**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-K**

 

**x****          ****Annual Report Under Section 13 or 15(d) ofThe Securities Exchange Act of 1934**

** **

**For The Fiscal Year December 31, 2009**

 

**Commission file number: 333-117053**

 

**CommunitySouthFinancial Corporation**

(Exact name of registrant as specified in its charter)

 

| **South Carolina**

(State or other jurisdiction of  incorporation or organization) |   | **20-0934786**

(I.R.S. Employer Identification  No.) |
|-------------------------------------------------------------------------------------|--------|-------------------------------------------------------|

 

| **6602 Calhoun Memorial Highway**        | ** ** | ** ** |
|------------------------------------------|------------|------------|
| **Easley, South Carolina**               | ** ** | **29640**  |
| (Address of principal executive offices) |       | (Zip Code) |

 

Issuer’s telephone number: **(864) 306-2540**

 

Securities registeredpursuant to Section 12(b) of the Exchange Act:  **None**

 

Securities registeredpursuant to Section 12(g) of the Exchange Act:  **Common Stock**

 

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act.  Yes  o  No  x

 

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act.  Yes   ̈  No  x

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Exchange Act of 1934 duringthe past 12 months (or for such shorter period that the registrant was requiredto file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes  x  No   ̈

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 ofthis chapter) during the preceding 12 months (or for such shorter period thatthe registrant was required to submit and post such files).  Yes   ̈  No   ̈

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K (§229.405 of this chapter) is not contained herein, and will notbe contained, to the best of registrant’s knowledge, in definitive proxy orinformation statement incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. x

 

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

 

| Large accelerated filer o                                              |   | Accelerated filer o         |
|------------------------------------------------------------------------|--------|-----------------------------|
| Non-accelerated filer o  (Do not check if a smaller reporting company) |   | Smaller reporting company x |

 

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Act). Yes  o  No  x

 

Theestimated aggregate market value of the Common Stock held by non-affiliates(shareholders holding less than 5% of an outstanding class of stock, excludingdirectors and executive officers) of the Company on June 30, 2009 was$7,225,843.

 

Thenumber of shares outstanding of the registrant’s common stock, as of February 18,2010 was 4,698,697.

 

*DOCUMENTS INCORPORATED BYREFERENCE*

 

ProxyStatement for the Annual Meeting of Shareholders                   Part III(Portions of Items 9-14)to be held on May 18, 2010

 

TransitionalSmall Business Disclosure Format.  (Checkone):  Yes  o  No  x

 

 

 

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**Part I**

 

**Item1.  Description of Business.**

 

This Report,including information included or incorporated by reference in this document,contains statements which constitute forward-looking statements within themeaning of Section 27A of the Securities Act of 1933 and Section 21Eof the Securities Exchange Act of 1934. These statements are based on manyassumptions and estimates and are not guarantees of future performance.  Our actual results may differ materially fromthose anticipated in any forward-looking statements, as they will depend onmany factors about which we are unsure, including many factors which are beyondour control.  The words “may,”  “would,” “could,” “will,” “expect,” “anticipate,”“believe,” “intend,” “plan,” and “estimate,” as well as similar expressions,are meant to identify such forward-looking statements.  Potential risks and uncertainties that couldcause our actual results to differ from those anticipated in anyforward-looking statements include, but are not limited to, those described belowunder Item 1A- Risk Factors and the following:

 
| · | our efforts to  raise capital or otherwise increase our regulatory capital ratios;                                                                                                                                                                                                                                                                      |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| · | the effects of  our efforts to raise capital on our balance sheet, liquidity, capital, and  profitability;                                                                                                                                                                                                                                              |
| · | our ability to  retain our existing customers, including our deposit relationships;                                                                                                                                                                                                                                                                     |
| · | our ability to  comply with the terms of the Consent Order and the Memorandum of  Understanding between the Bank and its supervisory authorities within the  timeframes specified;                                                                                                                                                                      |
| · | the rate of  delinquencies and amounts of loans charged-off;                                                                                                                                                                                                                                                                                            |
| · | our rapid growth  through 2008 and short operating history;                                                                                                                                                                                                                                                                                             |
| · | reduced earnings  due to higher credit losses generally and specifically because losses in the  sectors of our loan portfolio secured by real estate are greater than  expected due to economic factors, including declining real estate values,  decreasing interest rates, increasing unemployment, or changes in payment  behavior or other factors; |
| · | reduced earnings  due to higher credit losses because our loans are concentrated by loan type,  industry segment, borrower type, or location of the borrower or collateral;                                                                                                                                                                             |
| · | the amount of  our real estate based loans, and the weakness in the commercial real estate  market;                                                                                                                                                                                                                                                     |
| · | our reliance on  available secondary funding sources such as Federal Reserve Bank discount  window borrowings, sales of securities and loans, and secured federal funds  lines of credit from correspondent banks, to meet our liquidity needs;                                                                                                         |
| · | significant  increases in competitive pressure in the banking and financial services  industries;                                                                                                                                                                                                                                                       |
| · | changes in the  interest rate environment which could reduce anticipated or actual margins;                                                                                                                                                                                                                                                             |
| · | changes in  political conditions or the legislative or regulatory environment;                                                                                                                                                                                                                                                                          |
| · | general economic  conditions, either nationally or regionally and especially in our primary  service area, becoming less favorable than expected resulting in, among other  things, a deterioration in credit quality;                                                                                                                                  |
| · | changes  occurring in business conditions and inflation;                                                                                                                                                                                                                                                                                                |
| · | changes in  technology;                                                                                                                                                                                                                                                                                                                                 |
| · | changes in  deposits flows;                                                                                                                                                                                                                                                                                                                             |
| · | changes in  monetary and tax policies;                                                                                                                                                                                                                                                                                                                  |
| · | the lack of  seasoning of our loan portfolio, especially given our rapid loan growth  through 2008;                                                                                                                                                                                                                                                     |
| · | adequacy of the  level of our allowance for loan losses;                                                                                                                                                                                                                                                                                                |
| · | increased  funding costs due to market illiquidity, increased competition for funding,  and/or regulatory requirements;                                                                                                                                                                                                                                 |
| · | adverse changes  in asset quality and resulting credit risk-related losses and expenses,  including the risk of further impairment to the value of our collateral on  loans for which we have already taken specific reserves;                                                                                                                          |
| · | loss of consumer  confidence and economic disruptions resulting from terrorist activities or  other military actions;                                                                                                                                                                                                                                   |
| · | changes in the  securities markets; and                                                                                                                                                                                                                                                                                                                 |
| · | other risks and  uncertainties detailed from time to time in our filings with the Securities  and Exchange Commission (the “SEC”).                                                                                                                                                                                                            |

 

We have based our forward-looking statements on our currentexpectations about future events. Although we believe that the expectationsreflected in our forward-looking statements are reasonable, we cannot guaranteeyou that these expectations will be achieved. We undertake no obligation topublicly update or otherwise revise any forward-looking statements, whether asa result of new information, future events, or otherwise.

 

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These risks are exacerbated by the recent developments in national andinternational financial markets, and we are unable to predict what impact theseuncertain market conditions will have on us. During 2008 and 2009, the capital and credit markets experiencedextended volatility and disruption. There can be no assurance that these unprecedented recent developmentswill not continue to materially and adversely impact our business, financialcondition, and results of operations, as well as our ability to raise capitalor other funding for liquidity and business purposes.

 

**General**

 

CommunitySouth FinancialCorporation (the “Company”) was incorporated in South Carolina in March 2004for purposes of operating as a bank holding company.  Our wholly-owned subsidiary, CommunitySouthBank and Trust (the “Bank”), commenced business on January 18, 2005, andis primarily engaged in the business of accepting savings, demand, and timedeposits and providing mortgage, consumer and commercial loans to the generalpublic.

 

**MarketingFocus**

 

Most of the banks inAnderson, Greenville, Pickens and Spartanburg Counties are now local branchesof large regional banks.  Although sizegives the larger banks certain advantages in competing for business from largecorporations, including higher lending limits and the ability to offer servicesin all of South Carolina, we believe we have a niche in the community bankingmarket in our market area.  As a result,we generally do not attempt to compete for the banking relationships of largecorporations, but concentrate our efforts on small- to medium-sized businessesand professional concerns.  The Bankadvertises to emphasize the Company’s local ownership, community bank nature,and ability to provide more personalized service than its competition.

 

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**Location and Service Area**

 

Our main office islocated at 6602 Calhoun Memorial Highway, Easley, South Carolina 29640.  Our telephone number is (864) 306-2540. Oursite is approximately 1.2 acres in size, and the building is approximately10,000 square feet. We have five full service branch sites in addition to themain office. The branch sites are in the towns of Anderson, Greenville, Greer,Mauldin and Spartanburg, South Carolina. Our full service branches service theentire upstate of South Carolina, which we refer to as the “Upstate,” butprimarily the counties of Anderson, Greenville, Pickens and Spartanburg.  The Upstate is generally the northwestportion of South Carolina along the I-85 corridor between Atlanta, Georgia andCharlotte, North Carolina.

 

Like much of the Upstate,Pickens County’s primary source of economic growth is manufacturing.  With its access to applied automobilematerials research and technology at Clemson University and location in theautomobile hub of the southeast, the area is also developing a reputation amongleaders in the automobile industry. Major employers in the area include Clemson University, Pickens CountySchools, and Palmetto Health Alliance.

 

Anderson County islocated along the I-85 corridor west of Pickens County. Significant industriesin Anderson include manufacturers of automotive products, plastics, metalproducts, industrial machinery, publishing and textiles.

 

Greenville County islocated east of Pickens County and is South Carolina’s most populous countywith over 407,000 residents. Greenville is also one of the state’s wealthiestcounties, with a per capita income of $30,814 in 2005, compared to the stateaverage of $27,185.  Greenville County isthe home to more corporate headquarters than any other region in SouthCarolina.

 

Spartanburg County isalso located east of Greenville County and has an economic history rooted inagriculture and textiles.  BMW ManufacturingCorporation calls Spartanburg home.  Itbegan its assembly operation in Spartanburg in 1994.  The amenities and opportunities SpartanburgCounty offers are wide-ranging from housing, education, healthcare, shopping,recreation, and culture.  We believethese factors make the quality of life in the area attractive.  Additionally, Spartanburg’s mild climate andlocation and access to the mountains, the coast, and larger cities such asAtlanta and Charlotte add to the attractiveness of the area.

 

However, the Upstate hasbeen negatively affected by the economic challenges of the past two years.  Unemployment has been rising in our marketsand property values have declined.  Unemploymentrates at November 30, 2009 for the following counties were Greenville,10.5%; Spartanburg, 12.5%; Anderson, 12.7%; and Laurens, 12.0%.  The average state unemployment rate for SouthCarolina at November 30, 2009 was 12.3% compared to 10.0% for the UnitedStates.  Continued higher levels ofunemployment will continue to impact credit quality.  As a result, we are spending significant timeon credit solutions for our customers and managing and disposing of other realestate owned as effectively as possible. The weakening in the state and local economies has also negatively affectedour ability to generate local deposits.

 

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**Our Current Business Strategy**

 

As a result of thisweakening in the local economy and its effect on us, we are currently focusingour efforts in the following areas:

·                  increasing and strengthening our capital position;

·                  decreasing concentrations in our loan portfolio;

·                  reducing operating expenses;

·                  enhancing funds management and liquidity; and

·                  enhancing our bank’s relationship culture.

 

For a more detaileddescription of our business strategy, see Management’s Discussion and Analysisof Financial Condition and Results of Operation under the subsection entitledCurrent Business Strategy.

 

**LendingActivities**

 

Presented below are ourgeneral lending activities. However, due to the Bank’s efforts to restructurethe balance sheet, during 2009 the Bank strictly limited any new lending.

 

***General*****.**  We emphasize arange of lending services, including real estate, commercial, and equity-lineand consumer loans to individuals, small- to medium-sized businesses, andprofessional concerns that are located in or conduct a substantial portion oftheir business in our Bank’s market area.

 

***RealEstate Loans*****.**  A significant portion of our loan portfoliois secured by real estate.  As of December 31, 2009,approximately 90.3% of our loans had real estate as the primary or secondarycomponent of collateral.  Real estate loans generally fall into oneof three categories: construction real estate loans, mortgage loans, oracquisition and development (A&D) loans. Each of these categories isdiscussed in more detail below, including their specific risks.  Interestrates for all categories may be fixed or adjustable.  We generally chargean origination fee for each loan.  Since January 2009,we have effectively ceased making any new commercial real estate loans and weare decreasing the existing level of these loans through the normal sale ofreal estate by borrowers and by encouraging borrowers who are not fullrelationship clients of the Bank to seek other financing when their loansmature.

 

Real estate loans aresubject to the same general risks as other loans.  Real estate loans are also sensitive tofluctuations in the value of the real estate securing the loan.  The real estate collateral in each caseprovides an alternate source of repayment in the event of default by theborrower and may deteriorate in value during the time the credit isextended.  The recent downturn in the real estate market has resultedin increased loan delinquencies, defaults and foreclosures, primarily in ourresidential real estate construction and development portfolio.  These loans carry a higher degree of riskthan long-term financing of existing real estate since repayment is dependenton the ultimate completion of the project or home and usually on the sale ofthe property or permanent financing. Slow housing conditions have affected some of these borrowers’ abilityto sell the completed projects in a timely manner and we believe that thesetrends are likely to continue.  In some cases, this downturn hasresulted in a significant impairment to the value of our collateral and ourability to sell the collateral upon foreclosure.  If real estatevalues continue to decline, it is also more likely that we would be required toincrease our allowance for loan losses.  If, during a period ofreduced real estate values, we are required to liquidate the propertycollateralizing a loan to satisfy the debt or to increase the allowance forloan losses, it could materially reduce our profitability and adversely affectour financial condition.

 

On first and secondmortgage loans, we generally do not advance more than regulatory limits.  We require a valid mortgage lien on all realproperty loans along with a title lien policy which insures the validity andpriority of the lien.  We also requireborrowers to obtain hazard insurance policies and flood insurance, ifapplicable.  Additionally, certain typesof real estate loans have specific risk characteristics that vary according tothe collateral type securing the loan and the terms and repayment sources forthe loan.

 

We have the ability tooriginate some real estate loans for sale into the secondary market.  We can limit our interest rate and creditrisk on these loans by locking the interest rate for each loan with thesecondary investor and receiving the investor’s underwriting approval prior tooriginating the loan.

 

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·                  ***Real Estate Loans - Mortgage*****.**  Mortgage real estate loans generally haveterms of five years or less, although payments may be structured on a longeramortization basis.  Inherent in mortgage real estate loans’ credit riskis the risk that the primary source of repayment, the operating commercial realestate company or residential borrower, will be unable to service thedebt.  If a real estate loan is in default, we also run the risk that thevalue of the real estate securing the loan will decrease, and thereby beinsufficient to satisfy the loan.  To mitigate these risks, we evaluateeach borrower on an individual basis and attempt to determine their businessrisks and credit profile.  We attempt to reduce credit risk in the realestate portfolio by emphasizing loans on owner-occupied office/residential andretail buildings where the loan-to-value ratio is established by independentappraisals.  We typically review the personal financial statements of theprincipal owners/borrower and require their personal guarantees.  Thesereviews often reveal secondary sources of payment and liquidity to support aloan request.

 

·                  ***Real Estate Loans -Construction.**** *We have made adjustable and fixed rate residential andcommercial construction loans to builders and developers and to consumers whowish to build their own home.  The term of construction and developmentloans generally is limited to 18 months, although payments may be structured ona longer amortization basis.  Most loans mature and require payment infull upon the sale of the property.  Construction loans generally carry ahigher degree of risk than long term financing of existing properties. Repayment usually depends on the ultimate completion of the project within costestimates and on the sale of the property.  Specific risks include:

 

·                  cost overruns;

·                  mismanaged construction;

·                  inferior or improper constructiontechniques;

·                  economic changes or downturns duringconstruction;

·                  a downturn in the real estate market;

·                  rising interest rates which may preventsale of the property; and

·                  failure to sell completed projects in atimely manner.

 

We attempt to reduce riskby obtaining personal guarantees where possible, and by keeping theloan-to-value ratio of the completed project below specified percentages. We also reduce risk by selling participations in larger loans to otherinstitutions when possible.

 

·                  ***RealEstate Loans — Acquisition and Development.**** *A significant portion of our real estateloan portfolio is considered A&D loans, most of these are on propertieslocated in the Upstate of South Carolina and Western North Carolina. A&D loans are typically comprised of loans to borrowers for real estate tobe developed (into properties such as sub-divisions or spec houses) and containall of the risk and risk mitigating factors described for mortgages andconstruction loans above.  These loansare generally repaid with the proceeds from the sale of the developed property.

 

***CommercialLoans*****.** We make loans for commercial purposes in various lines ofbusinesses.  Equipment loans typicallyare made for a term of five years or less at fixed or variable rates, with theloan fully amortized over the term and secured by the financed equipment.  Working capital loans typically have termsnot exceeding one year and are usually secured by accounts receivable,inventory, or personal guarantees of the principals of the business.  For loans secured by accounts receivable orinventory, principal is typically repaid as the assets securing the loan areconverted into cash, and in other cases principal is due at maturity.  Trade letters of credit, standby letters ofcredit, and foreign exchange are handled through a correspondent bank as agentfor the Bank.  Commercial loans primarilyhave risk that the primary source of repayment, the borrowing business, will beunable to service the debt.  Often thisoccurs as the result of changes in local economic conditions or in the industryin which the borrower operates which impact cash flow or collateral value.

 

***Consumer Loans*****.**  We make avariety of loans to individuals for personal and household purposes, includingsecured and unsecured installment loans and revolving lines of credit such ascredit cards.  Installment loanstypically carry balances of less than $50,000 and are amortized over periods upto 60 or more months.  Consumer loans areoffered on a single maturity basis where a specific source of repayment isavailable.  Revolving loan productstypically require monthly payments of interest and a portion of the principal.

 

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Consumer loans aregenerally considered to have greater risk than first or second mortgages onreal estate because the value of the secured property may depreciate rapidly,they are often dependent on the borrower’s employment status as the sole sourceof repayment, and some of them are unsecured. To mitigate these risks, we analyze selective underwriting criteria foreach prospective borrower, which may include the borrower’s employment history,income history, credit bureau reports, or debt to income ratios.  If the consumer loan is secured by property,such as an automobile loan, we also attempt to offset the risk of rapiddepreciation of the collateral with a shorter loan amortization period.  Despite these efforts to mitigate our risks,consumer loans have a higher rate of default than real estate loans.  For this reason, we attempt to reduce ourloss exposure to these types of loans by limiting their sizes relative to othertypes of loans.

 

We also offer home equityloans.  Our underwriting criteria for andassessment of the risks associated with home equity loans and lines of creditare generally the same as those for first mortgage loans.  Home equity lines of credit typically haveterms of 10 years or less, carry balances less than $125,000, and may extend upto 90% of the available equity of each property.

 

We also have the abilityto offer small business loans utilizing government enhancements such as theSmall Business Administration’s 7(a) program and SBA’s 504 and “LowDoc”programs.  These loans will typically bepartially guaranteed by the government which may help to reduce the Bank’srisk.  Government guarantees of SBA loanswill not exceed 80% of the loan value, and will generally be less.

 

***RelativeRisks of Loans*****.**  Each category of loan has a different levelof credit risk.  Real estate loans typicallyare generally safer than loans secured by other assets because the value of theunderlying security, real estate, is generally ascertainable and ordinarilydoes not fluctuate as much as some other assets.  However, during the current economic and realestate market downturn, this has not been the case. The fluctuation of realestate values has increased the historically stable risk associated with loanscollateralized by real estate. Nevertheless, certain real estate loans are less risky than others.  Residential real estate loans are generallythe least risky type of real estate loans, followed by commercial real estateloans and construction and development loans. The prolonged weakening in the real estate market starting in 2008 hasaffected all categories of our real estate loans and has resulted in decreasesin real estate values and in an increase in our nonperforming loans.  Commercial loans, which can be secured byreal estate or other assets, or which can be unsecured, are generally more riskythan real estate loans, but less risky than consumer loans.  Finally, consumer loans, which can also besecured by real estate or other assets, or which can also be unsecured, aregenerally considered to be the most risky of these categories of loans.  Any type of loan which is unsecured isgenerally more risky than secured loans. These levels of risk are general in nature, and many factors includingthe creditworthiness of the borrower or the particular nature of the securedasset may cause any type of loan to be more or less risky than another.  Additionally, these levels of risk arelimited to an analysis of credit risk, and they do not take into account otherrisk factors associated with making loans such as the interest rate riskinherent in long-term, fixed-rate loans.

 

***LoanApproval and Review*****.**  Our loan approval policies provide forvarious levels of officer lending authority. When the amount of aggregate loans to a single borrower exceeds thatindividual officer’s lending authority, the loan request is considered andapproved by an officer with a higher lending limit, the management loancommittee or the board of directors’ loan committee.  We do not make any loans to any director ofthe Bank unless the loan is approved by the board of directors of the Bank andis made on terms not more favorable to the person than would be available to aperson not affiliated with the Bank.  Weadhere to Federal National Mortgage Association and Federal Home Loan MortgageCorporation guidelines in our mortgage loan review process, but we may chooseto alter this policy in the future.

 

***LendingLimits.***  Our lending activities are subject to avariety of lending limits imposed by federal law.  In general, we are subject to a legal limiton loans to a single borrower equal to 15% of the Bank’s capital and unimpairedsurplus.  Different limits may applybased on the type of loan or the nature of the borrower, including the borrower’srelationship to the Bank.  These limitswill increase or decrease as the Bank’s capital increases or decreases.

 

**BankingServices**

 

We offer a full range ofdeposit services that are typically available in most banks and savings andloan associations, including checking accounts, NOW accounts, commercial accounts,savings accounts, and other time deposits of various types, ranging from dailymoney market accounts to longer-term certificates of deposit.  The transaction accounts and timecertificates are tailored to our principal market area at rates competitive tothose offered in the upstate South Carolina region.  In addition, we offer certain retirementaccount services, including IRAs.

 

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**Other Banking Services**

 

We also offer safedeposit boxes, cashier’s checks, banking by mail, direct deposit of payroll andsocial security checks, U.S. Savings Bonds, and travelers checks.  Our Bank is associated with the Star and PlusATM networks that may be used by our customers throughout the country.  We believe that by being associated with ashared network of ATMs, we will be better able to serve our customers and willbe able to attract customers who are accustomed to the convenience of using ATMs. We also offer a debit card and credit card services through a correspondentbank as an agent for the Bank.

 

**Competition**

 

Thebanking business is highly competitive. We compete as a financial intermediary with other commercial banks,savings banks, credit unions, finance companies, and money market mutual fundsoperating in Anderson, Greenville, Pickens and Spartanburg Counties.  The competition among the various financialinstitutions is based upon a variety of factors, including interest ratesoffered on deposit accounts, interest rates charged on loans, credit andservice charges, the quality of services rendered, the convenience of bankingfacilities and, in the case of loans to large commercial borrowers, relativelending limits.  In addition to banks andsavings associations, we compete with other financial institutions includingsecurities firms, insurance companies, credit unions, leasing companies andfinance companies.  Size gives largerbanks certain advantages in competing for business from large corporations.  These advantages include higher lendinglimits and the ability to offer services in other areas of South Carolina.  As a result, we do not generally attempt tocompete for the banking relationships of large corporations, but concentrateour efforts on small- to medium-sized businesses and individuals.  We believe we have competed effectively inthis market by offering quality and personal service.

 

**Employees**

 

As of December 31,2009, we had 79 full-time employees and 10 part-time employees.

 

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**SUPERVISION AND REGULATION**

 

Both the Company and theBank are subject to extensive state and federal banking regulations that imposerestrictions on and provide for general regulatory oversight of theiroperations.  These laws generally are intendedto protect depositors and not shareholders. The following summary is qualified by reference to the statutory andregulatory provisions discussed.  Changesin applicable laws or regulations may have a material effect on our businessand prospects.  Our operations may beaffected by legislative changes and the policies of various regulatoryauthorities.  We cannot predict theeffect that fiscal or monetary policies, economic control, or new federal orstate legislation may have on our business and earnings in the future.

 

The following discussionis not intended to be a complete list of all the activities regulated by thebanking laws or of the impact of such laws and regulations on ouroperations.  It is intended only tobriefly summarize some material provisions.

 

**CommunitySouthFinancial Corporation**

 

We own 100% of theoutstanding capital stock of the Bank, and therefore we are considered to be abank holding company under the federal Bank Holding Company Act of 1956 (the “BankHolding Company Act”).  As a result, weare primarily subject to the supervision, examination and reportingrequirements of the Board of Governors of the Federal Reserve (the “FederalReserve”) under the Bank Holding Company Act and its regulations promulgatedthereunder.  As a bank holding companylocated in South Carolina, the South Carolina Board of Financial Institutionsalso regulates and monitors all significant aspects of our operations.

 

***Permitted Activities.*** Under theBank Holding Company Act, a bank holding company is generally permitted toengage in, or acquire direct or indirect control of more than 5% of the votingshares of any company engaged in, the following activities:

 

·                  banking or managing or controlling banks;

·                  furnishing services to or performingservices for our subsidiaries; and

·                  any activity that the Federal Reservedetermines to be so closely related to banking as to be a proper incident tothe business of banking.

 

Activities that theFederal Reserve has found to be so closely related to banking as to be a properincident to the business of banking include:

 

·                  factoring accounts receivable;

·                  making, acquiring, brokering or servicingloans and usual related activities;

·                  leasing personal or real property;

·                  operating a non-bank depositoryinstitution, such as a savings association;

·                  trust company functions;

·                  financial and investment advisoryactivities;

·                  conducting discount securities brokerageactivities;

·                  underwriting and dealing in governmentobligations and money market instruments;

·                  providing specified management consultingand counseling activities;

·                  performing selected data processingservices and support services;

·                  acting as agent or broker in sellingcredit life insurance and other types of insurance in connection with credittransactions; and

·                  performing selected insuranceunderwriting activities.

 

As a bank holding company we also can electto be treated as a “financial holding company,” which would allow us to engagein a broader array of activities.  Insum, a financial holding company can engage in activities that are financial innature or incidental or complementary to financial activities, including insuranceunderwriting, sales and brokerage activities, providing financial andinvestment advisory services, underwriting services and limited merchantbanking activities.  We have not soughtfinancial holding company status, but may elect such status in the future asour business matures.  If we were toelect in writing for financial holding company status, each insured depositoryinstitution we control would have to be well capitalized, well managed and haveat least a satisfactory rating under the CRA (discussed below).

 

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The Federal Reserve hasthe authority to order a bank holding company or its subsidiaries to terminateany of these activities or to terminate its ownership or control of anysubsidiary when it has reasonable cause to believe that the bank holdingcompany’s continued ownership, activity or control constitutes a serious riskto the financial safety, soundness or stability of it or any of its banksubsidiaries.

 

***Changein Control.***  In addition, and subject to certainexceptions, the Bank Holding Company Act and the Change in Bank Control Act,together with regulations promulgated there under, require Federal Reserveapproval prior to any person or company acquiring “control” of a bank holdingcompany.  Control is conclusively presumedto exist if an individual or company acquires 25% or more of any class ofvoting securities of a bank holding company. Following the relaxing of these restrictions by the Federal Reserve in September 2008,control will be rebuttably presumed to exist if a person acquires more than 33%of the total equity of a bank or bank holding company, of which it may own,control or have the power to vote not more than 15% of any class of votingsecurities.

 

***Sourceof Strength****.*  In accordance with Federal Reserve Boardpolicy, we are expected to act as a source of financial strength to the Bankand to commit resources to support the Bank in circumstances in which we mightnot otherwise do so.  Under the BankHolding Company Act, the Federal Reserve Board may require a bank holdingcompany to terminate any activity or relinquish control of a nonbanksubsidiary, other than a nonbank subsidiary of a bank, upon the Federal ReserveBoard’s determination that such activity or control constitutes a serious riskto the financial soundness or stability of any depository institutionsubsidiary of the bank holding company. Further, federal bank regulatory authorities have additional discretionto require a bank holding company to divest itself of any bank or nonbanksubsidiaries if the agency determines that divestiture may aid the depositoryinstitution’s financial condition. Further, any loans by a bank holding company to a subsidiary bank aresubordinate in right of payment to deposits and certain other indebtedness ofthe subsidiary bank.  In the event of abank holding company’s bankruptcy, any commitment by the bank holding companyto a federal bank regulatory agency to maintain the capital of a subsidiarybank at a certain level would be assumed by the bankruptcy trustee and entitledto priority payment.

 

***CapitalRequirements.***  The Federal Reserve Board imposes certaincapital requirements on the bank holding company under the Bank Holding CompanyAct, including a minimum leverage ratio and a minimum ratio of “qualifying”capital to risk-weighted assets.  Theserequirements are essentially the same as those that apply to the Bank and aredescribed below under “CommunitySouth Bank and Trust - Capital Regulations.”  Subject to our capital requirements andcertain other restrictions, we are able to borrow money to make a capitalcontribution to the Bank, and these loans may be repaid from dividends paidfrom the Bank to the Company.  Ourability to pay dividends depends on the Bank’s ability to pay dividends to us,which is subject to regulatory restrictions as described below in “CommunitySouthBank and Trust— Dividends.”  We are alsoable to raise capital for contribution to the Bank by issuing securitieswithout having to receive regulatory approval, subject to compliance withfederal and state securities laws.

 

***South Carolina State Regulation.***  As a SouthCarolina bank holding company under the South Carolina Banking and BranchingEfficiency Act, we are subject to limitations on sale or merger and toregulation by the South Carolina Board of Financial Institutions.  We are not required to obtain the approval ofthe South Carolina Board of Financial Institutions prior to acquiring thecapital stock of a national bank, but we must notify them at least 15 daysprior to doing so.  We must receive theSouth Carolina Board of Financial Institution’s approval prior to engaging inthe acquisition of a South Carolina state chartered bank or another SouthCarolina bank holding company.

 

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**CommunitySouth Bank and Trust**

 

The Bank operates as astate chartered bank incorporated under the laws of the State of South Carolinaand is subject to examination by the South Carolina Board of FinancialInstitutions.  Deposits in the Bank areinsured by the Federal Deposit Insurance Corporation (“FDIC”) up to a maximumamount, which  is currently $100,000 foreach non-retirement depositor and $250,000 for certain retirement-accountdepositors.  However, the FDIC hasincreased the coverage up to $250,000 for each non-retirement depositor throughDecember 13, 2013, and the Bank is participating in the FDIC’s TemporaryLiquidity Guarantee Program (discussed below in greater detail) which, in part,fully insures non-interest bearing transaction accounts.

 

The South Carolina Boardof Financial Institutions and the FDIC regulate or monitor virtually all areasof the Bank’s operations, including:

 

·                  security devices and procedures;

·                  adequacy of capitalization and lossreserves;

·                  loans;

·                  investments;

·                  borrowings;

·                  deposits;

·                  mergers;

·                  issuances of securities;

·                  payment of dividends;

·                  interest rates payable on deposits;

·                  interest rates or fees chargeable onloans;

·                  establishment of branches;

·                  corporate reorganizations;

·                  maintenance of books and records; and

·                  adequacy of staff training to carry onsafe lending and deposit gathering practices.

 

The South Carolina Boardof Financial Institutions requires the Bank to maintain specified capitalratios and imposes limitations on the Bank’s aggregate investment in realestate, bank premises, and furniture and fixtures.  The South Carolina Board of FinancialInstitutions also requires the Bank to prepare quarterly reports on the Bank’sfinancial condition in compliance with its minimum standards and procedures.

 

All insured institutionsmust undergo regular on site examinations by their appropriate bankingagency.  The cost of examinations ofinsured depository institutions and any affiliates may be assessed by theappropriate agency against each institution or affiliate as it deems necessaryor appropriate.  Insured institutions arerequired to submit annual reports to the FDIC, their federal regulatory agency,and their state supervisor when applicable. The FDIC has developed a method for insured depository institutions toprovide supplemental disclosure of the estimated fair market value of assetsand liabilities, to the extent feasible and practicable, in any balance sheet,financial statement, report of condition or any other report of any insureddepository institution.  The FDICImprovement Act (the “FDICIA”) also requires the federal banking regulatoryagencies to prescribe, by regulation, standards for all insured depositoryinstitutions and depository institution holding companies relating, among otherthings, to the following:

 

·                  internal controls;

·                  information systems and audit systems;

·                  loan documentation;

·                  credit underwriting;

·                  interest rate risk exposure; and

·                  asset quality.

 

***Prompt Corrective Action. ***As aninsured depository institution, the bank is required to comply with the capitalrequirements promulgated under the Federal Deposit Insurance Act and theregulations thereunder, which set forth****five capitalcategories, each with specific regulatory consequences.  Under these regulations, the categories are:

 

·                  WellCapitalized — The institution exceeds the required minimum level for eachrelevant capital measure.  A wellcapitalized institution is one (i) having a total capital ratio of 10% orgreater, (ii) having a tier 1 capital

 

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ratio of 6% or greater, (iii) having aleverage capital ratio of 5% or greater and (iv) that is not subject toany order or written directive to meet and maintain a specific capital levelfor any capital measure.

 

·                  AdequatelyCapitalized — The institution meets the required minimum level for eachrelevant capital measure.  No capitaldistribution may be made that would result in the institution becomingundercapitalized.  An adequatelycapitalized institution is one (i) having a total capital ratio of 8% orgreater, (ii) having a tier 1 capital ratio of 4% or greater and (iii) havinga leverage capital ratio of 4% or greater or a leverage capital ratio of 3% orgreater if the institution is rated composite 1 under the CAMELS (Capital,Assets, Management, Earnings, Liquidity and Sensitivity to market risk) ratingsystem.

 

·                  Undercapitalized— The institution fails to meet the required minimum level for any relevantcapital measure.  An undercapitalizedinstitution is one (i) having a total capital ratio of less than 8% or (ii) havinga tier 1 capital ratio of less than 4% or (iii) having a leverage capitalratio of less than 4%, or if the institution is rated a composite 1 under theCAMELS rating system, a leverage capital ratio of less than 3%.

 

·                  SignificantlyUndercapitalized — The institution is significantly below the required minimumlevel for any relevant capital measure. A significantly undercapitalized institution is one (i) having atotal capital ratio of less than 6% or (ii) having a tier 1 capital ratioof less than 3% or (iii) having a leverage capital ratio of less than 3%.

 

·                  CriticallyUndercapitalized — The institution fails to meet a critical capital level setby the appropriate federal banking agency. A critically undercapitalized institution is one having a ratio oftangible equity to total assets that is equal to or less than 2%.

 

If the FDIC determines, after notice and an opportunity for hearing,that the bank is in an unsafe or unsound condition, the regulator is authorizedto reclassify the bank to the next lower capital category (other thancritically undercapitalized) and require the submission of a plan to correctthe unsafe or unsound condition.

 

If the bank is not well capitalized, it cannot accept brokered depositswithout prior FDIC approval.  Inaddition, a bank that is undercapitalized cannot offer an effective yield inexcess of 75 basis points on interest paid on deposits (including brokereddeposits, if approval is granted for the bank to accept them) of comparablesize and maturity in either such institution’s normal market area or in themarket area in which such deposits would otherwise be accepted.  Thus, for deposits in its own normal marketarea, an undercapitalized institution must offer rates that are not in excessof 75 basis points over the average local rates.  For non-local deposits, the institution mustoffer rates that are not in excess of 75 basis points over either (1) theinstitution’s own local rates or (2) the applicable non-local rates.  In other words, the institution must adhereto the prevailing rates in its own normal market area for all deposits (whetherlocal or non-local) and also must adhere to the prevailing rates in thenon-local area for any non-local deposits. Thus, the institution will be unableto outbid non-local institutions for non-local deposits even if the non-localrates are lower than the rates in the institution’s own normal market area.

 

Moreover, if the bank becomes less than adequately capitalized, it mustadopt a capital restoration plan acceptable to the FDIC.  The bank also would become subject toincreased regulatory oversight, and would be increasingly restricted in thescope of its permissible activities. Each company having control over an undercapitalized institution alsomust provide a limited guarantee that the institution will comply with itscapital restoration plan.  Except underlimited circumstances consistent with an accepted capital restoration plan, anundercapitalized institution may not grow. An undercapitalized institution may not acquire another institution,establish additional branch offices or engage in any new line of businessunless determined by the appropriate Federal banking agency to be consistentwith an accepted capital restoration plan, or unless the FDIC determines thatthe proposed action will further the purpose of prompt corrective action.  The appropriate federal banking agency maytake any action authorized for a significantly undercapitalized institution ifan undercapitalized institution fails to submit an acceptable capitalrestoration plan or fails in any material respect to implement a plan acceptedby the agency.  A criticallyundercapitalized institution is subject to having a receiver or conservatorappointed to manage its affairs and for loss of its charter to conduct bankingactivities.

 

An insured depository institution may not pay a management fee to abank holding company controlling that institution or any other person havingcontrol of the institution if, after making the payment, the institution, wouldbe undercapitalized.  In addition, aninstitution cannot make a capital distribution, such as a dividend or otherdistribution that is

 

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in substance a distribution of capital to the owners of the institutionif following such a distribution the institution would be undercapitalized.  Thus, if payment of such a management fee orthe making of such would cause the Bank to become undercapitalized, it couldnot pay a management fee or dividend to us.

 

As of December 31, 2009, the Bank was deemed to be “undercapitalized.” As described further below, on February 23,2010, the Bank entered into a Consent Order (the “Consent Order”) withthe FDIC and the South Carolina Board of Financial Institutions which, amongother things, requires the Bank to achieve and maintain Total Risk Basedcapital at least equal to 10% of risk-weighted assets and Tier 1 at least equalto 8% of total assets within 120 days from the effective date of the order.

 

***Transactionswith Affiliates and Insiders.***  The Company isa legal entity separate and distinct from the Bank and its other subsidiaries.Various legal limitations restrict the Bank from lending or otherwise supplyingfunds to the Company or its non-bank subsidiaries. The Company and the Bank aresubject to Sections 23A and 23B of the Federal Reserve Act and Federal ReserveRegulation W.

 

Section 23A of theFederal Reserve Act places limits on the amount of loans or extensions ofcredit to, or investments in, or certain other transactions with, affiliatesand on the amount of advances to third parties collateralized by the securitiesor obligations of affiliates. The aggregate of all covered transactions islimited in amount, as to any one affiliate, to 10% of the Bank’s capital andsurplus and, as to all affiliates combined, to 20% of the Bank’s capital andsurplus. Furthermore, within the foregoing limitations as to amount, eachcovered transaction must meet specified collateral requirements. The Bank isforbidden to purchase low quality assets from an affiliate.

 

Section 23B of theFederal Reserve Act, among other things, prohibits an institution from engagingin certain transactions with certain affiliates unless the transactions are onterms substantially the same, or at least as favorable to such institution orits subsidiaries, as those prevailing at the time for comparable transactionswith nonaffiliated companies.

 

Regulation W generallyexcludes all non-bank and non-savings association subsidiaries of banks fromtreatment as affiliates, except to the extent that the Federal Reserve Board decidesto treat these subsidiaries as affiliates. The regulation also limits theamount of loans that can be purchased by a bank from an affiliate to not morethan 100% of the bank’s capital and surplus.

 

The Bank is also subjectto certain restrictions on extensions of credit to executive officers,directors, certain principal shareholders, and their related interests. Suchextensions of credit (i) must be made on substantially the same terms,including interest rates and collateral, as those prevailing at the time forcomparable transactions with third parties and (ii) must not involve morethan the normal risk of repayment or present other unfavorable features.

 

***Branching****.*  Under currentSouth Carolina law, we may open branch offices throughout South Carolina withthe prior approval of the South Carolina Board of Financial Institutions.  In addition, with prior regulatory approval,the Bank will be able to acquire existing banking operations in SouthCarolina.  Furthermore, federallegislation has been passed that permits interstate branching by banks ifallowed by state law, and interstate merging by banks.  However, South Carolina law, with limitedexceptions, currently permits branching across state lines only throughinterstate mergers.

