**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**(MARK ONE)**

** **

**x****        QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the Quarterly Period ended September 30, 2008**

 

**OR**

** **

**o****        TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

** **

**For the Transition Period from           to         **

 

**Commission File No. 000-51896**

 

**COMMUNITYSOUTHFINANCIAL CORPORATION**

(Exact name of registrant as specified in its charter)

 

| **South  Carolina**          |   | **20-0934786**      |
|------------------------------|--------|---------------------|
| (State or other jurisdiction |   | (I.R.S. Employer    |
| of incorporation)            |   | Identification No.) |

 

**6602 Calhoun Memorial Highway**

**Easley, South Carolina 29640**

(Address of principal executive offices)

 

**(864) 306-2540**

(Registrant’s telephone number, including area code)

 

----

 

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

 

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

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

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).

Yeso No x

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date:

4,698,697 shares of common stock, $0.01 par value per share, were issued andoutstanding as of October 31, 2008.

 

 

 

----

 

**Part I- Financial Information**

 

## **Item 1. FinancialStatements**.

## ** **

**CONSOLIDATEDBALANCE SHEETS**

** **
| ** **                                                                                                                                                                                  | ** ** | **September 30, 2008** | ** **  | **December 31, 2007** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|-------------|---------------------------------|------------|
| ** **                                                                                                                                                                                  | ** ** | **(Unaudited)**                  | ** **  | **(Audited)**                   | ** ** |
| **Assets**                                                                                                                                                                                  |       |                             |        |                            |       |
| Cash and cash  equivalents                                                                                                                                                                  |       |                             |        |                            |       |
| Cash and due  from bank                                                                                                                                                                     |       | $                                | 8,590,134   |                            | $          | 6,486,676 |   |
| Federal funds  sold                                                                                                                                                                         |       | 0                                |        | 33,665,005                      |       |
| Total cash and  cash equivalents                                                                                                                                                            |       | 8,590,134                        |        | 40,151,681                      |       |
| Investment  securities, available for sale                                                                                                                                                  |       | 43,795,862                       |        | 24,844,007                      |       |
| Other  investments, at cost                                                                                                                                                                 |       | 1,130,200                        |        | 446,800                         |       |
| Loans, net                                                                                                                                                                                  |       | 313,702,623                      |        | 298,720,357                     |       |
| Accrued interest  receivable                                                                                                                                                                |       | 1,481,167                        |        | 2,092,066                       |       |
| Property and  equipment, net                                                                                                                                                                |       | 4,735,955                        |        | 5,073,685                       |       |
| Bank-owned life  insurance                                                                                                                                                                  |       | 5,383,100                        |        | 5,226,806                       |       |
| Other assets                                                                                                                                                                                |       | 2,901,245                        |        | 1,311,799                       |       |
|                                                                                                                                                                                        |       |                             |        |                            |       |
| Total assets                                                                                                                                                                                |       | $                                | 381,720,286 |                            | $          | 377,867,201 |   |
|                                                                                                                                                                                        |       |                             |        |                            |       |
| **Liabilities and Shareholders’ Equity**                                                                                                                                               |       |                             |        |                            |       |
|                                                                                                                                                                                        |       |                             |        |                            |       |
| **Liabilities**                                                                                                                                                                             |       |                             |        |                            |       |
| Deposits                                                                                                                                                                                    |       |                             |        |                            |       |
| Non-interest  bearing                                                                                                                                                                       |       | $                                | 24,463,253  |                            | $          | 24,464,433 |   |
| Interest bearing                                                                                                                                                                            |       | 270,504,054                      |        | 303,199,212                     |       |
| Total deposits                                                                                                                                                                              |       | 294,967,307                      |        | 327,663,645                     |       |
| Federal Funds  Purchased                                                                                                                                                                    |       | 9,491,000                        |        | —                          |       |
| Line of Credit                                                                                                                                                                              |       | 1,570,000                        |        | —                          |       |
| Subordinated  Debt                                                                                                                                                                          |       | 3,545,000                        |        | —                          |       |
| Repurchase  agreements                                                                                                                                                                      |       | 30,000,000                       |        | 15,000,000                      |       |
| FHLB advances                                                                                                                                                                               |       | 10,000,000                       |        | —                          |       |
| Accrued interest  payable                                                                                                                                                                   |       | 1,434,298                        |        | 3,238,298                       |       |
| Accrued expenses                                                                                                                                                                            |       | 272,899                          |        | 427,380                         |       |
| Other  liabilities                                                                                                                                                                          |       | 79,432                           |        | 66,742                          |       |
|                                                                                                                                                                                        |       |                             |        |                            |       |
| Total  liabilities                                                                                                                                                                          |       | 351,359,936                      |        | 346,396,065                     |       |
|                                                                                                                                                                                        |       |                             |        |                            |       |
| **Shareholders’  Equity**                                                                                                                                                              |       |                             |        |                            |       |
| Preferred stock,  par value $.01 per share  10,000,000 shares authorized, no shares issued                                                                                                  |       | —                           |        | —                          |       |
| Common stock,  par value $.01 per share  10,000,000 shares authorized, 4,698,697 and 4,698,697 issued  and outstanding at September 30, 2008 and  December 31, 2007, respectively |       | 46,987                           |        | 46,987                          |       |
| Additional  paid-in capital                                                                                                                                                                 |       | 29,742,568                       |        | 29,691,467                      |       |
| Accumulated  other comprehensive income (loss)                                                                                                                                              |       | (45,745                          | )           | 152,050                         |       |
| Retained  earnings                                                                                                                                                                          |       | 616,540                          |        | 1,580,632                       |       |
| Total  shareholders’ equity                                                                                                                                                            |       | 30,360,350                       |        | 31,471,136                      |       |
|                                                                                                                                                                                        |       |                             |        |                            |       |
| Total  liabilities and shareholders’ equity                                                                                                                                            |       | $                                | 381,720,286 |                            | $          | 377,867,201 |   |

 

The accompanying notes are anintegral part of the consolidated financial statements.

 

2

----

 

**CONSOLIDATEDSTATEMENTS OF INCOME**

**(UNAUDITED)**

 
| ** **                                                 | ** ** | **Three months ended** | ** ** | **Three months ended** | ** ** |
|------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                 | ** ** | **September 30, 2008** | ** ** | **September 30, 2007** | ** ** |
| **Interest  income**                                       |       |                             |       |                             |       |
| Interest and  fees on loans                                |       | $                                | 5,029,718  |                             | $          | 5,676,825 |   |
| Interest and  dividends on investments                     |       | 603,894                          |       | 476,312                          |       |
| Total interest  income                                     |       | 5,633,612                        |       | 6,153,137                        |       |
|                                                       |       |                             |       |                             |       |
| **Interest  expense – deposits and other borrowings** |       | 2,994,547                        |       | 3,413,663                        |       |
|                                                       |       |                             |       |                             |       |
| Net interest  income                                       |       | 2,639,065                        |       | 2,739,474                        |       |
| ** **                                                 |       |                             |       |                             |       |
| **Provision  for loan losses**                             |       | 160,000                          |       | 362,000                          |       |
|                                                       |       |                             |       |                             |       |
| Net interest income  after provision for loan losses       |       | 2,479,065                        |       | 2,377,474                        |       |
| ** **                                                 |       |                             |       |                             |       |
| **Non-interest  income**                                   |       |                             |       |                             |       |
| Mortgage  origination fees                                 |       | 96,183                           |       | 285,600                          |       |
| Other                                                      |       | 207,468                          |       | 120,145                          |       |
| Total  non-interest income                                 |       | 303,651                          |       | 405,745                          |       |
| ** **                                                 |       |                             |       |                             |       |
| **Non-interest  expense**                                  |       |                             |       |                             |       |
| Salaries and  benefits                                     |       | 1,222,884                        |       | 1,079,416                        |       |
| Data processing                                            |       | 193,808                          |       | 156,561                          |       |
| Occupancy                                                  |       | 155,979                          |       | 110,853                          |       |
| Depreciation                                               |       | 178,108                          |       | 156,223                          |       |
| Equipment  maintenance and rental                          |       | 57,204                           |       | 25,637                           |       |
| Advertising                                                |       | 106,857                          |       | 100,217                          |       |
| Professional fees                                          |       | 226,202                          |       | 101,886                          |       |
| Office supplies                                            |       | 25,894                           |       | 29,094                           |       |
| Telephone                                                  |       | 42,107                           |       | 33,815                           |       |
| FDIC assessment                                            |       | 56,000                           |       | 92,160                           |       |
| Other                                                      |       | 358,530                          |       | 272,870                          |       |
| Total  non-interest expense                                |       | 2,623,573                        |       | 2,158,732                        |       |
|                                                       |       |                             |       |                             |       |
| **Income  (loss) before income taxes**                     |       | 159,143                          |       | 624,487                          |       |
|                                                       |       |                             |       |                             |       |
| **Income  tax expense (benefit)**                          |       | 74,300                           |       | 164,756                          |       |
| ** **                                                 |       |                             |       |                             |       |
| **Net  income (loss)**                                     |       | $                                | 84,843     |                             | $          | 459,731 |   |
| ** **                                                 |       |                             |       |                             |       |
| **Earnings  (losses) per share (1)**                       |       |                             |       |                             |       |
| Basic                                                      |       | $                                | 0.02       |                             | $          | 0.10 |   |
| Diluted                                                    |       | $                                | 0.02       |                             | $          | 0.09 |   |
|                                                       |       |                             |       |                             |       |
| **Weighted  average shares outstanding (1)**               |       |                             |       |                             |       |
| Basic                                                      |       | 4,698,697                        |       | 4,698,697                        |       |
| Diluted                                                    |       | 4,698,697                        |       | 5,089,566                        |       |

 

----

(1)  Adjusted for5-for-4 stock split effective January 16, 2007.

 

The accompanying notes are anintegral part of the consolidated financial statements.

