**Exhibit 13**

 

**CommunitySouth Bank & Trust**

**2008 Annual Report**

 

[Photo of CommunitySouth Bank & Trust branch with lightedsign]

 

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**Dear Shareholders, Customers and Friends:**

 

Itis no secret that 2008 represented a period unprecedented in the bankingindustry.  The real estate crisis andresulting economic downturn led to the failure of 25 US banks in 2008,including the $300 billion Washington Mutual, the largest bank failure inhistory.  Financial services industrystalwarts Wachovia, Bear Stearns, and Merrill Lynch were merged into otherinstitutions while Lehman Brothers is no longer in existence.  The two largest mortgage government sponsoredenterprises (GSEs), Fannie Mae and Freddie Mac, were placed in conservatorshipby the federal government.  The FederalReserve cut interest rates an unprecedented number of times in 2008, resultingin a significant contraction in many banks’ net interest margin.  These significant market events and economicforces have taken their toll on banks’ performances and their stock prices —including ours.

 

Despitethe challenges present in our industry, the banking sector remains highlycapitalized and well prepared to endure the current economic climate.  As of December 2008, equity capital inthe industry exceeded $1.3 trillion with an additional $173 billion held inreserve as a safeguard against possible losses. In fact, 97.6% of insured financial institutions, includingCommunitySouth, are “well capitalized,” the highest regulatory capitalstandard.  We are pleased to report thatas of December 31, 2008, the Bank’s total risk-based capital, Tier 1risk-based capital, and leverage ratios of 10.18%, 8.92%, and 7.98%,respectively, all exceed well capitalized standards.

 

Inconjunction with the difficulties present in the banking industry, 2008 was ayear marked by many challenges at CommunitySouth.  For the first time since our inaugural yearwe reported a loss.  In the secondquarter of 2008 we placed an additional $2.5 million into the allowance forloan losses for potential loan losses in a residential development on LakeKeowee in Seneca, South Carolina. Subsequently, in the fourth quarter of 2008, we charged off $3.0 millionof the total $4.9 million outstanding on these loans.  We continue to investigate whether fraud wasinvolved in these loans and have filed a notice of loss under our FinancialInstitution Bond.  We do believe theselosses to be an isolated event and not indicative of the overall quality of ourloan portfolio.  However, the rest of ourloan portfolio has not been immune from the problems caused by the currenteconomic downturn. Given the challenges in the overall economy and the generalpessimistic outlook for 2009, we have contributed an additional $4.3 million tothe loan loss reserve in the fourth quarter 2008.

 

Atthe end of fiscal year 2008 CommunitySouth reports total assets of $387.8million, an increase of 2.63% for the year. Given current industry and marketconditions, significant asset growth is not an objective for 2009.  In fact, one of our focused objectives for2009 is to continue to manage our balance sheet in order to enhance our totalrisk-based capital percentage.  Other2009 objectives include: reduce portfolio concentration of construction and landdevelopment loans, enhance credit risk management practices, tightly manageoverhead expense, increase non-interest income through our mortgage andservices divisions, improve margins, and lower our overall funding costs bygrowing core deposits.

 

Thispast year was a disappointing and challenging year for all financialinstitutions, including CommunitySouth, especially considering our stronghistorical performance.  However, webelieve we are well positioned to manage through this economic downturn and arepoised to take advantage of opportunities when economic conditions improve.

 

Ourmanagement team, employees, and Board of Directors greatly appreciate yourcontinued loyalty and support as we work toward our vision of being TheFinancial Services Provider of Choice in the Markets We Serve.

 

 

Sincerely,

 

 

| /s/  Daniel E. Youngblood |   | /s/  C. Allan Ducker, III |
|---------------------------|--------|--------------------------------|
|                      |   |                           |
|                      |   |                           |
| Daniel  E. Youngblood     |   | C.  Allan Ducker, III     |
| Chairman  of the Board    |   | Chief  Executive Officer       |

 

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**Selected Financial Data**

 

The following selected financial data for the years ended December 31,2008 and 2007 was derived from the consolidated financial statements and otherdata of CommunitySouth Financial Corporation and its subsidiary, CommunitySouthBank and Trust (the “Bank”) (collectively, the “Company”).  The selected financial data should be read inconjunction with the consolidated financial statements of the Company,including the accompanying notes, included elsewhere herein.

 

On January 16, 2007, the Company effected a 5-for-4 stock split inthe form of a stock dividend for shareholders of record as of December 15,2006.

 
| **(Dollars in thousands except per share data)** | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|--------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Income Statement Data:**                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest income – loans                                                   |       | $          | 20,163     |       | $          | 21,403 |   |
| Interest income – investments                                             |       | 2,547      |       | 1,813      |       |
| Total interest income                                                          |       | 22,710     |       | 23,216     |       |
| Interest expense – deposits                                               |       | (12,580    | )          | (13,069    | )          |
| Net interest income                                                            |       | 10,130     |       | 10,147     |       |
| Provision for loan losses                                                      |       | (7,168     | )          | (1,188     | )          |
| Net interest income after provision for  loan losses                           |       | 2,962      |       | 8,959      |       |
| Non-interest income                                                            |       | 1,392      |       | 1,575      |       |
| Non-interest expense                                                           |       | (9,510     | )          | (8,184     | )          |
| Income (loss) before income taxes                                              |       | (5,156     | )          | 2,350      |       |
| Income tax (expense) benefit                                                   |       | 1,806      |       | (782       | )          |
| Net income (loss)                                                              | ** ** | **$**      | **(3,350** | **)**      | **$**      | **1,568** | ** ** |
| ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Balance Sheet Data:**                                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total assets                                                                   |       | $          | 387,816    |       | $          | 377,867 |   |
| Earning assets                                                                 |       | 374,939    |       | 361,890    |       |
| Investment securities, available for sale  (1)                                 |       | 47,602     |       | 24,844     |       |
| Other investments (2)                                                          |       | 1,805      |       | 447        |       |
| Loans (3)                                                                      |       | 320,907    |       | 302,934    |       |
| Allowance for loan losses                                                      |       | (8,088     | )          | (4,214     | )          |
| Deposits                                                                       |       | 296,643    |       | 327,664    |       |
| Shareholders’ equity                                                      |       | 28,528     |       | 31,471     |       |
| ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Per-Share Data:**                                                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss) – basic                                                 |       | $          | (0.71      | )          | $          | 0.33 |   |
| Net income (loss) – diluted                                               |       | (0.71      | )          | 0.31       |       |
| Book value                                                                     |       | 6.07       |       | 6.70       |       |
|                                                                           |       |       |       |       |       |
| **Return on Equity and Assets:**                                               |       |       |       |       |       |
| Return on average assets                                                       |       | (0.87      | )%         | 0.50       | %          |
| Return on average equity                                                       |       | (10.91     | )%         | 5.12       | %          |
| Average equity to average assets ratio                                         |       | 7.99       | %          | 9.76       | %          |

 

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(1)   Marketable securities are stated at fair value.

(2)   Non-marketable securities are stated at cost.

(3)   Loans are stated at grossamounts before allowance for loan losses.

 

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**Forward Looking Statements**

 

Thisreport contains “forward-looking statements” within the meaning of the securitieslaws.  All statements that are nothistorical facts are “forward-looking statements.”  You can identify these forward-lookingstatements through our use of words such as “may,” “will,” “expect,” “anticipate,”“believe,” “intend,” “estimate,” “project,” “continue,” or other similarwords.  Forward-looking statementsinclude, but are not limited to, statements regarding our future businessprospects, revenues, working capital, liquidity, capital needs, interest costs,income, business operations and proposed services.

 

Theseforward-looking statements are based on current expectations, estimates andprojections about our industry, management’s beliefs, and assumptions made bymanagement.  Such information includes,without limitation, discussions as to estimates, expectations, beliefs, plans,strategies, and objectives concerning our future financial and operatingperformance.  These statements are notguarantees of future performance and are subject to risks, uncertainties andassumptions that are difficult to predict, particularly in light of the factthat we are a new company with limited operating history. Therefore, actualresults may differ materially from those expressed or forecasted in suchforward-looking statements.  The risksand uncertainties include, but are not limited to:

 

·  our rapid growth to date and short operating history;

·  significant increases in competitive pressure in thebanking and financial services industries;

·  changes in the interest rate environment which couldreduce anticipated or actual margins;

·  changes in political conditions or the legislative orregulatory environment;

·  general economic conditions, either nationally orregionally and especially in our primary service area, becoming less favorablethan expected resulting in, among other things, a deterioration in creditquality;

·  changes occurring in business conditions andinflation;

·  changes in technology;

·  changes in monetary and tax policies;

·  the lack of seasoning of our loan portfolio,especially given our rapid loan growth;

·  the level of allowance for loan losses;

·  the rate of delinquencies and amounts of charge-offs;

·  adverse changes in asset quality and resulting creditrisk-related losses and expenses;

·  loss of consumer confidence and economic disruptionsresulting from terrorist activities;

·  changes in the securities markets; and

·  other risks and uncertainties detailed from time totime in our filings with the Securities and Exchange Commission.

 

Weundertake no obligation to publicly update or revise any forward-lookingstatements, whether as a result of new information, future events orotherwise.  In light of these risks,uncertainties, and assumptions, the forward-looking events discussed in thisreport may not occur.

 

*A copy of the our Annual Report on Form 10-Kfor the fiscal year ended December 31, 2008, as filed with the Securitiesand Exchange Commission, which contains a discussion of certain risks anduncertainties that could affect our forward-looking statements, will be sent toany shareholder without charge upon written request to: CommunitySouthFinancial Corporation, Attn: John W. Hobbs, Chief Financial Officer, 6602Calhoun Memorial Highway, Easley, South Carolina 29640.*

 

**Market for Common Stock and Dividends**

 

SinceMarch 15, 2006, our common stock has been quoted on the OTC Bulletin Boardunder the symbol “CBSO.” Quotations on the OTC Bulletin Board reflectinter-dealer prices, without retail mark-up, mark-down, or commissions, and maynot represent actual transactions. Transactions of our common stock did not begin to occur on the OTCBulletin Board until March 16, 2006.

 

Thefollowing is a summary of the high and low bid prices for our common stockreported by the OTC Bulletin Board for the periods indicated (the bids priceshave been adjusted for all stock splits):

 
| **2008**       | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| Fourth Quarter |       | $        | 5.50       |    | $          | 1.75 |   |
| Third Quarter  |       | 7.00     |       | 2.53    |       |
| Second Quarter |       | 9.00     |       | 5.50    |       |
| First Quarter  |       | 10.00    |       | 7.30    |       |
|                |            |          |            |         |            |  |  |

 

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| **2007**       | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| Fourth Quarter |       | $        | 11.40      |    | $          | 8.55 |   |
| Third Quarter  |       | 13.50    |       | 11.00   |       |
| Second Quarter |       | 15.90    |       | 12.75   |       |
| First Quarter  |       | 18.00    |       | 13.68   |       |
|                |            |          |            |         |            |  |  |

 

Asof December 31, 2008, there were 4,698,697 shares of common stockoutstanding held by approximately 907 shareholders of record.

 

Wehave not declared or paid any cash dividends on our common stock since ourinception.  For the foreseeable future wedo not intend to declare cash dividends. We intend to retain earnings to grow our business and strengthen ourcapital base.  Our ability to paydividends depends on the ability of our subsidiary, CommunitySouth Bank andTrust, to pay dividends to us.  As aSouth Carolina state bank, CommunitySouth Bank and Trust may only pay dividendsout of its net profits, after deducting expenses, including losses and baddebts. In addition, the Bank is prohibited from declaring a dividend on itsshares of common stock unless its surplus equals or exceeds its stated capital.At December 31, 2008, the Bank had a deficit of $872,916.

 

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**COMMUNITYSOUTH FINANCIAL CORPORATION**

**MANAGEMENT’S DISCUSSION AND ANALYSIS**

 

**Basis of Presentation**

 

Thefollowing discussion should be read in conjunction with the Company’sConsolidated Financial Statements and the Notes thereto and the other financialdata included elsewhere in this Annual Report. The financial information provided below has been rounded in order tosimplify its presentation.  However, theratios and percentages provided below are calculated using the detailedfinancial information contained in the Consolidated Financial Statements, theNotes thereto and the other financial data included elsewhere in this AnnualReport.

 

# **General**

 

CommunitySouthFinancial Corporation is a bank holding company headquartered in Easley, SouthCarolina. Its subsidiary, CommunitySouth Bank and Trust, opened for business onJanuary 18, 2005.  The principalbusiness activity of the Bank is to provide banking services to domesticmarkets, principally in the upstate of South Carolina.  The deposits of the Bank are insured by theFederal Deposit Insurance Corporation (the “FDIC”). The Company completed aninitial public offering of its common stock in which it sold a total of4,681,069 shares at $6.40 per share (as adjusted for all previous stocksplits).  Proceeds of the offering wereused to pay organizational costs and provide the initial capital for the Bank.

 

# **Overview**

 

Thefollowing discussion describes our results of operations for the years ended December 31,2008 and 2007 and also analyzes our financial condition as of December 31,2008 and 2007.  We received approvalsfrom the FDIC, the Federal Reserve Board (“FRB”) and the State Board ofFinancial Institutions during January 2005, and commenced business on January 18,2005.

 

Likemost community banks, we derive most of our income from interest we receive onour loans and investments. Our primary source of funds for making these loansand investments is our deposits, on which we pay interest. Consequently, one ofthe key measures of our success is our amount of net interest income, or thedifference between the income on our interest-earning assets, such as loans andinvestments, and the expense on our interest-bearing liabilities, such asdeposits. Another key measure is the spread between the yield we earn on theseinterest-earning assets and the rate we pay on our interest-bearingliabilities.

 

Ofcourse, there are risks inherent in all loans, so we maintain an allowance forloan losses to absorb probable losses on existing loans that may becomeuncollectible. We establish and maintain this allowance by charging a provisionfor loan losses against our operating earnings. We have included a detaileddiscussion of this process in the following section.

 

Inaddition to earning interest on our loans and investments, we earn incomethrough fees and other expenses we charge to our customers. We describe thevarious components of this non-interest income, as well as our non-interestexpense, in the discussion below.

 

**Recent Legislative and Regulatory Initiatives to Address Financial andEconomic Crises**

 

TheCongress, Treasury Department and the federal banking regulators, including theFDIC, have taken broad action since early September 2008 to addressvolatility in the U.S. banking system.

 

In October 2008,the Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted. The EESAauthorizes the Treasury Department to purchase from financial institutions andtheir holding companies up to $700 billion in mortgage loans, mortgage-relatedsecurities and certain other financial instruments, including debt and equitysecurities issued by financial institutions and their holding companies in atroubled asset relief program (“TARP”). The purpose of TARP is to restore confidence and stability to the U.S.banking system and to encourage financial institutions to increase theirlending to customers and to each other. The Treasury Department has allocated $250 billion towards the TARPCapital Purchase Program (“CPP”).  Underthe CPP, the Treasury Department will purchase debt or equity securities fromparticipating institutions.  The TARPalso will include direct purchases or guarantees of troubled assets offinancial institutions. Participants in the CPP are subject to executivecompensation limits and are encouraged to expand their lending and mortgageloan modifications.

 

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EESAalso increased FDIC deposit insurance on most accounts from $100,000 to$250,000.  This increase is in placeuntil the end of 2009 and is not covered by deposit insurance premiums paid bythe banking industry.

 

Followinga systemic risk determination, the FDIC established the Temporary LiquidityGuarantee Program (“TLGP”) on October 14, 2008.  The TLGP includes the Transaction AccountGuarantee Program (“TAGP”), which provides unlimited deposit insurance coveragethrough December 31, 2009 for noninterest-bearing transaction accounts(typically business checking accounts) and certain funds swept intononinterest-bearing savings accounts. Institutions participating in the TLGP pay a 10 basis points fee(annualized) on the balance of each covered account in excess of $250,000,while the extra deposit insurance is in place. The TLGP also includes the Debt Guarantee Program (“DGP”), under whichthe FDIC guarantees certain senior unsecured debt of FDIC-insured institutionsand their holding companies.  Theunsecured debt must be issued on or after October 14, 2008 and not laterthan June 30, 2009, and the guarantee is effective through the earlier ofthe maturity date or June 30, 2012. The DGP coverage limit is generally 125% of the eligible entity’seligible debt outstanding on September 30, 2008 and scheduled to mature onor before June 30, 2009 or, for certain insured institutions, 2% of theirliabilities as of September 30, 2008. Depending on the term of the debt maturity, the nonrefundable DGP feeranges from 50 to 100 basis points (annualized) for covered debt outstandinguntil the earlier of maturity or June 30, 2012.  The TAGP and DGP are in effect for alleligible entities, unless the entity opted out on or before December 5,2008.  CommunitySouth opted toparticipate in both programs.

 

On February 17,2009, President Obama signed into law The American Recovery and ReinvestmentAct of 2009 (“ARRA”), more commonly known as the economic stimulus or economicrecovery package.  ARRA includes a widevariety of programs intended to stimulate the economy and provide for extensiveinfrastructure, energy, health, and education needs.  In addition, ARRA imposes certain newexecutive compensation and corporate expenditure limits on all current andfuture TARP recipients that are in addition to those previously announced bythe U.S. Treasury, until the institution has repaid the Treasury Department,which is now permitted under ARRA without penalty and without the need to raisenew capital, subject to the Treasury Department’s consultation with therecipient’s appropriate regulatory agency.

 

Furtherregulatory actions may arise as the Federal government continues to attempt toaddress the economic situation.

 

# **Results of Operations**

# ** **

***Results of operations are only presented for the years ended December 31,2008 and 2007.***

 

Netinterest income decreased $16,628, or 0.16%, to $10.13 million in 2008, downfrom $10.15 million in 2007. The primary component of interest income in 2008was interest on loans, including fees, of $20.2 million, as compared to $21.4million in 2007. The decrease in net interest income was due primarily to adecrease in rates, translating into lower loan yields.

 

TheCompany’s net interest spreads were 2.27% and 2.75% in 2008 and 2007,respectively. The Company’s net interest margins were 2.74% and 3.38% in 2008and 2007, respectively.  This decline of64 basis points in the net interest margin was due the decline in marketrates.  Yields on average earning assetsdecreased from 7.74% in 2007 to 6.13% in 2008. Rates on average interestbearing liabilities decreased from 4.99% in 2007 to 3.86% in 2008. Thesechanges in yields and rates resulted in a net decrease in net interest spreadof 48 basis points. Average shareholder equity was 9.5% of average interestbearing liabilities in 2008 and 11.7% of average interest bearing liabilitiesin 2007.

 

Theprovision for loan losses was $7.2 million in 2008, compared to $1.2 million in2007.  The charges to the provision wereto maintain the allowance for loan losses at a level sufficient to coverestimated losses inherent in the loan portfolio, given the current economicdownturn which has affected the entire banking industry.  CommunitySouth, like many community banks,has a significant amount of loans that directly or indirectly rely on the homebuilding industry, which has also experienced an extremely turbulent year.

 

Non-interestincome decreased $182,428, or 11.59%, to $1.4 million in 2008, down fromnon-interest income of $1.6 million in 2007. The decrease is attributable tothe $528,582 decrease, or 52.96%, in mortgage loan origination fees, which was$469,529 for the year ended December 31, 2008.  The decrease is due to our decreased volumein mortgage loan originations and departmental restructuring. Income frombank-owned life insurance was $210,525 in 2008, a slight decline from income of$222,048 in 2007.  Service charges ondeposit accounts increased $173,752, or 117.1%, to $322,090 in 2008, ascompared to service charges on deposit accounts of $148,338 in 2007, due to theincreased volume in deposit accounts.

 

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Non-interestexpense increased $1.3 million, or 16.2%, to $9.5 million in 2008, compared tonon-interest expense of $8.2 million in 2007. Non-interest expense increased inmost categories as a result of our continued growth. Salaries and employeebenefits increased $491,843 to $4.8 million for the year ended December 31,2008. This increase is attributable to normal pay increases, hiring ofadditional staff to meet the needs associated with our growth. The Company’sefficiency ratio was 82.5% in 2008 compared to 69.8% in 2007. The efficiencyratio is defined as non-interest expense divided by the sum of net interestincome and non-interest income, net of gains and losses on sales ofassets.  The deterioration in ourefficiency ratio is primarily attributable to the increased expenses describedabove, which we incurred to position our Bank for anticipated growth.

 

TheCompany’s net loss was $3.4 million in 2008, compared to net income of $1.6million in 2007. Return on average assets during 2008 was -0.87% compared to areturn of 0.50% in 2007. Net loss in 2008 was after an income tax benefit of$1.8 million and net income in 2007 was after an income tax expense of$781,656. The income tax expenses for 2008 and 2007 resulted in effective taxrates of 35.0% and 33.3%, respectively. See Notes 1 and 12 to the consolidatedfinancial statements for additional information about income taxes.