 

***Anti-Tying Restrictions***. Under amendments to the Bank Holding Company Act andFederal Reserve regulations, a bank is prohibited from engaging in certaintying or reciprocity arrangements with its customers. In general, a bank maynot extend credit, lease, sell property, or furnish any services or fix or varythe consideration for these on the condition that (i) the customer obtainor provide some additional credit, property, or services from or to the bank,the bank holding company or subsidiaries thereof or (ii) the customer maynot obtain some other credit, property, or services from a competitor, exceptto the extent reasonable conditions are imposed to assure the soundness of thecredit extended. Certain arrangements are permissible: a bank may offercombined-balance products and may otherwise offer more favorable terms if acustomer obtains two or more traditional bank products; and certain foreigntransactions are exempt from the general rule. A bank holding company or anybank affiliate also is subject to anti-tying requirements in connection withelectronic benefit transfer services.

 

***CommunityReinvestment Act****.*  The Community Reinvestment Act requires that,in connection with examinations of financial institutions within theirrespective jurisdictions, a financial institution’s primary regulator, which isthe FDIC for the Bank, shall evaluate the record of each financial institutionin meeting the credit needs of its local community, including low

 

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and moderate incomeneighborhoods.  These factors are alsoconsidered in evaluating mergers, acquisitions, and applications to open abranch or facility.  Failure toadequately meet these criteria could impose additional requirements andlimitations on our Bank.  Additionally,we must publicly disclose the terms of various Community ReinvestmentAct-related agreements.

 

***FinanceSubsidiaries.***  Under the Gramm-Leach-Bliley Act (the “GLBA”),subject to certain conditions imposed by their respective banking regulators,national and state-chartered banks are permitted to form “financialsubsidiaries” that may conduct financial or incidental activities, therebypermitting bank subsidiaries to engage in certain activities that previouslywere impermissible.  The GLBA imposesseveral safeguards and restrictions on financial subsidiaries, including thatthe parent bank’s equity investment in the financial subsidiary be deductedfrom the bank’s assets and tangible equity for purposes of calculating the bank’scapital adequacy.  In addition, the GLBAimposes new restrictions on transactions between a bank and its financialsubsidiaries similar to restrictions applicable to transactions between banksand non-bank affiliates.

 

***Consumer Protection Regulations.***Activities of the Bank are subject to avariety of statutes and regulations designed to protect consumers. Interest andother charges collected or contracted for by the Bank are subject to stateusury laws and federal laws concerning interest rates. The Bank’s loanoperations are also subject to federal laws applicable to credit transactions,such as the:

 

·                  The federal Truth-In-Lending Act, governing disclosures of credit termsto consumer borrowers;

·                  The Home Mortgage Disclosure Act of 1975, requiring financialinstitutions to provide information to enable the public and public officialsto determine whether a financial institution is fulfilling its obligation tohelp meet the housing needs of the community it serves;

·                  The Equal Credit Opportunity Act, prohibiting discrimination on thebasis of race, creed or other prohibited factors in extending credit;

·                  The Fair Credit Reporting Act of 1978, as amended by the Fair andAccurate Credit Transactions Act, governing the use and provision ofinformation to credit reporting agencies, certain identity theft protectionsand certain credit and other disclosures;

·                  The Fair Debt Collection Act, governing the manner in which consumerdebts may be collected by collection agencies; and

·                  The rules and regulations of the various federal agencies chargedwith the responsibility of implementing these federal laws.

 

The deposit operations ofthe Bank also are subject to:

 

·                  the Right to Financial Privacy Act, which imposes a duty to maintainconfidentiality of consumer financial records and prescribes procedures forcomplying with administrative subpoenas of financial records; and

·                  the Electronic Funds Transfer Act and Regulation E issued by theFederal Reserve Board to implement that Act, which governs automatic depositsto and withdrawals from deposit accounts and customers’ rights and liabilitiesarising from the use of automated teller machines and other electronic bankingservices.

 

***Enforcement Powers.***The Bank and its “institution-affiliated parties,”including its management, employees, agents, independent contractors, andconsultants such as attorneys and accountants and others who participate in theconduct of the financial institution’s affairs, are subject to potential civiland criminal penalties for violations of law, regulations or written orders ofa government agency. These practices can include the failure of an institutionto timely file required reports or the filing of false or misleadinginformation or the submission of inaccurate reports. Civil penalties may be ashigh as $1,000,000 a day for such violations. Criminal penalties for somefinancial institution crimes have been increased to 20 years. In addition,regulators are provided with greater flexibility to commence enforcementactions against institutions and institution-affiliated parties. Possibleenforcement actions include the termination of deposit insurance. Furthermore,banking agencies’ power to issue cease-and-desist orders were expanded. Suchorders may, among other things, require affirmative action to correct any harmresulting from a violation or practice, including restitution, reimbursement,indemnifications or guarantees against loss. A financial institution may alsobe ordered to restrict its growth, dispose of certain assets, rescindagreements or contracts, or take other actions as determined by the orderingagency to be appropriate.

 

***Anti-Money Laundering.***Financial institutions must maintain anti-moneylaundering programs that include established internal policies, procedures, andcontrols; a designated compliance officer; an ongoing employee trainingprogram; and testing of the program by an independent audit function. TheCompany and the Bank are also prohibited from

 

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entering into specifiedfinancial transactions and account relationships and must meet enhancedstandards for due diligence and “knowing your customer” in their dealings withforeign financial institutions and foreign customers. Financial institutionsmust take reasonable steps to conduct enhanced scrutiny of accountrelationships to guard against money laundering and to report any suspicioustransactions, and recent laws provide law enforcement authorities withincreased access to financial information maintained by banks. Anti-moneylaundering obligations have been substantially strengthened as a result of theUSA Patriot Act, enacted in 2001 and renewed in 2006. Bank regulators routinelyexamine institutions for compliance with these obligations and are required toconsider compliance in connection with the regulatory review of applications.The regulatory authorities have been active in imposing “cease and desist”orders and money penalty sanctions against institutions found to be violatingthese obligations.

* *

## ***USAPATRIOT Act.*** The USA PATRIOT Act becameeffective on October 26, 2001, amended, in part, the Bank Secrecy Act, andprovides, in part, for the facilitation of information sharing amonggovernmental entities and financial institutions for the purpose of combatingterrorism and money laundering by enhancing anti-money laundering and financialtransparency laws, as well as enhanced information collection tools andenforcement mechanics for the U.S. government, including: (i) requiringstandards for verifying customer identification at account opening; (ii) rules topromote cooperation among financial institutions, regulators, and lawenforcement entities in identifying parties that may be involved in terrorismor money laundering; (iii) reports by nonfinancial trades and businessesfiled with the Treasury Department’s Financial Crimes Enforcement Network fortransactions exceeding $10,000; and (iv) filing suspicious activitiesreports by brokers and dealers if they believe a customer may be violating U.S.laws and regulations and requires enhanced due diligence requirements forfinancial institutions that administer, maintain, or manage private bankaccounts or correspondent accounts for non-U.S. persons.  Bank regulators routinely examineinstitutions for compliance with these obligations and are required to considercompliance in connection with the regulatory review of applications.

## *** ***

Under the USA PATRIOT Act, the Federal Bureau of Investigation (“FBI”)can send our banking regulatory agencies lists of the names of personssuspected of involvement in terrorist activities.  The Bank can be requested to search itsrecords for any relationships or transactions with persons on those lists.  If the Bank finds any relationships ortransactions, it must file a suspicious activity report and contact the FBI.

 

The Office of Foreign Assets Control (“OFAC”), which is a division ofthe U.S. Department of the Treasury, is responsible for helping to insure thatUnited States entities do not engage in transactions with “enemies” of theUnited States, as defined by various Executive Orders and Acts ofCongress.  OFAC has sent, and will send,our banking regulatory agencies lists of names of persons and organizationssuspected of aiding, harboring or engaging in terrorist acts.  If the Bank finds a name on any transaction,account or wire transfer that is on an OFAC list, it must freeze such account,file a suspicious activity report and notify the FBI.  The Bank has appointed an OFAC complianceofficer to oversee the inspection of its accounts and the filing of anynotifications.  The Bank actively checkshigh-risk OFAC areas such as new accounts, wire transfers and customerfiles.  The Bank performs these checksutilizing software, which is updated each time a modification is made to thelists provided by OFAC and other agencies of Specially Designated Nationals andBlocked Persons.

 

***Privacy and Credit Reporting*****. **Financialinstitutions are required to disclose their policies for collecting andprotecting confidential information. Customers generally may prevent financial institutions from sharingnonpublic personal financial information with nonaffiliated third partiesexcept under narrow circumstances, such as the processing of transactionsrequested by the consumer or when the financial institution is jointlysponsoring a product or service with a nonaffiliated third party.  Additionally, financial institutionsgenerally may not disclose consumer account numbers to any nonaffiliated thirdparty for use in telemarketing, direct mail marketing or other marketing toconsumers.  It is the Bank’s policy notto disclose any personal information unless required by law.

 

Like other lendinginstitutions, the Bank utilizes credit bureau data in its underwritingactivities.  Use of such data isregulated under the Federal Credit Reporting Act on a uniform, nationwidebasis, including credit reporting, prescreening, sharing of information betweenaffiliates, and the use of credit data. The Fair and Accurate Credit Transactions Act of 2003 (the “FACT Act”)authorizes states to enact identity theft laws that are not inconsistent withthe conduct required by the provisions of the FACT Act.

 

***Payment of Dividends.*** A South Carolina state bank may not pay dividendsfrom its capital.  All dividends must bepaid out of undivided profits then on hand, after deducting expenses, includingreserves for losses and bad debts.  TheBank is authorized to pay cash dividends up to 100% of net income in anycalendar year without obtaining the prior approval of the South Carolina Boardof Financial Institutions, provided that the Bank received a composite ratingof one or two at the last

 

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federal or stateregulatory examination.  The Bank mustobtain approval from the South Carolina Board of Financial Institutions priorto the payment of any other cash dividends. In addition, under the FDICIA, the Bank may not pay a dividend if, afterpaying the dividend, the Bank would be undercapitalized.  As described further below, on February 23,2010, the Bank entered into the Consent Order with the FDIC and the SouthCarolina Board of Financial Institutions which, among other things, prohibitsthe Bank from declaring or paying any dividends or making any distributions ofinterest, principal, or other sums on subordinated debentures without the priorapproval of the supervisory authorities.

 

***Check 21.***  The Check Clearing for the 21stCentury Act gives “substitute checks,” such as a digital image of a check andcopies made from that image, the same legal standing as the original papercheck.  Some of the major provisionsinclude:

 

·                  allowing check truncation without makingit mandatory;

·                  demanding that every financialinstitution communicate to accountholders in writing a description of itssubstitute check processing program and their rights under the law;

·                  legalizing substitutions for andreplacements of paper checks without agreement from consumers;

·                  retaining in place the previouslymandated electronic collection and return of checks between financial institutionsonly when individual agreements are in place;

·                  requiring that when accountholdersrequest verification, financial institutions produce the original check (or acopy that accurately represents the original) and demonstrate that the accountdebit was accurate and valid; and

·                  requiring the re-crediting of funds to anindividual’s account on the next business day after a consumer proves that thefinancial institution has erred.

 

***Effectof Governmental Monetary Policies*****.**  Our earnings are affected by domesticeconomic conditions and the monetary and fiscal policies of the United Statesgovernment and its agencies.  The FederalReserve Bank’s monetary policies have had, and are likely to continue to have,an important impact on the operating results of commercial banks through itspower to implement national monetary policy in order, among other things, tocurb inflation or combat a recession. The monetary policies of the Federal Reserve Board have major effectsupon the levels of bank loans, investments and deposits through its open marketoperations in United States government securities and through its regulation ofthe discount rate on borrowings of member banks and the reserve requirementsagainst member bank deposits.  It is notpossible to predict the nature or impact of future changes in monetary andfiscal policies.

 

***Insurance of Accounts and Regulation by the FDIC.***** Our deposits are insured up toapplicable limits by the Deposit Insurance Fund of the FDIC.  TheDeposit Insurance Fund is the successor to the Bank Insurance Fund and theSavings Association Insurance Fund, which were merged effective March 31,2006.  As insurer, the FDIC imposes deposit insurance premiums and isauthorized to conduct examinations of and to require reporting by FDIC insuredinstitutions.  It also may prohibit any FDIC insured institution fromengaging in any activity the FDIC determines by regulation or order to pose aserious risk to the insurance fund.  The FDIC also has the authorityto initiate enforcement actions against savings institutions, after giving theOffice of Thrift Supervision an opportunity to take such action, and mayterminate the deposit insurance if it determines that the institution hasengaged in unsafe or unsound practices or is in an unsafe or unsound condition.

 

Under regulationseffective January 1, 2007, the FDIC adopted a new risk-based premiumsystem that provides for quarterly assessments based on an insured institution’sranking in one of four risk categories based upon supervisory and capitalevaluations.  For deposits held as of March 31,2009, institutions are assessed at annual rates ranging from 12 to 50basis points, depending on each institution’s risk of default as measuredby regulatory capital ratios and other supervisory measures.  Effective April 1, 2009,assessments will take into account each institution’s reliance on securedliabilities and brokered deposits.  This will result inassessments ranging from 7 to 77.5 basis points.  We anticipate our futureinsurance costs to be higher than in previous periods.

 

FDIC insured institutionsare required to pay a Financing Corporation assessment, in order to fund theinterest on bonds issued to resolve thrift failures in the 1980s.  Forthe first quarter of 2009, the Financing Corporation assessmentequaled 1.14 basis points for domestic deposits.  Theseassessments, which may be revised based upon the level of deposits, willcontinue until the bonds mature in the years 2017 through 2019.

 

The FDIC may terminatethe deposit insurance of any insured depository institution, including theBank, if it determines after a hearing that the institution has engaged inunsafe or unsound practices, is in an unsafe or unsound condition

 

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to continue operations orhas violated any applicable law, regulation, rule, order or condition imposedby the FDIC.  It also may suspend deposit insurance temporarilyduring the hearing process for the permanent termination of insurance, if the institutionhas no tangible capital.  If insurance of accounts is terminated, theaccounts at the institution at the time of the termination, less subsequentwithdrawals, shall continue to be insured for a period of six months to twoyears, as determined by the FDIC.

 

***ProposedLegislation and Regulatory Action*****.**  New regulations and statutes are regularlyproposed that contain wide-ranging proposals for altering the structures,regulations, and competitive relationships of the nation’s financialinstitutions.  We cannot predict whetheror in what form any proposed regulation or statute will be adopted or theextent to which our business may be affected by any new regulation or statute.

 

***RecentLegislative and Regulatory Initiatives to Address Financial and EconomicCrises. ***The Congress, Treasury Department and thefederal banking regulators, including the FDIC, have taken broad action sinceearly September 2008 to address volatility in the U.S. banking system.

 

In October 2008, theEmergency Economic Stabilization Act of 2008 (“EESA”) wasenacted. The EESA authorizes the Treasury Department to purchase fromfinancial institutions and their holding companies up to $700 billion inmortgage loans, mortgage-related securities and certain other financialinstruments, including debt and equity securities issued by financialinstitutions and their holding companies in a troubled asset relief program (“TARP”).  Thepurpose of TARP is to restore confidence and stability to the U.S. bankingsystem and to encourage financial institutions to increase their lending tocustomers and to each other.  The Treasury Department has allocated$250 billion towards the TARP Capital Purchase Program (“CPP”).  Underthe CPP, Treasury will purchase debt or equity securities from participatinginstitutions.  The TARP also will include direct purchases orguarantees of troubled assets of financial institutions. Participants inthe CPP are subject to executive compensation limits and are encouraged toexpand their lending and mortgage loan modifications.

 

EESA also increased FDICdeposit insurance on most accounts from $100,000 to $250,000.  Thisincrease is in place until the end of 2013 and is not covered by depositinsurance premiums paid by the banking industry.

 

Followinga systemic risk determination, the FDIC established the Temporary LiquidityGuarantee Program (“TLGP”) on October 14, 2008.  The TLGPincludes the Transaction Account Guarantee Program (“TAGP”), which providesunlimited deposit insurance coverage through December 31, 2009 fornoninterest-bearing transaction accounts (typically business checking accounts)and certain funds swept into noninterest-bearing savings accounts.  Thishas been extended until June 30, 2010.  Institutions participating inthe TLGP pay a 10 basis points fee (annualized) on the balance of each coveredaccount in excess of $250,000, while the extra deposit insurance is inplace.  The TLGP also includes the Debt Guarantee Program (“DGP”),under which the FDIC guarantees certain senior unsecured debt of FDIC-insuredinstitutions and their holding companies.  The unsecured debt must beissued on or after October 14, 2008 and not later than June 30, 2009,and the guarantee is effective through the earlier of the maturity date or June 30,2012.  On March 17, 2009, the FDIC adopted an interim rule thatextends the DGP and imposes surcharges on existing rates for certain debtissuances.  This extension allowed institutions that had issued guaranteeddebt before April 1, 2009 to issue guaranteed debt during the extendedissuance period that ended on October 31, 2009. For suchinstitutions, the guarantee on debt issued on or after April 1, 2009, willexpire no later than December 31, 2012.*** ***The DGP coverage limit isgenerally 125% of the eligible entity’s eligible debt outstanding on September 30,2008 and scheduled to mature on or before June 30, 2009 or, for certaininsured institutions, 2% of their liabilities as of September 30,2008.  Depending on the term of the debt maturity, the nonrefundableDGP fee ranges from 60 to 110 basis points (annualized) for covered debtoutstanding until the earlier of maturity or June 30, 2012 and 75 to 125basis points (annualized) for covered debt outstanding until after June 30,2012.  The TAGP and DGP are in effect forall eligible entities, unless the entity opted out on or before December 5,2008.  We participate in the TAGP and the DGP.

 

On February 17, 2009President Obama signed into law The American Recovery and Reinvestment Act of2009 (the “Recovery Act”), more commonly known as the economic stimulus oreconomic recovery package.  The RecoveryAct includes a wide variety of programs intended to stimulate the economy andprovide for extensive infrastructure, energy, health, and education needs. In addition,the Recovery Act imposes certain new executive compensation and corporateexpenditure limits on all current and future TARP recipients that are inaddition to those previously announced by the Treasury Department, until theTARP recipient has repaid the Treasury Department, which is now permitted underthe Recovery Act without penalty and without the need to raise new capital,subject to the Treasury Department’s consultation with the recipient’sappropriate regulatory agency.

 

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On March 23, 2009,the Treasury Department, in conjunction with the FDIC and the Federal Reserve,announced the Public-Private Partnership Investment Program for Legacy Assetswhich consists of the following two separate plans, addressing two distinctasset groups.

 

The first plan is theLegacy Loan Program, which has a primary purpose to facilitate the sale oftroubled mortgage loans by eligible institutions, including FDIC-insuredfederal or state banks and savings associations. Eligible assets are notstrictly limited to loans; however, what constitutes an eligible asset will bedetermined by participating banks, their primary regulators, the FDIC and theTreasury Department. Under the Legacy Loan Program, the FDIC has sold certaintroubled assets out of an FDIC receivership in two separate transactionsrelating to the failed Illinois bank, Corus Bank, NA, and the failed Texasbank, Franklin Bank, S.S.B. These transactions were completed in September 2009and October 2009, respectively.

 

The second plan is theSecurities Program, which is administered by the Treasury Department andinvolves the creation of public-private investment funds to target investmentsin eligible residential mortgage-backed securities and commercialmortgage-backed securities issued before 2009 that originally were rated AAA orthe equivalent by two or more nationally recognized statistical ratingorganizations, without regard to rating enhancements (collectively, “LegacySecurities”). Legacy Securities must be directly secured by actual mortgageloans, leases or other assets, and may be purchased only from financialinstitutions that meet TARP eligibility requirements. The Treasury Departmentreceived over 100 unique applications to participate in the Legacy SecuritiesPPIP and in July 2009 selected nine public-private investment fundmanagers.  As of December 31, 2009,public-private investment funds have completed initial and subsequent closingson approximately $6.2 billion of private sector equity capital, which wasmatched 100% by the Treasury Department, representing $12.4 billion of totalequity capital. The Treasury Department has also provided $12.4 billion of debtcapital, representing $24.8 billion of total purchasing power. As of December 31,2009, public-private investment funds have drawn-down approximately $4.3billion of total capital which has been invested in certain non-agencyresidential mortgage backed securities and commercial mortgage backedsecurities and cash equivalents pending investment.

 

On May 22, 2009, theFDIC levied a one-time special assessment on all banks due on September 30,2009.  In addition, on November 12,2009, the FDIC issued a final rule to require banks to prepay theirestimated quarterly risk-based assessments for the fourth quarter of 2009 andfor all of 2010, 2011 and 2012 and to increase assessment rates effective on January 1,2011.

 

Although it is likelythat further regulatory actions will arise as the federal government attemptsto address the economic situation, we cannot predict the effect that fiscal ormonetary policies, economic control, or new federal or state legislation mayhave on our business and earnings in the future.

 

**Item 1A.    RiskFactors.**

 

Our business, financialcondition, and results of operations could be harmed by any of the followingrisks, or other risks that have not been identified or which we believe areimmaterial or unlikely.  Shareholdersshould carefully consider the risks described below in conjunction with theother information in this Form 10-K and the information incorporated byreference in this Form 10-K, including our consolidated financialstatements and related notes.

 

***There is substantial doubt about our ability to continue asa going concern.***

 

We have prepared theconsolidated financial statements contained in this Report assuming that theCompany will be able to continue as a going concern, which contemplates therealization of assets and the discharge of liabilities in the normal course ofbusiness for the foreseeable future. However, as a result of recurring losses, as well as uncertaintiesassociated with the Bank’s ability to increase its capital levels to meetregulatory requirements, management has concluded that there is substantialdoubt about the Company’s ability to continue as a going concern. In its reportdated February 26, 2010, our independent registered public accounting firmstated that these uncertainties raise substantial doubt about our ability tocontinue as a going concern.  Our financial statements do not includeany adjustments that might be necessary if we are unable to continue as a goingconcern.  If we are unable to continue asa going concern, our shareholders will likely lose all of their investment inthe Company.  See Management’s Discussionand Analysis of Financial Condition and Results of Operations for management’sdiscussion of our financial condition at December 31, 2009.

 

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***We need to raise additional capital thatmay not be available to us.***

 

Regulatoryauthorities require us to maintain adequate levels of capital to support ouroperations. As described above, we are undercapitalized and have an immediateneed to raise capital.  In addition, even if we succeed in raisingthis capital, we may need to raise additional capital in the future due toadditional losses or regulatory mandates. The ability to raise additionalcapital, if needed, will depend in part on conditions in the capital markets atthat time, which are outside our control, and on our financial performance. Accordingly,additional capital may not be raised, if and when needed, on terms acceptableto us, or at all. If we cannot raise additional capital when needed, ourability to increase our capital ratios could be materially impaired and wecould face additional regulatory challenges. In addition, if we issueadditional equity capital, it may be at a lower price and in all cases ourexisting shareholders’ interest would be diluted.

 

***Liquidity needs at our Bank level couldadversely affect our financial condition and results of operation.***

 

Traditionally,the primary sources of funds of our Bank subsidiary have been customer depositsand loan repayments.  As of December 31,2009, we had brokered deposits of $202.8 million, representing 53.85% of ourtotal deposits, of which $79.7 million are scheduled to mature in the thirdquarter of 2010 and $94.9 million are scheduled to mature in the fourth quarterof 2010.  Because of the limitations on brokered deposits imposed bythe Consent Order and our undercapitalized status, we must find other sourcesof liquidity to replace these deposits as they mature.  Secondarysources of liquidity may include proceeds from Federal Home Loan Bank (“FHLB”)advances and federal funds lines of credit from correspondentbanks.  However, FHLB has informed us that due to our financialcondition we are not currently permitted to receive any more advances.  As a result, we must limit our growth, raiseadditional capital, or sell assets, which could materially and adversely affectour financial condition and results of operations.  Additionally, deposit levels may be affectedby a number of factors, including rates paid by competitors, general interestrate levels, regulatory capital requirements, returns available to customers onalternative investments and general economic conditions.  Because the Bank is not well capitalized, itis subject to the 75-basis-point interest rate cap that it can pay on deposits,as more fully described above.  Becauseof this interest rate cap, we may not be able to attract sufficient deposits tomeet our liquidity needs.  If this wereto occur, the Bank may be placed into a federal conservatorship or receivershipby the FDIC, with the FDIC appointed as conservator or receiver.

 

***We have sustained losses from a decline incredit quality and may see further losses.***

 

Ourability to generate earnings is significantly affected by our ability toproperly originate, underwrite, and service loans.  We have sustained losses primarily becauseborrowers, guarantors, or related parties have failed to perform in accordancewith the terms of their loans and we failed to detect or respond todeterioration in asset quality in a timely manner.  We could sustain additional losses for thesereasons.  Problems with credit quality orasset quality could cause our interest income and net interest margin todecrease, which could adversely affect our business, financial condition, andresults of operations.  We have recentlyidentified credit deficiencies with respect to certain loans in our loanportfolio which are primarily related to the downturn in the residentialhousing industry.  As a result of thedecline of the residential housing market, property values for this type ofcollateral have declined substantially.  In response to this determination,we increased our loan loss reserve throughout 2009 to a total loan loss reserveof $13.0 million at December 31, 2009 to address the risks inherent withinour loan portfolio.  Recent developments,including further deterioration in the South Carolina real estate market as awhole, may cause management to adjust its opinion of the level of creditquality in our loan portfolio.  Such adetermination may lead to an additional increase in our provisions for loanlosses, which could also adversely affect our business, financial condition,and results of operations.

 

***We may have higher loan losses than we haveallowed for in our allowance for loan losses.***

 

Ourloan losses could exceed our allowance for loan losses.  Our average loan size has increased in recentyears over historic levels, and reliance on our historic allowance for loanlosses may not be adequate.  In addition,our non-performing assets haveincreased dramatically over the past 12 months due to the severe housingdownturn and real estate market deterioration in each of our market areas.  As of December 31, 2009, we had$45.3 million in loans on our classified list. Classified loans are loans graded as substandard, doubtful, orloss.  Also as of December 31, 2009,$29.9 million, or 10.9% of our loan portfolio was comprised of either loans notaccruing interest or loans past due 90 days or more (and $34.2 million , or 12.4%of our loan portfolio was comprised of either loans not accruing interest orloans past due 30 days or more).  Industry

 

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experienceshows that a portion of loans will become delinquent and a portion of loanswill require partial or entire charge-off.  Regardless of the underwriting criteria utilized, losses may beexperienced as a result of various factors beyond our control, including:

 
| · | cost  overruns;                                                   |
|--------|-------------------------------------------------------------------|
|   |                                                              |
| · | declining  property values;                                       |
|   |                                                              |
| · | mismanaged  construction;                                         |
|   |                                                              |
| · | inferior  or improper construction techniques;                    |
|   |                                                              |
| · | economic  changes or downturns during construction;               |
|   |                                                              |
| · | rising  interest rates that may prevent sale of the property; and |
|   |                                                              |
| · | failure  to sell completed projects or units in a timely manner.  |

 

Theoccurrence of any of the preceding risks could result in the deterioration ofone or more of these loans which could significantly increase our percentage ofnonperforming assets. ** **Anincrease in nonperforming loans may result in a loss of earnings from theseloans, an increase in the related provision for loan losses and an increase incharge-offs, all of which could have a material adverse effect on our financialcondition and results of operations. Asof December 31, 2009, our non-performing assets were $42.4 million.  If the current economic conditions continuefor a prolonged period of time, it is very likely that the level ofnonperforming assets will rise to higher levels in 2010, requiring additional provisions forloan losses.

 

In addition, while wegenerally underwrite the loans in our portfolio in accordance with our owninternal underwriting guidelines and regulatory supervisory guidelines, incertain circumstances we have made loans which exceed either our internalunderwriting guidelines, supervisory guidelines, or both.  As of December 31, 2009, approximately$18.1 million of our loans, or 109% of our Company’s capital, had loan-to-valueratios that exceeded regulatory supervisory guidelines, of which 16 loanstotaling approximately $6.2 million had loan-to-value ratios of 100% or more.At December 31, 2008, $22.9 million of our loans, or 65% of our Company’scapital, exceeded the supervisory loan to value ratio.  The number of loans in our portfolio withloan-to-value ratios in excess of supervisory guidelines, our internalguidelines, or both could increase the risk of delinquencies and defaults inour portfolio.

 

***Wehave become subject to enforcement actions that will require us to take certainactions.***

 

On June 29, 2009,the Bank entered into a Memorandum of Understanding (the “MOU”) with theCommissioner of Banking of the South Carolina Board of Financial Institutionsand the Regional Director of the FDIC’s Atlanta Regional Office.  The MOU required the Bank to, among otherthings, (1) submit a capital plan to the supervisory authorities forreturning to a “well-capitalized” designation; (2) develop specific plansand proposals for the reduction and improvement of assets which are subject toadverse classification and past due loans; (3) implement a plan todecrease the concentration of commercial real estate loans; (4) developand implement an improved loan review program; and (5) review overallliquidity objectives and develop plans and procedures aimed at improvingliquidity and reducing reliance on volatile liabilities to fund longer-termassets.  In addition, the Bank may notpay dividends without the prior written consent of each supervisory authority. Since entering into the MOU, the Bank has been actively pursuing thecorrective actions required by the MOU in an effort to ensure that therequirements of the MOU are met in a timely manner.

 

The FDIC completed asafety and soundness examination of the Bank in the fourth quarter of2009.  Based on the Bank’s currentfinancial condition, the Bank entered into the Consent Order with the FDIC andthe South Carolina Board of Financial Institutions on February 23, 2010,which contains, among other things, a requirement that our Bank achieve andmaintain minimum capital requirements that exceed the minimum regulatorycapital ratios for “well capitalized” banks.   Under thisenforcement action, the Bank may no longer accept, renew, or roll over brokereddeposits.  In addition, under the ConsentOrder, we no longer meet the regulatory requirements to be eligible forexpedited processing of branch applications and certain other regulatoryapprovals, and we are required to obtain FDIC approval before making certain

 

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payments to departingexecutives and before adding new directors or senior executives.  Our regulators have considerable discretionin whether to grant required approvals, and no assurance can be given that suchapprovals would be forthcoming.  In addition, we are required to takecertain other actions in the areas of capital, liquidity, asset quality, andinterest rate risk management, as well as to file periodic reports with theFDIC and the South Carolina Board of Financial Institutions regarding ourprogress in complying with the Consent Order. The Consent Order supersedes the MOU. Any material failure to comply with the terms of the Consent Order couldresult in further enforcement action by the FDIC.  While we intend totake such actions as may be necessary to comply with the requirements of theConsent Order and subsequence FDIC guidance, we may be unable to comply fullywith the deadlines or other terms of the Consent Order.  For further discussion of the Consent Order,please see below.

 

***Our Bank may become subject to a federalconservatorship or receivership if it cannot comply with the Consent Order, orif its condition continues to deteriorate.***

 

Asnoted above, the Bank executed a Consent Order with the FDIC and the SouthCarolina Board of Financial Institutions. The Consent Order requires the Bank to, among other things, implement aplan to achieve and maintain minimum capital requirements, including provisionsfor contingency funding arrangements.  The condition of our loanportfolio may continue to deteriorate in the current economic environment andthus continue to deplete our capital and other financialresources.  Should we fail to comply with the capital and liquidityfunding requirements in the Consent Order, or suffer a continued deteriorationin our financial condition, we may be subject to being placed into a federalconservatorship or receivership by the FDIC, with the FDIC appointed asconservator or receiver.  If these events occur, we probably wouldsuffer a complete loss of the value of our ownership interest in the Bank andwe subsequently may be exposed to significant claims by the FDIC.  Federal conservatorship or receivership wouldalso result in a complete loss of your investment.

 

***We may face damage to our reputation andbusiness as a result of negative publicity, including an increase in depositoutflows.***

 

Webelieve that approximately $9.1million, or 2.4%, of our deposits are above FDICinsurance limits as of December 31, 2009, and these deposits areparticularly susceptible to withdrawal based on negative publicity about ourcurrent financial condition.  Although the increase in the FDICinsurance limit of $250,000 per depositor from $100,000 per depositor is inplace through December 31, 2013, we cannot predict whether the limit willbe maintained or reduced when it expires. Negative public opinion could adversely affect our ability to keep andattract customers, expose us to litigation, and raise withdrawal levels beyondthe capacity of our currently available liquidity, which would result in atakeover of the Bank by the FDIC.

 

***A significant portion of our loan portfoliois secured by real estate, and the recent weakening of the local real estatemarket could continue to hurt our business.***

 

Asignificant portion of our loan portfolio is secured by realestate.  As of December 31, 2009, approximately 90% of our loanshad real estate as the primary or secondary component ofcollateral.  The real estate collateral in each case provides analternate source of repayment in the event of default by the borrower and maydeteriorate in value during the time the credit is extended.  Therecent downturn in the real estate market has resulted in increased loandelinquencies, defaults and foreclosures, primarily in our residential realestate construction and development portfolio. These loans carry a higher degree of risk than long-term financing ofexisting real estate since repayment is dependent on the ultimate completion ofthe project or home and usually on the sale of the property or permanentfinancing.  Slow housing conditions haveaffected some of these borrowers’ ability to sell the completed projects in atimely manner and we believe that these trends are likely tocontinue.  In some cases, this downturn has resulted in a significantimpairment to the value of our collateral and our ability to sell thecollateral upon foreclosure.  If real estate values continue todecline, it is also more likely that we would be required to increase ourallowance for loan losses.  If, during a period of reduced realestate values, we are required to liquidate the property collateralizing a loanto satisfy the debt or to increase the allowance for loan losses, it couldmaterially reduce our profitability and adversely affect our financialcondition.

 

Thisprolonged weakening in the residential real estate market in 2008 and 2009 hasresulted in an increase in our nonperforming loans, and there is a risk thatthis trend will continue, which could result in a net loss of earnings and anincrease in our provision for loan losses and loan charge-offs, all of whichcould have a material adverse effect on our

 

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financialcondition and results of operations.  This weakened market has resulted and maycontinue to result in an increase in the number of borrowers who default ontheir loans and a reduction in the value of the collateral securing their loanscould have an adverse effect on our profitability and assetquality.  If we are required to liquidate the collateral securing aloan to satisfy the debt during a period of reduced real estate values, ourearnings and capital could be adversely affected.  Acts of nature,including hurricanes, tornados, earthquakes, fires and floods, which may causeuninsured damage and other loss of value to real estate that secures theseloans, may also negatively impact our financial condition.

 

Althoughwe believe that the combination of specific reserves in the allowance for loanlosses and established impairments of these loans will be adequate to accountfor the current risk associated with the loans secured by real estate in ourportfolio as of December 31, 2009, there can be no assurances in thisregard.

 

***We are unable to continue making interestpayments on our subordinated debentures.***

 

Due to diminishing cashavailable at the holding company level, if we are unable to raise additionalcapital, we will have to discontinue paying interest on the subordinateddebentures after the March 2010 payments due to lack of funds.  As a result of this development and ourfinancial condition, we expect that the debt markets will be unavailable to usas a potential source of capital at least until such time as we are able tomeet these obligations.

 

***We have only recently adopted our newbusiness plan and may not be able to implement it effectively.***

 

Ourfuture performance will depend on our ability to implement our new businessplan successfully.  This implementation will involve a variety ofcomplex tasks, including reducing our level of non-performing assets bycontinuing to aggressively work problem credits, exploring a bulk sale of loansor OREO, and possibly requiring significant write-downs to facilitatedisposition of nonperforming assets.  We  also plan to continue to increase coredeposits, reduce our dependency on wholesale funding (brokered CD’s and FHLBborrowings) and increase low-cost deposit accounts (DDA’s, NOW,etc.).  These actions should help expand our net interest margin andfuture earnings without requiring additional capital.   Anyfailure or delay in executing these initiatives, whether due to regulatorydelays or for other reasons, some of which may be beyond our control, is likelyto impede, and could ultimately preclude, our successful implementation of ourbusiness plan and could materially adversely affect our business, financialcondition, and results of operations.

 

***Our historical results of operations maynot be indicative of our future operating results.***

 

Wehave historically grown at a rapid rate through 2008, but in the currenteconomic climate, we do not plan to grow our business as we have in the pastand we have decided to contract our business in the near term by selling someof our assets.  Consequently, our historical results of operationswill not necessarily be indicative of our future operating results. Variousfactors, such as economic conditions, regulatory and legislativeconsiderations, and competition, may also impede our ability to maintain our marketpresence as we shrink our balance sheet. As we implement our plans to deleverage our balance sheet by reducingour assets, our business, financial condition, and results of operations may beadversely affected because a high percentage of our operating costs are fixedexpenses.  We may not experience adecrease in these costs in proportion to or as quickly as the decrease in ourassets.

 

***Recentnegative developments in the financial industry and the domestic andinternational credit markets may adversely affect our operations and results.***

 

Negative developmentsover the last two and a half years in the global credit and securitizationmarkets have resulted in uncertainty in the financial markets in general withthe expectation of the general economic downturn continuing into 2010.  As a result of this “credit crunch,”commercial as well as consumer loan portfolio performances have deteriorated atmany institutions and the competition for deposits and quality loans hasincreased significantly.  In addition,the values of real estate collateral supporting many commercial loans and homemortgages have declined and may continue to decline.  Global securities markets, and bank holdingcompany stock prices in particular, have been negatively affected, as has theability of banks and bank holding companies to raise capital or borrow in thedebt markets.  As a result, significantnew federal laws and regulations relating to financial institutions, including,without limitation, the EESA and the Treasury Department’s CPP, have beenadopted.  Furthermore, the potentialexists for additional federal or state laws and regulations regarding, amongother matters, lending and funding practices and liquidity standards, and bankregulatory agencies are expected to be active in responding to concerns andtrends identified in examinations, including the expected issuance of manyformal enforcement

 

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orders.  Negative developments in the financialindustry and the domestic and international credit markets, and the impact ofnew legislation in response to those developments, may negatively impact ouroperations by restricting our business operations, including our ability tooriginate or sell loans, and adversely impact our financial performance.  We can provide no assurance regarding themanner in which any new laws and regulations will affect us.

 

***There can be noassurance that recently enacted legislation will help stabilize the U.S.financial system.***

 

There can be no assurancethat the government actions that have been taken over the last 18 months,including EESA and the Recovery Act, will achieve their purpose.  The failure of the financial markets tostabilize, or a continuation or worsening of the current financial marketconditions, could have a material adverse affect on our business, our financialcondition, the financial condition of our customers, our common stock tradingprice, as well as our ability to access credit.  It could also resultin declines in our investment portfolio which could be “other-than-temporaryimpairments.”

 

***Continuation of theeconomic downturn could reduce our customer base, our level of deposits, anddemand for financial products such as loans.***

 

Our success significantlydepends upon the growth in population, income levels, deposits, and housingstarts in our markets.  The currenteconomic downturn has negatively affected the markets in which we operate and,in turn, the quality of our loan portfolio. If the communities in which we operate do not grow or if prevailingeconomic conditions locally or nationally remain unfavorable, our business maynot succeed.  A continuation of theeconomic downturn or prolonged recession would likely result in the continueddeterioration of the quality of our loan portfolio and reduce our level ofdeposits, which in turn would hurt our business.  Interest received on loans representedapproximately 88% of our interest income for the year ended December 31,2009.  If the economic downturn continuesor a prolonged economic recession occurs in the economy as a whole, borrowerswill be less likely to repay their loans as scheduled.  Moreover, in many cases the value of realestate or other collateral that secures our loans has been adversely affectedby the economic conditions and could continue to be negatively affected.  Unlike many larger institutions, we are notable to spread the risks of unfavorable local economic conditions across alarge number of diversified economies.  Acontinued economic downturn could, therefore, result in losses that materiallyand adversely affect our business.