 

3

----

 

**CONSOLIDATEDSTATEMENTS OF INCOME**

**(UNAUDITED)**

 
| ** **                                                 | ** ** | **Nine months ended**  | ** ** | **Nine months ended**  | ** ** |
|------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                 | ** ** | **September 30, 2008** | ** ** | **September 30, 2007** | ** ** |
| **Interest  income**                                       |       |                             |       |                             |       |
| Interest and  fees on loans                                |       | $                                | 15,580,959 |                             | $          | 15,474,063 |   |
| Interest and  dividends on investments                     |       | 2,006,557                        |       | 1,185,350                        |       |
| Total interest  income                                     |       | 17,587,516                       |       | 16,659,413                       |       |
|                                                       |       |                             |       |                             |       |
| **Interest  expense – deposits and other borrowings** |       | 9,984,837                        |       | 9,294,250                        |       |
|                                                       |       |                             |       |                             |       |
| Net interest  income                                       |       | 7,602,679                        |       | 7,365,163                        |       |
| ** **                                                 |       |                             |       |                             |       |
| **Provision  for loan losses**                             |       | 2,864,000                        |       | 994,000                          |       |
|                                                       |       |                             |       |                             |       |
| Net interest  income after provision for loan losses       |       | 4,738,679                        |       | 6,371,163                        |       |
| ** **                                                 |       |                             |       |                             |       |
| **Non-interest  income**                                   |       |                             |       |                             |       |
| Mortgage  origination fees                                 |       | 431,445                          |       | 807,612                          |       |
| Other                                                      |       | 589,313                          |       | 340,907                          |       |
| Total  non-interest income                                 |       | 1,020,758                        |       | 1,148,519                        |       |
|                                                       |       |                             |       |                             |       |
| **Non-interest  expense**                                  |       |                             |       |                             |       |
| Salaries and  benefits                                     |       | 3,685,615                        |       | 3,119,877                        |       |
| Data processing                                            |       | 561,206                          |       | 415,575                          |       |
| Occupancy                                                  |       | 476,019                          |       | 354,978                          |       |
| Depreciation                                               |       | 539,454                          |       | 437,451                          |       |
| Equipment  maintenance and rental                          |       | 143,431                          |       | 79,001                           |       |
| Advertising                                                |       | 145,859                          |       | 173,857                          |       |
| Professional  fees                                         |       | 357,990                          |       | 224,897                          |       |
| Office supplies                                            |       | 73,077                           |       | 105,361                          |       |
| Telephone                                                  |       | 111,970                          |       | 105,565                          |       |
| FDIC assessment                                            |       | 162,500                          |       | 146,044                          |       |
| Other                                                      |       | 915,708                          |       | 664,019                          |       |
| Total non-interest  expense                                |       | 7,172,829                        |       | 5,826,625                        |       |
|                                                       |       |                             |       |                             |       |
| **Income  (loss) before income taxes**                     |       | (1,413,392                       | )          | 1,693,057                        |       |
|                                                       |       |                             |       |                             |       |
| **Income  tax expense (benefit)**                          |       | (449,300                         | )          | 562,825                          |       |
| ** **                                                 |       |                             |       |                             |       |
| **Net  income (loss)**                                     |       | $                                | (964,092   | )                                | $          | 1,130,232 |   |
| ** **                                                 |       |                             |       |                             |       |
| **Earnings  (losses) per share (1)**                       |       |                             |       |                             |       |
| Basic                                                      |       | $                                | (0.21      | )                                | $          | 0.24 |   |
| Diluted                                                    |       | $                                | (0.21      | )                                | $          | 0.22 |   |
|                                                       |       |                             |       |                             |       |
| **Weighted  average shares outstanding (1)**               |       |                             |       |                             |       |
| Basic                                                      |       | 4,698,697                        |       | 4,698,613                        |       |
| Diluted                                                    |       | 4,698,697                        |       | 5,159,546                        |       |

 

----

(1)  Adjusted for5-for-4 stock split effective January 16, 2007.

 

The accompanying notes are anintegral part of the consolidated financial statements.

 

4

----

 

**CONSOLIDATEDSTATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY**

**For thenine month periods ended September 30, 2008 and September 30, 2007**

**(UNAUDITED)**

 
| ** **                                                      | ** ** | **Common Stock ** | ** ** | **Additional  Paid-in** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Retained** | ** ** | **Total  Shareholders’** | ** ** | **Total  Comprehensive** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------------|------------|-------------------------|------------|---------------------------------------|------------|--------------|------------|-------------------------------|------------|--------------------------|------------|
| ** **                                                      | ** ** | **Shares**** (1)**     | ** ** | **Amount (1)**     | ** ** | **Capital (1)**                  | ** ** | **Income**   | ** ** | **Earnings**                  | ** ** | **Equity**               | ** ** | **Income** | ** ** |
| Balance at  December 31, 2007                              |       | 4,698,697                   |       | $                       | 46,987     |                                  | $          | 29,691,467   |       | $                             | 152,050    |                     | $          | 1,580,632 |   | $ | 31,471,136 |   |   |   |
|                                                            |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Net income (loss)                                               |       | —                      |       | —                  |       | —                                |       | —       |       | (964,092                      | )          | (964,092                 | )          | $ | (964,062 | ) |
|                                                            |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Other  comprehensive income:                                    |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
|                                                            |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Unrealized gains  (losses) on  securities, net of income  taxes |       | —                      |       | —                  |       | —                                |       | (197,795     | )          | —                        |       | (197,795                 | )          | (197,795 | ) |
|                                                            |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Total  comprehensive income  (loss)                             |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       | $ | (1,161,857 | ) |
|                                                            |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Stock option  compensation                                      |       | —                      |       | —                  |       | 51,101                                |       | —       |       | —                        |       | 51,101                   |       |   |   |
|                                                            |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Balance at  September 30, 2008                             |       | 4,698,697                   |       | $                       | 46,987     |                                  | $          | 29,742,568   |       | $                             | (45,745    | )                        | $          | 616,540 |   | $ | 30,360,350 |   |   |   |

 
| ** **                                            | ** ** | **Common Stock ** | ** ** | **Additional  Paid-in** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Retained** | ** ** | **Total  Shareholders’** | ** ** | **Total  Comprehensive** | ** ** |
|-------------------------------------------------------|------------|-----------------------------|------------|-------------------------|------------|---------------------------------------|------------|--------------|------------|-------------------------------|------------|--------------------------|------------|
| ** **                                            | ** ** | **Shares**** (1)**     | ** ** | **Amount (1)**     | ** ** | **Capital (1)**                  | ** ** | **Income**   | ** ** | **Earnings**                  | ** ** | **Equity**               | ** ** | **Income** | ** ** |
|                                                  |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Balance at  December 31, 2006                    |       | 4,697,697                   |       | $                       | 46,977     |                                  | $          | 29,635,458   |       | $                             | —     |                     | $          | 12,520 |   | $ | 29,694,955 |   |   |   |
|                                                  |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Net income                                            |       | —                      |       | —                  |       | —                                |       | —       |       | 1,130,232                     |       | 1,130,232                |       | $ | 1,130,232 |   |
|                                                  |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Other  comprehensive income:                          |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
|                                                  |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Unrealized gains  on securities,  net of income taxes |       | —                      |       | —                  |       | —                                |       | 142,224      |       | —                        |       | 142,224                  |       | 142,224 |   |
|                                                  |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Total  comprehensive income                           |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       | $ | 1,272,456 |   |
|                                                  |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Stock option  compensation                            |       | —                      |       | —                  |       | 39,571                                |       | —       |       | —                        |       | 39,571                   |       |   |   |
|                                                  |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Cash paid for  fractional shares                      |       | —                      |       | —                  |       | (5,701                                | )          | —       |       | —                        |       | (5,701                   | )          |   |   |
|                                                  |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Stock options  exercised                              |       | 1,000                       |       | 10                      |       | 6,390                                 |       | —       |       | —                        |       | 6,400                    |       |   |   |
|                                                  |       |                        |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Balance at  September  30, 2007                  |       | 4,698,697                   |       | $                       | 46,987     |                                  | $          | 29,675,718   |       | $                             | 142,224    |                     | $          | 1,142,752 |   | $ | 31,007,681 |   |   |   |

 

----

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

 

5

----

 

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(UNAUDITED)**

 
| ** **                                                                          | ** ** | **Nine months  ended** | ** ** | **Nine Months  ended** | ** ** |
|-------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                                          | ** ** | **September 30,**      | ** ** | **September 30,**      | ** ** |
| ** **                                                                          | ** ** | **2008**                    | ** ** | **2007**                    | ** ** |
| **Operating activities**                                                            |       |                        |       |                        |       |
| Net income  (loss)                                                                  |       | $                           | (964,092   | )                           | $          | 1,130,232 |   |
| Adjustments to  reconcile net income to net cash provided by operating  activities: |       |                        |       |                        |       |
| Provision for  loan losses                                                          |       | 2,864,000                   |       | 994,000                     |       |
| Stock option  compensation                                                          |       | 51,101                      |       | 39,571                      |       |
| Appreciation of  bank-owned life insurance                                          |       | (156,294                    | )          | (166,536                    | )          |
| Depreciation                                                                        |       | 539,454                     |       | 437,451                     |       |
| Deferred income  tax benefit                                                        |       | (827,000                    | )          | 137,974                     |       |
| Decrease  (increase) in accrued interest receivable                                 |       | 610,899                     |       | (681,375                    | )          |
| Increase in  accrued interest payable                                               |       | (1,804,000                  | )          | 1,389,239                   |       |
| Decrease in  accrued expenses                                                       |       | (154,481                    | )          | 190,285                     |       |
| Decrease  (increase) in other assets                                                |       | (58,361                     | )          | (184,157                    | )          |
| Increase  (decrease) in other liabilities                                           |       | 12,690                      |       | 31,714                      |       |
| Loss on disposal  of property and equipment                                         |       | —                      |       | 709                         |       |
|                                                                                |       |                        |       |                        |       |
| Net cash  provided by operating activities                                          |       | 113,916                     |       | 3,319,107                   |       |
| **Investing activities**                                                            |       |                        |       |                        |       |
| Net increase in  loans outstanding                                                  |       | (18,402,351                 | )          | (72,024,583                 | )          |
| Purchases of  investment securities                                                 |       | (24,178,001                 | )          | (24,544,610                 | )          |
| Maturities of  investment securities                                                |       | 4,880,351                   |       | —                      |       |
| Purchases of  FHLB stock                                                            |       | (683,400                    | )          | (176,000                    | )          |
| Purchase of  property and equipment                                                 |       | (201,724                    | )          | (668,743                    | )          |
|                                                                                |       |                        |       |                        |       |
| Net cash used in  investing activities                                              |       | (38,585,125                 | )          | (97,413,936                 | )          |
| **Financing activities**                                                            | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Net increase  (decrease) in deposit accounts                                        |       | (32,696,338                 | )          | 95,674,547                  |       |
| Advances from  FHLB                                                                 |       | 10,000,000                  |       | —                      |       |
| Increase in  repurchase agreements                                                  |       | 15,000,000                  |       | —                      |       |
| Increase in Line  of Credit                                                         |       | 1,570,000                   |       | —                      |       |
| Increase in  Subordinated Debt                                                      |       | 3,545,000                   |       | —                      |       |
| Increase Federal  Funds Purchased                                                   |       | 9,491,000                   |       | —                      |       |
| Cash paid for  fractional shares                                                    |       | —                      |       | (5,701                      | )          |
| Stock options exercised                                                             |       | —                      |       | 6,400                       |       |
|                                                                                |       |                        |       |                        |       |
| Net cash  provided by financing activities                                          |       | 6,909,662                   |       | 95,675,246                  |       |
|                                                                                |       |                        |       |                        |       |
| Net increase  (decrease) in cash and cash equivalents                               |       | (31,561,547                 | )          | 1,580,417                   |       |
|                                                                                |       |                        |       |                        |       |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                 |       | 40,151,681                  |       | 21,041,070                  |       |
| **CASH  AND CASH EQUIVALENTS, END OF PERIOD**                                       |       | $                           | 8,590,134  |                        | $          | 22,621,487 |   |
|                                                                                |       |                        |       |                        |       |
| **SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION**                               |       |                        |       |                        |       |
| Cash paid for:                                                                      |       |                        |       |                        |       |
| Interest                                                                            |       | $                           | 11,788,837 |                        | $          | 7,905,011 |   |
| Income taxes                                                                        |       | $                           | 482,500    |                        | $          | 591,000 |   |
|                                                                                |       |                        |       |                        |       |
| **Schedule  of non-cash transactions**                                              |       |                        |       |                        |       |
| Unrealized gains  / (losses) on investment securities, net of income taxes          |       | $                           | 197,795    |                        | $          | 142,224 |   |