 

# **Net Interest Income**

# ** **

***General****.*  The largest component of the Company’s netincome is its net interest income, which is the difference between the incomeearned on assets and interest paid on deposits and borrowings used to supportsuch assets.  Net interest income isdetermined by the yields earned on the Company’s interest-earning assets andthe rates paid on its interest-bearing liabilities, as well as the relativeamounts of interest-earning assets and interest-bearing liabilities.  Net interest income divided by averageinterest-earning assets represents the Company’s net interest margin.  The net interest spread is the differencebetween the yield we earn on our interest-earning assets and the rate we pay onour interest-bearing liabilities.

 

***Rate/Volume Analysis****.*  Netinterest income can be analyzed in terms of the impact of changing interestrates and changing volumes.  Thefollowing tables set forth the effect which the varying levels ofinterest-earning assets and interest-bearing liabilities and the applicablerates have had on changes in the net interest income for the periods presented.

 
| ** **                           | ** ** | **December 31, 2008 vs. 2007** | ** ** |
|--------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **Increase (decrease) Due to**      | ** ** |
| ** **                           | ** ** | ** **                                         | ** ** | ** ** | ** ** | **Rate /** | ** ** | ** ** | ** ** |
| **(Dollars in thousands)** | ** ** | **Volume**                                         | ** ** | **Rate** | ** ** | **Volume** | ** ** | **Total** | ** ** |
| Interest Income                      |       |                                               |       |   |   |   |   |   |   |
| Loans                                |       | $                                                  | 4,067      |   | $ | (4,460 | ) | $ | (847 | ) | $ | (1,240 | ) |
| Investment securities (1)            |       | 1,926                                              |       | (72 | ) | (209 | ) | 1,645 |   |
| Federal funds                        |       | (754                                               | )          | (454 | ) | 298 |   | (910 | ) |
| Total Interest Income                | ** ** | **$**                                              | **5,239**  | ** ** | **$** | **(4,986** | **)** | **$** | **(758** | **)** | **$** | **(505** | **)** |
|                                 |       |                                               |       |   |   |   |   |   |   |
| Interest Expense                     |       |                                               |       |   |   |   |   |   |   |
| Deposits                             |       | $                                                  | 1,232      |   | $ | (2,549 | ) | $ | (241 | ) | $ | (1,558 | ) |
| Other borrowings                     |       | 1,076                                              |       | — |   | (7 | ) | 1,069 |   |
| Total Interest Expense               | ** ** | **$**                                              | **2,308**  | ** ** | **$** | **(2,549** | **)** | **$** | **(248** | **)** | **$** | **(489** | **)** |
|                                 |       |                                               |       |   |   |   |   |   |   |
| Net Interest Income                  | ** ** | **$**                                              | **2,931**  | ** ** | **$** | **(2,437** | **)** | **$** | **(510** | **)** | **$** | **(16** | **)** |

 

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(1)   For the purpose of this table,the investment securities include marketable and non-marketable securities.

 

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***Average Balances, Income and Expenses and Rates****.*  Thefollowing table sets forth, for the years ended December 31, 2008 and2007, information related to the Company’s average balance sheet and itsaverage yields on earning assets and average costs of interest-bearingliabilities.  Such yields are derived bydividing income or expense by the average balance of the corresponding earningassets or interest-bearing liabilities. Average balances have been derived from the daily balances throughoutthe periods indicated.

 
| ** **                                      | ** ** | **2008**    | ** **  | **2007**          | ** ** |
|-------------------------------------------------|------------|-------------|-------------|-------------------|------------|
| ** **                                      | ** ** | **Average** | ** **  | **Income /** | ** ** | **Yield/** | ** ** | **Average** | ** ** | **Income /** | ** ** | **Yield /** | ** ** |
| **(Dollars in thousands)**            | ** ** | **Balance** | ** **  | **Expense**       | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Expense** | ** ** | **Rate** | ** ** |
| **Assets**                                      |       |        |        |              |       |   |   |   |   |   |   |   |   |
| Earning assets:                                 |       |        |        |              |       |   |   |   |   |   |   |   |   |
| Loans (1)                                       |       | $           | 315,175     |              | $          | 20,163 |   | 6.40 | % | $ | 264,844 |   | $ | 1,403 |   | 8.08 | % |
| Investment securities (2)                       |       | 47,130      |        | 2,308             |       | 4.90 | % | 12,067 |   | 663 |   | 5.49 | % |
| Federal funds sold and other                    |       | 7,884       |        | 239               |       | 3.04 | % | 22,914 |   | 1,150 |   | 5.02 | % |
| Total earning assets                            |       | 370,189     |        | 22,710            |       | 6.13 | % | 299,825 |   | 23,216 |   | 7.74 | % |
| Cash and due from banks                         |       | 5,579       |        |              |       |   |   | 4,720 |   |   |   |   |   |
| Premises and equipment                          |       | 4,873       |        |              |       |   |   | 4,953 |   |   |   |   |   |
| Other assets                                    |       | 8,944       |        |              |       |   |   | 7,856 |   |   |   |   |   |
| Allowance for loan losses                       |       | (5,528      | )           |              |       |   |   | (3,686 | ) |   |   |   |   |
| Total assets                                    | ** ** | **$**       | **384,057** |              |       |   |   | ** ** | **$** | **313,668** |   |   |   |   |   |
| ** **                                      |       |        |        |              |       |   |   |   |   |   |   |   |   |
| **Liabilities**                                 |       |        |        |              |       |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                   |       |        |        |              |       |   |   |   |   |   |   |   |   |
| Repurchase agreements                           |       | $           | 28,525      |              | 700        |   | 2.46 | % | $ | 2,315 |   | 63 |   | 2.72 | % |
| Federal funds purchased                         |       | 1,312       |        | 24                |       | 1.85 | % | — |   | — |   | — | % |
| Federal Home Loan Bank advances                 |       | 9,645       |        | 224               |       | 2.33 | % | — |   | — |   | — | % |
| Note Payable                                    |       | 916         |        | 34                |       | 3.71 | % | — |   | — |   | — | % |
| Subordinated Debt                               |       | 1,294       |        | 149               |       | 11.50 | % | — |   | — |   | — | % |
| Interest-bearing transaction accounts           |       | 15,300      |        | 324               |       | 2.12 | % | 11,520 |   | 196 |   | 1.70 | % |
| Savings deposits                                |       | 18,881      |        | 223               |       | 1.18 | % | 19,107 |   | 648 |   | 3.39 | % |
| Time deposits                                   |       | 249,765     |        | 10,902            |       | 4.36 | % | 228,748 |   | 12,162 |   | 5.32 | % |
| Total interest-bearing liabilities              |       | 325,638     |        | 12,580            |       | 3.86 | % | 261,690 |   | 13,069 |   | 4.99 | % |
| Demand deposits                                 |       | 23,739      |        |              |       |   |   | 18,864 |   |   |   |   |   |
| Accrued interest and other liabilities          |       | 3,967       |        |              |       |   |   | 2,492 |   |   |   |   |   |
| Total liabilities                               |       | 353,344     |        |              |       |   |   | 283,046 |   |   |   |   |   |
| Shareholders’ equity                       |       | 30,713      |        |              |       |   |   | 30,622 |   |   |   |   |   |
| Total liabilities and shareholders’ equity |       | **$**       | **384,057** |              |       |   |   |   | **$** | **313,668** |   |   |   |   |   |
| ** **                                      |       |        |        |              |       |   |   |   |   |   |   |   |   |
| Net interest income                             | ** ** | ** **  | ** **  | **$**             | **10,130** |   |   |   |   |   | **$** | **10,147** |   |   |   |
| Net interest spread                             | ** ** | ** **  | ** **  | ** **        | ** ** | **2.27** | **%** | ** ** | ** ** | ** ** | ** ** | **2.75** | **%** |
| Net interest margin                             | ** ** | ** **  | ** **  | ** **        | ** ** | **2.74** | **%** | ** ** | ** ** | ** ** | ** ** | **3.38** | **%** |

 

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(1)   There were $9.9 million and$35,172 of loans in non-accrual status as of December 31, 2008 and 2007,respectively.  The effect of feescollected on loans in 2008 and 2007 totaled $260,966 and $654,596,respectively, and increased the annualized yield on loans by 9 basis pointsfrom 6.31% for 2008 and by 25 basis points from 7.83% for 2007.  The effect of such fees on the annualizedyield on earning assets was an increase of 7 basis points from 6.06% in 2008and an increase of 22 basis points from 7.52% in 2007.  The effects of such fees on net interestspread were an increase of 7 basis points from 2.20% for 2008 and an increaseof 22 basis points from 2.53% for 2007. The effects of such fees on net interest margin were an increase of 17basis points from 2.57% for 2008 and an increase of 21 basis points from 3.17%for 2007.

 

(2)   For the purpose of this table,the investment securities include marketable and non-marketable securities.

 

9

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***Interest Sensitivity****.* The Company monitors and manages the pricing and maturity of its assetsand liabilities in order to diminish the potential adverse impact that changesin interest rates could have on its net interest income.  The principal monitoring technique employedby the Company is the measurement of the Company’s interest sensitivity “gap”,which is the positive or negative dollar difference between assets andliabilities that are subject to interest rate repricing within a given periodof time.  Interest rate sensitivity canbe managed by repricing assets or liabilities, selling securities available forsale, replacing an asset or liability at maturity, or adjusting the interestrate during the life of an asset or liability. Managing the amount of assetsand liabilities repricing in this same time interval helps to hedge the riskand minimize the impact on net interest income of rising or falling interestrates.

 

The following table sets forth the Company’s interest rate sensitivityat December 31, 2008.

 
| ** **                                       | ** ** | ** ** | ** **  | **After**   | ** ** | ** **  | ** ** | ** **  | ** **  | ** ** | ** ** |
|--------------------------------------------------|------------|------------|-------------|-------------|------------|-------------|------------|-------------|-------------|------------|------------|
| ** **                                       | ** ** | ** ** | ** **  | **Three**   | ** ** | **One**     | ** ** | **Greater** | ** **  | ** ** | ** ** |
| ** **                                       | ** ** | **Within** | ** **  | **Through** | ** ** | **Through** | ** ** | **Than**    | ** **  | ** ** | ** ** |
| ** **                                       | ** ** | **Three**  | ** **  | **Twelve**  | ** ** | **Five**    | ** ** | **Five**    | ** **  | ** ** | ** ** |
| **(Dollars in thousands)**             | ** ** | **Months** | ** **  | **Months**  | ** ** | **Years**   | ** ** | **Years**   | ** **  | **Total**  | ** ** |
| **Assets**                                       | ** ** | ** ** | ** **  | ** **  | ** ** | ** **  | ** ** | ** **  | ** **  | ** ** | ** ** |
| Earning assets:                                  |       |       |        |        |       |        |       |        |        |       |       |
| Loans, gross                                     |       | $          | 182,297     |        | $          | 19,515      |       | $           | 110,307     |       | $          | 8,788 |   | $ | 320,907 |   |
| Investment securities, available for sale        |       | 1,500      |        | 1,500       |       | 17,594      |       | 27,008      |        | 47,602     |       |
| Other investments                                |       | —     |        | —      |       | —      |       | 1,805       |        | 1,805      |       |
| Fed Funds                                        |       | 4,625      |        | —      |       | —      |       | —      |        | 4,625      |       |
| Total earning assets                             |       | 188,422    |        | 21,015      |       | 127,901     |       | 37,601      |        | 374,939    |       |
|                                             |       |       |        |        |       |        |       |        |        |       |       |
| **Liabilities**                                  |       |       |        |        |       |        |       |        |        |       |       |
| Interest-bearing liabilities:                    |       |       |        |        |       |        |       |        |        |       |       |
| Interest-bearing deposits:                       |       |       |        |        |       |        |       |        |        |       |       |
| Repurchase agreements                            |       | —     |        | —      |       | 15,000      |       | 15,000      |        | 30,000     |       |
| Other Borrowings                                 |       | 25,000     |        | 1,570       |       | —      |       | 4,325       |        | 30,895     |       |
| Demand deposits                                  |       | 16,449     |        | —      |       | —      |       | —      |        | 16,449     |       |
| Savings deposits                                 |       | 14,461     |        | —      |       | —      |       | —      |        | 14,461     |       |
| Time deposits                                    |       | 199,302    |        | 40,349      |       | 3,920       |       | —      |        | 243,571    |       |
| Total interest-bearing liabilities               |       | 255,212    |        | 41,919      |       | 18,920      |       | 19,325      |        | 335,376    |       |
| Period gap                                       | ** ** | **$**      | **(66,790** | **)**       | **$**      | **(20,904** | **)**      | **$**       | **108,981** | ** ** | **$**      | **18,276** | ** ** | **$** | **39,563** | ** ** |
| Cumulative gap                                   | ** ** | **$**      | **(66,790** | **)**       | **$**      | **(87,694** | **)**      | **$**       | **21,287**  | ** ** | **$**      | **39,563** | ** ** | ** ** | ** ** |
| Ratio of cumulative gap to total earning  assets | ** ** | **(17.81** | **)%**      | **(23.39**  | **)%**     | **5.68**    | **%**      | **10.55**   | **%**       |       |       |

 

Theabove table reflects the balances of interest-earning assets andinterest-bearing liabilities at the earlier of their repricing or maturitydates.  Overnight federal funds arereflected at the earliest pricing interval due to the immediately availablenature of the instruments.  Scheduledpayment amounts of fixed rate amortizing loans are reflected at each scheduledpayment date.  Scheduled payment amountsof variable rate amortizing loans are reflected at each scheduled payment dateuntil the loan may be repriced contractually; the unamortized balance isreflected at that point. Interest-bearing liabilities with no contractual maturity, such assavings deposits and interest-bearing transaction accounts, are reflected inthe earliest repricing period due to contractual arrangements which give theCompany the opportunity to vary the rates paid on those deposits within athirty-day or shorter period.  Fixed ratetime deposits, principally certificates of deposit, are reflected at theircontractual maturity date.

 

The Company generally would benefit from increasing market rates ofinterest when it has an asset-sensitive gap position and generally wouldbenefit from decreasing market rates of interest when it isliability-sensitive.  The Company iscumulatively liability sensitive over the three-month to twelve-month periodand asset sensitive over all periods**greaterthan one year.  However, the Company’sgap analysis is not a precise indicator of its interest sensitivityposition.  The analysis presents only astatic view of the timing of maturities and repricing opportunities, withouttaking into consideration that changes in interest rates do not affect allassets and liabilities equally.  Netinterest income may be impacted by other significant factors in a giveninterest rate environment, including changes in the volume and mix of earningassets and interest-bearing liabilities.

 

10

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# **Provision and Allowance for Loan Losses**

 

***General****.*  The Company has developed policies andprocedures for evaluating the overall quality of its credit portfolio and thetimely identification of potential problem loans.  On a quarterly basis, the Company’s Board ofDirectors reviews and approves the appropriate level for the Company’sallowance for loan losses based upon management’s recommendations, the resultsof the internal monitoring and reporting system, and an analysis of economicconditions in its market.

 

Additionsto the allowance for loan losses, which are expensed through the provision forloan losses on the Company’s income statement, are made periodically tomaintain the allowance at an appropriate level based on management’s analysisof the estimated losses inherent in the loan portfolio.  Loan losses and recoveries are charged orcredited directly to the allowance.  Theamount of the provision is a function of the level of loans outstanding, thelevel of non-performing loans, historical loan loss experience, the amount ofloan losses actually charged against the reserve during a given period, andcurrent and anticipated economic conditions.

 

TheCompany’s allowance for loan losses is based upon judgments and assumptionsabout risk elements in the portfolio, future economic conditions, and otherfactors affecting borrowers.  The processincludes identification and analysis of loss potential in various portfoliosegments utilizing a credit risk grading process and specific reviews andevaluations of significant problem credits. However, there is no precise method of estimating credit losses, sinceany estimate of loan losses is necessarily subjective and the accuracy dependson the outcome of future events.  Inaddition, due to our rapid growth over the past several years and our limitedoperating history, a large portion of the loans in our loan portfolio wasoriginated recently.  In general, loansdo not begin to show signs of credit deterioration or default until they havebeen outstanding for some period of time, a process referred to asseasoning.  As a result, a portfolio ofmore mature loans will usually behave more predictably than a newerportfolio.  Because our loan portfolio isrelatively new, the current level of delinquencies and defaults may not berepresentative of the level that will prevail when the portfolio becomes moreseasoned, which may be higher than current levels.  If charge-offs in future periods increase, wemay be required to increase our provision for loan losses, which would decreaseour net income and possibly our capital.

 

Basedon present information and an ongoing evaluation, management considers theallowance for loan losses to be adequate to meet presently known and inherentlosses in the loan portfolio.  Management’sjudgment about the adequacy of the allowance is based upon a number ofassumptions about future events which it believes to be reasonable but whichmay or may not be accurate.  Thus, therecan be no assurance that charge-offs in future periods will not exceed theallowance for loan losses or that additional increases in the allowance forloan losses will not be required, especially considering the overall weaknessin the commercial real estate market in our market areas.

 

Thefollowing table sets forth certain information with respect to the Company’sallowance for loan losses and the composition of charge-offs and recoveries forthe years ended December 31, 2008 and 2007.

 

# **Allowance for Loan Losses**

 
| **(Dollars in thousands)**                       | ** ** | **2008** | ** **  | **2007**   | ** ** |
|------------------------------------------------------------|------------|----------|-------------|------------|------------|
| Total loans outstanding at end of period                   | ** ** | **$**    | **320,907** | ** ** | **$**      | **302,934** | ** ** |
| Average loans outstanding                                  | ** ** | **$**    | **315,175** | ** ** | **$**      | **264,844** | ** ** |
| Balance of allowance for loan losses at  beginning of year |       | $        | 4,214       |       | $          | 3,091 |   |
| Provision for loan losses                                  |       | 7,168    |        | 1,188      |       |
| Charge-offs                                                |       | (3,294   | )           | (65        | )          |
| Balance of allowance for loan losses at end  of year       | ** ** | **$**    | **8,088**   | ** ** | **$**      | **4,214** | ** ** |
| Allowance for loan losses to period end  loans             | ** ** | **2.52** | **%**       | **1.39**   | **%**      |

 

**Non-performing Assets**

 

***Non-performing Assets****.* There were $9.9 million and $35,172 ofnon-accrual loans at December 31, 2008 and December 31, 2007,respectively. There were $6,035 of loans past due 90 days or more and stillaccruing interest or restructured loans at December 31, 2008.  There were no loans past due 90 days or moreand still accruing interest or restructured loans at December 31,2007.  There was $415,229 and $0 in OtherReal Estate Owned at December 31, 2008 and 2007, respectively.

 

11

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TheCompany’s policy with respect to non-performing assets is as follows.  Accrual of interest will be discontinued on aloan when management believes, after considering economic and businessconditions and collection efforts that the borrower’s financial condition issuch that the collection of interest is doubtful.  A delinquent loan will generally be placed innon-accrual status when it becomes 90 days or more past due unless theestimated net realizable value of collateral exceeds the principal balance andaccrued interest.  When a loan is placedin non-accrual status, all interest which has been accrued on the loan butremains unpaid is reversed and deducted from current earnings as a reduction ofreported interest income.  No additionalinterest will be accrued on the loan balance until the collection of bothprincipal and interest becomes reasonably certain.  When a problem loan is finally resolved,there may ultimately be an actual write-down or charge-off of the principalbalance of the loan to the allowance for loan losses.

 

***Potential Problem Loans****.* Potential problem loans are loans that are not included in impairedloans, but about which management has become aware of information aboutpossible credit problems of the borrowers that causes doubt about their abilityto comply with current repayment terms. At December 31, 2008 and December 31,2007, the Company had identified $424,844 and $1,625,150, respectively, ofpotential problem loans through its internal review procedures.  The results of this internal review processare considered in determining management’s assessment of the adequacy of theallowance for loan losses.

 

# **Non-interest Income and Expense**

# ** **

***Non-interest Income****.*  Thelargest component of non-interest income was mortgage origination fees whichtotaled $469,529 and $998,111 for the years ended December 31, 2008 and2007, respectively.

 

Thefollowing table sets forth the principal components of non-interest income forthe years ended December 31, 2008 and 2007.

 
| **(Dollars in thousands)** | ** ** | **2008** | ** ** | **2007**   | ** ** |
|--------------------------------------|------------|----------|------------|------------|------------|
| Mortgage origination fees            |       | $        | 470        |       | $          | 998 |   |
| Service charges on deposit accounts  |       | 322      |       | 148        |       |
| Bank-owned life insurance            |       | 211      |       | 222        |       |
| Other income                         |       | 389      |       | 206        |       |
| Total non-interest income            | ** ** | **$**    | **1,392**  | ** ** | **$**      | **1,574** | ** ** |

 

***Non-interest Expense****. *Salaries and employee benefits comprised the largest component ofnon-interest expense which totaled $4.8 million and $4.3 million for the yearsended December 31, 2008 and 2007, respectively.  All of the other categories of non-interestexpense totaled $4.7 million and $3.9 million for the years ended December 31,2008 and 2007, respectively.