 

***Oursmall- to medium-sized business target markets may have fewer financialresources to weather the current downturn in the economy.***

 

We target the banking andfinancial services needs of small- and medium-sized businesses.  These businesses generally have fewerfinancial resources in terms of capital borrowing capacity than largerentities.  If general economic conditionscontinue to negatively impact these businesses in the markets in which weoperate, our business, financial condition, and results of operation maycontinue to be adversely affected.

 

***Weare exposed to changes in the regulation of financial services companies.***

 

Proposals for furtherregulation of the financial services industry are continually being introducedin the Congress of the United States of America and the General Assembly of theState of South Carolina.  The agenciesregulating the financial services industry also periodically adopt changes totheir regulations.  On September 7,2008, the Treasury Department announced that Fannie Mae (along with FreddieMac) had been placed into conservatorship under the control of the newlycreated Federal Housing Finance Agency. On October 3, 2008, EESA was signed into law, on October 14,2008 the Treasury Department announced the CPP under EESA, and on February 17,2009 the Recovery Act was signed into law. It is possible that additional legislative proposals may be adopted orregulatory changes may be made that would have an adverse effect on ourbusiness.  See “*Risk Factors— We are subject to extensive regulation that could restrict our activities”*below.

 

***The FDIC Deposit Insurance assessments that we are requiredto pay may materially increase in the future, which would have an adverseeffect on our earnings and our ability to pay our liabilities as they come due.***

 

As a member institution of the FDIC, we arerequired to pay semi-annual deposit insurance premium assessments to theFDIC.  During the year ended December 31,2009, we paid $1.1 million in deposit insurance assessments.  Due to the recent failure of severalunaffiliated FDIC insurance depository institutions, and the FDIC’s new TLGP,the deposit insurance

 

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premium assessments paid by all banks will likelyincrease.  In addition, new FDICrequirements shift a greater share of any increase in such assessments ontoinstitutions with higher risk profiles, including banks with heavy reliance onbrokered deposits, such as our Bank. Continued increases in this expense would have a material adverse effecton our financial condition.

 

***Changesin prevailing interest rates may reduce our profitability.***

 

Our results of operationsdepend in large part upon the level of our net interest income, which is thedifference between interest income from interest-earning assets, such as loansand mortgage-backed securities, and interest expense on interest-bearingliabilities, such as deposits and other borrowings.  Depending on the terms and maturities of ourassets and liabilities, a significant change in interest rates could have amaterial adverse effect on our profitability. Many factors cause changes in interest rates, including governmentalmonetary policies and domestic and international economic and politicalconditions.  While we intend to managethe effects of changes in interest rates by adjusting the terms, maturities,and pricing of our assets and liabilities, our efforts may not be effective andour financial condition and results of operations could suffer.

 

***Weare subject to extensive regulation that could limit or restrict ouractivities.***

 

We operate in a highlyregulated industry and are subject to examination, supervision, andcomprehensive regulation by various regulatory agencies.  Our compliance with these regulations iscostly and restricts certain of our activities, including payment of dividends,mergers and acquisitions, investments, loans and interest rates charged,interest rates paid on deposits, and locations of offices.  We are also subject to capitalizationguidelines established by our regulators, which require us to maintain adequatecapital to support our growth.

 

The laws and regulationsapplicable to the banking industry could change at any time, and we cannotpredict the effects of these changes on our business and profitability.  Because government regulation greatly affectsthe business and financial results of all commercial banks and bank holdingcompanies, our cost of compliance could adversely affect our ability to operateprofitably.

 

The Sarbanes-Oxley Act of2002, and the related rules and regulations promulgated by the Securitiesand Exchange Commission that are now applicable to us, have increased thescope, complexity, and cost of corporate governance, reporting, and disclosurepractices.

 

***Weface strong competition for customers, which could prevent us from obtainingcustomers and the interest rate that we can pay to attract customers is subjectto the national deposit rate cap restrictions****.*

 

The banking business ishighly competitive, and we experience competition in our market from many otherfinancial institutions.  We compete withcommercial banks, credit unions, savings and loan associations, mortgagebanking firms, consumer finance companies, securities brokerage firms,insurance companies, money market funds, and other mutual funds, as well asother super-regional, national, and international financial institutions thatoperate offices in our primary market areas and elsewhere.  We compete with these institutions both inattracting deposits and in making loans. In addition, we have to attract our client base from other existingfinancial institutions and from new residents. Many of our competitors are well-established, larger financialinstitutions.  These institutions offersome services, such as extensive and established branch networks, that we donot currently provide.  There is a riskthat we will not be able to compete successfully with other financialinstitutions in our market, and that we may have to pay higher interest ratesto attract deposits, resulting in reduced profitability.  In addition, competitors that are notdepository institutions are generally not subject to the extensive regulationsthat apply to us. Also, the Bank is under the national deposit rate caprestrictions imposed on banks that are considered less than well capitalized,which means that we may be prohibited from paying the same interest rates ondeposits as some of our competitors that are well capitalized.

 

***The costs of being an SEC registered company areproportionately higher for smaller companies such as CommunitySouth FinancialCorporation because of the requirements imposed by the Sarbanes-Oxley Act.***

 

The Sarbanes-Oxley Act of2002 and the related rules and regulations promulgated by the SEC haveincreased the scope, complexity, and cost of corporate governance, reporting,and disclosure practices. These regulations are applicable to our Company. Wehave experienced, and expect to continue to experience, increasing compliancecosts, including costs related to internal controls, as a result of theSarbanes-Oxley Act. These necessary costs are proportionately higher for a

 

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company of our size andwill affect our profitability more than that of some of our larger competitors.

 

**Item 2.  Properties.**

 

Our main office islocated at 6602 Calhoun Memorial Highway, Easley, South Carolina 29640. Oursite is approximately 1.2 acres in size, and the building is approximately10,000 square feet. We own our main office and lease all others. We have fivefull service branch sites in addition to the main office. The branch sites arein the towns of Anderson, Greenville, Greer, Mauldin and Spartanburg, South Carolina.Our full service branches service the entire upstate of South Carolina, butprimarily the counties of Anderson, Greenville, Pickens and Spartanburg.

 

We have a ten year leasethat began in November 2005 for our Spartanburg office.   The office is located at 531 East MainStreet, Spartanburg, S.C. 29302.

 

We have a ten year leasethat began in November 2005 for our Mauldin office. The office is locatedat 787 East Butler Road, Mauldin, S.C. 29662.

 

We have a ten year leasethat began in June 2006 for our Anderson office.  The office is located at 1510 North MainStreet, Anderson, S.C. 29621.

 

We have a ten year leasethat began in November 2006 for our Greer office.  The office is located at 530 West WadeHampton Blvd., Greer, S.C. 29650.

 

We have a three yearlease that began in May 2007 for our Loan Operations center.  The operations center is located at 6606Calhoun Memorial Highway, Easley, S.C. 29640.

 

We have a ten year leasethat began in October 2007 for our Greenville office.  The office is located at 2415 Laurens Road,Greenville, S.C. 29607.

 

We believe that all ofour properties are adequately covered by insurance.

 

**Item 3. Legal Proceedings.**

 

In theordinary course of operations, we may be a party to various legal proceedingsfrom time to time.  We do not believethat there is any pending or threatened proceeding against us, which, ifdetermined adversely, would have a material effect on our business, results ofoperations, or financial condition.

 

**Item 4. Submission of Matters to a Vote of Security Holders.**

 

At a special meeting ofthe shareholders on November 18, 2009, our shareholders approved theproposal to amend our articles of incorporation to increase the number ofauthorized shares of common stock from 10 million shares to 35 millionshares.  The shareholders voted on theproposal as indicated below:

 

| ** **     | ** ** | **Votes** | ** ** | **% of Outstanding Common Shares** | ** ** |
|----------------|------------|-----------|------------|------------------------------------|------------|
| Votes  For     |       | 3,419,747 |       | 72.78                              | %          |
| Votes  Against |       | 327,927   |       | 6.98                               | %          |
| Abstain        |       | —    |       | —                             |       |

 

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**Part II**

 

**Item 5. Market for Common Equity and Related Stockholder Matters****.**

 

On January 16, 2006,the Company effected a 5-for-4 stock split in the form of a stock dividend forshareholders of record as of December 15, 2005. 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 per share data has been adjusted for allperiods prior to the splits.

 

Since March 15,2006, our common stock has been quoted on the OTC Bulletin Board under thesymbol “CBSO.” Quotations on the OTC Bulletin Board reflect inter-dealerprices, without retail mark-up, mark-down, or commissions, and may notrepresent actual transactions. Transactions of our common stock did not begin to occur on the OTCBulletin Board until March 16, 2006.

 

The following is asummary of the high and low bid prices for our common stock reported by the OTCBulletin Board for the periods indicated (the bid prices have been adjusted forall stock splits):

 
| **2009**        | ** ** | **High** | ** ** | **Low** | ** ** |
|-----------------|------------|----------|------------|---------|------------|
| First  Quarter  |       | $        | 3.20       |    | $          | 1.10 |   |
| Second  Quarter |       | 3.00     |       | 1.30    |       |
| Third  Quarter  |       | 2.00     |       | 1.50    |       |
| Fourth  Quarter |       | 1.80     |       | 0.40    |       |
|                 |            |          |            |         |            |  |  |

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

 

Our articles ofincorporation authorize us to issue up to 35,000,000 shares of common stock, ofwhich 4,698,697 shares were outstanding as of December 31, 2009. We hadapproximately 897 shareholders of record as of December 31, 2009.

 

We have not declared orpaid any cash dividends on our common stock since our inception.  For the foreseeable future we do not intendto declare cash dividends.  We intend toretain earnings to grow our business and strengthen our capital base.  Our ability to pay dividends depends on theability of the Bank to pay dividends to us. As a South Carolina state chartered bank, the Bank may only paydividends out of its net profits, after deducting expenses, including losses andbad debts.  In addition, the Bank isprohibited from declaring a dividend on its shares of common stock unless itssurplus equals or exceeds its stated capital. At December 31, 2009, theBank had a deficit of $19,057,000.  Inaddition, pursuant to the terms of the Consent Order with the FDIC and theSouth Carolina Board of Financial Institutions, the Bank may not pay dividendswithout prior written consent of each supervisory authority.

 

The following table sets forth the equitycompensation plan information at December 31, 2009.  All option and warrant information has beenadjusted to reflect all prior stock splits and dividends.

 

25

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**Equity Compensation Plan Information**

** **
| **Plan  Category**                                          | ** ** | **(A)  Number of securities  to be issued  upon exercise of   outstanding options,   warrants and rights** | ** ** | **(B)  Weighted-average  exercise price of   outstanding options,   warrants and rights** | ** ** | **(C)  Number of securities  remaining available for  future issuance under  equity compensation plans  (excluding securities  reflected in column(a))** | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|                                                        |       |                                                                                                       |       |                                                                                      |       |                                                                                                                                                     |       |
| Equity compensation plans approved by security  holders     |       | 756,033                                                                                                    |       | $                                                                                         | 6.99       |                                                                                                                                                     | 230,693    |   |
|                                                        |       |                                                                                                       |       |                                                                                      |       |                                                                                                                                                     |       |
| Equity compensation plans not approved by security  holders |       | 171,404                                                                                                    |       | $                                                                                         | 6.40       |                                                                                                                                                     | 0          |   |
|                                                        |       |                                                                                                       |       |                                                                                      |       |                                                                                                                                                     |       |
| Total                                                       |       | 927,437                                                                                                    |       | $                                                                                         | 6.88       |                                                                                                                                                     | 230,693    |   |

 

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(1)          The shares available for issuance is currently set at 21% of ouroutstanding shares. On January 16, 2006 the Company adopted a resolutionthat terminated the “evergreen” provision of the Company’s 2005 Stock IncentivePlan. As a result, the number of shares of common stock issuable under the planshall not be further increased in connection with any future share issuances bythe Company.

 

(2)          Each of our organizers received, for no additional consideration, awarrant to purchase one share of common stock for $10.00 per share for everytwo shares they purchased in the offering, up to a maximum of 10,000 shares perorganizer.  The warrants are representedby separate warrant agreements.  Thewarrants vested on May 18, 2005, 120 days after the date of the opening ofthe Bank, and they are exercisable in whole or in part during the 10 yearperiod following that date.  If the SouthCarolina Board of Financial Institutions or the FDIC issues a capital directiveor other order requiring the Bank to obtain additional capital, the warrantswill be forfeited, if not immediately exercised.

 

26

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**Item6.  Selected Financial Data.**

 

**Selected Financial Data**

 

The following selected financial data for thefive years ended December 31, 2009 was derived from the consolidatedfinancial statements and other data of the Company and its subsidiary, theBank.  The selected financial data shouldbe read in conjunction with the consolidated financial statements of theCompany, including the accompanying notes, included elsewhere herein.

 

On January 16, 2006 the Company effecteda 5-for-4 stock split in the form of a stock dividend for shareholders ofrecord as of December 15, 2005.  On January 16,2007, the Company effected a 5-for-4 stock split in the form of a stockdividend for shareholders of record as of December 15, 2006.  All share and per share data has beenadjusted for all periods prior to the splits.

 
| **(Dollars in thousands except per share data)**     | ** ** | **2009**   | ** **  | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|------------------------------------------------------|------------|------------|-------------|------------|------------|------------|------------|------------|------------|------------|------------|
| **Income  Statement Data:**                          | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest  income — loans                        |       | $          | 16,959      |       | $          | 20,163     |       | $          | 21,403     |       | $          | 13,644 |   | $ | 4,544 |   |
| Interest  income — investments                  |       | 2,269      |        | 2,547      |       | 1,813      |       | 1,041      |       | 441        |       |
| Total  interest income                               |       | 19,228     |        | 22,710     |       | 23,216     |       | 14,685     |       | 4,985      |       |
| Interest  expense — deposits                    |       | (8,599     | )           | (12,580    | )          | (13,069    | )          | (7,281     | )          | (1,863     | )          |
| Net  interest income                                 |       | 10,629     |        | 10,130     |       | 10,147     |       | 7,404      |       | 3,122      |       |
| Provision  for loan losses                           |       | (16,990    | )           | (7,168     | )          | (1,188     | )          | (1,532     | )          | (1,558     | )          |
| Net  interest income after provision for loan losses |       | (6,361     | )           | 2,962      |       | 8,959      |       | 5,872      |       | 1,564      |       |
| Non-interest  income                                 |       | 2,723      |        | 1,392      |       | 1,575      |       | 842        |       | 321        |       |
| Non-interest  expense                                |       | (13,670    | )           | (9,510     | )          | (8,184     | )          | (5,197     | )          | (2,680     | )          |
| Income  (loss) before income taxes                   |       | (17,308    | )           | (5,156     | )          | 2,350      |       | 1,517      |       | (795       | )          |
| Income  tax (expense) benefit                        |       | (988       | )           | 1,806      |       | (782       | )          | (360       | )          | 179        |       |
| Net  income (loss)                                   | ** ** | **$**      | **(18,296** | **)**      | **$**      | **(3,350** | **)**      | **$**      | **1,568**  | ** ** | **$**      | **1,157** | ** ** | **$** | **(616** | **)** |
| ** **                                           | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Balance  Sheet Data:**                             | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total  assets                                        |       | $          | 421,534     |       | $          | 387,816    |       | $          | 377,867    |       | $          | 248,273 |   | $ | 136,826 |   |
| Earning  assets                                      |       | 411,384    |        | 374,939    |       | 361,890    |       | 235,959    |       | 133,285    |       |
| Investment  securities, available for sale (1)       |       | 103,638    |        | 47,602     |       | 24,844     |       | 100        |       | —     |       |
| Other  investments (2)                               |       | 1,599      |        | 1,805      |       | 447        |       | 271        |       | 83         |       |
| Loans  (3)                                           |       | 275,104    |        | 320,907    |       | 302,934    |       | 217,664    |       | 115,704    |       |
| Allowance  for loan losses                           |       | (12,963    | )           | (8,088     | )          | (4,214     | )          | (3,091     | )          | (1,558     | )          |
| Deposits                                             |       | 376,563    |        | 296,643    |       | 327,664    |       | 217,031    |       | 106,972    |       |
| Shareholders’  equity                           |       | 8,671      |        | 28,528     |       | 31,471     |       | 29,695     |       | 28,286     |       |
| ** **                                           | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Per-Share  Data:**                                 | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net  income (loss) — basic                      |       | $          | (3.89       | )          | $          | (0.71      | )          | $          | 0.33       |       | $          | 0.25 |   | $ | (0.13 | ) |
| Net  income (loss) — diluted                    |       | (3.89      | )           | (0.71      | )          | 0.31       |       | 0.22       |       | (0.13      | )          |
| Book  value                                          |       | 1.85       |        | 6.07       |       | 6.70       |       | 6.32       |       | 6.04       |       |
|                                                 |       |       |        |       |       |       |       |       |       |       |       |
| **Return  on Equity and Assets**:                    |       |       |        |       |       |       |       |       |       |       |       |
| Return  on average assets                            |       | (4.55      | )%          | (0.87      | )%         | 0.50       | %          | 0.59       | %          | (0.77      | )%         |
| Return  on average equity                            |       | (70.79     | )%          | (10.91     | )%         | 5.12       | %          | 4.08       | %          | (2.24      | )%         |
| Average  equity to average assets ratio              |       | 6.43       | %           | 7.99       | %          | 9.76       | %          | 14.53      | %          | 34.55      | %          |

 

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(1)   Marketable securities are stated at fairvalue.

(2)   Non-marketable securities are statedat cost.

(3)   Loans are stated at gross amountsbefore allowance for loan losses.

 

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**Item7.  Management’s Discussion and Analysisof Financial Condition and Results of Operation.**

 

**COMMUNITYSOUTH FINANCIALCORPORATION**

**MANAGEMENT’S DISCUSSION AND ANALYSIS**

 

**Basis of Presentation**

 

The following 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 on Form 10-K.  The financial information provided below hasbeen rounded in order to simplify its presentation.  However, the ratios and percentages providedbelow are calculated using the detailed financial information contained in theConsolidated Financial Statements, the Notes thereto and the other financialdata included elsewhere in this Annual Report on Form 10-K.

 

# **Overview**

 

The followingdiscussion describes our results of operations for the years ended December 31,2009 and 2008 and also analyzes our financial condition as of December 31,2009 and 2008.  We received approvalsfrom the FDIC, the Federal Reserve Board (“FRB”) and the South Carolina Boardof Financial Institutions during January 2005, and commenced business on January 18,2005.

 

The Company is a bank holding companyheadquartered in Easley, South Carolina. Our subsidiary, the Bank, opened for business on January 18,2005.  All Seasons Properties, LLC, asubsidiary of the Bank, was formed in 2009 for the purpose of holding andmarketing repossessed assets.  Inaddition to the main office in Easley, the Bank has five branch locations inthe upstate region of South Carolina.  Weopened our Mauldin branch in the fourth quarter of 2005, our Spartanburg branchin the first quarter of 2006, our Anderson branch in the third quarter of 2006,our Greer branch in the fourth quarter of 2006 and our Greenville branch in thethird quarter of 2007.  The Bank providesbanking services to domestic markets, principally in the Upstate of SouthCarolina.  The deposits of the Bank areinsured by the FDIC.

 

Likemost community banks, we derive most of our income from interest we receive onour loans and investments.  Our primarysource of funds for making these loans and investments is our deposits, onwhich we pay interest.  Consequently, oneof the 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 thespread between the yield we earn on these interest-earning assets and the ratewe pay on our interest-bearing liabilities.

 

**CurrentEconomic Environment**

 

Markets in the UnitedStates, including our market areas, have experienced extreme volatility anddisruption for more than 12 months. According to the National Bureau of Economic Research, the United Statesentered into an economic recession in December 2007.  Dramatic slowdowns in the residential housingindustry with falling home prices, increasing foreclosures, and risingunemployment levels have created strains on the loan portfolios of manyfinancial institutions.  Median homesales continued to decline during 2009 nationally and in our primary marketarea, South Carolina.  As a result, thelevel of foreclosures by homebuilders and homeowners continued toincrease.  The national averageunemployment rate and the unemployment rate in South Carolina continued to risethroughout 2009.  As of December 31,2009, the national average unemployment rate was 10.0% compared to 8.4% at December 31,2008.  As of December 31, 2009, theunemployment rate in South Carolina was 12.6% compared to 8.6% at December 31,2008.

 

As a result of thecurrent economic recession, many borrowers are unable to repay their loans, andthe collateral securing these loans has, in some cases, declined below the loanbalance with the drop in real estate values, making it difficult for financialinstitutions to fully recover the principal and interest owed.  In addition, the rapidly deterioratingeconomic conditions in our country have evolved into a crisis of confidence inthe safety and soundness of larger financial institutions, brokerage firms, andinsurance companies, resulting in extreme liquidity pressure throughout theUnited States financial system for all financial companies including communityfinancial institutions such as ours. This pressure has caused many banks to tighten lending standards, whichhas constrained the ability of businesses and consumers to obtain credit.  Anxiety over liquidity and credit risk hasgrown in recent months and banks have curbed lending to each other, furtherlimiting liquidity sources available to financial institutions.

 

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**TheEffect of the Current Economic Environment on our Bank**

 

Like manyfinancial institutions across the United States and in South Carolina, ouroperations have been adversely affected by the current economic crisis.  Beginning in 2008 and continuing through2009, we recognized that construction, acquisition, and development real estateprojects were slowing, guarantors were becoming financially stressed, andincreasing credit losses were surfacing. During 2009, delinquencies over 90 days increased resulting in anincrease in non-accrual loans indicating significant credit qualitydeterioration and probable losses.  Inparticular, loans secured by real estate, including acquisition, construction,and development projects, demonstrated stress given reduced cash flows ofindividual borrowers, limited bank financing and credit availability, and slowproperty sales.  This deteriorationmanifested itself in our borrowers in the following ways: (i) the cashflows from underlying properties supporting the loans decreased (e.g., slowerproperty sales for development type projects or lower occupancy rates or rentalrates for operating properties); (ii) cash flows from the borrowersthemselves and guarantors were under pressure given illiquid personal balancesheets and drainage by investing additional personal capital in the projects;and (iii) fair values of real estate related assets declined, resulting inlower cash proceeds from sales or fair values declining to the point thatborrowers were no longer willing to sell the assets at such deep discounts.

 

As of December 31,2009, approximately 90.3% of our loans had real estate as a primary orsecondary component of collateral. Included in our loans secured by real estate, we have approximately$37.8million of A&D loans as of December 31, 2009, most of which are onproperties located in the Upstate of South Carolina and Western NorthCarolina.  A&D loans are typically comprised of loans to borrowers forreal estate to be developed (into properties such as sub-divisions or spechouses).   Normally, these loans arerepaid with the proceeds from the sale of the developed property.  Thegreater degree of strain on these types of loans and the significance to ouroverall loan portfolio has caused us to apply a greater degree of scrutiny inanalyzing the ultimate collectability of amounts due.  The majority ofthese borrowers are having financial difficulties.  Our analysis has resulted in a significantprovision expense in order to meet the estimated allowance for loan lossreserve requirement.

 

Included in our loanssecured by real estate, we have approximately $40.6 million of acreage andfinished or buildable lot loans as of December 31, 2009.  These loans are comprised of loans toborrowers for raw land and lots in subdivisions that have utilities and areready to be built on individually but not as part of an entire developmentproject.  These loans are generallyrepaid with the proceeds from the sale of the property.  As with our A&D loans, many of theseborrowers are also experiencing financial difficulties and the greater degreeof strain on these types of loans and the significance to our overall loanportfolio has caused us to apply a greater degree of scrutiny in analyzing theultimate collectability of amounts due. Our analysis has resulted in a significant provision expense in order tomeet the estimated allowance for loan loss reserve requirement.

 

The result of the abovewas a significant increase in the level of our non-performing assets during2009.  As of December 31, 2009, ournon-performing assets equaled $42.4 million, or 10.05% of assets, as comparedto $10.3 million, or 2.67% of assets, as of December 31, 2008.  The increase in our non-performing assets ledto the increase in our provision for loan losses and other non-interestexpenses.  For the year ended December 31,2009, we recorded a provision for loan losses of $17.0 million and net loancharge-offs of $12.1 million, or 3.97% of average loans, as compared to a $7.2million provision for loan losses and net loan charge-offs of $3.3 million, or1.04% of average loans, for the year ended December 31, 2008.  In addition, our net interest margindecreased to 2.73% for the year ended December 31, 2009 from 2.74% for theyear ended December 31, 2008.  In total,the above reduced our 2009 earnings by more than $9.8 million compared to2008.  As a result, as of December 31,2009, we are deemed to be “undercapitalized.”

 

The adverse economicenvironment has also placed greater pressure on our deposits, as we have beentaking steps to decrease our reliance on brokered deposits, while at the sametime the competition for local deposits among banks in our market has beenincreasing.  We generally obtainout-of-market time deposits of $100,000 or more through brokers with whom wemaintain ongoing relationships.  As of December 31,2009, we had brokered deposits of $202.8 million, representing 53.85% of ourtotal deposits, of which $79.7 million are scheduled to mature in the thirdquarter of 2010 and $94.9 million are scheduled to mature in the fourth quarterof 2010.  As a result of the limitations on brokered deposits imposedby the Consent Order and our “undercapitalized” designation (as describedbelow), we must find other sources of liquidity to replace these deposits asthey mature.  Secondary sources of liquidity may include proceedsfrom FHLB advances and federal funds lines of credit from correspondentbanks.  However, the FHLB has informed us that due to our financialcondition we are not

 

29

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currently permitted toreceive any more advances.  As a result,we must limit our growth, raise additional capital, or sell assets, which couldmaterially and adversely affect our financial condition and results of operations.  Additionally, deposit levels may be affectedby a number of factors, including rates paid by competitors, general interestrate levels, regulatory capital requirements, returns available to customers onalternative investments and general economic conditions.  Because the Bank is not well capitalized, itis subject to the 75-basis-point interest rate cap that it can pay on deposits,as more fully described below.  As aresult of this interest rate cap, we may not be able to attract sufficientdeposits to meet our liquidity needs.  Ifthis were to occur, the Bank may be placed into a federal conservatorship orreceivership by the FDIC, with the FDIC appointed as conservator or receiver.

 

***Memorandumof Understanding***

 

As a result of the issuesstemming from the economic downturn, on June 29, 2009 the Bank enteredinto the MOU with the Commissioner of Banking of the South Carolina Board ofFinancial Institutions and the Regional Director of the FDIC’s Atlanta RegionalOffice.  The MOU requires the Bank to, amongother things, (1) submit a capital plan to the supervisory authorities forreturning to a “well-capitalized” designation; (2) develop specific plansand proposals for the reduction and improvement of assets which are subject toadverse classification and past due loans; (3) implement a plan todecrease the concentration of commercial real estate loans; (4) developand implement an adequate loan review program; and (5) review overallliquidity objectives and develop plans and procedures aimed at improvingliquidity and reducing reliance on volatile liabilities to fund longer-termassets.  In addition, the Bank may notpay dividends without the prior written consent of each supervisory authority.

 

Since entering into theMOU, the Bank has been actively pursuing the corrective actions required by theMOU in an effort to ensure that the requirements of the MOU are met in a timelymanner.  For example:

 

·                  As of December 31, 2009, we aredeemed to be “undercapitalized.”  We havedeveloped a capital plan for returning to a “well-capitalized” designation, andwe submitted this plan to the FDIC and the South Carolina Board of FinancialInstitutions in July 2009.  Ourcapital plan outlines how we intend to return our Bank’s risk-based capitalratio level over 10% by (i) reducing our overall amount of assets and, inparticular, our amount of risk-based assets and (ii) raising additionalcapital.  To reduce our amount of assets,we have sold assets such as our bank-owned life insurance and some of ouravailable for sale securities.  Inaddition, we are actively seeking buyers for part of our loan portfolio.  As a result of these steps, during 2009 wedecreased our amount of risk-based assets by $70.6 million.  We are also exploring additional financingalternatives to strengthen the capital levels of the Bank.

 

·                  We have developed and implemented a planto reduce our amount of classified loans by establishing an IMPAC committee(Improving Problem Asset Committee) to focus on the development of work-outplans for our other real estate owned (OREO) and classified loans and toexplore approaches to provide additional capital to support our classifiedloans or to reduce the level of such loans, such as through the sale of loansto third parties. As a result, we have created a more risk-based loan reviewprogram, which we believe has enhanced the underwriting and monitoring of ourloan portfolio.

 

·                  We have implemented a plan to decreasethe concentration of our commercial real estate loans.  Since January 2009, we have effectivelyceased making any new commercial real estate loans and we are decreasing theexisting level of these loans through the normal sale of real estate byborrowers and by encouraging borrowers who are not full relationship clients ofthe Bank to seek other financing when their loans mature.  We are also actively seeking secondary marketpermanent financing for recently completed residential constructionprojects.  As a result of these efforts,in 2009 our amount of commercial real estate loansdecreased from $151.6 million at December 31,2008 to $126.8 million at December 31, 2009.

 

·                  We have developed and implemented animproved loan review program, which includes the hiring of a new internal loanreview officer and the engagement of a new external loan review firm forongoing review and the establishment of a new system for tracking borrowerfinancial statements and the structure of our watch reports.  The new external review firm is active andsince its engagement has been on site three times to evaluate the effectivenessof the program.  The external review firmreviews both specific loans and the overall loan portfolio.

 

·                  On September 10, 2009, we submittedto the FDIC and the South Carolina State Board of Financial Institutions arevised Funds Management Policy to reflect our plan to continue to improveliquidity levels and reduce our reliance on brokered deposits and othernon-core funding sources over the next 18 months.  We grew rapidly in our initial 

 

30

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years ofoperations, which we funded with a combination of local deposits and wholesalefunding, including brokered deposits.  Asof December 31, 2009, we are deemed to be “undercapitalized” and, as aresult, can no longer accept, renew or roll over brokered deposits without theprior consent of the FDIC.  Thus, we areactively focused on eliminating brokered deposits on our balance sheet.  During 2009, we improved the Bank’s liquidityposition by raising approximately $68 million in new local deposits.

 

Inaddition, in mid-February 2010 the Bank received a supervisory letter from theFDIC dated February 11, 2010, which provided for additional restrictionsand mandatory actions to be taken by the Bank. These restrictions and actions were all substantially addressed by thesubsequent Consent Order discussed below. However, in order to comply with supervisory letter, the Bank mustprepare and submit to the FDIC  a capitalrestoration plan no later than March 26, 2010, which submission date is soonerthan a similar requirement under the Consent Order.

 

***ConsentOrder***

 

Following the FDIC’ssafety and soundness examination of the Bank in the fourth quarter of 2009, theBank entered into the Consent Order with the FDIC and the South Carolina Boardof Financial Institutions on February 23, 2010.  The Consent Order, which supersedes the MOU,conveys specific actions needed to address certain findings from the FDIC’sReport of Examination and to address the Bank’s current financial condition,primarily related to policy and planning issues, management oversight, loanconcentrations and classifications, non-performing loans, liquidity/fundsmanagement, and capital planning.

 

Under the terms of theConsent Order, the Bank’s various sources of liquidity will be restricted.  Based on information included in the FDIC’sreport, the Bank’s credit risk rating at the FHLB has been negatively impacted,resulting in reduced borrowing capacity. This action also restricts the Bank’s ability to accept, renew, or rollover brokered deposits.  In addition, theBank’s ability to borrow funds from the Federal Reserve Bank Discount Window asa source of short-term liquidity is not guaranteed. The Federal Reserve DiscountWindow borrowing capacity has been curtailed to only overnight terms,contingent upon credit approval for each transaction.

 

In addition, the ConsentOrder requires the Bank to, among other things,

 

·                  establish, within 30 days from the effective date ofthe Consent Order, a plan to monitor compliance with the Consent Order, whichshall be monitored by the Bank’s Board of Directors;

 

·                  ensure the Bank has qualified management in place to carryout the policies of the Bank’s Board of Directors and operate the Bank in asafe and sound manner;

 

·                  achieve and maintain, within 120 days from theeffective date of the Consent Order, Total Risk Based capital at least equal to10% of risk-weighted assets and Tier 1 capital at least equal to 8% of totalassets;

 

·                  determine, within 30 days of the last day of thecalendar quarter, its capital ratios. If any capital measure falls below theestablished minimum, within 30 days provide a written plan describing the meansand timing by which the Bank shall increase such ratios to or in excess of theestablished minimums;

 

·                  develop, within 45 days from the effective date of theConsent Order, a written analysis and assessment of the Bank’s management andstaffing needs;

 

·                  establish, within 60 days from the effective date ofthe Consent Order, a comprehensive policy for determining the adequacy of theBank’s allowance for loan and lease losses, which must provide for a review ofthe Bank’s allowance for loan and lease losses at least once each calendarquarter;

 

·                  enhance, within 60 days from the effective date of theConsent Order, our written plan for the reduction of classified assets, whichshall include, among other things, a reduction of the Bank’s risk position ineach asset in excess of $250,000 that is classified as “Substandard” or “Doubtful”;

 

·                  not extend any additional credit to any borrower whohas a loan or other extension of credit from the Bank that has been charged offor classified, in whole or in part, “loss” or “doubtful” and isuncollected.  In addition, the Bank maynot extend any additional credit to any borrower who has a loan or otherextension of credit from the Bank that has been classified, in whole or inpart, “substandard” and is uncollected, unless the Bank’s Board of Directorsdetermines that failure to extend further credit to a particular borrower wouldbe detrimental to the best interests of the Bank;

 

·                  perform, within 45 days from the effective date of theConsent Order, a risk segmentation analysis with respect to the Bank’sConcentrations of Credit and a written plan to systematically reduce anysegment of the portfolio that is an undue 

 

31

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concentration ofcredit;

 

·                  revise, within 60 days from the effective date of the ConsentOrder, the Bank’s internal loan review and grading system to provide for theperiodic review of the Bank’s loan portfolio in order to identify andcategorize the Bank’s loans, and other extensions of credit which are carriedon the Bank’s books as loans, on the basis of credit quality;

 

·                  formulate and implement, within 60 days from theeffective date of the Consent Order, a profit plan and comprehensive budget forall categories of income and expense, which must address, at minimum, goals andstrategies for improving and sustaining the earnings of the Bank, the majorareas in and means by which the Bank will seek to improve the Bank’s operatingperformance, and the operating assumptions that form the basis for andadequately support major projected income and expense components of the plan;

 

·                  enhance, within 60 days from the effective date of theConsent Order, our written funds management plan addressing liquidity,contingent funding, and asset liability management;

 

·                  not accept, renew, or rollover any brokereddeposits.  The Bank must develop andsubmit to the FDIC, within 30 days from the effective date of the order, a planfor eliminating its reliance on brokered deposits.  In addition, the Bank cannot offer aneffective yield in excess of 75 basis points on interest paid on deposits (includingbrokered deposits, if approval is granted for the Bank to accept them) ofcomparable size and maturity in either the Bank’s normal market area or in themarket area in which such deposits would otherwise be accepted.  Thus, for deposits in the Bank’s own normalmarket area, the Bank must offer rates that are not in excess of 75 basispoints over the average local rates.  Fornon-local deposits, the Bank must offer rates that are not in excess of 75basis points over either (1) the Bank’s own local rates or (2) theapplicable non-local rates;

 

·                  not declare or pay any dividends or bonuses or makeany distributions of interest, principal, or other sums on subordinateddebentures without the prior approval of the supervisory authorities; and

 

·                  furnish, by within 45 days from the effective date ofthe Consent Order and within 45 days of the end of each quarter thereafter,written progress reports to the supervisory authorities detailing the form andmanner of any actions taken to secure compliance with the Consent Order.

 

***GoingConcern Considerations***

 

Due to the conditions andevents discussed above and elsewhere in this Annual Report on Form 10-K,substantial doubt exists as to our ability to continue as a goingconcern.  We have determined that significant additional sources ofliquidity and capital will be required for us to continue operations through2010 and beyond.  We have engaged financial advisors to assist the Companyin its efforts to raise additional capital, sell assets, and explore otherstrategic alternatives to address our current and expected liquidity andcapital deficiencies.  To date, those efforts have not yielded anysignificant results.  As a result of our financial condition, ourregulators are continually monitoring our liquidity and capital adequacy.  In addition, our regulators have variousenforcement tools available to them, including the issuance of capitaldirectives, orders to cease engaging in certain business activities, or theissuance of modified or additional orders or agreements.

 

Notwithstanding theabove, accompanying consolidated financial statements have been prepared on agoing concern basis, which contemplates the realization of assets and thedischarge of liabilities in the normal course of business for the foreseeablefuture, and do not include any adjustments to reflect the possible futureeffects on the recoverability and classification of assets, or the amounts andclassification of liabilities that may result should we be unable to continueas a going concern.

 

***CurrentBusiness Strategy***

 

In addition to theactions required by the MOU, we have been actively pursuing the correctiveactions required by the Consent Order in an effort to ensure that therequirements of the Consent Order are met in a timely manner.  Specifically, we are currently focusing our effortsin the following areas:

 

·                  **Increasing and Strengthening OurCapital Position.**

As of December 31,2009, the Bank is deemed to be “undercapitalized.” Management has developed aplan to increase and preserve our capital with the goal of returning to andmaintaining a “well-capitalized” status. These

 

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initiatives include,among other things, restructuring the Bank’s balance sheet by limiting new loanactivity and aggressively attempting to sell certain real estate-related loansand other assets. We also intend to raise additional capital through a plannedcapital raise in the first or second quarter of 2010. Additionally, we areactively evaluating a number of capital sources and balance sheet managementstrategies to ensure that our projected level of regulatory capital can supportour balance sheet and meet or exceed minimum requirements.

 

·                  **Managing and Improving AssetQuality.**

The economic recessionand the deterioration of the housing and real estate markets have had anadverse impact on the credit quality of our loan portfolio. In response, ourBank intends to significantly reduce the amount of its non-performing assets.Non-performing assets hurt our profitability because they reduce the balance ofearning assets, may require additional loan loss provisions or write-downs, andrequire significant devotion of staff time and financial resources toresolve. We believe our asset quality plan aggressively addresses theseissues.  For example,

·                  In February of 2009, we restructured the creditadministration and loan operations departments and hired a skilled chief creditofficer to oversee the enhancement of our processes and procedures in thisarea.

·                  In June of 2009, we established an ImprovingProblem Asset Committee to assist Bank management in policy development,management strategy, and/or liquidation of problem assets. We are currentlyproactively seeking avenues to sell Bank-owned properties and problem assets tooutside investors.

·                  In January of 2009, we implemented a process forthe continuous review of all classified loans, watch loans, past due loans,relationships over $500,000, and any other potential risky loans and appliedconservative risk grades.

·                  Throughout 2009, we conducted disciplined watch loanmeetings to track and monitor progress, including the execution of workoutplans, obtainment of current financial data, and detailed progress updates.

·                  Throughout 2009, we maintained an adequate reserve forloan losses given the risk profile of our Bank.

·                  In May of 2009, we implemented a risk-focusedinternal and external loan review program.

·                  During 2010, we plan to create a special assetsdivision to focus our efforts and enhance staffing related to loan work-outsand collection processes.

 

·                  **Decreasing Concentrations in OurLoan Portfolio.**

We are focused onreducing our concentrations in commercial real estate (CRE), specificallyacquisition development and construction loans, and residential constructionloans. Since January 2009, we have effectively ceased making any new CREloans while proactively decreasing the level of these existing loan types. Wehave worked to decrease our concentration by various means, including (1) throughthe normal sale of real estate by borrowers, (2) by seeking avenues tosell a portion of the CRE portfolio to outside investors, (3) byproactively seeking secondary market permanent financing for recently completedresidential construction projects, and (4) encouraging transactional CREcustomers to seek other financing when their loans mature. As a result of theseefforts, our amount of CRE loans decreased 16% from $151.6 million of our totalloan portfolio at December 31, 2008 to $126.8 million of our loanportfolio at December 31, 2009. We have also reduced our residentialconstruction portfolio 84% from $33.8 million at December 31, 2008 to $5.5million at December 31, 2009. We expect commercial real estate loanportfolio balances to continue to decrease in 2010 through the continuedsuccessful implementation of the plans outlined above.