 

The accompanying notes are anintegral part of the consolidated financial statements.

 

6

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**Notes toUnaudited Consolidated Financial Statements**

 

**NOTE 1 – NATURE OF BUSINESS ANDBASIS OF PRESENTATION**

 

**Business Activity andOrganization –**CommunitySouth Financial Corporation (the “Company”)is a South Carolina corporation organized for the purpose of owning andcontrolling all of the capital stock of CommunitySouth Bank and Trust (the “Bank”).  The Bank is a state chartered bank organizedunder the laws of South Carolina.  Frominception on March 20, 2004 through January 18, 2005, the Companyengaged in organizational and pre-opening activities necessary to obtainregulatory approvals and to prepare its subsidiary, the Bank, to commencebusiness as a financial institution.  TheCompany received approval from the Federal Deposit Insurance Corporation (“FDIC”),the Federal Reserve Board (“FRB”) and the State Board of Financial Institutionsin January 2005.

 

The Bank began operationson January 18, 2005.  The Bankprimarily is engaged in the business of accepting deposits insured by the FDIC,and providing commercial, consumer and mortgage loans to the general public.

 

The Company sold4,681,069 shares of common stock at $6.40 per share in an initial publicoffering that was completed on February 15, 2005 (as adjusted for allstock splits).  The offering raised$29,430,810, net of offering costs.  Thedirectors and officers of the Company purchased 659,531 shares at $6.40 pershare for a total of $4,221,000.

 

**Basis of Presentation –**Theaccompanying financial statements have been prepared in accordance withgenerally accepted accounting principles in the United States of America and togeneral practices in the banking industry for interim financial information andwith the instructions to Form 10-Q. Accordingly, they do not include all the information and footnotesrequired by generally accepted accounting principles for complete financialstatements.  In the opinion ofmanagement, all adjustments (consisting of normal recurring accruals)considered necessary for a fair presentation have been included.  Operating results for the three month periodended September 30, 2008 is not necessarily indicative of the results thatmay be expected for the year ending December 31, 2008.  For further information, refer to the auditedconsolidated financial statements and footnotes dated December 31, 2007included in the Company’s Form 10-KSB for the year ended December 31,2007 as filed with the Securities and Exchange Commission.

 

**NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

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

 

**Management’sEstimates** – The preparation of consolidated financialstatements in conformity with generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements and the reported amounts of income andexpenses during the reporting period. Actual results could differ from those estimates.

 

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

 

**Cash and Cash Equivalents –** Forpurposes of reporting cash flows, cash and cash equivalents include cash onhand, amounts due from banks, short-term interest bearing deposits and federalfunds sold.  Cash and cash equivalentshave an original maturity of three months or less.

 

**Concentrationsof Credit Risk** – Financial instruments, which potentiallysubject the Company to concentrations of credit risk, consist principally ofloans receivable, investment securities, federal funds sold and amounts duefrom banks.

 

The Company makes loansto individuals and small businesses for various personal and commercialpurposes primarily in the upstate region of South Carolina.  The Company’s loan portfolio is notconcentrated in loans to any single borrower or to a relatively small number ofborrowers.  Additionally, management isnot aware of any concentrations of loans to classes of borrowers or industriesthat would be similarly affected by economic conditions.

 

7

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In addition to monitoringpotential concentrations of loans to particular borrowers or groups ofborrowers, industries and geographic regions, management monitors exposure tocredit risk that could arise from potential concentrations of lending productsand practices such as loans that subject borrowers to substantial payment increases(e.g. principal deferral periods, loans with initial interest-only periods,etc), and loans with high loan-to-value ratios. Additionally, there are industry practices that could subject theCompany to increased credit risk should economic conditions change over thecourse of a loan’s life.  For example,the Company makes variable rate loans and fixed rate principal-amortizing loanswith maturities prior to the loan being fully paid (i.e. balloon paymentloans).  These loans are underwritten andmonitored to manage the associated risks. Management has determined that there is no concentration of credit riskassociated with its lending policies or practices.

 

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

 

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

 

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

 

2.               *Held to maturity securities*: These areinvestment securities that the Company has the ability and intent to hold untilmaturity.  These securities are stated at cost, adjusted for amortizationof premiums and the accretion of discounts.

 

3.               *Trading securities*: These are securitiesthat are bought and held principally for the purpose of selling in the nearfuture.  Trading securities are reported at fair market value, and relatedunrealized gains and losses are recognized in the income statement.  TheCompany has no trading securities.

 

Gains or losses ondispositions of investment securities are based on the differences between thenet proceeds and the adjusted carrying amount of the securities sold, using thespecific identification method.  Premiums and discounts are amortizedor accreted into interest income by a method that approximates a level yield.

 

**Other Investments –**CommunitySouthBank and Trust, as a member institution, is required to own stock investmentsin the Federal Home Loan Bank ofAtlanta (“FHLB”).  Investment inthe FHLB is a condition of borrowing from the FHLB, and the stock is pledged tocollateralize such borrowings.  No readymarket exists for the stock and it has no quoted market value.  However, redemption of these stocks hashistorically been at par value.  The dividendreceived on this stock is included in interest and dividends on investments.

 

**LoansReceivable** – Loans are stated at their unpaid principalbalance less an allowance for loan losses and net deferred loan originationfees.  Interest income is computed usingthe simple interest method and is recorded in the period earned. Loanorigination fees collected and certain loan origination costs are deferred andthe net amount is accreted as income using a method that approximates the levelyield method over the life of the related loans.

 

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

 

8

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The Company identifiesimpaired loans through its normal internal loan review process.  Loans on the Company’s potential problem loanlist are considered potentially impaired loans. These loans are evaluated in determining whether all outstandingprincipal and interest are expected to be collected.  Loans are not considered impaired if a minimalpayment delay occurs and all amounts due, including accrued interest at thecontractual interest rate for the period of delay, are expected to becollected.  Management has determinedthat the Company had $8.7 million and approximately $35,000 in impaired loanswith related valuation allowances of $3,025,000 and $0 at September 30,2008 and December 31, 2007, respectively.

 

**Allowance for Loan Losses** – Theallowance for loan losses is established as losses are estimated to haveoccurred through a provision for loan losses charged to earnings.  Loan losses are charged against the allowancewhen management believes the uncollectability of a loan balance isconfirmed.  Subsequent recoveries, ifany, are credited to the allowance.

 

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

 

The allowance consists ofspecific, general and unallocated components. The specific component relates to loans that are classified as eitherdoubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance isestablished when the discounted cash flows (or collateral value or observablemarket price) of the impaired loan is lower than the carrying value of theloan. The general component covers non-classified loans and is based onhistorical loss experience adjusted for qualitative factors.  An unallocated component is maintained tocover uncertainties that could affect management’s estimate of probablelosses.  The unallocated component of theallowance reflects the margin of imprecision inherent in the underlyingassumptions used in the methodologies for estimating specific and generallosses in the portfolio.

 

A loan is consideredimpaired when, based on current information and events, it is probable that theCompany will be unable to collect the scheduled payments of principal orinterest when due according to the contractual terms of the loanagreement.  Factors considered bymanagement in determining impairment include payment status, collateral value,and the probability of collecting scheduled principal and interest paymentsdue.  Loans that experience insignificantpayment delays and payment shortfalls generally are not classified asimpaired.  Management determines thesignificance of payment delays and payment shortfalls on a case-by-case basis,taking into consideration all of the circumstances surrounding the loan and theborrower, including the length of the delay, the reasons for the delay, theborrower’s prior payment record and the amount of the shortfall in relation tothe principal and interest owed. Impairment is measured on a loan by loan basis for commercial andconstruction loans by either the present value of expected future cash flowsdiscounted at the loan’s effective interest rate, the loan’s obtainable marketprice, or the fair value of the collateral if the loan is collateral dependent.

 

Large groups of smallerbalance homogeneous loans are collectively evaluated for impairment.  Accordingly, the Company does not separatelyidentify individual consumer and residential loans for impairment disclosures,unless such loans are the subject of a restructuring agreement.

 

**Bank-OwnedLife Insurance** – TheCompany has purchased life insurance policies on certain key employees.  These policies are recorded in other assetsat their net cash surrender value, or the amount that can be realized.  Income from these policies and changes in thenet cash surrender value are recorded in non-interest income.

 

**Advertising –** Advertising,promotional, and other business development costs generally are expensed asincurred.  External costs incurred inproducing media advertising are expensed the first time the advertising takesplace.  External costs relating to directmailing costs are expensed in the period in which the direct mailings are sent.

 

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

 

**ResidentialLoan Origination Fees**– The Company offers residential loan origination services to its customers inits immediate market area.  The loans areoffered on terms and prices offered by the Company’s correspondents and areclosed in the name of the correspondents. The Company receives fees for services it provides in conjunction withthe origination services it provides. The fees are recognized at the time the loans are closed by the Company’scorrespondent.

