UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





FORM 10-Q





þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)


OF THE SECURITIES EXCHANGE ACT OF 1934





For the Quarterly Period Ended March 31, 2011





or





o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)


OF THE SECURITIES EXCHANGE ACT OF 1934





For the Transition Period from  to













CAPITAL BANK CORPORATION


(Exact name of registrant as specified in its charter)





North Carolina

000-30062

56-2101930(State or other jurisdiction of

incorporation or organization)

(Commission

File Number)

(I.R.S. Employer

Identification No.)





333 Fayetteville Street, Suite 700


Raleigh, North Carolina 27601


(Address of principal executive offices)





(919) 645-6400


(Registrant’s telephone number, including area code)





Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.Yes  þ  No  o





Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes oNo  o





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





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





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





As of May 10, 2011 there were 85,802,164 shares outstanding of the registrant’s common stock, no par value.





- 1 -


CAPITAL BANK CORPORATION


Form 10-Q for the Quarterly Period Ended March 31, 2011








INDEX





PART I – FINANCIAL INFORMATION
Page No.Item 1.
Financial StatementsUnaudited Condensed Consolidated Balance Sheets as of March 31, 2011 (Successor) and December 31, 2010 (Predecessor)
3Unaudited Condensed Consolidated Statements of Operations for the Period of January 29, 2011 to March 31, 2011 (Successor), the Period of January 1, 2011 to January 28, 2011 (Predecessor) and the Three Months Ended March 31, 2010 (Predecessor)
4Unaudited Condensed Consolidated Statements of Changes in Shareholders’ Equity for the Period of January 29, 2011 to March 31, 2011 (Successor), the Period of January 1, 2011 to January 28, 2011 (Predecessor) and the Three Months Ended March 31, 2010 (Predecessor)
5Unaudited Condensed Consolidated Statements of Cash Flows for the Period of January 29, 2011 to March 31, 2011 (Successor), the Period of January 1, 2011 to January 28, 2011 (Predecessor) and the Three Months Ended March 31, 2010 (Predecessor)
6Unaudited Notes to Condensed Consolidated Financial Statements
7Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
26Item 3.
Quantitative and Qualitative Disclosures about Market Risk
39Item 4.
Controls and Procedures
39PART II – OTHER INFORMATIONItem 1.
Legal Proceedings
40Item 1A.
Risk Factors
40Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
51Item 3.
Defaults upon Senior Securities
51Item 4.
(Removed and Reserved)
51Item 5.
Other Information
51Item 6.
Exhibits
52Signatures


- 2 -
 Index


PART I – FINANCIAL INFORMATION





Item 1.  Financial Statements





CAPITAL BANK CORPORATION


CONDENSED CONSOLIDATED BALANCE SHEETS


(Unaudited)

Successor

Company


Predecessor

CompanyMar. 31, 2011


Dec. 31, 2010(Dollars in thousands)AssetsCash and cash equivalents:Cash and due from banks

$
16,870


$
13,646Interest-bearing deposits with banks


99,780



53,099Total cash and cash equivalents


116,650



66,745Investment securities:Investment securities – available for sale, at fair value


296,632



214,991Other investments


8,270



8,301Total investment securities


304,902



223,292Mortgage loans held for sale


1,424



6,993Loans:Loans – net of unearned income and deferred fees


1,125,260



1,254,479Allowance for loan losses


(167
)


(36,061
)Net loans


1,125,093



1,218,418Other real estate


14,535



18,334Premises and equipment, net


27,098



25,034Goodwill


30,994



–Other intangible assets, net


4,813



1,774Deferred tax asset


54,529



–Other assets


24,618



24,957Total assets

$
1,704,656


$
1,585,547LiabilitiesDeposits:Demand, noninterest checking

$
119,742


$
116,113NOW accounts


189,340



185,782Money market accounts


146,543



137,422Savings accounts


31,794



30,639Time deposits


862,242



873,330Total deposits


1,349,661



1,343,286Borrowings


93,513



121,000Subordinated debt


19,431



34,323Other liabilities


13,291



10,250Total liabilities


1,475,896



1,508,859Shareholders’ EquityPreferred stock, $1,000 par value; 100,000 shares authorized; 41,279 shares issued and outstanding (liquidation preference of $41,279) at December 31, 2010


–



40,418Common stock, no par value; 300,000,000 shares authorized; 85,489,260 and 12,877,846 shares issued and outstanding


227,961



145,594Accumulated deficit


(574
)


(108,027
)Accumulated other comprehensive income (loss)


1,373



(1,297
)Total shareholders’ equity


228,760



76,688Total liabilities and shareholders’ equity

$
1,704,656


$
1,585,547





The accompanying notes are an integral part of these condensed consolidated financial statements.


- 3 -
 Index


CAPITAL BANK CORPORATION


CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


(Unaudited)

Successor

Company


Predecessor

CompanyJan. 29, 2011

to

Mar. 31, 2011


Jan. 1, 2011

to

Jan. 28, 2011

Three Months Ended

Mar. 31, 2010(Dollars in thousands except per share data)Interest income:Loans and loan fees

$
11,056


$
5,479

$
17,411Investment securities:Taxable interest income


990



391


2,026Tax-exempt interest income


159



74


601Dividends


29



–


18Federal funds and other interest income


47



11


10Total interest income


12,281



5,955


20,066Interest expense:Deposits


1,774



1,551


6,151Borrowings and repurchase agreements


486



445


1,365Total interest expense


2,260



1,996


7,516Net interest income


10,021



3,959


12,550Provision for loan losses


167



40


11,734Net interest income after provision for loan losses


9,854



3,919


816Noninterest income:Service charges and other fees


548



291


868Bank card services


300



174


415Mortgage origination and other loan fees


263



210


327Brokerage fees


96



78


187Bank-owned life insurance


20



10


239Net gain on sale of investment securities


–



–


263Other


25



69


232Total noninterest income


1,252



832


2,531Noninterest expense:Salaries and employee benefits


3,957



1,977


5,400Occupancy


1,140



548


1,502Furniture and equipment


544



275


745Data processing and telecommunications


276



180


517Advertising and public relations


181



131


430Office expenses


229



93


332Professional fees


335



190


475Business development and travel


246



87


267Amortization of other intangible assets


191



62


235ORE losses and miscellaneous loan costs


523



176


1,317Directors’ fees


40



68


298FDIC deposit insurance


563



266


665Contract termination fees


3,581



–


–Other


423



102


407Total noninterest expense


12,229



4,155


12,590Net income (loss) before income taxes


(1,123
)


596


(9,243
)Income tax expense (benefit)


(549
)


–


(3,909
)Net income (loss)


(574
)


596


(5,334
)Dividends and accretion on preferred stock


–



861


589Net income (loss) attributable to common shareholders

$
(574
)

$
(265
)
$
(5,923
)Net loss per common share – basic

$
(0.01
)

$
(0.02
)
$
(0.49
)Net loss per common share – diluted

$
(0.01
)

$
(0.02
)
$
(0.49
)





The accompanying notes are an integral part of these condensed consolidated financial statements.


- 4 -
 Index


CAPITAL BANK CORPORATION


CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY


(Unaudited)
 Preferred Stock

Common Stock

Other

Comprehensive

Income

AccumulatedPredecessor Company

Shares

Amount

Shares

Amount

(Loss)

Deficit

Total(Dollars in thousands)Balance at January 1, 2010

41,279

$
40,127


11,348,117

$
139,909

$
3,955

$
(44,206
)
$
139,785Comprehensive loss:Net loss
















(5,334
)

(5,334
)Net unrealized loss on securities, net of tax benefit of $234













(372
)




(372
)Amortization of prior service cost on SERP













2





2Total comprehensive loss



















(5,704
)Accretion of preferred stock discount




73











(73
)

–Issuance of common stock







1,468,770


5,065








5,065Stock option expense










12








12Directors’ deferred compensation







64,467


150








150Dividends on preferred stock
















(516
)

(516
)Balance at March 31, 2010

41,279

$
40,200


12,881,354

$
145,136

$
3,585

$
(50,129
)
$
138,792Balance at January 1, 2011

41,279

$
40,418


12,877,846

$
145,594

$
(1,297
)
$
(108,027
)
$
76,688Comprehensive income:Net income
















596


596Net unrealized loss on securities, net of tax benefit of $204













(324
)




(324
)Amortization of prior service cost on SERP













1





1Total comprehensive income



















273Accretion of preferred stock discount




24











(24
)

–Stock option expense










5








5Directors’ deferred compensation










35








35Dividends on preferred stock
















(172
)

(172
)Balance at January 28, 2011

41,279

$
40,442


12,877,846

$
145,634

$
(1,620
)
$
(107,627
)
$
76,829Preferred Stock

Common Stock

Other

Comprehensive

AccumulatedSuccessor Company

Shares

Amount

Shares

Amount

Income

Deficit

Total(Dollars in thousands)Balance at January 28, 2011

–

$
–


83,877,846

$
224,085

$
–

$
–

$
224,085Comprehensive income:Net loss
















(574
)

(574
)Net unrealized gain on securities, net of tax of $862













1,373





1,373Total comprehensive income



















799Issuance of common stock, net of offering costs of $300







1,613,165


3,814








3,814Stock option expense










69








69Restricted stock







(1,751
)

(7
)







(7
)Balance at March 31, 2011

–

$
–


85,489,260

$
227,961

$
1,373

$
(574
)
$
228,760


The accompanying notes are an integral part of these condensed consolidated financial statements.


- 5 -
 Index


CAPITAL BANK CORPORATION


CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(Unaudited)


Successor

Company


Predecessor

CompanyJan. 29, 2011

to

Mar. 31, 2011


Jan. 1, 2011

to

Jan. 28, 2011

Three Months Ended

Mar. 31, 2010(Dollars in thousands)Cash flows from operating activities:Net income (loss)

$
(574
)

$
596

$
(5,334
)Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:Accretion of purchased credit-impaired loans


(10,265
)


–


–Amortization /accretion of fair value premium/discount on acquired time deposits, borrowings and subordinated debt, net


(1,441
)


–


–Provision for loan losses


167



40


11,734Amortization of other intangible assets


191



62


236Depreciation


490



203


635Stock-based compensation


137



42


192Gain on sale of securities, net


–



–


(263
)Amortization of premium on securities, net


238



171


34Loss (gain) on disposal of premises, equipment and ORE


(102
)


(9
)

225ORE valuation adjustments


131



–


646Bank-owned life insurance income


(20
)


(10
)

(251
)Deferred income tax expense


–



–


640Net change in:Mortgage loans held for sale


1,145



4,424


–Accrued interest receivable and other assets


(554
)


(1,309
)

(6,128
)Accrued interest payable and other liabilities


2,696



(3,939
)

(559
)Net cash provided by (used in) operating activities


(7,761
)


271


1,807Cash flows from investing activities:Principal repayments on loans, net of loans originated or acquired


19,380



14,547


(3,743
)Purchases of premises and equipment


(241
)


(416
)

(1,469
)Proceeds from sales of premises, equipment and ORE


1,485



201


3,541Purchases of FHLB stock


–



–


(2,025
)Purchases of securities – available for sale


(88,209
)


(6,840
)

(18,013
)Proceeds from sales of securities – available for sale


–



–


17,305Proceeds from principal repayments/calls/maturities of securities – available for sale


10,577



3,936


14,803Proceeds from principal repayments/calls/maturities of securities – held to maturity


–



–


330Net cash provided by (used in) investing activities


(57,008
)


11,428


10,729Cash flows from financing activities:Increase (decrease) in deposits, net


(650
)


(4,960
)

2,574Decrease in repurchase agreements, net


–



–


(3,316
)Proceeds from borrowings


–



–


141,000Principal repayments of borrowings


(30,000
)


(5,000
)

(136,000
)Proceeds from issuance of subordinated debentures


–



–


3,393Repurchase of preferred stock


–



(41,279
)

–Proceeds from North American Financial Holdings, Inc. Investment


–



181,050Proceeds from issuance of common stock, net of offering costs


3,814



–


5,065Dividends paid


–



–


(1,424
)Net cash provided by (used in) financing activities


(26,836
)


129,811


11,292(continued on next page)


- 6 -
 Index


CAPITAL BANK CORPORATION


CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)


(Unaudited)


Successor

Company


Predecessor

CompanyJan. 29, 2011

to

Mar. 31, 2011


Jan. 1, 2011

to

Jan. 28, 2011

Three Months

Ended

Mar. 31, 2010(Dollars in thousands)Net change in cash and cash equivalents

$
(91,605
)

$
141,510

$
23,828Cash and cash equivalents at beginning of period


208,255



66,745


29,513Cash and cash equivalents at end of period

$
116,650


$
208,255

$
53,341Supplemental Disclosure of Cash Flow InformationNoncash investing activities:Transfers of loans and premises to ORE

$
1,646


$
248

$
9,305Transfers of ORE to loans


857



146


–Cash paid for:Income taxes

$
–


$
–

$
–Interest


4,088



1,531


7,368





Supplemental cash flow information related to the NAFH Investment is disclosed in Note 2 (NAFH Acquisition).





The accompanying notes are an integral part of these condensed consolidated financial statements.






1.  Basis of Presentation and Significant Accounting Policies





Organization and Nature of Operations





Capital Bank Corporation (the “Company”) is a bank holding company incorporated under the laws of North Carolina on August 10, 1998. The Company’s primary wholly-owned subsidiary is Capital Bank (the “Bank”), a state-chartered banking corporation that was incorporated under the laws of North Carolina on May 30, 1997 and commenced operations on June 20, 1997. In addition, the Company has interest in three trusts, Capital Bank Statutory Trust I, II, and III (hereinafter collectively referred to as the “Trusts”).





On January 28, 2011, the Company completed the issuance and sale of 71,000,000 shares of its common stock to North American Financial Holdings, Inc. (“NAFH”) for $181,050,000 in cash (the “NAFH Investment”). As a result of the NAFH Investment and the Company’s rights offering on March 11, 2011 (the “Rights Offering”), NAFH currently owns approximately 83% of the Company’s common stock. Upon closing of the NAFH Investment, R. Eugene Taylor, NAFH’s Chief Executive Officer, Christopher G. Marshall, NAFH’s Chief Financial Officer, and R. Bruce Singletary, NAFH’s Chief Risk Officer, were named as the Company’s CEO, CFO and CRO, respectively, and as members of the Company’s Board of Directors. In addition, the Company’s Board of Directors was reconstituted with a combination of two existing members (Oscar A. Keller III and Charles F. Atkins), Messrs. Taylor, Marshall and Singletary, and two additional NAFH-designated members (Peter N. Foss and William A. Hodges).





Basis of Presentation and Use of Estimates





The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and the Bank. The Trusts have not been consolidated with the financial statements of the Company.The interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). They do not include all of the information and footnotes required by such accounting principles for complete financial statements, and therefore should be read in conjunction with the audited consolidated financial statements and accompanying footnotes in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.




- 7 -
 Index





In the opinion of management, all adjustments necessary for a fair presentation of the financial position and results of operations for the periods presented have been included, and all significant intercompany transactions have been eliminated in consolidation. Certain amounts reported in prior periods have been reclassified to conform to the current presentation. Such reclassifications have no effect on total assets, net income or shareholders’ equity as previously reported. The results of operations for the period of January 29, 2011 to March 31, 2011 (Successor Company) and the period of January 1, 2011 to January 28, 2011 (Predecessor Company) are not necessarily indicative of the results of operations that may be expected for the year ending December 31, 2011. The condensed consolidated balance sheet at December 31, 2010 has been derived from the audited consolidated financial statements contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.





The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. A description of the accounting policies followed by the Company are as set forth in Note 1 of the Notes to Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010. Due to the NAFH Investment, the Company has added an accounting policy related to purchased credit-impaired loans, which is described as follows:





Purchased Credit-Impaired Loans





Loans acquired in a transfer, including business combinations and transactions similar to the NAFH Investment, where there is evidence of credit deterioration since origination and it is probable at the date of acquisition that the Company will not collect all contractually required principal and interest payments, are accounted for under accounting guidance for purchased credit-impaired (“PCI”) loans. This guidance provides that the excess of the cash flows initially expected to be collected over the fair value of the loans at the acquisition date (i.e., the accretable yield) is accreted into interest income over the estimated remaining life of the purchased credit-impaired loans using the effective yield method, provided that the timing and amount of future cash flows is reasonably estimable. Accordingly, such loans are not classified as nonaccrual and they are considered to be accruing because their interest income relates to the accretable yield recognized under accounting for purchased credit-impaired loans and not to contractual interest payments. The difference between the contractually required payments and the cash flows expected to be collected at acquisition, considering the impact of prepayments, is referred to as the nonaccretable difference.





Subsequent to acquisition, estimates of cash flows expected to be collected are updated each reporting period based on updated assumptions regarding default rates, loss severities, and other factors that are reflective of current market conditions. If the Company has probable decreases in cash flows expected to be collected (other than due to decreases in interest rate indices), the Company charges the provision for credit losses, resulting in an increase to the allowance for loan losses. If the Company has probable and significant increases in cash flows expected to be collected, the Company will first reverse any previously established allowance for loan losses and then increase interest income as a prospective yield adjustment over the remaining life of the pool of loans. The impact of changes in variable interest rates is recognized prospectively as adjustments to interest income. The accounting pools of acquired loans are defined as of the date of acquisition of a portfolio of loans and are comprised of groups of loans with similar collateral types and credit risk.





Recent Accounting Pronouncements





In April 2011, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) 2011-2, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring, to amend FASB Accounting Standards Codification (“ASC”) Topic 320,Receivables. The amendments in this update clarify the guidance on a creditor’s evaluation of whether it has granted a concession and whether a borrower is experiencing financial difficulties. The amendments in this update are effective for the first interim or annual period beginning on or after June 15, 2011, and should be applied retrospectively to the beginning of the annual period of adoption. This update also indicates that companies should disclose the information regarding troubled debt restructurings required by paragraphs 310-10-50-33 through 50-34, which was deferred by ASU 2011-01, Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20,for interim and annual periods beginning on or after June 15, 2011. Management does not believe that adoption of this update will have a material impact on the Company’s financial position or results of operations.





In December 2010, the FASB issued ASU 2010-29, Disclosure of Supplementary Pro Forma Information for Business Combinations, to amend ASC Topic 805,Business Combinations. The amendments in this update specify that if a public entity presents comparative financial statements, the entity should disclose revenue and earnings of the combined entity as though the business combination(s) that occurred during the current year had occurred as of the beginning of the comparable prior annual reporting period only. The amendments in this update are effective prospectively for business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2010. Adoption of this update did not have a material impact on the Company’s financial position or results of operations.


- 8 -
 Index





In July 2010, the FASB issued ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses, to amend ASC Topic 320, Receivables. The amendments in this update are intended to provide disclosures that facilitate financial statement users’ evaluation of the nature of credit risk inherent in the entity’s portfolio of financing receivables, how that risk is analyzed and assessed in arriving at the allowance for credit losses, and the changes and reasons for those changes in the allowance for credit losses. The disclosures as of the end of a reporting period were effective for interim and annual periods ending on or after December 15, 2010. The disclosures about activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010. Adoption of this update did not have a material impact on the Company’s financial position or results of operations.





2.  NAFH Acquisition





As discussed in Note 1 (Basis of Presentation and Significant Accounting Policies), on January 28, 2011, the Company completed the issuance and sale of 71,000,000 shares of its common stock to NAFH for $181,050,000 in cash. As a result of this NAFH Investment and the Rights Offering on March 11, 2011, NAFH currently owns approximately 83% of the Company’s common stock. In connection with the NAFH Investment, each Company shareholder as of January 27, 2011 received one contingent value right per share (“CVR”) that entitles the holder to receive up to $0.75 in cash per CVR at the end of a five-year period based on the credit performance of the Bank’s existing loan portfolio.