 

Thefollowing table sets forth the primary components of non-interest expense forthe years ended December 31, 2008 and 2007.

 
| **(Dollars in thousands)** | ** ** | **2008** | ** ** | **2007**   | ** ** |
|--------------------------------------|------------|----------|------------|------------|------------|
| Salaries and benefits                |       | $        | 4,828      |       | $          | 4,336 |   |
| Net occupancy                        |       | 638      |       | 500        |       |
| Depreciation                         |       | 718      |       | 601        |       |
| Equipment maintenance and rental     |       | 194      |       | 109        |       |
| Advertising                          |       | 248      |       | 270        |       |
| Professional fees                    |       | 449      |       | 335        |       |
| Office supplies                      |       | 95       |       | 146        |       |
| Telephone                            |       | 148      |       | 145        |       |
| Data processing                      |       | 758      |       | 603        |       |
| Other                                |       | 1,435    |       | 1,139      |       |
| Total non-interest expense           | ** ** | **$**    | **9,511**  | ** ** | **$**      | **8,184** | ** ** |

 

12

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**Earning Assets**

 

***Loans****.*Loansare the largest category of earning assets and typically provide higher yieldsthan the other types of earning assets. Loans also entail greater credit and liquidity risks than most of theCompany’s other investments and short-term interest-earning cash and cashequivalents, which management attempts to control and counterbalance.  Loans averaged $315.2 million and $264.8million in 2008 and 2007, respectively. Total loans were $320.9 million and$302.9 million at December 31, 2008 and 2007, respectively.

 

Thefollowing table sets forth the composition of the loan portfolio by category atDecember 31, 2008 and 2007 and highlights the Company’s general emphasison mortgage lending.

 
| ** **                           | ** ** | **2008**   | ** **  | **2007**          | ** ** |
|--------------------------------------|------------|------------|-------------|-------------------|------------|
| ** **                           | ** ** | ** ** | ** **  | **Percent**       | ** ** | ** ** | ** ** | **Percent** | ** ** |
| **(Dollars in thousands)** | ** ** | **Amount** | ** **  | **Of Total** | ** ** | **Amount** | ** ** | **Of Total** | ** ** |
| Real estate – construction      |       | $          | 129,777     |              | 40.44      | % | $ | 124,016 |   | 40.94 | % |
| Real estate – mortgage          |       | 154,838    |        | 48.25             | %          | 149,369 |   | 49.31 | % |
| Commercial and industrial            |       | 33,303     |        | 10.38             | %          | 26,095 |   | 8.61 | % |
| Consumer                             |       | 2,989      |        | 0.93              | %          | 3,454 |   | 1.14 | % |
| Total loans, gross                   |       | 320,907    | ** **  | **100.00**        | **%**      | 302,934 | ** ** | **100.00** | **%** |
| Allowance for loan losses            |       | (8,088     | )           |              |       | (4,214 | ) |   |   |
| Net loans                            | ** ** | **$**      | **312,819** |              |       | ** ** | **$** | **298,720** |   |   |   |

 

Thelargest component of loans in the Company’s loan portfolio is real estate mortgageloans.  At December 31, 2008 and2007, real estate mortgage loans, which consist of first and second mortgageson single or multi-family residential dwellings, loans secured by commercialand industrial real estate and other loans secured by multi-family propertiesand farmland, totaled $154.8 million and $149.4 million, respectively andrepresented 48.25% and 49.31%, respectively of the total loan portfolio.  In the context of this discussion, a “realestate mortgage loan” is defined as any loan, other than a loan forconstruction purposes, secured by real estate, regardless of the purpose of theloan.  It is common practice forfinancial institutions in the Company’s market area to obtain a securityinterest in real estate whenever possible, in addition to any other availablecollateral.  This collateral is taken toreinforce the likelihood of the ultimate repayment of the loan and tends toincrease the magnitude of the real estate loan portfolio component.  Real estate mortgage loans represent 25% ofour impaired loans.

 

Thedemand for residential and commercial real estate loans in the upstate SouthCarolina market is strong due to the historically low interest rateenvironment.  Commercial real estateloans are generally viewed as having more risk of default than residential realestate loans.  They are also typicallylarger than residential real estate loans and consumer loans and depend on cashflows from the owner’s business or the property to service the debt.  Cash flows may be affected significantly bygeneral economic conditions (including rising interest rates), a downturn inthe local economy, or a decline in occupancy rates in the local economy wherethe property is located.  Because ourloan portfolio contains a number of commercial real estate loans withrelatively large balances, the deterioration of one or a few of these loanscould cause a significant increase in our level of non-performing loans.  An increase in non-performing loans couldresult in a loss of earnings from these loans, an increase in the relatedprovision for loan losses and an increase in charge-offs, all of which couldhave a material adverse effect on our financial condition and results ofoperations.

 

Realestate construction loans totaled $129.8 million and $124.0 million at December 31,2008 and 2007, respectively. In the context of this discussion, a “real estateconstruction loan” is defined as any loan for construction purposes, secured byreal estate.  Real estate constructionloans represent 74% of our impaired loans.

 

Commercialand industrial loans totaled $33.3 million and $26.1 million at December 31,2008 and 2007, respectively and comprised 10.38% and 8.61%, respectively of thetotal portfolio. In the context of this discussion, a “commercial and industrialloan” is defined as any loan for a non-consumer purpose, not secured by realestate.

 

TheCompany’s loan portfolio also includes consumer loans.  At December 31, 2008 and 2007, consumerloans totaled $3.0 million and $3.5 million, respectively and represented 0.93%and 1.14%, respectively of the total loan portfolio.

 

TheCompany’s loan portfolio reflects the diversity of its upstate South Carolinamarket.  The Company’s offices arelocated in Easley, Spartanburg, Mauldin, Greer, Anderson and Greenville, SouthCarolina.  Management expects the area toremain stable with continued growth in the near future.  The diversity of the economy createsopportunities for all types of lending. The Company does not engage in foreign lending.

 

13

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Therepayment of loans in the loan portfolio as they mature is also a source ofliquidity for the Company.  The followingtables set forth the Company’s loans maturing within specified intervals at December 31,2008 and 2007.

 

**2008**

 
| ** **                           | ** ** | ** **        | ** **  | **Over One** | ** ** | ** **  | ** ** | ** ** | ** **  |
|--------------------------------------|------------|-------------------|-------------|-------------------|------------|-------------|------------|------------|-------------|
| ** **                           | ** ** | ** **        | ** **  | **Year**          | ** ** | ** **  | ** ** | ** ** | ** **  |
| ** **                           | ** ** | ** **        | ** **  | **Through**       | ** ** | **Over**    | ** ** | ** ** | ** **  |
| ** **                           | ** ** | **One Year** | ** **  | **Five**          | ** ** | **Five**    | ** ** | ** ** | ** **  |
| **(Dollars in thousands)** | ** ** | **or Less**  | ** **  | **Years**         | ** ** | **Years**   | ** ** | **Total**  | ** **  |
| Real estate – construction      |       | $                 | 76,579      |              | $          | 51,914      |       | $          | 1,284       |   | $ | 129,777 |   |
| Real estate – mortgage          |       | 24,951            |        | 106,620           |       | 23,267      |       | 154,838    |        |
| Commercial and industrial            |       | 17,384            |        | 13,863            |       | 2,056       |       | 33,303     |        |
| Consumer                             |       | 686               |        | 1,641             |       | 662         |       | 2,989      |        |
| ** **                           | ** ** | **$**             | **119,600** | ** **        | **$**      | **174,038** | ** ** | **$**      | **27,269**  | ** ** | **$** | **320,907** | ** ** |
|                                 |       |              |        |              |       |        |       |       |        |
| Loans maturing after one year with:  |       |              |        |              |       |        |       |       |        |
| Fixed interest rates                 |       |              |        |              |       |        |       | $          | 169,843     |   |
| Floating interest rates              |       |              |        |              |       |        |       | 31,464     |        |
| ** **                           | ** ** | ** **        | ** **  | ** **        | ** ** | ** **  | ** ** | **$**      | **201,307** | ** ** |

 

**2007**

 
| ** **                           | ** ** | ** **        | ** **  | **Over One** | ** ** | ** **  | ** ** | ** ** | ** **  |
|--------------------------------------|------------|-------------------|-------------|-------------------|------------|-------------|------------|------------|-------------|
| ** **                           | ** ** | ** **        | ** **  | **Year**          | ** ** | ** **  | ** ** | ** ** | ** **  |
| ** **                           | ** ** | ** **        | ** **  | **Through**       | ** ** | **Over**    | ** ** | ** ** | ** **  |
| ** **                           | ** ** | **One Year** | ** **  | **Five**          | ** ** | **Five**    | ** ** | ** ** | ** **  |
| **(Dollars in thousands)** | ** ** | **or Less**  | ** **  | **Years**         | ** ** | **Years**   | ** ** | **Total**  | ** **  |
| Real estate – construction      |       | $                 | 66,972      |              | $          | 49,908      |       | $          | 7,136       |   | $ | 124,016 |   |
| Real estate – mortgage          |       | 34,964            |        | 93,976            |       | 20,429      |       | 149,369    |        |
| Commercial and industrial            |       | 13,351            |        | 11,313            |       | 1,431       |       | 26,095     |        |
| Consumer                             |       | 1,408             |        | 1,262             |       | 784         |       | 3,454      |        |
| ** **                           | ** ** | **$**             | **116,695** | ** **        | **$**      | **156,459** | ** ** | **$**      | **29,780**  | ** ** | **$** | **302,934** | ** ** |
|                                 |       |              |        |              |       |        |       |       |        |
| Loans maturing after one year with:  |       |              |        |              |       |        |       |       |        |
| Fixed interest rates                 |       |              |        |              |       |        |       | $          | 132,590     |   |
| Floating interest rates              |       |              |        |              |       |        |       | 53,649     |        |
| ** **                           | ** ** | ** **        | ** **  | ** **        | ** ** | ** **  | ** ** | **$**      | **186,239** | ** ** |

 

Theinformation presented in the above table is based on the contractual maturitiesof the individual loans, including loans which may be subject to renewal attheir contractual maturity.  Renewal ofsuch loans is subject to review and credit approval as well as modification ofterms upon their maturity.  Consequently,management believes this treatment presents fairly the maturity and repricingstructure of the loan portfolio shown in the above table.

 

***Investment Securities and Other Investments****.* The investment securities portfolio, whichaveraged $47.1 million and $12.0 million in 2008 and 2007, respectively, is acomponent of the Company’s total earning assets.  At December 31, 2008 and 2007, the totalinvestment securities portfolio was $49.4 million and $25.3 million,respectively.  Investment securities wereprimarily marketable investments recorded at their fair value. Otherinvestments consisted of Federal Home Loan Bank of Atlanta (“FHLB”) stock recorded at cost.

 

Thefollowing table sets forth the fair value of the securities held by the Companyat December 31, 2008 and 2007.

 
| **(Dollars in thousands)**  | ** ** | **2008** | ** ** | **2007**   | ** ** |
|---------------------------------------|------------|----------|------------|------------|------------|
| Investment securities                 |       | $        | 47,602     |       | $          | 24,844 |   |
| Other investments                     |       | 1,805    |       | 447        |       |
| Total investment securities portfolio | ** ** | **$**    | **49,407** | ** ** | **$**      | **25,291** | ** ** |

 

***Short-Term Investments****.* Short-term investments, which consistprimarily of federal funds sold, averaged $7.9 million and $22.9 million in2008 and 2007, respectively with a weighted average yield of 3.04% and 5.02% in2008 and 2007, respectively.  These fundsare an important source of the Company’s liquidity. Federal funds are generallyinvested in an earning capacity on an overnight basis. At December 31,2008 and 2007, federal funds were $4.6 million and $33.7 million at anannualized overnight rate of 0.50% and 4.15%, respectively. The maximumoutstanding balance of federal funds sold at any month end during the years2008 and 2007 was $16.4 million and $40.8 million, respectively.

 

14

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# **Deposits**

 

***General. ***Average interest-bearing liabilities totaled $325.8 million and $261.7million in 2008 and 2007, respectively. Average total deposits totaled $307.7 million and $278.2 million during2008 and 2007, respectively.  At December 31,2008 and 2007 total deposits were $296.6 million and $327.7 million,respectively.

 

The following table sets forth the averagedeposits of the Company by category for the year ended December 31, 2008and 2007.

 
| ** **                           | ** ** | **2008**   | ** **  | **2007**    | ** ** |
|--------------------------------------|------------|------------|-------------|-------------|------------|
| ** **                           | ** ** | ** ** | ** **  | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **(Dollars in thousands)** | ** ** | **Amount** | ** **  | **Rate**    | ** ** | **Amount** | ** ** | **Rate** | ** ** |
| Non-interest bearing demand          |       | $          | 23,739      |        | —     | % | $ | 18,864 |   | — | % |
| Interest bearing demand              |       | 15,300     |        | 2.12        | %          | 11,520 |   | 1.70 | % |
| Savings                              |       | 18,881     |        | 1.18        | %          | 19,107 |   | 3.39 | % |
| Time                                 |       | 249,765    |        | 4.36        | %          | 228,748 |   | 5.32 | % |
| Total                                | ** ** | **$**      | **307,685** | ** **  | ** ** |   | **$** | **278,239** |   |   |   |

 

The following table setsforth the deposits of the Company by category as of December 31, 2008 and2007.

 
| ** **                           | ** ** | **2008**   | ** **  | **2007**      | ** ** |
|--------------------------------------|------------|------------|-------------|---------------|------------|
| ** **                           | ** ** | ** ** | ** **  | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** |
| **(Dollars in thousands)** | ** ** | **Amount** | ** **  | **Deposits**  | ** ** | **Amount** | ** ** | **Deposits** | ** ** |
| Non-interest bearing demand          |       | $          | 22,162      |          | 7.47       | % | $ | 24,464 |   | 7.46 | % |
| Interest bearing demand              |       | 16,449     |        | 5.55          | %          | 13,721 |   | 4.19 | % |
| Savings                              |       | 14,461     |        | 4.87          | %          | 24,634 |   | 7.52 | % |
| Time deposits less than $100         |       | 32,111     |        | 10.82         | %          | 59,528 |   | 18.17 | % |
| Time deposits of $100 or over        |       | 25,162     |        | 8.49          | %          | 47,118 |   | 14.38 | % |
| Brokered deposits                    |       | 186,298    |        | 62.80         | %          | 158,199 |   | 48.28 | % |
| Total                                | ** ** | **$**      | **296,643** | ** **    | **100.00** | **%** | **$** | **327,664** | ** ** | **100.00** | **%** |

 

Core deposits, which excludecertificates of deposit of $100,000 or more and brokered deposits, provide arelatively stable funding source for the Company’s loan portfolio and otherearning assets.  The Company’s coredeposits were $85.2 million and $122.3 million at December 31, 2008 and2007, respectively, or 28.7% and 37.3%, respectively of total deposits.  Certificates of deposit of $100,000 or moreand brokered deposits are not considered core deposits because their retentioncan be expected to be heavily influenced by rates offered at renewal.  Due to the developed national market forcertificates of deposit, we anticipate being able to either renew or replacethese deposits when they renew; however, no assurance can be given that we willbe able to replace them with deposits with the same terms.

 

For the years ended December 31,2008 and 2007, our non-core deposits included wholesale funding in the form ofbrokered CDs of $186.3 million and $158.2 million, respectively.  We generally obtain out-of-market timedeposits of $100,000 or more through brokers with whom we maintain ongoingrelationships.  The guidelines governingour participation in brokered CD programs are part of our Asset LiabilityManagement Program Policy, which is reviewed, revised and approved annually bythe Asset Liability Committee.  Theseguidelines limit our brokered CDs to 65% of total deposits, dictate that our currentinterest rate risk profile determines the terms and that we only acceptbrokered CDs from approved correspondents. In addition, we do not obtain time deposits through the Internet.  These guidelines allow us to take advantageof the attractive terms that wholesale funding can offer while mitigating theinherent related risk.

 

Deposits have been a primarysource of funding.  Managementanticipates that deposits will continue to be the Company’s primary source offunding in the future.  The Company’s loan-to-depositratio was 108.17% and 92.45% at December 31, 2008 and 2007,respectively.  The maturity distributionof the Company’s time deposits of $100,000 or over at December 31, 2008and 2007, is set forth in the following tables.

 

15

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**Maturities of Certificates of Deposit of$100,000 or More (Including Brokered Deposits)**

 
| ** **                                  | ** ** | ** ** | ** ** | **After**   | ** ** | **After**   | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|-------------|------------|-------------|------------|------------|------------|------------|------------|
| ** **                                  | ** ** | ** ** | ** ** | **Three**   | ** ** | **Six**     | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                  | ** ** | **Within** | ** ** | **Through** | ** ** | **Through** | ** ** | **After**  | ** ** | ** ** | ** ** |
| ** **                                  | ** ** | **Three**  | ** ** | **Six**     | ** ** | **Twelve**  | ** ** | **Twelve** | ** ** | ** ** | ** ** |
| **(Dollars in thousands)**        | ** ** | **Months** | ** ** | **Months**  | ** ** | **Months**  | ** ** | **Months** | ** ** | **Total**  | ** ** |
| **December 31, 2008**                  | ** ** | ** ** | ** ** | ** **  | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Certificates of deposit of $100,000 or more |       | $          | 188,080    |        | $          | 11,231      |       | $          | 10,494     |       | $          | 1,655 |   | $ | 211,460 |   |
|                                        |       |       |       |        |       |        |       |       |       |       |       |
| **December 31, 2007**                  | ** ** | ** ** | ** ** | ** **  | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Certificates of deposit of $100,000 or more |       | $          | 17,479     |        | $          | 81,361      |       | $          | 98,331     |       | $          | 8,146 |   | $ | 205,317 |   |

 

Of the Company’s time deposits of $100,000 orover as of December 31, 2008 and 2007, 88.95% and 8.51% are scheduledmaturities within three months, respectively. As of December 31, 2008 and2007, 99.22% and 96.03%, respectively, of the Company’s time deposits of$100,000 or over had maturities within twelve months.

 

# **Other Borrowings**

# ** **

The following table outlinesour various sources of borrowed funds during the years ended December 31,2008 and December 31, 2007, the amounts outstanding at the end of eachperiod and the weighted-average interest rates paid for each borrowing source.

 
| ** **                                     | ** ** | ** **  | ** ** | ** **  | ** ** | ** **  | ** ** | **Weighted**      | ** ** | **Maximum**        | ** ** |
|------------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|-------------------|------------|--------------------|------------|
| ** **                                     | ** ** | ** **  | ** ** | **Period-** | ** ** | ** **  | ** ** | **-Average**      | ** ** | **Outstanding**    | ** ** |
| ** **                                     | ** ** | **Ending**  | ** ** | **End**     | ** ** | **Average** | ** ** | **Rate for** | ** ** | **at any**    | ** ** |
| **(Dollars in thousands)**           | ** ** | **Balance** | ** ** | **Rate**    | ** ** | **Balance** | ** ** | **Year**          | ** ** | **Month End** | ** ** |
| **December 31, 2008**                     |       |        |       |        |       |        |       |              |       |               |       |
| Federal Home Loan Bank advances                |       | $           | 25,000     |        | 1.49       | %           | $          | 9,645             |       | 2.33               | %          | $ | 30,000 |   |
| Federal funds purchased                        |       | —      |       | —      | %          | 1,312       |       | 1.85              | %          | 9,491              |       |
| Securities sold under agreement to  repurchase |       | 30,000      |       | 3.24        | %          | 28,525      |       | 2.46              | %          | 30,000             |       |
| Bank of Tennessee note payable                 |       | 1,570       |       | 3.25        | %          | 916         |       | 3.71              | %          | 1,570              |       |
| Subordinated debt                              |       | 4,325       |       | 11.50       | %          | 1,294       |       | 11.50             | %          | 4,325              |       |
|                                           |       |        |       |        |       |        |       |              |       |               |       |
| **December 31, 2007**                     |       |        |       |        |       |        |       |              |       |               |       |
| Securities sold under agreement to  repurchase |       | 15,000      |       | 2.58        | %          | 2,315       |       | 2.72              | %          | 15,000             |       |
|                                                |            |             |            |             |            |             |            |                   |            |                    |            |  |  |  |

 

***Subordinated Debt. ***During the thirdquarter of 2008, we commenced a subordinated debt offering to enhance andstrengthen the levels of capital and liquidity at the holding company such thatwe could maintain the resources needed to maintain “well-capitalized” levels ofregulatory capital at the bank. We raised $4.325 million in additional capitalbefore we closed the offering on October 15, 2008.  The subordinated notes were sold to a limitednumber of purchasers in a private offering, bear an interest rate of 11.5%, arecallable after September 30, 2011, at a premium, and mature in 2018. Thesubordinated debt has been structured to fully count as Tier 2 regulatorycapital on a consolidated basis.

 

# **Capital**

# ** **

The FRB and bank regulatoryagencies require bank holding companies and financial institutions to maintaincapital at adequate levels based on a percentage of assets and off-balancesheet exposures, adjusted for risk weights ranging from 0% to 100%.