 

9

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

 

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

 

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

 

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

 

**Stock–based Compensation**– On January 1, 2006, the Company adopted the fair value recognitionprovisions of the Financial Accounting Standards Board’s (“FASB”) SFAS No. 123(R),“Share-Based Payment”, which is a revision of SFAS No. 123, “Accountingfor Stock-Based Compensation”, to account for compensation costs under its stockoption plans.  The Company previouslyutilized the intrinsic value method under Accounting Principles Board (“APB”)Opinion No. 25, “Accounting for Stock Issued to Employees (as amended)” (“APB25”).  Under the intrinsic value methodprescribed by APB 25, no compensation costs were recognized for the Company’sstock options because the option exercise price in its plans equaled the marketprice on the date of grant.  Prior to January 1,2006, the Company only disclosed the pro forma effects on net income andearnings per share as if the fair value recognition provisions of SFAS No. 123(R) hadbeen utilized.

 

# **Inadopting SFAS No. 123(R), the Company elected to use the modifiedprospective method to account for the transition from the intrinsic value methodto the fair value recognition method. Under the modified prospective method, compensation cost is recognizedfrom the adoption date forward for all new stock options granted and for anyoutstanding unvested awards as if the fair value method had been applied tothose awards as of the date of grant.**

# ** **

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

 

**Recently Issued AccountingStandards –**The following is a summary of recentauthoritative pronouncements that could impact the accounting, reporting, and /or disclosure of financial information by the Company.

 

Effective January 1,2008, the Company adopted SFAS No. 157, “Fair Value Measurements” (“SFAS157”) which provides a framework for measuring and disclosing fair value undergenerally accepted accounting principles. SFAS 157 requires disclosures about the fair value of assets andliabilities recognized in the balance sheet in periods subsequent to initialrecognition, whether the measurements are made on a recurring basis (forexample, available-for-sale investment securities) or on a non-recurring basis(for example, impaired loans).

 

10

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SFAS 157 defines fairvalue as the exchange price that would be received for an asset or paid totransfer a liability (an exit price) in the principal or most advantageousmarket for the asset or liability in an orderly transaction between marketparticipants on the measurement date. SFAS 157 also establishes a fair value hierarchy which requires anentity to maximize the use of observable inputs and minimize the use ofunobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used tomeasure fair value:

 
| Level 1 | Quoted prices in active  markets for identical assets or liabilities.   Level 1 assets and liabilities include debt and equity securities and  derivative contracts that are traded in an active exchange market, as well as  U.S. Treasury, other U.S. Government and agency mortgage-backed debt  securities that are highly liquid and are actively traded in over-the-counter  markets.

                                                                                                                                                                                                                                                                                                                                                                |
|---------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Level 2 | Observable inputs other  than Level 1 prices such as quoted prices for similar assets or liabilities;  quoted prices in markets that are not active; or other inputs that are observable  or can be corroborated by observable market data for substantially the full  term of the assets or liabilities.   Level 2 assets and liabilities include debt securities with quoted  prices that are traded less frequently than exchange-traded instruments and  derivative contracts whose value is determined using a pricing model with  inputs that are observable in the market or can be derived principally from  or corroborated by observable market data.   This category generally includes certain derivative contracts and  impaired loans.

  |
| Level 3 | Unobservable inputs  that are supported by little or no market activity and that are significant  to the fair value of the assets or liabilities.  Level 3 assets and liabilities include  financial instruments whose value is determined using pricing models,  discounted cash flow methodologies, or similar techniques, as well as  instruments for which the determination of fair value requires significant  management judgment or estimation.  For  example, this category generally includes certain private equity investments,  retained residual interests in securitizations, residential mortgage  servicing rights, and highly-structured or long-term derivative contracts.                                                                |

 

Available-for-saleinvestment securities (approximately $43.8 million at September 30, 2008)are the only assets whose fair values are measured on a recurring basis usingLevel 1 inputs (active market quotes).

 

The Company has noliabilities carried at fair value or measured at fair value on a non-recurringbasis.

 

The Company ispredominantly an asset-based lender with real estate serving as collateral on asubstantial majority of loans.  Loanswhich are deemed to be impaired are primarily valued on a non-recurring basisat the fair values of the underlying real estate collateral.  When practical, such fair values are obtainedusing independent appraisals, which the Company considers to be Level 2inputs.   The aggregate carrying amountof impaired loans at September 30, 2008 was $8.7 million.

 

FASB Staff Position No. FAS157-2 delays the implementation of SFAS 157 until the first quarter of 2009with respect to goodwill, other intangible assets, real estate and other assetsacquired through foreclosure and other non-financial assets measured at fairvalue on a non-recurring basis.

 

The Company has no assetsor liabilities whose fair values are measured using Level 3 inputs.

 

Other accountingstandards that have been issued or proposed by the FASB or otherstandards-setting bodies are not expected to have a material impact on theCompany’s financial position, results of operations or cash flows.

 

**Risks and Uncertainties**– In the normal course of its business, the Company encounters two significanttypes of risk: economic and regulatory. There are three main components of economic risk:  interest rate risk, credit risk and marketrisk.  The Company is subject to interestrate risk to the degree that its interest-bearing liabilities mature or repriceat different speeds, or on different bases, than its interest-earningassets.  Credit risk is the risk ofdefault on the Company’s loan portfolio that results from the borrower’sinability or unwillingness to make contractually required payments.  Market risk reflects changes in the value ofcollateral underlying loans receivable and the valuation of real estate held bythe Company.

 

The Company is subject tothe regulations of various governmental agencies.  These regulations can and do changesignificantly from period to period.  TheCompany also undergoes periodic examinations by the regulatory agencies, whichmay subject it to further changes with respect to asset valuations, amounts ofrequired loss allowances and operating restrictions from the regulators’judgments based on information available to them at the time of their examination.

 

**Reclassifications**- Certain captions and amounts in the prior financial statements werereclassified to conform with the 2008 presentation.  Such reclassifications had no effect onpreviously reported net income or shareholders’ equity.

 

11

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**NOTE 3 – INVESTMENT SECURITIES**

 

# **The amortized costs and fair values of investment securities are asfollows:**

 
| ** **                        | ** ** | **Amortized** | ** **     | **Gross Unrealized** | ** ** | **Fair**    | ** ** |
|-----------------------------------|------------|---------------|----------------|---------------------------|------------|-------------|------------|
| **As of September 30, 2008**      | ** ** | **Cost**      | ** **     | **Gains**                 | ** ** | **Losses**  | ** ** | **Value** | ** ** |
| **Available  for sale**           |       |          |           |                      |       |        |       |   |   |
| Government  sponsored enterprises |       | $             | 20,502,533     |                      | $          | 56,912      |       | $ | 57,900 |   | $ | 20,501,545 |   |
| Mortgage-backed                   |       | 23,297,874    |           | 144,280                   |       | 247,837     |       | 23,194,317 |   |
| Marketable  securities            |       | 100,000       |           | —                    |       | —      |       | 100,000 |   |
| Total available  for sale         | ** ** | **$**         | **43,900,407** | ** **                | **$**      | **201,192** | ** ** | **$** | **305,737** | ** ** | **$** | **43,795,862** | ** ** |

 

**NOTE 4 – LEASES**

 

The Company leases twobranch locations in Spartanburg, other branch locations in Mauldin, Anderson,Greer and Greenville as well as the loan operations center in Easley. Theinitial lease terms range from three to ten years with various renewal options.The minimum future rental payments under non-cancelable operating leases havingremaining terms in excess of one year, for each of the next five years and inthe aggregate are:

 
| 2008                                  |       | $         | 87,377        |       |
|---------------------------------------|------------|-----------|---------------|------------|
| 2009                                  |       | 409,771   |          |
| 2010                                  |       | 428,364   |          |
| 2011                                  |       | 427,862   |          |
| 2012                                  |       | 441,471   |          |
| Thereafter                            |       | 1,952,756 |          |
| Total minimum  future rental payments | ** ** | **$**     | **3,747,601** | ** ** |

 

The loan operations center in Easley is leased from apartnership in which a Company director has a partnership interest.

 

**NOTE 5 – RELATED PARTY TRANSACTIONS**

 

Certain parties(principally certain directors and executive officers of the Company, theirimmediate families and business interests) (“affiliates”) are loan customers inthe normal course of business with the Bank. These loans are made on substantially the same terms, including interestrates and collateral, as those prevailing at the time for comparabletransactions with unrelated persons and do not involve more than the normalrisk of collectability.

 

### **NOTE 6 – COMMITMENTS ANDCONTINGENCIES**

### ** **

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

 

**NOTE 7 – STOCK-BASED COMPENSATION**

 

Upon completion of theoffering, the Company agreed to issue warrants to the organizing directors forthe purchase of one share of common stock at $6.40 per share for every twoshares purchased in the stock offering, up to a maximum of 15,625 warrants perdirector. The warrants were fully vested 120 days after January 18, 2005and will expire on January 18, 2015. Warrants held by directors of the Company will expire 90 days after thedirector ceases to be a director or officer of the Company (365 days if due todeath or disability). The Company issued a total of 171,404 warrants.  In addition, the Company has adopted a stockoption plan.  As of September 30,2008 the Company has 774,287 outstanding options to employees and directors. OnJanuary 16, 2006 the Company adopted a resolution that terminated the “evergreen”provision of the Company 2005 Stock Incentive Plan. As a result, the number ofshares of common stock issuable under the plan shall not be further increasedin connection with any future share issuances by the Company. The exerciseprice of each option is equal to the market price of the Company’s stock on thedate of grant. The maximum term is ten years, and they typically vest in nogreater than five years. When necessary, the Company may purchase shares on theopen market to satisfy share option exercises. During the ensuing year, theCompany is expected to acquire no shares.

 

The table set forth belowsummarizes stock option activity for the Company’s stock compensation plans forthe quarter ended September 30, 2008 as adjusted for all stock splits.