Also in connection with the NAFH Investment, the Company’s Series A Preferred Stock and warrant to purchase shares of common stock issued by the Company to the U.S. Treasury in connection with the Troubled Asset Relief Program (“TARP”) were repurchased. Following the TARP Repurchase, the Series A Preferred Stock and warrant are no longer outstanding, and accordingly, the Company is no longer subject to the restrictions imposed by the terms of the Series A Preferred Stock or certain regulatory provisions of the Emergency Economic Stabilization Act of 2008 (“EESA”) and the American Recovery and Reinvestment Act of 2009 (“ARRA”) that are imposed on TARP recipients.





Pursuant to the NAFH Investment, shareholders as of January 27, 2011 received non-transferable rights to purchase a number of shares of the Company’s common stock proportional to the number of shares of common stock held by such holders on such date, at a purchase price equal to $2.55 per share, subject to certain limitations. The Company issued 1,613,165 shares of common stock in exchange for $4,113,571 upon completion of the Rights Offering on March 11, 2011. Direct offering costs of $300,000 were recorded as a reduction to the proceeds of the Rights Offering.





Also in connection with the closing of the NAFH Investment, the Company amended its Supplemental Executive Retirement Plan (the “Executive Plan” or “SERP”) to waive, with respect to unvested amounts only, any change in control provision and corresponding entitlement to change in control benefits that would otherwise be triggered by the NAFH Investment or any subsequent transaction or series of transactions that result in an affiliate of NAFH holding the Company’s outstanding voting securities or total voting power. On January 28, 2011, the Company received written waivers from each of the participants in the Executive Plan pursuant to which such executives waived the previously described change in control benefits under the SERP and the accelerated vesting of their outstanding unvested Company stock options in connection with the transactions contemplated by the NAFH Investment. Cash payments made to participants in the Executive Plan upon change in control related to vested benefits totaled $1,119,000.The Supplemental Retirement Plan for Directors was not amended, and cash payments made to participants upon change in control pursuant to terms of this plan totaled $3,156,000.





In Staff Accounting Bulletin Topic No. 5.J,Push Down Basis of Accounting Required in Certain Limited Circumstances, the Securities and Exchange Commission (“SEC”) staff indicated that it believes push-down accounting is required in purchase transactions that result in an entity becoming substantially wholly owned. In determining whether a company has become substantially wholly owned, the SEC staff has stated that push-down accounting would be required if 95% or more of the company has been acquired, permitted if 80% to 95% has been acquired, and prohibited if less than 80% of the company is acquired. The Company determined push-down accounting to be appropriate for this transaction, and as such, has applied the acquisition method of accounting due to NAFH’s acquisition of 85% of the Company’s outstanding common stock on January 28, 2011.


- 9 -
 Index


The following table summarizes the NAFH Investment and the Company’s opening balance sheet:




As of

Jan. 28, 2011(Dollars in thousands)Fair value of assets acquired:Cash and cash equivalents

$
208,255Investment securities


225,336Mortgage loans held for sale


2,569Loans


1,135,164Goodwill


30,994Other intangible assets


5,004Deferred tax asset


55,391Other assets


66,663Total assets acquired


1,729,376Fair value of liabilities assumed:Deposits


1,351,467Borrowings


123,837Subordinated debt


19,392Other liabilities


10,595Total liabilities assumed


1,505,291Net assets acquired


224,085Less: non-controlling interest at fair value


(43,785
)180,300Underwriting and legal costs


750Purchase price

$
181,050


The above estimated fair values of assets acquired and liabilities assumed are based on the information that was available to make preliminary estimates of the fair value. While the Company believes that information provides a reasonable basis for estimating the fair values, it expects to obtain additional information and evidence during the measurement period (not to exceed one year from the acquisition date) that may result in changes to the estimated fair value amounts. Thus, the provisional measurements of fair value reflected are subject to change and such changes could be significant. The Company expects to finalize the valuation and complete the purchase price allocation as soon as practicable but no later than one year from the acquisition date. Subsequent adjustments, if any, will be retrospectively reflected in future filings.





A summary and description of the assets, liabilities and non-controlling interests fair valued in conjunction with applying the acquisition method of accounting is as follows:





Cash and Cash Equivalents





The cash and cash equivalents, which include proceeds from the NAFH Investment, held at acquisition date approximated fair value on that date and did not require a fair value adjustment.





Investment Securities





Investment securities are reported at fair value at acquisition date. To account for the NAFH Investment, the difference between the fair value and par value became the new premium or discount for each security held by the Company. The fair value of investment securities is primarily based on values obtained from third parties pricing models which are based on recent trading activity for the same or similar securities. Two equity securities were valued at their respective stock market prices, and two corporate bonds were valued using an internal valuation model. Immediately before the acquisition, the investment portfolio had an amortized cost of $228,106,000 and was in a net unrealized loss position of $2,770,000.


- 10 -
 Index


Loans





All loans in the loan portfolio were adjusted to estimated fair value at the NAFH Investment date. Upon analyzing estimated credit losses as well as evaluating differences between contractual interest rates and market interest rates at acquisition, the Company recorded a loan fair value discount of $104,380,000. All acquired loans were considered to be PCI loans with the exception of certain consumer revolving lines of credit. Subsequent to the NAFH Investment, PCI loans will be accounted for as described in Note 1 (Basis of Presentation and Significant Accounting Policies) and in Note 6 (Loans).





Goodwill and Other Intangible Assets





Goodwill represents the excess of purchase price over the fair value of acquired net assets. This acquisition was nontaxable and, as a result, there is no tax basis in the goodwill. Accordingly, none of the goodwill associated with the acquisition is deductible for tax purposes. Other intangible assets identified as part of the valuation of the NAFH Investment were Core Deposit Intangibles (“CDI”) and the Trade Name Intangible. All of the identified intangible assets are amortized as noninterest expense over their estimated useful lives.





Core Deposit Intangible





The estimated value of the CDI at acquisition date was $4,400,000. This amount represents the present value of the difference between a market participant’s cost of obtaining alternative funds and the cost to maintain the acquired deposit base. The present value is calculated over the estimated life of the acquired deposit base and will be amortized on an accelerated method over an eight year period. Deposit accounts evaluated for the CDI were demand deposit accounts, money market accounts and savings accounts.





Trade Name Intangible





Trademarks, service marks and other registered marks (collectively referred to as the “Trade Name”) can have great significance to customers. The function of a mark is to indicate to the consumer the sources from which goods and services originate. The Trade Name considered to have value is Capital Bank. The Trade Name value of $604,000 at acquisition date was based on the present value of the Company’s projected income multiplied by an assumed royalty rate. This intangible will be amortized on a straight-line basis over a three year period.





Other Assets





A majority of other assets held by the Company did not have a fair value adjustment as part of acquisition accounting since their carrying value approximated fair value. The most significant other asset impacted by the application of the acquisition method of accounting was the recognition of a net deferred tax asset of $55,391,000. The net deferred tax asset is primarily related to the recognition of differences between certain tax and book bases of assets and liabilities related to the acquisition method of accounting, including fair value adjustments discussed elsewhere in this section, along with federal and state net operating losses that the Company determined to be realizable as of the acquisition date. A valuation allowance is recorded for deferred tax assets, including net operating losses, if the Company determines that it is more likely than not that some portion or all of the deferred tax assets will not be realized.





Deposits





Time deposits were not included in the CDI valuation. Instead, a separate valuation of term deposit liabilities was conducted due to the contractual time frame associated with these liabilities. Term deposits evaluated for acquisition accounting consisted of certificates of deposit (“CDs”), brokered deposits and CDs through the Certificate of Deposit Account Registry Services (“CDARS”). The fair value of these deposits was determined by first stratifying the deposit pool by maturity and calculating the interest rate for each maturity period. Then cash flows were projected by period and discounted to present value using current market interest rates.





The outstanding balance of CDs at acquisition date was $730,481,000, and the estimated fair value premium totaled $12,433,000. The outstanding balance of brokered deposits was $100,479,000, and the estimated fair value premium totaled $616,000. The outstanding balance of CDARS was $27,020,000, and the estimated fair value premium totaled $111,000. The Company will amortize these premiums into income as a reduction of interest expense on a level-yield basis over the weighted average term.


- 11 -
 Index





Borrowings





Included in borrowings are FHLB advances and structured repurchase agreements. Fair values for these borrowings were estimated by developing cash flow estimates for each of these debt instruments based on scheduled principal and interest payments, current interest rates, and prepayment penalties. Once the cash flows were determined, a market rate for comparable debt was used to discount the cash flows to the present value. The outstanding balance of FHLB advances and structured repurchase agreements at acquisition date was $66,000,000 and $50,000,000, respectively, and the estimated fair value premiums on each totaled $1,799,000 and $6,038,000, respectively. The Company will amortize the premium into income as a reduction of interest expense on a level-yield basis over the contractual term of each debt instrument.





Subordinated Debt





Included in subordinated debt are variable rate trust preferred securities issued by the Company and fixed rate subordinated debt issued as part of a private placement offering early in 2010. Fair values for the trust preferred securities and subordinated debt were estimated by developing cash flow estimates for each of these debt instruments based on scheduled principal and interest payments and current interest rates. Once the cash flows were determined, a market rate for comparable subordinated debt was used to discount the cash flows to the present value. The outstanding balance of trust preferred securities and subordinated debt at acquisition date was $30,930,000 and $3,393,000, respectively, and the estimated fair value (discount)/premium on each totaled ($15,143,000) and $211,000, respectively. The Company will accrete the discount as an increase to interest expense and will amortize the premium as a decrease to interest expense on a level-yield basis over the contractual term of each debt instrument.





Contingent Value Rights





In connection with the NAFH Investment, each existing shareholder as of January 27, 2011 received one contingent value right per share that entitles the holder to receive up to $0.75 in cash per CVR at the end of a five-year period based on the credit performance of the Bank’s existing loan portfolio. The Company estimated the fair value of these CVRs at $568,000, which was based on its estimate of credit losses on the existing loan portfolio over the five-year life of these instruments. These CVRs were recorded at fair value in other liabilities in acquisition accounting.





Non-controlling Interest





In determining the estimated fair value of the non-controlling interest, the Company utilized the closing market price of its common stock on the acquisition date, which was $3.40, and multiplied this stock price by the number of outstanding non-controlling shares at that date.





Transaction Expenses





As required by the NAFH Investment, the Company incurred and reimbursed third party expenses of $750,000 which were recorded as a reduction of proceeds received from the issuance of common shares to NAFH.





There were no indemnification assets in this transaction, nor was there any contingent consideration to be recognized.





3.  Earnings (Loss) Per Share





Basic earnings (loss) per share (“EPS”) excludes dilution and is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS assumes the conversion, exercise or issuance of all potential common stock instruments, such as stock options and warrants, unless the effect is to reduce a loss or increase earnings. Basic EPS is adjusted for outstanding stock options and warrants using the treasury stock method in order to compute diluted EPS. The calculation of basic and diluted EPS for the period of January 29, 2011 to March 31, 2011 (Successor), the period of January 1, 2011 to January 28, 2011 (Predecessor) and the three months ended March 31, 2010 (Predecessor) was as follows:


- 12 -
 Index


Successor

Company


Predecessor

CompanyJan. 29, 2011

to

Mar. 31, 2011


Jan. 1, 2011

to

Jan. 28, 2011

Three Months Ended

Mar. 31, 2010(Dollars in thousands except per share data)Net loss attributable to common shareholders

$
(574
)

$
(265
)
$
(5,923
)Shares used in the computation of earnings per share:Weighted average number of shares outstanding – basic


84,970,748



13,188,612


12,014,430Incremental shares from assumed exercise of stock options and warrants


–



–


–Weighted average number of shares outstanding – diluted


84,970,748



13,188,612


12,014,430Earnings (loss) per common share – basic

$
(0.01
)

$
(0.02
)
$
(0.49
)Earnings (loss) per common share – diluted

$
(0.01
)

$
(0.02
)
$
(0.49
)
 
 For both the period of January 29, 2011 to March 31, 2011 (Successor), the period of January 1, 2011 to January 28, 2011 (Predecessor) and the three months ended March 31, 2010 (Predecessor), outstanding options to purchase 296,880, 297,880 and 336,261 shares, respectively, of common stock were excluded from the diluted calculation because the option exercise prices exceeded the average market value of the associated shares of common stock. For both the period of January 1, 2011 to January 28, 2011 (Predecessor) and the three months ended March 31, 2010 (Predecessor), outstanding warrants to purchase 749,619 shares of common stock were excluded from the diluted calculation because the warrant exercise price exceeded the average fair market value of the associated shares of common stock.
 4.  Comprehensive Income (Loss)





Comprehensive income (loss) represents the change in the Company’s equity during the period from transactions and other events and circumstances from non-owner sources. Total comprehensive income (loss) consists of net income (loss) and other comprehensive income (loss). The Company’s other comprehensive income (loss) and accumulated other comprehensive income (loss) are comprised of unrealized gains and losses on certain investments in debt securities and derivatives that qualify as cash flow hedges to the extent that the hedge is effective. The Company’s other comprehensive income (loss) for the period of January 29, 2011 to March 31, 2011 (Successor), the period of January 1, 2011 to January 28, 2011 (Predecessor) and the three months ended March 31, 2010 (Predecessor)was as follows:




Successor

Company


Predecessor

CompanyJan. 29, 2011

to

Mar. 31, 2011


Jan. 1, 2011

to

Jan. 28, 2011

Three Months Ended

Mar. 31, 2010(Dollars in thousands)Unrealized gain (loss) on securities – available for sale

$
2,235


$
(528
)
$
(606
)Amortization of prior service cost on SERP


–



1


2Income tax effect


(862
)


204


234Other comprehensive income (loss)

$
1,373


$
(323
)
$
(370
)
 - 13 -
 Index





5.  Investment Securities





Investment securities as of March 31, 2011 (Successor) and December 31, 2010 (Predecessor) are summarized as follows:





March 31, 2011

(Successor Company)

Amortized Cost

Unrealized

Gains

Unrealized

Losses

Fair Value(Dollars in thousands)Available for sale:U.S. agency obligations

$
13,917

$
14

$
5

$
13,926Municipal bonds


20,584


964


–


21,548Mortgage-backed securities issued by GSEs


251,516


1,354


122


252,748Non-agency mortgage-backed securities


5,541


41


1


5,581Other securities


2,838


–


9


2,829294,396


2,373


137


296,632Other investments


8,270


–


–


8,270Total

$
302,666

$
2,373

$
137

$
304,902December 31, 2010

(Predecessor Company)

Amortized Cost

Unrealized

Gains

Unrealized

Losses

Fair Value(Dollars in thousands)Available for sale:U.S. agency obligations

$
19,003

$
18

$
87

$
18,934Municipal bonds


22,455


75


1,521


21,009Mortgage-backed securities issued by GSEs


165,540


78


195


165,423Non-agency mortgage-backed securities


6,790


39


242


6,587Other securities


3,252


–


214


3,038217,040


210


2,259


214,991Other investments


8,301


–


–


8,301Total

$
225,341

$
210

$
2,259

$
223,292





On at least a quarterly basis, the Company completes an other than temporary impairment (“OTTI”) assessment of its investment portfolio. The Company considers many factors, including the severity and duration of the impairment and recent events specific to the issuer or industry, including any changes in credit ratings. The following table summarizes the gross unrealized losses and fair value of the Company’s investments in an unrealized loss position for which OTTI has not been recognized in earnings, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, as of March 31, 2011 (Successor) and December 31, 2010 (Predecessor):




March 31, 2011

(Successor Company)

Less than 12 Months

12 Months or Greater

Total(Dollars in thousands)

Fair Value

Unrealized

Losses

Fair Value

Unrealized

Losses

Fair Value

Unrealized

LossesAvailable for sale:U.S. agency obligations

$
2,978

$
5

$
–

$
–

$
2,978

$
5Mortgage-backed securities issued by GSEs


24,382


122


–


–


24,382


122Non-agency mortgage-backed securities


1,503


1


–


–


1,503


1Other securities


1,722


9


–


–


1,722


9Total

$
30,585

$
137

$
–

$
–

$
30,585

$
137


- 14 -
 Index





December 31, 2010

(Predecessor Company)

Less than 12 Months

12 Months or Greater

Total(Dollars in thousands)

Fair Value

Unrealized

Losses

Fair Value

Unrealized

Losses

Fair Value

Unrealized

LossesAvailable for sale:U.S. agency obligations

$
8,916

$
87

$
–

$
–

$
8,916

$
87Municipal bonds


14,886


1,134


2,453


387


17,339


1,521Mortgage-backed securities issued by GSEs


14,473


195


–


–


14,473


195Non-agency mortgage-backed securities


–


–


4,183


242


4,183


242Other securities


–


–


2,536


214


2,536


214Total

$
38,275

$
1,416

$
9,172

$
843

$
47,447

$
2,259





As of March 31, 2011 (Successor), the majority of unrealized losses related to four mortgage-backed securities issued by government-sponsored enterprises (“GSEs”). These unrealized losses are a result of changes in market interest rates since the NAFH Investment on January 28, 2011. Because of their GSE status, there is minimal credit risk in these securities. No investment securities were in an unrealized loss position greater than 1% or for a period of more than 12 months as of March 31, 2011 (Successor).





The securities in an unrealized loss position as of March 31, 2011 (Successor) continue to perform and are expected to perform through maturity, and the issuers have not experienced significant adverse events that would call into question their ability to repay these debt obligations according to contractual terms. Further, because the Company does not intend to sell these investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider unrealized losses on such securities to represent OTTI as of March 31, 2011 (Successor).





Other investment securities primarily include an investment in Federal Home Loan Bank (“FHLB”) stock, which has no readily determinable market value and is recorded at cost. As of both March 31, 2011 (Successor) and December 31, 2010 (Predecessor), the Company’s investment in FHLB stock totaled $7,668,000. Based on its quarterly evaluation, management has concluded that the Company’s investment in FHLB stock was not impaired as of March 31, 2011 (Successor) and that ultimate recoverability of the par value of this investment is probable.





The amortized cost and estimated market values of debt securities as of March 31, 2011 (Successor) by final contractual maturities are summarized in the table below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.





March 31, 2011

(Successor Company)

Available for Sale(Dollars in thousands)

Amortized Cost

Fair ValueDebt securities:Due within one year

$
–

$
–Due after one year through five years


15,842


15,861Due after five years through ten years


129,828


130,604Due after ten years


146,995


148,445Total debt securities


292,665


294,910Equity securities


1,731


1,722Total investment securities

$
294,396

$
296,632


- 15 -
 Index








6.  Loans





The composition of the loan portfolio by loan classification as of March 31, 2011 (Successor) and December 31, 2010 (Predecessor) was as follows:





Successor

Company


Predecessor

CompanyMar. 31, 2011


Dec. 31, 2010(Dollars in thousands)Commercial real estate:Construction and land development

$
274,541


$
350,587Real estate – non-owner occupied


275,005



283,943Real estate – owner occupied


163,934



170,470Total commercial real estate


713,480



805,000Consumer real estate:Residential mortgage


172,574



173,777Home equity lines


79,253



89,178Total consumer real estate


251,827



262,955Commercial and industrial


118,510



145,435Consumer


6,416



6,163Other loans


33,759



33,7421,123,992



1,253,295Deferred loan fees and origination costs, net


1,268



1,184$
1,125,260


$
1,254,479





Loans pledged as collateral for certain borrowings totaled $324,313,000 and $341,520,000 as of March 31, 2011 (Successor) and December 31, 2010 (Predecessor), respectively.