 

·                  **Reducing Operating Expenses.**

We have always focused oncontrolling expenses and managing efficient overhead. During 2010, managementintends to further reduce costs in a manner which does not impact the qualityof our customer service. Given the prolonged economic recession, we haveembarked on an extremely aggressive expense reduction campaign. Management hasalready reduced salary and benefits expenses by reducing staffing levels,freezing salaries at 2008 levels, and reducing compensation in severalpositions. Additionally, we will continue to renegotiate vendor contracts andimplement several other cost-saving measures to reduce noninterestexpenses.  Reducing our level of nonperforming assets will also lowerour operating costs.

 

·                  **Enhancing Funds Management andLiquidity.**

We have grown rapidlysince our inception through 2008, and have historically funded our asset growthwith a combination of local deposits and wholesale funding, specificallybrokered deposits. As of December 31, 2009, we had brokered deposits of$202.8 million, representing 53.85% of our total deposits, of which $79.7million are scheduled to mature in the third quarter of 2010 and $94.9 millionare scheduled to mature in the fourth quarter of 

 

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2010.  Becauseof the limitations on brokered deposits imposed by the Consent Order and ourundercapitalized status, the Bank may no longer accept, renew, or roll overbrokered deposits.  Thus, we must findother sources of liquidity to replace these deposits as they mature. We haveamended our funds management policy to reflect our plan to continue to improveliquidity levels and reduce our use of brokered deposits and other non-corefunding sources. Our funds management policy also includes our plan to reduceassets, certain loans, and other Bank-owned real estate. We plan to reduce ourbrokered deposit usage by executing on our comprehensive deposit acquisitionprogram, which creates an environment of consistent deposit growth based onrelationship-based banking, advocate-based selling and an aggressive, focusedcalling program. Our experienced team of bankers is actively cross-selling coredeposits to our local depositors and borrowers, and is held accountable forproduction through twice-weekly sales meetings. Production is enhanced by ourrelationship-based culture training, which includes advanced customer servicetechniques and one-on-one coaching. We also plan to generate local deposits througha combination of competitive products and pricing, customer service excellence,and targeted marketing campaigns.

 

·                  **Enhancing Our Bank’s RelationshipCulture.**

While the bulk of ourstrategic plan encompasses strategies to survive the prolonged economicrecession, management recognizes that we must also place the Bank in the bestposition to thrive as we emerge from this recession. In this regard, planninghas also centered on enhancing the Bank’s culture. We believe the enhancementof our culture will place the Bank in the best position possible to provideunmatched customer service and to take advantage of market opportunitiesthrough advocate-based selling and relationship banking strategies. Enhancementplans include, among others, the following:

·                  implementing consistent customer service andcommunication standards in all areas of the Bank;

·                  training and certifying the non-negotiables ofrelationship banking to all employees;

·                  ensuring all employees are engaged and motivated whileenabling management to measure the enhancement of the culture by conductingquarterly employee engagement surveys;

·                  implementing consistent management standards for allsupervisors resulting in internal and external advocacy;

·                  refining the Bank’s customer experience measurements,including branch mystery shopping and customer survey programs; and ensuringall programs evaluate and measure the Bank’s expectations and areas of focus.

 

We will continue to servecustomers in all areas, including processing banking transactions, meetingcustomer deposit needs, and providing access to lines of credit. All customerdeposits are fully insured to the highest limits set by the FDIC, which are$250,000 for individually titled accounts and $250,000 for individually titledIRA accounts. In addition, we participate in the FDIC Transaction AccountGuarantee Program. Under this program, all non-interest bearing transactionaccounts are fully guaranteed by the FDIC for the entire amount of the account.The guarantee also applies to interest bearing transaction accounts withinterest rates of 0.50 percent or less. This program is in addition to andseparate from the coverage available under the FDIC general deposit insurancerules.

 

However, should we failto comply with the capital and liquidity funding requirements in the ConsentOrder, or suffer a continued deterioration in our financial condition, we maybe subject to being placed into a federal conservatorship or receivership bythe FDIC, with the FDIC appointed as conservator or receiver.

 

**Recent Legislative and RegulatoryInitiatives to Address Financial and Economic Crises**

 

Markets in the United Statesand elsewhere have experienced extreme volatility and disruption for more than12 months.  These circumstances haveexerted significant downward pressure on prices of equity securities andvirtually all other asset classes, and have resulted in substantially increasedmarket volatility, severely constrained credit and capital markets,particularly for financial institutions, and an overall loss of investorconfidence.  Loan portfolio performanceshave deteriorated at many institutions resulting from, among other factors, aweak economy and a decline in the value of the collateral supporting theirloans.  Dramatic slowdowns in the housingindustry, due in part to falling home prices and increasing foreclosures andunemployment, have created strains on financial institutions.  Many borrowers are now unable to repay theirloans, and the collateral securing these loans has, in some cases, declinedbelow the loan balance.   In response tothe challenges facing the financial services sector, several regulatory andgovernmental actions have recently been announced including:

 

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·                  The EmergencyEconomic Stabilization Act of 2008 (“EESA”), approved by Congress and signed byPresident Bush on October 3, 2008, which, among other provisions, allowedthe U.S. Treasury to purchase up to $700 billion of mortgages, mortgage-backedsecurities and certain other financial instruments from financial institutionsfor the purpose of stabilizing and providing liquidity to the U.S. financialmarkets.  EESA also temporarily raisedthe basic limit of FDIC deposit insurance from $100,000 to $250,000 through December 31,2013;

 

·                  On October 7,2008, the FDIC approved a plan to increase the rates banks pay for depositinsurance;

 

·                  On October 14,2008, the U.S. Treasury announced the creation of a new program, the TroubledAsset Relief Program (the “TARP”) Capital Purchase Program (the “CPP”) thatencourages and allows financial institutions to build capital through the saleof senior preferred shares to the U.S. Treasury on terms that arenon-negotiable;

 

·                  On October 14,2008, the FDIC announced the creation of the Temporary Liquidity GuaranteeProgram (the “TLGP”), which seeks to strengthen confidence and encourageliquidity in the banking system.  The TLGP has two primary components thatare available on a voluntary basis to financial institutions:

 

·                  The Transaction Account Guarantee Program (“TAGP”),which provides unlimited deposit insurance coverage through December 31,2009 for noninterest-bearing transaction accounts (typically business checkingaccounts) and certain funds swept into noninterest-bearing savingsaccounts.  Institutions participating inthe TLGP pay a 10 basis points fee (annualized) on the balance of each coveredaccount in excess of $250,000, while the extra deposit insurance is in place.This program was extended until June 30, 2010.

 

·                  The Debt Guarantee Program (“DGP”), underwhich the FDIC guarantees certain senior unsecured debt of FDIC-insuredinstitutions and their holding companies. The unsecured debt must be issued on or after October 14, 2008 andnot later than June 30, 2009, and the guarantee is effective through theearlier of the maturity date or June 30, 2012.  The DGP coverage limit is generally 125% ofthe eligible entity’s eligible debt outstanding on September 30, 2008 andscheduled to mature on or before June 30, 2009 or, for certain insuredinstitutions, 2% of their liabilities as of September 30, 2008.  Depending on the term of the debt maturity,the nonrefundable DGP fee ranges from 50 to 100 basis points (annualized) forcovered debt outstanding until 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.

 

 

·                  On February 10,2009, the U.S. Treasury announced the Financial Stability Plan, which earmarked$350 billion of the TARP funds authorized under EESA.  Among other things, the Financial StabilityPlan includes:

 

·                  A capital assistance program that will investin mandatory convertible preferred stock of certain qualifying institutionsdetermined on a basis and through a process similar to the CPP;

 

·                  A consumer and business lending initiative tofund new consumer loans, small business loans and commercial mortgageasset-backed securities issuances;

 

·                  A new public-private investment fund thatwill leverage public and private capital with public financing to purchase upto $500 billion to $1 trillion of legacy “toxic assets” from financialinstitutions; and

 

·                  Assistance for homeowners by providing up to$75 billion to reduce mortgage payments and interest rates and establishingloan modification guidelines for government and private programs.

 

·                  On February 17, 2009 President Obamasigned into law the Recovery Act, which includes a wide variety of programsintended to stimulate the economy and provide for extensive infrastructure,energy, health, and education needs.  Inaddition, the Recovery Act imposes certain new executive compensation andcorporate expenditure limits on all current and future TARP recipients that arein addition to those previously announced by the U.S. Treasury. These newlimits are in place until the institution has repaid the Treasury, which is nowpermitted under the Recovery Act without penalty and without the need to raisenew capital, subject to the Treasury’s consultation with the recipientinstitution’s appropriate regulatory agency.

 

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·                  On March 23,2009, the U.S. Treasury, in conjunction with the FDIC and the Federal Reserve,announced the Public-Private Partnership Investment Program (PPIP) for LegacyAssets which consists of two separate plans, addressing two distinct assetgroups:

 

·                  The firstplan is the Legacy Loan Program, which has a primary purpose to facilitate thesale of troubled mortgage loans by eligible institutions, includingFDIC-insured federal or state banks and savings associations.  Eligible assets are not strictly limited toloans; however, what constitutes an eligible asset will be determined byparticipating banks, their primary regulators, the FDIC and the Treasury. Underthe Legacy Loan Program, the FDIC has sold certain troubled assets out of anFDIC receivership in two separate transactions relating to the failed Illinoisbank, Corus Bank, NA, and the failed Texas bank, Franklin Bank, S.S.B. Thesetransactions were completed in September 2009 and October 2009,respectively.

 

·                  The second planis the Securities Program, which is administered by the Treasury and involvesthe creation of public-private investment funds to target investments ineligible residential mortgage-backed securities and commercial mortgage-backedsecurities issued before 2009 that originally were rated AAA or the equivalentby two or more nationally recognized statistical rating organizations, withoutregard to rating enhancements (collectively, “Legacy Securities”). LegacySecurities must be directly secured by actual mortgage loans, leases or otherassets, and may be purchased only from financial institutions that meet TARPeligibility requirements. The Treasury received over 100 unique applications toparticipate in the Legacy Securities PPIP and in July 2009 selected ninepublic-private investment fund managers. As of December 31, 2009, public-private investment funds havecompleted initial and subsequent closings on approximately $6.2 billion ofprivate sector equity capital, which was matched 100% by Treasury, representing$12.4 billion of total equity capital. Treasury has also provided $12.4 billionof debt capital, representing $24.8 billion of total purchasing power. As of December 31,2009, public-private investment funds have drawn-down approximately $4.3 billionof total capital which has been invested in certain non-agency residentialmortgage-backed securities and commercial mortgage-backed securities and cashequivalents pending investment.

 

·             On May 22, 2009, the FDIC levied a one-timespecial assessment on all banks due on September 30, 2009.

 

·             On November 12, 2009, the FDIC issued a final rule torequire banks to prepay their estimated quarterly risk-based assessments forthe fourth quarter of 2009 and for all of 2010, 2011 and 2012 and to increaseassessment rates effective on January 1, 2011.

 

It is likely that furtherregulatory actions may arise as the Federal government continues to attempt toaddress the economic situation.

 

We are participating in theTAGP component of the TLGP.  As a resultof the enhancements to deposit insurance protection and the expectation thatthere will be demands on the FDIC’s deposit insurance fund, our depositinsurance costs have increased and will continue to increase significantlythrough the remainder of 2009 and throughout 2010.  We have elected not to participate in theCPP.  Regardless of our lack ofparticipation, governmental intervention and new regulations under theseprograms could materially and adversely affect our business, financialcondition and results of operations.

** **

**ProposedLegislation and Regulatory Action**

 

Legislativeand regulatory proposals regarding changes in banking, and the regulation ofbanks, federal savings institutions, and other financial institutions and bankand bank holding company powers are being considered by the executive branch ofthe federal government, Congress and various state governments. Certain ofthese proposals, if adopted, could significantly change the regulation oroperations of banks and the financial services industry. New regulations andstatutes are regularly proposed that contain wide-ranging proposals foraltering the structures, regulations, and competitive relationships of thenation’s financial institutions. On June 17, 2009, the U.S. Treasuryreleased a white paper entitled “Financial Regulatory Reform — A NewFoundation: Rebuilding Financial Supervision and Regulation” (the “Proposal”)which calls for sweeping regulatory and supervisory reforms for the entirefinancial sector and seeks to advance the following six key objectives: (i) promoterobust supervision and regulation of financial firms, (ii) establishcomprehensive supervision of financial markets, (iii) protect consumersand investors from financial abuse, (iv) provide the government withadditional powers to monitor

 

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systemicrisks, supervise and regulate financial products and markets, and to resolvefirms that threaten financial stability, and (v) raise internationalregulatory standards and improve international cooperation.

 

TheProposal includes the creation of a new federal government agency, the NationalBank Supervisor (“NBS”) that would charter and supervise all federallychartered depository institutions, and all federal branches and agencies offoreign banks. It is proposed that the NBS take over the responsibilities ofthe Office of the Comptroller of the Currency, which currently charters andsupervises nationally chartered banks, and the responsibility for theinstitutions currently supervised by the Office of Thrift Supervision, whichsupervises federally chartered savings institutions and federal savingsinstitution holding companies.

 

TheProposal also includes the creation of a new federal agency designed to enforceconsumer protection laws. The Consumer Financial Protection Agency (“CFPA”)would have authority to protect consumers of financial products and servicesand to regulate all providers (bank and non-bank) of such services. The CFPAwould be authorized to adopt rules for all providers of consumer financialservices, supervise and examine such institutions for compliance, and enforcecompliance through orders, fines, and penalties. The rules of the CFPAwould serve as a “floor” and individual states would be permitted to adopt andenforce stronger consumer protection laws. If adopted as proposed, we maybecome subject to multiple laws affecting its provision of loans and othercredit services to consumers, which may substantially increase the cost ofproviding such services.

 

OnFebruary 2, 2010, President Obama called on Congress to create a new SmallBusiness Lending Fund.  Under thisproposal, $30 billion in TARP funds would be transferred to a new programoutside of TARP to support small business lending.  As proposed, only small- and medium-sizedbanks would qualify to participate in the program.

 

Newregulations and statutes are regularly proposed that contain wide-rangingproposals for altering the structures, regulations, and competitiverelationships of the nation’s financial institutions.  We cannot predict whether or in what form anyproposed regulation or statute will be adopted or the extent to which ourbusiness may be affected by any new regulation or statute.

 

# **Resultsof Operations**

 

***Results of operations are only presented for the years ended December 31,2009 and 2008.***

 

Net interest income increased $498,000, or 4.92%, to $10.6 million in2009, up from $10.1 million in 2008. The primary component of interest incomein 2009 was interest on loans, including fees, of $17.0 million, as compared to$20.2 million in 2008. The increase in net interest income was due primarily toa decrease in deposit rates, translating into lower interest expense.

 

The Company’s net interest spreads were 2.49% and 2.27% in 2009 and2008, respectively. The Company’s net interest margins were 2.73% and 2.74% in2009 and 2008, respectively.  Yields onaverage earning assets decreased from 6.13% in 2008 to 4.93% in 2009. Rates onaverage interest bearing liabilities decreased from 3.86% in 2008 to 2.44% in2009. These changes in yields and rates resulted in a net decrease in netinterest spread of 22 basis points. Average shareholder equity was 7.3% ofaverage interest bearing liabilities in 2009 and 9.5% of average interestbearing liabilities in 2008.

 

The provision for loan losses was $17.0 million in 2009, compared to$7.2 million in 2008.  The charges to theprovision were to maintain the allowance for loan losses at a level sufficientto cover estimated losses inherent in the loan portfolio, given the currenteconomic downturn which has affected the entire banking industry.  The Bank, like many community banks, has asignificant amount of loans that directly or indirectly rely on the homebuilding industry, which has also experienced an extremely turbulent secondyear.

 

Non-interest income increased $1.3 million, or 95.62%, to $2.7 millionin 2009, up from non-interest income of $1.4 million in 2008. The increase ismainly attributable to gains on sale of investments totaling $1.2 million in2009.  Mortgage loan origination feesincreased $239,000, or 50.85%, which was $709,000 for the year ended December 31,2009.  The increase is due to ourincreased volume in mortgage loan originations. Income from bank-owned lifeinsurance was $51,000 in 2009, compared to income of $210,525 in 2008.  The Company executed a sale of its Bank OwnedLife Insurance in the first quarter of 2009. Service charges on depositaccounts increased $58,000, or 18.01%, to $380,000 in 2009, as compared toservice charges on deposit accounts of $322,000 in 2008, due to the increasedvolume in deposit accounts.

 

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Non-interest expense increased $4.2 million, or 43.73%, to $13.7million in 2009, compared to non-interest expense of $9.5 million in 2008.Salaries and employee benefits increased $407,000 to $5.2 million for the yearended December 31, 2009. This increase is attributable to growth of themortgage division. FDIC insurance premiums totaled $1.1 million for the yearended December 31, 2009 compared to $226,000 in 2008.  The increase in the FDICassessment includes increased annual premiums by the FDIC due to the increasein our deposit base and our current financial condition as well as a one-timeFDIC insurance premium that equated to a $178,000 one time charge to the Bankin 2009.  The Company also had awritedown to Other Real Estate Owned and Repossessed Collateral of $2.1 millionfor the year ended December 31, 2009. The Company’sefficiency ratio was 102.4% in 2009 compared to 82.5% in 2008. 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 our efficiency ratio is primarily attributable tothe increased expenses described above.

 

The Company’s net loss was $18.3 million in 2009, compared to net lossof $3.4 million in 2008. The significant increase in the net loss in 2009 wasprimarily due to the increase in the provision for loan losses which increased$9.8 million to $17.0 million from $7.2 million for the years ended December 31,2009 and 2008, respectively.  Return onaverage assets during 2009 was -4.55% compared to a return of -0.87% in 2008.Net loss in 2009 was after an income tax expense of $1.0 million and net lossin 2008 was after an income tax benefit of $1.8 million. The income taxexpenses for 2009 and 2008 resulted in effective tax rates of -5.7% and 35.0%,respectively. The 2009 income tax benefit computed on the pretax loss wasreduced by the $6.6 million expense of providing a 100% valuation allowanceagainst the deferred tax assets.  SeeNotes 1 and 13 to the consolidated financial statements for additionalinformation about income taxes.

# ** **

# **NetInterest Income**

*** ***

***General****.* The largest component of the Company’s net income is its net interestincome, which is the difference between the income earned on assets andinterest paid on deposits and borrowings used to support such assets.  Net interest income is determined by the yieldsearned on the Company’s interest-earning assets and the rates paid on itsinterest-bearing liabilities, as well as the relative amounts ofinterest-earning assets and interest-bearing liabilities.  Net interest income divided by average interest-earningassets 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. If the general economic downturn continues,we anticipate continued changes in payment behavior causing a further reductionin net interest income in the future. If interest rates were to rise, webelieve it would have a positive effect on our net interest income.

 

***Rate/Volume Analysis****.* Net interest income can be analyzed in terms of the impact of changinginterest rates 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, 2009 vs. 2008** | ** ** | **December 31, 2008 vs. 2007** | ** ** |
|----------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|
| ** **                 | ** ** | **Increase (decrease) Due to**      | ** ** | **Increase (decrease) Due to**      | ** ** |
| ** **                 | ** ** | ** **                          | ** ** | ** **                          | ** ** | **Rate /** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Rate /** | ** ** | ** ** | ** ** |
| **(Dollars in thousands)** | ** ** | **Volume**                          | ** ** | **Rate**                            | ** ** | **Volume** | ** ** | **Total** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Volume** | ** ** | **Total** | ** ** |
| Interest Income            |       |                                |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans(1)                   |       | $                                   | (621       | )                                   | $          | (2,666 | ) | $ | 83 |   | $ | (3,204 | ) | $ | 4,067 |   | $ | (4,460 | ) | $ | (847 | ) | $ | (1,240 | ) |
| Investment securities  (2) |       | 991                                 |       | (751                                | )          | (323 | ) | (83 | ) | 1,926 |   | (72 | ) | (209 | ) | 1,645 |   |
| Federal funds              |       | 269                                 |       | (219                                | )          | (246 | ) | (196 | ) | (754 | ) | (454 | ) | 298 |   | (910 | ) |
| Total Interest Income      | ** ** | **$**                               | **639**    | ** **                          | **$**      | **(3,636** | **)** | **$** | **(486** | **)** | **$** | **(3,483** | **)** | **$** | **5,239** | ** ** | **$** | **(4,986** | **)** | **$** | **(758** | **)** | **$** | **(505** | **)** |
|                       |       |                                |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest Expense           |       |                                |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits                   |       | $                                   | (46        | )                                   | $          | 488 |   | $ | (20 | ) | $ | 422 |   | $ | 1,232 |   | $ | (2,549 | ) | $ | (241 | ) | $ | (1,558 | ) |
| Other borrowings           |       | 1,124                               |       | (5,032                              | )          | (495 | ) | (4,403 | ) | 1,076 |   | — |   | (7 | ) | 1,069 |   |
| Total Interest Expense     | ** ** | **$**                               | **1,078**  | ** **                          | **$**      | **(4,544** | **)** | **$** | **(515** | **)** | **$** | **(3,981** | **)** | **$** | **2,308** | ** ** | **$** | **(2,549** | **)** | **$** | **(248** | **)** | **$** | **(489** | **)** |
|                       |       |                                |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net Interest Income        | ** ** | **$**                               | **(439**   | **)**                               | **$**      | **908** | ** ** | **$** | **29** | ** ** | **$** | **498** | ** ** | **$** | **2,931** | ** ** | **$** | **(2,437** | **)** | **$** | **(510** | **)** | **$** | **(16** | **)** |

 

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(1)        For the purpose of thistable, loans include non-performing loans such as those in non-accrual and pastdue 90 days or more and still accruing interest.

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

 

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***Average Balances, Income andExpenses and Rates****.*  The followingtable sets forth, for the years ended December 31, 2009, 2008 and 2007,information related to the Company’s average balance sheet and its averageyields 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.

 
| ** **                                          | ** ** | **2009**    | ** **  | **2008**     | ** ** | **2007**    | ** ** |
|-----------------------------------------------------|------------|-------------|-------------|--------------|------------|-------------|------------|
| ** **                                          | ** ** | **Average** | ** **  | **Income /** | ** ** | **Yield /** | ** ** | **Average** | ** ** | **Income /** | ** ** | **Yield /** | ** ** | **Average** | ** ** | **Income /** | ** ** | **Yield /** | ** ** |
| **(Dollars in thousands)**                          | ** ** | **Balance** | ** **  | **Expense**  | ** ** | **Rate**    | ** ** | **Balance** | ** ** | **Expense** | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Expense** | ** ** | **Rate** | ** ** |
| **Assets**                                          |       |        |        |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Earning assets:                                     |       |        |        |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans (1)                                           |       | $           | 305,472     |         | $          | 16,959      |       | 5.55 | % | $ | 315,175 |   | $ | 20,163 |   | 6.40 | % | $ | 264,844 |   | $ | 21,403 |   | 8.08 | % |
| Investment  securities (2)                          |       | 67,456      |        | 2,225        |       | 3.30        | %          | 47,130 |   | 2,308 |   | 4.90 | % | 12,067 |   | 663 |   | 5.49 | % |
| Federal funds  sold and other                       |       | 16,749      |        | 44           |       | 0.26        | %          | 7,884 |   | 239 |   | 3.04 | % | 22,914 |   | 1,150 |   | 5.02 | % |
| Total earning  assets                               |       | 389,677     |        | 19,228       |       | 4.93        | %          | 370,189 |   | 22,710 |   | 6.13 | % | 299,825 |   | 23,216 |   | 7.74 | % |
| Cash and due from  banks                            |       | 7,202       |        |         |       |        |       | 5,579 |   |   |   |   |   | 4,720 |   |   |   |   |   |
| Premises and  equipment                             |       | 4,377       |        |         |       |        |       | 4,873 |   |   |   |   |   | 4,953 |   |   |   |   |   |
| Other assets                                        |       | 9,550       |        |         |       |        |       | 8,944 |   |   |   |   |   | 7,856 |   |   |   |   |   |
| Allowance for  loan losses                          |       | (8,744      | )           |         |       |        |       | (5,528 | ) |   |   |   |   | (3,686 | ) |   |   |   |   |
| Total assets                                        | ** ** | **$**       | **402,062** |         |       |        |       |   | **$** | **384,057** |   |   |   |   | ** ** | **$** | **313,668** |   |   |   |   |   |
| ** **                                          |       |        |        |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Liabilities**                                     |       |        |        |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:                      |       |        |        |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Repurchase  agreements                              |       | $           | 30,000      |         | $          | 976         |       | 3.25 | % | $ | 28,525 |   | $ | 700 |   | 2.46 | % | $ | 2,315 |   | $ | 63 |   | 2.72 | % |
| Federal funds  purchased                            |       | 155         |        | 1            |       | 0.57        | %          | 1,312 |   | 24 |   | 1.85 | % | — |   | — |   | — | % |
| Other borrowings                                    |       | 10,018      |        | 576          |       | 5.75        | %          | 11,855 |   | 407 |   | 3.43 | % | — |   | — |   | — | % |
| Interest-bearing  transaction accounts              |       | 18,247      |        | 219          |       | 1.20        | %          | 15,300 |   | 324 |   | 2.12 | % | 11,520 |   | 196 |   | 1.70 | % |
| Savings deposits                                    |       | 60,101      |        | 1,531        |       | 2.55        | %          | 18,881 |   | 223 |   | 1.18 | % | 19,107 |   | 648 |   | 3.39 | % |
| Time deposits                                       |       | 233,472     |        | 5,296        |       | 2.27        | %          | 249,765 |   | 10,902 |   | 4.36 | % | 228,748 |   | 12,162 |   | 5.32 | % |
| Total  interest-bearing liabilities                 |       | 351,993     |        | 8,599        |       | 2.44        | %          | 325,638 |   | 12,580 |   | 3.86 | % | 261,690 |   | 13,069 |   | 4.99 | % |
| Demand deposits                                     |       | 22,290      |        |         |       |        |       | 23,739 |   |   |   |   |   | 18,864 |   |   |   |   |   |
| Accrued interest  and other liabilities             |       | 1,935       |        |         |       |        |       | 3,535 |   |   |   |   |   | 2,492 |   |   |   |   |   |
| Total liabilities                                   |       | 376,218     |        |         |       |        |       | 353,103 |   |   |   |   |   | 283,046 |   |   |   |   |   |
| Shareholders’  equity                          |       | 25,844      |        |         |       |        |       | 30,713 |   |   |   |   |   | 30,622 |   |   |   |   |   |
| Total liabilities  and****shareholders’ equity |       | **$**       | **402,062** |         |       |        |       |   | **$** | **384,057** |   |   |   |   |   | **$** | **313,668** |   |   |   |   |   |
| ** **                                          |       |        |        |         |       |        |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest  income                                |       |        | ** **  | **$**        | **10,629** |        |       |   |   | ** ** | **$** | **10,130** |   |   |   |   | ** ** | **$** | **10,147** |   |   |   |
| Net interest  spread                                |       |        |        |         | ** ** | **2.49**    | **%**      |   |   |   | ** ** | **2.27** | **%** |   |   |   | ** ** | **2.75** | **%** |
| Net interest  margin                                |       |        |        |         | ** ** | **2.73**    | **%**      |   |   |   | ** ** | **2.74** | **%** |   |   |   | ** ** | **3.38** | **%** |

 

----

(1)          There were $29.4million, $9.9 million, and $35,172 of loans in non-accrual status as of December 31,2009, 2008 and 2007, respectively.  Theeffect of fees collected on loans in 2009, 2008 and 2007 totaled $158,000, $261,000and $655,000, respectively, and increased the annualized yield on loans by 5basis points from 5.50% for 2009, by 9 basis points from 6.31% for 2008, and by25 basis points from 7.83% for 2007.  Theeffect of such fees on the annualized yield on earning assets was an increaseof 4 basis points from 4.89% in 2009, an increase of 7 basis points from 6.06%in 2008, and an increase of 22 basis points from 7.52% in 2007.  The effects of such fees on net interest spreadwere an increase of 4 basis points from 2.45% for 2009, an increase of 7 basispoints from 2.20% for 2008, and an increase of 22 basis points from 2.53% for2007.  The effects of such fees on netinterest margin were an increase of 4 basis points from 2.69% for 2009, anincrease of 17 basis points from 2.57% for 2008, and an increase of 21 basispoints from 3.17% for 2007.

 

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

 

 

39

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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, 2009.

 
| ** **                                       | ** ** | ** ** | ** ** | **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                                     |       | $          | 152,129    |         | $          | 20,166       |       | $           | 96,875      |       | $          | 5,934 |   | $ | 275,104 |   |
| Investment  securities, available for sale       |       | —     |       | —       |       | —       |       | 103,638     |        | 103,638    |       |
| Other investments                                |       | —     |       | —       |       | —       |       | 1,599       |        | 1,599      |       |
| Fed funds                                        |       | 31,043     |       | —       |       | —       |       | —      |        | 31,043     |       |
| Total earning  assets                            |       | 183,172    |       | 20,166       |       | 96,875       |       | 111,171     |        | 411,384    |       |
|                                             |       |       |       |         |       |         |       |        |        |       |       |
| **Liabilities**                                  |       |       |       |         |       |         |       |        |        |       |       |
| Interest-bearing  liabilities:                   |       |       |       |         |       |         |       |        |        |       |       |
| Interest-bearing  deposits:                      |       |       |       |         |       |         |       |        |        |       |       |
| Repurchase agreements                            |       | —     |       | 15,000       |       | —       |       | 15,000      |        | 30,000     |       |
| Other borrowings                                 |       | —     |       |  — |       | —       |       | 4,325       |        | 4,325      |       |
| Demand deposits                                  |       | 18,588     |       | —       |       | —       |       | —      |        | 18,588     |       |
| Savings deposits                                 |       | 82,295     |       | —       |       | —       |       | —      |        | 82,295     |       |
| Time deposits                                    |       | 19,968     |       | 229,363      |       | 4,520        |       | —      |        | 253,851    |       |
| Total  interest-bearing liabilities              |       | 120,851    |       | 244,363      |       | 4,520        |       | 19,325      |        | 389,059    |       |
| Period gap                                       | ** ** | **$**      | **62,321** | ** **   | **$**      | **(224,197** | **)**      | **$**       | **92,355**  | ** ** | **$**      | **91,846** | ** ** | **$** | **22,325** | ** ** |
| Cumulative gap                                   | ** ** | **$**      | **62,321** | ** **   | **$**      | **(161,876** | **)**      | **$**       | **(69,521** | **)**      | **$**      | **22,325** | ** ** | ** ** | ** ** |
| Ratio of  cumulative gap to total earning assets | ** ** | **15.15**  | %          | **(39.35**   | **)**%     | **(16.90**   | **)**%     | **5.43**    | %           |       |       |

 

The above 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.

 

TheCompany generally would benefit from increasing market rates of interest whenit has an asset-sensitive gap position and generally would benefit fromdecreasing market rates of interest when it is liability-sensitive.  The Company is cumulatively liabilitysensitive over the three-month to twelve-month period and asset sensitive overall periods**greater than oneyear.  However, the Company’s gapanalysis is not a precise indicator of its interest sensitivity position.  The analysis presents only a static view ofthe timing of maturities and repricing opportunities, without taking intoconsideration that changes in interest rates do not affect all assets andliabilities equally.  Net interest incomemay be impacted by other significant factors in a given interest rateenvironment, including changes in the volume and mix of earning assets andinterest-bearing liabilities.

 

40

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# ** **

# **Provisionand Allowance for Loan Losses**

# ** **

***General****.* The Company has developed policies and procedures for evaluating theoverall quality of its credit portfolio and the timely identification ofpotential problem loans.  On a quarterlybasis, the Company’s Board of Directors reviews and approves the appropriatelevel for the Company’s allowance for loan losses based upon management’srecommendations, the results of the internal monitoring and reporting system,and an analysis of economic conditions in its market.

 

In addition to the Company’s portfolio review process, variousregulatory agencies periodically review the Company’s allowance for loanlosses.  These agencies may require theCompany to recognize additions to the allowance for loan losses based on theirjudgments and information available to them at the time of their examinations.While the Company uses available information to recognize inherent losses onloans, future adjustments to the allowance for loan losses may be necessarybased on changes in economic conditions and other factors and the impact ofsuch changes and other factors on the Bank’s borrowers.

 

Portionsof the allowance for loan losses may be allocated for specific loans orportfolio segments.  However, the entireallowance for loan losses is available for any loan that, in management’sjudgment, should be charged-off.  Whilemanagement utilizes the best judgment and information available to it, theultimate adequacy of the allowance for loan losses depends on a variety offactors beyond the Company’s control, including the performance of the Company’sloan portfolio, the economy, changes in interest rates, and the view of theregulatory authorities toward loan classifications.

 

Additions to the allowance for loan losses, which are expensed throughthe provision for loan losses on the Company’s income statement, are madeperiodically to maintain the allowance at an appropriate level based onmanagement’s analysis of the estimated losses inherent in the loanportfolio.  Loan losses and recoveriesare charged or credited directly to the allowance.  The amount of the provision is a function ofthe level of loans outstanding, the level of non-performing loans, historicalloan loss experience, the amount of loan losses actually charged against thereserve during a given period, and current and anticipated economic conditions.

 

The Company’s allowance for loan losses is based upon judgments andassumptions about risk elements in the portfolio, economic conditions, andother factors affecting borrowers.  Theprocess includes identification and analysis of loss potential in variousportfolio segments utilizing a credit risk grading process and specific reviewsand evaluations 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.

 

Based on present information and an ongoing evaluation, managementconsiders the allowance for loan losses to be adequate to meet presently knownand inherent losses in the loan portfolio. However, underlying assumptions may be impacted in future periods bychanges in economic conditions, the impact of regulatory examinations, and thediscovery of information with respect to borrowers, which was not known tomanagement at the time of the issuance of the Company’s consolidated financialstatements.  Therefore, management’sassumptions may or may not prove valid. Thus, there can be no assurance that charge-offs in future periods willnot exceed the allowance for loan losses or that additional increases in theallowance for loan losses will not be required, especially considering theoverall weakness in the commercial real estate market in our market areas.  Additionally, no assurance can be given thatmanagement’s ongoing evaluation of the loan portfolio, in light of changingeconomic conditions and other relevant factors, will not require significantfuture additions to the allowance for loan losses, thus adversely impacting theCompany’s business, financial condition, results of operations, and cash flows.

 

The following table sets forth certain information with respect to theCompany’s allowance for loan losses and the composition of charge-offs andrecoveries for the five years ended December 31, 2009.

 

41

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# **Allowancefor Loan Losses**

 
| **(Dollars in thousands)**                                 | ** ** | **2009** | ** **  | **2008**   | ** ** | **2007**    | ** ** | **2006** | ** **  | **2005**   | ** ** |
|------------------------------------------------------------|------------|----------|-------------|------------|------------|-------------|------------|----------|-------------|------------|------------|
| Total  loans outstanding at end of period                  | ** ** | **$**    | **275,104** | ** ** | **$**      | **320,907** | ** ** | **$**    | **302,934** | ** ** | **$**      | **217,644** | ** ** | **$** | **115,704** | ** ** |
| Average  loans outstanding                                 | ** ** | **$**    | **305,472** | ** ** | **$**      | **315,175** | ** ** | **$**    | **264,844** | ** ** | **$**      | **168,107** | ** ** | **$** | **63,985** | ** ** |
| Balance  of allowance for loan losses at beginning of year |       | $        | 8,088       |       | $          | 4,214       |       | $        | 3,091       |       | $          | 1,558 |   | $ | — |   |
| Loans  charged off:                                        |       |     |        |       |       |        |       |     |        |       |       |
| Real  estate — construction                           |       | 6,871    |        | 3,112      |       | 15          |       | —   |        | —     |       |
| Real  estate — mortgage                               |       | 3,985    |        | 120        |       | —      |       | —   |        | —     |       |
| Commercial  and industrial                                 |       | 1,441    |        | —     |       | —      |       | —   |        | —     |       |
| Consumer  and other                                        |       | 243      |        | 62         |       | 54          |       | —   |        | —     |       |
| Total  loan losses                                         |       | 12,540   |        | 3,294      |       | 69          |       | —   |        | —     |       |
| Recoveries  of previous loan losses:                       |       |     |        |       |       |        |       |     |        |       |       |
| Real  estate — construction                           |       | 402      |        | —     |       | 4           |       | —   |        | —     |       |
| Real  estate — mortgage                               |       | —   |        | —     |       | —      |       | —   |        | —     |       |
| Commercial  and industrial                                 |       | 1        |        | —     |       | —      |       | —   |        | —     |       |
| Consumer  and other                                        |       | 22       |        | —     |       | —      |       | —   |        | —     |       |
| Total  recoveries                                          |       | 425      |        | —     |       | 4           |       | —   |        | —     |       |
| Net  charge-offs                                           |       | 12,115   |        | 3,294      |       | 65          |       | —   |        | —     |       |
| Provision  for loan losses                                 |       | 16,990   |        | 7,168      |       | 1,188       |       | 1,533    |        | 1,558      |       |
| Balance  of allowance for loan losses at end of year       | ** ** | **$**    | **12,963**  | ** ** | **$**      | **8,088**   | ** ** | **$**    | **4,214**   | ** ** | **$**      | **3,091** | ** ** | **$** | **1,558** | ** ** |
| Net  charge-offs to average loans outstanding              |       | 3.97     | %           | 1.05       | %          | 0.02        | %          | —   | %           | —     | %          |

 

Ourallowance for loan losses totaled $13.0 million at December 31, 2009compared with $8.1 million at December 31, 2008, representing 4.71% and2.52% of gross loans, respectively.  The December 31, 2009 allowance for loanlosses, and, therefore indirectly the provision for loan losses for the yearended December 31, 2009, was determined based on the following specificfactors, though not intended to be an all inclusive list:

 

·                  The impact of the ongoingdepressed overall economic environment, including those within our geographicmarket,

·                  The cumulative impact of theextended duration of this economic deterioration on our borrowers, inparticular those with real estate related loans,

·                  The declining asset qualitytrends in our loan portfolio,

·                  The increasing trend in thehistorical loan loss rates within our loan portfolio,

·                  The results of our internaland external loan reviews during the second, third and fourth quarters of 2009resulting in loan downgrades,

·                  Our internal and externalimpaired loan analysis which identified:

·                  Increased stress onborrowers given increasing lack of liquidity, and limited bank financing andcredit availability, and

·                  Continued downward trends inappraised values and market assumptions used to value real estate dependentloans.

 

**Non-performing Assets**

 

***Non-performing Assets****.* There were $29.4 million and $9.9million of non-accrual loans at December 31, 2009 and December 31,2008, respectively. There were $5.3 million and $6,035 of loans past due 90days or more and still accruing interest or restructured loans at December 31,2009 and 2008, respectively.  There was$6.7 million and $415,229 in Other Real Estate Owned at December 31, 2009and 2008, respectively. There was $942,000 in Repossessed Collateral at December 31,2009 and none at December 31, 2008.