 

12

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| ** **                                  | ** ** | **Stock Options** | ** ** | **Warrants**  | ** ** |
|---------------------------------------------|------------|------------------------|------------|---------------|------------|
| ** **                                  | ** ** | ** **             | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **                                  | ** ** | ** **             | ** ** | **Average**   | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                  | ** ** | ** **             | ** ** | **Exercise**  | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                                  | ** ** | **Number**             | ** ** | **Price**     | ** ** | **Number** | ** ** | **Price** | ** ** |
| **Outstanding  at December 31, 2007**  |       | 761,493                |       | $             | 7.17       |   | 171,404 |   | $ | 6.40 |   |
| Granted                                     |       | 24,550                 |       | 8.36          |       | — |   | — |   |
| Forfeited                                   |       | 11,756                 |       | 14.20         |       | — |   | — |   |
| Exercised                                   |       | —                 |       | —        |       | — |   | — |   |
| **Outstanding  at September 30, 2008** | ** ** | **774,287**            | ** ** | **7.10**      | ** ** | **171,404** | ** ** | **6.40** | ** ** |
|                                             |            |                        |            |               |            |  |  |  |  |  |  |

 

The table set forth belowsummarizes non-vested stock options as of September 30, 2008.

 
| ** **                                  | ** ** | ** ** | ** ** | **Fair**  | ** ** |
|---------------------------------------------|------------|------------|------------|-----------|------------|
| ** **                                  | ** ** | **Number** | ** ** | **Value** | ** ** |
| **Outstanding  at December 31, 2007**  |       | 42,273     |       | $         | 6.79       |   |
| Granted                                     |       | 24,550     |       | 3.76      |       |
| Vested                                      |       | 8,623      |       | 7.22      |       |
| Forfeited                                   |       | 4,900      |       | 7.26      |       |
| **Outstanding  at September 30, 2008** | ** ** | **53,300** | ** ** | **5.41**  | ** ** |
|                                             |            |            |            |           |            |  |

 

As of September 30,2008, there was $248,669 in total unrecognized compensation cost related tonon-vested share-based compensation arrangements, which is expected to berecognized over a weighted average period of 45 months. As of December 31,2007, there was $255,917 in total unrecognized compensation cost related tonon-vested share-based compensation arrangements, which was expected to berecognized over a weighted average period of 49 months.

 

The fair value of eachoption granted is estimated on the grant date using the Black-Scholesoption-pricing model with the following assumptions for 2008 and 2007: dividendyield of 0%, expected term of 10 years, risk-free interest rate of 5.0%,expected life of 10 years, and expected volatility of 20%.

 

The following tablesummarizes information about stock options outstanding under the Company’splans at September 30, 2008 and December 31, 2007.

 
| **September 30, 2008** | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** |
|----------------------------------|------------|-----------------|------------|-----------------|------------|
| Number of  options               |       | 774,287         |       | 720,987         |       |
| Weighted average  remaining life |       | 6.48 years      |       | 6.51 years      |       |
| Weighted average  exercise price |       | $               | 7.10       |            | $          | 6.74 |   |
| High exercise  price             |       | $               | 16.80      |            | $          | 16.80 |   |
| Low exercise  price              |       | $               | 6.40       |            | $          | 6.40 |   |
|                             |       |            |       |            |       |
| **December 31, 2007**       | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** |
| Number of  options               |       | 761,493         |       | 719,220         |       |
| Weighted average  remaining life |       | 7.35 years      |       | 7.25 years      |       |
| Weighted average  exercise price |       | $               | 7.17       |            | $          | 6.71 |   |
| High exercise  price             |       | $               | 16.80      |            | $          | 16.80 |   |
| Low exercise  price              |       | $               | 6.40       |            | $          | 6.40 |   |

 

There were no optionsexercised during the quarter and thus no cash was received related to this typeof transaction. The intrinsic value of options exercised during 2008 and 2007was $0 and $2,880, respectively.

 

At September 30,2008, all of the 171,404 warrants were exercisable and had an average remaininglife of 6.30 years. At December 31, 2007, all of the 171,404 warrants wereexercisable and had an average remaining life of 7.05 years.

 

13

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**Item 2.  Management’s Discussion and Analysis orPlan of Operation.**

 

*The following discussion reviewsour results of operations and assesses our financial condition.  You should read the following discussion andanalysis in conjunction with the accompanying consolidated financialstatements.  The commentary should beread in conjunction with the discussion of forward-looking statements, thefinancial statements, and the related notes and the other statistical informationincluded in this report.*

 

**DISCUSSION OF FORWARD-LOOKING STATEMENTS**

 

Thisreport contains “forward-looking statements” relating to, without limitation,future economic performance, plans and objectives of management for futureoperations, and projections of revenues and other financial items that arebased on the beliefs of management, as well as assumptions made by andinformation currently available to management. The words “may,” “will,” “anticipate,” “should,” “would,” “believe,” “contemplate,”“expect,” “estimate,” “continue,” and “intend,” as well as other similar wordsand expressions of the future, are intended to identify forward-lookingstatements.  Our actual results maydiffer materially from the results anticipated in the forward-looking statementsas a result of, and our operating performance each quarter is subject to,various risks and uncertainties that include, without limitation, thosedescribed under the heading “Risk Factors” in our Annual Report on Form 10-KSBfor the year ended December 31, 2007 as filed with the Securities andExchange Commission and the following:

 

·                  our rapid growthto date and short operating history;

 

·                  potentialadditional loan loss reserves or write-offs related to a real estatedevelopment project on Lake Keowee, South Carolina, which is discussed below;

 

·                  the opening ofadditional full-service branches and the resulting pressure this could cause onour management team;

 

·                  significantincreases in competitive pressure in the banking and financial servicesindustries;

 

·                  changes in theinterest rate environment which could reduce anticipated or actual margins;

 

·                  changes inpolitical conditions or the legislative or regulatory environment;

 

·                  general economicconditions, either nationally or regionally and especially in our primaryservice area, becoming less favorable than expected resulting in, among otherthings, a deterioration in credit quality;

 

·                  changesoccurring in business conditions and inflation;

 

·                  changes intechnology;

 

·                  changes indeposits flows;

 

·                  changes inmonetary and tax policies;

 

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

 

·                  the amount ofour real estate based loans, and the weakness in the commercial real estatemarket;

 

·                  the level ofallowance for loan losses;

 

·                  the rate ofdelinquencies and amounts of charge-offs;

 

·                  adverse changesin asset quality and resulting credit risk-related losses and expenses;

 

·                  loss of consumerconfidence and economic disruptions resulting from terrorist activities;

 

·                  changes in thesecurities markets; and

 

·                  other risks anduncertainties detailed from time to time in our filings with the Securities andExchange Commission.

 

These risks are exacerbated by the recent developmentsin national and international financial markets, and we are unable to predictwhat effect these uncertain market conditions will have on our company.  During 2008, the capital and credit marketshave experienced extended volatility and disruption. In the last 90 days, thevolatility and disruption have reached unprecedented levels.  There can be no assurance that these unprecedentedrecent developments will not materially and adversely affect our business,financial condition and results of operations.

 

All forward-lookingstatements in this report are based on information available to us as of thedate of this report.  We undertake noobligation to publicly update or otherwise revise any forward-lookingstatements, whether as a result of new information, future events, orotherwise.

 

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# ** **

# **Overview**

# ** **

CommunitySouth FinancialCorporation is a bank holding company headquartered in Easley, SouthCarolina.  Our subsidiary, CommunitySouthBank and Trust, opened for business on January 18, 2005.  In addition to the main office in Easley, theBank has five branch locations in the upstate region of South Carolina.  We opened our Mauldin branch in the fourthquarter of 2005, our Spartanburg branch in the first quarter of 2006, ourAnderson branch in the third quarter of 2006, our Greer branch in the fourthquarter of 2006 and our Greenville branch in the third quarter of 2007.  We anticipate continued branch expansion inthe Upstate region as opportunities arise. The Bank provides banking services to domestic markets, principally inthe Upstate of South Carolina.  Thedeposits of the Bank are insured by the Federal Deposit InsuranceCorporation.  All share and per shareinformation in this report has been adjusted for the 5-for-4 stock splitseffected in the form of a stock dividend paid on January 16, 2007 and January 16,2006 to shareholders of record as of December 15, 2006 and December 15,2005, respectively.

 

Like most community banks, we derive most of ourincome from interest we receive on our loans and investments.  Our primary source of funds for making theseloans and investments is our deposits, on which we pay interest.  Consequently, one of the key measures of oursuccess is our amount of net interest income, or the difference between theincome on our interest-earning assets, such as loans and investments, and theexpense on our interest-bearing liabilities, such as deposits.  Another key measure is the spread between theyield we earn on these interest-earning assets and the rate we pay on ourinterest-bearing liabilities.

 

Of course, there are risks inherent in all loans, sowe maintain an allowance for loan losses to absorb probable losses on existingloans that may become uncollectible.  Weestablish and maintain this allowance by charging a provision for loan lossesagainst our operating earnings.  In thefollowing section we have included a detailed discussion of this process.

 

In addition to earning interest on our loans andinvestments, we earn income through fees and other expenses we charge to ourcustomers.  We describe the variouscomponents of this non-interest income, as well as our non-interest expense, inthe following discussion.

 

During the third quarterof 2008, we commenced a subordinated debt offering to enhance and strengthenthe levels of capital and liquidity at the holding company such that we couldmaintain the resources needed to maintain “well-capitalized” levels ofregulatory capital at the bank. Through September 30, 2008, we raised$3.545 million in additional capital through the offering and another $780thousand in October before we closed the offering on October 15,2008.  We raised this capital tostrengthen our capital position in light of the continuing substantialdeterioration of the residential real estate markets nationally and in ourlocal markets. This continued deterioration has resulted in increasingly higherlevels of nonperforming assets, higher provisions for loan losses andassociated expenses.

 

In response to financial conditions affecting thebanking system and financial markets and the potential threats to the solvencyof investment banks and other financial institutions, the United Statesgovernment has taken unprecedented actions. On October 3, 2008, PresidentBush signed into law the Emergency Economic Stabilization Act of 2008 (the “EESA”).  Pursuant to the EESA, the U.S. Treasury willhave the authority to, among other things, purchase mortgages, mortgage-backedsecurities, and other financial instruments from financial institutions for thepurpose of stabilizing and providing liquidity to the U.S. financial markets.On October 14, 2008, the U.S. Department of Treasury announced the CapitalPurchase Program under the EESA, pursuant to which the Treasury intends to makesenior preferred stock investments in participating financialinstitutions.  We are evaluating whetherto participate in the Capital Purchase Program. Regardless of our participation, governmental intervention and newregulations under these programs could materially and adversely affect ourbusiness, financial condition and results of operations.