Successor Company:





Purchased credit-impaired loans for which it was probable at acquisition that all contractually required payments would not be collected are as follows:




As of

Jan. 28, 2011(Dollars in thousands)Contractually required payments

$
1,318,702Nonaccretable difference


(98,777
)Cash flows expected to be collected at acquisition


1,219,925Accretable yield


(163,892
)Fair value of acquired loans at acquisition

$
1,056,033






Accretable yield, or income expected to be collected, related to purchased credit-impaired loans is as follows:





Jan. 29, 2011

to

Mar. 31, 2011(Dollars in thousands)Balance, beginning of period

$
163,892New loans purchased


–Accretion of income


(10,265
)Reclassifications from nonaccretable difference


–Balance, end of period

$
153,627


- 16 -
 Index


The contractually required payments represent the total undiscounted amount of all uncollected contractual principal and contractual interest payments both past due and scheduled for the future, adjusted for the timing of estimated prepayments and any full or partial charge-offs prior to the NAFH Investment. Nonaccretable difference represents contractually required payments in excess of the amount of estimated cash flows expected to be collected. The accretable yield represents the excess of estimated cash flows expected to be collected over the initial fair value of the PCI loans, which is their fair value at the time of the NAFH Investment. The accretable yield is accreted into interest income over the estimated life of the PCI loans using the level yield method. The accretable yield will change due to changes in:





•
the estimate of the remaining life of PCI loans which may change the amount of future interest income, and possibly principal, expected to be collected;•
the estimate of the amount of contractually required principal and interest payments over the estimated life that will not be collected (the nonaccretable difference); and•
indices for PCI loans with variable rates of interest.





For PCI loans, the impact of loan modifications is included in the evaluation of expected cash flows for subsequent decreases or increases of cash flows. For variable rate PCI loans, expected future cash flows will be recalculated as the rates adjust over the lives of the loans. At acquisition, the expected future cash flows were based on the variable rates that were in effect at that time.


7.  Allowance for Loan Losses and Credit Quality
 
 The following is a summary of activity in the allowance for loan losses for the period from January 29, 2011 to March 31, 2011 (Successor), the period from January 1, 2011 to January 28, 2011 (Predecessor) and the three months ended March 31, 2010 (Predecessor):
  Successor

Company


Predecessor

CompanyJan. 29, 2011

to

Mar. 31, 2011


Jan. 1, 2011

to

Jan. 28, 2011

Three Months

Ended

Mar. 31, 2010(Dollars in thousands)Balance at beginning of year, predecessor

$
–


$
36,061

$
26,081Loans charged off


–



(49
)

(8,758
)Recoveries of loans previously charged off


–



9


103Net charge-offs


–



(40
)

(8,655
)Provision for loan losses


167



40


11,734Balance at the end of period, predecessor

$
–


$
36,061

$
29,160Acquisition accounting adjustment


–



(36,061
)

–Balance at end of period, successor

$
167


$
–

$
–
 The allowance for credit losses includes the allowance for loan losses, detailed above, and the reserve for unfunded lending commitments, which is included in other liabilities on the Condensed Consolidated Balance Sheets. As of March 31, 2011 (Successor) and December 31, 2010 (Predecessor), the reserve for unfunded lending commitments totaled $1,040,000 and $623,000, respectively.The following is an analysis of the allowance for loan losses by portfolio segment in addition to the disaggregation of the allowance and outstanding loan balances by impairment method as of March 31, 2011 (Successor):
  - 17 -
 Index
 
 Allowance for Loan Losses

LoansMarch 31, 2011

(Successor Company)

Individually

Evaluated for

Impairment

Collectively

Evaluated for

Impairment

Purchased –

Credit

Impaired

Individually

Evaluated for

Impairment

Collectively

Evaluated for

Impairment

Purchased –

Credit

Impaired(Dollars in thousands)Commercial real estate

$
–

$
113

$
–

$
–

$
7,610

$
705,870Consumer real estate


–


39


–


–


77,784


174,043Commercial and industrial


–


9


–


–


1,264


117,246Consumer


–


4


–


–


2,361


4,055Other


–


2


–


–


199


33,560$
–

$
167

$
–

$
–

$
89,218

$
1,034,774Allowance for Loan Losses

LoansDecember 31, 2010

(Predecessor Company)

Individually

Evaluated for

Impairment

Collectively

Evaluated for

Impairment

Purchased –

Credit

Impaired

Individually

Evaluated for

Impairment

Collectively

Evaluated for

Impairment

Purchased –

Credit

Impaired(Dollars in thousands)Commercial real estate

$
351

$
24,039

$
–

$
65,840

$
739,160

$
–Consumer real estate


87


4,645


–


3,879


259,076


–Commercial and industrial


89


6,343


–


6,013


139,422


–Consumer


2


352


–


6


6,157


–Other


–


153


–


781


32,961


–$
529

$
35,532

$
–

$
76,519

$
1,176,776

$
–
 To monitor and quantify credit risk in the loan portfolio, the Company uses a two-dimensional risk rating system. The first digit represents the credit quality of the borrower and is used to calculate the probability of default used in the “pooled” reserve calculation on loans evaluated collectively for impairment, while the second digit represents the loan collateral type and is used to calculate the loss given default also used in the “pooled” reserve calculation. The first digit ranges from 1 to 9, where a higher rating represents higher credit risk, and is selected on the financial strength and overall resources of the borrower, and the second digit is chosen by the type of primary collateral securing the loan. Based on these two components, the Company determines the risk profile for every commercial loan and non-pass rated consumer loans in the portfolio. The nine risk rating categories (first digit) can generally be described by the following groupings:
 
 •
Pass (risk rating 1–6) – These loans range from superior quality with minimal credit risk to loans requiring heightened management attention but that are still an acceptable risk and continue to perform as contracted.•
Special Mention (risk rating 7) – Loans in this category have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or the institution’s credit position at some future date. They contain unfavorable characteristics and are generally undesirable. Loans in this category are currently protected by current sound net worth and paying capacity of the obligor or of the collateral pledged, if any, but are potentially weak and constitute an undue and unwarranted credit risk, but not to the point of a Substandard classification. A Special Mention loan has potential weaknesses, which if not checked or corrected, weaken the asset or inadequately protect the Bank’s position at some future date.•
Substandard (risk rating 8) – Loans in this category are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets classified substandard. A substandard loan normally has one or more well-defined weaknesses that could jeopardize repayment of the debt. The likely need to liquidate assets to correct the problem, rather than repayment from successful operations is the key distinction between Special Mention and Substandard.
 - 18 -
 Index
 
 •
Doubtful (risk rating 9) – For loans in this category, the borrower’s ability to continue repayment is highly unlikely. Full collection based on currently known facts, conditions, and values is highly questionable and improbable. The possibility of loss is extremely high, but because of certain important and specific reasonable pending factors, which work to the bank’s advantage and strengthen the asset in the near term, its classification as loss is deferred until its more exact status may be determined. Loans in this category are immediately placed on nonaccrual with all payments applied to principal until such time as the potential loss exposure is eliminated.
 
 The following is an analysis of the Company’s credit risk profile, excluding purchased credit-impaired loans, based on internally assigned risk ratings as of March 31, 2011 (Successor) and December 31, 2010 (Predecessor):
 
 Commercial LoansMarch 31, 2011

(Successor Company)

Construction

and Land

Development

Non-Owner

Occupied

Real Estate

Owner

Occupied

Real Estate

Commercial

and

Industrial

Other

Total(Dollars in thousands)Pass

$
5,417

$
392

$
1,756

$
1,264

$
199

$
9,028Special mention


–


–


–


–


–


–Substandard


45


–


–


–


–


45Doubtful


–


–


–


–


–


–Total

$
5,462

$
392

$
1,756

$
1,264

$
199

$
9,073
  Consumer LoansMarch 31, 2011

(Successor Company)

Residential

Mortgage

Home Equity

Lines

Other

Consumer

Total(Dollars in thousands)Pass

$
3,799

$
73,556

$
2,361

$
79,716Special mention


–


91


–


91Substandard


–


338


–


338Doubtful


–


–


–


–Total

$
3,799

$
73,985

$
2,361

$
80,145
 Commercial LoansDecember 31, 2010

(Predecessor Company)

Construction

and Land

Development

Non-Owner

Occupied

Real Estate

Owner

Occupied

Real Estate

Commercial

and

Industrial

Other

Total(Dollars in thousands)Pass

$
250,557

$
266,523

$
154,156

$
101,674

$
32,961

$
805,871Special mention


20,178


12,505


2,287


20,488


–


55,458Substandard


79,852


4,610


13,967


23,266


781


122,476Doubtful


–


305


60


7


–


372Total

$
350,587

$
283,943

$
170,470

$
145,435

$
33,742

$
984,177
 Consumer LoansDecember 31, 2010

(Predecessor Company)

Residential

Mortgage

Home Equity

Lines

Other

Consumer

Total(Dollars in thousands)Pass

$
162,002

$
85,000

$
5,803

$
252,805Special mention


5,518


1,972


188


7,678Substandard


6,138


2,110


172


8,420Doubtful


119


96


–


215Total

$
173,777

$
89,178

$
6,163

$
269,118
 - 19 -
 Index
 
 The following is an aging analysis of the Company’s portfolio by loan class as of March 31, 2011 (Successor) and December 31, 2010 (Predecessor):
 
 March 31, 2011

(Successor Company)

30–59

Days

Past Due

60–89

Days

Past Due

Over 90 Days

Past Due and

Accruing

Nonaccrual

Loans

Current

Loans

Total

Loans(Dollars in thousands)Commercial real estate:Construction and land development

$
11,051

$
3,078

$
52,973

$
–

$
207,439

$
274,541Real estate – non-owner occupied


8,620


1,361


5,857


–


259,167


275,005Real estate – owner occupied


2,465


2,471


8,117


–


150,881


163,934Consumer real estate:Residential mortgage


2,076


87


3,916


–


166,495


172,574Home equity lines


606


162


366


–


78,119


79,253Commercial and industrial


6,746


325


3,141


–


108,298


118,510Consumer


–


–


51


–


6,365


6,416Other loans


–


–


–


–


33,759


33,759Total

$
31,564

$
7,484

$
74,421

$
–

$
1,010,523

$
1,123,992December 31, 2010

(Predecessor Company)

30–59

Days

Past Due

60–89

Days

Past Due

Over 90 Days

Past Due and

Accruing

Nonaccrual

Loans

Current

Loans

Total

Loans(Dollars in thousands)Commercial real estate:Construction and land development

$
6,166

$
204

$
–

$
50,693

$
293,524

$
350,587Real estate – non-owner occupied


509


–


–


2,678


280,756


283,943Real estate – owner occupied


3,165


–


–


8,198


159,107


170,470Consumer real estate:Residential mortgage


2,213


329


–


3,481


167,754


173,777Home equity lines


498


109


–


277


88,294


89,178Commercial and industrial


175


146


–


5,830


139,284


145,435Consumer


4


4


–


6


6,149


6,163Other loans


–


–


–


781


32,961


33,742Total

$
12,730

$
792

$
–

$
71,944

$
1,167,829

$
1,253,295
 
 Purchased credit-impaired loans are not classified as nonaccrual because interest income on these loans relates to the accretable yield recognized subsequent to the acquisition date and not to contractual interest payments.
 
 There were no troubled debt restructurings as of March 31, 2011 (Successor).
 
 8.  Stock-Based Compensation
 
 Stock Options
 
 Pursuant to the Capital Bank Corporation Equity Incentive Plan (“Equity Incentive Plan”), the Company has a stock option plan providing for the issuance of options for the purchase of up to 1,150,000 shares of the Company’s common stock to officers and directors. As of March 31, 2011 (Successor), options for 296,880 shares of common stock were outstanding and options for 604,709 shares of common stock remained available for future issuance. Grants of options are made by the Board of Directors. All grants must be made with an exercise price at no less than fair market value on the date of grant, must be exercised no later than 10 years from the date of grant, and may be subject to certain vesting provisions.
 
 A summary of the activity during the period of January 29, 2011 to March 31, 2011 (Successor), the period of January 1, 2011 to January 28, 2011 (Predecessor) and the three months ended March 31, 2010 (Predecessor) of the Company’s stock option plans, including the weighted average exercise price (“WAEP”), is presented below:
  - 20 -
 Index
 
 Successor Company


Predecessor CompanyPeriod of

Jan. 29 to Mar. 31, 2011


Period of

Jan. 1 to Jan. 28, 2011

Three Months Ended

Mar. 31, 2010Shares

WAEP


Shares

WAEP

Shares

WAEPOutstanding options, beginning of period


297,880

$
12.11



297,880

$
12.11


366,583

$
11.76Granted


–


–



–


–


–


–Exercised


–


–



–


–


–


–Forfeited and expired


(1,000
)

11.29



–


–


(30,322
)

8.08Outstanding options, end of period


296,880

$
12.12



297,880

$
12.11


336,261

$
12.09Options exercisable at end of period


257,680

$
12.96



226,430

$
13.53


256,161

$
12.83
 
 The following table summarizes information about the Company’s stock options as of March 31, 2011 (Successor):
 
 Exercise Price

Number

Outstanding

Weighted Average

Remaining Contractual

Life in Years

Number

Exercisable

Intrinsic

Value$3.85 – $6.00


78,250


8.05


42,250

$
–$6.01 – $9.00


–


–


–


–$9.01 – $12.00


74,880


0.95


74,880


–$12.01 – $15.00


20,000


5.38


16,800


–$15.01 – $18.00


70,000


3.92


70,000


–$18.00 – $18.37


53,750


3.74


53,750


–296,880


4.33


257,680

$
–
 
 The fair values of options granted are estimated on the date of the grants using the Black-Scholes option pricing model. Option pricing models require the use of highly subjective assumptions, including expected stock price volatility, which when changed can materially affect fair value estimates. There were no options granted in the period of January 29, 2011 to March 31, 2011 (Successor), the period of January 1, 2011 to January 28, 2011 (Predecessor) and the three months ended March 31, 2010 (Predecessor).
 
 As of March 31, 2011 (Successor), the Company had unamortized compensation expense related to unvested stock options of $27,000, which is expected to be fully amortized over the next two years. For the period from January 29, 2011 to March 31, 2011 (Successor), the period from January 1, 2011 to January 28, 2011 (Predecessor) and the three months ended March 31, 2010 (Predecessor), the Company recorded total compensation expense related to stock options of $69,000, $5,000 and $12,000, respectively, related to stock options. On January 28, 2011, vesting was accelerated on certain outstanding stock options in connection with the NAFH Investment. Compensation expense related to the accelerated vesting was recorded in the Successor period.
 
 Restricted Stock
 
 Pursuant to the Equity Incentive Plan, the Board of Directors may grant restricted stock to certain employees and Board members at its discretion. Nonvested shares are subject to forfeiture if employment terminates prior to the vesting dates. The Company expenses the cost of the stock awards, determined to be the fair value of the shares at the date of grant, ratably over the period of the vesting. Nonvested restricted stock for the three months ended March 31, 2011 is summarized in the following table:
  Shares

Weighted Avg.

Grant Date

Fair ValueNonvested at beginning of period


11,700

$
6.00Granted


–


–Vested


(11,700
)

6.00Nonvested at end of period


–

$
–
 - 21 -
 Index
 
  Total compensation expense related to these restricted stock awards for the period of January 29, 2011 to March 31, 2011 (Successor), the period of January 1, 2011 to January 28, 2011 (Predecessor) and the three months ended March 31, 2010 (Predecessor) totaled $68,000, $2,000 and $30,000, respectively.On January 28, 2011, vesting was accelerated on all remaining nonvested restricted shares in connection with the NAFH Investment. Compensation expense related to the accelerated vesting was recorded in the Successor period.
 
 Deferred Compensation for Non-employee Directors
 
 Until the NAFH Investment, the Company administered the Capital Bank Corporation Deferred Compensation Plan for Outside Directors (“Deferred Compensation Plan”). Eligible directors may have elected to participate in the Deferred Compensation Plan by deferring all or part of their directors’ fees for at least one calendar year, in exchange for common stock of the Company. If a director did not elect to defer all or part of his fees, then he was not considered a participant in the Deferred Compensation Plan. The amount deferred was equal to 125% of total director fees. Each participant was fully vested in his account balance. The Deferred Compensation Plan provides for payment of share units in shares of common stock of the Company after the participant ceased to serve as a director for any reason.
 
 Upon closing of the NAFH Investment, the Deferred Compensation Plan was terminated and all phantom shares in the Plan were distributed to the participants. For the period of January 29, 2011 to March 31, 2011 (Successor), the period of January 1, 2011 to January 28, 2011 (Predecessor) and the three months ended March 31, 2010 (Predecessor), the Company recognized stock-based compensation expense of $0, $35,000 and $150,000, respectively, related to the Deferred Compensation Plan.
 
 9.  Derivative Instruments
 
 The Company enters into interest rate lock commitments with customers and commitments to sell mortgages to investors. The period of time between the issuance of a mortgage loan commitment and the closing and sale of the mortgage loan is generally less than 60 days. Interest rate lock commitments and forward loan sale commitments represent derivative instruments which are carried at fair value. These derivative instruments do not qualify for hedge accounting. The fair values of the Company’s interest rate lock commitments and forward loan sales commitments are based on current secondary market pricing and are included on the Condensed Consolidated Balance Sheets in mortgage loans held for sale and on the Condensed Consolidated Statements of Operations in mortgage origination and other loan fees.
 
 As of March 31, 2011 (Successor) and December 31, 2010 (Predecessor), the Company had $4,677,000 and $10,318,000, respectively, of commitments outstanding to originate mortgage loans held for sale at fixed rates and $6,101,000 and $17,311,000, respectively, of forward commitments under best efforts contracts to sell mortgages to four different investors. The fair value of the interest rate lock commitments and forward loan sales commitments were not considered material as of March 31, 2011 (Successor) or December 31, 2010 (Predecessor). Thus, there was no impact to the Condensed Consolidated Statements of Operations in either the Successor or Predecessor periods.
 
 10.  Commitments and Contingencies
 
 To meet the financial needs of its customers, the Company is party to financial instruments with off-balance-sheet risk in the normal course of business. These financial instruments are comprised of various types of commitments to extend credit, including unused lines of credit and overdraft lines, as well as standby letters of credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the balance sheet.
 
 The Company’s exposure to credit loss in the event of nonperformance by the other party is represented by the contractual amount of those instruments. The Company uses the same credit policies in making these commitments as it does for on-balance-sheet instruments. The amount of collateral obtained, if deemed necessary by the Company, upon extension of credit is based on management’s credit evaluation of the borrower. Collateral held varies but may include trade accounts receivable, property, plant and equipment, and income-producing commercial properties. Since many unused lines of credit expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.
 - 22 -
 Index
 The Company’s exposure to off-balance-sheet credit risk as of March 31, 2011 (Successor) and December 31, 2010 (Predecessor) was as follows:
 
 Successor

Company


Predecessor

CompanyMar. 31, 2011


Dec. 31, 2010(Dollars in thousands)Commitments to extend credit

$
164,640


$
175,318Standby letters of credit


9,718



10,285Total commitments

$
174,358


$
185,603
 
 The Company has limited partnership investments in two related private investment funds which totaled $1,829,000 as of both March 31, 2011 (Successor) and December 31, 2010 (Predecessor). These investments are recorded on the cost basis and were included in other assets on the Condensed Consolidated Balance Sheets. Remaining capital commitments to these funds totaled $1,550,000 as of March 31, 2011 (Successor).
 
 11.  Fair Value
 
 Fair Value Measurements
 
 The Company utilizes fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. For example, investment securities, available for sale, are recorded at fair value on a recurring basis. Additionally, the Company may be required to record at fair value other assets on a nonrecurring basis, such as loans held for sale, impaired loans and certain other assets. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets. The following is a description of valuation methodologies used for assets and liabilities recorded at fair value.
 