 

The table below represents non-performing assets for the five yearsended December 31, 2009.

 
| **(Dollars in thousands)**                          | ** ** | **2009** | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Non-accrual  loans                                  |       | $        | 29,369     |     | $          | 9,916    |       | $        | 35         |     | $          | 284 |   | $ | — |   |
| Loans  past due 90 days or more and still accruing  |       | 560      |       | 6        |       | —   |       | —   |       | —   |       |
| Other  Real Estate Owned and Repossessed Collateral |       | 7,645    |       | 415      |       | —   |       | —   |       | —   |       |
| Restructured  loans                                 |       | 4,789    |       | —   |       | —   |       | —   |       | —   |       |
| Total  non-performing assets                        |       | $        | 42,363     |     | $          | 10,337   |       | $        | 35         |     | $          | 284 |   | $ | — |   |

 

 

42

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The increase of $19.5million in non-performing loans from December 31,2008 to December 31, 2009 is related primarily to continued deteriorationin the Bank’s overall commercial real estate loan portfolio. The number ofloans on non-accrual status has increased from 30 to 50 since December 31,2008. The average non-accrual loan balance is $330,000 and $352,000 as of December 31,2008 and December 31, 2009, respectively. 99.9% of the non-accrual loans are secured by real estate. $3.1 millionof the allowance for loan loss has been specifically allocated to theserelationships. This increase in non-performing loans is a direct result of thepoor economic environment, as noted below, taking a toll on numerous borrowers’ability to pay as scheduled. At this time, management is unable to determinethe length of the economic downturn and therefore unable to determine theultimate impact on the Bank’s A&D loan portfolio.

 

The Company’s policy with respect to non-performing assets is asfollows.  Accrual of interest will bediscontinued on a loan when management believes, after considering economic andbusiness conditions and collection efforts that the borrower’s financialcondition is such 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, 2009 and December 31,2008, the Company had identified $15.9 million and $424,844, 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-interestIncome and Expense**

# ** **

***Non-interest Income****.* The largest component of non-interest income was gain on sale ofinvestments which totaled $1.2 million for the year ended December 31,2009.  There was no gain on sale ofinvestments in 2008.

 

The following table sets forth the principal components of non-interestincome for the years ended December 31, 2009 and 2008.

 
| **(Dollars in thousands)**           | ** ** | **2009** | ** ** | **2008**   | ** ** |
|--------------------------------------|------------|----------|------------|------------|------------|
| Mortgage origination  fees           |       | $        | 709        |       | $          | 470 |   |
| Service charges on  deposit accounts |       | 380      |       | 322        |       |
| Bank-owned life  insurance           |       | 51       |       | 211        |       |
| Gain on sale of  investments         |       | 1,162    |       | —     |       |
| Other income                         |       | 421      |       | 389        |       |
| Total non-interest income            | ** ** | **$**    | **2,723**  | ** ** | **$**      | **1,392** | ** ** |

 

***Non-interest Expense****. *Salaries and employee benefits comprised the largestcomponent of non-interest expense which totaled $5.2 million and $4.8 millionfor the years ended December 31, 2009 and 2008, respectively. Thisincrease is attributable to growth of the mortgage division. FDIC insurancepremiums totaled $1.1 million for the year ended December 31, 2009compared to $226,000 in 2008.  The increase inthe FDIC assessment includes increased annual premiums by the FDIC due to theincrease in our deposit base and our current financial condition as well as aone-time FDIC insurance premium that equated to a $178,000 one time charge tothe Bank in 2009.  The Company also had awritedown to Other Real Estate Owned and Repossessed Collateral of $2.1 millionfor the year ended December 31, 2009.

 

43

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The following table sets forth the primary components of non-interestexpense for the years ended December 31, 2009 and 2008.

 
| **(Dollars in thousands)**                         | ** ** | **2009** | ** ** | **2008**   | ** ** |
|----------------------------------------------------|------------|----------|------------|------------|------------|
| Salaries and benefits                              |       | $        | 5,235      |       | $          | 4,828 |   |
| Net occupancy                                      |       | 682      |       | 638        |       |
| Depreciation                                       |       | 735      |       | 718        |       |
| Equipment maintenance  and rental                  |       | 210      |       | 194        |       |
| Advertising                                        |       | 227      |       | 248        |       |
| Professional fees                                  |       | 351      |       | 449        |       |
| Office supplies                                    |       | 82       |       | 95         |       |
| Telephone                                          |       | 146      |       | 148        |       |
| Data processing                                    |       | 921      |       | 758        |       |
| FDIC assessment                                    |       | 1,136    |       | 226        |       |
| Writedown/loss on sale  of other real estate owned |       | 2,044    |       | —     |       |
| Writedown of  repossessed collateral               |       | 174      |       | —     |       |
| Other                                              |       | 1,727    |       | 1,209      |       |
| Total non-interest  expense                        | ** ** | **$**    | **13,670** | ** ** | **$**      | **9,511** | ** ** |

 

**Earning Assets**

 

***Loans****.*Loans are the largest category of earningassets and typically provide higher yields than the other types of earningassets.  Loans also entail greater creditand liquidity risks than most of the Company’s other investments and short-terminterest-earning cash and cash equivalents, which management attempts tocontrol and counterbalance.  Loansaveraged $305.5 million and $315.2 million in 2009 and 2008, respectively.Total loans were $275.1 million and $320.9 million at December 31, 2009and 2008, respectively.

 

The following table sets forth the composition of the loan portfolio bycategory for the five years ended December 31, 2009 and highlights theCompany’s general emphasis on mortgage lending.

 
| ** **                       | ** ** | **2009**   | ** **  | **2008**      | ** ** | **2007**   | ** ** | **2006**      | ** ** | **2005**   | ** ** |
|----------------------------------|------------|------------|-------------|---------------|------------|------------|------------|---------------|------------|------------|------------|
| ** **                       | ** ** | ** ** | ** **  | **Percent**   | ** ** | ** ** | ** ** | **Percent**   | ** ** | ** ** | ** ** | **Percent** | ** ** | ** ** | ** ** | **Percent** | ** ** | ** ** | ** ** | **Percent** | ** ** |
| **(Dollars  in thousands)**      | ** ** | **Amount** | ** **  | **Of  Total** | ** ** | **Amount** | ** ** | **Of  Total** | ** ** | **Amount** | ** ** | **Of  Total** | ** ** | **Amount** | ** ** | **Of  Total** | ** ** | **Amount** | ** ** | **Of  Total** | ** ** |
| Real estate —  construction |       | $          | 81,128      |          | 29.49      | %          | $          | 129,777       |       | 40.44      | %          | $ | 124,016 |   | 40.94 | % | $ | 69,021 |   | 31.71 | % | $ | 35,742 |   | 30.89 | % |
| Real estate —  mortgage     |       | 167,296    |        | 60.81         | %          | 154,838    |       | 48.25         | %          | 149,369    |       | 49.31 | % | 128,709 |   | 59.13 | % | 68,965 |   | 59.60 | % |
| Commercial and  industrial       |       | 25,028     |        | 9.10          | %          | 33,303     |       | 10.38         | %          | 26,095     |       | 8.61 | % | 17,239 |   | 7.92 | % | 9,082 |   | 7.85 | % |
| Consumer                         |       | 1,652      |        | 0.60          | %          | 2,989      |       | 0.93          | %          | 3,454      |       | 1.14 | % | 2,695 |   | 1.24 | % | 1,915 |   | 1.66 | % |
| Total loans,  gross              |       | 275,104    | ** **  | **100.00**    | **%**      | 320,907    | ** ** | **100.00**    | **%**      | 302,934    | ** ** | **100.00** | **%** | 217,664 | ** ** | **100.00** | **%** | 115,704 | ** ** | **100.00** | **%** |
| Allowance for  loan losses       |       | (12,963    | )           | ** **    |       | (8,088     | )          | ** **    |       | (4,214     | )          |   |   | (3,091 | ) | ** ** |   | (1,558 | ) |   |   |
| Net loans                        | ** ** | **$**      | **262,141** | ** **    | ** ** | ** ** | **$**      | **312,819**   | ** ** | ** ** | ** ** | **$** | **298,720** | ** ** | ** ** | ** ** | **$** | **214,573** |   |   | ** ** | **$** | **114,146** |   |   |   |

 

The largest component of loans in the Company’s loan portfolio is realestate mortgage loans.  At December 31,2009 and 2008, real estate mortgage loans, which consist of first and secondmortgages on single or multi-family residential dwellings, loans secured bycommercial and industrial real estate and other loans secured by multi-familyproperties and farmland, totaled $167.3 million and $154.8 million,respectively and represented 60.81% and 48.25%, respectively of the total loanportfolio.  In the context of thisdiscussion, a “real estate mortgage loan” is defined as any loan, other than aloan for construction purposes, secured by real estate, regardless of thepurpose of the loan.  It is commonpractice for financial institutions in the Company’s market area to obtain asecurity interest in real estate whenever possible, in addition to any otheravailable collateral.  This collateral istaken to reinforce the likelihood of the ultimate repayment of the loan andtends to increase the magnitude of the real estate loan portfoliocomponent.  Real estate mortgage loansrepresent $10.9 million or 37.3% of our impaired loans.

 

44

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The demand for residential and commercial real estate loans in theUpstate of South Carolina has been historically stable due to the historicallylow interest rate environment. Commercial real estate loans are generally viewed as having more risk ofdefault than residential real estate loans. They are also typically larger than residential real estate loans andconsumer loans and depend on cash flows from the owner’s business or theproperty to service the debt.  Cash flowsmay be affected significantly by general economic conditions (including risinginterest rates), a downturn in the local economy, or a decline in occupancyrates in the local economy where the property is located.  Because our loan portfolio contains a numberof commercial real estate loans with relatively large balances, thedeterioration of one or a few of these loans could cause a significant increasein our level of non-performing loans.  Anincrease in non-performing loans could result in a loss of earnings from theseloans, an increase in the related provision for loan losses and an increase incharge-offs, all of which could have a material adverse effect on our financialcondition and results of operations.

 

Real estate construction loans totaled $81.1 million and $129.8 millionat December 31, 2009 and 2008, respectively. In the context of thisdiscussion, a “real estate construction loan” is defined as any loan forconstruction purposes, secured by real estate. Real estate construction loans represent $28.5 million or 56.2% of ourimpaired loans.

 

Commercial and industrial loans totaled $25.0 million and $33.3 millionat December 31, 2009 and 2008, respectively and comprised 9.10% and10.38%, respectively of the total portfolio. In the context of this discussion,a “commercial and industrial loan” is defined as any loan for a non-consumerpurpose, not secured by real estate.

 

The Company’s loan portfolio also includes consumer loans.  At December 31, 2009 and 2008, consumerloans totaled $1.7 million and $3.0 million, respectively and represented 0.60%and 0.93%, respectively of the total loan portfolio.

 

The Company’s loan portfolio reflects the diversity of its upstateSouth Carolina market.  The Company’soffices are located in Easley, Spartanburg, Mauldin, Greer, Anderson and Greenville,South Carolina.  Management expects thearea to remain 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.

 

The repayment of loans in the loan portfolio as they mature is also asource of liquidity for the Company. Due to the current economic downturn, allcontractual maturities may not parallel actual payoffs due to the inability ofborrowers to repay their loans. The following tables set forth the Company’sloans maturing within specified intervals at December 31, 2009 and 2008.

 

**2009**

 
| ** **                           | ** ** | ** **   | ** **  | **Over One** | ** ** | ** **  | ** ** | ** ** | ** **  |
|--------------------------------------|------------|--------------|-------------|--------------|------------|-------------|------------|------------|-------------|
| ** **                           | ** ** | ** **   | ** **  | **Year**     | ** ** | ** **  | ** ** | ** ** | ** **  |
| ** **                           | ** ** | ** **   | ** **  | **Through**  | ** ** | **Over**    | ** ** | ** ** | ** **  |
| ** **                           | ** ** | **One Year** | ** **  | **Five**     | ** ** | **Five**    | ** ** | ** ** | ** **  |
| **(Dollars in thousands)**           | ** ** | **or Less**  | ** **  | **Years**    | ** ** | **Years**   | ** ** | **Total**  | ** **  |
| Real estate —  construction     |       | $            | 62,205      |         | $          | 18,762      |       | $          | 161         |   | $ | 81,128 |   |
| Real estate —  mortgage         |       | 47,712       |        | 97,429       |       | 22,155      |       | 167,296    |        |
| Commercial and  industrial           |       | 14,690       |        | 10,017       |       | 321         |       | 25,028     |        |
| Consumer                             |       | 539          |        | 802          |       | 311         |       | 1,652      |        |
|                                 | ** ** | **$**        | **125,146** | ** **   | **$**      | **127,010** | ** ** | **$**      | **22,948**  | ** ** | **$** | **275,104** | ** ** |
|                                 |       |         |        |         |       |        |       |       |        |
| Loans maturing  after one year with: |       |         |        |         |       |        |       |       |        |
| Fixed interest  rates                |       |         |        |         |       |        |       | $          | 140,182     |   |
| Floating  interest rates             |       |         |        |         |       |        |       | 9,776      |        |
|                                 |       |         |        |         |       |        | ** ** | **$**      | **149,958** | ** ** |

 

45

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**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** | ** ** |

 

The information presented in the above table is based on thecontractual maturities of the individual loans, including loans which may besubject to renewal at their contractual maturity.  Renewal of such loans is subject to reviewand credit approval as well as modification of terms upon their maturity.  Consequently, management believes thistreatment presents fairly the maturity and repricing structure of the loanportfolio shown in the above table.

 

***Investment Securities and OtherInvestments****.*The investment securities portfolio, which averaged $67.5 million and $47.1million in 2009 and 2008, respectively, is a component of the Company’s totalearning assets.  At December 31,2009 and 2008, the total investment securities portfolio was $105.2 million and$49.4 million, respectively.  Investmentsecurities were primarily marketable investments recorded at their fair value.Other investments consisted of FHLB stock recorded at cost.

 

The following table sets forth the amortized cost and fair value of thesecurities held by the Company for the three years ended December 31,2009.

 
| ** **                            | ** ** | **2009**                  | ** **  | **2008**              | ** ** | **2007**                  | ** ** |
|---------------------------------------|------------|---------------------------|-------------|-----------------------|------------|---------------------------|------------|
| **(Dollars in thousands)**            | ** ** | **Amortized********Cost** | ** **  | **Fair********Value** | ** ** | **Amortized********Cost** | ** ** | **Fair********Value** | ** ** | **Amortized********Cost** | ** ** | **Fair********Value** | ** ** |
| U.S. government agencies              |       | $                         | —      |                  | $          | —                    |       | $ | 19,001 |   | $ | 19,086 |   | $ | 15,487 |   | $ | 15,623 |   |
| Mortgage-backed securities            |       | 104,672                   |        | 103,538               |       | 27,768                    |       | 28,416 |   | 9,014 |   | 9,121 |   |
| Other securities                      |       | 100                       |        | 100                   |       | 100                       |       | 100 |   | 100 |   | 100 |   |
| Other investments                     |       | 1,599                     |        | 1,599                 |       | 1,805                     |       | 1,805 |   | 447 |   | 447 |   |
| Total investment securities portfolio | ** ** | **$**                     | **106,371** | ** **            | **$**      | **105,237**               | ** ** | **$** | **48,674** | ** ** | **$** | **49,407** | ** ** | **$** | **25,048** | ** ** | **$** | **25,291** | ** ** |

 

The following table sets forth securities maturing within specified intervals at December 31,2009 and their weighted average yields.

 
| ** **                  | ** ** | ** **    | ** ** | ** **    | ** ** | **Over  One** | ** ** | ** **    | ** ** | **Over  Five** | ** ** | ** **    | ** ** | ** **    | ** ** | ** **    | ** ** | ** **  | ** ** | ** **    | ** ** |
|-----------------------------|------------|---------------|------------|---------------|------------|---------------|------------|---------------|------------|----------------|------------|---------------|------------|---------------|------------|---------------|------------|-------------|------------|---------------|------------|
| ** **                  | ** ** | ** **    | ** ** | ** **    | ** ** | **Year**      | ** ** | ** **    | ** ** | **Years**      | ** ** | ** **    | ** ** | ** **    | ** ** | ** **    | ** ** | ** **  | ** ** | ** **    | ** ** |
| ** **                  | ** ** | ** **    | ** ** | **Weighted-** | ** ** | **Through**   | ** ** | **Weighted-** | ** ** | **Through**    | ** ** | **Weighted-** | ** ** | ** **    | ** ** | **Weighted-** | ** ** | ** **  | ** ** | **Weighted-** | ** ** |
| ** **                  | ** ** | **One  Year** | ** ** | **Average**   | ** ** | **Five**      | ** ** | **Average**   | ** ** | **Ten**        | ** ** | **Average**   | ** ** | **Over  Ten** | ** ** | **Average**   | ** ** | ** **  | ** ** | **Average**   | ** ** |
| **(Dollars  in thousands)** | ** ** | **or Less**   | ** ** | **Yield**     | ** ** | **Years**     | ** ** | **Yield**     | ** ** | **Years**      | ** ** | **Yield**     | ** ** | **Years**     | ** ** | **Yield**     | ** ** | **Total**   | ** ** | **Yield**     | ** ** |
| U.S. government  agencies   |       | $             | —     |          | —     | %             | $          | —        |       | —         | %          | $             | —     |          | —     | %             | $          | —      |       | —        | %          | $ | — |   | — | % |
| Mortgage-backed  securities |       | —        |       | —        | %          | —        |       | —        | %          | —         |       | —        | %          | 104,672       |       | 3.10          | %          | 104,672     |       | 3.10          | %          |
| Other securities            |       | —        |       | —        | %          | —        |       | —        | %          | —         |       | —        | %          | 100           |       | —        | %          | 100         |       | —        | %          |
| Other investments           |       | —        |       | —        | %          | —        |       | —        | %          | —         |       | —        | %          | 1,599         |       | —        | %          | 1,599       |       | —        | %          |
|                        | ** ** | **$**         | —     |          | —     | %             | **$**      | —        |       | —         | %          | **$**         | —     |          | —     | %             | **$**      | **106,371** | ** ** | **3.05**      | **%**      | **$** | **106,371** | ** ** | **3.05** | **%** |

 

***Short-Term Investments****.* Short-term investments, which consistprimarily of federal funds sold, averaged $16.7 million and $7.9 million in2009 and 2008, respectively with a weighted average yield of 0.26% and 3.04% in2009 and 2008, 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 31,2009 and 2008, federal funds were $31.0 million and $4.6 million at anannualized overnight rate of 0.14% and 0.50%, respectively. The maximumoutstanding balance of federal funds sold at any month end during the years2009 and 2008 was $31.0 million and $16.4 million, respectively.

 

46

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# **OtherReal Estate Owned and Repossessed Assets**

# ** **

Asof December 31, 2009 the Company had other real estate owned totaling $6.7million compared to $415,000 as of December 31, 2008.  Other real estate owned consists ofapproximately $2.2 million of residential properties, $4.0 million of land andapproximately $481,000 of commercial real estate.  Repossessed assets consist of approximately$902,000 of equipment and $40,000 of stock. Two properties were sold during the year ended December 31, 2009resulting in a loss of $143,000 and two repossessed assets were sold during theyear ended December 31, 2009 with no resulting loss.  Subsequent to repossession, based on new marketinformation, $2.1 million was charged to expense to write down the value ofother real estate owned and repossessed assets.

 

# **Deposits**

# ** **

***General. ***Average interest-bearing liabilitiestotaled $352.0 million and $325.8 million in 2009 and 2008, respectively.  Average total deposits totaled $334.1 millionand $307.7 million during 2009 and 2008, respectively.  At December 31, 2009 and 2008 totaldeposits were $376.6 million and $296.6 million, respectively.

 

The following table sets forth the average deposits of the Company bycategory for the year ended December 31, 2009, 2008 and 2007.

 
| ** **                   | ** ** | **2009**   | ** **  | **2008**    | ** ** | **2007**   | ** ** |
|------------------------------|------------|------------|-------------|-------------|------------|------------|------------|
| ** **                   | ** ** | ** ** | ** **  | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **(Dollars in thousands)**   | ** ** | **Amount** | ** **  | **Rate**    | ** ** | **Amount** | ** ** | **Rate** | ** ** | **Amount** | ** ** | **Rate** | ** ** |
| Non-interest  bearing demand |       | $          | 22,290      |        | —     | %          | $          | 23,739 |   | — | % | $ | 18,864 |   | — | % |
| Interest bearing  demand     |       | 18,247     |        | 1.20        | %          | 15,300     |       | 2.12 | % | 11,520 |   | 1.70 | % |
| Savings                      |       | 60,101     |        | 2.55        | %          | 18,881     |       | 1.18 | % | 19,107 |   | 3.39 | % |
| Time                         |       | 233,472    |        | 2.27        | %          | 249,765    |       | 4.36 | % | 228,748 |   | 5.32 | % |
| Total                        | ** ** | **$**      | **334,110** |        |       | ** ** | **$**      | **307,685** |   |   | ** ** | **$** | **278,239** |   |   |   |

 

The following table sets forth the deposits of theCompany by category as of December 31, 2009, 2008 and 2007.

 
| ** **                     | ** ** | **2009**   | ** **  | **2008**     | ** ** | **2007**   | ** ** |
|--------------------------------|------------|------------|-------------|--------------|------------|------------|------------|
| ** **                     | ** ** | ** ** | ** **  | **% of**     | ** ** | ** ** | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** |
| **(Dollars in thousands)**     | ** ** | **Amount** | ** **  | **Deposits** | ** ** | **Amount** | ** ** | **Deposits** | ** ** | **Amount** | ** ** | **Deposits** | ** ** |
| Non-interest  bearing demand   |       | $          | 21,829      |         | 5.80       | %          | $          | 22,162 |   | 7.47 | % | $ | 24,464 |   | 7.46 | % |
| Interest bearing  demand       |       | 18,588     |        | 4.94         | %          | 16,449     |       | 5.55 | % | 13,721 |   | 4.19 | % |
| Savings                        |       | 82,295     |        | 21.85        | %          | 14,461     |       | 4.87 | % | 24,634 |   | 7.52 | % |
| Time deposits  less than $100  |       | 30,054     |        | 7.98         | %          | 32,111     |       | 10.82 | % | 59,528 |   | 18.17 | % |
| Time deposits of  $100 or over |       | 21,014     |        | 5.58         | %          | 25,162     |       | 8.49 | % | 47,118 |   | 14.38 | % |
| Brokered  deposits             |       | 202,783    |        | 53.85        | %          | 186,298    |       | 62.80 | % | 158,199 |   | 48.28 | % |
| Total                          | ** ** | **$**      | **376,563** | ** **   | **100.00** | **%**      | **$**      | **296,643** | ** ** | **100.00** | **%** | **$** | **327,664** | ** ** | **100.00** | **%** |

 

Core deposits, which exclude certificates of depositof $100,000 or more and brokered deposits, provide a relatively stable fundingsource for the Company’s loan portfolio and other earning assets.  The Company’s core deposits were $152.8million and $85.2 million at December 31, 2009 and 2008, respectively, or40.6% and 28.7%, 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.

 

47

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For the years ended December 31, 2009 and 2008,our non-core deposits included wholesale funding in the form of brokered CDs of$202.8 million and $186.3 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 ourcurrent interest rate risk profile determines the terms and that we only acceptbrokered CDs from approved correspondents. These guidelines allow us to takeadvantage of the attractive terms that wholesale funding can offer whilemitigating the inherent related risk.

 

As of December 31, 2009, we had brokered depositsof $202.8 million, representing 53.85% of our total deposits, of which $79.7million are scheduled to mature in the third quarter of 2010 and $94.9 millionare scheduled to mature in the fourth quarter of 2010.  Because of the limitations on brokered depositsimposed by the MOU, the Consent Order, and our “undercapitalized” status, wemust find other sources of liquidity to replace these deposits as theymature.  Secondary sources of liquiditymay include proceeds from FHLB advances and federal funds lines of credit fromcorrespondent banks.  However, FHLB hasinformed us that due to our financial condition we are not currently permittedto receive any more advances.  As aresult, we must limit our growth, raise additional capital, or sell assets,which could materially and adversely affect our financial condition and resultsof operations.

 

In addition, because the Bank is “undercapitalized,”we cannot offer an effective yield in excess of 75 basis points on interestpaid on deposits (including brokered deposits, if approval is granted for theBank to accept them) of comparable size and maturity in either the Bank’snormal market area or in the market area in which such deposits would otherwisebe accepted.  Thus, for deposits in theBank’s own normal market area, the Bank must offer rates that are not in excessof 75 basis points over the average local rates.  For non-local deposits, the Bank must offerrates that are not in excess of 75 basis points over either (1) the Bank’sown local rates or (2) the applicable non-local rates.  In other words, the Bank must adhere to theprevailing rates in its own normal market area for all deposits (whether localor non-local) and also must adhere to the prevailing rates in the non-localarea for any non-local deposits.  Thus,the Bank will be unable to outbid non-local institutions for non-local depositseven if the non-local rates are lower than the rates in the Bank’s own normalmarket area.  Because of this interestrate cap, we may not be able to attract sufficient deposits to meet ourliquidity needs.  If this were to occur,the Bank may be placed into a federal conservatorship or receivership by theFDIC, with the FDIC appointed as conservator or receiver.

 

Deposits have been a primary source of funding.  Management anticipates that deposits willcontinue to be the Company’s primary source of funding in the future.  The Company’s loan-to-deposit ratio was73.06% and 108.17% at December 31, 2009 and 2008, respectively.  The maturity distribution of the Company’stime deposits of $100,000 or over at December 31, 2009 and 2008, is setforth in the following tables.

 

**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,  2009**                 |       |       | ** ** | ** **  | ** ** | ** **   | ** ** | ** **  | ** ** | ** **   | ** ** |
| Brokered Deposits                           |       | $          | 6,800      | ** **  | $          | 21,269       | ** ** | $           | 174,714    | ** **   | $          | — | ** ** | $ | 202,783 | ** ** |
| Certificates of deposit of $100,000 or more |       | 4,692      |       | 7,868       |       | 6,624        |       | 1,830       |       | 21,014       |       |
| Total                                       |       | $          | 11,492     |        | $          | 29,137       |       | $           | 181,338    |         | $          | 1,830 |   | $ | 223,797 |   |
|                                        |       |       |       |        |       |         |       |        |       |         |       |
| **December 31,  2008**                 |       |       | ** ** | ** **  | ** ** | ** **   | ** ** | ** **  | ** ** | ** **   | ** ** |
| Brokered Deposits                           |       | $          | 186,298    | ** **  | $          | —       | ** ** | $           | —     | ** **   | $          | — | ** ** | $ | 186,298 | ** ** |
| Certificates of deposit of $100,000 or more |       | 1,782      |       | 11,231      |       |  10,494 |       |  1,655 |       |  25,162 |       |
| Total                                       |       | $          | 188,080    |        | $          | 11,231       |       | $           | 10,494     |         | $          | 1,655 |   | $ | 211,460 |   |

 

Of the Company’s time deposits of $100,000 or over as of December 31,2009 and 2008, 5.14% and 88.94% had scheduled maturities within three months,respectively. As of December 31, 2009 and 2008, 99.18% and 99.22%,respectively, of the Company’s time deposits of $100,000 or over had maturitieswithin twelve months.

 

48

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# **OtherBorrowings**

# ** **

The following table outlines our various sources ofborrowed funds during the years ended December 31, 2009, 2008 and 2007,the amounts outstanding at the end of each period and the weighted-averageinterest rates paid for each borrowing source.

 
| ** **                                    | ** ** | ** **  | ** ** | **Period-** | ** ** | ** **  | ** ** | **Weighted-  Average** | ** ** | **Maximum   Outstanding** | ** ** |
|-----------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|------------------------|------------|---------------------------|------------|
| ** **                                    | ** ** | **Ending**  | ** ** | **End**     | ** ** | **Average** | ** ** | **Rate for**           | ** ** | **at any**                | ** ** |
| **(Dollars in thousands)**                    | ** ** | **Balance** | ** ** | **Rate**    | ** ** | **Balance** | ** ** | **Year**               | ** ** | **Month End**             | ** ** |
| **December 31,  2009**                   |       |        |       |        |       |        |       |                   |       |                      |       |
| Federal Home Loan Bank advances               |       | $           | —     |        | —     | %           | $          | 5,384                  |       | 1.34                      | %          | $ | 25,000 |   |
| Federal funds purchased                       |       | —      |       | —      | %          | 155         |       | 0.57                   | %          | 3,144                     |       |
| Federal reserve discount window               |       | —      |       | —      | %          | 63          |       | 0.00                   | %          | —                    |       |
| Securities sold under agreement to repurchase |       | 30,000      |       | 3.24        | %          | 30,000      |       | 3.25                   | %          | 30,000                    |       |
| Bank of  Tennessee note payable               |       | —      |       | —      | %          | 246         |       | 2.85                   | %          | 1,570                     |       |
| Subordinated  debt                            |       | 4,325       |       | 11.50       | %          | 4,325       |       | 11.50                  | %          | 4,325                     |       |
| ** **                                    |       |        |       |        |       |        |       |                   |       |                      |       |
| **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 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 couldimprove the levels of regulatory capital at the Bank. We raised $4.325 millionin additional capital 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 after September 30, 2011, at a premium, and maturein 2018. The subordinated debt has been structured to fully count as Tier 2regulatory capital on a consolidated basis.

 

Dueto diminishing cash available at the holding company level, if we are unable toraise additional capital, we will have to discontinue paying interest on thesubordinated debentures after the March 2010 payments due to lack offunds.

 

***Federal Home Loan Bank Advances, Fed Funds Lines of Credit and Federal Reserve Discount Window.***  Our other borrowings have traditionally included proceeds from FHLB advances and federal funds lines of credit from correspondent banks.  As of December 31, 2009, the FHLB has informed us that due to our financial condition we are not currently permitted to receive any more advances. At December 31, 2009, we had federal funds lines of credit with unrelated banks totaling $5 million.  These lines are available for general corporate purposes.  These lines may be terminated at any time based on our financial condition. We also have credit availability through the Federal Reserve Discount Window.  As of December 31, 2009, $5.9 million was available, based on qualifying collateral.  The Federal Reserve Discount Window borrowing capacity has been curtailed to only overnight terms, contingent upon credit approval for each transaction.  Availability of the Federal Reserve Discount Window may be terminated at any time by the Federal Reserve, and we can make no assurances that this funding source will continue to be available to us.

 

# **Capital**

# ** **

The FRB and bank regulatory agencies requirebank holding companies and financial institutions to maintain capital atadequate levels based on a percentage of assets and off-balance sheetexposures, adjusted for risk weights ranging from 0% to 100%.

 

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The FRB guidelines contain an exemption fromthe capital requirements for “small bank holding companies” which in 2006 wereamended to cover most bank holding companies with less than $500 million intotal assets that do not have a material amount of debt or equity securitiesoutstanding registered with the SEC. Although our class of common stock is registered under Section 12of the Securities Exchange Act, we believe that because our stock is not listedon any exchange or otherwise actively traded, the FRB will interpret its newguidelines to mean that we qualify as a small bank holding company.  Nevertheless, our Bank remains subject tothese capital requirements.  Failure tomeet minimum capital requirements can initiate certain mandatory and possiblyadditional discretionary actions by regulators that, if undertaken, could havea direct material effect on the Bank’s financial statements.  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 classifications are also subject to qualitative judgments by theregulators about components, risk weightings, and other factors.

 

Under the capital adequacy guidelines,regulatory capital is classified into two tiers.  These guidelines require an institution to maintaina certain level of Tier 1 and Tier 2 capital to risk-weighted assets.  Tier 1 capital consists of commonshareholders’ equity, excluding the unrealized gain or loss on securitiesavailable 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 are subject to variousregulatory capital requirements administered by the federal bankingagencies.  Under the regulations adoptedby the federal regulatory authorities, a bank will be categorized as:

 

·                  Well capitalized if theinstitution has a total risk-based capital ratio of 10.0% or greater, aTier 1 risk-based capital ratio of 6.0% or greater, a leverage ratio of5.0% or greater, and is not subject to any order or written directive by anysuch regulatory authority to meet and maintain a specific capital level for anycapital measure.

·                  Adequately capitalized ifthe institution has a total risk-based capital ratio of 8.0% or greater, aTier 1 risk-based capital ratio of 4.0% or greater, a leverage ratio of4.0% or greater, and is not categorized as well capitalized.

·                  Undercapitalized if theinstitution has a total risk-based capital ratio that is less than 8.0%, a Tier1 risk-based capital ratio of less than 4.0%, or a leverage ratio of less than4.0%.

·                  Significantlyundercapitalized if the institution has a total risk-based capital ratio ofless than 6.0%, a Tier 1 risk-based capital ratio of less than 3.0%, or aleverage ratio of less than 3.0%.

·                  Critically undercapitalizedif the institution’s tangible equity is equal to or less than 2.0% of averagequarterly tangible assets.

 

Inaddition, an institution may be downgraded to, or deemed to be in, a capitalcategory that is lower than indicated by its capital ratios if it is determinedto be in an unsafe or unsound condition or if it receives an unsatisfactoryexamination rating with respect to certain matters.  A bank’s capital category is determinedsolely for the purpose of applying prompt corrective action regulations, andthe capital category may not constitute an accurate representation of a bank’soverall financial condition or prospects for other purposes.

 

If a bank is not well capitalized,it cannot accept brokered deposits without prior FDIC approval and, if approvalis granted, cannot offer an effective yield in excess of 75 basis points on interestpaid on deposits of comparable size and maturity in such institution’s normalmarket area for deposits accepted from within its normal market area, ornational rate paid on deposits of comparable size and maturity for depositsaccepted outside the bank’s normal market area. Moreover, the FDIA generally prohibits a depository institutionfrom making any capital distributions (including payment of a dividend) orpaying any management fee to its parent holding company if the depositoryinstitution would thereafter be categorized as undercapitalized.Undercapitalized institutions are subject to growth limitations (anundercapitalized institution may not acquire another institution, establishadditional branch offices or engage in any new line of business unlessdetermined by the appropriate federal banking agency to be consistent with anaccepted capital restoration plan, or unless the FDIC determines that theproposed action will further the purpose of prompt corrective action) and arerequired to submit a capital restoration plan. The agencies may not accept acapital restoration plan without determining, among other things, that the planis based on realistic assumptions and is likely to succeed in restoring thedepository institution’s capital. In addition, for a capital restoration planto be acceptable, the depository institution’s parent holding company mustguarantee that the institution will comply with the capital restoration plan.The aggregate liability of the parent holding company is limited to the lesserof an amount equal to 5.0% of the depository institution’s total assets at thetime it became categorized as undercapitalized or the amount that is necessary(or would have been necessary) to bring the institution into compliance withall capital standards

 

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applicablewith respect to such institution as of the time it fails to comply with theplan. If a depository institution fails to submit an acceptable plan, it iscategorized as significantly undercapitalized.

 

Significantlyundercapitalized categorized depository institutions may be subject to a numberof requirements and restrictions, including orders to sell sufficient votingstock to become categorized as adequately capitalized, requirements to reducetotal assets, and cessation of receipt of deposits from correspondentbanks.  The appropriate federal bankingagency may take any action authorized for a significantly undercapitalizedinstitution if an undercapitalized institution fails to submit an acceptablecapital restoration plan or fails in any material respect to implement a planaccepted by the agency.  A criticallyundercapitalized institution is subject to having a receiver or conservatorappointed to manage its affairs and for loss of its charter to conduct bankingactivities.

 

Aninsured depository institution may not pay a management fee to a bank holdingcompany controlling that institution or any other person having control of theinstitution if, after making the payment, the institution would beundercapitalized.  In addition, aninstitution cannot make a capital distribution, such as a dividend or otherdistribution, that is in substance a distribution of capital to the owners ofthe institution if following such a distribution the institution would beundercapitalized.  Thus, if payment of sucha management fee or the making of such would cause a bank to becomeundercapitalized, it could not pay a management fee or dividend to the bankholding company.

 

As of December 31, 2009, the Bank wascategorized “undercapitalized” under the regulatory framework.

 

**Analysis of Regulatory Capital and Capital Ratios**

** **
| **(Dollars  in thousands)**                                         | ** ** | **2009**   | ** **  | **2008**   | ** ** |
|---------------------------------------------------------------------|------------|------------|-------------|------------|------------|
| Tier 1 capital                                                      |       | $          | 13,643      |       | $          | 30,836 |   |
| Tier 2 capital                                                      |       | 3,558      |        | 4,369      |       |
| Total qualifying  capital                                           | ** ** | **$**      | **17,201**  | ** ** | **$**      | **35,205** | ** ** |
|                                                                | ** ** | ** ** | ** **  | ** ** | ** ** |
| Risk-adjusted  total assets (including off-balance sheet exposures) | ** ** | **$**      | **275,206** | ** ** | **$**      | **345,829** | ** ** |
|                                                                |       |       |        |       |       |
| Total risk-based  capital ratio                                     |       | 6.25       | %           | 10.18      | %          |
| Tier 1  risk-based capital ratio                                    |       | 4.96       | %           | 8.92       | %          |
| Tier 1 leverage  ratio                                              |       | 3.12       | %           | 7.98       | %          |

 

Ourloss for 2009 has adversely impacted our capital. As a result, we have beenpursuing a plan to increase our capital ratios in order to strengthen ourbalance sheet and satisfy the commitments required under the Consent Order thatwe entered into with the FDIC and the South Carolina Board of Financial Institutionson February 23, 2010. In addition, the Consent Order requires us toachieve and maintain, by May 24, 2010, Total Risk Based capital at leastequal to 10% of risk-weighted assets and Tier 1 capital at least equal to 8% oftotal assets.

 

**Off-Balance Sheet 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, 2009 and2008, the Bank had issued commitments, including standby letters of credit, toextend credit of $16.0 million and $39.7 million, respectively through varioustypes of commercial lending arrangements.

 

The following tables set forth the length oftime until maturity for unused commitments to extend credit at December 31,2009 and 2008.

 

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| ** **                           | ** ** | ** ** | ** ** | **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,  2009**          |       |       | ** ** | ** **  |       |        | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** |
| Unused  commitments to extend credit |       | $          | 2,397      |        | $          | 1,117       |       | $          | 4,385      |        | $          | 7,899      |       | $ | 6,552 |   | $ | 14,451 |   |
| Standby letters  of credit           |       | 74         |       | 321         |       | 680         |       | 1,075      |       | 450         |       | 1,525      |       |
|                                 | ** ** | **$**      | **2,471**  | ** **  | **$**      | **1,438**   | ** ** | **$**      | **5,065**  | ** **  | **$**      | **8,974**  | ** ** | **$** | **7,002** | ** ** | **$** | **15,976** | ** ** |
|                                 |       |       |       |        |       |        |       |       |       |        |       |       |       |
| **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** | ** ** |

 

Approximately $11.4 million and $30.9 million ofthese commitments to extend credit had variable rates as of December 31,2009 and 2008, 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**

 

We have adopted variousaccounting policies that govern the application of accounting principlesgenerally accepted in the United States of America and with general practiceswithin the banking industry in the preparation of our financialstatements.  Our significant accountingpolicies are described in Note 1 to the financial statements in Item 1.

 

Certain accounting policies involvesignificant judgments and assumptions by us that have a material impact on thecarrying value of certain assets and liabilities.  We consider these accounting policies to becritical accounting policies.  Thejudgments and assumptions we use are based on historical experience and otherfactors, which we believe to be reasonable under the circumstances.  Because of the nature of the judgments andassumptions we make, actual results could differ from these judgments andestimates that could have a material impact on the carrying values of ourassets and liabilities and our results of operations.

 

We believe the allowance for loan losses is the critical accounting policy that requires the most significant judgments and estimates used in preparation of our consolidated financial statements.  Some of the more critical judgments supporting the amount of our allowance for loan losses include judgments about the credit worthiness of borrowers, the estimated value of the underlying collateral, the assumptions about cash flows, the determination of loss factors for estimating credit losses, the impact of current events, and conditions, and other factors impacting the level of probable inherent losses.  Under different conditions or using different assumptions, the actual amount of credit losses incurred by us may be different from management’s estimates provided in our consolidated financial statements.  Refer to the portion of this discussion that addresses our allowance for loan losses for a more complete discussion of our processes and methodology for determining our allowance for loan losses.