 

16

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The FRB guidelines contain anexemption from the capital requirements for “small bank holding companies”which in 2006 were amended to cover most bank holding companies with less than$500 million in total assets that do not have a material amount of debt orequity securities outstanding registered with the SEC.  Although our class of common stock isregistered under Section 12 of the Securities Exchange Act, we believethat because our stock is not listed on any exchange or otherwise activelytraded, the FRB will interpret its new guidelines to mean that we qualify as asmall bank holding company. Nevertheless, our Bank remains subject to these capital requirements.  Failure to meet minimum capital requirementscan initiate certain mandatory and possibly additional discretionary actions byregulators that, if undertaken, could have a direct material effect on the Bank’sfinancial statements.  Under capitaladequacy guidelines and the regulatory framework for prompt corrective action,the Bank must meet specific capital guidelines that involve quantitativemeasures of the Bank’s assets, liabilities, and certain off-balance sheet itemsas calculated under regulatory accounting practices.  The Bank’s capital amounts andclassifications are also subject to qualitative judgments by the regulatorsabout components, risk weightings, and other factors.  Regardless, at December 31, 2008, ourBank is “well capitalized” under these minimum capital requirements as set perbank regulatory agencies.

 

Under the capital adequacyguidelines, regulatory capital is classified into two tiers.  These guidelines require an institution tomaintain a certain level of Tier 1 and Tier 2 capital to risk-weightedassets.  Tier 1 capital consists ofcommon shareholders’ equity, excluding the unrealized gain or loss onsecurities available for sale, minus certain intangible assets.  In determining the amount of risk-weightedassets, all assets, including certain off-balance sheet assets, are multipliedby a risk-weight factor of 0% to 100% based on the risks believed to beinherent in the type of asset.  Tier 2capital consists of Tier 1 capital plus the general reserve for loan losses,subject to certain limitations.  We arealso required to maintain capital at a minimum level based on total averageassets, which is known as the Tier 1 leverage ratio.

 

At the bank level, we aresubject to various regulatory capital requirements administered by the federalbanking agencies.  To be considered “adequatelycapitalized” under these capital guidelines, we must maintain a minimum totalrisk-based capital of 8%, with at least 4% being Tier 1 capital.  In addition, we must maintain a minimum Tier1 leverage ratio of at least 4%.  To beconsidered “well-capitalized,” we must maintain total risk-based capital of atleast 10%, Tier 1 capital of at least 6%, and a leverage ratio of at least 5%.

 

Failure to meet minimum capitalrequirements can initiate certain mandatory and possibly additionaldiscretionary actions by regulators that, if undertaken, could have a materialeffect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework forprompt corrective action, the Bank must meet specific capital guidelines thatinvolve quantitative measures of the Bank’s assets, liabilities, and certainoff-balance sheet items as calculated under regulatory accountingpractices.  The Bank’s capital amountsand classifications are also subject to qualitative judgments by the regulatorsabout components, risk weightings, and other factors.

 

The Bank exceeded theregulatory capital requirements at December 31, 2008 and 2007 as set forthin the following table.

 

**Analysis of Capital and Capital Ratios**

 
| **(Dollars in thousands)**                                | ** ** | **2008**   | ** **  | **2007**   | ** ** |
|---------------------------------------------------------------------|------------|------------|-------------|------------|------------|
| Tier 1 capital                                                      |       | $          | 30,836      |       | $          | 30,102 |   |
| Tier 2 capital                                                      |       | 4,369      |        | 4,214      |       |
| Total qualifying capital                                            | ** ** | **$**      | **35,205**  | ** ** | **$**      | **34,316** | ** ** |
| ** **                                                          | ** ** | ** ** | ** **  | ** ** | ** ** |
| Risk-adjusted total assets (including  off-balance sheet exposures) | ** ** | **$**      | **345,829** | ** ** | **$**      | **337,586** | ** ** |
|                                                                |       |       |        |       |       |
| Total risk-based capital ratio                                      |       | 10.18      | %           | 10.17      | %          |
| Tier 1 risk-based capital ratio                                     |       | 8.92       | %           | 8.92       | %          |
| Tier 1 leverage ratio                                               |       | 7.98       | %           | 8.26       | %          |

 

**Off-BalanceSheet Risk**

 

Through its operations, the Bank has madecontractual commitments to extend credit in the ordinary course of its businessactivities. These commitments are legally binding agreements to lend money tothe Bank’s customers at predetermined interest rates for a specified period oftime.  At December 31, 2008 and2007, the Bank had issued commitments, including standby letters of credit, toextend credit of $39.7 million and $52.5 million, respectively through varioustypes of commercial lending arrangements.

 

17

----

 

The following tables setforth the length of time until maturity for unused commitments to extend creditat December 31, 2008 and 2007.

** **
| ** **                           | ** ** | ** ** | ** ** | **After**   | ** ** | **After**   | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** |
|--------------------------------------|------------|------------|------------|-------------|------------|-------------|------------|------------|------------|-------------|------------|------------|------------|
| ** **                           | ** ** | ** ** | ** ** | **One**     | ** ** | **Three**   | ** ** | ** ** | ** ** | **Greater** | ** ** | ** ** | ** ** |
| ** **                           | ** ** | **Within** | ** ** | **Through** | ** ** | **Through** | ** ** | **Within** | ** ** | **Than**    | ** ** | ** ** | ** ** |
| ** **                           | ** ** | **One**    | ** ** | **Three**   | ** ** | **Twelve**  | ** ** | **One**    | ** ** | **One**     | ** ** | ** ** | ** ** |
| **(Dollars in thousands)** | ** ** | **Month**  | ** ** | **Months**  | ** ** | **Months**  | ** ** | **Year**   | ** ** | **Year**    | ** ** | **Total**  | ** ** |
| **December 31, 2008**           | ** ** | ** ** | ** ** | ** **  | ** ** | ** **  | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** |
| Unused commitments to extend credit  |       | $          | 2,941      |        | $          | 1,889       |       | $          | 11,989     |        | $          | 16,819     |       | $ | 19,441 |   | $ | 36,260 |   |
| Standby letters of credit            |       | 717        |       | 80          |       | 2,617       |       | 3,414      |       | 74          |       | 3,488      |       |
| ** **                           | ** ** | **$**      | **3,658**  | ** **  | **$**      | **1,969**   | ** ** | **$**      | **14,606** | ** **  | **$**      | **20,233** | ** ** | **$** | **19,515** | ** ** | **$** | **39,748** | ** ** |
|                                 |       |       |       |        |       |        |       |       |       |        |       |       |       |
| **December 31, 2007**           | ** ** | ** ** | ** ** | ** **  | ** ** | ** **  | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** |
| Unused commitments to extend credit  |       | $          | 2,479      |        | $          | 891         |       | $          | 17,370     |        | $          | 20,740     |       | $ | 28,603 |   | $ | 49,343 |   |
| Standby letters of credit            |       | 578        |       | 833         |       | —      |       | 1,411      |       | 1,766       |       | 3,177      |       |
| ** **                           | ** ** | **$**      | **3,057**  | ** **  | **$**      | **1,724**   | ** ** | **$**      | **17,370** | ** **  | **$**      | **22,151** | ** ** | **$** | **30,369** | ** ** | **$** | **52,520** | ** ** |

 

Approximately $30.9 million and $37.6 million ofthese commitments to extend credit had variable rates as of December 31,2008 and 2007, respectively.

 

The Bank evaluates each customer’s creditworthinesson a case-by-case basis.  The amount ofcollateral obtained, if deemed necessary by the Bank upon extension of credit,is based on its credit evaluation of the borrower.  Collateral varies but may include accountsreceivable, inventory, property, plant and equipment, commercial andresidential real estate.

 

**Critical Accounting Policies**

 

The Company has adopted various accounting policieswhich govern the application of accounting principles generally accepted in theUnited States of America in the preparation of its financial statements.  Significant accounting policies are describedin the footnotes to the consolidated financial statements at December 31,2008, included in this Annual Report to Shareholders, and as filed with theCompany’s Annual Report on Form 10-K. Certain accounting policies involve significant judgments andassumptions which have a material impact on the carrying value of certainassets and liabilities. These accounting policies are considered to be criticalaccounting policies.  The judgments andassumptions used are based on historical experience and other factors, whichare believed to be reasonable under the circumstances.  Because of the nature of the judgments and assumptions,actual results could differ from these judgments and estimates which could havea material impact on the carrying values of assets and liabilities and resultsof operations.

 

Management believes the allowance for loanlosses is a critical accounting policy that requires the most significantjudgments and estimates used in preparation of the consolidated financialstatements.  Refer to the portion of thisdiscussion that addresses the allowance for loan losses for a description ofour processes and methodology for determining our allowance for loan losses.

 

**LiquidityManagement**

 

Liquidity management involves monitoring theCompany’s sources and uses of funds in order to meet its day-to-day cash flowrequirements while maximizing profits. Liquidity represents the ability of a company to convert assets intocash or cash equivalents without significant loss and to raise additional fundsby increasing liabilities.  Withoutproper liquidity management, the Company would not be able to perform the primaryfunction of a financial intermediary and would, therefore, not be able to meetthe needs of the communities it serves.

 

Liquidity management is mademore complex because different balance sheet components are subject to varyingdegrees of management control.  Forexample, the timing of maturities of the investment portfolio is verypredictable and subject to a high degree of control at the time investmentdecisions are made.  However, net depositinflows and outflows are far less predictable and are not subject to nearly thesame degree of control.  The Company alsohas the ability to obtain funds from various financial institutions should theneed arise.

 

The bank has a policy to maintain a liquidity ratio of at least 12%.Liquidity for this purpose is defined as cash, cash equivalents, and securitiesavailable for sale divided by total assets plus one half of any outstandingloan commitments. The bank’s liquidity ratio at December 31, 2008was 14.10%.

 

18

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**Impact ofInflation**

 

Unlike most industrial companies, the assetsand liabilities of financial institutions such as the Bank are primarilymonetary in nature.  Therefore, interestrates have a more significant effect on the Bank’s performance than do the effectsof changes in the general rate of inflation and change in prices.  In addition, interest rates do notnecessarily move in the same direction or in the same magnitude as the pricesof goods and services.  As discussedpreviously, management seeks to manage the relationships between interestsensitive assets and liabilities in order to protect against wide interest ratefluctuations, including those resulting from inflation.

 

**RecentlyIssued Accounting Standards**

 

Accounting standards and pronouncements of arecent nature are discussed in Notes to Consolidated Financial Statements, Note1 — Summary of Significant Accounting Policies. Other accounting standards that have been issued or proposed byauthoritative standards-setting bodies that do not require adoption until afuture date are not expected to have a material impact on the consolidatedfinancial statements upon adoption.

 

19

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

Tothe Shareholders and Board of Directors

CommunitySouthFinancial Corporation and Subsidiary

Easley,South Carolina

 

                We have audited the accompanying consolidatedbalance sheets of CommunitySouth Financial Corporation and Subsidiary (the “Company”)as of December 31, 2008 and 2007, and the related consolidated statementsof operations, changes in shareholders’ equity and comprehensive income, andcash flows for the years then ended. These financial statements are the responsibility of the Company’smanagement.  Our responsibility is toexpress an opinion on these financial statements based on our audits.

 

                We conducted our audits in accordance withthe standards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audits to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that our auditsprovide a reasonable basis for our opinion.

 

                In our opinion, the financial statementsreferred to above present fairly, in all material respects, the financialposition of CommunitySouth Financial Corporation and Subsidiary as of December 31,2008 and 2007 and the results of their operations and their cash flows for theyears then ended in conformity with accounting principles generally accepted inthe United States of America.

 

                We were not engaged to examine management’sassessment of the effectiveness of the Company’s internal control overfinancial reporting as of December 31, 2008 included in the accompanyingManagement’s Report on Internal Controls Over Financial Reporting and,accordingly, we do not express an opinion thereon.

 

 

 

Greenville, South Carolina

March 28, 2009

 

20

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**COMMUNITYSOUTHFINANCIAL CORPORATION**

**CONSOLIDATEDBALANCE SHEETS**

** **
| ** **                                                                                                                                                   | ** ** | **December 31,**  | ** **  |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|-------------|
| ** **                                                                                                                                                   | ** ** | **2008**               | ** **  | **2007** | ** ** |
|                                                                                                                                                         |       |                   |        |   |   |
| **Assets**                                                                                                                                                   |       |                   |        |   |   |
|                                                                                                                                                         |       |                   |        |   |   |
| Cash and cash equivalents                                                                                                                                    |       |                   |        |   |   |
| Cash and due from bank                                                                                                                                       |       | $                      | 5,250,751   |   | $ | 6,486,676 |   |
| Federal funds sold                                                                                                                                           |       | 4,625,000              |        | 33,665,005 |   |
| Total cash and cash equivalents                                                                                                                              |       | 9,875,751              |        | 40,151,681 |   |
| Investment securities, available for sale                                                                                                                    |       | 47,601,552             |        | 24,844,007 |   |
| Other investments, at cost                                                                                                                                   |       | 1,805,200              |        | 446,800 |   |
| Loans, net of allowance for loan loss of  $8,088,218 and $4,213,547 in 2008 and 2007, respectively                                                           |       | 312,818,938            |        | 298,720,357 |   |
| Accrued interest receivable                                                                                                                                  |       | 1,628,073              |        | 2,092,066 |   |
| Property and equipment, net                                                                                                                                  |       | 4,618,188              |        | 5,073,685 |   |
| Bank-owned life insurance                                                                                                                                    |       | 5,437,331              |        | 5,226,806 |   |
| Other assets                                                                                                                                                 |       | 4,031,269              |        | 1,311,799 |   |
|                                                                                                                                                         |       |                   |        |   |   |
| Total assets                                                                                                                                                 |       | $                      | 387,816,302 |   | $ | 377,867,201 |   |
|                                                                                                                                                         |       |                   |        |   |   |
| **Liabilities  and Shareholders’ Equity**                                                                                                               |       |                   |        |   |   |
|                                                                                                                                                         |       |                   |        |   |   |
| **Liabilities**                                                                                                                                              |       |                   |        |   |   |
| Deposits                                                                                                                                                     |       |                   |        |   |   |
| Non-interest bearing                                                                                                                                         |       | $                      | 22,161,873  |   | $ | 24,464,433 |   |
| Interest bearing                                                                                                                                             |       | 274,481,473            |        | 303,199,212 |   |
| Total deposits                                                                                                                                               |       | 296,643,346            |        | 327,663,645 |   |
| Repurchase agreements                                                                                                                                        |       | 30,000,000             |        | 15,000,000 |   |
| Federal Home Loan Bank advances                                                                                                                              |       | 25,000,000   |        | — |   |
| Note payable                                                                                                                                                 |       | 1,570,000              |        | — |   |
| Subordinated debt                                                                                                                                            |       | 4,325,000              |        | — |   |
| Accrued expenses                                                                                                                                             |       | 192,795                |        | 427,380 |   |
| Accrued interest payable                                                                                                                                     |       | 1,405,712              |        | 3,238,298 |   |
| Other liabilities                                                                                                                                            |       | 150,972                |        | 66,742 |   |
|                                                                                                                                                         |       |                   |        |   |   |
| Total liabilities                                                                                                                                            |       | 359,287,825            |        | 346,396,065 |   |
|                                                                                                                                                         |       |                   |        |   |   |
| Commitments and contingencies (Note 14)                                                                                                                      |       |                   |        |   |   |
|                                                                                                                                                         |       |                   |        |   |   |
| **Shareholders’ Equity**                                                                                                                                |       |                   |        |   |   |
| Preferred stock, par value $.01 per share 10,000,000  shares authorized, no shares issued                                                                    |       | —                 |        | — |   |
| Common stock, par value $.01 per share 10,000,000  shares authorized; 4,698,697 issued and outstanding at December 31, 2008  and December 31, 2007 |       | 46,987                 |        | 46,987 |   |
| Additional paid-in capital                                                                                                                                   |       | 29,759,965             |        | 29,691,467 |   |
| Accumulated other comprehensive income                                                                                                                       |       | 491,384                |        | 152,050 |   |
| Retained earnings (deficit)                                                                                                                                  |       | (1,769,859             | )           | 1,580,632 |   |
|                                                                                                                                                         |       |                   |        |   |   |
| Total shareholders’ equity                                                                                                                              |       | 28,528,477             |        | 31,471,136 |   |
|                                                                                                                                                         |       |                   |        |   |   |
| Total liabilities and shareholders’ equity                                                                                                              |       | $                      | 387,816,302 |   | $ | 377,867,201 |   |

 

The accompanying notes are an integral part ofthe consolidated financial statements.

 

21

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**COMMUNITYSOUTH FINANCIAL CORPORATION**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

** **
| ** **                                           | ** ** | **For the years ended December 31,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2008**                                                      | ** ** | **2007** | ** ** |
| **Interest income**                                  |       |                                                          |       |   |   |
| Interest and fees on loans                           |       | $                                                             | 20,163,191 |   | $ | 21,402,981 |   |
| Interest and dividends on investments                |       | 2,547,461                                                     |       | 1,813,059 |   |
|                                                 |       |                                                          |       |   |   |
| Total interest income                                |       | 22,710,652                                                    |       | 23,216,040 |   |
|                                                 |       |                                                          |       |   |   |
| **Interest expense**                                 |       | 12,579,825                                                    |       | 13,068,585 |   |
|                                                 |       |                                                          |       |   |   |
| Net interest income                                  |       | 10,130,827                                                    |       | 10,147,455 |   |
|                                                 |       |                                                          |       |   |   |
| **Provision for loan losses**                        |       | 7,168,000                                                     |       | 1,188,000 |   |
|                                                 |       |                                                          |       |   |   |
| Net interest income after provision for  loan losses |       | 2,962,827                                                     |       | 8,959,455 |   |
|                                                 |       |                                                          |       |   |   |
| **Non-interest income**                              |       |                                                          |       |   |   |
| Mortgage origination fees                            |       | 469,529                                                       |       | 998,111 |   |
| Other                                                |       | 922,263                                                       |       | 576,109 |   |
| Total non-interest income                            |       | 1,391,792                                                     |       | 1,574,220 |   |
|                                                 |       |                                                          |       |   |   |
| **Non-interest expense**                             |       |                                                          |       |   |   |
| Salaries and benefits                                |       | 4,827,948                                                     |       | 4,336,105 |   |
| Occupancy                                            |       | 637,881                                                       |       | 500,458 |   |
| Depreciation                                         |       | 717,735                                                       |       | 601,017 |   |
| Equipment maintenance and rental                     |       | 194,012                                                       |       | 108,856 |   |
| Advertising                                          |       | 248,117                                                       |       | 269,860 |   |
| Professional fees                                    |       | 449,110                                                       |       | 334,978 |   |
| Office supplies                                      |       | 95,306                                                        |       | 145,633 |   |
| Telephone                                            |       | 147,967                                                       |       | 144,771 |   |
| Data processing                                      |       | 757,822                                                       |       | 602,975 |   |
| Other                                                |       | 1,435,018                                                     |       | 1,139,254 |   |
| Total non-interest expense                           |       | 9,510,916                                                     |       | 8,183,907 |   |
|                                                 |       |                                                          |       |   |   |
| **Income (loss) before income taxes**                |       | (5,156,297                                                    | )          | 2,349,768 |   |
|                                                 |       |                                                          |       |   |   |
| **Income tax expense (benefit)**                     |       | (1,805,806                                                    | )          | 781,656 |   |
|                                                 |       |                                                          |       |   |   |
| **Net income (loss)**                                |       | $                                                             | (3,350,491 | ) | $ | 1,568,112 |   |
|                                                 |       |                                                          |       |   |   |
| **Earnings (loss) per share****(1)**                 |       |                                                          |       |   |   |
| **Basic**                                            |       | $                                                             | (0.71      | ) | $ | 0.33 |   |
| **Diluted**                                          |       | $                                                             | (0.71      | ) | $ | 0.31 |   |
| Weighted average basic shares outstanding (1)        |       | 4,698,697                                                     |       | 4,698,634 |   |
| Weighted average diluted shares outstanding  (1)     |       | 4,698,697                                                     |       | 5,126,601 |   |

 

----

(1) Adjusted for 5-for-4 stock split January 16,2007.

 

The accompanying notes are an integral part ofthe consolidated financial statements.