 Investment securities, available for sale, are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets, and money market funds. Level 2 securities include mortgage-backed securities issued by government sponsored entities and corporate entities as well as municipal bonds. Securities classified as Level 3 include corporate debt instruments that are not actively traded and where certain assumptions are used to calculate fair value.
 
 Mortgage loans held for sale are carried at the lower of cost or estimated fair value. The fair values of mortgage loans held for sale are based on commitments on hand from investors within the secondary market for loans with similar characteristics. As such, the fair value adjustment for mortgage loans held for sale is classified as nonrecurring Level 2.
 
 Loans are not recorded at fair value on a recurring basis. However, certain loans are determined to be impaired, and those loans are charged down to estimated fair value. The fair value of impaired loans that are collateral dependent is based on collateral value. For impaired loans that are not collateral dependent, estimated value is based on either an observable market price, if available, or the present value of expected future cash flows. Those impaired loans not requiring a charge-off represent loans for which the estimated fair value exceeds the recorded investments in such loans. When the fair value of an impaired loan is based on an observable market price or a current appraised value with no adjustments, the Company records the impaired loan as nonrecurring Level 2. When an appraised value is not available, or management determines the fair value of the collateral is further impaired below the appraised value, and there is no observable market price, the Company classifies the impaired loan as nonrecurring Level 3.
 
 Other real estate, which includes foreclosed assets, is adjusted to fair value upon transfer of loans and premises to other real estate. Subsequently, other real estate is carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Company records other real estate as nonrecurring Level 2. When an appraised value is not available, or management determines the fair value of the collateral is further impaired below the appraised value, and there is no observable market price, the Company classifies other real estate as nonrecurring Level 3.
 - 23 -
 Index
 
 Assets and liabilities measured at fair value on a recurring basis as of March 31, 2011 (Successor) and December 31, 2010 (Predecessor) are summarized below:
 
 March 31, 2011

(Successor Company)

Quoted Prices in

Active Markets

(Level 1)

Significant Other

Observable

Inputs

(Level 2)

Significant

Unobservable

Inputs

(Level 3)

Total(Dollars in thousands)Investment securities – available for sale:U.S. agency obligations

$
–

$
13,926

$
–

$
13,926Municipal bonds


–


21,548


–


21,548Mortgage-backed securities issued by GSEs


–


252,748


–


252,748Non-agency mortgage-backed securities


–


5,581


–


5,581Other securities


1,722


–


1,107


2,829Total

$
1,722

$
293,803

$
1,107

$
296,632December 31, 2010

(Predecessor Company)

Quoted Prices in

Active Markets

(Level 1)

Significant Other

Observable

Inputs

(Level 2)

Significant

Unobservable

Inputs

(Level 3)

Total(Dollars in thousands)Investment securities – available for sale:U.S. agency obligations

$
–

$
18,934

$
–

$
18,934Municipal bonds


–


21,009


–


21,009Mortgage-backed securities issued by GSEs


–


165,423


–


165,423Non-agency mortgage-backed securities


–


6,587


–


6,587Other securities


1,738


–


1,300


3,038Total

$
1,738

$
211,953

$
1,300

$
214,991
 
 The table below presents a reconciliation and income statement classification of gains and losses for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the period of January 29, 2011 to March 31, 2011 (Successor), the period of January 1, 2011 to January 28, 2011 (Predecessor) and the three months ended March 31, 2010 (Predecessor):
 
 Successor

Company


Predecessor

CompanyJan. 29, 2011

to

Mar. 31, 2011


Jan. 1, 2011

to

Jan. 28, 2011

Three Months

Ended

Mar. 31, 2010(Dollars in thousands)Balance at beginning of period

$
1,107


$
1,300

$
1,300Total unrealized losses included in:Net income


–



–


–Other comprehensive income


–



(193
)

–Purchases, sales and issuances, net


–



–


–Transfers in and (out) of Level 3


–



–


–Balance at end of period

$
–


$
1,107

$
1,300
 - 24 -
 Index
 
  Assets and liabilities measured at fair value on a nonrecurring basis as of March 31, 2011 (Successor) and December 31, 2010 (Predecessor) are summarized below:
 
 March 31, 2011

(Successor Company)

Quoted Prices in

Active Markets

(Level 1)

Significant Other

Observable

Inputs

(Level 2)

Significant

Unobservable

Inputs

(Level 3)

Total(Dollars in thousands)Impaired loans

$
–

$
–

$
–

$
–Other real estate


–


–


14,535


14,535December 31, 2010

(Predecessor Company)

Quoted Prices in

Active Markets

(Level 1)

Significant Other

Observable

Inputs

(Level 2)

Significant

Unobservable

Inputs

(Level 3)

Total(Dollars in thousands)Impaired loans

$
–

$
61,006

$
14,985

$
75,990Other real estate


–


18,334


–


18,334
 
 Fair Value of Financial Instruments
 
 Due to the nature of the Company’s business, a significant portion of its assets and liabilities consist of financial instruments. Accordingly, the estimated fair values of these financial instruments are disclosed. Quoted market prices, if available, are utilized as an estimate of the fair value of financial instruments. Because no quoted market prices exist for a significant part of the Company’s financial instruments, the fair value of such instruments has been derived based on management’s assumptions with respect to future economic conditions, the amount and timing of future cash flows and estimated discount rates. Different assumptions could significantly affect these estimates. Accordingly, the net amounts ultimately collected could be materially different from the estimates presented below. In addition, these estimates are only indicative of the values of individual financial instruments and should not be considered an indication of the fair value of the Company taken as a whole.
 
 Fair values of cash and cash equivalents are equal to the carrying value. Estimated fair values of investment securities are based on quoted market prices, if available, or model-based values from pricing sources for mortgage-backed securities and municipal bonds. Fair value of the loan portfolio has been estimated using the present value of expected future cash flows, discounted at a current market rate for each loan type. The amount of expected credit losses and the timing of those losses have also been factored into expected future cash flows. As of March 31, 2011 (Successor), the carrying amount of loans equaled the estimated fair value since the portfolio was adjusted to fair value on January 28, 2011 in connection with the NAFH Investment. Carrying amounts for accrued interest approximate fair value given the short-term nature of interest receivable and payable.
 
 Fair values of time deposits and borrowings are estimated by discounting the future cash flows using the current rates offered for similar deposits and borrowings with the same remaining maturities. Fair value of subordinated debt is estimated based on current market prices for similar trust preferred issues of financial institutions with equivalent credit risk. The estimated fair value for the Company’s subordinated debt is significantly lower than carrying value since credit spreads (i.e., spread to LIBOR) on similar trust preferred issues are currently much wider than when these securities were originally issued. Interest-bearing deposit liabilities and repurchase agreements with no stated maturities are predominately at variable rates and, accordingly, the fair values have been estimated to equal the carrying amounts (the amount payable on demand).
 
 The carrying values and estimated fair values of the Company’s financial instruments as of March 31, 2011 (Successor) and December 31, 2010 (Predecessor) were as follows:
  - 25 -
 Index
 
 Successor

Company


Predecessor

CompanyMar. 31, 2011


Dec. 31, 2010(Dollars in thousands)

Carrying

Amount

Estimated

Fair Value


Carrying

Amount

Estimated

Fair ValueFinancial Assets:Cash and cash equivalents

$
116,650

$
116,650


$
66,745

$
66,745Investment securities


304,902


304,902



223,292


223,292Mortgage loans held for sale


1,424


1,424



6,993


6,993Loans


1,125,093


1,125,093



1,218,418


1,146,256Accrued interest receivable


5,909


5,909



5,158


5,158Financial Liabilities:Non-maturity deposits

$
487,419

$
487,419


$
469,956

$
469,956Time deposits


862,242


862,997



873,330


885,105Borrowings


93,513


93,513



121,000


126,787Subordinated debt


19,431


19,431



34,323


19,164Accrued interest payable


1,442


1,442



1,363


1,363Unrecognized financial instruments:Commitments to extend credit


164,640


157,596



175,318


167,817Standby letters of credit


9,718


9,718



10,285


10,285
 
 12.  TARP Capital Purchase Program
 
 On December 12, 2008, the Company entered into a Securities Purchase Agreement with the U.S. Treasury pursuant to which, among other things, the Company sold to the Treasury 41,279 shares of Series A Preferred Stock and warrants to purchase up to 749,619 shares of common stock (“Warrants”) of the Company for an aggregate purchase price of $41,279,000.
 
 On January 28, 2011, in connection with the NAFH Investment, all outstanding shares of Series A Preferred Stock and the Warrants were repurchased and cancelled for an aggregate purchase price of $41,279,000.The Company recognized a charge of $861,000 for dividends and accretion on preferred stock during the period of January 1, 2011 to January 28, 2011 (Predecessor), which reflected the difference between the carrying value of the preferred stock and its redemption price.
 
 13.  Subsequent Events
 
 On April 27, 2011, NAFH received the required regulatory approval to merge Capital Bank into NAFH National Bank, a banking subsidiary owned by NAFH and its affiliate, TIB Financial Corp. In the merger, which the Company expects to complete in June 2011, the Company expects to receive shares of NAFH National Bank in exchange for its shares of Capital Bank at an exchange ratio based on the relative tangible book values of Capital Bank and NAFH National Bank.
  Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
 The following discussion presents an overview of the unaudited financial statements for the period of January 29 to March 31, 2011 (Successor), the period of January 1 to January 28, 2011 (Predecessor) and the three months ended March 31, 2011 (Predecessor) for Capital Bank Corporation (the “Company”), and its wholly owned subsidiary, Capital Bank (the “Bank”). This discussion and analysis is intended to provide pertinent information concerning financial condition, results of operations, liquidity, and capital resources for the periods covered and should be read in conjunction with the unaudited financial statements and related footnotes contained in Part I, Item 1 of this report.
 
 Information set forth below contains various forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act, which statements represent the Company’s judgment concerning the future and are subject to risks and uncertainties that could cause the Company’s actual operating results to differ materially. Such forward-looking statements can be identified by the use of forward-looking terminology, such as “may,” “will,” “expect,” “anticipate,” “estimate,” “believe,” or “continue,” or the negative thereof or other variations thereof or comparable terminology. The Company cautions that such forward-looking statements are further qualified by important factors that could cause the Company’s actual operating results to differ materially from those in the forward-looking statements, as well as the factors set forth in Part II, Item 1A of this report, and the Company’s periodic reports and other filings with the Securities and Exchange Commission, or SEC.
  - 26 -
 Index
 Overview
 
 Capital Bank Corporation is a financial holding company incorporated under the laws of North Carolina on August 10, 1998. The Company’s primary wholly-owned subsidiary is Capital Bank, a state-chartered banking corporation. The Bank was incorporated under the laws of the State of North Carolina on May 30, 1997 and commenced operations on June 20, 1997. The Company also serves as the holding company for CB Trustee, LLC and has interests in three trusts, Capital Bank Statutory Trust I, II, and III (hereinafter collectively referred to as the “Trusts”). As of March 31, 2011, the Company conducted no business other than holding stock in the Bank and in three trusts.
 
 Capital Bank is a community bank engaged in the general commercial banking business and primarily operates in markets in central and western North Carolina. As of March 31, 2011, the Company had approximately $1.7 billion in total assets, $1.1 billion in loans, $1.3 billion in deposits, and $228.8 million in shareholders’ equity. The Bank operates 32 branch offices in North Carolina: five in Raleigh, four in Asheville, four in Fayetteville; three in Burlington, three in Sanford, two in Cary, and one each in Clayton, Graham, Hickory, Holly Springs, Mebane, Morrisville, Oxford, Pittsboro, Siler City, Wake Forest and Zebulon.
 
 The Bank offers a full range of banking services, including the following: checking accounts; savings accounts; NOW accounts; money market accounts; certificates of deposit; individual retirement accounts; loans for real estate, construction, businesses, agriculture, personal use, home improvement and automobiles; equity lines of credit; mortgage loans; credit loans; consumer loans; credit cards; safe deposit boxes; bank money orders; internet banking; electronic funds transfer services including wire transfers and remote deposit capture; traveler’s checks; and free notary services to all Bank customers. In addition, the Bank provides automated teller machine access to its customers for cash withdrawals through nationwide ATM networks. Through a partnership between the Bank’s financial services division and Capital Investment Companies, an unaffiliated Raleigh, North Carolina-based broker-dealer, the Bank also makes available a complete line of uninsured investment products and services. The securities involved in these services are not deposits or other obligations of the Bank and are not insured by the Federal Deposit Insurance Corporation (“FDIC”).
 
 The Bank’s business consists principally of attracting deposits from the general public and investing these funds in loans secured by commercial real estate, secured and unsecured commercial and consumer loans, single-family residential mortgage loans and home equity lines. As a community bank, the Bank’s profitability depends primarily upon its levels of net interest income, which is the difference between interest income from interest-earning assets and interest expense on interest-bearing liabilities. When interest-earning assets approximate or exceed interest-bearing liabilities, any positive interest rate spread will generate net interest income.
 
 The Bank’s profitability is also affected by its provision for loan losses, noninterest income and other operating expenses. Noninterest income primarily consists of service charges and ATM fees, debit card transaction fees, fees generated from originating mortgage loans, commission income generated from brokerage activity, the increase in cash surrender value of bank-owned life insurance (“BOLI”), and gains or losses recognized on the sale of investment securities. Operating expenses primarily consist of employee compensation and benefits, occupancy related expenses, depreciation and maintenance expenses on furniture and equipment, data processing and telecommunications, advertising and public relations expenses, professional fees, business development and travel costs, other real estate losses and miscellaneous loan costs, FDIC deposit insurance and other noninterest expenses.
 
 The Bank’s operations are influenced significantly by local economic conditions and by policies of financial institution regulatory authorities. The Bank’s cost of funds is influenced by interest rates on competing investments and by rates offered on similar investments by competing financial institutions in our market area, as well as general market interest rates. Lending activities are affected by the demand for financing, which in turn is affected by the prevailing interest rates.
 
 As a bank holding company, the Company is subject to the supervision of the Board of Governors of the Federal Reserve System (“Federal Reserve”). The Company is required to file with the Federal Reserve reports and other information regarding its business operations and the business operations of its subsidiaries. As a North Carolina chartered bank, the Bank is subject to primary supervision, periodic examination and regulation by the North Carolina Commissioner of Banks (“NC Commissioner”), and by the FDIC, as its primary federal regulator.
 - 27 -
 Index
 North American Financial Holdings, Inc. Investment
 
 On January 28, 2011, the Company completed the issuance and sale to NAFH of 71,000,000 shares of common stock for $181,050,000 in cash. As a result of the NAFH Investment and the Rights Offering on March 11, 2011, NAFH currently owns approximately 83% of the Company’s common stock. The Company’s shareholders approved the issuance of such shares to NAFH, and an amendment to the Company’s articles of incorporation to increase the authorized shares of common stock to 300,000,000 shares from 50,000,000 shares, at a special meeting of shareholders held on December 16, 2010. In connection with the NAFH Investment, each Company shareholder as of January 27, 2011 received one contingent value right per share that entitles the holder to receive up to $0.75 in cash per CVR at the end of a five-year period based on the credit performance of the Bank’s existing loan portfolio.
 
 Also in connection with the NAFH Investment, pursuant to an agreement among NAFH, the Treasury, and the Company, the Company’s Series A Preferred Stock and warrant to purchase shares of common stock issued by the Company to the Treasury in connection with the TARP were repurchased. Following the TARP repurchase, the Series A Preferred Stock and warrant are no longer outstanding, and accordingly the Company no longer expects to be subject to the restrictions imposed by the terms of the Series A Preferred Stock, or certain regulatory provisions of the EESA andthe ARRA that are imposed on TARP recipients.
 
 Pursuant to the Investment, shareholders as of January 27, 2011 received non-transferable rights to purchase a number of shares of the Company’s common stock proportional to the number of shares of common stock held by such holders on such date, at a purchase price equal to $2.55 per share, subject to certain limitations. The Company issued 1,613,165 shares of common stock in exchange for $4,113,571 upon completion of the Rights Offering on March 11, 2011.
 
 Upon closing of the Investment, R. Eugene Taylor, NAFH’s Chief Executive Officer, Christopher G. Marshall, NAFH’s Chief Financial Officer, and R. Bruce Singletary, NAFH’s Chief Risk Officer, were named as the Company’s CEO, CFO and CRO, respectively, and as members of the Company’s Board of Directors. In addition, the Company’s Board of Directors was reconstituted with a combination of two existing members (Oscar A. Keller III and Charles F. Atkins), Messrs. Taylor, Marshall and Singletary, and two additional NAFH-designated members (Peter N. Foss and William A. Hodges).
 
 On April 27, 2011, NAFH received the required regulatory approval to merge Capital Bank into NAFH National Bank, a banking subsidiary owned by NAFH and its affiliate, TIB Financial Corp. In the merger, which the Company expects to complete in June 2011, the Company expects to receive shares of NAFH National Bank in exchange for its shares of Capital Bank at an exchange ratio based on the relative tangible book values of Capital Bank and NAFH National Bank.
 
 Critical Accounting Policies and Estimates
 
 The following discussion and analysis of the Company’s financial condition and results of operations are based on the Company’s condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States (U.S. GAAP). The preparation of these financial statements requires the Company to make estimates and judgments regarding uncertainties that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. However, because future events and their effects cannot be determined with certainty, actual results may differ from these estimates under different assumptions or conditions, and the Company may be exposed to gains or losses that could be material.
 
 The Company has identified the following accounting policies as being critical in terms of significant judgments and the extent to which estimates are used: allowance for loan losses, other-than-temporary impairment on investment securities, valuation allowance on deferred income tax assets, and impairment of goodwill and long-lived assets. These policies are important in understanding management’s discussion and analysis. For more information on the Company’s critical accounting policies, refer to Part II, Item 7 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.
 
 Executive Summary
 
 The following is a brief summary of the Company’s financial results for the period of January 29 to March 31, 2011 (Successor), the period of January 1 to January 28, 2011 (Predecessor) and the three months ended March 31, 2010 (Predecessor):
 
 •
NAFH completed its controlling investment of approximately $181 million in the Company on January 28, 2011;•
In connection with the NAFH Investment, the Company’s Series A Preferred Stock and warrant to purchase shares of the Company’s common stock issued to the U.S. Treasury through the TARP were repurchased in full;
  - 28 -
 Index
 •
The Company raised an additional $4.1 million of common equity through completion of a rights offering to shareholders of record as of January 27, 2011;•
As a result of the NAFH Investment, the Company’s Tier 1 leverage ratio, Tier 1 risk-based capital ratio and total risk-based capital ratio increased to 9.99%, 13.18% and 13.57%, respectively, as of March 31, 2011;•
Net loss to common shareholders for the period of January 29 to March 31, 2011 (Successor) totaled ($574) thousand, or ($0.01) per share, and after dividends and accretion on preferred stock of $861 thousand, net loss to common shareholders for the period of January 1 to January 28, 2011 (Predecessor) totaled ($265) thousand, or ($0.02) per share; and•
Net interest margin increased to 4.15% in the period of January 29 to March 31, 2011 (Successor) from 3.09% in the period of January 1 to January 28, 2011 (Predecessor) and 3.22% in the three months ended March 31, 2010 (Predecessor).
 
 Results of Operations
 
 Financial results for the first quarter of 2011 were significantly impacted by the controlling investment in the Company by NAFH. The Company has used push-down accounting, and as such, has applied the acquisition method of accounting to the NAFH Investment.Accordingly, the Company’s assets and liabilities were adjusted to estimated preliminary fair value at the acquisition date, and the allowance for loan losses was eliminated at that date. Further, the Company’s operating results in periods subsequent to the acquisition date have been and will continue to be impacted by these fair value adjustments as the underlying assets and liabilities are converted in the normal course of business. The Company is still in the process of completing its fair value analysis of assets and liabilities, and final fair value adjustments may differ significantly from the preliminary estimates recorded to date.
 