 

15

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**Resultsof Operations**

 

*Three Months ended September 30,2008 and 2007*

 

*Overview*

 

Our net income was$84,843 for the three months ended September 30, 2008, as compared to netincome of $459,731 for the three months ended September 30, 2007.  Since we began operations in the firstquarter of 2005, we have experienced significant growth, which has led to asubstantial increase in revenues and expenses. For the three months ended September 30,2008, we realized $5,633,612 in interest income, of which $603,894 was frominvestment activities and $5,029,718 was from loan activities.  For the three months ended September 30,2007, we realized $6,153,137 in interest income, of which $476,312 was frominvestment activities and $5,676,825 was from loan activities.  Although we have grown rapidly to date, givencurrent industry and market conditions, asset growth is not currently a primarygoal for our company.  Our currentstrategic objectives are to preserve capital, manage loan growth, reduceportfolio concentration of construction and land development loans, manageportfolio risk, enhance credit management practices, improve margins, and lowerour overall funding costs, primarily through the growth of core deposits.  As a result of our current focus, ourinterest and fees on loans decreased modestly during the quarter ended September 30,2008 from the quarter ended September 30, 2007.

 

The primary source offunding for our loan portfolio is deposits that are acquired both locally andvia the national brokered certificate market. We incurred interest expense of $2,994,547 and $3,413,663 for the threemonths ended September 30, 2008 and September 30, 2007,respectively.  This decrease in ourinterest expense was a result of decreased deposit rates due to the currentrate environment.  We have experienced adecline in our net interest margin to 2.85% from 3.52% for the quarters ended September 30,2008 and 2007, respectively.  The declinewas due to the competitive pressure on commercial loan pricing and on depositpricing, as well as changes in the overall interest rate environment.  On September 18, 2007, the FederalReserve began to decrease short-term rates with an initial 50 basis pointreduction and continued the decrease with an additional 275 basis pointsthrough the end of 2007 and the first nine months of 2008.  We had more assets, such as loans, thanliabilities, such as deposits, that repriced down during the three months endedSeptember 30, 2008, which contributed to the decline in our net interestmargin.

 

*Provision for Loan Losses*

 

Our provision for loanlosses for the three months ended September 30, 2008 was $160,000 comparedto $362,000 for the comparable prior year period. The $202,000 decrease in 2008compared to the same period in 2007 was the result of reduced loan production.The increase in gross loans outstanding was $4.8 million for the third quarterof 2008 as compared to an increase of $25.8 million for the third quarter of2007.

 

*Non-interest Income*

 

We had non-interestincome of $303,651 and $405,745 for the three months ended September 30,2008 and 2007, respectively.  Mortgageorigination fee income for the three months ended September 30, 2008 was$96,183.  We had $285,600 in mortgageorigination fee income in the third quarter of 2007.  The decrease was the result of the overalldecline in the demand for home mortgages due to the current economicconditions.  Further, changes in stateand federal laws regarding the oversight of mortgage brokers and lenders couldincrease our costs of operations and affect our mortgage origination volumewhich could negatively impact our non-interest income in the future.

 

*Non-interest Expense*

 

We incurred non-interestexpense of $2,623,573 during the three months ended September 30, 2008.  Included in the expense was $1,222,884 ofsalaries and employee benefits, $193,808 of data processing expense, $226,202of professional fees expense, $106,857 of advertising expense, $25,894 ofexpense related to office supplies, $42,107 of telephone expense and $56,000 ofassessments related to FDIC.  Thenon-interest expense incurred in the three months ended September 30, 2007was $2,158,732.  Included in the expensewas $1,079,416 of salaries and employee benefits, $156,561 of data processingexpense, $101,886 of professional fee expense, $100,217 of advertising expense,$29,094 of expense related to office supplies, $33,815 of telephone expense and$92,160 of assessments related to FDIC.

 

16

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For the three monthsended September 30, 2008, we incurred other fixed asset expenses of$178,108 in depreciation and $57,204 in equipment maintenance and rental.  For the three months ended September 30,2007, we incurred other fixed asset expenses of $156,223 in depreciation and$25,637 in equipment maintenance and rental. We incurred $155,979 and $110,853 in occupancy expense related to all ofour office locations for the three months ended September 30, 2008 and2007, respectively.

 

The increase in non-interestexpense is the result of the addition of a new branch and personnel over thepast year as well as expense related to customer growth at the new and existingbranches.

 

*Nine Months ended September 30,2008 and 2007*

 

*Overview*

 

Our net loss was $964,092for the nine months ended September 30, 2008 as compared to net income of$1,130,232 for the nine months ended September 30, 2007.  Our net loss for the nine months ended September 30,2008 is primarily due to an additional $1.9 million in provision for loanlosses.  For the nine months ended September 30,2008, we realized $17,587,516 in interest income, of which $2,006,557 was frominvestment activities and $15,580,959 was from loan activities.  For the nine months ended September 30,2007, we realized $16,659,413 in interest income, of which $1,185,350 was frominvestment activities and $15,474,063 was from loan activities.   As discussed above, although we have grownrapidly to date, given current industry and market conditions, asset growth isnot currently a primary goal for our company. Our current strategic objectives are to preserve capital, manage loangrowth, reduce portfolio concentration of construction and land developmentloans, manage portfolio risk, enhance credit management practices, improvemargins, and lower our overall funding costs, primarily through the growth ofcore deposits.  As a result of ourcurrent focus, our interest and fees on loans increased modestly during thenine months ended September 30, 2008 from the quarter ended September 30,2007.

 

The primary source offunding for our loan portfolio is deposits that are acquired both locally andvia the national brokered certificate market. We incurred interest expense of $9,984,837 and $9,294,250 for the ninemonths ended September 30, 2008 and September 30, 2007,respectively.  This increase in ourinterest expense was a result of increased levels of interest bearingdeposits.  We have experienced a declinein our net interest margin to 2.75% from 3.48% for the nine months ended September 30,2008 and 2007, respectively. As discussed above, the decline was due to thecompetitive pressure on commercial loan pricing and on deposit pricing, as wellas that fact that in response to the Federal Reserve’s decreases to short termrates more of our rate-sensitive liabilities repriced than our rate-sensitiveassets during the twelve month period ended September 30, 2008.

 

*Provision for Loan Losses*

 

Our provision for loanlosses for the nine months ended September 30, 2008 was $2,864,000 comparedto $994,000 for the comparable prior year period. The $1.9 million increase in2008 compared to the same period in 2007 was the result of the financing ofpurchases for several residential lots and the construction of several housesin a real estate development project on Lake Keowee, South Carolina (OconeeCounty) called Sweetwater.  The Bank has determined that these loans havebeen over-disbursed and that the associated houses on these properties will notbe completed on schedule.  Although the construction loans are nearlyfully funded, the houses are in various stages of completion.  The Bankhas approximately $4.9 million in secured loans to 11 borrowers in thisdevelopment.  The Bank has not yet taken any charge-offs but anticipatesit will likely do so over the next several quarters. The Bank has designated$3.0 million of the allowance for loan losses to cover any potential lossassociated with this matter.  Theincrease in gross loans outstanding was $17.7 million for the first threequarters of 2008 as compared to an increase of $72.0 million for the firstthree quarters of 2007.

 

*Non-interest Income*

 

We had non-interestincome of $1,020,758 and $1,148,519 for the nine months ended September 30,2008 and 2007, respectively.  Mortgageorigination fee income for the nine months ended September 30, 2008 was$431,445.  We had $807,612 in mortgageorigination fee income in the first three quarters of 2007.  The decrease was the result of the overalldecline in the demand for home mortgages due to the current economicconditions.  Further, changes in stateand federal laws regarding the oversight of mortgage brokers and lenders couldincrease our costs of operations and affect our mortgage origination volumewhich could negatively impact our non-interest income in the future.

 

17

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*Non-interest Expense*

 

We incurred non-interestexpense of $7,172,829 during the nine months ended September 30,2008.  Included in the expense was$3,685,615 of salaries and employee benefits, $561,206 of data processingexpense, $357,990 of professional fees expense, $145,859 of advertisingexpense, $73,077 of expense related to office supplies, $111,970 of telephoneexpense and $162,500 of assessments related to FDIC.  The non-interest expense incurred in the ninemonths ended September 30, 2007 was $5,826,625.  Included in the expense was $3,119,877 ofsalaries and employee benefits, $415,575 of data processing expense, $224,897of professional fee expense, $173,857 of advertising expense, $105,361 ofexpense related to office supplies, $105,565 of telephone expense and $146,044of assessments related to FDIC.

 

For the nine months endedSeptember 30, 2008, we incurred other fixed asset expenses of $539,454 indepreciation and $143,431 in equipment maintenance and rental.  For the nine months ended September 30,2007, we incurred other fixed asset expenses of $437,451 in depreciation and$79,001 in equipment maintenance and rental. We incurred $476,019 and $354,978 in occupancy expense related to all ofour office locations for the nine months ended September 30, 2008 and2007, respectively.

 

The increase innon-interest expense is the result of the addition of a new branch andpersonnel over the past year as well as expense related to customer growth atthe new and existing branches.

 

**Assets and Liabilities**

 

*General*

 

At September 30,2008, total assets increased 1.02% to $381.7 million as compared to $377.9million at December 31, 2007.  Grossloans increased $17.7 million, or 5.83%, during the first nine months of2008.  As described below, federal fundssold decreased to zero at September 30, 2008 compared to $33.7 million at December 31,2007.  Cash and cash equivalentsdecreased $31.6 million, or 78.61%, since December 31, 2007.  As described below, deposits decreased $32.7million, or 9.98%, during the first nine months of 2008.  At September 30, 2008, shareholders’equity was $30.4 million.

 

*Investment Securities*

 

Investments available forsale increased by $19.0 million, or 76.28%, since December 31, 2007 due tothe purchase and the related appreciation of government agency bonds andmortgaged-backed securities.  Since December 31,2007 the rationale for the general change of investing in federal funds toinvesting in securities available for sale was to take advantage of higherearning rates and longer terms on the Bank’s investable funds.  As part of its investment portfolio, the Bankholds Freddie Mac and Fannie Mae debt securities which are guaranteed by theUnited States government.

 

*Other Investments*

 

Other investmentsincreased by $683,400 since December 31, 2007 due to the purchase ofadditional FHLB stock.  All of the FHLBstock is used to collateralize advances from the FHLB.

 

*Loans*

 

Since loans typicallyprovide higher interest yields than other types of interest earning assets, weallocate the majority of our earning assets to our loan portfolio.  Gross loans increased by $17.7 million, or5.83%, during the first nine months of 2008. Loan demand has slowed during the first three quarters of 2008 due togeneral economic conditions and the real estate market.  We expect this trend to continue during thenext several quarters.