 

*Allowance for Loan Losses*

 

Theallowance for loan losses represents an amount that we believe will be adequateto absorb probable losses on existing loans that may becomeuncollectible. Assessing the adequacy of the allowance for loan losses isa process that requires considerable judgment. Our judgment in determiningthe adequacy of the allowance is based on evaluations of the collectability ofloans, including consideration of factors such as the balance of impairedloans; the quality, mix and size of our overall loan portfolio; economicconditions that may affect the borrower’s ability to repay; the amount andquality of collateral securing the loans; our historical loan loss experience;and a review of specific problem loans. We adjust the amount of theallowance periodically based on changing circumstances as a component of theprovision for loan losses. We charge recognized losses against theallowance and add subsequent recoveries back to the allowance.

 

Wecalculate the allowance for loan losses for specific types of loans andevaluate the adequacy on an overall portfolio basis utilizing our creditgrading system which we apply to each loan.  We combine our estimates ofthe reserves needed for each

 

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componentof the portfolio, including loans analyzed on a pool basis and loans analyzedindividually.  The allowance is divided into two portions: (1) anamount for specific allocations on significant individual credits and (2) ageneral reserve amount.

 

*Specific Reserve*

 

Weanalyze individual loans within the portfolio and make allocations to theallowance based on each individual loan’s specific factors and othercircumstances that affect the collectability of the credit. Significantindividual credits classified as doubtful or substandard/special mention withinour credit grading system require both individual analysis and specificallocation.

 

Loansin the substandard category are characterized by deterioration in qualityexhibited by any number of well-defined weaknesses requiring corrective actionsuch as declining or negative earnings trends and declining or inadequate liquidity. Loans in the doubtful category exhibit the same weaknesses found in thesubstandard loan; however, the weaknesses are more pronounced.  Theseloans, however, are not yet rated as loss because certain events may occurwhich could salvage the debt such as injection of capital, alternativefinancing, or liquidation of assets.

 

Inthese situations where a loan is determined to be impaired (primarily becauseit is probable that all principal and interest due according to the terms ofthe loan agreement will not be collected as scheduled), the loan is excludedfrom the general reserve calculations described below and is assigned aspecific reserve.  We calculate specific reserves on those impairedloans exceeding $250,000.  These reserves are based on a thoroughanalysis of the most probable source of repayment which is usually theliquidation of the underlying collateral, but may also include discountedfuture cash flows or, in rare cases, the market value of the loan itself.

 

Generally,for larger collateral dependent loans, current market appraisals are ordered toestimate the current fair value of the collateral.  However, insituations where a current market appraisal is not available, management usesthe best available information (including recent appraisals for similarproperties, communications with qualified real estate professionals,information contained in reputable trade publications and other observablemarket data) to estimate the current fair value.  The estimated coststo sell the subject property are then deducted from the estimated fair value toarrive at the “net realizable value” of the loan and to determine the specificreserve on each impaired loan reviewed.  The credit risk managementgroup periodically reviews the fair value assigned to each impaired loan andadjusts the specific reserve accordingly.

 

*General Reserve*

 

Wecalculate our general reserve based on a percentage allocation for each of thecategories of the following unclassified loan types such as:  real estate,commercial, consumer, A&D/construction and mortgage.  We applyour historical trend loss factors to each category and adjust these percentagesfor qualitative or environmental factors, as discussed below.  Thegeneral estimate is then added to the specific allocations made to determinethe amount of the total allowance for loan losses.

 

Wealso maintain our general reserve in accordance with December 2006regulatory interagency guidance in our assessment of the loan lossallowance.  This general reserve considers qualitative orenvironmental factors that are likely to cause estimated credit lossesincluding, but not limited to:  changes in delinquent loan trends,trends in risk grades and net chargeoffs, concentrations of credit, trends inthe nature and volume of the loan portfolio, general and local economic trends,collateral valuations, the experience and depth of lending management andstaff, lending policies and procedures, the quality of loan review systems, andother external factors.

 

Thecurrent economic environment has adversely affected our general reserverequirement.  Historical data,environmental factors and loan trends have all deteriorated over the pastyear.  This has resulted in a largercalculated general reserve requirement than compared to a year ago.

 

*OtherReal Estate Owned*

 

Weobtain current appraisals upon possession of all properties to be held as otherreal estate owned and adjust property values as appropriate.  Updated appraisals are obtained periodicallyand further adjustments are also made as appropriate based on general marketconditions and other related factors.

 

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**Liquidity Management**

 

Liquidity is the  ability  to meet  current  and future  obligations  through liquidation or maturity ofexisting  assets or the  acquisition of  liabilities. We manage both assets and liabilities to achieve appropriate levels ofliquidity.  Cash, federal funds andinvestments available for sale are our primary sources of asset liquidity.  These funds provide a cushion againstshort-term fluctuations in cash flow from both deposits and loans.  Historically, individual and commercialdeposits have been our primary source of funds for credit activities.  These include brokered deposits, whichcomprise 54% of our deposit base as of December 31, 2009.  These have proven to be a reliable source offunds.  However, pursuant to the MOU, theConsent Order, and our current financial condition, our ability to accessbrokered deposits through the wholesale funding market is restricted.  Specifically, the Consent Order will restrictthe Bank’s ability to accept, renew, or rollover brokered deposits.  Management believes that this will not haveany liquidity impact in the first or second quarter of 2010 due to the extendedmaturities of the brokered deposits, but would cause funding issues in thethird and fourth quarters of 2010.  Withaccess to the brokered deposit market unavailable, the Bank must replace thosefunds with local deposits.  Depositbalances, net of brokered deposits, have increased $63.4 million from December 31,2008 to December 31, 2009.  This wasdue to intentional restructuring to replace brokered deposits with localdeposits.  We anticipate that our fundingcost and funding mix will now remain stable until the maturity of the brokereddeposits in the third quarter of 2010.

 

In addition to our on balance sheet sources of funds, we also rely on off-balance sheet lines of credit.  At December 31, 2009, we had lines of credit with unrelated banks totaling $5 million.  These lines are available for general corporate purposes.  These lines may be terminated at any time based on our financial condition. We also have credit availability through the Federal Reserve Discount Window.  As of December 31, 2009, $5.9 million was available, based on qualifying collateral.  The Federal Reserve Discount Window borrowing capacity has been curtailed to only overnight terms, contingent upon credit approval for each transaction.  Availability of the Federal Reserve Discount Window may be terminated at any time by the Federal Reserve, and we can make no assurances that this funding source will continue to be available to us.  The FHLB has informed us that due to our financial condition we are not permitted to receive any more advances.

 

Following the execution of the Consent Orderwith the FDIC and the South Carolina Board of Financial Institutions, we willbe required to revise our comprehensive liquidity risk management program.  This program will assess our current and projectedfunding needs to ensure that sufficient funds or access to funds exist to meetthose needs.  The program must alsoinclude effective methods to achieve and maintain sufficient liquidity and tomeasure and monitor liquidity risk including the preparation and submission ofliquidity reports on a regular basis to the FDIC.  The program will also contain a contingencyfunding plan that forecasts funding needs and funding sources under differentstress scenarios.  This plan will detailhow the Bank will comply with the restrictions in the Consent Order, includingthe restriction against brokered deposits, as well as require reports detailingall funding sources and obligations under best case and worse case scenarios.

 

The level of liquidity is measured by the cash, cash equivalents and securities available for sale to total assets ratio, which was at 23.8% at December 31, 2009. We anticipate that this will increase with the combination of deposit growth and shrinkage of assets in 2010.

 

Webelieve our liquidity sources are adequate to meet our first and second quarterneeds.  However, based on current sourcesof liquidity, our sources may be insufficient in the third quarter of 2010. Seesection “Maturities of Certificates of Deposit of $100,000 or More (IncludingBrokered Deposits)” above. If this were to occur, the Bank may be placed into afederal conservatorship or receivership by the FDIC, with the FDIC appointed asconservator or receiver.

 

**Impact of Inflation**

 

Unlike most industrial companies, the assets and liabilities offinancial institutions such as the Bank are primarily monetary in nature.  Therefore, interest rates have a moresignificant effect on the Bank’s performance than do the effects of changes inthe 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.

 

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**Recently Issued AccountingStandards**

 

Accounting standards and pronouncements of a recent nature arediscussed in Notes to Consolidated Financial Statements, Note 1 - Summary ofSignificant Accounting Policies.  Otheraccounting standards that have been issued or proposed by authoritativestandards-setting bodies that do not require adoption until a future date arenot expected to have a material impact on the consolidated financial statementsupon adoption.

 

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**Item 8. Financial Statements and Supplementary Data.**

 

 

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

To the Shareholders andBoard of Directors

CommunitySouth FinancialCorporation and Subsidiary

Easley, South Carolina

 

We have audited the accompanying consolidated balance sheets ofCommunitySouth Financial Corporation and Subsidiary (the “Company”) as of December 31,2009 and 2008, and the related consolidated statements of operations, changesin shareholders’ equity and comprehensive income, and cash flows for the yearsthen ended.  These financial statementsare the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States).  Those standards require that we plan andperform the audits to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the financial statements.  An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position ofCommunitySouth Financial Corporation and Subsidiary as of December 31,2009 and 2008 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.

 

The accompanying consolidated financialstatements have been prepared assuming that the Company will continue as agoing concern.  As discussed in Note 2 tothe consolidated financial statements, the Company’s subsidiary bank (the“Bank”) has significant capital and liquidity issues.  The Company has incurred approximately $19 millionand $3 million in losses during 2009 and 2008, respectively, and the Bank is“undercapitalized” under regulatory capital guidelines.  In addition to being “undercapitalized”,effective February 23, 2010, the Bank became subject to a regulatoryConsent Order with the Federal Deposit Insurance Corporation (“FDIC”) and theSouth Carolina Board of Financial Institutions. The uncertainty of the Company’s ability to obtain sufficient capital aswell as the uncertainty of the Bank’s liquidity raises substantial doubt aboutthe Company’s ability to continue as a going concern.  The consolidated financial statements do notinclude any adjustments that might result from the outcome of this uncertainty.Management’s plans in regard to these matters are described in Note 2.

 

We were not engaged to examine management’s assessment of theeffectiveness of the Company’s internal control over financial reporting as of December 31,2009 included in the accompanying Management’s Report on Internal Controls OverFinancial Reporting and, accordingly, we do not express an opinion thereon.

 

 

Greenville, South Carolina

February 26, 2010

 

56

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** **

**COMMUNITYSOUTH FINANCIALCORPORATION**

**CONSOLIDATED BALANCE SHEETS**

(dollars in thousands)

 
| ** **                                                                                                                                                                                                                        | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                        | ** ** | **2009**              | ** ** | **2008** | ** ** |
|                                                                                                                                                                                                                              |       |                  |       |   |   |
| **Assets**                                                                                                                                                                                                                        |       |                  |       |   |   |
|                                                                                                                                                                                                                              |       |                  |       |   |   |
| Cash  and cash equivalents                                                                                                                                                                                                        |       |                  |       |   |   |
| Cash  and due from bank                                                                                                                                                                                                           |       | $                     | 6,876      |   | $ | 5,251 |   |
| Federal  funds sold                                                                                                                                                                                                               |       | 31,043                |       | 4,625 |   |
| Total  cash and cash equivalents                                                                                                                                                                                                  |       | 37,919                |       | 9,876 |   |
| Investment  securities, available for sale                                                                                                                                                                                        |       | 103,638               |       | 47,602 |   |
| Other  investments, at cost                                                                                                                                                                                                       |       | 1,599                 |       | 1,805 |   |
| Loans,  net of allowance for loan losses of $12,963 and $8,088 in 2009 and 2008,  respectively                                                                                                                                    |       | 262,141               |       | 312,819 |   |
| Accrued  interest receivable                                                                                                                                                                                                      |       | 1,440                 |       | 1,628 |   |
| Property  and equipment, net                                                                                                                                                                                                      |       | 3,867                 |       | 4,618 |   |
| Bank-owned  life insurance                                                                                                                                                                                                        |       | —                |       | 5,437 |   |
| Other  real estate owned                                                                                                                                                                                                          |       | 6,703                 |       | 415 |   |
| Repossessed  collateral                                                                                                                                                                                                           |       | 942                   |       | — |   |
| Other  assets                                                                                                                                                                                                                     |       | 3,285                 |       | 3,616 |   |
|                                                                                                                                                                                                                              |       |                  |       |   |   |
| Total  assets                                                                                                                                                                                                                     |       | $                     | 421,534    |   | $ | 387,816 |   |
|                                                                                                                                                                                                                              |       |                  |       |   |   |
| **Liabilities and Shareholders’  Equity**                                                                                                                                                                                    |       |                  |       |   |   |
| ** **                                                                                                                                                                                                                        |       |                  |       |   |   |
| **Liabilities**                                                                                                                                                                                                                   |       |                  |       |   |   |
| Deposits                                                                                                                                                                                                                          |       |                  |       |   |   |
| Non-interest  bearing                                                                                                                                                                                                             |       | $                     | 21,829     |   | $ | 22,162 |   |
| Interest  bearing                                                                                                                                                                                                                 |       | 354,734               |       | 274,481 |   |
| Total  deposits                                                                                                                                                                                                                   |       | 376,563               |       | 296,643 |   |
| Repurchase  agreements                                                                                                                                                                                                            |       | 30,000                |       | 30,000 |   |
| Federal  Home Loan Bank advances                                                                                                                                                                                                  |       | —                |       | 25,000 |   |
| Note  payable                                                                                                                                                                                                                     |       | —                |       | 1,570 |   |
| Subordinated  debt                                                                                                                                                                                                                |       | 4,325                 |       | 4,325 |   |
| Accrued  expenses                                                                                                                                                                                                                 |       | 665                   |       | 193 |   |
| Accrued  interest payable                                                                                                                                                                                                         |       | 1,307                 |       | 1,406 |   |
| Other  liabilities                                                                                                                                                                                                                |       | 3                     |       | 151 |   |
|                                                                                                                                                                                                                              |       |                  |       |   |   |
| Total  liabilities                                                                                                                                                                                                                |       | 412,863               |       | 359,288 |   |
|                                                                                                                                                                                                                              |       |                  |       |   |   |
| 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 35,000,000 shares authorized at  December 31, 2009, and 10,000,000 shares authorized at December 31,  2008; 4,698,697 issued and outstanding at December 31, 2009 and 2008 |       | 47                    |       | 47 |   |
| Additional  paid-in capital                                                                                                                                                                                                       |       | 29,824                |       | 29,760 |   |
| Accumulated  other comprehensive income (loss)                                                                                                                                                                                    |       | (1,134                | )          | 491 |   |
| Retained  deficit                                                                                                                                                                                                                 |       | (20,066               | )          | (1,770 | ) |
|                                                                                                                                                                                                                              |       |                  |       |   |   |
| Total  shareholders’ equity                                                                                                                                                                                                  |       | 8,671                 |       | 28,528 |   |
|                                                                                                                                                                                                                              |       |                  |       |   |   |
| Total  liabilities and shareholders’ equity                                                                                                                                                                                  |       | $                     | 421,534    |   | $ | 387,816 |   |

 

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

 

57

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**COMMUNITYSOUTH FINANCIAL CORPORATION**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

(dollars in thousands, except per share data)

 
| ** **                                                  | ** ** | **For the years ended  December 31,** | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                  | ** ** | **2009**                                   | ** ** | **2008** | ** ** |
| **Interest  income**                                        |       |                                       |       |   |   |
| Interest  and fees on loans                                 |       | $                                          | 16,959     |   | $ | 20,163 |   |
| Interest  and dividends on investments                      |       | 2,269                                      |       | 2,548 |   |
| Total  interest income                                      |       | 19,228                                     |       | 22,711 |   |
|                                                        |       |                                       |       |   |   |
| **Interest  expense**                                       |       | 8,599                                      |       | 12,580 |   |
| Net  interest income                                        |       | 10,629                                     |       | 10,131 |   |
|                                                        |       |                                       |       |   |   |
| **Provision  for loan losses**                              |       | 16,990                                     |       | 7,168 |   |
|                                                        |       |                                       |       |   |   |
| Net  interest income (loss) after provision for loan losses |       | (6,361                                     | )          | 2,963 |   |
|                                                        |       |                                       |       |   |   |
| **Non-interest  income**                                    |       |                                       |       |   |   |
| Mortgage  origination fees                                  |       | 709                                        |       | 470 |   |
| Gain  on sale of investments                                |       | 1,162                                      |       | — |   |
| Other                                                       |       | 852                                        |       | 922 |   |
| Total  non-interest income                                  |       | 2,723                                      |       | 1,392 |   |
|                                                        |       |                                       |       |   |   |
| **Non-interest  expense**                                   |       |                                       |       |   |   |
| Salaries  and benefits                                      |       | 5,235                                      |       | 4,828 |   |
| Occupancy                                                   |       | 682                                        |       | 638 |   |
| Depreciation                                                |       | 735                                        |       | 718 |   |
| Equipment  maintenance and rental                           |       | 210                                        |       | 194 |   |
| Advertising                                                 |       | 227                                        |       | 248 |   |
| Professional  fees                                          |       | 351                                        |       | 449 |   |
| Office  supplies                                            |       | 82                                         |       | 95 |   |
| Telephone                                                   |       | 146                                        |       | 148 |   |
| Data  processing                                            |       | 921                                        |       | 758 |   |
| FDIC  Assessment                                            |       | 1,136                                      |       | 226 |   |
| Writedown/loss  on sale of other real estate owned          |       | 2,044                                      |       | — |   |
| Writedown  of repossessed collateral                        |       | 174                                        |       | — |   |
| Other                                                       |       | 1,727                                      |       | 1,209 |   |
| Total  non-interest expense                                 |       | 13,670                                     |       | 9,511 |   |
|                                                        |       |                                       |       |   |   |
| **Loss  before income taxes**                               |       | (17,308                                    | )          | (5,156 | ) |
|                                                        |       |                                       |       |   |   |
| **Income  tax expense (benefit)**                           |       | 988                                        |       | (1,806 | ) |
|                                                        |       |                                       |       |   |   |
| **Net  loss**                                               |       | $                                          | (18,296    | ) | $ | (3,350 | ) |
|                                                        |       |                                       |       |   |   |
| **Loss  per share**                                         |       |                                       |       |   |   |
| **Basic**                                                   |       | $                                          | (3.89      | ) | $ | (0.71 | ) |
| **Diluted**                                                 |       | $                                          | (3.89      | ) | $ | (0.71 | ) |
| Weighted  average basic shares outstanding                  |       | 4,698,697                                  |       | 4,698,697 |   |
| Weighted  average diluted shares outstanding                |       | 4,698,697                                  |       | 4,698,697 |   |

 

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

 

58

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**COMMUNITYSOUTH FINANCIAL CORPORATION**

**CONSOLIDATED STATEMENTS OFCHANGES IN**

**SHAREHOLDERS’ EQUITY ANDCOMPREHENSIVE INCOME**

**For the years ended December 31,2009 and December 31, 2008**

(dollars in thousands)

** **
| ** **                                                                               | ** ** | ** **        | ** ** | ** **  | ** ** | **Additional**    | ** ** | **Accumulated  Other** | ** ** | **Retained**           | ** ** | **Total**         | ** ** | **Total**          | ** ** |
|------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------|------------|-------------------|------------|------------------------|------------|------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                                                                               | ** ** | **Common  Stock** | ** ** | **Paid-in** | ** ** | **Comprehensive** | ** ** | **Earnings  /**        | ** ** | **Shareholders’** | ** ** | **Comprehensive** | ** ** |
| ** **                                                                               | ** ** | **Shares**        | ** ** | **Amount**  | ** ** | **Capital**       | ** ** | **Income  (Loss)**     | ** ** | **(Deficit)**          | ** ** | **Equity**        | ** ** | **Income  (Loss)** | ** ** |
| **Balance at December 31, 2007**                                                    | ** ** | **4,698,697**     | ** ** | **$**       | **47**     | ** **        | **$**      | **29,691**             | ** ** | **$**                  | **152**    | ** **        | **$**      | **1,580**          | ** ** | **$** | **31,470** |   |   |   |
|                                                                                     |       |              |       |        |       |              |       |                   |       |                   |       |              |       |               |       |
| Net  loss                                                                                |       | —            |       | —      |       | —            |       | —                 |       | (3,350                 | )          | (3,350            | )          | $                  | (3,350     | ) |
|                                                                                     |       |              |       |        |       |              |       |                   |       |                   |       |              |       |               |       |
| Other  comprehensive income (loss):                                                      |       |              |       |        |       |              |       |                   |       |                   |       |              |       |               |       |
|                                                                                     |       |              |       |        |       |              |       |                   |       |                   |       |              |       |               |       |
| Unrealized  gains (losses) on securities, net of income taxes of $149,000                |       | —            |       | —      |       | —            |       | 339                    |       | —                 |       | 339               |       | 339                |       |
|                                                                                     |       |              |       |        |       |              |       |                   |       |                   |       |              |       |               |       |
| Total  comprehensive loss                                                                |       |              |       |        |       |              |       |                   |       |                   |       |              |       | $                  | (3,011     | ) |
|                                                                                     |       |              |       |        |       |              |       |                   |       |                   |       |              |       |               |       |
| Stock  based compensation                                                                |       | —            |       | —      |       | 69                |       | —                 |       | —                 |       | 69                |       |               |       |
|                                                                                     |       |              |       |        |       |              |       |                   |       |                   |       |              |       |               |       |
| **Balance at December 31, 2008**                                                    | ** ** | **4,698,697**     | ** ** | **$**       | **47**     | ** **        | **$**      | **29,760**             | ** ** | **$**                  | **491**    | ** **        | **$**      | **(1,770**         | **)**      | **$** | **28,528** |   |   |   |
|                                                                                     |       |              |       |        |       |              |       |                   |       |                   |       |              |       |               |       |
| Net  loss                                                                                |       | —            |       | —      |       | —            |       | —                 |       | (18,296                | )          | (18,296           | )          | $                  | (18,296    | ) |
|                                                                                     |       |              |       |        |       |              |       |                   |       |                   |       |              |       |               |       |
| Other  comprehensive income (loss):                                                      |       |              |       |        |       |              |       |                   |       |                   |       |              |       |               |       |
|                                                                                     |       |              |       |        |       |              |       |                   |       |                   |       |              |       |               |       |
| Unrealized  gains (losses) on securities, net of income taxes of $0                      |       | —            |       | —      |       | —            |       | (858                   | )          | —                 |       | (858              | )          | (858               | )          |
|                                                                                     |       |              |       |        |       |              |       |                   |       |                   |       |              |       |               |       |
| Reclassification  adjustment for gains included in net loss, net of income taxes of $395 |       | —            |       | —      |       | —            |       | (767                   | )          | —                 |       | (767              | )          | (767               | )          |
|                                                                                     |       |              |       |        |       |              |       |                   |       |                   |       |              |       |               |       |
| Total  comprehensive loss                                                                |       |              |       |        |       |              |       |                   |       |                   |       |              |       | $                  | (19,921    | ) |
|                                                                                     |       |              |       |        |       |              |       |                   |       |                   |       |              |       |               |       |
| Stock  based compensation                                                                |       | —            |       | —      |       | 64                |       | —                 |       | —                 |       | 64                |       |               |       |
|                                                                                     |       |              |       |        |       |              |       |                   |       |                   |       |              |       |               |       |
| **Balance at December 31, 2009**                                                    | ** ** | **4,698,697**     | ** ** | **$**       | **47**     | ** **        | **$**      | **29,824**             | ** ** | **$**                  | **(1,134** | **)**             | **$**      | **(20,066**        | **)**      | **$** | **8,671** |   |   |   |

 

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

 

59

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**COMMUNITYSOUTH FINANCIALCORPORATION**

**CONSOLIDATED STATEMENTS OF CASHFLOWS**

(dollars in thousands)

*** ***
| ** **                                                            | ** ** | **For the years ended  December 31,** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                            | ** ** | **2009**                                   | ** ** | **2008** | ** ** |
| **Operating activities**                                              |       |                                       |       |   |   |
| Net  loss                                                             |       | $                                          | (18,296    | ) | $ | (3,350 | ) |
| Adjustments  to reconcile net loss to net cash provided by            |       |                                       |       |   |   |
| operating  activities:                                                |       |                                       |       |   |   |
| Provision  for loan losses                                            |       | 16,990                                     |       | 7,168 |   |
| Stock  based compensation                                             |       | 64                                         |       | 69 |   |
| Depreciation                                                          |       | 735                                        |       | 718 |   |
| Writedown  of other real estate owned                                 |       | 1,901                                      |       | — |   |
| Loss  on sale of other real estate owned                              |       | 143                                        |       | — |   |
| Writedown  of repossessed collateral                                  |       | 174                                        |       | — |   |
| Loss  on disposal of equipment                                        |       | 1                                          |       | — |   |
| Appreciation  of bank-owned life insurance                            |       | (51                                        | )          | (211 | ) |
| Deferred  income tax expense (benefit)                                |       | 90                                         |       | (2,273 | ) |
| Decrease  in accrued interest receivable                              |       | 188                                        |       | 464 |   |
| Decrease  in accrued interest payable                                 |       | (99                                        | )          | (1,833 | ) |
| Increase  (decrease) in accrued expenses                              |       | 472                                        |       | (235 | ) |
| Decrease  (increase) in other assets                                  |       | 483                                        |       | (598 | ) |
| Increase  (decrease) in other liabilities                             |       | (148                                       | )          | 84 |   |
| Net  cash provided by operating activities                            |       | 2,647                                      |       | 3 |   |
|                                                                  |       |                                       |       |   |   |
| **Investing activities**                                              |       |                                       |       |   |   |
| Net  decrease (increase) in loans outstanding                         |       | 22,623                                     |       | (21,267 | ) |
| Purchase  of investments and FHLB stock                               |       | (171,608                                   | )          | (23,625 | ) |
| Sale/call/maturity  of investments and FHLB stock                     |       | 113,911                                    |       | — |   |
| Disposal  (purchase) of property and equipment                        |       | 15                                         |       | (262 | ) |
| Sale  of bank-owned life insurance                                    |       | 5,488                                      |       | — |   |
| Sale  of other real estate owned                                      |       | 1,295                                      |       | — |   |
| Sale  of repossessed collateral                                       |       | 322                                        |       | — |   |
| Net  cash used in investing activities                                |       | (27,954                                    | )          | (45,154 | ) |
|                                                                  |       |                                       |       |   |   |
| **Financing****activities**                                           |       |                                       |       |   |   |
| Net  increase (decrease) in deposit accounts                          |       | 79,920                                     |       | (31,020 | ) |
| Increase  in repurchase agreements                                    |       | —                                     |       | 15,000 |   |
| Proceeds  from and (repayment) of Federal Home Loan Bank advances     |       | (25,000                                    | )          | 25,000 |   |
| Subordinated  debt issuance                                           |       | —                                     |       | 4,325 |   |
| Proceeds  from and (repayment) of Bank of Tennessee note payable      |       | (1,570                                     | )          | 1,570 |   |
| Net  cash provided by financing activities                            |       | 53,350                                     |       | 14,875 |   |
|                                                                  |       |                                       |       |   |   |
| Net  increase (decrease) in cash and cash equivalents                 |       | 28,043                                     |       | (30,276 | ) |
|                                                                  |       |                                       |       |   |   |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF YEAR**                     |       | 9,876                                      |       | 40,152 |   |
|                                                                  |       |                                       |       |   |   |
| **CASH  AND CASH EQUIVALENTS, END OF YEAR**                           | ** ** | **$**                                      | **37,919** | ** ** | **$** | **9,876** | ** ** |
|                                                                  |       |                                       |       |   |   |
| **SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION**                 |       |                                       |       |   |   |
| Cash  paid for:                                                       |       |                                       |       |   |   |
| Interest                                                              | ** ** | **$**                                      | **8,698**  | ** ** | **$** | **14,412** | ** ** |
| Income  taxes                                                         | ** ** | **$**                                      | **358**    | ** ** | **$** | **620** | ** ** |
|                                                                  |       |                                       |       |   |   |
| **SCHEDULE  OF NON-CASH TRANSACTIONS:**                               | ** ** | ** **                                 | ** ** | ** ** | ** ** |
| Unrealized  gain (loss) on investment securities, net of income taxes | ** ** | **$**                                      | **(1,625** | **)** | **$** | **339** | ** ** |
| Loans  charged-off                                                    | ** ** | **$**                                      | **12,140** | ** ** | **$** | **3,293** | ** ** |

 

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

 

60

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### **NOTE1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

**Business Activity andOrganization -**CommunitySouth Financial Corporation (the “Company”)is a South Carolina corporation organized for the purpose of owning andcontrolling all of the capital stock of CommunitySouth Bank and Trust (the “Bank”).  The Bank is a state chartered bank organizedunder the laws of South Carolina.  Frominception on March 20, 2004 through January 18, 2005, the Companyengaged in organizational and pre-opening activities necessary to obtainregulatory approvals and to prepare its subsidiary, the Bank, to commencebusiness as a financial institution.  TheCompany received approval from the Federal Deposit Insurance Corporation (“FDIC”),the Federal Reserve Board (“FRB”) and the State Board of Financial Institutionsin 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 4,681,069 shares of commonstock at $6.40 per share in an initial public offering that was completed on February 15,2005 (as adjusted for all stock splits). The offering raised $29,430,810, net of offering costs.  The directors and officers of the Companypurchased 659,531 shares at $6.40 per share for a total of $4,221,000.

 

**Basis of Presentation -**The accountingand reporting policies conform to accounting principles generally accepted inthe United States of America and to general practices in the banking industry.The Company uses the accrual basis of accounting.

 

**Principles of Consolidation -**The consolidated financial statements include the accounts of CommunitySouth Financial Corporation, the parent company, CommunitySouth Bank and Trust, its wholly owned subsidiary, and All Seasons Properties, LLC, a subsidiary of the Bank, was formed in 2009 for the purpose of holding and marketing repossessed assets. 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 asone operating segment, as management reviews the results of operations of theCompany as a single enterprise.

 

**Cash and Cash Equivalents**- For purposes of reportingcash flows, cash and cash equivalents include cash on hand, amounts due frombanks, short-term interest bearing deposits and federal funds sold. Cash andcash equivalents have an original maturity of three months or less.

 

**Concentrationsof Credit Risk** - Financial instruments, which potentially subjectthe Company to concentrations of credit risk, consist principally of loansreceivable, investment securities, federal funds sold and amounts due frombanks.

 

TheCompany makes loans to individuals and small businesses for various personaland commercial purposes primarily in the upstate region of South Carolina.  The Company’s loan portfolio is notconcentrated in loans to any single borrower or to a relatively small number ofborrowers.  The Bank does have aconcentration of loans classified as commercial real estate.  These loans are especially susceptible tobeing adversely effected by the current economic downturn.  The current downturn in the real estatemarket has resulted in an increase in loan delinquencies, defaults andforeclosures, and we believe these trends are likely to continue.  In some cases, this downturn has resulted ina significant impairment to the value of our collateral and our ability to sellthe collateral upon foreclosure, and there is a risk that his trend willcontinue.  The commercial real estatecollateral in each case provides an alternate source of repayment in the eventof default by the borrower and may deteriorate in value during the time thecredit is extended.  If real estatevalues continue to decline, it is also more likely that we would be required toincrease our allowance for loan losses.

 

61

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Inaddition to monitoring potential concentrations of loans to particular borrowersor groups of borrowers, industries and geographic regions, management monitorsexposure to credit risk that could arise from potential concentrations oflending products and practices such as loans that subject borrowers tosubstantial payment increases (e.g. principal deferral periods, loans withinitial interest-only periods, etc), and loans with high loan-to-valueratios.  Additionally, there are industrypractices that could subject the Company to increased credit risk shouldeconomic 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.

 

The Company’s investment portfolio consistsof both marketable and non-marketable equity securities.  Management believes credit risk associatedwith the equity securities is not significant. The Company places its depositsand correspondent accounts with and sells its federal funds to high qualityinstitutions.  Management believes creditrisk associated with correspondent accounts is not significant.

 

**Investment Securities** — The Company classifies investments in equity and debt securities three categories:

 

1.  *  Availablefor sale securities*: These are securities that are not classified aseither held to maturity or as trading securities.  These securities arereported at fair market value.  Unrealized gains and losses are reported,net of income taxes, as separate components of shareholders’ equity(accumulated other comprehensive income).

2. * Held to maturity securities*:These are investment securities that the Company has the ability and intent tohold until maturity.  These securities are stated at cost, adjusted foramortization of premiums and the accretion of discounts.

3. * Trading securities*: Theseare securities that are bought and held principally for the purpose of sellingin the near future.  Trading securities are reported at fair market value,and related unrealized gains and losses are recognized in the incomestatement.  The Company has no trading securities.

 

Gains or losses on dispositions of investmentsecurities are based on the differences between the net proceeds and theadjusted 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.

 

**OtherInvestments —**CommunitySouth Bank and Trust, as a memberinstitution, is required to own stock investments in the FHLB.  Investment in the FHLB is a condition ofborrowing from the FHLB, and the stock is pledged to collateralize suchborrowings.  No ready market exists forthe stock and it has no quoted market value. However, redemption of thesestocks has historically been at par value. At December 31, 2009 and 2008, the Company’s investment in FHLBstock was $1,599,300 and $1,805,200, respectively. The dividend received onthis stock is included in interest and dividends on investments.

 

**LoansReceivable** - Loans are stated at their unpaid principal balanceless an allowance for loan losses and net deferred loan origination fees.  Interest income is computed using the simpleinterest method and is recorded in the period earned. Loan origination feescollected and certain loan origination costs are deferred and the net amount isaccreted as income using a method that approximates the level yield method overthe life of the related loans.

 

Loans are considered to be impaired when, inmanagement’s judgment and based on current information, the full collection ofprincipal and interest becomes doubtful. A loan is also considered impaired if its terms are modified in atroubled debt restructuring.  Impairedloans are placed in non-performing status, and future payments are applied toprincipal until such time as collection of the obligation is no longerdoubtful. Interest accrual resumes only when loans return to performingstatus.  To return to performing status,loans must be fully current, and continued timely payments must be a reasonableexpectation.  Loans are generally placedon non-accrual status when principal or interest becomes ninety days past due,or when payment in full is not anticipated.  When a loan is placed onnon-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.

 

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The Company identifies impaired loans throughits normal internal loan review process. Loans on the Company’s potential problem loan list are consideredpotentially impaired loans.  These loansare evaluated in determining whether all outstanding principal and interest areexpected to be collected.  Loans are notconsidered impaired if a minimal payment delay occurs and all amounts due,including accrued interest at the contractual interest rate for the period ofdelay, are expected to be collected. Management has determined that the Company had $34,158,000 and $13,172,000in impaired loans at December 31, 2009 and 2008, respectively.

 

**Allowance for Loan Losses** — The allowance for loanlosses is established as losses are estimated to have occurred through aprovision for loan losses charged to earnings. Loan losses are charged againstthe allowance when management believes the uncollectability of a loan balanceis confirmed. Subsequent recoveries, if any, are credited to the allowance.

 

The allowance for loan losses is evaluated ona regular basis by management and is based upon management’s periodic review ofthe collectability of the loans in light of historical experiences, the natureand volume of the loan portfolio, adverse situations that may affect theborrower’s ability to repay, estimated value of any underlying collateral andprevailing economic conditions. This evaluation is inherently subjective as itrequires estimates that are susceptible to significant revision as moreinformation becomes available.

 

The allowance consists of specific, generaland unallocated components. The specific component relates to loans that areclassified as either doubtful, substandard or special mention. For such loansthat are also classified as impaired, an allowance is established when thediscounted cash flows (or collateral value or observable market price) of theimpaired loan is lower than the carrying value of the loan. The generalcomponent covers non-classified loans and is based on historical lossexperience adjusted for qualitative factors. An unallocated component ismaintained to cover uncertainties that could affect management’s estimate ofprobable losses. The unallocated component of the allowance reflects the marginof imprecision inherent in the underlying assumptions used in the methodologiesfor estimating specific and general losses in the portfolio.

 

A loan is considered impaired when, based oncurrent information and events, it is probable that the Company will be unableto collect the scheduled payments of principal or interest when due accordingto the contractual terms of the loan agreement. Factors considered bymanagement in determining impairment include payment status, collateral value,and the probability of collecting scheduled principal and interest paymentsdue. Loans that experience insignificant payment delays and payment shortfallsgenerally are not classified as impaired. Management determines thesignificance of payment delays and payment shortfalls on a case-by-case basis,taking into consideration all of the circumstances surrounding the loan and theborrower, including the length of the delay, the reasons for the delay, theborrower’s prior payment record and the amount of the shortfall in relation tothe principal and interest owed. Impairment is measured on a loan by loan basisfor commercial and construction loans by either the present value of expectedfuture cash flows discounted at the loan’s effective interest rate, the loan’sobtainable market price, or the fair value of the collateral if the loan iscollateral dependent.

 

Large groups of smaller balance homogeneousloans are collectively evaluated for impairment. Accordingly, the Company doesnot separately identify individual consumer and residential loans forimpairment disclosures, unless such loans are the subject of a restructuringagreement.

 

**Bank-OwnedLife Insurance** — The Companymade the decision to sell these policies in order to help reduce assets,thereby improving the Bank’s risk based capital ratio.  During the first quarter of 2009, the Companybegan the process of divesting of its key employee life insurance policies byselling policies at no gain or loss. Income from these policies and changes in the net cash surrender valueare currently recorded in non-interest income. The final policy was sold in April 2009.

 

**Advertising -** Advertising, promotional, and other businessdevelopment costs generally are expensed as incurred. External costs incurredin producing media advertising are expensed the first time the advertisingtakes place. External costs relating to direct mailing costs are expensed inthe period in which the direct mailings are sent.

 

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**Propertyand Equipment** - Premises, furniture and equipment are stated atcost, less accumulated depreciation. Depreciation expense is computed using the straight-line method, basedon the estimated useful lives for furniture and equipment of 5 to 10years.  Leasehold improvements areamortized over the life of the lease. Maintenance and repairs are charged to current expense.  The costs of major renewals and improvementsare capitalized.

 

**ResidentialLoan Origination Fees** - The Companyoffers residential loan origination services to its customers in its immediatemarket area.  The loans are offered onterms and prices offered by the Company’s correspondents and are closed in thename of the correspondents. The Company receives fees for services it providesin conjunction with the origination services it provides.  The fees are recognized at the time the loansare 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 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.

 

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.  As of December 31, 2009, in consideration of recent financial results, the uncertainty involved in projecting near-term profitability, and evaluation of appropriate tax planning strategies, management has provided a 100% valuation allowance to reflect its estimate that the deferred tax assets are not more-than-likely-than-not to be realized.

 

**Earnings Per Share** - Basicearnings per share represents the net income allocated to shareholders dividedby the weighted-average number of common shares outstanding during theperiod.  Diluted earnings per sharereflect the impact of additional common shares that would have been outstandingif dilutive potential common shares had been issued.  Potential common shares that may be issued bythe Company relate to both outstanding warrants and stock options, and aredetermined using the treasury stock method.

 

**Stock–based Compensation** — The Companyhas adopted the fair value recognition provisions to account for compensationcosts under its stock option plans.  TheCompany previously utilized the intrinsic value method.  Under the intrinsic value method, no compensationcosts were recognized for the Company’s stock options because the optionexercise price in its plans equaled the market price on the date of grant.

 

# **TheCompany elected to use the modified prospective method to account for thetransition from the intrinsic value method to the fair value recognitionmethod.  Under the modified prospectivemethod, compensation cost is recognized from the adoption date forward for allnew stock options granted and for any outstanding unvested awards as if thefair value method had been applied to those awards as of the date of grant.**

 

**Off-BalanceSheet Financial Instruments** - In the ordinary course ofbusiness, 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.

 

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**Recently Issued AccountingStandards -**The following is a summary of recent authoritativepronouncements that could impact the accounting, reporting, and / or disclosureof financial information by the Company.

 

In June 2009, the Financial AccountingStandards Board (“FASB”) issued guidance which restructured generally acceptedaccounting principles (“GAAP”) and simplified access to all authoritative literatureby providing a single source of authoritative nongovernmental GAAP.  The guidance is presented in a topicallyorganized structure referred to as the FASB Accounting Standards Codification (“ASC”).The new structure is effective for interim or annual periods ending after September 15,2009. All existing accounting standards have been superseded and all otheraccounting literature not included is considered nonauthoritative.