 Net loss to common shareholders for the period of January 29 to March 31, 2011 (Successor) totaled ($574) thousand, or ($0.01) per share, and after dividends and accretion on preferred stock of $861 thousand, net loss to common shareholders for the period of January 1 to January 28, 2011 totaled ($265) thousand, or ($0.02) per share. For the three months ended March 31, 2010 (Predecessor), net loss to common shareholders, after dividends and accretion on preferred stock of $589 thousand, totaled ($5.9) million or ($0.49) per share.
 
 Net Interest Income
 
 Net interest income for the period of January 29 to March 31, 2011 (Successor), the period of January 1 to January 28, 2011 (Predecessor), and the three months ended March 31, 2010 (Predecessor) totaled $10.0 million, $4.0 million and $12.6 million, respectively. Average earning assets decreased from $1.64 billion in the three months ended March 31, 2010 (Predecessor) to $1.54 billion in the period of January 1 to 28, 2011 (Predecessor) to $1.52 billion in the period of January 29 to March 31, 2011 (Successor), while net interest margin was 3.22%, 3.09% and 4.15%, respectively. On a fully tax equivalent basis, net interest spread was 4.03%, 2.92% and 2.98% for theperiod of January 29 to March 31, 2011 (Successor), the period of January 1 to January 28, 2011 (Predecessor), and the three months ended March 31, 2010 (Predecessor), respectively.Among other things, fair value adjustments, principal paydowns and charge-offs on the loan portfolio contributed to the reduction in earning assets over these periods.
 
 Net interest margin for the period of January 1 to January 28, 2011 (Predecessor) was negatively affected by a decline in asset yields, partially offset by a decline in funding costs. Yields on earning assets fell from 5.08% for the three months ended March 31, 2010 (Predecessor) to 4.61% for the period of January 1 to January 28, 2011 (Predecessor), and rates on total interest-bearing liabilities fell from 2.10% for the three months ended March 31, 2010 (Predecessor) to 1.69% for the period of January 1 to January 28, 2011 (Predecessor). The significant decline in funding costs over this period was primarily due to disciplined pricing controls and a declining interest rate environment. Net interest margin for the period of January 29 to March 31, 2011 (Successor) was primarily affected by fair value adjustments to earning assets and liabilities at acquisition. Yields and rates in the successor period reflect prevailing market yields and rates on the acquisition date in addition to subsequent activity.
 
 The following table, Average Balances, Interest Earned or Paid, and Interest Yields/Rates, reflects the Company’s effective yield on earning assets and cost of funds. Yields and costs are computed by dividing income or expense for the year by the respective daily average asset or liability balance. Changes in net interest income from year to year can be explained in terms of fluctuations in volume and rate.
 - 29 -
 Index
 Average Balances, Interest Earned or Paid, and Interest Yields/Rates
 Tax Equivalent Basis1
 
 Successor Company


Predecessor CompanyPeriod of

Jan. 29 to Mar. 31, 2011


Period of

Jan. 1 to Jan. 28, 2011

Three Months Ended

Mar. 31, 2010(Dollars in thousands)

Average

Balance

Amount

Earned

Average

Rate


Average

Balance

Amount

Earned

Average

Rate

Average

Balance

Amount

Earned

Average

RateAssetsLoans 2

$
1,139,698

$
11,155


6.06
%

$
1,253,296

$
5,530


5.20
%
$
1,393,169

$
17,562


5.11
%Investment securities 3


242,840


1,254


3.10



225,971


504


2.68


225,819


2,956


5.24Interest-bearing deposits


138,309


47


0.21



63,350


11


0.20


20,226


10


0.20Total interest-earning assets


1,520,847

$
12,456


5.07
%


1,542,617

$
6,045


4.61
%

1,639,214

$
20,528


5.08
%Cash and due from banks


16,373









16,112








19,450Other assets


156,724









70,195








102,321Allowance for loan losses


(54
)








(36,174
)







(28,045
)Total assets

$
1,693,890








$
1,592,750







$
1,732,940Liabilities and EquityNOW and money market accounts

$
344,189

$
418


0.75
%

$
334,668

$
211


0.74
%
$
342,048

$
886


1.05
%Savings accounts


31,521


6


0.12



30,862


3


0.11


28,992


10


0.14Time deposits


851,424


1,350


0.98



870,146


1,337


1.81


871,507


5,255


2.45Total interest-bearing deposits


1,227,134


1,774


0.89



1,235,676


1,551


1.48


1,242,547


6,151


2.01Borrowed funds


98,599


254


1.59



120,032


343


3.36


170,956


1,145


2.72Subordinated debt


19,313


232


7.43



34,323


102


3.50


31,232


218


2.83Repurchase agreements


–


–


–



–


–


–


4,667


2


0.17Total interest-bearing liabilities


1,345,046

$
2,260


1.04
%


1,390,031

$
1,996


1.69
%

1,449,402

$
7,516


2.10
%Noninterest-bearing deposits


113,607









114,660








131,973Other liabilities


8,814









9,635








10,658Total liabilities


1,467,467









1,514,326








1,592,033Shareholders’ equity


226,423









78,424








140,907Total liabilities and shareholders’ equity

$
1,693,890








$
1,592,750







$
1,732,940Net interest spread 4








4.03
%








2.92
%







2.98
%Tax equivalent adjustment




$
175








$
90







$
462Net interest income and net interest margin 5




$
10,196


4.15
%




$
4,049


3.09
%



$
13,012


3.22
%
 
 1
The tax equivalent basis is computed using a federal tax rate of 34%.2
Loans include mortgage loans held for sale in addition to nonaccrual loans for which accrual of interest has not been recorded.3
The average balance for investment securities represents the average amortized cost of the securities portfolio.4
Net interest spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.5
Net interest margin represents net interest income divided by average interest-earning assets.
 
 Provision for Loan Losses
 
 Provision for loan losses for the period of January 29 to March 31, 2011 (Successor), the period of January 1 to January 28, 2011 (Predecessor), and the quarter ended March 31, 2010 (Predecessor) totaled $167 thousand, $40 thousand and $11.7 million, respectively. The loan loss provision in the successor period reflects estimated losses inherent in loans originated subsequent to the NAFH Investment date. Acquired loans were marked to fair value, and no provision was recorded on those loans during the successor period. As of January 28, 2011, the total fair value discount recorded exceeded 8% of outstanding loan balances at acquisition.
  - 30 -
 Index
 There were no net charge-offs recorded in the period of January 29 to March 31, 2011 (Successor). Net charge-offs totaled $40 thousand, or 0.01% of average loans, in the period of January 1 to January 28, 2011 (Predecessor) and $8.7 million, or 2.48% of average loans, in the quarter ended March 31, 2010 (Predecessor).
 
 Loans acquired in the NAFH Investment where there was evidence of credit deterioration since origination and where it is probable that the Company will not collect all contractually required principal and interest payments are accounted for as purchased credit-impaired (“PCI”) loans. For these loans, the excess of the cash flows initially expected to be collected over the fair value of the loans at the acquisition date (i.e., the accretable yield) is accreted into interest income over the estimated remaining life of the PCI loans using the effective yield method, provided that the timing and amount of future cash flows is reasonably estimable. Accordingly, such loans are not classified as nonaccrual and they are considered to be accruing because their interest income relates to the accretable yield recognized under accounting for PCI loans and not to contractual interest payments. The Company identified approximately 93% of its acquisition-date loan portfolio as PCI.
 
 Noninterest Income
 
 Noninterest income for the period of January 29 to March 31, 2011 (Successor), the period of January 1 to January 28, 2011 (Predecessor), and the three months ended March 31, 2010 (Predecessor) totaled $1.3 million, $832 thousand and $2.5 million, respectively. The following table presents the detail of noninterest income for each respective period:
  Successor

Company


Predecessor

CompanyJan. 29, 2011

to

Mar. 31, 2011


Jan. 1, 2011

to

Jan. 28, 2011

Three Months

Ended

Mar. 31, 2010(Dollars in thousands)Service charges and other fees

$
548


$
291

$
868Bank card services


300



174


415Mortgage origination and other loan fees


263



210


327Brokerage fees


96



78


187Bank-owned life insurance


20



10


239Net gain on sale of investment securities


–



–


263Other


25



69


232Total noninterest income

$
1,252


$
832

$
2,531
 Noninterest income in the first quarter of 2010 (Predecessor) benefited from $263 thousand of gains recorded on the sale of investment securities, while no such gains were recorded in either the successor or predecessor period in the first quarter of 2011. Additionally, income from bank-owned life insurance (“BOLI”) in the first quarter of 2010 (Predecessor) was elevated due to a higher balance and number of BOLI contracts owned during that period. The Company surrendered certain BOLI contracts on former employees and directors late in 2010. Other noninterest income for the successor period of January 29 to March 31, 2011 was negatively impacted by a $63 thousand loss recorded from a decline in stock price of an equity security that the Company marks to market through noninterest income, while the Company recorded a gain of $65 thousand from appreciation in value of this security in the first quarter of 2010 (Predecessor). Mortgage origination and other loan fees in the predecessor period of January 1 to January 28, 2011 benefited from strong demand and favorable interest rates for residential mortgage refinancing late in 2010.
 
 Noninterest Expense
 
 Noninterest expense for the period of January 29 to March 31, 2011 (Successor), the period of January 1 to January 28, 2011 (Predecessor), and the quarter ended March 31, 2010 (Predecessor) totaled $12.2 million, $4.2 million and $12.6 million, respectively. The following table presents the detail of noninterest expense for each respective period:
  - 31 -
 Index
 Successor

Company


Predecessor

CompanyJan. 29, 2011

to

Mar. 31, 2011


Jan. 1, 2011

to

Jan. 28, 2011

Three Months

Ended

Mar. 31, 2010(Dollars in thousands)Salaries and employee benefits

$
3,957


$
1,977

$
5,400Occupancy


1,140



548


1,502Furniture and equipment


544



275


745Data processing and telecommunications


276



180


517Advertising and public relations


181



131


430Office expenses


229



93


332Professional fees


335



190


475Business development and travel


246



87


267Amortization of other intangible assets


191



62


235ORE losses and miscellaneous loan costs


523



176


1,317Directors’ fees


40



68


298FDIC deposit insurance


563



266


665Contract termination fees


3,581



–


–Other


423



102


407Total noninterest expense

$
12,229


$
4,155

$
12,590
 Expenses in the successor period were significantly impacted by a nonrecurring $3.6 million charge for contract termination fees related to the conversion and integration of the Company’s operations into a common technology platform utilized by all NAFH-owned banks. This system conversion is intended to create operating efficiencies and better position the Company for future growth.
 
 Additionally, salaries and benefits expense increased in the successor period from the accelerated vesting of stock options and restricted shares at closing of the NAFH Investment. Salaries expense also increased in the successor period and period of January 1 to January 28, 2011 (Predecessor) from declining deferred loan costs due to lower loan origination volume. Occupancy expense was increased in the successor period and period of January 1 to January 28, 2011 (Predecessor) from the relocation of two previously existing branch offices into larger facilities that were opened early in the first quarter of 2011. Other real estate losses and miscellaneous loan costs in the successor period were decreased somewhat by an adjustment to reduce the value of certain bank-owned properties at the NAFH Investment date. Directors’ fees were reduced significantly in the successor period as the Company’s board of directors was reconstituted post-acquisition and the Capital Bank Corporation Deferred Compensation Plan for Outside Directors was terminated. FDIC deposit insurance expense increased in the successor period and period of January 1 to January 28, 2011 (Predecessor) as Capital Bank’s assessment rate was raised in 2010.
 
 Income Taxes
 
 The income tax benefit recorded in the period of January 29 to March 31, 2011 (Successor) totaled $549 thousand and represented a 48.89% effective tax rate based on the Company’s pre-tax loss. The effective tax rate is higher than the Company’s blended federal and state statutory rates due primarily to the impact of nontaxable income from BOLI earnings and municipal bond interest. No income tax expense was recorded in the period of January 1 to January 28, 2011 (Predecessor) as prior net operating losses with a full valuation allowance were carried forward and used to offset income in the predecessor period.
 
 Analysis of Financial Condition
 
 Overview
 
 The Company’s financial condition is measured by its asset and liability composition as well as asset quality.The Company’s financial condition was significantly impacted by the controlling investment in the Company by NAFH on January 28, 2011. Immediately following the NAFH Investment, NAFH owned approximately 85% of the Company’s outstanding common stock and as a result of the Rights Offering, now owns approximately 83% of the Company’s outstanding common stock. Because of the NAFH Investment, the Company’s assets and liabilities were adjusted to estimated preliminary fair value at the acquisition date, and the allowance for loan losses was eliminated at that date. The Company is still in the process of completing its fair value analysis of assets and liabilities, and final fair value adjustments may differ significantly from the preliminary estimates recorded to date.
  - 32 -
 Index
 Total assets were $1.70 billion and $1.59 billion as of March 31, 2011 (Successor) and December 31, 2010 (Predecessor), respectively. Earning assets, which represented 89.8% and 97.0% of total assets as of March 31, 2011 (Successor) and December 31, 2010 (Predecessor), respectively, decreased from $1.54 billion as of December 31, 2010 (Predecessor) to $1.53 billion as of March 31, 2011 (Successor). Loans totaled $1.25 billion and $1.13 billion as of December 31, 2010 (Predecessor) and March 31, 2011 (Successor), respectively.The declining loan balances primarily reflect the $104.4 million fair value discount recorded by the Company at the NAFH Investment date. The remaining decline is from net principal paydowns on the loan portfolio during the first quarter of 2011. Allowance for loan losses was $167 thousand as of March 31, 2011 (Successor) compared to $36.1 million as of December 31, 2010 (Predecessor). This decrease was due to elimination of the predecessor allowance for loan losses in acquisition accounting. The allowance for loan losses as of March 31, 2011 was related entirely to new loans originated in the successor period.
 
 Investment securities totaled $304.9 million and $223.3 million as of March 31, 2011 (Successor) and December 31, 2010 (Predecessor), respectively. This increase was primarily due to the Company’s purchase of mortgage-backed securities issued by GSEs with increased liquidity from the NAFH Investment. These mortgage bonds carry minimal credit risk and have a weighted average duration of less than four years.
 
 Goodwill and other intangible assets totaled $35.8 million as of March 31, 2011 (Successor) and were recorded through acquisition accounting. Other intangible assets identified were the core deposit intangible and the trade name intangible. The net deferred tax asset was $54.5 million as of March 31, 2011 (Successor) and represents the tax impact of fair value adjustments in acquisition accounting as well as predecessor company net operating losses that are available to be carried forward and used to offset future taxable income.
 
 Total deposits were $1.35 billion and $1.34 billion as of March 31, 2011 (Successor) and December 31, 2010 (Predecessor), respectively. The largest increase by type of deposit over this period was in money market accounts, which grew by $9.1 million. Time deposits represented 63.9% of total deposits at March 31, 2011 (Successor) compared to 65.0% at December 31, 2010 (Predecessor). The Company recorded a $13.2 million fair value premium on time deposits at the NAFH Investment date.Borrowings totaled $93.5 million and $121.0 million as of March 31, 2011 (Successor) and December 31, 2010 (Predecessor). During this period, $20.0 million of short term borrowings at the Federal Home Loan Bank of Atlanta (“FHLB”) were paid off while $15.0 of fixed rate FHLB advances matured. The Company recorded a $7.8 million fair value premium on borrowed funds at the NAFH Investment date. Subordinated debt was $19.4 million and $34.3 million as of March 31, 2011 (Successor) and December 31, 2010 (Predecessor), respectively. This decrease was almost entirely due to the $14.9 million fair value discount recorded on subordinated debt in acquisition accounting.
 
 Total shareholders’ equity was $228.8 million as of March 31, 2011 (Successor) and was a significant increase from the balance as of December 31, 2010 due to the NAFH Investment on January 28, 2011. Common stock, no par value, totaled $228.0 million as of March 31, 2011 (Successor). This amount represents the fair value of net assets acquired of $224.1 million at the NAFH Investment date, which includes the non-controlling interest at fair value, in addition to net proceeds of $3.8 million from the issuance of 1,613,165 shares of the Company’s common stock upon completion of the Rights Offering on March 11, 2011. Other smaller changes in the common stock account primarily relate to stock option expense recognized in the successor period. The accumulated deficit was $574 thousand as of March 31, 2011 (Successor), which represents the Company’s net loss in the successor period. Accumulated other comprehensive income was $1.4 million as of March 31, 2011 (Successor) and reflects the change in value of the Company’s available-for-sale securities portfolio, net of tax, in the successor period.
 
 Loans
 
 The Company’s loan portfolio is comprised primarily of loans to small- and mid-sized businesses as well as individuals primarily located in the central and western regions of North Carolina. The Bank originates a variety of loans, including loans secured by commercial real estate, secured and unsecured commercial and consumer loans, single-family residential mortgage loans and home equity lines of credit.A significant portion of the loan portfolio is secured by or related to real estate. The economic trends of the areas in North Carolina served by the Company are influenced by the significant businesses and industries within these regions. The ultimate collectability of the Company’s loan portfolio is highly susceptible to changes in the market conditions of these geographic regions.
 - 33 -
 Index
 The composition of the loan portfolio as of March 31, 2011 (Successor) and December 31, 2010 (Predecessor) was as follows:
  Successor

Company


Predecessor

CompanyMar. 31, 2011


Dec. 31, 2010(Dollars in thousands)Commercial real estate:Residential land and development

$
77,983


$
102,797Residential construction


65,948



77,120Commercial land and development


90,571



121,415Commercial construction


40,039



49,255Multifamily


38,838



39,831Real estate – non-residential, non-owner occupied


236,167



244,112Real estate – non-residential, owner occupied


163,934



170,470Total commercial real estate


713,480



805,000Consumer real estate:Residential mortgage – first lien


160,868



160,866Residential mortgage – junior lien


11,706



12,911Home equity lines


79,253



89,178Total consumer real estate


251,827



262,955Commercial and industrial


118,510



145,435Consumer


6,416



6,163Other loans


33,759



33,7421,123,992



1,253,295Deferred loan fees and origination costs, net


1,268



1,184$
1,125,260


$
1,254,479
  Loans acquired in the NAFH Investment where there was evidence of credit deterioration since origination and where it is probable that the Company will not collect all contractually required principal and interest payments are accounted for as purchased credit-impaired (“PCI”) loans. For these loans, the excess of the cash flows initially expected to be collected over the fair value of the loans at the acquisition date (i.e., the accretable yield) is accreted into interest income over the estimated remaining life of the PCI loans using the effective yield method, provided that the timing and amount of future cash flows is reasonably estimable. Accordingly, such loans are not classified as nonaccrual and they are considered to be accruing because their interest income relates to the accretable yield recognized under accounting for PCI loans and not to contractual interest payments. The Company has identified approximately 93% of its acquisition-date loan portfolio as PCI.
 
 Nonperforming Assets and Impaired Loans
 
 Non-PCI loans are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well secured and in the process of collection. If a loan or a portion of a loan is classified as doubtful or as partially charged off, the loan is generally classified as nonaccrual. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt. Loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment performance of interest and principal by the borrower in accordance with the contractual terms. There were no non-PCI loans in nonaccrual status as of March 31, 2011 (Successor).
 