 

22

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**COMMUNITYSOUTHFINANCIAL CORPORATION**

**CONSOLIDATEDSTATEMENTS OF CHANGES IN**

**SHAREHOLDERS’EQUITY AND COMPREHENSIVE INCOME**

**For theyears ended December 31, 2008 and December 31, 2007**

** **
| ** **                                                       | ** ** | **Common Stock** | ** ** | **Additional  Paid-in** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Retained  Earnings /** | ** ** | **Total  Shareholders’** | ** **  | **Total  Comprehensive** | ** ** |
|------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|---------------------------------------|------------|-------------------------------|------------|-------------------------------|-------------|--------------------------|------------|
| ** **                                                       | ** ** | **Shares(1)**         | ** ** | **Amount(1)**           | ** ** | **Capital**                           | ** ** | **Income**                    | ** ** | **(Deficit)**                 | ** **  | **Equity**               | ** ** | **Income (Loss)** | ** ** |
| **Balance  at December 31, 2006**                           | ** ** | **4,697,697**         | ** ** | **46,977**              | ** ** | **29,635,458**                        | ** ** | **—**                    | ** ** | **12,520**                    | ** **  | **29,694,955**           |       |   |   |
|                                                             |       |                  |       |                    |       |                                  |       |                          |       |                          |        |                     |       |   |   |
| Net income                                                       |       | —                |       | —                  |       | —                                |       | —                        |       | 1,568,112                     |        | 1,568,112                |       | $ | 1,568,112 |   |
|                                                             |       |                  |       |                    |       |                                  |       |                          |       |                          |        |                     |       |   |   |
| Other  comprehensive income:                                     |       |                  |       |                    |       |                                  |       |                          |       |                          |        |                     |       |   |   |
|                                                             |       |                  |       |                    |       |                                  |       |                          |       |                          |        |                     |       |   |   |
| Unrealized gains  on securities, net of income taxes of $89,200  |       | —                |       | —                  |       | —                                |       | 152,050                       |       | —                        |        | 152,050                  |       | 152,050 |   |
|                                                             |       |                  |       |                    |       |                                  |       |                          |       |                          |        |                     |       |   |   |
| Total  comprehensive income                                      |       |                  |       |                    |       |                                  |       |                          |       |                          |        |                     |       | $ | 1,720,162 |   |
|                                                             |       |                  |       |                    |       |                                  |       |                          |       |                          |        |                     |       |   |   |
| Stock based  compensation                                        |       | —                |       | —                  |       | 55,320                                |       | —                        |       | —                        |        | 55,320                   |       |   |   |
|                                                             |       |                  |       |                    |       |                                  |       |                          |       |                          |        |                     |       |   |   |
| Cash paid for  fractional shares                                 |       | —                |       | —                  |       | (5,701                                | )          | —                        |       | —                        |        | (5,701                   | )          |   |   |
|                                                             |       |                  |       |                    |       |                                  |       |                          |       |                          |        |                     |       |   |   |
| Stock options  exercised                                         |       | 1,000                 |       | 10                      |       | 6,390                                 |       | —                        |       | —                        |        | 6,400                    |       |   |   |
|                                                             |       |                  |       |                    |       |                                  |       |                          |       |                          |        |                     |       |   |   |
| **Balance  at December 31, 2007**                           | ** ** | **4,698,697**         | ** ** | **$**                   | **46,987** | ** **                            | **$**      | **29,691,467**                | ** ** | **$**                         | **152,050** | ** **               | **$**      | **1,580,632** | ** ** | **$** | **31,471,136** |   |   |   |
|                                                             |       |                  |       |                    |       |                                  |       |                          |       |                          |        |                     |       |   |   |
| Net loss                                                         |       | —                |       | —                  |       | —                                |       | —                        |       | (3,350,491                    | )           | (3,350,491               | )          | $ | (3,350,491 | ) |
|                                                             |       |                  |       |                    |       |                                  |       |                          |       |                          |        |                     |       |   |   |
| Other comprehensive  income (loss):                              |       |                  |       |                    |       |                                  |       |                          |       |                          |        |                     |       |   |   |
|                                                             |       |                  |       |                    |       |                                  |       |                          |       |                          |        |                     |       |   |   |
| Unrealized gains  on securities, net of income taxes of $148,678 |       | —                |       | —                  |       | —                                |       | 339,334                       |       | —                        |        | 339,334                  |       | 39,334 |   |
|                                                             |       |                  |       |                    |       |                                  |       |                          |       |                          |        |                     |       |   |   |
| Total  comprehensive income (loss)                               |       |                  |       |                    |       |                                  |       |                          |       |                          |        |                     |       | $ | (3,011,157 | ) |
|                                                             |       |                  |       |                    |       |                                  |       |                          |       |                          |        |                     |       |   |   |
| Stock based  compensation                                        |       | —                |       | —                  |       | 68,498                                |       | —                        |       | —                        |        | 68,498                   |       |   |   |
|                                                             |       |                  |       |                    |       |                                  |       |                          |       |                          |        |                     |       |   |   |
| **Balance  at December 31, 2008**                           | ** ** | **4,698,697**         | ** ** | **$**                   | **46,987** | ** **                            | **$**      | **29,759,965**                | ** ** | **$**                         | **491,384** | ** **               | **$**      | **(1,769,859** | **)** | **$** | **28,528,477** |   |   |   |

 

----

(1) Adjusted for 5-for-4stock splits effective January 16, 2007.

 

The accompanying notes are an integral part ofthe consolidated financial statements.

 

23

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**COMMUNITYSOUTHFINANCIAL CORPORATION**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

*** ***
| ** **                                                                                | ** ** | **For the years ended December 31,** | ** **     |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|----------------|
| ** **                                                                                | ** ** | **2008**                                                      | ** **     | **2007** | ** ** |
| **Operating  activities**                                                                 |       |                                                          |           |   |   |
| Net income (loss)                                                                         |       | $                                                             | (3,350,491     | ) | $ | 1,568,112 |   |
| Adjustments to reconcile net income (loss)  to net cash provided by operating activities: |       |                                                          |           |   |   |
| Provision for loan losses                                                                 |       | 7,168,000                                                     |           | 1,188,000 |   |
| Stock based compensation                                                                  |       | 68,498                                                        |           | 55,320 |   |
| Depreciation                                                                              |       | 717,736                                                       |           | 601,017 |   |
| Appreciation of bank-owned life insurance                                                 |       | (210,525                                                      | )              | (222,048 | ) |
| Deferred income tax benefit                                                               |       | (2,273,206                                                    | )              | (275,892 | ) |
| Decrease (increase) in accrued interest  receivable                                       |       | 463,993                                                       |           | (914,264 | ) |
| Increase (decrease) in accrued interest  payable                                          |       | (1,832,586                                                    | )              | 1,813,192 |   |
| Increase (decrease) in accrued expenses                                                   |       | (234,585                                                      | )              | 327,050 |   |
| Decrease (increase) in other assets                                                       |       | (598,314                                                      | )              | 237,534 |   |
| Increase in other liabilities                                                             |       | 84,230                                                        |           | 45,038 |   |
| Net cash provided by operating activities                                                 |       | 2,750                                                         |           | 4,423,059 |   |
|                                                                                      |       |                                                          |           |   |   |
| **Investing  activities**                                                                 |       |                                                          |           |   |   |
| Net increase in loans outstanding                                                         |       | (21,266,581                                                   | )              | (85,335,311 | ) |
| Purchase of investments and FHLB stock, net                                               |       | (23,624,561                                                   | )              | (24,678,757 | ) |
| Purchase of property and equipment                                                        |       | (262,239                                                      | )              | (931,536 | ) |
| Net cash used in investing activities                                                     |       | (45,153,381                                                   | )              | (110,945,604 | ) |
|                                                                                      |       |                                                          |           |   |   |
| **Financing****activities**                                                               |       |                                                          |           |   |   |
| Net increase (decrease) in deposit accounts                                               |       | (31,020,299                                                   | )              | 110,632,457 |   |
| Increase in repurchase agreements                                                         |       | 15,000,000                                                    |           | 15,000,000 |   |
| Change in Federal Home Loan Bank advances                                                 |       | 25,000,000                                                    |           | — |   |
| Subordinated debt issuance                                                                |       | 4,325,000                                                     |           | — |   |
| Bank of Tennessee note payable                                                            |       | 1,570,000                                                     |           | — |   |
| Cash paid for fractional shares                                                           |       | —                                                        |           | (5,701 | ) |
| Stock options exercised                                                                   |       | —                                                        |           | 6,400 |   |
| Net cash provided by financing activities                                                 |       | 14,874,701                                                    |           | 125,633,156 |   |
|                                                                                      |       |                                                          |           |   |   |
| Net increase (decrease) in cash and cash  equivalents                                     |       | (30,275,930                                                   | )              | 19,110,611 |   |
|                                                                                      |       |                                                          |           |   |   |
| **CASH AND CASH EQUIVALENTS, BEGINNING OF  YEAR**                                         |       | 40,151,681                                                    |           | 21,041,070 |   |
|                                                                                      |       |                                                          |           |   |   |
| **CASH AND CASH EQUIVALENTS, END OF YEAR**                                                | ** ** | **$**                                                         | **9,875,751**  | ** ** | **$** | **40,151,681** | ** ** |
|                                                                                      |       |                                                          |           |   |   |
| **SUPPLEMENTAL DISCLOSURE OF CASH FLOW  INFORMATION**                                     |       |                                                          |           |   |   |
| Cash paid for:                                                                            |       |                                                          |           |   |   |
| Interest                                                                                  | ** ** | **$**                                                         | **14,412,411** | ** ** | **$** | **11,255,393** | ** ** |
| Income taxes                                                                              | ** ** | **$**                                                         | **619,500**    | ** ** | **$** | **900,197** | ** ** |
|                                                                                      |       |                                                          |           |   |   |
| **SCHEDULE OF NON-CASH TRANSACTIONS:**                                                    | ** ** | ** **                                                    | ** **     | ** ** | ** ** |
| Unrealized gain on investment securities,  net of income taxes                            | ** ** | **$**                                                         | **491,384**    | ** ** | **$** | **152,050** | ** ** |
| Loans charged-off                                                                         | ** ** | **$**                                                         | **3,294,000**  | ** ** | **$** | **65,000** | ** ** |

 

The accompanying notes are an integral part ofthe consolidated financial statements.

 

24

----

### ** **

### **NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

### ** **

**BusinessActivity and Organization -**CommunitySouth FinancialCorporation (the “Company”) is a South Carolina corporation organized for thepurpose of owning and controlling all of the capital stock of CommunitySouthBank and Trust (the “Bank”).  The Bank isa state chartered bank organized under the laws of South Carolina.  From inception on March 20, 2004 throughJanuary 18, 2005, the Company engaged in organizational and pre-openingactivities necessary to obtain regulatory approvals and to prepare itssubsidiary, the Bank, to commence business as a financial institution.  The Company received approval from theFederal Deposit Insurance Corporation (“FDIC”), the Federal Reserve Board (“FRB”)and the State Board of Financial Institutions in January 2005.

 

The Bank began operations on January 18,2005. The Bank primarily is engaged in the business of accepting depositsinsured by the FDIC, and providing commercial, consumer and mortgage loans tothe general public.

 

The Company sold 4,681,069shares of common stock at $6.40 per share in an initial public offering thatwas completed on February 15, 2005 (as adjusted for all stocksplits).  The offering raised$29,430,810, net of offering costs.  Thedirectors and officers of the Company purchased 659,531 shares at $6.40 pershare for a total of $4,221,000.

 

**Basis ofPresentation -**The accounting and reporting policiesconform to accounting principles generally accepted in the United States ofAmerica and to general practices in the banking industry. The Company uses theaccrual basis of accounting.

 

**Principles of Consolidation -**The consolidated financial statements include the accounts of CommunitySouth Financial Corporation, the parent company, and CommunitySouth Bank and Trust, its wholly owned subsidiary. All significant intercompany items have been eliminated in the consolidated financial statements.

 

**Management’sEstimates** - The preparation of consolidated financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of income and expenses during the reporting period.  Actual results could differ from thoseestimates.

 

**Disclosure Regarding Segments**- The Company reports as one operating segment, as management reviews theresults of operations of the Company as a single enterprise.

 

**Cash and Cash Equivalents**-For purposes of reporting cash flows, cash and cash equivalents include cash onhand, amounts due from banks, short-term interest bearing deposits and federalfunds sold. Cash and cash equivalents have an original maturity of three monthsor less.

 

**Concentrationsof Credit Risk** - Financial instruments, whichpotentially subject the Company to concentrations of credit risk, consistprincipally of loans receivable, investment securities, federal funds sold andamounts due from banks.

 

The Company makes loans to individuals and small businesses for variouspersonal and commercial purposes primarily in the upstate region of SouthCarolina.  The Company’s loan portfoliois not concentrated in loans to any single borrower or to a relatively smallnumber of borrowers.  Additionally,management is not aware of any concentrations of loans to classes of borrowersor industries that would be similarly affected by economic conditions.

 

In addition to monitoring potential concentrations of loans toparticular borrowers or groups of borrowers, industries and geographic regions,management monitors exposure to credit risk that could arise from potentialconcentrations of lending products and practices such as loans that subjectborrowers to substantial payment increases (e.g. principal deferral periods,loans with initial interest-only periods, etc), and loans with highloan-to-value ratios.  Additionally, thereare industry practices that could subject the Company to increased credit riskshould economic conditions change over the course of a loan’s life.  For example, the Company makes variable rateloans and fixed rate principal-amortizing loans with maturities prior to theloan being fully paid (i.e. balloon payment loans).  These loans are underwritten and monitored tomanage the associated risks.  Managementhas determined that there is no concentration of credit risk associated withits lending policies or practices.

 

25

----

 

The Company’s investmentportfolio consists of both marketable and non-marketable equitysecurities.  Management believes creditrisk associated with the equity securities is not significant. The Companyplaces its deposits and correspondent accounts with and sells its federal fundsto high quality institutions.  Managementbelieves credit risk associated with correspondent accounts is not significant.

 

**Investment Securities** – The Company accounts for investment securities in accordance with Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115”).  The statement requires investments in equity and debt securities to be classified into three categories:

 

1.               *Available for sale securities*: These aresecurities that are not classified as either held to maturity or as tradingsecurities.  These securities are reported at fair market value. Unrealized gains and losses are reported, net of income taxes, as separatecomponents of shareholders’ equity (accumulated other comprehensive income).

2.               *Held to maturity securities*: These are investment securities that thecompany has the ability and intent to hold until maturity.  Thesesecurities are stated at cost, adjusted for amortization of premiums and theaccretion of discounts.

3.               *Trading securities*: These are securities that are bought andheld principally for the purpose of selling in the near future.  Tradingsecurities are reported at fair market value, and related unrealized gains andlosses are recognized in the income statement.  The company has no tradingsecurities.

 

Gains or losses on dispositionsof investment securities are based on the differences between the net proceedsand the adjusted carrying amount of the securities sold, using the specificidentification method.   Premiums and discounts are amortized oraccrued into interest income by a method that approximates a level yield.

 

**Other Investments –**CommunitySouthBank and Trust, as a member institution, is required to own stock investmentsin the FHLB.  Investment in the FHLB is acondition of borrowing from the FHLB, and the stock is pledged to collateralizesuch borrowings.  No ready market existsfor the stock and it has no quoted market value. However, redemption of thesestocks has historically been at par value. At December 31, 2008 and 2007, the Company’s investment in FHLBstock was $1,805,200 and $446,800, respectively. The dividend received on thisstock is included in interest and dividends on investments.

 

**LoansReceivable** - Loans are stated at their unpaidprincipal balance less an allowance for loan losses and net deferred loanorigination fees.  Interest income iscomputed using the simple interest method and is recorded in the period earned.Loan origination fees collected and certain loan origination costs are deferredand the net amount is accreted as income using a method that approximates thelevel yield method over the life of the related loans.

 

In accordance with SFAS No. 114,“Accounting by Creditors for Impairment of a Loan,” (“SFAS 114”) loans areconsidered to be impaired when, in management’s judgment and based on currentinformation, the full collection of principal and interest becomesdoubtful.  A loan is also consideredimpaired if its terms are modified in a troubled debt restructuring.  Impaired loans are placed in non-performingstatus, and future payments are applied to principal until such time ascollection of the obligation is no longer doubtful. Interest accrual resumesonly when loans return to performing status. To return to performing status, loans must be fully current, andcontinued timely payments must be a reasonable expectation.  Loans are generally placed on non-accrualstatus when principal or interest becomes ninety days past due, or when paymentin full is not anticipated.  When a loan is placed on non-accrual status,interest accrued but not received is generally reversed against interestincome.  Cash receipts on non-accrual loans are not recorded as interestincome, but are used to reduce principal.

 

The Company identifies impairedloans through its normal internal loan review process.  Loans on the Company’s potential problem loanlist are considered potentially impaired loans. These loans are evaluated in determining whether all outstandingprincipal and interest are expected to be collected.  Loans are not considered impaired if aminimal payment delay occurs and all amounts due, including accrued interest atthe contractual interest rate for the period of delay, are expected to becollected.  Management has determinedthat the Company had $9,921,917 and $35,172 in impaired loans at December 31,2008 and 2007, respectively.

 

**Allowance for Loan Losses**– The allowance for loan losses is established as losses are estimated to haveoccurred through a provision for loan losses charged to earnings. Loan lossesare charged against the allowance when management believes the uncollectabilityof a loan balance is confirmed. Subsequent recoveries, if any, are credited tothe allowance.

 

26

----

 

The allowance for loan lossesis evaluated on a regular basis by management and is based upon management’speriodic review of the collectability of the loans in light of historicalexperiences, the nature and volume of the loan portfolio, adverse situationsthat may affect the borrower’s ability to repay, estimated value of anyunderlying collateral and prevailing economic conditions. This evaluation isinherently subjective as it requires estimates that are susceptible tosignificant revision as more information becomes available.

 

The allowance consists ofspecific, general and unallocated components. The specific component relates toloans that are classified as either doubtful, substandard or special mention.For such loans that are also classified as impaired, an allowance isestablished when the discounted cash flows (or collateral value or observablemarket price) of the impaired loan is lower than the carrying value of theloan. The general component covers non-classified loans and is based onhistorical loss experience adjusted for qualitative factors. An unallocatedcomponent is maintained to cover uncertainties that could affect management’sestimate of probable losses. The unallocated component of the allowancereflects the margin of imprecision inherent in the underlying assumptions usedin the methodologies for estimating specific and general losses in theportfolio.

 

A loan is considered impairedwhen, based on current information and events, it is probable that the Companywill be unable to collect the scheduled payments of principal or interest whendue according to the contractual terms of the loan agreement. Factorsconsidered by management in determining impairment include payment status,collateral value, and the probability of collecting scheduled principal andinterest payments due. Loans that experience insignificant payment delays andpayment shortfalls generally are not classified as impaired. Management determinesthe significance of payment delays and payment shortfalls on a case-by-casebasis, taking into consideration all of the circumstances surrounding the loanand the borrower, including the length of the delay, the reasons for the delay,the borrower’s prior payment record and the amount of the shortfall in relationto the principal and interest owed. Impairment is measured on a loan by loanbasis for commercial and construction loans by either the present value ofexpected future cash flows discounted at the loan’s effective interest rate,the loan’s obtainable market price, or the fair value of the collateral if theloan is collateral dependent.

 

Large groups of smaller balancehomogeneous loans are collectively evaluated for impairment. Accordingly, theCompany does not separately identify individual consumer and residential loansfor impairment disclosures, unless such loans are the subject of arestructuring agreement.

 

**Bank-OwnedLife Insurance**- The Company has purchased life insurance policies on certain keyemployees.  These policies are recordedin other assets at their cash surrender value, or the amount that can berealized.  Income from these policies andchanges in the net cash surrender value are recorded in non-interest income.

 

**Advertising -**Advertising, promotional, and other business development costs generally areexpensed as incurred. External costs incurred in producing media advertisingare expensed the first time the advertising takes place. External costsrelating to direct mailing costs are expensed in the period in which the directmailings are sent.

 

**Propertyand Equipment** - Premises, furniture and equipment arestated at cost, less accumulated depreciation. Depreciation expense is computed using the straight-line method, based onthe estimated useful lives for furniture and equipment of 5 to 10 years andbuildings of 39 years.  Leaseholdimprovements are amortized over the life of the lease.  Maintenance and repairs are charged tocurrent expense.  The costs of majorrenewals and improvements are capitalized.

 

**ResidentialLoan Origination Fees** - The Company offers residential loan origination services to itscustomers in its immediate market area. The loans are offered on terms and prices offered by the Company’scorrespondents and are closed in the name of the correspondents. The Companyreceives fees for services it provides in conjunction with the originationservices it provides.  The fees arerecognized at the time the loans are closed by the Company’s correspondent.

 

**Income Taxes** - The consolidated financial statements have been prepared on the accrual basis.  When income and expenses are recognized in different periods for financial reporting purposes versus for the purposes of computing income taxes currently payable, deferred taxes are provided on such temporary differences.  The Company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”).

 

27

 

In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (“FIN 48”) to clarify the accounting and disclosure for uncertainty in tax positions, as defined. FIN 48 seeks to reduce the diversity in practice associated with certain aspects of the recognition and measurement related to accounting for income taxes. The Company implemented the provisions of FIN 48 as of January 1, 2007, and has analyzed filing positions in all of the federal and state jurisdictions where it is required to file income tax returns, as well as all open tax years in these jurisdictions. The Company believes that its income tax filing positions taken or expected to be taken in an its tax returns will more likely than not be sustained upon audit by the taxing authorities and does not anticipate any adjustments that will result in a material adverse impact on the Company’s financial condition, results of operations, or cash flow. Therefore, no reserves for uncertain income tax positions have been recorded pursuant to FIN 48. In addition, the Company did not record a cumulative effect adjustment in 2007 related to the adoption of FIN 48.

 

Under SFAS 109 and FIN 48, deferred tax assets and liabilities are recognized for the expected future tax consequences of events that have been recognized in the consolidated financial statements or tax returns.  Income taxes are the sum of amounts currently payable to taxing authorities and the net changes in income taxes payable or refundable in future years.  Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be realized or settled.  Income taxes deferred to future years are determined utilizing an asset and liability approach.  This method gives consideration to the future tax consequences associated with differences between financial accounting and tax bases of certain assets and liabilities which are principally the allowance for loan losses, depreciable premises and equipment, and net operating loss carry-forwards.