 

Balances within majorloan categories are as follows:

 
| **(dollar amounts in thousands)** | ** ** | **September 30, 2008** | ** **  | **December 31, 2007** | ** ** |
|--------------------------------------------------|------------|----------------------------------|-------------|---------------------------------|------------|
| Real estate -  construction                      |       | $                                | 133,605     |                            | $          | 124,016 |   |
| Real estate -  mortgage                          |       | 153,549                          |        | 149,370                         |       |
| Commercial and  industrial                       |       | 30,599                           |        | 26,095                          |       |
| Consumer and  other                              |       | 2,833                            |        | 3,453                           |       |
| Total loans,  gross                              |       | 320,586                          |        | 302,934                         |       |
| Less allowance  for loan losses                  |       | (6,883                           | )           | (4,214                          | )          |
| Total loans, net                                 | ** ** | **$**                            | **313,703** | ** **                      | **$**      | **298,720** | ** ** |

 

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We discontinue accrual of interest on a loan when we conclude it is doubtful that we will be able to collect interest from the borrower.  We reach this conclusion by taking into account factors such as the borrower’s financial condition, economic and business conditions, and the results of our previous collection efforts.  Generally, we place a delinquent loan in non-accrual status when the loan becomes 90 days or more past due.  When we place a loan in non-accrual status, we reverse all interest which has been accrued on the loan but remains unpaid and we deduct this interest from earnings as a reduction of reported interest income.  We do not accrue any additional interest on the loan balance until we conclude the collection of both principal and interest is reasonably certain.  At September 30, 2008, there were $8.7 million in loans that were non-accruing and $662,930 in loans that were 30 days past due and still accruing.  As described further below, this increase is primarily a result of the recent downturn in the real estate market.  At December 31, 2007, there were approximately $35,000 in loans that were non-accruing and about $725,000 in loans that were 30 days past due and still accruing.

 

Changes in the allowance for loan losses for were asfollows:

 
| ** **                       | ** ** | **Three-months ended  September 30, 2008** | ** **    | **Three-months ended  September 30, 2007** | ** ** |
|----------------------------------|------------|-----------------------------------------------------------|---------------|-----------------------------------------------------------|------------|
| Balance,  beginning of period    |       | $                                                         | 6,745,000     |                                                      | $          | 3,712,000 |   |
| Provision  charged to operations |       | 160,000                                                   |          | 362,000                                                   |       |
| Net charge-offs                  |       | 22,000                                                    |          | —                                                    |       |
| Balance, end of  period          | ** ** | **$**                                                     | **6,883,000** | ** **                                                | **$**      | **4,074,000** | ** ** |

 
| ** **                       | ** ** | **Nine-months ended  September 30, 2008** | ** **    | **Nine-months ended  September 30, 2007** | ** ** |
|----------------------------------|------------|----------------------------------------------------------|---------------|----------------------------------------------------------|------------|
| Balance,  beginning of period    |       | $                                                        | 4,214,000     |                                                     | $          | 3,091,000 |   |
| Provision  charged to operations |       | 2,864,000                                                |          | 994,000                                                  |       |
| Net charge-offs                  |       | 195,000                                                  |          | 11,000                                                   |       |
| Balance, end of  period          | ** ** | **$**                                                    | **6,883,000** | ** **                                               | **$**      | **4,074,000** | ** ** |

 

*Potential Problem Loans*

 

Potential problem loans are loans that are not included in impaired loans (non-accrual loans or loans past due 90 days or more and still accruing), but about which management has become aware of information about possible credit problems of the borrowers that causes doubt about their ability to comply with current repayment terms.  At September 30, 2008 and December 31, 2007, the Company had identified $2.2 million and $1.6 million, respectively, of potential problem loans through its internal review procedures.  The results of this internal review process are considered in determining management’s assessment of the adequacy of the allowance for loan losses.

 

*Provision and Allowance for Loan Losses*

 

The Company has developedpolicies and procedures for evaluating the overall quality of its creditportfolio and the timely identification of potential problem loans.  On a quarterly basis, the Company’s Board ofDirectors reviews the appropriate level for the Company’s allowance for loanlosses as determined by management based on the results of the internalmonitoring and reporting system and an analysis of economic conditions in itsmarket.

 

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

 

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The Company’s allowancefor loan losses is based upon judgments and assumptions about risk elements inthe portfolio, future economic conditions, and other factors affectingborrowers.  The process includesidentification and analysis of loss potential in various portfolio segmentsutilizing a credit risk grading process and specific reviews and evaluations ofsignificant problem credits.  However,there is no precise method of estimating credit losses, since any estimate ofloan losses is necessarily subjective and the accuracy depends on the outcomeof future events.  In addition, due toour rapid growth over the past several years and our limited operating history,a large portion of the loans in our loan portfolio was originated recently.  In general, loans do not begin to show signsof credit deterioration or default until they have been outstanding for someperiod of time, a process referred to as seasoning.  As a result, a portfolio of more mature loanswill usually behave more predictably than a newer portfolio.  Because our loan portfolio is relatively new,the current level of delinquencies and defaults may not be representative ofthe level that will prevail when the portfolio becomes more seasoned, which maybe higher than current levels.  Ifcharge-offs in future periods increase, we may be required to increase ourprovision for loan losses, which would decrease our net income and possibly ourcapital.

 

In addition, the recentdownturn in the real estate market has resulted in an increase in loandelinquencies, defaults and foreclosures, and we believe these trends arelikely to continue.  In some cases, thisdownturn has resulted in a significant impairment to the value of ourcollateral and our ability to sell the collateral upon foreclosure, and thereis a risk that this trend will continue. The real estate collateral in each case provides an alternate source ofrepayment in the event of default by the borrower and may deteriorate in valueduring the time the credit is extended. If real estate values continue to decline, it is also more likely thatwe would be required to increase our allowance for loan losses.  Based on present information and an ongoingevaluation, management considers the allowance for loan losses to be adequateto meet presently known and inherent losses in the loan portfolio.  Management’s judgment about the adequacy ofthe allowance is based upon a number of assumptions about future events whichit believes to be reasonable but which may or may not be accurate.  Thus, there can be no assurance that charge-offsin future periods will not exceed the allowance for loan losses or thatadditional increases in the allowance for loan losses will not berequired.  The Company does not allocatethe allowance for loan losses to specific categories of loans but evaluates theadequacy on an overall portfolio basis utilizing a risk grading system.

 

*Deposits*

 

Our primary source offunds for loans and investments is our deposits.  We have chosen to obtain a portion of ourcertificates of deposits from areas outside of our market, which are brokereddeposits. The deposits obtained outside of our market area generally have ratescomparable to those being offered for certificates of deposits in our localmarket.  As of September 30, 2008,total deposits had decreased by $32.7 million, or 9.98%, from December 31,2007.  The largest percentage decrease indeposits was in savings which decreased $8.5 million, or 34.40%, from December 31,2007 to September 30, 2008.  Thiswas primarily the result of a run-off of money market accounts that had beenestablished as temporary holding accounts for IRS section 1031 exchangetransactions.  The second largestpercentage decrease was in time deposits less than $100,000 which decreased$11.7 million, or 19.6%, from December 31, 2007 to September 30,2008.  The decline in deposits was alsoaffected by certain Bank deposit pricing methods that resulted in a decline incertificates and allowed us to shift a portion of our funding to FHLB advancesand repurchase agreements, which together increased $25 million since December 31,2007.  We anticipate that future depositgrowth will be positive and will be sufficient to fund our anticipated loangrowth.

 

Balances within the majordeposit categories are as follows:

 
| **(dollar amounts in thousands)** | ** ** | **September 30, 2008** | ** **  | **December 31, 2007** | ** ** |
|--------------------------------------------------|------------|----------------------------------|-------------|---------------------------------|------------|
| Non-interest  bearing demand                     |       | $                                | 24,463      |                            | $          | 24,464 |   |
| Interest bearing  demand                         |       | 15,612                           |        | 13,721                          |       |
| Savings                                          |       | 16,157                           |        | 24,634                          |       |
| Time deposits  less than $100,000                |       | 47,852                           |        | 59,528                          |       |
| Time deposits of  $100,000 or over               |       | 42,645                           |        | 47,118                          |       |
| Brokered  deposits                               |       | 148,238                          |        | 158,199                         |       |
| Total deposits                                   | ** ** | **$**                            | **294,967** | ** **                      | **$**      | **327,664** | ** ** |

 

*Federal Funds Purchased*

 

Our increase in borrowedmoney is primarily related to a $9.5 million purchase of federal funds andsecurities sold under agreements to repurchase. The Company utilizes thesesources as necessary to meet funding needs.

 

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* *

*Subordinated Debt*

 

During the third quarterof 2008, we commenced a subordinated debt offering to enhance and strengthen thelevels of capital and liquidity at the holding company such that we couldmaintain the resources needed to maintain “well-capitalized” levels ofregulatory capital at the bank. Through September 30, 2008, we raised$3.545 million in additional capital through the offering and another $780thousand in October before we closed the offering on October 15,2008.  The subordinated notes were soldto a limited number of purchasers in a private offering, bear an interest rateof 11.5%, are callable after September 30, 2011, at a premium, and maturein 2018. The subordinated debt has been structured to fully count as Tier 2regulatory capital on a consolidated basis.

 

Another aspect of EESA(in addition to the Capital Purchase Plan described above) which became effectiveon October 3, 2008 is a temporary increase of the basic limit on federaldeposit insurance coverage from $100,000 to $250,000 per depositor.  The basic deposit insurance limit will returnto $100,000 after December 31, 2009. At September 30, 2008 the Bank had time deposits of $100,000 ormore of $42.6 million.  Approximately$33.7 million or 79.11% of these deposits would be covered under the new FDICinsurance coverage.

 

In addition, weanticipate participating the FDIC’s Temporary Liquidity Guarantee Program whichwas announced October 14, 2008 as part of EESA.  This guarantee applies to the followingtransactions:

 

·                                         Allnewly issued senior unsecured debt (up to $1.5 trillion) issued on or before June 30,2009, including promissory notes, commercial paper, inter-bank funding, and anyunsecured portion of secured debt. For eligible debt issued on or before June 30,2009, coverage would only be provided for three years beyond that date, even ifthe liability has not matured; and

 

·                                         Fundsin non-interest-bearing transaction deposit accounts (up to $500 billion) heldby FDIC-insured banks until December 31, 2009.