 The table below presents an analysis of nonperforming assets as ofMarch 31, 2011 (Successor) and December 31, 2010 (Predecessor). PCI loans that are greater than 90 days past due are considered to be nonperforming loans but are not on nonaccrual status since income recognized on these loans relates to the accretable yield and not performance against contractual terms.
  - 34 -
 Index
 Successor

Company


Predecessor

CompanyMar. 31, 2011


Dec. 31, 2010(Dollars in thousands)Nonperforming loans:Total nonaccrual loans

$
–


$
71,944PCI loans greater than 90 days past due


74,421



–Total nonperforming loans


74,421



71,944Other real estate:Construction, land development, and other land


8,132



10,7971-4 family residential properties


4,838



4,5291-4 family residential properties sold with 100% financing


–



1,004Commercial properties


665



1,086Closed branch offices


900



918Total other real estate


14,535



18,334Total nonperforming assets

$
88,956


$
90,278Accruing restructured loans

$
–


$
4,463Asset quality ratios:Nonperforming loans to total loans


6.61
%


5.73
%Nonperforming assets to total assets


5.22



5.69Allowance for loan losses to nonperforming loans, predecessor


N/A



50.12
 Other real estate, which includes foreclosed assets and other real property held for sale, totaled $14.5 million as of March 31, 2011 (Successor) compared to $18.3 million as of December 31, 2010 (Predecessor). The Company is actively marketing all of its foreclosed properties. Such properties are adjusted to fair value upon transfer of the loans or premises to other real estate. Subsequently, these properties are carried at the lower of carrying value or updated fair value. The Company obtains updated appraisals and/or internal evaluations for all other real estate.
 
 In the predecessor period, impaired loans primarily consisted of nonaccrual loans and accruing troubled debt restructurings but also included other loans identified by management as being impaired. Impaired loans totaled $0 and $76.5 million as of March 31, 2011 (Successor) and December 31, 2010 (Predecessor), respectively. The elevated level of impaired loans as of December 31, 2010 (Predecessor) was primarily due to weakness experienced in the local economy and real estate markets from the recent economic recession.
 
 The following table summarizes the Company’s impaired loans as of March 31, 2011 (Successor) and December 31, 2010 (Predecessor):
 
 Successor

Company


Predecessor

CompanyMar. 31, 2011


Dec. 31, 2010(Dollars in thousands)Impaired loans:Impaired loans with related allowance for loan losses

$
–


$
2,378Impaired loans for which the full loss has been charged off


–



74,141Total impaired loans


–



76,519Allowance for loan losses related to impaired loans


–



(529
)Net carrying value of impaired loans

$
–


$
75,990
 
 Allowance for Loan Losses
 
 The allowance for loan losses represents management’s best estimate of probable credit losses that are inherent in the loan portfolio at the balance sheet date and is determined by management through at least quarterly evaluations of the loan portfolio. The allowance calculation consists of reserves on loans individually evaluated for impairment and reserves on loans collectively evaluated for impairment.
  - 35 -
 Index
 The evaluation of the allowance for loan losses is inherently subjective, and management uses the best information available to establish this estimate. However, if factors such as economic conditions differ substantially from assumptions, or if amounts and timing of future cash flows expected to be received on impaired loans vary substantially from the estimates, future adjustments to the allowance for loan losses may be necessary. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance for loan losses based on their judgments about all relevant information available to them at the time of their examination. Any adjustments to original estimates are made in the period in which the factors and other considerations indicate that adjustments to the allowance for loan losses are necessary.
 
 The allowance is established through a provision for loan losses charged to expense. Non-PCI loans are charged against the allowance for loan losses when management believes that the collectability of the principal is unlikely.The following is a summary of activity in the allowance for loan losses for the period from January 29, 2011 to March 31, 2011 (Successor), the period from January 1, 2011 to January 28, 2011 (Predecessor) and the three months ended March 31, 2010 (Predecessor):
  Successor

Company


Predecessor

CompanyJan. 29, 2011

to

Mar. 31, 2011


Jan. 1, 2011

to

Jan. 28, 2011

Three Months

Ended

Mar. 31, 2010(Dollars in thousands)Balance at beginning of year, predecessor

$
–


$
36,061

$
26,081Loans charged off


–



(49
)

(8,758
)Recoveries of loans previously charged off


–



9


103Net charge-offs


–



(40
)

(8,655
)Provision for loan losses


167



40


11,734Balance at the end of period, predecessor

$
–


$
36,061

$
29,160Acquisition accounting adjustment


–



(36,061
)

–Balance at end of period, successor

$
167


$
–

$
–
 Loans Individually Evaluated for Impairment
 
 A non-PCI loan is considered individually impaired, based on current information and events, if it is probable that the Company will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Reserves, or charge-offs, on individually impaired loans that are collateral dependent are based on the fair value of the underlying collateral while reserves, or charge-offs, on loans that are not collateral dependent are based on either an observable market price, if available, or the present value of expected future cash flows discounted at the historical effective interest rate. Management evaluates non-PCI loans that are classified as doubtful, substandard or special mention to determine whether they are individually impaired. This evaluation includes several factors, including review of the loan payment status and the borrower’s financial condition and operating results such as cash flows, operating income or loss, etc.
 
 There were no non-PCI loans that were identified as impaired as of March 31, 2011 (Successor). As of December 31, 2010 (Predecessor), the recorded investment in impaired loans for which the full loss was charged-off totaled $74.1 million, and the aggregate unpaid principal balances of these loans totaled $92.1 million. The difference between the recorded investment and unpaid principal balance represents cumulative charge-offs over the life of these impaired loans. As of December 31, 2010 (Predecessor), the recorded investment in impaired loans with a related allowance totaled $2.4 million with related reserves of $529 thousand. The Company currently charges down all individually impaired loans to estimated fair value except for the small group of individually impaired loans on borrower relationships less than $500 thousand that are aggregated for impairment measurement purposes. Given the Company’s concentration in real estate lending, the vast majority of individually impaired loans are collateral dependent and are therefore valued based on underlying collateral values. In the case of unsecured loans that become impaired, unpaid principal balances are fully charged off.
 
 The Company employs a dedicated Special Assets Group that monitors problem loans and formulates collection and/or resolution plans for those borrowers. Special Assets and the lender who underwrote the problem loan remain updated on market conditions and inspect the collateral on a regular basis. If there is reason to believe that collateral values have been negatively affected by market or other forces, an updated appraisal is ordered to assess the change in value. The Company’s management generally seeks to ensure that appraisals are not more than twelve months old for all individually impaired loans.
  - 36 -
 Index
 For most individually impaired loans, the fair value of underlying collateral is estimated based on a current independent appraised value, adjusted for estimated costs to sell. These are considered Level 2 fair value estimates. For certain impaired loans where appraisals are aged or where market conditions have significantly changed since the appraisal date, a further reduction is made to appraised value to arrive at the fair value of collateral. These are considered Level 3 fair value estimates. In other situations, management will use broker price opinions, internal valuations or other valuation sources. These are also considered Level 3 fair value estimates. Estimated fair value on impaired loans totaled $76.0 million as of December 31, 2010 (Predecessor). Of this amount, $61.0 million of impaired loans were valued based on current independent appraisals, and $15.0 million of impaired loans were valued based on a combination of adjusted appraised values, internal valuations, and other valuation sources or methods. Internal valuations are used primarily for equipment valuations or for certain real estate valuations where recent home sales data was used to estimate value for similar fully or partially built houses. For any impaired loan where a reserve has previously been established, or where a partial charge-off has been recorded, an updated appraisal that reflects a further decline in value will result in an additional reserve or partial charge-off during the current period.
 
 Loans Collectively Evaluated for Impairment
 
 Reserves on loans collectively evaluated for impairment are determined by applying loss rates to pools of loans that are grouped according to the Company’s two-dimensional risk rating system. The first digit of the risk rating represents the credit quality of the borrower and is used to calculate the probability of default used in the “pooled” reserve calculation, while the second digit represents the loan collateral type and is used to calculate the loss given default also used in the “pooled” reserve calculation. The first digit ranges from 1 to 9, where a higher rating represents higher credit risk, and is selected on the financial strength and overall resources of the borrower, and the second digit is chosen by the type of primary collateral securing the loan.
 
 At the origination of each commercial loan, the loan officer evaluates the relative risk of the loan and assigns a corresponding risk rating based upon completion a standardized risk rating worksheet that is reviewed by management. To ensure that loans are properly risk rated after origination, loan officers are required to re-evaluate assigned risk ratings whenever the borrower’s financial condition or ability to repay their loan changes. At a minimum, risk ratings are reassigned whenever a loan is renewed or modified. Additionally, the Bank employs a loan review department that audits loans based on a defined scope. Loans are reviewed for credit quality, sufficiency of credit and collateral documentation, proper loan approval, covenant, policy and procedure adherence, and continuing accuracy of the loan’s risk rating. The loan review department reports its findings to senior management and the Audit Committee of the Company’s Board of Directors.
 
 In addition to usinghistorical default and charge-off experience for each pool to calculate loss rates on loans collectively evaluated for impairment, management also considers the following environmental factors in establishing these loss rates:
 
 •
Levels of and trends in delinquencies, impaired loans and classified assets;•
Levels of and trends in charge-offs and recoveries;•
Trends in nature, volume and terms of loans;•
Existence of and changes in portfolio concentrations by product type and geographical location;•
Changes in national, regional and local economic conditions;•
Changes in the experience, ability and depth of lending management;•
Changes in the quality of the loan review system; and•
The effect of other external factors such as legal and regulatory requirements.
 
 As of March 31, 2011 (Successor) and December 31, 2010 (Predecessor), the Company used two years of default and charge-off history for purposes of calculating reserves on loans evaluated collectively. Nonperforming loans and net charge-offs have significantly increased over the past two years, particularly in the commercial real estate portfolio, and such increases have directly impacted loss rates and the resulting allowance for loan losses for each loan pool.
 
 - 37 -
 Index
 Capital Resources
 
 The Company and the Bank are subject to various regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial position and results of operation. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios. The Company’s and the Bank’s actual capital amounts and ratios as of March 31, 2011 (Successor) are presented in the following table:
 Minimum Requirements To Be:Actual

Adequately Capitalized

Well Capitalized(Dollars in thousands)


Amount


Ratio


Amount


Ratio


Amount


RatioCapital Bank Corporation:Total capital (to risk-weighted assets)

$
165,807


13.57
%
$
97,740


8.00
%

N/A


N/ATier I capital (to risk-weighted assets)


160,998


13.18


48,870


4.00


N/A


N/ATier I capital (to average assets)


160,998


9.99


64,467


4.00


N/A


N/ACapital Bank:Total capital (to risk-weighted assets)

$
146,042


11.97
%
$
97,637


8.00
%

122,046


10.00
%Tier I capital (to risk-weighted assets)


141,442


11.59


48,818


4.00


73,228


6.00
%Tier I capital (to average assets)


141,442


8.81


64,240


4.00


80,300


5.00
%
 
 Total shareholders’ equity was $228.8 million as of March 31, 2011 (Successor) and was a significant increase from the balance as of December 31, 2010 due to the NAFH Investment on January 28, 2011. Common stock, no par value, totaled $228.0 million as of March 31, 2011 (Successor). This amount represents the fair value of net assets acquired of $224.1 million at the NAFH Investment date, which includes the non-controlling interest at fair value, in addition to net proceeds of $3.8 million from the issuance of 1,613,165 shares of the Company’s common stock upon completion of the Rights Offering on March 11, 2011. Other smaller changes in the common stock account primarily relate to stock option expense recognized in the successor period. The accumulated deficit was $574 thousand as of March 31, 2011 (Successor), which represents the Company’s net loss in the successor period. Accumulated other comprehensive income was $1.4 million as of March 31, 2011 (Successor) and reflects the change in value of the Company’s available-for-sale securities portfolio, net of tax, in the successor period.
 
 The Company’s tangible equity to tangible assets ratio was 11.56% as of March 31, 2011 (Successor).
 
 NAFH Investment
 
 On January 28, 2011, the Company completed the issuance and sale of 71,000,000 shares of its common stock to NAFH  for approximately $181 million in cash. As a result of the NAFH Investment and the Rights Offering on March 11, 2011, NAFH currently owns approximately 83% of the Company’s common stock. In connection with the NAFH Investment, each Company shareholder as of January 27, 2011 received one contingent value right per share that entitles the holder to receive up to $0.75 in cash per CVR at the end of a five-year period based on the credit performance of the Bank’s existing loan portfolio.
 
 Also in connection with the NAFH Investment, the Company’s Series A Preferred Stock and warrant to purchase shares of common stock issued by the Company to the U.S. Treasury in connection with the TARP were repurchased. Following the TARP Repurchase, the Series A Preferred Stock and warrant are no longer outstanding, and accordingly, the Company is no longer subject to the restrictions imposed by the terms of the Series A Preferred Stock or certain regulatory provisions of the EESA and the ARRA that are imposed on TARP recipients.
 
 Pursuant to the NAFH Investment, shareholders as of January 27, 2011 received non-transferable rights to purchase a number of shares of the Company’s common stock proportional to the number of shares of common stock held by such holders on such date, at a purchase price equal to $2.55 per share, subject to certain limitations. The Company issued 1,613,165 shares of common stock in exchange for net proceeds of $3.8 million, net of offering costs, upon completion of the Rights Offering on March 11, 2011.
 - 38 -
 Index
 Informal Regulatory Agreement
 
 On October 28, 2010, the Company entered into an informal Memorandum of Understanding (“MOU”) with the FDIC and the NC Commissioner. An MOU is characterized by regulatory authorities as an informal action that is not published or publicly available and that is used when circumstances warrant a milder form of action than a formal supervisory action, such as a formal written agreement or order. In accordance with the terms of the MOU, the Company has agreed to, among other things, (i) increase regulatory capital to achieve and maintain a minimum Tier 1 leverage capital ratio of at least 8% and a total risk-based capital ratio of at least 12%, (ii) monitor and reduce its commercial real estate concentration, (iii) timely identify and reduce its overall level of problem loans, (iv) establish and maintain an adequate allowance for loan losses, and (v) ensure adherence to loan policy guidelines. The MOU will remain in effect until modified, terminated, lifted, suspended or set aside by the regulatory authorities. In addition, the Company consults with the Federal Reserve Bank of Richmond prior to payment of any dividends or interest on debt.
 
 Liquidity Management
 
 Liquidity management involves the ability to meet the cash flow requirements of depositors desiring to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. To ensure the Company is positioned to meet immediate and future cash demands, management relies on internal analysis and projections of its liquidity needs, stress testing of its liquidity requirements, knowledge of current economic and market trends and forecasts of future conditions. Regulatory agencies set certain minimum liquidity standards, including the setting of a reserve requirement by the Federal Reserve. The Company must submit weekly reports to the Federal Reserve to ensure compliance with those requirements. As of March 31, 2011, the Company met all of its regulatory liquidity requirements.
 
 The Company had $116.7 million in its most liquid assets, cash and cash equivalents, as of March 31, 2011 (Successor). The Company’s principal sources of funds are loan repayments, investment repayments, deposits, short-term borrowings, and capital. Core deposits (total deposits less certificates of deposits in the amount of $100 thousand or more), one of the most stable sources of liquidity, together with equity capital funded $1.26 billion, or 73.6%, of total assets as of March 31, 2011 (Successor) compared to $1.09 billion, or 68.9%, of total assets as of December 31, 2010 (Predecessor).
 
 Additional sources of liquidity are available to the Company through the Federal Reserve Bank (“FRB”) and through membership in the FHLB system. As of March 31, 2011 (Successor), the Company had a maximum and available borrowing capacity of $91.7 million and $20.7 million, respectively, through the FHLB. These funds can be made available with various maturities and interest rate structures. Borrowings with the FHLB are collateralized by a blanket lien on certain qualifying assets. The Company also maintains a credit line at the FRB’s discount window that is used for short-term funding needs and as an additional source of available liquidity. As of March 31, 2011 (Successor), the Company had a maximum and available borrowing capacity of $77.0 million at the discount window. Available credit at the discount window is collateralized by eligible commercial construction and commercial and industrial loans. The Company also maintains off-balance sheet liquidity from other sources such as federal funds lines, repurchase agreement lines and through brokered deposit sources.
 
 Item 3.Quantitative and Qualitative Disclosures about Market Risk
 
 As described in more detail in Part II, Item 7A of our Annual Report on Form 10-K for the year ended December 31, 2010, asset/liability management involves the evaluation, monitoring and management of interest rate risk, liquidity and funding. While the Board of Directors has overall responsibility for the Company’s asset/liability management policies, the Bank’s Asset and Liability Committee monitors loan, investment, and liability portfolios to ensure comprehensive management of interest rate risk and adherence to the Bank’s policies.The Company has not experienced any material change in the risk of its portfolios of interest-earning assets and interest-bearing liabilities from December 31, 2010 (Predecessor) to March 31, 2011 (Successor).
 
 Item 4.Controls and Procedures
 
 The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer, or CEO, and Chief Financial Officer, or CFO, as appropriate, to allow timely decisions regarding disclosure. Management necessarily applies its judgment in assessing the costs and benefits of such controls and procedures, which, by their nature, can provide only reasonable assurance regarding management’s control objectives.
 - 39 -
 Index
 As required by paragraph (b) of Rule 13a-15 under the Exchange Act, an evaluation was carried out under the supervision and with the participation of the Company’s management, including the CEO and CFO, of the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based upon that evaluation, the CEO and CFO concluded that, as of the end of the period covered by the report, the Company’s disclosure controls and procedures are effective in that the information the Company is required to disclose in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods required by the SEC’s rules and forms.
 
 Changes in Internal Control over Financial Reporting
 
 There were no changes in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) that occurred during the period covered by this report that have materially affected or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
 
 
 PART II – OTHER INFORMATION
 
 Item 1.  Legal Proceedings
 
 There are no material pending legal proceedings to which the Company or its subsidiaries is a party or to which any of the Company’s or its subsidiaries’ property is subject. In addition, the Company is not aware of any threatened litigation, unasserted claims or assessments that could have a material adverse effect on the Company’s business, liquidity, operating results or condition.
 
 Item 1A.  Risk Factors
 
 The following discussion addresses some of the risks and uncertainties that could cause, or contribute to causing, actual results to differ materially from expectations. In evaluating our business, you should pay particular attention to the descriptions of risks and uncertainties described below. If any of the events described below occur, the Company’s business, financial condition, or results of operations could be materially adversely affected. In that event, the trading price of the Company’s common stock may decline, in which case the value of your investment may decline as well. References herein to “we”, “us”, and “our” refer to Capital Bank Corporation, a North Carolina corporation, and its subsidiaries, unless the context otherwise requires.
 
 Risks Relatedto Our Business
 
 U.S. and international credit markets and economic conditions could adversely affect our liquidity, financial condition and profitability.
 
 Global market and economic conditions continue to be disruptive and volatile and the disruption has particularly had a negative impact on the financial sector. The capital and credit markets have placed downward pressure on stock prices, and the availability of capital, credit and liquidity has been adversely affected for many issuers, in some cases, without regard to those issuers’ underlying financial condition or performance. Although we have not suffered any significant liquidity problems as a result of these recent events, the cost and availability of funds may be adversely affected by illiquid credit markets. Continued turbulence in U.S. and international markets and economies may also adversely affect our liquidity, financial condition and profitability.
 
 Legislative and regulatory actions taken now or in the future to address the recent liquidity and credit crisis in the financial industry may significantly affect our liquidity or financial condition.
 