 

The FASB issued new accounting guidance onaccounting for transfers of financial assets in June 2009.  The guidance limits the circumstances inwhich a financial asset should be derecognized when the transferor has nottransferred the entire financial asset by taking into consideration thetransferor’s continuing involvement.  Thestandard requires that a transferor recognize and initially measure at fairvalue all assets obtained (including a transferor’s beneficial interest) andliabilities incurred as a result of a transfer of financial assets accountedfor as a sale.  The concept of aqualifying special-purpose entity is no longer applicable.  The standard is effective for the firstannual reporting period that begins after November 15, 2009, for interimperiods within the first annual reporting period, and for interim and annualreporting periods thereafter.  Earlierapplication is prohibited.  The Companydoes not expect the guidance to have any impact on the Company’s financialstatements.  The ASC was amended inDecember, 2009, to include this guidance.

 

Guidance was issued in June 2009requiring a company to analyze whether its interest in a variable interestentity (“VIE”) gives it a controlling financial interest that should beincluded in consolidated financial statements. A company must assess whether it has an implicit financialresponsibility to ensure that the VIE operates as designed when determiningwhether it has the power to direct the activities of the VIE that significantlyimpact its economic performance, making it the primary beneficiary.  Ongoing reassessments of whether a company isthe primary beneficiary are also required by the standard.  This guidance amends the criteria to qualifyas a primary beneficiary as well as how to determine the existence of a VIE.  The standard also eliminates certainexceptions that were previously available. This guidance is effective as of the beginning of each reporting entity’sfirst annual reporting period that begins after November 15, 2009, forinterim periods within that first annual reporting period, and for interim andannual reporting periods thereafter. Earlier application is prohibited. Comparative disclosures will be required for periods after the effectivedate.  The Company does not expect theguidance to have any impact on the Company’s financial position.  An update was issued in December, 2009, toinclude this guidance in the ASC.

 

Also in January, 2010, an amendment wasissued to clarify the scope of subsidiaries for consolidation purposes.  The amendment provides that the decrease inownership guidance should apply to (1) a subsidiary or group of assetsthat is a business or nonprofit activity, (2) a subsidiary that is abusiness or nonprofit activity that is transferred to an equity method investeeor joint venture, and (3) an exchange of a group of assets thatconstitutes a business or nonprofit activity for a noncontrolling interest inan entity.  The guidance does not applyto a decrease in ownership in transactions related to sales of in substancereal estate or conveyances of oil and gas mineral rights.  The update is effective for the interim orannual reporting periods ending on or after December 15, 2009 and had noimpact on the Company’s financial statements.

 

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 and Uncertainties** - In thenormal course of its business, the Company encounters two significant types ofrisk: economic and regulatory.  There arethree main components of economic risk: interest rate risk, credit risk and market risk.  The Company is subject to interest rate riskto the degree that its interest-bearing liabilities mature or reprice atdifferent speeds, or on different 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.

 

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The Company is subject to the regulations ofvarious governmental agencies.  Theseregulations can and do change significantly from period to period.  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.  On June 29, 2009, the Bank entered intoa the MOU with the Commissioner of Banking of the South Carolina State Board ofFinancial Institutions and the Regional Director of the FDIC’s Atlanta RegionalOffice.  In addition on February 23,2010 the Bank hassuccessfully completed negotiations with the FDIC and has agreed to enter intothe Consent Order with the South Carolina State Board of Financial Institutionsand the FDIC.  The ConsentOrder supersedes the MOU.  Please seemore details regarding the MOU and Consent Order in Note 2.

 

The Bank is subject to the FDIC insurancepremiums.  Legislation has recentlypassed that imposed a one time FDIC insurance premium that equated to a$178,000 one time charge to the Bank in 2009. This was expensed in June 2009 and was paid September 30,2009.

 

**Reclassifications** - Certaincaptions and amounts in the prior financial statements were reclassified to conformwith the 2009 presentation. Such reclassifications had no effect on previouslyreported net income or shareholders’ equity.

 

**NOTE 2 —REGULATORY ACTIONS AND GOING CONCERN CONSIDERATIONS**

 

***Consent Order***

 

Following the FDIC’ssafety and soundness examination of the Bank in the fourth quarter of 2009, theBank entered into the Consent Order with the FDIC and the South Carolina Boardof Financial Institutions on February 23, 2010.  The Consent Order conveys specific actionsneeded to address certain findings from the FDIC’s Report of Examination and toaddress the Bank’s current financial condition, primarily related to policy andplanning issues, oversight, loan concentrations and classifications,non-performing loans, liquidity/funds management, and capital planning.

 

Under the terms of theConsent Order, the Bank’s various sources of liquidity will be restricted.  Based on information included in the FDIC’sreport, the Bank’s credit risk rating at the FHLB has been negatively impacted,resulting in reduced borrowing capacity. This action also restricts the Bank’s ability to accept, renew, or rollover brokered deposits.  In addition, theBank’s ability to borrow funds from the Federal Reserve Bank Discount Window asa source of short-term liquidity is not guaranteed. The Federal Reserve DiscountWindow borrowing capacity has been curtailed to only overnight terms,contingent upon credit approval for each transaction.

 

In addition, the ConsentOrder requires the Bank to, among other things,

 

·                  establish, within 30 days from the effective date ofthe Consent Order, a plan to monitor compliance with the Consent Order, whichshall be monitored by the Bank’s Board of Directors;

 

·                  ensure the Bank has qualified management in place tocarry out the policies of the Bank’s Board of Directors and operate the Bank ina safe and sound manner;

 

·                  achieve and maintain, within 120 days from theeffective date of the Consent Order, Total Risk Based capital at least equal to10% of risk-weighted assets and Tier 1 capital at least equal to 8% of totalassets;

 

·                  determine, within 30 days of the last day of thecalendar quarter, its capital ratios. If any capital measure falls below theestablished minimum, within 30 days provide a written plan describing the meansand timing by which the Bank shall increase such ratios to or in excess of theestablished minimums;

 

·                  develop, within 45 days from the effective date of theConsent Order, a written analysis and assessment of the Bank’s management andstaffing needs;

 

·                  establish, within 60 days from the effective date ofthe Consent Order, a comprehensive policy for determining the

 

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adequacy of theBank’s allowance for loan and lease losses, which must provide for a review ofthe Bank’s allowance for loan and lease losses at least once each calendarquarter;

 

·                  enhance, within 60 days from the effective date of theConsent Order, our written plan for the reduction of classified assets, whichshall include, among other things, a reduction of the Bank’s risk position ineach asset in excess of $250,000 that is classified as “Substandard” or “Doubtful”;

 

·                  not extend any additional credit to any borrower whohas a loan or other extension of credit from the Bank that has been charged offor classified, in whole or in part, “loss” or “doubtful” and isuncollected.  In addition, the Bank maynot extend any additional credit to any borrower who has a loan or otherextension of credit from the Bank that has been classified, in whole or inpart, “substandard” and is uncollected, unless the Bank’s Board of Directorsdetermines that failure to extend further credit to a particular borrower wouldbe detrimental to the best interests of the Bank;

 

·                  perform, within 45 days from the effective date of theConsent Order, a risk segmentation analysis with respect to the Bank’sConcentrations of Credit and a written plan to systematically reduce anysegment of the portfolio that is an undue concentration of credit;

 

·                  revise, within 60 days from the effective date of the ConsentOrder, the Bank’s internal loan review and grading system to provide for theperiodic review of the Bank’s loan portfolio in order to identify andcategorize the Bank’s loans, and other extensions of credit which are carriedon the Bank’s books as loans, on the basis of credit quality;

 

·                  formulate and implement, within 60 days from theeffective date of the Consent Order, a profit plan and comprehensive budget forall categories of income and expense, which must address, at minimum, goals andstrategies for improving and sustaining the earnings of the Bank, the majorareas in and means by which the Bank will seek to improve the Bank’s operatingperformance, and the operating assumptions that form the basis for andadequately support major projected income and expense components of the plan;

 

·                  enhance, within 60 days from the effective date of theConsent Order, our written funds management plan addressing liquidity,contingent funding, and asset liability management;

 

·                  not accept, renew, or rollover any brokereddeposits.  The Bank must develop andsubmit to the FDIC, within 30 days from the effective date of the order, a planfor eliminating its reliance on brokered deposits.  In addition, the Bank cannot offer aneffective yield in excess of 75 basis points on interest paid on deposits (includingbrokered deposits, if approval is granted for the Bank to accept them) ofcomparable size and maturity in either the Bank’s normal market area or in themarket area in which such deposits would otherwise be accepted.  Thus, for deposits in the Bank’s own normalmarket area, the Bank must offer rates that are not in excess of 75 basispoints over the average local rates.  Fornon-local deposits, the Bank must offer rates that are not in excess of 75basis points over either (1) the Bank’s own local rates or (2) theapplicable non-local rates;

 

·                  not declare or pay any dividends or bonuses or makeany distributions of interest, principal, or other sums on subordinateddebentures without the prior approval of the supervisory authorities; and

 

·                  furnish, by within 45 days from the effective date ofthe Consent Order and within 45 days of the end of each quarter thereafter,written progress reports to the supervisory authorities detailing the form andmanner of any actions taken to secure compliance with the Consent Order.

 

The Bank will continue toserve customers in all areas, including processing banking transactions, payingcompetitive rates on deposits, and providing access to lines of credit. Allcustomer deposits are fully insured to the highest limits set by the FDIC,which are $250,000 for individually titled accounts and $250,000 forindividually titled IRA accounts. In addition, the Bank participates in theFDIC Transaction Account Guarantee Program. Under

 

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this program, allnon-interest bearing transaction accounts are fully guaranteed by the FDIC forthe entire amount of the account. The guarantee also applies to interestbearing transaction accounts with interest rates of 0.50 percent or less. Thisprogram is in addition to and separate from the coverage available under theFDIC general deposit insurance rules.

 

Should the Bank fail tocomply with the capital and liquidity funding requirements in the ConsentOrder, or suffer a continued deterioration in our financial condition, the Bankmay be subject to being placed into a federal conservatorship or receivershipby the FDIC, with the FDIC appointed as conservator or receiver.

 

***Going ConcernConsiderations***

 

The going concernassumption is a fundamental principle in the preparation of financialstatements. It is the responsibility of management to assess the Company’sability to continue as a going concern. In assessing this assumption, theCompany has taken into account all available information about the future,which is at least, but is not limited to, twelve months from the balance sheetdate of December 31, 2009. The Company has a history of profitableoperations and sufficient sources of liquidity to meet its short-term andlong-term funding needs. However, the Bank’s financial condition has suffered during 2009 from theextraordinary effects of what may ultimately be the worst economic downturnsince the Great Depression.

 

The effects of thecurrent economic environment are being felt across many industries, withfinancial services and residential real estate being particularly hard hit. Theeffects of the economic downturn have been particularly severe during the last150 days. The Bank, with a loan portfolio consisting of a concentration incommercial real estate loans including residential construction and developmentloans, has seen a decline in the value of the collateral securing its portfolioas well as rapid deterioration in its borrowers’ cash flow and ability to repaytheir outstanding loans to the Bank. As a result, the Bank’s level ofnonperforming assets has increased substantially during 2009 to $42.4 million.For the year ended December 31, 2009, the Bank recorded a $17.0 millionprovision increase the allowance for loan losses to a level which, inmanagements’ best judgment, adequately reflected the increased risk inherent inthe loan portfolio as of December 31, 2009.

 

The Company and the Bankoperate in a highly-regulated industry and must plan for the liquidity needs ofeach entity separately. A variety of sources of liquidity are available to theBank to meet its short-term and long-term funding needs. Although a number ofthese sources have been limited following execution of the Consent Order withthe FDIC and the South Carolina Board of Financial Institutions, management hasprepared forecasts of these sources of funds and the Bank’s projected uses offunds during 2010 in an effort to ensure that the sources available aresufficient to meet the Bank’s projected liquidity needs for this period.

 

The Company relies on dividendsfrom the Bank as its primary source of liquidity. The Company is a legal entityseparate and distinct from the Bank. Various legal limitations restrict theBank from lending or otherwise supplying funds to the Company to meet itsobligations, including paying dividends. In addition, the terms of the ConsentOrder described above will further limit the Bank’s ability to pay dividends tothe Company to satisfy its funding needs.

 

The Company will alsoneed to raise additional capital to increase capital levels to meet thestandards set forth by the FDIC. As a result of the recent downturn in thefinancial markets, the availability of many sources of capital (principally tofinancial services companies) has become significantly restricted or has becomeincreasingly costly as compared to the prevailing market rates prior to thevolatility. Management cannot predict when or if the capital markets willreturn to more favorable conditions. Management is actively evaluating a numberof capital sources asset reductions and other balance sheet managementstrategies to ensure that the Bank’s projected level of regulatory capital cansupport its balance sheet.

 

There can be noassurances that the Company will be successful in its efforts to raiseadditional capital during 2010. An equity financing transaction of this type wouldresult in substantial dilution to the Company’s current shareholders and couldadversely affect the market price of the Company’s common stock. It isdifficult to predict if these efforts will be successful, either on ashort-term or long-term basis. Should these efforts be unsuccessful, due to the

 

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regulatory restrictionswhich exist that restrict cash payments between the Bank and the Company, theCompany may be unable to realize its assets and discharge its liabilities inthe normal course of business.

 

As a result of management’sassessment of the Company’s ability to continue as a going concern, theaccompanying consolidated financial statements for the Company have beenprepared on a going concern basis, which contemplates the realization of assetsand the discharge of liabilities in the normal course of business for theforeseeable future, and does not include any adjustments to reflect thepossible future effects on the recoverability or classification of assets.

 

**NOTE 3 — RESTRICTIONS ON CASH ANDDUE FROM BANKS**

 

The Bank is required to maintain averagereserve balances, computed by applying prescribed percentages to its varioustypes of deposits, either at the Bank or on deposit with the Federal ReserveBank. At December 31, 2009 and 2008, these required reserves were met byvault cash.

 

### **NOTE4 — INVESTMENT SECURITIES**

 

# **The amortized costs and fair valuesof investment securities are as follows (in thousands):**

 
| ** **                        | ** ** | **Amortized** | ** **  | **Gross  Unrealized** | ** ** | **Fair**   | ** ** |
|-----------------------------------|------------|---------------|-------------|-----------------------|------------|------------|------------|
| ** **                        | ** ** | **Cost**      | ** **  | **Gains**             | ** ** | **Losses** | ** ** | **Value** | ** ** |
| **As of  December 31, 2009** |       |          |        |                  |       |       |       |   |   |
| **Available  for sale**           |       |          |        |                  |       |       |       |   |   |
| Mortgage-backed                   |       | $             | 104,672     |                  | $          | 77         |       | $ | (1,211 | ) | $ | 103,538 |   |
| Equity  securities                |       | 100           |        | —                |       | —     |       | 100 |   |
| Total available  for sale         | ** ** | **$**         | **104,772** | ** **            | **$**      | **77**     | ** ** | **$** | (1,211 | ) | **$** | **103,638** | ** ** |
| ** **                        |       |          |        |                  |       |       |       |   |   |
| **As of  December 31, 2008** |       |          |        |                  |       |       |       |   |   |
| **Available  for sale**           |       |          |        |                  |       |       |       |   |   |
| Government  sponsored enterprises |       | $             | 19,001      |                  | $          | 85         |       | $ | — |   | $ | 19,086 |   |
| Mortgage-backed                   |       | 27,768        |        | 648                   |       | —     |       | 28,416 |   |
| Equity  securities                |       | 100           |        | —                |       | —     |       | 100 |   |
| Total available  for sale         | ** ** | **$**         | **46,869**  | ** **            | **$**      | **733**    | ** ** | **$** | — | ** ** | **$** | **47,602** | ** ** |

 

# **The amortized costs and fair valuesof investment securities available for sale at December 31, 2009 and 2008,by contractual maturity, are shown below (in thousands).**

 
| ** **                        | ** ** | **December 31,  2009** | ** **  | **December 31,  2008** | ** ** |
|-----------------------------------|------------|-----------------------------|-------------|-----------------------------|------------|
| ** **                        | ** ** | **Amortized**               | ** **  | **Fair**                    | ** ** | **Amortized** | ** ** | **Fair** | ** ** |
| ** **                        | ** ** | **Cost**                    | ** **  | **Value**                   | ** ** | **Cost** | ** ** | **Value** | ** ** |
| **Available  for sale**           |       |                        |        |                        |       |   |   |   |   |
| Due within one  year(1)           |       | $                           | 100         |                        | $          | 100 |   | $ | 3,101 |   | $ | 3,140 |   |
| Due after one  through five years |       | —                      |        | —                      |       | 17,594 |   | 17,694 |   |
| Due after five  through ten years |       | —                      |        | —                      |       | 5,225 |   | 5,437 |   |
| Due after ten  years              |       | 104,672                     |        | 103,538                     |       | 20,949 |   | 21,331 |   |
| Total available  for sale         | ** ** | **$**                       | **104,772** | ** **                  | **$**      | **103,638** | ** ** | **$** | **46,869** | ** ** | **$** | **47,602** | ** ** |

 

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

 

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 31,2009 (in thousands).

 

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| ** **                        | ** ** | **Less  than 12 months** | ** ** | **12  months or longer** | ** ** | **Total** | ** ** |
|-----------------------------------|------------|--------------------------|------------|--------------------------|------------|-----------|------------|
| ** **                        | ** ** | **Fair**                 | ** ** | **Unrealized**           | ** ** | **Fair**  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| **As of  December 31, 2009** | ** ** | **Value**                | ** ** | **Loss**                 | ** ** | **Value** | ** ** | **Gain/(Loss)** | ** ** | **Value** | ** ** | **Gain/(Loss)** | ** ** |
| **Available  for sale**           |       |                     |       |                     |       |      |       |   |   |   |   |   |   |
| Mortgage-backed                   |       | $                        | 89,987     |                     | $          | 1,211     |       | $ | — |   | $ | — |   | $ | 89,987 |   | $ | 1,211 |   |
| Total available  for sale         | ** ** | **$**                    | **89,987** | ** **               | **$**      | **1,211** | ** ** | **$** | **—** | ** ** | **$** | **—** | ** ** | **$** | **89,987** | ** ** | **$** | **1,211** | ** ** |

 

At December 31, 2009, the Company had mortgage-backed securitiesin an unrealized loss position.  TheCompany believes, based on industry analyst reports and credit ratings that thedeterioration in value is attributed to changes in market interest rates andnot in the credit quality of the issuer and therefore, these losses are notconsidered other-than-temporary.  TheCompany has the intent to hold these securities.

 

At December 31, 2008, the Company did not have any securities inan unrealized loss position.

 

# **The Company recognized $1.2 million in gains on sale ofinvestments for the year ended December 31, 2009.  No investment securities were sold during2008.**

# ** **

# **At December 31, 2009, there were $37.8 million ofsecurities pledged as collateral for repurchase agreements from brokers and$5.2 million pledged against secured federal funds lines. There were $36.1million of securities pledged as collateral for repurchase agreements frombrokers at December 31, 2008 and $6 million pledged against securedfederal funds lines.**

# ** **

Management limits its credit risk bygenerally investing its portfolio principally in obligations of the UnitedStates of America, its agencies or it corporations. Included in the investmentportfolio at December 31, 2009, are mortgage-backed securities issued bythe Government National Mortgage Association totaling $104.7 million.

 

### **NOTE5 — OTHER INVESTMENTS**

### ** **

Other investments consisted of FHLB stock with a cost of $1,599,000 and$1,805,000 at December 31, 2009 and 2008, respectively.  All of the FHLB stock is used tocollateralize advances with the FHLB. Upon request, the stock may be sold back to the FHLB, at cost.  Due to regulatory restrictions the FHLB isunder, such stock repurchases have been indefinitely put on hold.

 

### **NOTE6 — LOANS RECEIVABLE**

### ** **

Major classifications ofloans receivable for the years ended December 31, 2009 and 2008 aresummarized as follows (in thousands):

 
| ** **                      | ** ** | **December 31,** | ** **  |
|---------------------------------|------------|-----------------------|-------------|
| ** **                      | ** ** | **2009**              | ** **  | **2008** | ** ** |
| Real  estate - construction     |       | $                     | 81,128      |   | $ | 129,777 |   |
| Real  estate - mortgage         |       | 167,296               |        | 154,838 |   |
| Commercial  and industrial      |       | 25,028                |        | 33,303 |   |
| Consumer  and other             |       | 1,652                 |        | 2,989 |   |
| Total  loans, gross             |       | 275,104               |        | 320,907 |   |
| Less  allowance for loan losses |       | (12,963               | )           | (8,088 | ) |
| Total  loans, net               | ** ** | **$**                 | **262,141** | ** ** | **$** | **312,819** | ** ** |

 

Loans are stated net of deferred fees andcosts.

 

The Bank had $29,369,000 and $9,916,000 ofloans classified as non-accrual status as of December 31, 2009 and 2008,respectively.  At December 31, 2009and 2008, loans past due 90 days or more and still accruing amounted to$560,000 and $6,000, respectively. See additional disclosures regarding LoansReceivable and Allowance for Loan Losses in Note 1.

 

70

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Activity in the allowance for loan losses during the years ended December 31,2009 and 2008 is summarized below (in thousands):

 
| ** **                       | ** ** | **Year  Ended December 31,** | ** ** |
|----------------------------------|------------|-----------------------------------|------------|
| ** **                       | ** ** | **2009**                          | ** ** | **2008** | ** ** |
| Balance,  beginning of year      |       | $                                 | 8,088      |   | $ | 4,213 |   |
| Provision  charged to operations |       | 16,990                            |       | 7,168 |   |
| Charge-offs,  net                |       | (12,115                           | )          | (3,293 | ) |
| Balance,  end of year            | ** ** | **$**                             | **12,963** | ** ** | **$** | **8,088** | ** ** |

 
| ** **                                               | ** ** | **Year  Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|-----------------------------------|------------|
| **Impaired  Loans:**                                     | ** ** | **2009**                          | ** ** | **2008** | ** ** |
| No  valuation allowance required                         |       | $                                 | 19,525     |   | $ | 2,590 |   |
| Valuation  allowance required                            |       | 14,633                            |       | 10,582 |   |
| Total  impaired loans                                    | ** ** | **$**                             | **34,158** | ** ** | **$** | **13,172** | ** ** |
|                                                     | ** ** | ** **                        | ** ** | ** ** | ** ** |
| Allowance  for loan losses on impaired loans at year end | ** ** | **$**                             | **2,039**  | ** ** | **$** | **2,802** | ** ** |
|                                                     |       |                              |       |   |   |
| Average  investment in impaired loans                    |       | $                                 | 24,374     |   | $ | 5,109 |   |
| Interest  income recognized on impaired loans:           |       |                              |       |   |   |
| Accrual  basis                                           |       | $                                 | 1,240      |   | $ | 671 |   |
| Potential  problem loans                                 |       | $                                 | 15,933     |   | $ | 425 |   |

 

At December 31, 2009 and 2008, $36.4 million and$90.9 million of loans were pledged to the FHLB to secure advances.

 

### **NOTE7 — PROPERTY AND EQUIPMENT**

### ** **

Property and equipment consisted of thefollowing (in thousands):

 
| ** **                            | ** ** | **December 31,** | ** ** |
|---------------------------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **2009**              | ** ** | **2008** | ** ** |
| Land                                  |       | $                     | 786        |   | $ | 786 |   |
| Buildings  and leasehold improvements |       | 2,845                 |       | 2,845 |   |
| Property  and equipment               |       | 2,833                 |       | 2,758 |   |
| Construction  in progress             |       | —                |       | 95 |   |
| Total                                 |       | 6,464                 |       | 6,484 |   |
| Less,  accumulated depreciation       |       | (2,597                | )          | (1,866 | ) |
| Property  and equipment, net          | ** ** | **$**                 | **3,867**  | ** ** | **$** | **4,618** | ** ** |

 

The Company recorded$735,000 and $718,000 in depreciation expense of property and equipment for theyears ended December 31, 2009 and 2008, respectively.  Construction in progress related to a pendingbranch in Spartanburg, however, the project was abandoned in 2009.  All costs associated with the pending branchwere either expensed or reimbursed.

 

71

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### **NOTE8 — DEPOSITS**

### ** **

The following table sets forth the deposits of theCompany by category as of December 31, 2009 and 2008 (in thousands).

 
| ** **                         | ** ** | **December 31,** | ** **  |
|------------------------------------|------------|-----------------------|-------------|
| ** **                         | ** ** | **2009**              | ** **  | **2008** | ** ** |
| Non-interest  bearing demand       |       | $                     | 21,829      |   | $ | 22,162 |   |
| Interest bearing  demand           |       | 18,588                |        | 16,449 |   |
| Savings                            |       | 82,295                |        | 14,461 |   |
| Time deposits  less than $100,000  |       | 30,054                |        | 32,112 |   |
| Time deposits of  $100,000 or over |       | 21,014                |        | 25,161 |   |
| Brokered time  deposits            |       | 202,783               |        | 186,298 |   |
| Total deposits                     | ** ** | **$**                 | **376,563** | ** ** | **$** | **296,643** | ** ** |

 

Deposits from outside the Company’s marketarea obtained through brokers amounted to 53.85% and 62.80% of total depositsat December 31, 2009 and 2008, respectively.

 

Interest expense on time deposits of $100,000or over was $796,000 and $2,050,000 for years ending December 31, 2009 and2008, respectively.

 

At December 31, 2009,the scheduled maturities of certificates of deposit were as follows (inthousands):

 
| **Maturing  In:** | ** ** | **Amount** | ** **  |
|-------------------|------------|------------|-------------|
| 2010              |       | $          | 249,331     |   |
| 2011              |       | 4,381      |        |
| 2012              |       | 45         |        |
| 2013              |       | 94         |        |
| Total             | ** ** | **$**      | **253,851** | ** ** |

 

### **NOTE9 — REPURCHASE AGREEMENTS**

### ** **

At December 31, 2009and 2008, the Bank had sold $30.0 million of securities under agreements torepurchase with brokers with a weighted average rate of 3.24% and an averagematurity of 78 months at December 31, 2009.  The maximum amount outstanding at any month-end during 2009and 2008 was $30.0 million.  The averagebalance for the year was $30.0.  Theseagreements were secured with approximately $37.6 million of investmentsecurities.

 

### **NOTE10 — FEDERAL HOME LOAN BANK ADVANCES**

### ** **

At December 31, 2009 the Bank did not have anyoutstanding FHLB advances.

 

At December 31, 2008, the Bank had $25 million inFHLB advances.  The advances were securedwith approximately $45.5 million in loans and $1.8 million of stock in theFHLB.  These advances were repaid in2009.

 

### **NOTE11 — NOTE PAYABLE**

### ** **

AtDecember 31, 2008, the Company had a $1.6 million outstanding on a line ofcredit at the Bank of Tennessee. The Company had pledged all of the stock ofthe Bank as collateral for this line of credit. The Company repaid this note payable on February 27, 2009 and theline was terminated.

 

72

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### **NOTE12 — SUBORDINATED DEBT**

 

During the third quarter of 2008, wecommenced a subordinated debt offering to enhance and strengthen the levels ofcapital and liquidity at the holding company such that we could improve thelevels of regulatory capital at the Bank. We raised $4.325 million before weclosed the offering on October 15, 2008. The subordinated notes were sold to a limited number of purchasers in aprivate offering, bear an interest rate of 11.5%, are callable by the Companyafter 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.

 
| ** **                  | ** ** | ** **  | ** ** | **Period-** | ** ** | ** **  | ** ** | **Weighted  -Average** | ** ** | **Maximum  Outstanding** | ** ** |
|-----------------------------|------------|-------------|------------|-------------|------------|-------------|------------|------------------------|------------|--------------------------|------------|
| ** **                  | ** ** | **Ending**  | ** ** | **End**     | ** ** | **Average** | ** ** | **Rate for**           | ** ** | **at any**               | ** ** |
| **(Dollars in thousands)**  | ** ** | **Balance** | ** ** | **Rate**    | ** ** | **Balance** | ** ** | **Year**               | ** ** | **Month End**            | ** ** |
| **December 31,  2009** |       |        |       |        |       |        |       |                   |       |                     |       |
| Subordinated  debt          |       | $           | 4,325      |        | 11.50      | %           | $          | 4,325                  |       | 11.50                    | %          | $ | 4,325 |   |
|                             |            |             |            |             |            |             |            |                        |            |                          |            |  |  |  |

 

Dueto diminishing cash available at the Holding company level, if we are unable toraise additional capital, we will have to discontinue paying interest on thesubordinated debentures after the March 2010 payments due to lack offunds.

 

### **NOTE13 — INCOME TAXES**

### ** **

Income tax expense for theyear ended December 31, 2009 and 2008 is summarized as follows (inthousands):

 
| ** **                            | ** ** | **2009** | ** ** | **2008**   | ** ** |
|---------------------------------------|------------|----------|------------|------------|------------|
| Current portion:                      |       |     |       |       |       |
| Federal                               |       | $        | (1,592     | )          | $          | (253 | ) |
| State                                 |       | —   |       | —     |       |
| Total current income tax expense      |       | (1,592   | )          | (253       | )          |
| Deferred income tax expense (benefit) |       | 2,580    |       | (1,553     | )          |
| Income  tax expense (benefit)         | ** ** | **$**    | **988**    | ** ** | **$**      | **(1,806** | **)** |

 

A reconciliation between the income tax expense and the amount iscomputed by applying the Federal statutory rate of 34% for 2009 and 2008 toincome before income taxes follows:

 
| ** **                                       | ** ** | **2009** | ** ** | **2008**   | ** ** |
|--------------------------------------------------|------------|----------|------------|------------|------------|
| Federal income tax expense at statutory rate     |       | $        | (5,885     | )          | $          | (1,753 | ) |
| Change in deferred tax asset valuation allowance |       | 6,648    |       | —     |       |
| Other                                            |       | 225      |       | (53        | )          |
| Income  tax expense                              | ** ** | **$**    | **988**    | ** ** | **$**      | **(1,806** | **)** |

 

73

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Thegross amounts of deferred tax assets and deferred tax liabilities are asfollows:

 
| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2009**              | ** ** | **2008** | ** ** |
| **Deferred tax assets**                         |       |                  |       |   |   |   |   |
| Allowance for loan losses                       |       | $                     | 3,426      |   | $ | 2,417 |   |
| Organization and start-up costs                 |       | 79                    |       | 84 |   |
| Investment securities mark-to-market adjustment |       | 386                   |       | — |   |
| Accrued interest on non-accrual loans           |       | 46                    |       | 367 |   |
| Other real estate owned                         |       | 655                   |       | — |   |
| NOL carryforward                                |       | 2,603                 |       | — |   |
| Other                                           |       | 54                    |       | 9 |   |
| Total deferred tax assets                       |       | 7,249                 |       | 2,877 |   |
| Deferred  tax asset valuation allowance         |       | (7,034                | )          | — |   |
| Deferred  tax assets after valuation allowance  |       | 215                   |       | 2,877 |   |
|                                            |       |                  |       |   |   |
| **Deferred tax liabilities**                    |       |                  |       |   |   |
| Loan origination costs                          |       | (69                   | )          | (89 | ) |
| Investment securities mark-to-market adjustment |       | —                |       | (238 | ) |
| Depreciation                                    |       | (45                   | )          | (139 | ) |
| Prepaid expenses                                |       | (101                  | )          | (69 | ) |
| Total deferred tax liabilities                  |       | (215                  | )          | (535 | ) |
| Net  deferred tax asset                         |       | $                     | —     | ** ** | **$** | **2,342** | ** ** |

 

Deferred tax assets represent the future tax benefit of deductibledifferences and, if it is more likely than not that a tax asset will not berealized, a valuation allowance is required to reduce the recorded deferred taxassets to net realizable value.  As of December 31,2009, in consideration of the recent poor financial results, the uncertaintyinvolved in projecting near-term profitability, and evaluation of appropriatetax planning strategies, management has provided a 100% valuation allowance toreflect its estimate of the amount of deferred tax assets which aremore-than-likely-than-not to be realized. As of December 31, 2008, management determined that no valuationallowance was required as it was more-likely-than-not that the recorded netdeferred tax assets would be realized in full. The net deferred tax asset isincluded in the caption “other assets” on the balance sheet.

 

The Worker, Homeownership and Business Assistance Act of 2009, ingeneral, extended the loss carryback of net operating losses to five years fromtwo.  The Company booked and additionaltax refund of $420,000 under the Act from the carryback of net operating lossesin addition to booking $2.0 million of refunds under tax regulations in effectbefore the 2009 Act.

 

The Company has analyzed the tax positions taken or expected to betaken in its tax returns and concluded it has no liability related to uncertaintax positions.

 

74

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### **NOTE14 — 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 (in thousands):

 
| 2010                                  |       | $     | 320       |       |
|---------------------------------------|------------|-------|-----------|------------|
| 2011                                  |       | 329   |      |
| 2012                                  |       | 343   |      |
| 2013                                  |       | 348   |      |
| 2014                                  |       | 353   |      |
| Thereafter                            |       | 606   |      |
| Total  minimum future rental payments | ** ** | **$** | **2,299** | ** ** |

 

### **NOTE15 — COMMITMENTS AND CONTINGENCIES**

### ** **

The Company is subject to claims and lawsuitswhich arise primarily in the ordinary course of business.  Management is not aware of any legalproceedings which would have a material adverse effect on the financialposition or operating results of the Company.

 

### **NOTE16 — RELATED PARTY TRANSACTIONS**

### ** **

Certain parties (principally certaindirectors and executive officers of the Company, their immediate families andbusiness interests) (“affiliates”) are loan customers in the normal course ofbusiness with the Bank.  These loans aremade on substantially the same terms, including interest rates and collateral,as those prevailing at the time for comparable transactions with unrelatedpersons and do not involve more than the normal risk of collectability.  As of December 31, 2009 and 2008 theBank had related party loans totaling $19,578,004 and $20,539,348,respectively.  During 2009, advances onrelated party loans totaled $1,314,265 and repayments were $2,275,609. During2008, advances on related party loans totaled $7,310,239 and repayments were$8,717,781.

 

Both at December 31, 2009 and 2008,affiliates had deposits with the Bank in the amounts of $2.0 million and $2.5million, respectively.

 

The Company sold $1.85 million of itssubordinated debt to related parties. The debt was issued at the same terms of the other investors in theCompany’s subordinated debt offering.

 

The Company also enters into othertransactions 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 transaction wasentered into with affiliates during the years ended December 31, 2009 and2008:

 

·                  The loanoperations center in Easley was leased from a partnership in which a Companydirector has a partnership interest. Lease payments on that office totaled $42,750 and $36,000 for the yearsended December 31, 2009 and 2008, respectively.

 

### **NOTE17 — SHARES OUTSTANDING AND EARNINGS PER SHARE**

### ** **

Basic earnings per share is computed by dividing the net income by theweighted-average number of common shares outstanding.  Diluted earnings per share is computed bydividing the net income by the sum of the weighted-average number of commonshares outstanding and dilutive common share equivalents using the treasurystock method.  Dilutive common shareequivalents include common shares issuable upon exercise of outstanding stockwarrants and stock options.

 

Thefollowing is the basic and diluted income per share computation (in thousands,except per share data):

 

75

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| ** **                                                 | ** ** | **December 31,** | ** **  |
|------------------------------------------------------------|------------|-----------------------|-------------|
| ** **                                                 | ** ** | **2009**              | ** **  | **2008** | ** ** |
| Net  loss to common shareholders                           | ** ** | **$**                 | **(18,296** | **)** | **$** | **(3,350** | **)** |
| Weighted-average  common shares outstanding — basic   | ** ** | **4,698,697**         | ** **  | **4,698,697** | ** ** |
| Weighted-average  common shares outstanding — diluted | ** ** | **4,698,697**         | ** **  | **4,698,697** | ** ** |
| Loss  per share — basic                               | ** ** | **$**                 | **(3.89**   | **)** | **$** | **(0.71** | **)** |
| Loss per share —  diluted                             | ** ** | **$**                 | **(3.89**   | **)** | **$** | **(0.71** | **)** |

 

**NOTE 18 — STOCK COMPENSATION PLANS**

 

Upon completion of the offering, the Companyagreed to issue warrants to the organizing directors for the purchase of oneshare of common stock at $6.40 per share for every two shares purchased in thestock offering, up to a maximum of 15,625 warrants per director. The warrantswere fully vested 120 days after January 18, 2005 and will expire on January 18,2015.  Warrants held by directors of theCompany will expire 90 days after the director ceases to be a director orofficer of the Company (365 days if due to death or disability). The Companyissued a total of 171,404 warrants.  Inaddition, the Company has adopted a stock option plan.  Asof December 31, 2009 the Company has 756,033 outstanding options toemployees and directors. On January 16, 2006 the Company adopted aresolution that terminated the “evergreen” provision of the Company 2005 StockIncentive Plan. As a result, the number of shares of common stock issuableunder the plan shall not be further increased in connection with any futureshare issuances by the Company. The exercise price of eachoption is equal to the market price of the Company’s stock on the date ofgrant. The maximum term is ten years, and they vest in no greater than fiveyears. When necessary, the Company may purchase shares on the open market tosatisfy share option exercises. During the ensuing year, the Company isexpecting to acquire no shares.

 

The table set forth below summarizes stockoption activity for the Company’s stock compensation plans for the years ended December 31,2009 and 2008 as adjusted for all stock splits.

 
| ** **                                | ** ** | **Stock Options** | ** ** | **Warrants**  | ** ** |
|-------------------------------------------|------------|-------------------|------------|---------------|------------|
| ** **                                | ** ** | ** **        | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **                                | ** ** | ** **        | ** ** | **Average**   | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                | ** ** | ** **        | ** ** | **Exercise**  | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                                | ** ** | **Number**        | ** ** | **Price**     | ** ** | **Number** | ** ** | **Price** | ** ** |
| **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** | ** ** |
| Granted                                   |       | 18,850            |       | 2.51          |       | — |   | — |   |
| Forfeited                                 |       | (26,930           | )          | 6.57          |       | — |   | — |   |
| Exercised                                 |       | —            |       | —        |       | — |   | — |   |
| **Outstanding at December 31, 2009** | ** ** | **756,033**       | ** ** | **$**         | **6.99**   | ** ** | **171,404** | ** ** | **$** | **6.40** | ** ** |

 

At December 31, 2009 there was no intrinsic value for stockoptions outstanding and stock options exercisable.

 

76

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The table set forth belowsummarizes non-vested stock options as of December 31, 2009 and 2008.

 
| ** **                                | ** ** | **Weighted-Average** | ** ** | **Weighted-Average********Grant Date** | ** ** |
|-------------------------------------------|------------|----------------------|------------|----------------------------------------|------------|
| ** **                                | ** ** | **Number**           | ** ** | **Fair Value**                         | ** ** |
| **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**                               | ** ** |
| Granted                                   |       | 18,850               |       | 1.45                                   |       |
| Vested during the year                    |       | (10,897              | )          | 5.85                                   |       |
| Forfeited during the year                 |       | (11,340              | )          | 2.76                                   |       |
| **Outstanding at December 31, 2009** | ** ** | **48,423**           | ** ** | **$**                                  | **4.32**   | ** ** |

 

As of December 31, 2009, there was$159,989 in total unrecognized compensation cost related to non-vestedshare-based compensation arrangements, which is expected to be recognized overa weighted average period of 32 months. As of December 31, 2008, there was$223,689 in total unrecognized compensation cost related to non-vestedshare-based compensation arrangements, which is expected to be recognized overa weighted average period of 42 months.

