edwin N. Clift                     |   |
|--------|-----------------------------------------------|--------|
|   | * 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  Executive Officer (Principal  executive officer) |   | March  27, 2002 |
| Edwin N. Clift                         |
|                                   |
|                                   |   |                                                                             |   |            |
| /s/ Deborah A. Jordan                  |   | Treasurer (Principal  financial  officer)                                        |   | March  27, 2002 |
| Deborah A. Jordan                      |
|                                   |   |                                                                             |   |            |
| /s/ William C. Bullock,  Jr.           |   | Chairman of the Board                                                            |   | March  27, 2002 |
| William C. Bullock, Jr.                |
|                                   |   |                                                                             |   |            |
| /s/ Joseph H. Cyr                      |   | Director                                                                         |   | March  27, 2002 |
| Joseph H. Cyr                          |
|                                   |   |                                                                             |   |            |
| /s/ Perry B. Hansen                    |   | Director                                                                         |   | March  27, 2002 |
| Perry B. Hansen                        |
|                                   |   |                                                                             |   |            |
| /s/ Robert E. Knowles                  |   | Director                                                                         |   | March  27, 2002 |
| Robert E. Knowles                      |
|                                   |   |                                                                             |   |            |
| /s/ Frederick A.  Oldenburg, Jr., M.D. |   | Director                                                                         |   | March  27, 2002 |
| Frederick A. Oldenburg,  Jr., M.D.     |
|                                   |   |                                                                             |   |            |
| /s/ Lloyd D. Robinson                  |   | Director                                                                         |   | March  27, 2002 |
| Lloyd D. Robinson                      |
|                                   |   |                                                                             |   |            |
| /s/ Dennis L. Shubert,  M.D., Ph.D.    |   | Director                                                                         |   | March  27, 2002 |
| Dennis L. Shubert, M.D.,  Ph.D.        |
|                                   |   |                                                                             |   |            |
| /s/ Susan B. Singer                    |   | Director                                                                         |   | March  27, 2002 |
| Susan B. Singer                        |

 

 

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