 The Federal Reserve, U.S. Congress, the Treasury, the FDIC and others have taken numerous actions to address the current liquidity and credit situation in the financial markets. These measures include actions to encourage loan restructuring and modification for homeowners; the establishment of significant liquidity and credit facilities for financial institutions and investment banks; and coordinated efforts to address liquidity and other weaknesses in the banking sector. The EESA, which established TARP, was enacted on October 3, 2008. As part of TARP, the Treasury created the Capital Purchase Program (“CPP”), which authorized the Treasury to invest up to $250 billion in senior preferred stock of U.S. banks and savings associations or their holding companies for the purpose of stabilizing and providing liquidity to the U.S. financial markets.
 - 40 -
 Index
 On February 17, 2009, the ARRA was enacted as a sweeping economic recovery package intended to stimulate the economy and provide for extensive infrastructure, energy, health and education needs. We participated in the CPP and sold $41.3 million of our Series A Preferred Stock and a warrant to purchase 749,619 shares of our common stock to the Treasury, which securities are no longer outstanding as a result of the TARP Repurchase. There can be no assurance as to the actual impact that EESA or its programs, including the CPP, and ARRA or its programs, will have on the national economy or financial markets. The failure of these significant legislative measures to help stabilize the financial markets and a continuation or worsening of current financial market conditions could materially and adversely affect our financial condition, results of operations, liquidity or stock price.
 
 On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which was intended primarily to overhaul the financial regulatory framework following the global financial crisis and will impact all financial institutions including our holding company and Capital Bank. The Dodd-Frank Act contains provisions that will, among other things, establish a Bureau of Consumer Financial Protection, establish a systemic risk regulator, consolidate certain federal bank regulators and impose increased corporate governance and executive compensation requirements. While many of the provisions in the Dodd-Frank Act are aimed at financial institutions significantly larger than us, and some will affect only institutions with different charters than us or institutions that engage in activities in which we do not engage, it will likely increase our regulatory compliance burden and may have a material adverse effect on us, including by increasing the costs associated with our regulatory examinations and compliance measures.
 
 The Dodd-Frank Act requires various federal agencies to adopt a broad range of new implementing rules and regulations and to prepare numerous studies and reports for the U.S. Congress. The federal agencies are given significant discretion in drafting the implementing rules and regulations, and consequently, many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years. We are closely monitoring all relevant sections of the Dodd-Frank Act to ensure continued compliance with laws and regulations. While the ultimate effect of the Dodd-Frank Act on us cannot be determined yet, the law is likely to result in increased compliance costs and fees paid to regulators, along with possible restrictions on our operations.
 
 Further, the U.S. Congress and state legislatures and federal and state regulatory authorities continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including interpretation and implementation of statutes, regulation or policies, including the Dodd-Frank Act, could affect us in substantial and unpredictable ways, including limiting the types of financial services and products we may offer or increasing the ability of non-banks to offer competing financial services and products. While we cannot predict the regulatory changes that may be borne out of the current economic crisis, and we cannot predict whether we will become subject to increased regulatory scrutiny by any of these regulatory agencies, any regulatory changes or scrutiny could increase or decrease the cost of doing business, limit or expand our permissible activities, or affect the competitive balance among banks, credit unions, savings and loan associations and other institutions. We cannot predict whether additional legislation will be enacted and, if enacted, the effect that it, or any regulations, would have on our business, financial condition or results of operations.
 
 Changes in local economic conditions could lead to higher loan charge-offs and reduce our net income and growth.
 
 Our business is subject to periodic fluctuations based on local economic conditions in central and western North Carolina. These fluctuations are not predictable, cannot be controlled and may have a material adverse impact on our operations and financial condition even if other favorable events occur. Our operations are locally oriented and community-based. Accordingly, we expect to continue to be dependent upon local business conditions as well as conditions in the local residential and commercial real estate markets we serve. For example, an increase in unemployment, a decrease in real estate values or increases in interest rates, as well as other factors, could weaken the economies of the communities we serve.
 
 Weakness in our market areas could depress our earnings and consequently our financial condition because:
 
 •
customers may not want or need our products or services;•
borrowers may not be able to repay their loans;•
the value of the collateral securing loans to borrowers may decline; and•
the quality of our loan portfolio may decline.
 
 Any of the latter three scenarios could require us to charge off a higher percentage of loans and/or increase provisions for credit losses, which would reduce our net income.
  - 41 -
 Index
 Because the majority of our borrowers are individuals and businesses located and doing business in Wake, Granville, Lee, Cumberland, Johnston, Chatham, Alamance, Buncombe and Catawba Counties, North Carolina, our success will depend significantly upon the economic conditions in those and the surrounding counties. Unfavorable economic conditions or a continued increase in unemployment rates in those and the surrounding counties may result in, among other things, a deterioration in credit quality or a reduced demand for credit and may harm the financial stability of our customers. Due to our limited market areas, these negative conditions may have a more noticeable effect on us than would be experienced by a larger institution that is able to spread these risks of unfavorable local economic conditions across a large number of diversified economies.
 
 We are exposed to risks in connection with the loans we make.
 
 A significant source of risk for us arises from the possibility that losses will be sustained because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loans. We have underwriting and credit monitoring procedures and credit policies, including the establishment and review of the allowance for loan losses, that we believe are appropriate to minimize this risk by assessing the likelihood of nonperformance, tracking loan performance and diversifying our loan portfolio. Such policies and procedures, however, may not prevent unexpected losses that could adversely affect our results of operations. Loan defaults result in a decrease in interest income and may require the establishment of or an increase in loan loss reserves. Furthermore, the decrease in interest income resulting from a loan default or defaults may be for a prolonged period of time as we seek to recover, primarily through legal proceedings, the outstanding principal balance, accrued interest and default interest due on a defaulted loan plus the legal costs incurred in pursuing our legal remedies. No assurance can be given that recent market conditions will not result in our need to increase loan loss reserves or charge off a higher percentage of loans, thereby reducing net income.
 
 A significant portion of our loan portfolio is secured by real estate, and events that negatively impact the real estate market could hurt our business.
 
 A significant portion of our loan portfolio is secured by real estate. As of March 31, 2011, approximately 86% of our loans had real estate as a primary or secondary component of collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. A continued weakening of the real estate market in our primary market areas could continue to result in an increase in the number of borrowers who default on their loans and a reduction in the value of the collateral securing their loans, which in turn could have an adverse effect on our profitability and asset quality. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and shareholders’ equity could be adversely affected. The declines in home prices in the markets we serve, along with the reduced availability of mortgage credit, also may result in increases in delinquencies and losses in our portfolio of loans related to residential real estate construction and development. Further declines in home prices coupled with a deepened economic recession and continued rises in unemployment levels could drive losses beyond that which is provided for in our allowance for loan losses. In that event, our earnings could be adversely affected.
 
 Additionally, recent weakness in the secondary market for residential lending could have an adverse impact on our profitability. Significant ongoing disruptions in the secondary market for residential mortgage loans have limited the market for and liquidity of most mortgage loans other than conforming Fannie Mae and Freddie Mac loans. The effects of ongoing mortgage market challenges, combined with the ongoing correction in residential real estate market prices and reduced levels of home sales, could result in further price reductions in single family home values, adversely affecting the value of collateral securing mortgage loans held, mortgage loan originations and gains on sale of mortgage loans. Continued declines in real estate values and home sales volumes, and financial stress on borrowers as a result of job losses or other factors, could have further adverse effects on borrowers that result in higher delinquencies and greater charge-offs in future periods, which could adversely affect our financial condition or results of operations.
 
 Our real estate and land acquisition and development loans are based upon estimates of costs and the value of the complete project.
 
 We extend real estate land loans, construction loans, and acquisition and development loans to builders and developers, primarily for the construction/development of properties. We originate these loans on a presold and speculative basis and they include loans for both residential and commercial purposes. As of March 31, 2011, these loans totaled $274.5 million, or 24% of our total loan portfolio. Approximately $65.9 million of this amount was for construction of residential properties and $40.0 million was for construction of commercial properties. Additionally, approximately $105.3 million was for acquisition and development loans for both residential and commercial properties. Land loans, which are loans made with raw land as security, totaled $63.3 million, or 6% of our portfolio, as of March 31, 2011.
 - 42 -
 Index
 In general, construction and land lending involves additional risks because of the inherent difficulty in estimating a property’s value both before and at completion of the project. Construction costs may exceed original estimates as a result of increased materials, labor or other costs. In addition, because of current uncertainties in the residential and commercial real estate markets, property values have become more difficult to determine than they have been historically. Construction and land acquisition and development loans often involve the repayment dependent, in part, on the ability of the borrower to sell or lease the property. These loans also require ongoing monitoring. In addition, speculative construction loans to a residential builder are often associated with homes that are not presold, and thus pose a greater potential risk than construction loans to individuals on their personal residences. As of March 31, 2011, $54.6 million of our residential construction loans were for speculative construction loans. Slowing housing sales have been a contributing factor to an increase in nonperforming loans as well as an increase in delinquencies.
 
 Our non-owner occupied commercial real estate loans may be dependent on factors outside the control of our borrowers.
 
 We originate non-owner occupied commercial real estate loans for individuals and businesses for various purposes, which are secured by commercial properties. These loans typically involve repayment dependent upon income generated, or expected to be generated, by the property securing the loan in amounts sufficient to cover operating expenses and debt service. This may be adversely affected by changes in the economy or local market conditions. Non-owner occupied commercial real estate loans expose a lender to greater credit risk than loans secured by residential real estate because the collateral securing these loans typically cannot be liquidated as easily as residential real estate. If we foreclose on a non-owner occupied commercial real estate loan, our holding period for the collateral typically is longer than a 1-4 family residential property because there are fewer potential purchasers of the collateral. Additionally, non-owner occupied commercial real estate loans generally have relatively large balances to single borrowers or related groups of borrowers. Accordingly, charge-offs on non-owner occupied commercial real estate loans may be larger on a per loan basis than those incurred with our residential or consumer loan portfolios. As of March 31, 2011, our non-owner occupied commercial real estate loans totaled $275.0 million, or 24% of our total loan portfolio.
 
 Repayment of our commercial business loans is dependent on the cash flows of the borrower, which may be unpredictable, and the collateral securing these loans may fluctuate in value.
 
 We offer different types of commercial loans to a variety of small to medium-sized businesses. The types of commercial loans offered are owner-occupied term real estate loans, business lines of credit and term equipment financing. Commercial business lending involves risks that are different from those associated with non-owner occupied commercial real estate lending. Our commercial business loans are primarily underwritten based on the cash flow of the borrower and secondarily on the underlying collateral, including real estate. The borrowers’ cash flow may be unpredictable, and collateral securing these loans may fluctuate in value. Some of our commercial business loans are collateralized by equipment, inventory, accounts receivable or other business assets, and the liquidation of collateral in the event of default is often an insufficient source of repayment because accounts receivable may be uncollectible and inventories may be obsolete or of limited use.
 
 As of March 31, 2011, our commercial business loans totaled $282.4 million, or 25% of our total loan portfolio. Of this amount, $163.9 million was secured by owner-occupied real estate and $118.5 million was secured by business assets.
 
 A portion of our commercial real estate loan portfolio utilizes interest reserves which may not accurately portray the financial condition of the project and the borrower’s ability to repay the loan.
 
 Some of our commercial real estate loans utilize interest reserves to fund the interest payments and are funded from loan proceeds. Our decision to establish a loan-funded interest reserve upon origination of a loan is based on the feasibility of the project, the creditworthiness of the borrower and guarantors and the protection provided by the real estate and other collateral. When applied appropriately, an interest reserve can benefit both the lender and the borrower. For the lender, an interest reserve provides an effective means for addressing the cash flow characteristics of a properly underwritten acquisition, development and construction loan. Similarly, for the borrower, interest reserves provide the funds to service the debt until the property is developed, and cash flow is generated from the sale or lease of the developed property.
 
 Although potentially beneficial to the lender and the borrower, our use of interest reserves carries certain risks. Of particular concern is the possibility that an interest reserve may not accurately reflect problems with a borrower’s willingness or ability to repay the debt consistent with the terms and conditions of the loan obligation. For example, a project that is not completed in a timely manner or falters once completed may appear to perform if the interest reserve keeps the loan current. In some cases, we may extend, renew or restructure the term of certain loans, providing additional interest reserves to keep the loan current. As a result, the financial condition of the project may not be apparent and developing problems may not be addressed in a timely manner. Consequently, we may end up with a matured loan where the interest reserve has been fully advanced, and the borrower’s financial condition has deteriorated. In addition, the project may not be complete, its sale or lease-up may not be sufficient to ensure timely repayment of the debt or the value of the collateral may have declined, exposing us to increasing credit losses.
  - 43 -
 Index
 As of March 31, 2011, we had a total of 20 active residential and commercial acquisition, development and construction loans funded by an interest reserve with a total outstanding balance of $49.9 million, representing approximately 4% of our total outstanding loans. Total commitments on these loans equaled $53.6 million with total remaining interest reserves of $815 thousand, representing a weighted average term of approximately four months of remaining interest coverage.
 
 Our allowance for loan losses may prove to be insufficient to absorb losses in our loan portfolio.
 
 Lending money is a substantial part of our business, and each loan carries a certain risk that it will not be repaid in accordance with its terms or that any underlying collateral will not be sufficient to assure repayment. This risk is affected by, among other things:
 
 •
cash flow of the borrower and/or the project being financed;•
the changes and uncertainties as to the future value of the collateral, in the case of a collateralized loan;•
the duration of the loan;•
the credit history of a particular borrower; and•
changes in economic and industry conditions.
 
 We maintain an allowance for loan losses, which is a reserve established through a provision for loan losses charged to expense, which we believe is appropriate to provide for probable losses in our loan portfolio. The amount of this allowance is determined by our management through periodic reviews and consideration of several factors, including, but not limited to:
 
 •
our general reserve, based on our historical default and loss experience and certain other qualitative factors; and•
our specific reserve, based on our evaluation of impaired loans and their underlying collateral.
 
 The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Continuing deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in the allowance for loan losses. In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for probable loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. In addition, if charge-offs in future periods exceed the allowance for loan losses, we will need additional provisions to increase the allowance for loan losses. Any increases in the allowance for loan losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on our financial condition and results of operations.
 
 We have extended the maturity date and terms of a large amount of loans, which could increase the level of our troubled debt restructured loans.
 
 A significant portion of our loans are renewed, or extended, upon maturity. As a prudent risk management strategy, in certain situations we prefer to fund loans with a relatively short maturity date, which provides us with the flexibility of reviewing the borrower’s financial condition and the appropriateness of loan terms on a more frequent basis. Upon renewal, loans are underwritten in the same manner and pursuant to the same approval process as a new loan origination. As of March 31, 2011, outstanding loans totaling $687.1 million had been renewed or had terms extended at a previous maturity date.
 
 While this practice provides certain benefits and flexibility to us as the lender, the extension or renewal of loans carries certain risks. If interest rates or other terms are modified upon extension of credit or if loan terms are renewed in situations where the borrower is experiencing financial difficulty and a concession is granted, the modification or renewal may require classification as a troubled debt restructuring (“TDR”).
 - 44 -
 Index
 In accordance with accounting standards, we classify loans as TDRs when certain modifications are made to the loan terms and concessions are granted to the borrowers due to their financial difficulty. Our practice is to only restructure loans for borrowers in financial difficulty that have designed a viable business plan to fully pay off all obligations, including outstanding debt, interest and fees, either by generating additional income from the business or through liquidation of assets. Generally, these loans are restructured to provide the borrower additional time to execute its business plan. With respect to restructured loans, we grant concessions by (1) reduction of the stated interest rate for the remaining original life of the debt or (2) extension of the maturity date at a stated interest rate lower than the current market rate for new debt with similar risk. Restructured loans where a concession has been granted through extension of the maturity date generally include extension of payments in an interest only period, extension of payments with capitalized interest and extension of payments through a forbearance agreement. These extended payment terms are also combined with a reduction of the stated interest rate in certain cases. In situations where a TDR is unsuccessful and the borrower is unable to satisfy the terms of the restructured agreement, the loan is placed on nonaccrual status and is written down to the underlying collateral value.
 
 We continue to hold and acquire a significant amount of other real estate, which has led to increased operating expenses and vulnerability to additional declines in real property values.
 
 We foreclose on and take title to the real estate serving as collateral for many of our loans as part of our business. Real estate owned by the Bank and not used in the ordinary course of its operations is referred to as “other real estate” or “ORE” property. At March 31, 2011, we had ORE with an aggregate book value of $14.5 million. Increased ORE balances have led to greater expenses as we incur costs to manage and dispose of the properties. We expect that our earnings will continue to be negatively affected by various expenses associated with ORE, including personnel costs, insurance and taxes, completion and repair costs, valuation adjustments and other expenses associated with property ownership, as well as by the funding costs associated with assets that are tied up in ORE. Any further decrease in real estate market prices may lead to additional ORE write-downs, with a corresponding expense in our statement of operations. We evaluate ORE properties periodically and write down the carrying value of the properties if the results of our evaluation require it. The expenses associated with ORE and any further property write-downs could have a material adverse effect on our financial condition and results of operations.
 
 We are subject to environmental liability risk associated with lending activities.
 
 A significant portion of our loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require us to incur substantial expenses to address unknown liabilities and may materially reduce the affected property’s value or limit our ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. Although we have policies and procedures to perform an environmental review before initiating any foreclosure action on nonresidential real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our financial condition and results of operations.
 
 Changes in interest rates may have an adverse effect on our profitability.
 
 Our earnings and financial condition are dependent to a large degree upon net interest income, which is the difference between interest earned from loans and investments and interest paid on deposits and borrowings. Approximately 56% of our loans were variable rate loans as of March 31, 2011, which means that our interest income will generally decrease in lower interest rate environments and rise in higher interest rate environments. Our net interest income will be adversely affected if market interest rates change such that the interest we earn on loans and investments decreases faster than the interest we pay on deposits and borrowings. We cannot predict with certainty or control changes in interest rates. Regional and local economic conditions and the policies of regulatory authorities, including monetary policies of the Federal Reserve, affect interest income and interest expense. We have ongoing policies and procedures designed to manage the risks associated with changes in market interest rates. However, changes in interest rates still may have an adverse effect on our earnings and financial condition.
 
 The fair value of our investments could decline.
 
 The majority of our investment portfolio as of March 31, 2011 has been designated as available-for-sale. Unrealized gains and losses in the estimated value of the available-for-sale portfolio must be “marked to market” and reflected as a separate item in shareholders’ equity (net of tax) as accumulated other comprehensive income. As of March 31, 2011, we maintained $296.6 million, or 97%, of our total investment securities as available-for-sale. Shareholders’ equity will continue to reflect the unrealized gains and losses (net of tax) of these investments. The fair value of our investment portfolio may decline, causing a corresponding decline in shareholders’ equity.
  - 45 -
 Index
 Management believes that several factors affect the fair values of our investment portfolio. These include, but are not limited to, changes in interest rates or expectations of changes, changes to the credit ratings and financial condition of security issuers, the degree of volatility in the securities markets, inflation rates or expectations of inflation, and the slope of the interest rate yield curve. The yield curve refers to the differences between shorter-term and longer-term interest rates; a positively sloped yield curve means shorter-term rates are lower than longer-term rates. These and other factors may impact specific categories of the portfolio differently, and we cannot predict the effect these factors may have on any specific category.
 
 Government regulations may prevent or impact our ability to pay dividends, engage in acquisitions or operate in other ways.
 
 Current and future legislation and the policies established by federal and state regulatory authorities will affect our operations. Banking regulations, designed primarily for the protection of depositors, may limit our growth and the return to our current and/or potential investors by restricting certain of our activities, such as:
 
 •
payment of dividends to our shareholders;•
possible mergers with, or acquisitions of or by, other institutions;•
our desired investments;•
loans and interest rates on loans;•
interest rates paid on our deposits;•
the possible expansion of our branch offices; and/or•
our ability to provide securities or trust services.
 
 We cannot predict what changes, if any, will be made to existing federal and state legislation and regulations or the effect that such changes may have on our future business and earnings prospects. Many of these regulations are intended to protect depositors, the public and the FDIC, not shareholders. The cost of compliance with regulatory requirements including those imposed by the SEC may adversely affect our ability to operate profitably.
 