 

All FDIC institutions arecovered for the first 30 days at no cost. After the initial 30 day period expires, the institution must opt out ifit no longer wishes to participate in the program; otherwise, it will beassessed for future participation. There will be a 75-basis point fee toprotect new debt issues and an additional 10-basis point fee to fully covernon-interest bearing deposit transaction accounts.

 

*Advances from FHLB*

 

Advances from FHLB are asource of funding that the Bank uses depending on the current level of depositsand the availability of collateral to secure FHLB borrowings.  At September 30, 2008, the Bank hadreceived advances of $10.0 million from FHLB.

 

*Repurchase Agreements*

 

At September 30,2008, the Bank had sold $30.0 million of securities under agreements torepurchase with brokers with a weighted average rate of 2.21% and an averagematurity of 93 months.  The maximumamount outstanding at any month-end was $30.0 million.  These agreements were secured withapproximately $34.7 million of investment securities.

 

**Liquidity**

 

Liquidity is the ability to meet current and future obligations through liquidation or maturity of existing assets or the acquisition of liabilities.  We manage both assets and liabilities to achieve appropriate levels of liquidity.  Cash and short-term investments are our primary sources of asset liquidity.  These funds provide a cushion against short-term fluctuations in cash flow from both deposits and loans.  Individual and commercial deposits and borrowings are our primary source of funds for credit activities.  At September 30, 2008, we had lines of credit with unrelated banks totaling $20.5 million.  These lines, $15.5 million of which are unsecured, are available on a one-to-seven day basis for general corporate purposes.  We believe our liquidity sources are adequate to meet our operating needs as well as our construction commitments.  The level of liquidity is measured by the cash, cash equivalents and securities available for sale-to-total assets ratio, which was at 13.72% at September 30, 2008.

 

As members of the Federal Home Loan Bank of Atlanta, we have credit availability of up to 15% of the Bank’s total assets, which meant $47.4 million was available as of September 30, 2008.  Advances under this credit facility are subject to qualifying collateral.

 

21

 

**Impactof Off-Balance Sheet Instruments**

 

Through the operations ofour Bank, we have made contractual commitments to extend credit in the ordinarycourse of our business activities.  Thesecommitments are legally binding agreements to lend money to our customers atpredetermined interest rates for a specified period of time.  At September 30, 2008, we had issuedcommitments to extend credit of $52.1 million through various types of lendingarrangements.  We evaluate each customer’scredit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by us uponextension of credit, is based on our credit evaluation of the borrower.  Collateral varies but may include accountsreceivable, inventory, property, plant and equipment, commercial andresidential real estate.  We manage thecredit risk on these commitments by subjecting them to normal underwriting andrisk management processes.  The followingtable summarizes our off-balance-sheet financial instruments whose contractamounts represent credit risk:

 
| **(dollar amounts in thousands)** | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
|                                             |       |                             |       |                            |       |
| Commitments to  extend credit                    |       | $                                | 48,486     |                            | $          | 49,343 |   |
|                                             |       |                             |       |                            |       |
| Standby letters  of credit                       |       | $                                | 3,621      |                            | $          | 3,177 |   |

 

**Capital Resources**

 

Total shareholders’equity decreased from $31.5 million at December 31, 2007 to $30.4 millionat September 30, 2008.  The decreaseis principally due to the net unrealized losses on securities available forsale of $197,795 (net of income taxes) and to the net loss for the nine monthsended September 30, 2008 of $964,092.

 

The FRB and bankregulatory agencies require bank holding companies and financial institutionsto maintain capital at adequate levels based on a percentage of assets andoff-balance sheet exposures, adjusted for risk weights ranging from 0% to100%.  FRB guidelines contain anexemption from the capital requirements for “small bank holding companies,”which in 2006 were amended to cover most bank holding companies with less than$500 million in total assets that do not have a material amount of debt orequity securities outstanding registered with the SEC.  Although our class of common stock isregistered under Section 12 of the Securities Exchange Act, we believethat because our stock is not listed on any exchange or otherwise activelytraded, the Federal Reserve Board will interpret its new guidelines to meanthat we qualify as a small bank holding company.  Nevertheless, our Bank remains subject tothese capital requirements.  Failure tomeet minimum capital requirements can initiate certain mandatory and possiblyadditional discretionary actions by regulators that, if undertaken, could havea direct material effect on the Bank’s financial statements.  Under capital adequacy guidelines and theregulatory framework for prompt corrective action, the Bank must meet specificcapital guidelines that involve quantitative measures of the Bank’s assets,liabilities and certain off-balance sheet items as calculated under regulatoryaccounting practices.  The Bank’s capitalamounts and classifications are also subject to qualitative judgments by theregulators about components, risk weightings, and other factors.  Regardless, our Bank is “well capitalized”under these minimum capital requirements as set per bank regulatory agencies.

 

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

 

The Bank is also requiredto maintain capital at a minimum level based on quarterly average assets, whichis known as the leverage ratio.  Only thestrongest banks are allowed to maintain capital at the minimum requirement of3%.  All others are subject tomaintaining ratios at least 1% to 2% above the minimum.

 

The Bank exceeded theregulatory capital requirements at September 30, 2008 and December 31,2007 as set forth in the following table.

 

22

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| ** **                                | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                | ** ** | **Amount**                       | ** ** | **Ratio**                       | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
|                                      |       |                             |       |                            |       |   |   |   |   |
| Tier 1 capital  (to risk-weighted assets) |       | $                                | 32,557,000 |                            | 9.31       | % | $ | 30,102,000 |   | 8.92 | % |
| Total capital  (to risk-weighted assets)  |       | 36,959,000                       |       | 10.57                           |       | 34,316,000 |   | 10.17 |   |
| Tier 1 capital  (to average assets)       |       | 32,557,000                       |       | 8.53                            |       | 30,102,000 |   | 8.26 |   |
|                                           |            |                                  |            |                                 |            |  |  |  |  |  |  |

 

We recently raisedadditional capital, in the form of subordinated notes, to bolster our capitaland to support anticipated growth.

 

**Critical Accounting Policies**

 

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

 

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

 

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

 

**Item 3. Quantitative andQualitative Disclosures About Market Risk.**

 

Not applicable.

 

**Item 4. Controls and Procedures.**

 

As of the end of theperiod covered by this report, we carried out an evaluation, under thesupervision and with the participation of our management, including our ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of ourdisclosure controls and procedures as defined in Exchange Act Rule 13a-15(e).  Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer have concluded that our currentdisclosure controls and procedures are effective as of September 30,2008.  There have been no significantchanges in our internal controls over financial reporting during the fiscalquarter ended September 30, 2008 that have materially affected, or arereasonably likely to materially affect, our internal controls over financial reporting.

 

The design of any systemof controls and procedures is based in part upon certain assumptions about thelikelihood of future events.  There canbe no assurance that any design will succeed in achieving its stated goalsunder all potential future conditions, regardless of how remote.

 
| **Part II - Other  Information**                                     |
|---------------------------------------------------------------------------|
|                                                                      |
| **Item 1.  Legal Proceedings.**                                           |
|                                                                      |
| Not Applicable.                                                           |
|                                                                      |
| **Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds.** |
|                                                                      |
| Not applicable.                                                           |

 

23

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| **Item 3. Defaults Upon Senior Securities.**                    |
|-----------------------------------------------------------------|
|                                                            |
| Not applicable.                                                 |
|                                                            |
| **Item 4. Submission of Matters to Vote of  Security Holders.** |
|                                                            |
| Not applicable.                                                 |

 
| **Item 6.** |   | **Exhibits.**                                                                                                                                                                                          |
|-------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |   |                                                                                                                                                                                                   |
| 10.1        |   | Subordinated Note  Purchase Agreement, dated August 22, 2008, (incorporated by reference to  Exhibit 10.1 of the Company’s Form 8-K filed August 28, 2008).                   |
|        |   |                                                                                                                                                                                                   |
| 10.2        |   | Form of  CommunitySouth Financial Corporation 11.5% Subordinated Note Due 2018  (incorporated by reference to Exhibit 10.2 of the Company’s  Form 8-K filed August 28, 2008). |
|        |   |                                                                                                                                                                                                   |
| 31.1        |   | Rule 13a-14(a) Certification  of the Principal Executive Officer.                                                                                                                            |
|        |   |                                                                                                                                                                                                   |
| 31.2        |   | Rule 13a-14(a) Certification  of the Principal Financial Officer.                                                                                                                            |
|        |   |                                                                                                                                                                                                   |
| 32          |   | Section 1350  Certifications.                                                                                                                                                                     |

 

24

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# **SIGNATURES**

# ** **

In accordance with therequirements of the Securities Exchange Act of 1934, the Registrant caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.

 

 
| Date: November 13,  2008 | By:                                           | /s/ C. Allan  Ducker, III |
|-------------------------------|-----------------------------------------------|--------------------------------|
|                          | C. Allan Ducker, III                     |
|                          | Chief Executive Officer                       |
|                          | (Principal Executive  Officer)                |
|                          |                                          |
| Date: November 13,  2008 | By:                                           | /s/ John W. Hobbs              |
|                          | John W. Hobbs                                 |
|                          | Chief Financial Officer                       |
|                          | (Principal Financial  and Accounting Officer) |

 

25

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**EXHIBITINDEX**

 
| **Exhibit** | ** ** | ** **                                                                                                                                                                                            |
|-------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number**  | ** ** | **Description**                                                                                                                                                                                       |
|        |       |                                                                                                                                                                                                  |
| 10.1        |       | Subordinated Note Purchase Agreement, dated  August 22, 2008, (incorporated by reference to Exhibit 10.1 of the  Company’s Form 8-K filed August 28, 2008).                  |
|        |       |                                                                                                                                                                                                  |
| 10.2        |       | Form of CommunitySouth Financial Corporation  11.5% Subordinated Note Due 2018 (incorporated by reference to  Exhibit 10.2 of the Company’s Form 8-K filed August 28, 2008). |
|        |       |                                                                                                                                                                                                  |
| 31.1        |       | Rule 13a-14(a) Certification of the  Principal Executive Officer.                                                                                                                           |
|        |       |                                                                                                                                                                                                  |
| 31.2        |       | Rule 13a-14(a) Certification of the  Principal Financial Officer.                                                                                                                           |
|        |       |                                                                                                                                                                                                  |
| 32          |       | Section 1350 Certifications.                                                                                                                                                                     |

 

26

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