 

**EarningsPer Share** - Basic earnings per share represents thenet income allocated to shareholders divided by the weighted-average number ofcommon shares outstanding during the period. Diluted earnings per share reflect the impact of additional commonshares that would have been outstanding if dilutive potential common shares hadbeen issued.  Potential common sharesthat may be issued by the Company relate to both outstanding warrants and stockoptions, and are determined using the treasury stock method.

 

**Stock–basedCompensation** - On January 1, 2006, the Companyadopted the fair value recognition provisions of the Financial AccountingStandards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 123(R),Share-Based Payment, which is a revision of SFAS No. 123, Accounting forStock-Based Compensation, to account for compensation costs under its stockoption plans.  The Company previouslyutilized the intrinsic value method under Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees (as amended) (“APB 25”).  Under the intrinsic value method prescribedby APB 25, no compensation costs were recognized for the Company’s stockoptions because the option exercise price in its plans equaled the market priceon the date of grant.  Prior to January 1,2006, the Company only disclosed the pro forma effects on net income andearnings per share as if the fair value recognition provisions of SFAS No. 123(R) hadbeen utilized.

 

# **Inadopting SFAS No. 123, the Company elected to use the modified prospectivemethod to account for the transition from the intrinsic value method to thefair value recognition method.  Under themodified prospective method, compensation cost is recognized from the adoptiondate forward for all new stock options granted and for any outstanding unvestedawards as if the fair value method had been applied to those awards as of thedate of grant.**

# ** **

**Off-BalanceSheet Financial Instruments** - In the ordinary courseof business, the Company enters into off-balance sheet financial instrumentsconsisting of commitments to extend credit and letters of credit.  These financial instruments are recorded inthe financial statements when they become payable by the customer.

 

**RecentlyIssued Accounting Standards -**The following is asummary of recent authoritative pronouncements that could impact theaccounting, reporting, and / or disclosure of financial information by theCompany.

 

In December 2007, the Financial AccountingStandards Board*(“*FASB*”)*issued Statement of Financial Accounting Standard (“SFAS”) No. 141(R), “BusinessCombinations,” (“SFAS 141(R)”) which replaces SFAS 141. SFAS 141(R) establishesprinciples and requirements for how an acquirer in a business combinationrecognizes and measures in its financial statements the identifiable assetsacquired, the liabilities assumed, and any controlling interest; recognizes andmeasures goodwill acquired in the business combination or a gain from a bargainpurchase; and determines what information to disclose to enable users of thefinancial statements to evaluate the nature and financial effects of thebusiness combination. SFAS 141(R) is effective for acquisitions by theCompany taking place on or after January 1, 2009. Early adoption isprohibited. Accordingly, a calendar year-end company is required to record anddisclose business combinations following existing accounting guidance until January 1,2009. The Company will assess the impact of SFAS 141(R) if and when afuture 

 

28

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acquisition occurs.

 

In February 2008,the FASB issued FASB Staff Position No. 140-3, “Accounting for Transfersof Financial Assets and Repurchase Financing Transactions,” (“FSP 140-3”). This FSP provides guidance on accounting for a transfer of a financial assetand the transferor’s repurchase financing of the asset.  This FSP presumesthat an initial transfer of a financial asset and a repurchase financing areconsidered part of the same arrangement (linked transaction) under SFAS 140.However, if certain criteria are met, the initial transfer and repurchasefinancing are not evaluated as a linked transaction and are evaluatedseparately under SFAS 140.  FSP 140-3 was effective for the Company on January 1,2009.  The adoption of FSP 140-3 had no impact on the Company’s financialposition, results of operations or cash flows.

 

In May, 2008, the FASBissued SFAS No. 162, “The Hierarchy of Generally Accepted AccountingPrinciples,” (“SFAS 162”).  SFAS 162identifies the sources of accounting principles and the framework for selectingthe principles used in the preparation of financial statements ofnongovernmental entities that are presented in conformity with generallyaccepted accounting principles (GAAP) in the United States (the GAAPhierarchy).  SFAS 162 is effective November 15,2008.  The FASB has stated that it doesnot expect SFAS 162 will result in a change in current practice. Theapplication of SFAS 162 had no effect on the Company’s financial position,results of operations or cash flows.

 

The SEC’s Office of the Chief Accountant andthe staff of the FASB issued press release 2008-234 on September 30, 2008(“Press Release”) to provide clarifications on fair value accounting.  The Press Release includes guidance on theuse of management’s internal assumptions and the use of “market” quotes.  It also reiterates the factors in SEC StaffAccounting Bulletin (“SAB”) Topic 5M which should be considered whendetermining other-than-temporary impairment: the length of time and extent towhich the market value has been less than cost; financial condition andnear-term prospects of the issuer; and the intent and ability of the holder toretain its investment for a period of time sufficient to allow for anyanticipated recovery in market value.

 

On October 10, 2008, the FASB issued FSPSFAS 157-3, “Determining the Fair Value of a Financial Asset When the Marketfor That Asset Is Not Active” (“FSP SFAS 157-3”). This FSP clarifies theapplication of SFAS No. 157, “Fair Value Measurements” (see Note 24) in amarket that is not active and provides an example to illustrate keyconsiderations in determining the fair value of a financial asset when themarket for that asset is not active.  TheFSP is effective upon issuance, including prior periods for which financialstatements have not been issued. For the Company, this FSP was effective forthe quarter ended September 30, 2008.

 

The Company considered the guidance in thePress Release and in FSP SFAS 157-3 when conducting its review forother-than-temporary impairment as of December 31, 2008 as discussed inNote 24.

 

Other accounting standards that have beenissued or proposed by the FASB or other standards-setting bodies are notexpected to have a material impact on the Company’s financial position, resultsof operations or cash flows.

 

**Risks andUncertainties** - In the normal course of its business,the Company encounters two significant types of risk: economic andregulatory.  There are three maincomponents of economic risk:  interestrate risk, credit risk and market risk. The Company is subject to interest rate risk to the degree that itsinterest-bearing liabilities mature or reprice at different speeds, or ondifferent bases, than its interest-earning assets.  Credit risk is the risk of default on theCompany’s loan portfolio that results from borrower’s inability orunwillingness to make contractually required payments.  Market risk reflects changes in the value ofcollateral underlying loans receivable and the valuation of real estate held bythe Company.

 

The Company is subject to theregulations of various governmental agencies. These regulations can and do change significantly from period toperiod.  The Company also undergoes periodicexaminations by the regulatory agencies, which may subject it to furtherchanges with respect to asset valuations, amounts of required loss allowancesand operating restrictions from the regulators’ judgments based on informationavailable to them at the time of their examination.

 

**Reclassifications**- Certain captions and amounts in the prior financial statements werereclassified to conform with the 2007 presentation. Such reclassifications hadno effect on previously reported net income or shareholders’ equity.

 

29

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**NOTE2 – RESTRICTIONS ON CASH AND DUE FROM BANKS**

 

The Bank is required tomaintain average reserve balances, computed by applying prescribed percentagesto its various types of deposits, either at the Bank or on deposit with theFRB. At December 31, 2008 and 2007, these required reserves were met byvault cash.

 

### **NOTE 3 – INVESTMENT SECURITIES**

### ** **

# **The amortized costs and fair values of investmentsecurities are as follows:**

 
| ** **                                      | ** ** | **Amortized** | ** **     | **Gross Unrealized** | ** ** | **Fair**    | ** ** |
|-------------------------------------------------|------------|---------------|----------------|---------------------------|------------|-------------|------------|
| ** **                                      | ** ** | **Cost**      | ** **     | **Gains**                 | ** ** | **Losses**  | ** ** | **Value** | ** ** |
| **As of December 31, 2008** | ** ** | ** **    | ** **     | ** **                | ** ** | ** **  | ** ** | ** ** | ** ** |
| **Available for sale**                          |       |          |           |                      |       |        |       |   |   |
| Government sponsored enterprises                |       | $             | 19,000,824     |                      | $          | 84,601      |       | $ | — |   | $ | 19,085,425 |   |
| Mortgage-backed                                 |       | 27,768,143    |           | 647,984                   |       | —      |       | 28,416,127 |   |
| Marketable securities                           |       | 100,000       |           | —                    |       | —      |       | 100,000 |   |
| Total Available for sale                        | ** ** | **$**         | **46,868,967** | ** **                | **$**      | **732,585** | ** ** | **$** | **—** | ** ** | **$** | **47,601,552** | ** ** |

 
| **As of December 31, 2007** | ** ** | ** ** | ** **     | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** |
|-------------------------------------------------|------------|------------|----------------|------------|------------|-------------|------------|------------|------------|
| **Available for sale**                | ** ** | ** ** | ** **     | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** |
| Government sponsored enterprises                |       | $          | 15,488,584     |       | $          | 136,049     |       | $          | —     |   | $ | 15,624,633 |   |
| Mortgage-backed                                 |       | 9,014,173  |           | 115,428    |       | 10,227      |       | 9,119,374  |       |
| Marketable securities                           |       | 100,000    |           | —     |       | —      |       | 100,000    |       |
| Total Available for sale                        | ** ** | **$**      | **24,602,757** | ** ** | **$**      | **251,477** | ** ** | **$**      | **10,227** | ** ** | **$** | **24,844,007** | ** ** |

 

# **The amortized costs and fair values of investmentsecurities available for sale at December 31, 2008, by contractualmaturity, are shown below.**

 
| ** **                       | ** ** | **December 31, 2008** | ** **     | **December 31, 2007** | ** ** |
|----------------------------------|------------|---------------------------------|----------------|---------------------------------|------------|
| ** **                       | ** ** | **Amortized**                   | ** **     | **Fair**                        | ** ** | **Amortized** | ** ** | **Fair** | ** ** |
| ** **                       | ** ** | **Cost**                        | ** **     | **Value**                       | ** ** | **Cost** | ** ** | **Value** | ** ** |
| **Available for sale**           |       |                            |           |                            |       |   |   |   |   |
| Due within one year(1)           |       | $                               | 3,100,824      |                            | $          | 3,139,345 |   | $ | 4,093,646 |   | $ | 3,555,000 |   |
| Due after one through five years |       | 17,594,284                      |           | 17,694,068                      |       | 11,494,940 |   | 11,622,834 |   |
| Due after five through ten years |       | 5,224,429                       |           | 5,436,898                       |       | 6,755,981 |   | 6,293,676 |   |
| Due after ten years              |       | 20,949,430                      |           | 21,331,241                      |       | 2,258,190 |   | 3,372,497 |   |
| Total Available for sale         | ** ** | **$**                           | **46,868,967** | ** **                      | **$**      | **47,601,552** | ** ** | **$** | **24,602,757** | ** ** | **$** | **24,844,007** | ** ** |

 

----

(1)   Marketable securities are included as due within one year.

 

At December 31, 2008, the Company didnot have any securities in an unrealized loss position.

 

The table below summarizes gross unrealizedlosses on investment securities and the fair market value of the relatedsecurities, aggregated by investment category and length of time thatindividual securities have been in a continuous unrealized loss position, at December 31,2007.

 
| ** **                                      | ** ** | **Less than 12 months** | ** **    | **12 months or longer** | ** ** | **Total**  | ** ** |
|-------------------------------------------------|------------|----------------------------------------|---------------|----------------------------------------|------------|------------|------------|
| ** **                                      | ** ** | **Fair**                               | ** **    | **Unrealized**                         | ** ** | **Fair**   | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                                      | ** ** | **Value**                              | ** **    | **Loss**                               | ** ** | **Value**  | ** ** | **Gain/(Loss)** | ** ** | **Value** | ** ** | **Gain/(Loss)** | ** ** |
| **As of December 31, 2007** |       |                                   |          |                                   |       |       |       |   |   |   |   |   |   |
| **Available for sale**                          |       |                                   |          |                                   |       |       |       |   |   |   |   |   |   |
| Mortgage-backed                                 |       | $                                      | 9,119,374     |                                   | $          | 10,227     |       | $ | — |   | $ | — |   | $ | 9,119,374 |   | $ | 10,227 |   |
| Total Available for sale                        | ** ** | **$**                                  | **9,119,374** | ** **                             | **$**      | **10,227** | ** ** | **$** | **—** | ** ** | **$** | **—** | ** ** | **$** | **9,119,374** | ** ** | **$** | **10,227** | ** ** |

 

30

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At December 31, 2007, the Company hadmortgage-backed securities in an unrealized loss position.  The Company believes, based on industryanalyst reports and credit ratings that the deterioration in value isattributed to changes in market interest rates and not in the credit quality ofthe issuer and therefore, these losses are not consideredother-than-temporary.  The Company hasthe ability and intent to hold these securities until such time as the valuerecovers or the securities mature.

 

# **No investment securities were sold during 2008 or 2007.Accordingly, no gains or losses were recorded. At December 31, 2008, therewere $36.1 million of securities pledged as collateral for repurchaseagreements from brokers. There were $16 million of securities pledged ascollateral for repurchase agreements from brokers at December 31, 2007.**

# ** **

Management limits its creditrisk by generally investing its portfolio principally in obligations of theUnited States of America, its agencies or it corporations. Included in theinvestment portfolio at December 31, 2008, are mortgage-backed securitiesissued by the Federal National Mortgage Association and the Federal Home LoanMortgage Corporation totaling $20.7 million and $2.5 million, respectively.

 

### **NOTE 4 – OTHER INVESTMENTS**

### ** **

Other investments consisted of FHLB stockwith a cost of $1,805,200 and $446,800 at December 31, 2008 and 2007,respectively.  All of the FHLB stock isused to collateralize advances with the FHLB.

 

### **NOTE 5 – LOANS RECEIVABLE**

### ** **

Major classifications of loansreceivable for the years ended December 31, 2008 and 2007 are summarizedas follows:

 
| ** **                     | ** ** | **December 31,** | ** **      |
|--------------------------------|------------|-----------------------|-----------------|
| ** **                     | ** ** | **2008**              | ** **      | **2007** | ** ** |
| Real estate - construction     |       | $                     | 129,776,522     |   | $ | 124,016,089 |   |
| Real estate - mortgage         |       | 154,838,390           |            | 149,369,530 |   |
| Commercial and industrial      |       | 33,303,276            |            | 26,094,711 |   |
| Consumer and other             |       | 2,988,968             |            | 3,453,574 |   |
| Total loans, gross             |       | 320,907,156           |            | 302,933,904 |   |
| Less allowance for loan losses |       | (8,088,218            | )               | (4,213,547 | ) |
| Total loans, net               | ** ** | **$**                 | **312,818,938** | ** ** | **$** | **298,720,357** | ** ** |

 

Loans are stated net ofdeferred fees and costs.

 

The Bank had $9,915,883 and$35,172 of loans classified as non-accrual status as of December 31, 2008and 2007, respectively.  At December 31,2008 and 2007, loans past due 90 days or more and still accruing amounted to$6,035 and $0, respectively. See additional disclosures regarding LoansReceivable and Allowance for Loan Losses in Note 1.

 

Activity in the allowance for loan losses during the years ended December 31,2008 and 2007 is summarized below:

 
| ** **                      | ** ** | **Year Ended December 31,** | ** **    |
|---------------------------------|------------|--------------------------------------------|---------------|
| ** **                      | ** ** | **2008**                                   | ** **    | **2007** | ** ** |
| Balance, beginning of year      |       | $                                          | 4,213,547     |   | $ | 3,090,500 |   |
| Provision charged to operations |       | 7,168,000                                  |          | 1,188,000 |   |
| Charge-offs                     |       | (3,293,329                                 | )             | (64,953 | ) |
| Balance, end of year            | ** ** | **$**                                      | **8,088,218** | ** ** | **$** | **4,213,547** | ** ** |

 
| ** **                                               | ** ** | **Year Ended December 31,** | ** **     |
|----------------------------------------------------------|------------|--------------------------------------------|----------------|
| ** **                                               | ** ** | **2008**                                   | ** **     | **2007** | ** ** |
| **Impaired Loans:**                                 |       |                                       |           |   |   |
| No valuation allowance required                          |       | $                                          | 2,590,369      |   | $ | 10,643 |   |
| Valuation allowance required                             |       | 10,581,526                                 |           | 24,529 |   |
| Total impaired loans                                     | ** ** | **$**                                      | **13,171,895** | ** ** | **$** | **35,172** | ** ** |
| ** **                                               | ** ** | ** **                                 | ** **     | ** ** | ** ** |
| Allowance for loan losses on impaired loans  at year end | ** ** | **$**                                      | **2,801,565**  | ** ** | **$** | **24,529** | ** ** |
| Average investment in impaired loans                     |       | $                                          | 5,109,022      |   | $ | 55,632 |   |
| Interest income recognized on impaired  loans:           |       |                                       |           |   |   |
| Accrual basis                                            |       | 671,091                                    |           | 553 |   |

 

31

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### **NOTE 6 – PROPERTY AND EQUIPMENT**

### ** **

Property and equipmentconsisted of the following:

 
| ** **                           | ** ** | **December 31,** | ** **    |
|--------------------------------------|------------|-----------------------|---------------|
| ** **                           | ** ** | **2008**              | ** **    | **2007** | ** ** |
| Land                                 |       | $                     | 785,811       |   | $ | 785,811 |   |
| Buildings and leasehold improvements |       | 2,845,179             |          | 2,837,874 |   |
| Property and equipment               |       | 2,757,967             |          | 2,562,922 |   |
| Construction in progress             |       | 95,411                |          | — |   |
| Total                                |       | 6,484,368             |          | 6,186,607 |   |
| Less, accumulated depreciation       |       | (1,866,180            | )             | (1,112,922 | ) |
| Property and equipment, net          | ** ** | **$**                 | **4,618,188** | ** ** | **$** | **5,073,685** | ** ** |

 

The Company recorded $717,736and $601,017 in depreciation expense of property and equipment for the yearsended December 31, 2008 and 2007, respectively.  Construction in progress relates to a newbranch in Spartanburg.

 

### **NOTE 7 – DEPOSITS**

### ** **

The following table sets forth the depositsof the Company by category as of December 31, 2008 and 2007.

 
| ** **                        | ** ** | **December 31,** | ** **      |
|-----------------------------------|------------|-----------------------|-----------------|
| ** **                        | ** ** | **2008**              | ** **      | **2007** | ** ** |
| Non-interest bearing demand       |       | $                     | 22,161,873      |   | $ | 24,463,939 |   |
| Interest bearing demand           |       | 16,449,191            |            | 13,720,505 |   |
| Savings                           |       | 14,460,941            |            | 24,634,385 |   |
| Time deposits less than $100,000  |       | 32,111,689            |            | 59,528,027 |   |
| Time deposits of $100,000 or over |       | 25,161,652            |            | 47,117,789 |   |
| Brokered time deposits            |       | 186,298,000           |            | 158,199,000 |   |
| Total deposits                    | ** ** | **$**                 | **296,643,346** | ** ** | **$** | **327,663,645** | ** ** |

 

Deposits from outside theCompany’s market area obtained through brokers amounted to 62.80% and 48.28% oftotal deposits at December 31, 2008 and 2007, respectively.

 

Interest expense on timedeposits of $100,000 or over was $2,050,217 and $2,551,994 for years ending December 31,2008 and 2007, respectively.

 

At December 31, 2008, thescheduled maturities of certificates of deposit were as follows:

 
| **Maturing In:** | ** ** | **Amount** | ** **      |
|-----------------------|------------|------------|-----------------|
| 2009                  |       | $          | 239,651,062     |   |
| 2010                  |       | 3,691,021  |            |
| 2011                  |       | 136,698    |            |
| 2012                  |       | —     |            |
| 2013                  |       | 92,560     |            |
| Thereafter            |       | —     |            |
| Total                 | ** ** | **$**      | **243,571,341** | ** ** |

 

32

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### ** **

### **NOTE 8 – REPURCHASE AGREEMENTS**

### ** **

At December 31, 2008, theBank had sold $30.0 million of securities under agreements to repurchase withbrokers with a weighted average rate of 3.24% and an average maturity of 90months.  The maximum amountoutstanding at any month-end was $30.0 million.  The average balance for the year was$28,524,590.  These agreements weresecured with approximately $36.1 million of investment securities.

 

At December 31, 2007, theBank had sold $15.0 million of securities under agreements to repurchase withbrokers with a weighted average rate of 2.58% and an average maturity of 82months.  The maximum amountoutstanding at any month-end was $15.0 million.  The average balance for the year was$2,315,068.  These agreements weresecured with approximately $16.0 million of investment securities.

 

### **NOTE 9 – FEDERAL HOME LOAN BANK ADVANCES**

### ** **

At December 31, 2008, the bank had $25million in FHLB advances.  The advanceswere secured with approximately $45.5 million in loans and $1.8 million ofstock in the FHLB.  Listed below is asummary of the terms and maturities of the advances.

 
| **Amount** | ** ** | **Rate** | ** ** | **Maturity**         | ** **             |
|------------|------------|----------|------------|----------------------|------------------------|
| $          | 10,000,000 |     | 1.53       | %                    | January 14,  2009 |   |
| 10,000,000 |       | 1.03     | %          | March 23,  2009 |                   |
| 5,000,000  |       | 2.32     | %          | March 31,  2009 |                   |
| $          | 25,000,000 |     |       |                 |                   |   |

 

### **NOTE 10 – NOTE PAYABLE**

### ** **

At December 31, 2008, theCompany had a $1.6 million outstanding on a line of credit at the Bank ofTennessee.  The line of credit matures onSeptember 2, 2009 and bears interest at Lender’s Prime, which at December 31,2008 was 3.25%.  The company had pledgedall of the stock of the Bank as collateral for this line of credit.  The Company repaid this note payable on February 27,2009 and funds are no longer available to the Company.