 Specifically, federal and state governments could pass additional legislation responsive to current credit conditions that reduces the amounts borrowers are contractually required to pay under existing loan contracts or that limits our ability to foreclose on property or other collateral. If proposals such as these, or other proposals limiting our rights as a creditor, were to be implemented, we could experience higher credit losses on our loans or increased expense in pursuing our remedies as a creditor.
 
 We have entered into an MOU that requires us to maintain elevated capital ratios and take other actions, and failure to comply with the terms of the MOU may result in adverse consequences.
 
 On October 28, 2010, the Bank entered into an informal Memorandum of Understanding with the FDIC and the NC Commissioner. Regulatory oversight and actions are on the rise as a result of the current severe economic conditions and the related impact on the banking industry, specifically real estate loans.
 
 In accordance with the terms of the MOU, the Bank has agreed to, among other things, (i) increase regulatory capital to achieve and maintain a minimum Tier 1 leverage capital ratio of at least 8% and a total risk-based capital ratio of at least 12%, (ii) monitor and reduce its commercial real estate concentration, (iii) timely identify and reduce its overall level of problem loans, (iv) establish and maintain an adequate allowance for loan losses, and (v) ensure adherence to loan policy guidelines. The MOU will remain in effect until modified, terminated, lifted, suspended or set aside by the regulatory authorities. In addition, the Bank must obtain regulatory approval prior to paying any dividends to the Company. The MOU may limit our ability to commit capital resources as we are required to preserve capital to meet the MOU’s requirements. In addition, the Company consults with the Federal Reserve Bank of Richmond prior to payment of any dividends or interest on debt.
 
 We are committed to expeditiously addressing and resolving all the issues raised in the MOU, and our Board of Directors and management have initiated actions to comply with its provisions, including the recent completion of the NAFH Investment. A material failure to comply with the terms of the MOU could subject us to additional regulatory actions, including a cease and desist order or other action, and further regulation, which may have a material adverse effect on our future business, results of operations and financial condition.
  - 46 -
 Index
 We are subject to examination and scrutiny by a number of regulatory authorities, and, depending upon the findings and determinations of our regulatory authorities, we may be required to make adjustments to our business, operations or financial position and could become subject to formal or informal regulatory orders.
 
 We are subject to examination by federal and state banking regulators. Federal and state regulators have the ability to impose substantial sanctions, restrictions and requirements on us and our banking subsidiaries if they determine, upon conclusion of their examination or otherwise, violations of laws with which we or our subsidiaries must comply or weaknesses or failures with respect to general standards of safety and soundness, including, for example, in respect of any financial concerns that the regulators may identify and desire for us to address. Such enforcement may be formal or informal and can include directors’ resolutions, memoranda of understanding, cease and desist orders, civil money penalties and termination of deposit insurance and bank closures. Enforcement actions may be taken regardless of the capital levels of the institutions, and regardless of prior examination findings. In particular, institutions that are not sufficiently capitalized in accordance with regulatory standards may also face capital directives or prompt corrective actions. Enforcement actions may require certain corrective steps (including staff additions or changes), impose limits on activities (such as lending, deposit taking, acquisitions or branching), prescribe lending parameters (such as loan types, volumes and terms) and require additional capital to be raised, any of which could adversely affect our financial condition and results of operations. The imposition of regulatory sanctions, including monetary penalties, may have a material impact on our financial condition and results of operations and/or damage our reputation. In addition, compliance with any such action could distract management’s attention from our operations, cause us to incur significant expenses, restrict us from engaging in potentially profitable activities and limit our ability to raise capital.
 
 We are dependent on our key personnel, including our senior management and directors, and our inability to integrate our new management and directors into our business and hire and retain key personnel may adversely affect our operations and financial performance.
 
 We are, and for the foreseeable future will be, dependent on the services of our senior management and directors. In connection with the NAFH Investment, R. Eugene Taylor, Christopher G. Marshall, Peter N. Foss, William A. Hodges and R. Bruce Singletary were appointed to our Board of Directors. Mr. Oscar A. Keller, III and Charles F. Atkinsremained as members of our Board of Directors following the closing of the NAFH Investment and all other prior directors of the Company resigned effective January 28, 2011. In addition, we appointed several new executive officers in connection with the NAFH Investment: R. Eugene Taylor as President, Chief Executive Officer and Chairman of the Board, Christopher G. Marshall as Executive Vice President and Chief Financial Officer and R. Bruce Singletary as Executive Vice President and Chief Risk Officer. B. Grant Yarber remained with the Company as Market President for North Carolina and Michael R. Moore, David C. Morgan and Mark Redmond remained with the Company as Executive Vice Presidents. We may not be able to integrate our new management and directors into our business without encountering potential difficulties, including but not limited to the loss of key employees and customers; possible changes in strategic direction, business plan, operations, control procedures and policies; and transitional issues related to changing responsibilities of management.
 
 In addition, successful execution of our growth strategy will continue to place significant demands on our management and directors. The loss of any such person’s services may disrupt our operations and growth, and there can be no assurance that a suitable successor could be retained upon the terms and conditions that we would offer. Further, as we continue to grow our operations both in our current markets and other markets that we may target, we expect to continue to be dependent on our senior management and their relationships in such markets. Our inability to attract or retain additional personnel could materially adversely affect our business or growth prospects in one or more markets.
 
 We may enter into acquisitions, combinations, or other strategic transactions at any time, which could expose us to potential risks.
 
 We intend to continue to explore expanding our branch system through selective acquisitions of existing banks or bank branches, including through FDIC-assisted transactions. We are also exploring combinations with other banks or bank branches in which NAFH has an indirect majority interest, or other strategic transactions. We cannot say with any certainty that we will be able to consummate, or if consummated, successfully integrate, future acquisitions or combinations, or that we will not incur disruptions or unexpected expenses in integrating such acquisitions. In the ordinary course of business, we evaluate potential acquisitions, combinations, and other transactions that would bolster our ability to cater to the small business, individual and residential lending markets in our target markets. In attempting to make such acquisitions, combinations, and other transactions we may compete with other financial institutions, many of which have greater financial and operational resources.
  - 47 -
 Index
 The process of identifying transaction opportunities, negotiating potential transactions, obtaining the required regulatory approvals and integrating new operations and personnel requires a significant amount of time and expense and may divert management’s attention from our existing business. In addition, since the consideration for an acquired bank or branch may involve cash, notes or the issuance of shares of common stock, existing shareholders could experience dilution in the value of their shares of our common stock in connection with such acquisitions. Any given transaction, if and when consummated, may adversely affect our results of operations or overall financial condition. In addition, we may expand our branch network through de novo branches in existing or new markets. These de novo branches will have expenses in excess of revenues for varying periods after opening, which could decrease our reported earnings.
 
 Our ability to raise additional capital could be limited, could affect our liquidity and could be dilutive to existing shareholders.
 
 We may be required or choose to raise additional capital, including for strategic, regulatory or other reasons. Current conditions in the capital markets are such that traditional sources of capital may not be available to us on reasonable terms if we need to raise additional capital, and the inability to access the capital markets could impair our liquidity, which is important to our business. In such case, there is no guarantee that we will be able to successfully raise additional capital at all or on terms that are favorable or otherwise not dilutive to existing shareholders.
 
 We compete with larger companies for business.
 
 The banking and financial services business in our market areas continues to be a competitive field and is becoming more competitive as a result of:
 
 •
changes in regulations;•
changes in technology and product delivery systems; and•
the accelerating pace of consolidation among financial services providers.
 
 We may not be able to compete effectively in our markets, and our results of operations could be adversely affected by the nature or pace of change in competition. We compete for loans, deposits and customers with various bank and nonbank financial services providers, many of which have substantially greater resources, including higher total assets and capitalization, greater access to capital markets and a broader offering of financial services.
 
 The failure of other financial institutions could adversely affect us.
 
 Our ability to engage in routine transactions, including, for example, funding transactions, could be adversely affected by the actions and potential failures of other financial institutions. We have exposure to many different industries and counterparties, and we routinely execute transactions with a variety of counterparties in the financial services industry. As a result, defaults by, or even rumors or concerns about, one or more financial institutions with which we do business, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by others. In addition, our credit risk may be exacerbated when the collateral we hold cannot be sold at prices that are sufficient for us to recover the full amount of our exposure. Any such losses could materially and adversely affect our financial condition and results of operations.
 
 Consumers may decide not to use banks to complete their financial transactions, which could limit our revenue.
 
 Technology and other changes are allowing parties to complete financial transactions through alternative methods that historically have involved banks. For example, consumers can now maintain funds in brokerage accounts or mutual funds that would have historically been held as bank deposits. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks through the use of various electronic payment systems. The process of eliminating banks as intermediaries could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on our financial condition and results of operations.
 - 48 -
 Index
 Technological advances impact our business.
 
 The banking industry is undergoing rapid technological changes with frequent introductions of new technology-driven products and services. In addition to improving customer services, the effective use of technology increases efficiency and enables financial institutions to reduce costs. Our future success will depend, in part, on our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources than we do to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or successfully market such products and services to our customers.
 
 Our information systems, or those of our third party contractors, may experience an interruption or breach in security.
 
 We rely heavily on our communications and information systems, and those of third party contractors, to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that we can prevent any such failures, interruptions or security breaches of our information systems, or those of our third party contractors, or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of such information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
 
 Our controls and procedures may fail or be circumvented.
 
 Management regularly reviews and updates our internal controls, disclosure controls and procedures and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations and financial condition.
 
 We have experienced net losses during the last three completed fiscal years, and we are uncertain as to whether or when we will again be profitable.
 
 We have experienced net losses during the years ended December 31, 2010, 2009 and 2008, and losses may continue. Our ability to generate profit in the future requires successful growth in revenues and management of expenses, among other factors. While we expect to be able to generate profit over time, our operating losses may continue for an unknown period of time.
 
 Risks Related to Ownership of Our Common Stock
 
 NAFH is a controlling shareholder and may have interests that differ from the interests of our other shareholders.
 
 NAFH currently owns approximately 83.1% of the Company’s outstanding voting power. As a result, NAFH will be able to control the election of our directors, determine our corporate and management policies and determine the outcome of any corporate transaction or other matter submitted to our shareholders for approval. Such transactions may include mergers and acquisitions (which may include mergers of the Company and/or its subsidiaries with or into NAFH and/or NAFH’s other subsidiaries), sales of all or some of the Company’s assets (including sales of such assets to NAFH and/or NAFH’s other subsidiaries) or purchases of assets from NAFH and/or NAFH’s other subsidiaries, and other significant corporate transactions.
 
 Fiveof our seven directors, our Chief Executive Officer, our Chief Financial Officer, and our Chief Risk Officerare affiliated with NAFH. NAFH also has sufficient voting power to amend our organizational documents. The interests of NAFH may differ from those of our other shareholders, and it may take actions that advance its interests to the detriment of our other shareholders. Additionally, NAFH is in the business of making investments in or acquiring financial institutions and may, from time to time, acquire and hold interests in businesses that compete directly or indirectly with us. NAFH may also pursue, for its own account, acquisition opportunities that may be complementary to our business, and as a result, those acquisition opportunities may not be available to us.
 
 This concentration of ownership could also have the effect of delaying, deferring or preventing a change in our control or impeding a merger or consolidation, takeover or other business combination that could be favorable to the other holders of our common stock, and the trading price of our common stock may be adversely affected by the absence or reduction of a takeover premium in the trading price.
  - 49 -
 Index
 As a controlled company, we are exempt from certain NASDAQ corporate governance requirements.
 
 NAFH owns more than 50% of our voting power for the election of directors. Accordingly, we are exempt from certain corporate governance requirements, and holders of our common stock may not have all the protections that these rules are intended to provide.
 
 The trading volume in our common stock has been low, and market conditions and other factors may affect the value of our common stock, which may make it difficult for you to sell your shares at times, volumes or prices you find attractive.
 
 While our common stock is traded on the NASDAQ Global Select Market, our common stock is thinly traded and has substantially less liquidity than the average trading market for many other publicly traded companies. Trading volume may remain low as a result of the NAFH Investment and NAFH’s acquisition of a majority stake in the Company. Thinly traded stocks can be more volatile than stock trading in an active public market. Our stock price has been volatile in the past and several factors could cause the price to fluctuate substantially in the future. These factors include but are not limited to changes in analysts’ recommendations or projections, our announcement of developments related to our business, operations and stock performance of other companies deemed to be peers, news reports of trends, concerns, irrational exuberance on the part of investors and other issues related to the financial services industry. Recently, the stock market has experienced a high level of price and volume volatility, and market prices for the stock of many companies, including those in the financial services sector, have experienced wide price fluctuations that have not necessarily been related to operating performance. Our stock price may fluctuate significantly in the future, and these fluctuations may be unrelated to our performance. General market declines or market volatility in the future, especially in the financial institutions sector of the economy, could adversely affect the price of our common stock, and the current market price may not be indicative of future market prices. Therefore, our shareholders may not be able to sell their shares at the volume, prices or times that they desire.
 
 We may choose to voluntarily delist our common stock from NASDAQ or cease to be a reporting issuer under SEC rules.
 
 We may choose to, or our majority shareholder NAFH may cause us to, voluntarily delist from the NASDAQ Global Select Market. If we were to delist from NASDAQ, we may or may not list ourselves on another exchange, and may or may not be required to continue to file periodic and current reports and other information as a reporting issuer under SEC rules. A delisting of our common stock could negatively impact you by reducing the liquidity and market price of our common stock, reducing information available to you about the Company on an ongoing basis and potentially reducing the number of investors willing to hold or acquire our common stock. In addition, if we were to delist from NASDAQ, we would no longer be subject to any of the corporate governance rules applicable to NASDAQ listed companies. See also “—As a controlled company, we are exempt from certain NASDAQ corporate governance requirements.”
 
 We may issue additional shares of common stock or convertible securities that will dilute the percentage ownership interest of existing shareholders and may dilute the book value per share of our common stock and adversely affect the terms on which we may obtain additional capital.
 
 Our authorized capital includes 300,000,000 shares of common stock. As of May 10, 2011, we had 85,802,164 shares of common stock outstanding and had reserved for issuance 257,680 shares underlying options that are exercisable at an average price of $12.96 per share. In addition, as of May 10, 2011, we had the ability to issue 605,359 shares of common stock pursuant to options and restricted stock that may be granted in the future under our existing equity compensation plans. Although we presently do not have any intention of issuing additional common stock (other than pursuant to our equity compensation plans), we may do so in the future in order to meet our capital needs and regulatory requirements, and we will be able to do so without shareholder approval. Subject to applicable NASDAQ Listing Rules, our Board of Directors generally has the authority, without action by or vote of the shareholders, to issue all or part of any authorized but unissued shares of common stock for any corporate purpose, including issuance of equity-based incentives under or outside of our equity compensation plans. We may seek additional equity capital in the future as we develop our business and expand our operations. Any issuance of additional shares of common stock or convertible securities will dilute the percentage ownership interest of our shareholders and may dilute the book value per share of our common stock.
 - 50 -
 Index
 Our ability to pay dividends and other obligations is subject to regulatory limitations and the Bank’s ability to pay dividends to us, which is also subject to regulatory limitations.
 
 Our ability to pay our obligations and declare and pay dividends depends on certain federal regulatory considerations, including the guidelines of the Federal Reserve regarding capital adequacy and dividends. The Company consults with the Federal Reserve Bank of Richmond prior to payment of any dividends or interest on debt. If we are not permitted to make these payments, we may experience adverse consequences under our agreements with the holders of our debt. Holders of our common stock are only entitled to receive such dividends as our Board of Directors may declare out of funds legally available for such payments. Although we have historically paid cash dividends on our common stock, we are not required to do so and our Board of Directors voted in the first quarter of 2010 to suspend the payment of our quarterly cash dividend. This may continue to adversely affect the market price of our common stock.
 
 We are a separate legal entity from the Bank and our other subsidiaries, and we do not have significant operations of our own. We have historically depended on the Bank’s cash and liquidity as well as dividends to pay our operating expenses. Various federal and state statutory provisions limit the amount of dividends that subsidiary banks can pay to their holding companies without regulatory approval. The Bank is also subject to limitations under state law regarding the payment of dividends, including the requirement that dividends may be paid only out of undivided profits and only if the Bank has surplus of a specified level. In addition, the Bank’s MOU requires the Bank to obtain regulatory approval prior to paying any cash dividends to us.
 
 It is possible, depending upon the financial condition of the Bank and other factors, that the federal and state regulatory agencies could take the position that payment of dividends by the Bank would constitute an unsafe or unsound banking practice. In the event the Bank is unable to pay dividends sufficient to satisfy our obligations or is otherwise unable to pay dividends to us, we may not be able to service our obligations as they become due or to pay dividends on our common stock. Consequently, the inability to receive dividends from the Bank could adversely affect our financial condition, results of operations, cash flows and prospects.
 
 The holders of our subordinated debentures have rights that are senior to those of our shareholders.
 
 We have issued $34.3 million of subordinated debentures, which are senior to our shares of common stock. As a result, we must make payments on the subordinated debentures (and the trust preferred securities related to a portion of the subordinated debentures) before any dividends can be paid on our common stock and, in the event of bankruptcy, dissolution or liquidation, the holders of the debentures must be satisfied before any distributions can be made to the holders of common stock.
 
 An investment in our common stock is not an insured deposit.
 
 Our common stock is not a bank deposit and, therefore, is not insured against loss by the FDIC, any other deposit insurance fund or by any other public or private entity. Investment in our common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company. As a result, our shareholders may lose some or all of their investment in our common stock.
 
 Item 2.Unregistered Sales of Equity Securities and Use of Proceeds
 
 As previously reported on our Current Report on Form 8-K filed on February 1, 2011, on January 28, 2011, during the three months ended March 31, 2011, we completed the issuance and sale to NAFH of 71,000,000 shares of Common Stock for aggregate consideration of $181,050,000. This issuance and sale was exempt from registration under the Securities Act of 1933, as amended (the “Securities Act”), pursuant to Section 4(2) of the Securities Act.
 
 There were no repurchases (both open market and private transactions) during the three months ended March 31, 2011 of any of the Company’s securities registered under Section 12 of the Exchange Act, by or on behalf of the Company, or any affiliated purchaser of the Company.
 
 Item 3.Defaults upon Senior Securities
 
 None
 
 Item 4.  (Removed and Reserved)
 
 Item 5.OtherInformation
 
 None
  - 51 -
 Index
 Item 6.  Exhibits
 
 Exhibit No.

DescriptionExhibit 4.1

In accordance with Item 601(b)(4)(iii)(A) of Regulation S-K, certain instruments respecting long-term debt of the registrant have been omitted but will be furnished to the Commission upon request.Exhibit 31.1

Certification of R. Eugene Taylor pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002Exhibit 31.2

Certification of Christopher G. Marshall pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002Exhibit 32.1

Certification of R. Eugene Taylor pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002Exhibit 32.2

Certification of Christopher G. Marshall pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 - 52 -
 Index
 Signatures
 
 Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in Raleigh, North Carolina, on the 16th day of May 2011.
 
 CAPITAL BANK CORPORATIONBy:
/s/ Christopher G. MarshallChristopher G. MarshallChief Financial Officer
 - 53 -
 Index
 Exhibit Index
 
 Exhibit No.

DescriptionExhibit 4.1

In accordance with Item 601(b)(4)(iii)(A) of Regulation S-K, certain instruments respecting long-term debt of the registrant have been omitted but will be furnished to the Commission upon request.Exhibit 31.1

Certification of R. Eugene Taylor pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002Exhibit 31.2

Certification of Christopher G. Marshall pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002Exhibit 32.1

Certification of R. Eugene Taylor pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002Exhibit 32.2

Certification of Christopher G. Marshall pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 - 54 -
 Index