 

The fair value of each option granted isestimated on the grant date using the Black-Scholes option-pricing model withthe following assumptions for 2009: dividend yield of 0%, expected term of 10 years, risk-free interest rateequal to the 10-year treasury rate on the respective grant date, and expectedlife of 10 years.  Volatility assumed foroptions granted during 2009 ranged from 38% to 51%.  The following assumptions were used for the2008 estimates:  dividend yield of 0%,expected term of 10 years, risk-free interest rate of 5.0%, expected life of 10years, and expected volatility of 20%.

 

Stock compensation expense recognized in 2009 and 2008 was $63,899 and$68,498, respectively.

 

The following tablesummarizes information about stock options outstanding under the Company’splans at December 31, 2009 and 2008.

 
| ** **                       | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** |
|----------------------------------|------------|-----------------|------------|-----------------|------------|
| **2009**                         |       |            |       |            |       |
| Number  of options               |       | 756,033         |       | 707,610         |       |
| Weighted  average remaining life |       | 5.47 years      |       | 5.29 years      |       |
| Weighted  average exercise price |       | $               | 6.99       |            | $          | 6.83 |   |
| High  exercise price             |       | $               | 16.80      |            | $          | 16.80 |   |
| Low  exercise price              |       | $               | 1.75       |            | $          | 4.55 |   |
| **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 |   |

 

No options were exercised in 2009 or 2008.

 

At December 31, 2009, all of the 171,404warrants were exercisable and had an average remaining life of 5.05 years. At December 31,2008, all of the 171,404 warrants were exercisable and had an average remaininglife of 6.05 years.

 

77

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### **NOTE19 — EMPLOYEE BENEFIT PLAN**

### ** **

TheBank maintains an employee benefit plan for all eligible employees of the Bankunder the provisions of Internal Revenue Code Section 401(k).  TheCommunitySouth 401(k) Plan (the “Plan”), adopted in 2006, allows for employeecontributions.  The Bank matches 25% of employee contributions up to amaximum of 1.25% of annual compensation.  A total of $31,735 and $25,292was charged to operations in 2009 and 2008, respectively, for the Company’smatching contribution.  Employees are immediately vested in theircontributions to the Plan and become fully vested in the employer matchingcontribution after five years of service.

 

### **NOTE20 — REGULATORY MATTERS**

### ** **

TheBank is subject to various regulatory capital requirements administered by thefederal banking agencies.  Failure tomeet minimum capital requirements can initiate certain mandatory and possiblyadditional discretionary actions by regulators that, if undertaken, could havea direct material 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 measuresestablished by regulation to ensure capital adequacy require the Bank tomaintain minimum ratios of Tier 1 and total capital as a percentage of assetsand off-balance sheet exposures, adjusted for risk weights ranging from 0% to100%.  Tier 1 capital consists of commonshareholders’ equity, excluding the unrealized gain or loss on securitiesavailable-for-sale, minus certain intangible assets.  Tier 2 capital consists of the allowance forloan losses subject to certain limitations. Total capital for purposes of computing the capital ratios consists ofthe sum of Tier 1 and Tier 2 capital. The regulatory minimum requirements are 4% for Tier 1 and 8% for totalrisk-based capital.

 

TheBank is also required to maintain capital at a minimum level based on totalassets, which is known as the leverage ratio. Only the strongest banks are allowed to maintain capital at the minimumrequirement of 3%.  All others aresubject to maintaining ratios 1% to 2% above the minimum.

 

As of December 31,2009, the most recent notification from the Bank’s primary regulatorcategorized it as “undercapitalized” under the regulatory framework for promptcorrective action.

 

The FDIC completed itssafety and soundness examination of the Bank in the fourth quarter of2010.  Based on the Bank’s currentfinancial condition, the Bank entered into the Consent Order with the FDIC andthe South Carolina Board of Financial Institutions on February 23, 2010,which contains, among other things, a requirement that our Bank achieve andmaintain minimum capital requirements that exceed the minimum regulatorycapital ratios for “well capitalized” banks.   Under thisenforcement action, the Bank may no longer accept, renew, or roll over brokereddeposits.  In addition, under the ConsentOrder, the Bank no longer meets the regulatory requirements to be eligible forexpedited processing of branch applications and certain other regulatoryapprovals, and the Bank is required to obtain FDIC approval before makingcertain payments to departing executives and before adding new directors orsenior executives.  The Bank’s regulatorshave considerable discretion in whether to grant required approvals, and noassurance can be given that such approvals would be forthcoming.  Inaddition, the Bank is required to take certain other actions in the areas ofcapital, liquidity, asset quality, and interest rate risk management, as wellas to file periodic reports with the FDIC and the South Carolina Board ofFinancial Institutions regarding its progress in complying with the ConsentOrder.  Any material failure to complywith the terms of the Consent Order could result in further enforcement actionby the FDIC.  While the Bank intends to take such actions as may benecessary to comply with the requirements of the Consent Order and subsequenceFDIC guidance, the Bank may be unable to comply fully with the deadlines orother terms of the Consent Order.  SeeNote 2 for further discussion of the Consent Order.

 

78

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The following table summarizesthe capital amounts and ratios of the Bank and the regulatory minimumrequirements at December 31, 2009 and December 31, 2008.

 
| ** **                                | ** ** | ** ** | ** ** | ** **            | ** ** | **To Be Well-**       | ** ** |
|-------------------------------------------|------------|------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                | ** ** | ** ** | ** ** | ** **            | ** ** | **Capitalized Under** | ** ** |
| ** **                                | ** ** | ** ** | ** ** | **For Capital**       | ** ** | **Prompt Corrective** | ** ** |
| ** **                                | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| ** **                                | ** ** | **Amount** | ** ** | **Ratio**             | ** ** | **Amount**            | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| **December 31, 2009**                |       |       |       |                  |       |                  |       |   |   |   |   |   |   |
| Tier 1 capital (to  risk-weighted assets) |       | $          | 13,643,000 |                  | 4.96       | %                     | $          | 11,008,000 |   | 4.00 | % | $ | 16,512,000 |   | 6.00 | % |
| Total capital (to  risk-weighted assets)  |       | 17,201,000 |       | 6.25                  |       | 22,016,000            |       | 8.00 |   | 27,521,000 |   | 10.00 |   |
| Tier 1 capital (to average  assets)       |       | 13,643,000 |       | 3.12                  |       | 17,474,000            |       | 4.00 |   | 21,843,000 |   | 5.00 |   |
| **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 |   |

 

TheFRB has similar requirements for bank holding companies. The Company currentlyis not subject to these requirements because the FRB applies its guidelines ona bank-only basis for bank holding companies with less than $500 million inconsolidated assets.

 

### **NOTE21 — LINES OF CREDIT**

### ** **

Asof December 31, 2009 and 2008, the Bank had unused lines of credit topurchase federal funds from unrelated banks totaling $5,000,000 and$14,500,000, respectively.  These linesof credit are available for general banking purposes.  As of December 31, 2009 and 2008, the Bankhas no funds drawn from these lines. These lines may be withdrawn without notice.

 

**NOTE 22 — RESTRICTIONS ON SUBSIDIARY DIVIDENDS, LOANS,OR ADVANCES**

 

Theability of the Company to pay cash dividends is dependent upon receiving cashin the form of dividends from the Bank. However, there are restrictions on the ability of the Bank to transferfunds to the Company in the form of cash dividends, loans, or advances.  As a South Carolina state bank, the Bank mayonly pay dividends out of its net profits, after deducting expenses, includinglosses and bad debts.  In addition, theBank is prohibited from declaring a dividend on its shares of common stockuntil its surplus equals its stated capital and provisions of the Consent Orderprohibiting the payment of dividends are lifted.  At December 31, 2009 and 2008, the Bank had adeficit of $19.1 million and $872,916, respectively.

 

### **NOTE23 — FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK**

### ** **

TheCompany is a party to financial instruments with off-balance sheet risk in thenormal course of business 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 notnecessarily represent future cash requirements. The Company uses the same credit policies in making commitments toextend credit as it does for on-balance-sheet instruments.  Letters of credit are conditional commitmentsissued to guarantee a customer’s performance to a third party and haveessentially the same credit risk as other lending facilities.  The Company has not recorded a liability forthe current carrying amount of the obligation to perform as a guarantor and nocontingent liability was considered necessary, as such amounts were notconsidered material.

 

79

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Collateralheld for commitments to extend credit and letters of credit varies but mayinclude accounts receivable, inventory, property, plant, equipment andincome-producing commercial properties.

 

Thefollowing table summarizes the Company’s off-balance sheet financialinstruments whose contract amounts represent credit risk (in thousands):

 
| ** **                   | ** ** | **December 31,** | ** ** |
|------------------------------|------------|------------------|------------|
| ** **                   | ** ** | **2009**         | ** ** | **2008** | ** ** |
|                         |       |             |       |   |   |
| Commitments to extend credit |       | **$**            | **14,451** | ** ** | **$** | **36,260** |   |
|                         |       | ** **       | ** ** | ** ** |   |
| Standby letters of credit    |       | **$**            | **1,525**  | ** ** | **$** | **3,488** |   |

 

### **NOTE24 — FAIR VALUE OF FINANCIAL INSTRUMENTS**

### ** **

GAAPrequires disclosure of fair value information, whether or not recognized in theconsolidated balancesheets, when it is practical to estimate the fair value.  GAAP defines a financial instrument as cash,evidence of an ownership interest in an entity or contractual obligations,which require the exchange of cash, or other financial instruments.  Certain items are specifically excluded fromthe disclosure requirements, including the Company’s common stock, premises andequipment, accrued interest receivable and payable, and other assets andliabilities.

 

Thefair value of a financial instrument is the amount at which the asset orobligation could be exchanged in a current transaction between willing parties,other than in a forced or liquidation sale. Fair value estimates are made at a specific point in time based onrelevant market information and information about the financialinstruments.  Because no market valueexists for a significant portion of the financial instruments, fair valueestimates are based on judgments regarding future expected loss experience,current economic conditions, risk characteristics of various financialinstruments, and other factors.

 

TheCompany has used management’s best estimate of fair value based on the aboveassumptions.  Thus, the fair valuespresented may not be the amounts, which could be realized, in an immediate saleor settlement of the instrument. In addition, any income taxes or otherexpenses, which would be incurred in an actual sale or settlement, are nottaken into consideration in the fair values presented.

 

Thefollowing methods and assumptions were used to estimate the fair value ofsignificant financial instruments:

 

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

 

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

 

***Investment Securities*** - The fairvalues of marketable equity securities are valued using quoted fair marketprices.

 

***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 lifeinsurance policies held by the Bank approximates fair values of the policies.

 

# ***Loans Receivable***- Forcertain categories of loans, such as variable rate loans which are repricedfrequently and have no significant change in credit risk, fair values are basedon the carrying amounts.  The fair valueof other types of loans is estimated by discounting the future cash flows usingthe current rates at which similar loans would be made to borrowers withsimilar credit ratings and for the same remaining maturities.  In order to capture the change in creditrisk, the current allowance for loan losses is also considered when determiningfair value of loans receivable.

 

80

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***Deposits*****- The fairvalue of demand deposits, savings, and money market accounts is the amountpayable on demand at the reporting date. The fair values of certificates of deposit are estimated using adiscounted cash flow calculation that applies current interest rates to aschedule of aggregated expected maturities.

 

***Repurchase Agreements*** - The fairvalue of repurchase agreements is estimated using a discounted cash flowcalculation that applies prevailing market rates for comparable debtinstruments.

 

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

 

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

 

***Subordinated Debt*** — The fairvalue of subordinated debt is estimated using a discounted cash flowcalculation that applies prevailing market rates for comparableinstruments.  Due to diminishing cashavailable at the holding company level, if we are unable to raise additionalcapital, we will have to discontinue paying interest on the subordinateddebentures after the March 2010 payments due to lack of funds, and our2009 fair value calculation reflects this.

 

Thecarrying values and estimated fair values of the Company’s financialinstruments at December 31, 2009 and 2008 are shown in the following table(in thousands).

 
| ** **                                                          | ** ** | **Carrying** | ** ** | **Estimated**  | ** ** |
|---------------------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                                          | ** ** | **Amount**   | ** ** | **Fair Value** | ** ** |
| **December 31, 2009**                                     |       |         |       |           |       |
| **Financial Assets**                                                |       |         |       |           |       |
| Cash and due from banks                                             |       | $            | 6,876      |           | $          | 6,876 |   |
| Federal funds sold                                                  |       | 31,043       |       | 31,043         |       |
| Investment securities,  available for sale                          |       | 103,638      |       | 103,638        |       |
| Other investments                                                   |       | 1,599        |       | 1,599          |       |
| Loans, gross                                                        |       | 275,104      |       | 260,894        |       |
| ** **                                                          |       |         |       |           |       |
| **Financial Liabilities**                                           |       |         |       |           |       |
| Demand deposit,  interest-bearing transaction, and savings accounts |       | $            | 122,712    |           | $          | 122,712 |   |
| Certificates of deposit  and other time deposits                    |       | 253,851      |       | 254,930        |       |
| Repurchase agreements                                               |       | 30,000       |       | 31,558         |       |
| Subordinated debt                                                   |       | 4,325        |       | 2,062          |       |
|                                                                |       |         |       |           |       |
| **December 31, 2008**                                     |       |         |       |           |       |
| **Financial Assets**                                                |       |         |       |           |       |
| Cash and due from banks                                             |       | $            | 5,251      |           | $          | 5,251 |   |
| Federal funds sold                                                  |       | 4,625        |       | 4,625          |       |
| Investment securities,  available for sale                          |       | 47,602       |       | 47,602         |       |
| Other investments                                                   |       | 1,805        |       | 1,805          |       |
| Loans, gross                                                        |       | 320,907      |       | 350,620        |       |
| Bank-owned life insurance                                           |       | 5,437        |       | 5,437          |       |
|                                                                |       |         |       |           |       |
| **Financial Liabilities**                                           |       |         |       |           |       |
| Demand deposit, interest-bearing  transaction, and savings accounts |       | $            | 53,072     |           | $          | 53,072 |   |
| Certificates of deposit  and other time deposits                    |       | 243,571      |       | 244,001        |       |
| Repurchase agreements                                               |       | 30,000       |       | 30,190         |       |
| FHLB advances                                                       |       | 25,000       |       | 25,000         |       |
| Note payable                                                        |       | 1,570        |       | 1,570          |       |
| Subordinated debt                                                   |       | 4,325        |       | 5,500          |       |

 

81

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| ** **                                    | ** ** | **2009**             | ** ** | **2008**                  | ** ** |
|-----------------------------------------------|------------|----------------------|------------|---------------------------|------------|
| **(Dollars in thousands)**                    | ** ** | **Notional  Amount** | ** ** | **Estimated  Fair Value** | ** ** | **Notional  Amount** | ** ** | **Estimated  Fair Value** | ** ** |
| ** **                                    |       |                 |       |                      |       |   |   |   |   |
| **Off-Balance Sheet Financial  Instruments:** |       |                 |       |                      |       |   |   |   |   |
| ** **                                    |       |                 |       |                      |       |   |   |   |   |
| Commitments to extend  credit                 |       | $                    | 14,451     |                      | $          | — |   | $ | 36,260 |   | $ | — |   |
| Standby Letters of Credit                     |       | $                    | 1,525      |                      | $          | — |   | $ | 3,488 |   | $ | — |   |

 

# **GAAPrequires new disclosure that establishes a framework for measuring fair value,and expands disclosure about fair value measurements.  This disclosure 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. Assets and liabilities carried at fair value will be classified anddisclosed 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.

 

Indetermining appropriate levels, the Company performs a detailed analysis of theassets and liabilities that are subject to fair value measurement.  At each reporting period, all assets andliabilities for which the fair value measurement is based on significantunobservable inputs are classified as Level 3.

 

82

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Thetables below present the balances of assets and liabilities measured at fairvalue on a recurring basis by level within the valuation hierarchy (asdescribed above) as of December 31, 2009 and 2008.

 
| ** **                                 | ** ** | **December, 31, 2009** | ** ** |
|--------------------------------------------|------------|------------------------|------------|
| **(Dollars in thousands)**                 | ** ** | **Total**              | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Investment securities,  available for sale |       | $                      | 103,638    |   | $ | — |   | $ | 103,638 |   | $ | — |   |
|                                            |            |                        |            |  |  |  |  |  |  |  |  |  |  |

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

 

Certainassets and liabilities are measured at fair value on a nonrecurring basis; thatis, the instruments are not measured at fair value on an ongoing basis but aresubject to fair value adjustments in certain circumstances (for example, whenthere is evidence of impairment).  Thefollowing tables present the assets and liabilities carried on the balancesheet by caption and by level within the valuation hierarchy (as describedabove) as of December 31, 2009 for which a nonrecurring change in fairvalue has been recorded during the year ended December 31, 2009.

 
| ** **                 | ** ** | **Carrying Value at December, 31,  2009** | ** ** |
|----------------------------|------------|-------------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Total**                                 | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Impaired loans             |       | $                                         | 34,158     |   | $ | — |   | $ | — |   | $ | 34,158 |   |
| Other real estate owned    |       | 6,703                                     |       | — |   | — |   | 6,703 |   |
| Repossessed collateral     |       | 942                                       |       | — |   | — |   | 942 |   |
|                            |            |                                           |            |  |  |  |  |  |  |  |  |  |  |

 
| ** **                           | ** ** | **Fair Value Measurements Using  Significant Unobservable Inputs** | ** ** |
|--------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                           | ** ** | **(Level 3)**                                                      | ** ** |
| **(Dollars in thousands)**           | ** ** | **Impaired  Loans**                                                | ** ** | **Other Real  Estate Owned** | ** ** | **Repossessed  Collateral** | ** ** | **Total** | ** ** |
| Beginning balance                    |       | $                                                                  | —     |   | $ | — |   | $ | — |   | $ | — |   |
| Gains/(losses) included in  earnings |       | —                                                             |       | (143 | ) | — |   | (143 | ) |
| Net additions                        |       | 20,986                                                             |       | 6,431 |   | 942 |   | 28,359 |   |
| Transfers in/(out) of  level 3       |       | 13,172                                                             |       | 415 |   | — |   | 13,587 |   |
| Ending balance                       |       | $                                                                  | 34,158     |   | $ | 6,703 |   | $ | 942 |   | $ | 41,803 |   |

 
| ** **                 | ** ** | **Carrying Value at December, 31,  2008** | ** ** |
|----------------------------|------------|-------------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Total**                                 | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Impaired Loans             |       | $                                         | 13,172     |   | $ | — |   | $ | 13,172 |   | $ | — |   |
| Other real estate owned    |       | 415                                       |       | — |   | 415 |   | — |   |
|                            |            |                                           |            |  |  |  |  |  |  |  |  |  |  |

 

83

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# ** **

# **NOTE 25 — COMMUNITYSOUTH FINANCIAL CORPORATION(PARENT COMPANY ONLY**)

 

Presented below are the condensed financial statements forCommunitySouth Financial Corporation (Parent Company only).

 

**CondensedBalance Sheets**

(dollarsin thousands)

 
| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2009**              | ** ** | **2008** | ** ** |
| **Assets**                                      |       |                  |       |   |   |
| Cash                                            |       | $                     | 357        |   | $ | 3,029 |   |
| Investment securities, available for sale       |       | 100                   |       | 100 |   |
| Investment in the Bank                          |       | 12,509                |       | 31,327 |   |
| Other assets                                    |       | 155                   |       | 97 |   |
| Total assets                                    | ** ** | **$**                 | **13,121** | ** ** | **$** | **34,553** | ** ** |
| ** **                                      | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Liabilities and shareholders’ equity**   |       |                  |       |   |   |
| Other liabilities                               |       | $                     | 125        | ** ** | $ | 130 |   |
| Other  borrowings                               |       | —                |       | 1,570 |   |
| Subordinated  debt                              |       | 4,325                 |       | 4,325 |   |
| Shareholders’ equity                       |       | 8,671                 |       | 28,528 |   |
| Total liabilities and shareholders’ equity | ** ** | **$**                 | **13,121** | ** ** | **$** | **34,553** | ** ** |

 

**Condensed Statements ofOperations**

**For theyears ended December 31, 2009 and 2008**

(dollarsin thousands)

 
| ** **                                                                   | ** ** | **2009** | ** **  | **2008** | ** ** |
|------------------------------------------------------------------------------|------------|----------|-------------|----------|------------|
| **Income**                                                                   |       | $        | —      |     | $          | — |   |
|                                                                         |       |     |        |     |       |
| **Expenses**                                                                 |       | (602     | )           | (257     | )          |
|                                                                         |       |     |        |     |       |
| **Loss before income taxes and equity in****undistributed loss of the Bank** |       | (602     | )           | (257     | )          |
|                                                                         |       |     |        |     |       |
| **Equity in undistributed loss of the Bank**                                 |       | (17,694  | )           | (3,093   | )          |
|                                                                         |       |     |        |     |       |
| **Net loss before taxes**                                                    |       | (18,296  | )           | (3,350   | )          |
|                                                                         |       |     |        |     |       |
| **Income tax**                                                               |       | —   |        | —   |       |
|                                                                         |       |     |        |     |       |
| **Net loss**                                                                 | ** ** | **$**    | **(18,296** | **)**    | **$**      | **(3,350** | **)** |

 

84

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**Condensed Statements of Cash Flows**

**For the year ended December 31, 2009 and December 31,2008**

(dollarsin thousands)

** **
| ** **                                                                       | ** ** | **2009** | ** ** | **2008**   | ** ** |
|----------------------------------------------------------------------------------|------------|----------|------------|------------|------------|
| **Cash flows from operating activities**                                         |       |     |       |       |       |
| Net loss                                                                         |       | $        | (18,296    | )          | $          | (3,350 | ) |
| Adjustments to reconcile net loss to net  cash used in by operating  activities: |       |     |       |       |       |
| Increase in other assets                                                         |       | (59      | )          | (90        | )          |
| Stock based compensation                                                         |       | 64       |       | 68         |       |
| Equity in undistributed loss of the Bank                                         |       | 19,319   |       | 2,754      |       |
| Change in accumulated other comprehensive income                                 |       | (1,625   | )          | 339        |       |
| Increase (decrease) in other liabilities                                         |       | (5       | )          | 119        |       |
| Net cash used in operating activities                                            |       | (602     | )          | (160       | )          |
|                                                                             |       |     |       |       |       |
| **Cash flows from investing activities**                                         |       |     |       |       |       |
| Investments in Bank subsidiary                                                   |       | (500     | )          | (2,800     | )          |
| Net cash used in investing activities                                            |       | (500     | )          | (2,800     | )          |
|                                                                             |       |     |       |       |       |
| **Cash flows from financing activities**                                         |       |     |       |       |       |
| Subordinated debt issue                                                          |       | —   |       | 4,325      |       |
| Increase (decrease) in other borrowings                                          |       | (1,570   | )          | 1,570      |       |
| Net cash provided by (used in) financing  activities                             |       | (1,570   | )          | 5,895      |       |
|                                                                             |       |     |       |       |       |
| **Net increase (decrease) in cash**                                              |       | (2,672   | )          | 2,935      |       |
|                                                                             |       |     |       |       |       |
| **Cash, beginning of year**                                                      |       | 3,029    |       | 94         |       |
|                                                                             |       |     |       |       |       |
| **Cash, end of year**                                                            | ** ** | **$**    | **357**    | ** ** | **$**      | **3,029** | ** ** |

# ** **

# **NOTE 26 — SUBSEQUENT EVENTS**

 

The Bank has evaluatedevents and transactions through the filing date for potential recognition ordisclosure in the consolidated financial statements and has determined thereare no subsequent events to disclose.

 

**Item9.  Changes in and Disagreements withAccountants on Accounting and Financial Disclosure.**

 

None

 

**Item 9A. Controls and Procedures.**

 

As of the end ofthe period covered by this report, we carried out an evaluation, under the supervisionand with the participation of our management, including our Chief ExecutiveOfficer and Chief Financial Officer, of the effectiveness of our disclosurecontrols and procedures as defined in Exchange Act Rule 13a-15(e).  Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer have concluded that our currentdisclosure controls and procedures are effective as of December 31, 2009.   There have been no significant changes in our internal controls overfinancial reporting during the fourth fiscal quarter ended December 31,2009 that have materially affected, or are reasonably likely to materiallyaffect, our internal controls over financial reporting.

 

The design of anysystem of controls and procedures is based in part upon certain assumptionsabout the likelihood of future events. There can be no assurance that any design will succeed in achieving itsstated goals under all potential future conditions, regardless of how remote.

 

85

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**Management’s Report on InternalControls Over Financial Reporting**

 

Management is responsiblefor establishing and maintaining adequate internal control over financialreporting, as such term is defined in the Exchange Act Rules 13a-15(f). Asystem of internal control over financial reporting is a process designed toprovide reasonable assurance regarding the reliability of financial reportingand the preparation of financial statements for external purposes in accordancewith generally accepted accounting principles.

 

Under the supervision andwith the participation of management, including the principal executive officerand the principal financial officer, the Company’s management has evaluated theeffectiveness of its internal control over financial reporting as of December 31,2009 based on the criteria established in a report entitled “Internal Control -Integrated Framework issued by the Committee of Sponsoring Organizations of theTreadway Commission” and the interpretive guidance issued by the Commission inRelease No. 34-55929. Based on this evaluation, the Company’s managementhas evaluated and concluded that the Company’s internal control over financialreporting was effective as of December 31, 2009.

 

The Company iscontinuously seeking to improve the efficiency and effectiveness of itsoperations and of its internal controls. This results in modifications to itsprocesses throughout the Company. However, there has been no change in itsinternal control over financial reporting that occurred during the Company’smost recent fiscal quarter that has materially affected, or is reasonablylikely to materially affect, the Company’s internal control over financialreporting.

 

This annual report doesnot include an attestation report of the Company’s independent registeredpublic accounting firm regarding internal control over financial reporting. TheCompany’s registered public accounting firm was not required to issue anattestation on its internal controls over financial reporting pursuant to temporaryrules of the SEC.

 

**Part III**

 

**Item 10. Directors, Executive Officers and Corporate Governance.**

 

The information required by Item 10 is herebyincorporated by reference from our proxy statement for our 2010 annual meetingof shareholders to be held on May 18, 2010.

 

**Item11.  Executive Compensation.**

 

The information required by Item 11 is herebyincorporated by reference from our proxy statement for our 2010 annual meetingof shareholders to be held on May 18, 2010.

 

**Item 12. Security Ownership of Certain Beneficial Owners and Management andRelated Stockholder Matters.**

 

The information required by Item 12 is herebyincorporated by reference from our proxy statement for our 2010 annual meetingof shareholders to be held on May 18, 2010.

 

**Item 13.  Certain Relationships and RelatedTransactions, and Director Independence.**

 

The information required by Item 13 is herebyincorporated by reference from our proxy statement for our 2010 annual meetingof shareholders to be held on May 18, 2010.

 

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**Item14.  Principal Accountant Fees andServices.**

 

The information required by Item 14 is herebyincorporated by reference from our proxy statement for our 2010 annual meetingof shareholders to be held on May 18, 2010.

 

**Item 15.  Exhibits.**

 

3.1.          Articlesof Incorporation (incorporated by reference to Exhibit 3.1 of the Company’sForm SB-2, File No. 333-117053).

 

3.2.          Bylaws (incorporated by reference to Exhibit 3.2of the Company’s Form SB-2, File No. 333-117053).

 

3.3.          Articles of Amendment to the Articles of Incorporation(incorporated by reference to Exhibit 3.1 of the Company’s Form 8-Kfiled November 23, 2009).

 

4.1.          See Exhibits 3.1, 3.2 and 3.3 for provisions inCommunitySouth Bancshares, Inc.’s Articles of Incorporation and Bylawsdefining the rights of holders of the common stock (incorporated by referenceto Exhibit 4.1 of the Company’s Form SB-2, File No. 333-117053).

 

4.2.          Form of certificate of common stock (incorporatedby reference to Exhibit 4.2 of the Company’s Form SB-2, File No. 333-117053).

 

10.1         Form of Stock Warrant Agreement (incorporated byreference to Exhibit 10.1 of the Company’s Form 10-QSB filed on August 15,2005).*

 

10.2         Master Loan Purchase Agreement between Bank ofTennessee and CommunitySouth Bank and Trust (incorporated by reference to Exhibit 10.6of the Company’s Form SB-2, File No. 333-117053).

 

10.3         Commercial Loan Agreement between Nexity Bank andCommunity Bancshares, Inc. dated July 26, 2004 (incorporated byreference to Exhibit 10.9 of the Company’s Form SB-2, File No. 333-117053).

 

10.4         Option and Agreement of Sale dated August 18,2004 by and between CommunitySouth Bancshares, Inc. and Daniel E.Youngblood (incorporated by reference to Exhibit 10.10 of the Company’s Form SB-2as, File No. 333-117053).

 

10.5         Ground Lease Agreement dated August 18, 2004 byand between CommunitySouth Bancshares, Inc. and Daniel E. Youngblood(incorporated by reference to Exhibit 10.11 of the Company’s Form SB-2,File No. 333-117053).

 

10.6         CommunitySouth Bancshares, Inc. 2005 StockIncentive Plan and Form of Option Agreement (incorporated by reference to Exhibit 10.9of the Company’s Form 10-KSB for the year ended December 31, 2004).*

 

10.7         Standard Form of Design-Build Agreement andGeneral Conditions between CommunitySouth Bancshares, Inc. and TrehelCorporation dated August 3, 2005 (incorporated by reference to Exhibit 10.1of the Company’s Form 10-QSB filed on November 14, 2005).

 

10.8         Employment Agreement by and between C. Allan DuckerIII and CommunitySouth Financial Corporation dated December 31, 2008(incorporated by reference to Exhibit 10.1 of the Company’s Form 8-Kfiled January 5, 2009).*

 

10.9         Employment Agreement by and between David A. Millerand CommunitySouth Financial Corporation dated December 31, 2008(incorporated by reference to Exhibit 10.2 of the Company’s Form 8-Kfiled January 5, 2009).*

 

10.10       Employment Agreement by and between John W. Hobbs andCommunitySouth Financial Corporation dated December 31, 2008 (incorporatedby reference to Exhibit 10.3 of the Company’s Form 8-K filed January 5,2009).*

 

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10.11       Amendment No. 1 to the CommunitySouth Bancshares, Inc.2005 Stock Incentive Plan and Form of Option Agreement, adopted November 18,2008 (incorporated by reference as Exhibit 10.11 to the Company’s Form 10-Kfiled March 30, 2009).*

 

10.12       Subordinated Note Purchase Agreement, dated August 22,2008 (incorporated by reference as Exhibit 10.1 to the Company’s Form 8-Kfiled August 28, 2008).*

 

10.13       Form of CommunitySouth Financial Corporation11.5% Subordinated Note Due 2018 (incorporated by reference as Exhibit 10.2to the Company’s Form 8-K filed August 28, 2008).*

 

10.14       Consent Order with the FDIC and the South CarolinaBoard of Financial Institutions dated February 23, 2010.

 

21.1         Subsidiaries of the Company.

 

23.1         Consent of Elliott Davis, LLC

 

24.1.        Power of Attorney (filed as part of the signature page herewith).

 

31.1         Rule 13a-14(a) Certification of the ChiefExecutive Officer.

 

31.2         Rule 13a-14(a) Certification of the ChiefFinancial Officer.

 

32            Section 1350 Certifications.

 

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*              Management contract of compensatory plan orarrangement required to be filed as an Exhibit to this Annual Report on Form 10-K.

 

If you wish to receive apaper copy of any exhibit to our reports filed with or furnished to the SEC,the exhibit may be obtained, upon payment of reasonable expenses, by writingto: CommunitySouth Financial Corporation, Attn: John W. Hobbs, Chief FinancialOfficer, 6602 Calhoun Memorial Highway, Easley, South Carolina 29640.

 

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**SIGNATURES**

 

In accordance withSection 13 or 15(d) of the Securities Exchange Act of 1934, theregistrant caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 

 
|   |                    |   | **COMMUNITYSOUTH FINANCIAL CORPORATION** |
|--------|-------------------------|--------|------------------------------------------|
|   |                    |   | ** **                               |
|   |                    |   |                                     |
| Date:  | February 26,  2010 |   | By:                                      | /s/ C. Allan  Ducker, III |
|   |                    |   | C. Allan  Ducker, III               |
|   |                    |   | Chief Executive Officer                  |
|        |                         |        |                                          |  |

 

KNOW ALL MEN BY THESE PRESENTS, that each person whose signatureappears below constitutes and appoints C. Allan Ducker, III, his true andlawful attorney-in-fact and agent, with full power of substitution andresubstitution, for him and in his name, place and stead, in any and allcapacities, to sign any and all amendments to this Annual Report on Form 10-K,and to file the same, with all exhibits thereto, and other documents inconnection therewith, with the Securities and Exchange Commission, grantingunto attorney-in-fact and agent full power and authority to do and perform eachand every act and thing requisite or necessary to be done in and about thepremises, as fully to all intents and purposes as he might or could do inperson, hereby ratifying and confirming all that attorney-in-fact and agent, orhis substitute or substitutes, may lawfully do or cause to be done by virtuehereof.

 

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

 
| **Signature**                 | ** ** | **Title**                                                           | ** ** | **Date**               |
|-------------------------------|------------|---------------------------------------------------------------------|------------|------------------------|
|                          |       |                                                                |       |                   |
|                          |       |                                                                |       |                   |
| /s/ David Larry  Brotherton   |       | Director                                                            |       | February 26, 2010 |
| David Larry Brotherton        |       |                                                                |       |                   |
|                          |       |                                                                |       |                   |
| /s/ G. Dial Dubose            |       | Director                                                            |       | February 26, 2010 |
| G. Dial DuBose                |       |                                                                |       |                   |
|                          |       |                                                                |       |                   |
| /s/ C. Allan Ducker, III |       | Chief Executive Officer,  Director                                  |       | February 26, 2010 |
| C. Allan Ducker, III     |       |                                                                |       |                   |
|                          |       |                                                                |       |                   |
| /s/ David W. Edwards          |       | Director                                                            |       | February 26, 2010 |
| David W. Edwards              |       |                                                                |       |                   |
|                          |       |                                                                |       |                   |
| /s/ R. Wesley Hammond         |       | Director                                                            |       | February 26, 2010 |
| R. Wesley Hammond             |       |                                                                |       |                   |
|                          |       |                                                                |       |                   |
| /s/ David A. Miller           |       | President, Director                                                 |       | February 26, 2010 |
| David A. Miller               |       |                                                                |       |                   |
|                          |       |                                                                |       |                   |
| /s/ John W. Hobbs             |       | Chief Financial Officer  and Principal Accounting Officer, Director |       | February 26, 2010 |
| John W. Hobbs                 |       |                                                                |       |                   |
|                          |       |                                                                |       |                   |
| /s/ W. Michael Riddle         |       | Director                                                            |       | February 26, 2010 |
| W. Michael Riddle             |       |                                                                |       |                   |
|                          |       |                                                                |       |                   |
| /s/ Joanne M. Rogers          |       | Director                                                            |       | February 26, 2010 |
| Joanne M. Rogers              |       |                                                                |       |                   |

 

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| /s/ B. Lynn Spencer            |   | Director |   | February 26, 2010 |
|--------------------------------|--------|----------|--------|------------------------|
| B. Lynn Spencer                |   |     |   |                   |
|                           |   |     |   |                   |
| /s/ J. Neal  Workman, Jr. |   | Director |   | February 26, 2010 |
| J. Neal  Workman, Jr.     |   |     |   |                   |
|                           |   |     |   |                   |
| /s/ Daniel E.  Youngblood      |   | Director |   | February 26, 2010 |
| Daniel E. Youngblood           |   |     |   |                   |

 

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**Exhibit Index**

 

3.1.          Articles of Incorporation (incorporated by referenceto Exhibit 3.1 of the Company’s Form SB-2, File No. 333-117053).

 

3.2.          Bylaws (incorporated by reference to Exhibit 3.2of the Company’s Form SB-2, File No. 333-117053).

 

3.3           Articles of Amendment to the Articles of Incorporation(incorporated by reference to Exhibit 3.1 of the Company’s Form 8-Kfiled November 23, 2009).

 

4.1.          See Exhibits 3.1, 3.2 and 3.3 for provisions inCommunitySouth Bancshares, Inc.’s Articles of Incorporation and Bylawsdefining the rights of holders of the common stock (incorporated by referenceto Exhibit 4.1 of the Company’s Form SB-2, File No. 333-117053).

 

4.2.          Form of certificate of common stock (incorporatedby reference to Exhibit 4.2 of the Company’s Form SB-2, File No. 333-117053).

 

10.1         Form of Stock Warrant Agreement (incorporated byreference to Exhibit 10.1 of the Company’s Form 10-QSB filed on August 15,2005).*

 

10.2         Master Loan Purchase Agreement between Bank ofTennessee and CommunitySouth Bank and Trust (incorporated by reference to Exhibit 10.6of the Company’s Form SB-2, File No. 333-117053).

 

10.3         Commercial Loan Agreement between Nexity Bank andCommunity Bancshares, Inc. dated July 26, 2004 (incorporated byreference to Exhibit 10.9 of the Company’s Form SB-2, File No. 333-117053).

 

10.4         Option and Agreement of Sale dated August 18,2004 by and between CommunitySouth Bancshares, Inc. and Daniel E.Youngblood (incorporated by reference to Exhibit 10.10 of the Company’s Form SB-2as, File No. 333-117053).

 

10.5         Ground Lease Agreement dated August 18, 2004 byand between CommunitySouth Bancshares, Inc. and Daniel E. Youngblood(incorporated by reference to Exhibit 10.11 of the Company’s Form SB-2,File No. 333-117053).

 

10.6         CommunitySouth Bancshares, Inc. 2005 StockIncentive Plan and Form of Option Agreement (incorporated by reference to Exhibit 10.9of the Company’s Form 10-KSB for the year ended December 31, 2004).*

 

10.7         Standard Form of Design-Build Agreement andGeneral Conditions between CommunitySouth Bancshares, Inc. and TrehelCorporation dated August 3, 2005 (incorporated by reference to Exhibit 10.1of the Company’s Form 10-QSB filed on November 14, 2005).

 

10.8         Employment Agreement by and between C. Allan DuckerIII and CommunitySouth Financial Corporation dated December 31, 2008(incorporated by reference to Exhibit 10.1 of the Company’s Form 8-Kfiled January 5, 2009).*

 

10.9         Employment Agreement by and between David A. Millerand CommunitySouth Financial Corporation dated December 31, 2008(incorporated by reference to Exhibit 10.2 of the Company’s Form 8-Kfiled January 5, 2009).*

 

10.10       Employment Agreement by and between John W. Hobbs andCommunitySouth Financial Corporation dated December 31, 2008 (incorporatedby reference to Exhibit 10.3 of the Company’s Form 8-K filed January 5,2009).*

 

10.11       Amendment No. 1 to the CommunitySouth Bancshares, Inc.2005 Stock Incentive Plan and Form of Option Agreement, adopted November 18,2008 (incorporated by reference as Exhibit 10.11 to the Company’s Form 10-Kfiled March 30, 2009).*

 

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10.12       Subordinated Note Purchase Agreement, dated August 22,2008 (incorporated by reference as Exhibit 10.1 to the Company’s Form 8-Kfiled August 28, 2008).*

 

10.13       Form of CommunitySouth Financial Corporation11.5% Subordinated Note Due 2018 (incorporated by reference as Exhibit 10.2to the Company’s Form 8-K filed August 28, 2008).*

 

10.14       Consent Order with the FDIC and the South CarolinaBoard of Financial Institutions dated February 23, 2010.

 

21.1         Subsidiaries of the Company.

 

23.1         Consent of Elliott Davis, LLC

 

24.1.        Power of Attorney (filed as part of the signature page herewith).

 

31.1         Rule 13a-14(a) Certification of the ChiefExecutive Officer.

 

31.2         Rule 13a-14(a) Certification of the ChiefFinancial Officer.

 

32            Section 1350 Certifications.

 

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*              Management contract of compensatory plan orarrangement required to be filed as an Exhibit to this Annual Report on Form 10-K.

 

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