 

### **NOTE 11 – SUBORDINATED DEBT**

 

During the third quarter of2008, we commenced a subordinated debt offering to enhance and strengthen thelevels of capital and liquidity at the holding company such that we couldmaintain the “well-capitalized” levels of regulatory capital at the bank. Weraised $4.325 million before we closed the offering on October 15,2008.  The subordinated notes were soldto a limited number of purchasers in a private offering, bear an interest rateof 11.5%, are callable by the Company after September 30, 2011, at apremium, and mature in 2018. The subordinated debt has been structured to fullycount as Tier 2 regulatory capital on a consolidated basis.

 
| ** **                           | ** ** | ** **  | ** ** | **Period-** | ** ** | ** **  | ** ** | **Weighted-Average** | ** ** | **Maximum  Outstanding** | ** ** |
|--------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|----------------------|------------|--------------------------|------------|
| ** **                           | ** ** | **Ending**  | ** ** | **End**     | ** ** | **Average** | ** ** | **Rate for**    | ** ** | **at any**          | ** ** |
| **(Dollars in thousands)** | ** ** | **Balance** | ** ** | **Rate**    | ** ** | **Balance** | ** ** | **Year**             | ** ** | **Month End**       | ** ** |
| **December 31, 2008**           |       |        |       |        |       |        |       |                 |       |                     |       |
| Subordinated debt                    |       | 4,325       |       | 11.50       | %          | 1,485       |       | 11.50                | %          | 4,325                    |       |

 

33

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### ** **

### **NOTE 12 – INCOME TAXES**

### ** **

Income tax expense for the yearended December 31, 2008 and 2007 is summarized as follows:

 
| ** **                            | ** ** | **2008**   | ** **     | **2007**  | ** ** |
|---------------------------------------|------------|------------|----------------|-----------|------------|
| Current portion:                      |       |       |           |      |       |
| Federal                               |       | $          | (252,629       | )         | $          | 984,495 |   |
| State                                 |       | —     |           | 73,053    |       |
| Total current income tax expense      |       | (252,629   | )              | 1,057,548 |       |
| Deferred income tax expense (benefit) |       | (1,553,177 | )              | (275,892  | )          |
| Income tax expense (benefit)          | ** ** | **$**      | **(1,805,806** | **)**     | **$**      | **781,656** | ** ** |

 

A reconciliationbetween the income tax expense and the amount is computed by applying theFederal statutory rate of 34% for 2008 and 2007 to income before income taxesfollows:

 
| ** **                                    | ** ** | **2008** | ** **     | **2007** | ** ** |
|-----------------------------------------------|------------|----------|----------------|----------|------------|
| Federal income tax expense at statutory  rate |       | $        | (1,753,141     | )        | $          | 798,921 |   |
| State income taxes, net of federal benefit    |       | —   |           | 48,216   |       |
| Other                                         |       | (52,665  | )              | (65,481  | )          |
| Income tax expense                            | ** ** | **$**    | **(1,805,806** | **)**    | **$**      | **781,656** | ** ** |

 

The grossamounts of deferred tax assets and deferred tax liabilities are as follows:

 
| ** **                                  | ** ** | **December 31,** | ** **    |
|---------------------------------------------|------------|-----------------------|---------------|
| ** **                                  | ** ** | **2008**              | ** **    | **2007** | ** ** |
| **Deferred tax assets**           |       |                  |          |   |   |
| Allowance for loan losses                   |       | $                     | 2,416,674     |   | $ | 1,122,861 |   |
| Organization and start-up costs             |       | 84,431                |          | 114,168 |   |
| Accrued interest on non-accrual loans       |       | 367,472               |          | 1,552 |   |
| Other                                       |       | 8,500                 |          | 33,497 |   |
| Total deferred tax assets                   |       | 2,877,077             |          | 1,272,078 |   |
|                                        |       |                  |          |   |   |
| **Deferred tax liabilities**                |       |                  |          |   |   |
| Loan origination costs                      |       | (89,236               | )             | (88,236 | ) |
| SFAS No. 115 mark-to-market adjustment |       | (237,878              | )             | (89,200 | ) |
| Depreciation                                |       | (138,716              | )             | (89,512 | ) |
| Prepaid expenses                            |       | (68,856               | )             | (67,238 | ) |
| Total deferred tax liabilities              |       | (534,686              | )             | (334,186 | ) |
| Net deferred tax asset                      | ** ** | **$**                 | **2,342,391** | ** ** | **$** | **937,892** | ** ** |

 

Deferred taxassets represent the future tax benefit of deductible differences and, if it ismore likely than not that a tax asset will not be realized, a valuationallowance is required to reduce the recorded deferred tax assets to netrealizable value.  As of December 31,2008 and 2007, management has determined that no valuation allowance isrequired as it is more likely than not that the recorded net deferred taxassets will be realized in full. The net deferred tax asset is included in thecaption “other assets” on the balance sheet.

 

The Company hasanalyzed the tax positions taken or expected to be taken in its tax returns andconcluded it has no liability related to uncertain tax positions in accordancewith FIN 48.

 

34

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### **NOTE 13 — LEASES**

### ** **

The Company leases branchlocations in Spartanburg, Mauldin, Anderson, Greer and Greenville as well asthe loan operations center in Easley. The initial lease terms range from threeto ten years with various renewal options. The minimum future rental paymentsunder non-cancelable operating leases having remaining terms in excess of oneyear, for each of the next five years and in the aggregate are:

 
| 2009                                 |       | $         | 401,771       |       |
|--------------------------------------|------------|-----------|---------------|------------|
| 2010                                 |       | 428,364   |          |
| 2011                                 |       | 427,870   |          |
| 2012                                 |       | 441,471   |          |
| 2013                                 |       | 446,817   |          |
| Thereafter                           |       | 1,505,939 |          |
| Total minimum future rental payments | ** ** | **$**     | **3,652,232** | ** ** |

 

### **NOTE 14 — COMMITMENTS ANDCONTINGENCIES**

### ** **

The Company is subject toclaims and lawsuits which arise primarily in the ordinary course ofbusiness.  Management is not aware of anylegal proceedings which would have a material adverse effect on the financialposition or operating results of the Company.

 

The bank has entered into alease for a new branch in Spartanburg. It is a 10 year lease with annual payments of $96,000 in years 1-5 and$105,600 in years 6-10.  The lease beginsat occupancy.  The project is currentlyin process.

 

### **NOTE 15 — RELATED PARTYTRANSACTIONS**

### ** **

Certain parties (principallycertain directors and executive officers of the Company, their immediatefamilies and business interests) (“affiliates”) are loan customers in thenormal course of business with the Bank. These loans are made on substantially the same terms, including interestrates and collateral, as those prevailing at the time for comparable transactionswith unrelated persons and do not involve more than the normal risk ofcollectability.  As of December 31,2008 and 2007 the Bank had related party loans totaling $20,539,348 and$21,946,890, respectively.  During 2008,advances on related party loans totaled $7,310,239 and repayments were$8,717,781. During 2007, advances on related party loans totaled $11,026,237and repayments were $4,330,197.

 

Both at December 31, 2008and 2007, affiliates had deposits with the Bank in the amounts of $2.5 millionand $3.7 million, respectively.

 

The Company also enters intoother transactions in the ordinary course of business with affiliates.  Company policy requires transactions withaffiliates to be on terms no more favorable than could be obtained from anunaffiliated third party and to be approved by a majority of disinteresteddirectors.  The following aretransactions entered into with affiliates during the years ended December 31,2008 and 2007:

 

·                  The Spartanburg branch location wasleased from a partnership in which two Company directors have a partnershipinterest.  The property was sold to athird party in October 2007.  Leasepayments on that office totaled $80,000 for the year ended December 31,2007.

·                  The loan operations center in Easleywas leased from a partnership in which a Company director has a partnershipinterest.  Lease payments on that officetotaled $36,000 and $24,000 for the years ended December 31, 2008 and2007, respectively.

 

### **NOTE 16 — SHARESOUTSTANDING AND EARNINGS PER SHARE**

### ** **

On January 16, 2007,the Company effected a 5-for-4 stock split in the form of a stock dividend forshareholders of record as of December 15, 2006. All share and per sharedata has been adjusted for all periods prior to the splits.

 

Basic earnings per shareis computed by dividing the net income by the weighted-average number of commonshares outstanding.  Diluted earnings pershare is computed by dividing the net income by the sum of the weighted-averagenumber of common shares outstanding and dilutive common share equivalents usingthe treasury stock method.  Dilutivecommon share equivalents include common shares issuable upon exercise ofoutstanding stock warrants and stock options.

 

35

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The following isthe basic and diluted income per share computation:

 
| ** **                                                 | ** ** | **December 31,** | ** **     |
|------------------------------------------------------------|------------|-----------------------|----------------|
| ** **                                                 | ** ** | **2008**              | ** **     | **2007** | ** ** |
| Net income (loss) to common shareholders                   | ** ** | **$**                 | **(3,350,491** | **)** | **$** | **1,568,112** | ** ** |
|                                                       |       |                  |           |   |   |
| Weighted-average common shares outstanding  — basic   | ** ** | **4,698,697**         | ** **     | **4,698,634** | ** ** |
|                                                       |       |                  |           |   |   |
| Weighted-average common shares outstanding  — diluted | ** ** | **4,698,697**         | ** **     | **5,126,601** | ** ** |
|                                                       |       |                  |           |   |   |
| Earnings (loss) per share — basic                     | ** ** | **$**                 | **(0.71**      | **)** | **$** | **0.33** | ** ** |
|                                                       |       |                  |           |   |   |
| Earnings (loss) per share — diluted                   | ** ** | **$**                 | **(0.71**      | **)** | **$** | **0.31** | ** ** |

 

**NOTE 17 — STOCK COMPENSATION PLANS**

 

Upon completion of theoffering, the Company agreed to issue warrants to the organizing directors forthe purchase of one share of common stock at $6.40 per share for every twoshares purchased in the stock offering, up to a maximum of 15,625 warrants perdirector. The warrants were fully vested 120 days after January 18, 2005and will expire on January 18, 2015. Warrants held by directors of the Company will expire 90 days after thedirector ceases to be a director or officer of the Company (365 days if due todeath or disability). The Company issued a total of 171,404 warrants.  In addition, the Company has adopted a stock optionplan.  As of December 31, 2008 theCompany has 764,113 outstanding options to employees and directors. On January 16,2006 the company adopted a resolution that terminated the “evergreen” provisionof the Company 2005 Stock Incentive Plan. As a result, the number of shares ofcommon stock issuable under the plan shall not be further increased inconnection with any future share issuances by the company. The exerciseprice of each option is equal to the market price of the Company’s stock on thedate of grant. The maximum term is ten years, and they vest in no greater thanfive years. When necessary, the Company may purchase shares on the open marketto satisfy share option exercises. During the ensuing year, the Company isexpected to acquire no shares.

 

The table set forth belowsummarizes stock option activity for the Company’s stock compensation plans forthe years ended December 31, 2008 and 2007 as adjusted for all stocksplits.

 
| ** **                                 | ** ** | **Stock Options** | ** ** | **Warrants**  | ** ** |
|--------------------------------------------|------------|------------------------|------------|---------------|------------|
| ** **                                 | ** ** | ** **             | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **                                 | ** ** | ** **             | ** ** | **Average**   | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                 | ** ** | ** **             | ** ** | **Exercise**  | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                                 | ** ** | **Number**             | ** ** | **Price**     | ** ** | **Number** | ** ** | **Price** | ** ** |
| **Outstanding  at December 31, 2006** |       | 738,013                |       | $             | 6.87       |   | 171,404 |   | $ | 6.40 |   |
| Granted                                    |       | 37,173                 |       | 15.33         |       | — |   | — |   |
| Forfeited                                  |       | (12,693                | )          | 13.31         |       | — |   | — |   |
| Exercised                                  |       | (1,000                 | )          | 6.40          |       | — |   | — |   |
| **Outstanding at December 31, 2007**  | ** ** | **761,493**            | ** ** | **7.17**      | ** ** | **171,404** | ** ** | **6.40** | ** ** |
| Granted                                    |       | 28,600                 |       | 7.82          |       | — |   | — |   |
| Forfeited                                  |       | (25,980                | )          | 10.57         |       | — |   | — |   |
| Exercised                                  |       | —                 |       | —        |       | — |   | — |   |
| **Outstanding at December 31, 2008**  | ** ** | **764,113**            | ** ** | **$**         | **7.08**   | ** ** | **171,404** | ** ** | **$** | **6.40** | ** ** |

 

At December 31, 2008 there was nointrinsic value for stock options outstanding and stock options exercisable.

 

36

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The table setforth below summarizes non-vested stock options as of December 31, 2008and 2007.

 
| ** **                                | ** ** | **Weighted-Average** | ** ** | **Weighted-Average  Grant Date** | ** ** |
|-------------------------------------------|------------|----------------------|------------|---------------------------------------|------------|
| ** **                                | ** ** | **Number**           | ** ** | **Fair Value**                   | ** ** |
| **Outstanding at December 31, 2006** |       | 11,500               |       | 6.47                                  |       |
| Granted                                   |       | 37,173               |       | 6.88                                  |       |
| Vested during the year                    |       | (2,300               | )          | 6.44                                  |       |
| Forfeited during the year                 |       | (4,100               | )          | 7.06                                  |       |
| **Outstanding at December 31, 2007** | ** ** | **42,273**           | ** ** | **6.79**                              | ** ** |
| Granted                                   |       | 28,600               |       | 3.51                                  |       |
| Vested during the year                    |       | 7,913                |       | 7.12                                  |       |
| Forfeited during the year                 |       | 11,150               |       | 5.62                                  |       |
| **Outstanding at December 31, 2008** | ** ** | **51,810**           | ** ** | **5.33**                              | ** ** |

 

As of December 31, 2008,there was $223,689 in total unrecognized compensation cost related tonon-vested share-based compensation arrangements, which is expected to berecognized over a weighted average period of 42 months. As of December 31,2007, there was $255,917 in total unrecognized compensation cost related tonon-vested share-based compensation arrangements, which is expected to berecognized over a weighted average period of 49 months.

 

The fair value of each optiongranted is estimated on the grant date using the Black-Scholes option-pricingmodel with the following assumptions for 2008 and 2007:  dividend yield of 0%, expected term of 10years, risk-free interest rate of 5.0%, expected life of 10 years, and expectedvolatility of 20%.

 

Stock compensation expense recognized in 2008and 2007 was $68,498 and $55,320, respectively.

 

The followingtable summarizes information about stock options outstanding under the Company’splans at December 31, 2008 and 2007 as adjusted for the 5-for-4 stocksplits effective January 16, 2007.

 
| ** **                      | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** |
|---------------------------------|------------|-----------------|------------|-----------------|------------|
| **2008**                        |       |            |       |            |       |
| Number of options               |       | 764,113         |       | 712,203         |       |
| Weighted average remaining life |       | 6.42 years      |       | 6.26 years      |       |
| Weighted average exercise price |       | $               | 7.08       |            | $          | 6.74 |   |
| High exercise price             |       | $               | 16.80      |            | $          | 16.80 |   |
| Low exercise price              |       | $               | 6.40       |            | $          | 6.40 |   |
| **2007**                        | ** ** | ** **      | ** ** | ** **      | ** ** |
| Number of options               |       | 761,493         |       | 719,220         |       |
| Weighted average remaining life |       | 7.35 years      |       | 7.25 years      |       |
| Weighted average exercise price |       | $               | 7.17       |            | $          | 6.71 |   |
| High exercise price             |       | $               | 16.80      |            | $          | 16.80 |   |
| Low exercise price              |       | $               | 6.40       |            | $          | 6.40 |   |

 

No options were exercised in2008.  Cash received from the exercise ofoptions during 2007 was $6,400. The intrinsic value of options exercised during2007 was $2,880.

 

At December 31, 2008, allof the 171,404 warrants were exercisable and had an average remaining life of6.05 years. At December 31, 2007, all of the 171,404 warrants wereexercisable and had an average remaining life of 7.05 years.

 

37

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### **NOTE 18 — EMPLOYEEBENEFIT PLAN**

### ** **

The Bank maintains an employeebenefit plan for all eligible employees of the Bank under the provisions ofInternal Revenue Code Section 401(k).  The CommunitySouth 401(k) Plan(the “Plan”), adopted in 2006, allows for employee contributions.  TheBank matches 25% of employee contributions up to a maximum of 1.25% of annualcompensation.  A total of $25,292 and $31,495 was charged to operations in2008 and 2007, respectively, for the Company’s matching contribution. Employees are immediately vested in their contributions to the Plan and becomefully vested in the employer matching contribution after five years of service.

 

### **NOTE 19 — REGULATORYMATTERS**

### ** **

The Bank is subject to variousregulatory capital requirements administered by the federal bankingagencies.  Failure to meet minimumcapital requirements can initiate certain mandatory and possibly additionaldiscretionary actions by regulators that, if undertaken, could have a directmaterial adverse effect on the Bank’s financial condition.  Under capital adequacy guidelines and theregulatory framework for prompt corrective action, the Bank must meet specificcapital guidelines that involve quantitative measures of the Bank’s assets,liabilities, and certain off-balance sheet items as calculated under regulatoryaccounting practices.  The Bank’s capitalamounts and classification are also subject to qualitative judgments by theregulators about components, risk weightings, and other factors.

 

Quantitative measures established by regulation to ensure capitaladequacy require the Bank to maintain minimum ratios of Tier 1 and totalcapital as a percentage of assets and off-balance sheet exposures, adjusted forrisk weights ranging from 0% to 100%. Tier 1 capital consists of common shareholders’ equity, excluding theunrealized gain or loss on securities available-for-sale, minus certainintangible assets.  Tier 2 capitalconsists of the allowance for loan losses subject to certain limitations.  Total capital for purposes of computing thecapital ratios consists of the sum of Tier 1 and Tier 2 capital.  The regulatory minimum requirements are 4%for Tier 1 and 8% for total risk-based capital.

 

The Bank is also required tomaintain capital at a minimum level based on total assets, which is known asthe leverage ratio.  Only the strongestbanks are allowed to maintain capital at the minimum requirement of 3%.  All others are subject to maintaining ratios1% to 2% above the minimum.

 

As of December 31, 2008, the most recent notification from theBank’s primary regulator categorized it as well-capitalized under theregulatory framework for prompt corrective action.  There are no conditions or events thatmanagement believes have changed the Bank’s category.

 

The following table summarizes the capital amounts andratios of the Bank and the regulatory minimum requirements at December 31,2008 and December 31, 2007.

 
| ** **                               | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **To Be Well-**  | ** ** |
|------------------------------------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                               | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **                 | ** ** | **Capitalized Under** | ** ** |
| ** **                               | ** ** | ** ** | ** ** | ** **                 | ** ** | **For Capital**       | ** ** | **Prompt Corrective** | ** ** |
| ** **                               | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| ** **                               | ** ** | **Amount** | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio** | ** ** |
| **December 31, 2008**               |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Tier 1 capital (to risk-weighted assets) |       | $          | 30,836,000 |                       | 8.92       | %                          | $          | 13,833,000                 |       | 4.00                       | %          | $ | 20,750,000 |   | 6.00 | % |
| Total capital (to risk-weighted assets)  |       | 35,205,000 |       | 10.18                      |       | 27,666,000                 |       | 8.00                       |       | 34,583,000                 |       | 10.00 |   |
| Tier 1 capital (to average assets)       |       | 30,836,000 |       | 7.98                       |       | 15,450,000                 |       | 4.00                       |       | 19,313,000                 |       | 5.00 |   |
| **December 31, 2007**               |       |       |       |                       |       |                       |       |                       |       |                       |       |   |   |
| Tier 1 capital (to risk-weighted assets) |       | $          | 30,102,000 |                       | 8.92       | %                          | $          | 13,503,000                 |       | 4.00                       | %          | $ | 20,255,000 |   | 6.00 | % |
| Total capital (to risk-weighted assets)  |       | 34,316,000 |       | 10.17                      |       | 27,007,000                 |       | 8.00                       |       | 33,759,000                 |       | 10.00 |   |
| Tier 1 capital (to average assets)       |       | 30,102,000 |       | 8.26                       |       | 14,573,000                 |       | 4.00                       |       | 18,217,000                 |       | 5.00 |   |

 

The FRB has similarrequirements for bank holding companies. The Company currently is not subjectto these requirements because the FRB applies its guidelines on a bank-onlybasis for bank holding companies with less than $500 million in consolidatedassets.

 

38

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### ** **

### **NOTE 20 —LINES OF CREDIT**

### ** **

As of December 31, 2008and 2007, the Bank had unused lines of credit to purchase federal funds fromunrelated banks totaling $14,500,000 and $15,000,000, respectively.  These lines of credit are available on a oneto fourteen day basis for general banking purposes.  As of December 31, 2008 and 2007, theBank has no funds drawn from these lines. The Company also has a line of creditto borrow funds from the FHLB up to 15% in 2008 and 10% in 2007 of the Bank’stotal assets subject to available collateral. At December 31, 2008, the total line of credit was $57,240,000,with $25,000,000 having been drawn, leaving $32,240,000 available.  At December 31, 2007, the availabilityon this line of credit was $34,670,000 with no amount drawn on the line.

 

**NOTE 21 — RESTRICTIONS ON SUBSIDIARYDIVIDENDS, LOANS, OR ADVANCES**

 

The ability of CommunitySouthFinancial Corporation to pay cash dividends is dependent upon receiving cash inthe form of dividends from the Bank. However, there are restrictions on the ability of the Bank to transferfunds to CommunitySouth Financial Corporation in the form of cash dividends,loans, or advances.  As a South Carolinastate bank, the Bank may only pay dividends out of its net profits, afterdeducting expenses, including losses and bad debts.  In addition, the Bank is prohibited fromdeclaring a dividend on its shares of common stock until its surplus equals itsstated capital.  At December 31,2007, the Bank was no longer prohibited from declaring a dividend because ithad a surplus of $1,970,050. However, at December 31, 2008, theBank had a deficit of $872,916.

 

### **NOTE 22 — FINANCIALINSTRUMENTS WITH OFF-BALANCE SHEET RISK**

### ** **

The Company is a party tofinancial instruments with off-balance sheet risk in the normal course ofbusiness to meet the financing needs of its customers.  These financial instruments consist ofcommitments to extend credit and standby letters of credit.  Commitments to extend credit are agreementsto lend to a customer as long as there is no violation of any conditionestablished in the contract.  Commitmentsgenerally have fixed expiration dates or other termination clauses and mayrequire payment of a fee.  A commitmentinvolves, to varying degrees, elements of credit and interest rate risk inexcess of the amount recognized in the balance sheet.  The Company’s exposure to credit loss in theevent of non-performance by the other party to the instrument is represented bythe contractual notional amount of the instrument.  Since certain commitments are expected toexpire without being drawn upon, the total commitment amounts do not necessarilyrepresent future cash requirements.  TheCompany uses the same credit policies in making commitments to extend credit asit does for on-balance-sheet instruments. Letters of credit are conditional commitments issued to guarantee acustomer’s performance to a third party and have essentially the same creditrisk as other lending facilities.  TheCompany has not recorded a liability for the current carrying amount of theobligation to perform as a guarantor and no contingent liability was considerednecessary, as such amounts were not considered material.

 

Collateral held for commitmentsto extend credit and letters of credit varies but may include accountsreceivable, inventory, property, plant, equipment and income-producingcommercial properties.

 

The following table summarizesthe Company’s off-balance sheet financial instruments whose contract amountsrepresent credit risk:

 
| ** **                   | ** ** | **December 31,** | ** **     |
|------------------------------|------------|-----------------------|----------------|
| ** **                   | ** ** | **2008**              | ** **     | **2007** | ** ** |
| ** **                   | ** ** | ** **            | ** **     | ** ** | ** ** |
| Commitments to extend credit | ** ** | **$**                 | **36,259,688** | ** ** | **$** | **49,342,960** | ** ** |
|                         |       |                  |           |   |   |
| Standby letters of credit    | ** ** | **$**                 | **3,488,081**  | ** ** | **$** | **3,176,854** | ** ** |

 

### **NOTE 23 — FAIR VALUE OFFINANCIAL INSTRUMENTS**

### ** **

SFAS No. 107, “Disclosuresabout Fair Value of Financial Instruments” (“SFAS 107”), requires disclosure offair value information, whether or not recognized in the consolidatedbalance sheets, when it is practical to estimate the fair value.  SFAS 107 defines a financial instrument ascash, evidence of an ownership interest in an entity or contractualobligations, which require the exchange of cash, or other financialinstruments.  Certain items are specificallyexcluded from the disclosure requirements, including the Company’s commonstock, premises and equipment, accrued interest receivable and payable, andother assets and liabilities.

 

39

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The fair value of a financialinstrument is the amount at which the asset or obligation could be exchanged ina current transaction between willing parties, other than in a forced orliquidation sale.  Fair value estimatesare made at a specific point in time based on relevant market information andinformation about the financial instruments. Because no market value exists for a significant portion of thefinancial instruments, fair value estimates are based on judgments regarding futureexpected loss experience, current economic conditions, risk characteristics ofvarious financial instruments, and other factors.

 

The Company has used management’sbest estimate of fair value based on the above assumptions.  Thus, the fair values presented may not bethe amounts, which could be realized, in an immediate sale or settlement of theinstrument. In addition, any income taxes or other expenses, which would beincurred in an actual sale or settlement, are not taken into consideration inthe fair values presented.

 

The following methods andassumptions were used to estimate the fair value of significant financialinstruments:

 

***Cash and Due from Banks*** - The carryingamount is a reasonable estimate of fair value.

 

***Federal Funds Sold*** - Federal funds soldare for a term of one day, and the carrying amount approximates the fair value.

 

***Investment Securities*** - The fair values ofmarketable equity securities are valuedusing quoted fair market prices.

 

***Other Investments*** - The carrying value ofnon-marketable equity securities approximates the fair value since no readymarket exists for the stocks.

 

***Bank-owned Life Insurance*** - The cash surrender value of life insurancepolicies held by the Bank approximates fair values of the policies.

 

# ***Loans receivable***- For certain categories ofloans, such as variable rate loans which are repriced frequently and have nosignificant change in credit risk, fair values are based on the carryingamounts.  The fair value of other typesof loans is estimated by discounting the future cash flows using the currentrates at which similar loans would be made to borrowers with similar creditratings and for the same remaining maturities.

# ** **

***Deposits*****- The fair value of demand deposits, savings, and money marketaccounts is the amount payable on demand at the reporting date.  The fair values of certificates of depositare estimated using a discounted cash flow calculation that applies currentinterest rates to a schedule of aggregated expected maturities.

 

***Repurchase Agreements*** - The carrying valueof these instruments is a reasonable estimate of fair value.

 

***FHLB Advances -***The carrying value ofthese instruments is a reasonable estimate of fair value.

 

***Note Payable -***The carrying value of theseinstruments is a reasonable estimate of fair value.

 

***Subordinated Debt -***The carrying value ofthese instruments is a reasonable estimate of fair value.

 

The carryingvalues and estimated fair values of the Company’s financial instruments at December 31,2008 and 2007 are shown in the following table.

 

40

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| ** **                                                          | ** ** | **Carrying** | ** ** | **Estimated**       | ** ** |
|---------------------------------------------------------------------|------------|--------------|------------|---------------------|------------|
| ** **                                                          | ** ** | **Amount**   | ** ** | **Fair Value** | ** ** |
| **December 31, 2008**                                     |       |         |       |                |       |
| **Financial Assets**                                                |       |         |       |                |       |
| Cash and due from banks                                             |       | $            | 5,250,751  |                | $          | 5,250,751 |   |
| Federal funds sold                                                  |       | 4,625,000    |       | 4,625,000           |       |
| Investment securities, available for sale                           |       | 47,601,552   |       | 47,601,552          |       |
| Other investments                                                   |       | 1,805,200    |       | 1,805,200           |       |
| Loans, gross                                                        |       | 320,907,156  |       | 358,708,274         |       |
| Bank-owned life insurance                                           |       | 5,437,331    |       | 5,437,331           |       |
|                                                                |       |         |       |                |       |
| **Financial Liabilities**                                           |       |         |       |                |       |
| Demand deposit, interest-bearing  transaction, and savings accounts |       | $            | 53,072,007 |                | $          | 53,072,007 |   |
| Certificates of deposit and other time  deposits                    |       | 243,571,339  |       | 244,000,955         |       |
| Repurchase agreements                                               |       | 30,000,000   |       | 30,000,000          |       |
| FHLB advances                                                       |       | 25,000,000   |       | 25,000,000          |       |
| Note payable                                                        |       | 1,570,000    |       | 1,570,000           |       |
| Subordinated debt                                                   |       | 4,325,000    |       | 5,500,000           |       |
|                                                                |       |         |       |                |       |
| **December 31, 2007**                                     |       |         |       |                |       |
| **Financial Assets**                                                |       |         |       |                |       |
| Cash and due from banks                                             |       | $            | 6,486,676  |                | $          | 6,486,676 |   |
| Federal funds sold                                                  |       | 33,665,005   |       | 33,665,005          |       |
| Investment securities, available for sale                           |       | 24,844,007   |       | 24,884,007          |       |
| Other investments                                                   |       | 446,800      |       | 446,800             |       |
| Loans, gross                                                        |       | 302,933,904  |       | 302,838,045         |       |
| Bank-owned life insurance                                           |       | 5,226,806    |       | 5,226,806           |       |
|                                                                |       |         |       |                |       |
| **Financial Liabilities**                                           |       |         |       |                |       |
| Demand deposit, interest-bearing  transaction, and savings accounts |       | $            | 62,819,326 |                | $          | 62,819,326 |   |
| Certificates of deposit and other time  deposits                    |       | 264,844,319  |       | 265,698,742         |       |
| Repurchase agreements                                               |       | 15,000,000   |       | 15,000,000          |       |

 
| ** **                                   | ** ** | **2008**             | ** ** | **2007**                       | ** ** |
|----------------------------------------------|------------|----------------------|------------|--------------------------------|------------|
| **(Dollars in thousands)**         | ** ** | **Notional  Amount** | ** ** | **Estimated  Fair Value** | ** ** | **Notional  Amount** | ** ** | **Estimated  Fair Value** | ** ** |
| **Off-Balance Sheet Financial Instruments:** |       |                 |       |                           |       |   |   |   |   |
| ** **                                   |       |                 |       |                           |       |   |   |   |   |
| Commitments to extend credit                 |       | $                    | 36,260     |                           | $          | — |   | $ | 49,343 |   | $ | — |   |
| Standby Letters of Credit                    |       | 3,488                |       | $                              | —     |   | 3,177 |   | $ | — |   |
|                                              |            |                      |            |                                |            |  |  |  |  |  |  |  |  |

 

# **The company adopted Statement No. 157 at thebeginning of our 2008 fiscal year.  SFAS No. 157applies to all assets and liabilities that are being measured and reported on afair value basis.  SFAS No. 157requires new disclosure that establishes a framework for measuring fair valuein GAAP, and expands disclosure about fair value measurements.  This statement enables the reader of thefinancial statements to assess the inputs used to develop those measurements byestablishing a hierarchy for ranking the quality and reliability of theinformation used to determine fair values. The statement requires that assets and liabilities carried at fair valuewill be classified and disclosed in one of the following three categories:**

# ** **

·                  Level 1:  Quoted market prices in active markets foridentical assets or liabilities.

 

·                  Level 2:  Observable market based inputs orunobservable inputs that are corroborated by market data.

 

·                  Level 3:  Unobservable inputs that are not corroboratedby market data.

 

In determining appropriate levels, the Company performs a detailedanalysis of the assets and liabilities that re subject to SFAS No. 157.  At each reporting period, all assets andliabilities for which the fair value measurement is based on significantunobservable inputs are classified as Level 3.

 

The table below presents the balances of assets and liabilitiesmeasured at fair value on a recurring basis by level within the hierarchy.

 
| ** **                                | ** ** | **December, 31, 2008** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|
| **(Dollars in thousands)**      | ** ** | **Total**                        | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Investment securities, available for sale |       | $                                | 47,602     |   | $ | 47,602 |   | $ | — |   | $ | — |   |
|                                           |            |                                  |            |  |  |  |  |  |  |  |  |  |  |

 

41

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Certain assets and liabilities are measured at fair value on anonrecurring basis; that is, the instruments are not measured at fair value onan ongoing basis but are subject to fair value adjustments in certaincircumstances (for example, when there is evidence of impairment).  The following table presents the assets andliabilities carried on the balance sheet by caption and by level within theSFAS No. 157 valuation hierarchy (as described above) as of December 31,2008 for which a nonrecurring change in fair value has been recorded during theyear ended December 31, 2008.

 
| ** **                           | ** ** | **Carrying Value at December, 31, 2008** | ** ** |
|--------------------------------------|------------|-------------------------------------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Total**                                                         | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Impaired Loans                       |       | $                                                                 | 13,172     |   | $ | — |   | $ | 13,172 |   | $ | — |   |
|                                      |            |                                                                   |            |  |  |  |  |  |  |  |  |  |  |

 

# **NOTE 24 — COMMUNITYSOUTH FINANCIAL CORPORATION (PARENTCOMPANY ONLY)**

# ** **

Presented below are the condensed financial statementsfor CommunitySouth Financial Corporation (Parent Company only).

 

**Condensed Balance Sheets**

** **
| ** **                                      | ** ** | **December 31,** | ** **     |
|-------------------------------------------------|------------|-----------------------|----------------|
| ** **                                      | ** ** | **2008**              | ** **     | **2007** | ** ** |
| **Assets**                                      |       |                  |           |   |   |
| Cash                                            |       | $                     | 3,029,319      |   | $ | 94,125 |   |
| Investment securities, available for sale       |       | 100,000               |           | 100,000 |   |
| Investment in the Bank                          |       | 31,327,084            |           | 31,280,850 |   |
| Other assets                                    |       | 96,945                |           | 6,692 |   |
| Total assets                                    | ** ** | **$**                 | **34,553,348** | ** ** | **$** | **31,481,667** | ** ** |
| ** **                                      | ** ** | ** **            | ** **     | ** ** | ** ** |
| **Liabilities and shareholders’ equity**   |       |                  |           |   |   |
| Other liabilities                               |       | $                     | 129,871        |   | $ | 10,531 |   |
| Other borrowings                                |       | 1,570,000             |           | — |   |
| Subordinated debt                               |       | 4,325,000             |           | — |   |
| Shareholders’ equity                       |       | 28,528,477            |           | 31,471,136 |   |
| Total liabilities and shareholders’ equity | ** ** | **$**                 | **34,553,348** | ** ** | **$** | **31,481,667** | ** ** |

 

**Condensed Statements ofIncome**

**For the years ended December 31, 2008and 2007**

 
| ** **                                                                            | ** ** | **2008**   | ** **     | **2007**  | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|----------------|-----------|------------|
| **Income**                                                                            |       | $          | —         |      | $          | — |   |
|                                                                                  |       |       |           |      |       |
| **Expenses**                                                                          |       | (257,391   | )              | (55,320   | )          |
|                                                                                  |       |       |           |      |       |
| **Income (loss) before income taxes and  equity in undistributed income of the Bank** |       | (257,391   | )              | (55,320   | )          |
|                                                                                  |       |       |           |      |       |
| **Equity in undistributed income (loss) of  the Bank**                                |       | (3,093,100 | )              | 1,623,432 |       |
|                                                                                  |       |       |           |      |       |
| **Net income (loss) before taxes**                                                    |       | (3,350,491 | )              | 1,568,112 |       |
|                                                                                  |       |       |           |      |       |
| **Income tax expense (benefit)**                                                      |       | —     |           | —    |       |
|                                                                                  |       |       |           |      |       |
| **Net income (loss)**                                                                 | ** ** | **$**      | **(3,350,491** | **)**     | **$**      | **1,568,112** | ** ** |

 

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** **

**Condensed Statements of Cash Flows**

**For the year ended December 31, 2008 andDecember 31, 2007**

** **
| ** **                                                                               | ** ** | **2008**   | ** **    | **2007**   | ** ** |
|------------------------------------------------------------------------------------------|------------|------------|---------------|------------|------------|
| **Cash flows from operating activities**                                                 |       |       |          |       |       |
| Net income (loss)                                                                        |       | $          | (3,350,491    | )          | $          | 1,568,112 |   |
| Adjustments to reconcile net income (loss)  to net cash used in by operating activities: |       |       |          |       |       |
| Increase in other assets                                                                 |       | (90,253    | )             | —     |       |
| Stock based compensation                                                                 |       | 68,498     |          | 55,320     |       |
| Equity in undistributed  (income) loss of the Bank                                       |       | 2,753,766  |          | (1,623,432 | )          |
| Change in accumulated other comprehensive  income                                        |       | 339,334    |          | —     |       |
| Increase in other liabilities                                                            |       | 119,340    |          | —     |       |
| Net cash used in operating activities                                                    |       | (159,806   | )             | —     |       |
|                                                                                     |       |       |          |       |       |
| **Cash flows from investing activities**                                                 |       |       |          |       |       |
| Investments in Bank subsidiary                                                           |       | (2,800,000 | )             | (900,000   | )          |
| Net cash used in investing activities                                                    |       | (2,800,000 | )             | (900,000   | )          |
|                                                                                     |       |       |          |       |       |
| **Cash flows from financing activities**                                                 |       |       |          |       |       |
| Subordinated debt issue                                                                  |       | 4,325,000  |          | —     |       |
| Increase in other borrowings                                                             |       | 1,570,000  |          | —     |       |
| Cash paid for fractional shares                                                          |       | —     |          | (5,701     | )          |
| Stock options exercised                                                                  |       | —     |          | 6,400      |       |
| Net cash provided by financing activities                                                |       | 5,895,000  |          | 699        |       |
|                                                                                     |       |       |          |       |       |
| **Net increase (decrease) in cash**                                                      |       | 2,935,194  |          | (899,301   | )          |
|                                                                                     |       |       |          |       |       |
| **Cash, beginning of year**                                                              |       | 94,125     |          | 993,426    |       |
|                                                                                     |       |       |          |       |       |
| **Cash, end of year**                                                                    | ** ** | **$**      | **3,029,319** | ** ** | **$**      | **94,125** | ** ** |

### ** **

### **NOTE 25 — SUBSEQUENTEVENT**

### ** **

On February 27, 2009, the bank repaid the $1,570,000 note payableto the Bank of Tennessee.

 

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—  **Shareholder Information**—

 

**Headquarters**

CommunitySouth Financial Corporation

6602 Calhoun Memorial Hwy

Easley, South Carolina 29640

866.421.CSBT

communitysouthbankandtrust.com

 

**Annual Meeting**

May 19, 2009 at 11:00 a.m.

Marriott Hotel

One Parkway East

Greenville, SC 29615

** **

**Counsel**

Nelson, Mullins, Riley & Scarborough

104 South Main Street, Suite 900

Greenville, SC 29601

 

**Independent Auditors**

Elliott Davis, LLC

200 East Broad Street

PO Box 6286

Greenville, SC 29601

** **

**Stock Transfer Agent**

Registrar and Transfer Company

10 Commerce Drive

Cranford, NJ 07016

 

**CommunitySouth Online**Visit our investors resource center at communitysouthbankandtrust.com. Click on“Investors” for SEC filings, financial news, calculators, and more.

 

**Annual Report & Form 10-K**

Additional copies of CommunitySouth’s AnnualReport and Form 10-K are available by writing to:

Shareholder Relations

CommunitySouth Financial Corporation

PO Box 2849

Easley, SC 29641

** **

**Stock Information**

Symbol: CBSO

Over the Counter Bulletin Board QuotationSystem

 

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—  **Boardof Directors**  —

 

C. Allan Ducker, III

Chief Executive Officer, CommunitySouth

 

David A. Miller

President / Chief Operating Officer,CommunitySouth

 

John W. Hobbs

Chief Financial Officer, CommunitySouth

 

Daniel E. Youngblood

Board Chairman

Owner and President

Youngblood Development Corp.

 

David W. Edwards

Board Vice Chairman

Owner and President

Dave Edwards Toyota

 

David Larry Brotherton, Ph.D.Owner and PresidentOrtec, Inc.

 

G. Dial DuBose

Vice President of Operations

Town and Country Realty of Easley, Inc.

President

Nalley Garrett Motels, Inc.

 

R. Wesley Hammond

Former President

HBJ Home Furnishings

 

Arnold J. Ramsey

Owner and President

Ramsey Appraisal Service

 

Dr. W. Michael Riddle

Oral and Maxillofacial Surgeon

 

Joanne M. Rogers

Partner and President

Lakeview Partners and Palmetto Storage

 

B. Lynn Spencer

Co-Owner and Broker-in-Charge

Spencer/Hines Properties

 

J. Neal Workman, Jr.

Owner, President and Chairman

Trehel Corporation

 

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—  **Senior Management Team** —

 

C. Allan Ducker, III

Chief Executive Officer

 

David A. Miller

President

Chief Operating Officer

 

John W. Hobbs

Chief Financial Officer

 

Joe Albright

Senior Vice President

Mortgage Department Manager

 

Barbra Anderson

Senior Vice President

Marketing Director

 

Lary Heichel

Senior Vice President

Chief Risk Officer

 

Kathy King

Senior Vice President

Branch Coordinator

 

Darlene Nations

Vice President

Human Resources Director

 

Jay Ratterree

Senior Vice President

Chief Credit Officer

 

Buddy White

Senior Vice President

Services Department Manager

 

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[CommunitySouth Bank & Trust logo]

 

 

—  www.communitysouthbankandtrust.com —

 

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