** **

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**(MARK ONE)**

 

**x****  QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For theQuarterly Period ended June 30, 2010**

 

**OR**

 

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

 

**For theTransition Period from           to           **

 

**Commission File No. 000-51896**

 

**COMMUNITYSOUTH FINANCIAL CORPORATION**

(Exact name of registrant asspecified 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 principalexecutive offices)

 

**(864) 306-2540**

(Registrant’s telephonenumber, including area code)

 

----

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.  Yes x  No o

 

Indicate by check mark whether the registrant has submittedelectronically and posted on its corporate Web site, if any, every InteractiveData File required to be submitted and posted pursuant to Rule 405 ofRegulation S-T (§232.405 of this chapter) during the preceding 12 months (orfor such shorter period that the registrant was required to submit and postsuch files).  o  Yes  o No

 

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

 

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

 

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

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date: 4,698,697 shares ofcommon stock, $0.01 par value per share, were issued and outstanding as of July29, 2010.

 

 

 

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**CommunitySouthFinancial Corporation**

 

**Part I - Financial Information**

 

**Item 1.Financial Statements****.**

 

**CONSOLIDATED BALANCE SHEETS**

(dollars in thousands)

** **
| ** **                                                                                                                                     | ** ** | **June 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                                     | ** ** | **(Unaudited)**             | ** ** | **(Audited)**                   | ** ** |
| **Assets**                                                                                                                                     |       |                        |       |                            |       |
|                                                                                                                                           |       |                        |       |                            |       |
| Cash and cash equivalents                                                                                                                      |       |                        |       |                            |       |
| Cash and due from bank                                                                                                                         |       | $                           |       | 7,109                           |       | $ |   | 6,876 |   |
| Federal funds sold                                                                                                                             |       | 14,965                      |       | 31,043                          |       |
| Total cash and cash  equivalents                                                                                                               |       | 22,074                      |       | 37,919                          |       |
| Investment securities,  available for sale                                                                                                     |       | 191,546                     |       | 103,638                         |       |
| Other investments, at cost                                                                                                                     |       | 1,599                       |       | 1,599                           |       |
| Loans, net of allowance  for loan losses of $11,601 at June 30, 2010 and $12,963 at December 31, 2009                                          |       | 233,175                     |       | 262,141                         |       |
| Accrued interest  receivable                                                                                                                   |       | 1,002                       |       | 1,440                           |       |
| Property and equipment,  net                                                                                                                   |       | 3,548                       |       | 3,867                           |       |
| Other real estate owned                                                                                                                        |       | 8,272                       |       | 6,703                           |       |
| Repossessed collateral                                                                                                                         |       | 767                         |       | 942                             |       |
| Other assets                                                                                                                                   |       | 2,109                       |       | 3,285                           |       |
|                                                                                                                                           |       |                        |       |                            |       |
| Total assets                                                                                                                                   |       | $                           |       | 464,092                         |       | $ |   | 421,534 |   |
|                                                                                                                                           |       |                        |       |                            |       |
| **Liabilities  and Shareholders’ Equity**                                                                                                 |       |                        |       |                            |       |
|                                                                                                                                           |       |                        |       |                            |       |
| **Liabilities**                                                                                                                                |       |                        |       |                            |       |
| Deposits                                                                                                                                       |       |                        |       |                            |       |
| Non-interest bearing                                                                                                                           |       | $                           |       | 22,750                          |       | $ |   | 21,829 |   |
| Interest bearing                                                                                                                               |       | 398,832                     |       | 354,734                         |       |
| Total deposits                                                                                                                                 |       | 421,582                     |       | 376,563                         |       |
| Repurchase agreements                                                                                                                          |       | 30,000                      |       | 30,000                          |       |
| Subordinated debt                                                                                                                              |       | 4,325                       |       | 4,325                           |       |
| Accrued interest payable                                                                                                                       |       | 1,296                       |       | 1,307                           |       |
| Accrued expenses                                                                                                                               |       | 903                         |       | 665                             |       |
| Other liabilities                                                                                                                              |       | 3                           |       | 3                               |       |
|                                                                                                                                           |       |                        |       |                            |       |
| Total liabilities                                                                                                                              |       | 458,109                     |       | 412,863                         |       |
|                                                                                                                                           |       |                        |       |                            |       |
| Commitments and  contingencies                                                                                                                 |       |                        |       |                            |       |
| ** **                                                                                                                                     |       |                        |       |                            |       |
| **Shareholders’ Equity**                                                                                                                  |       |                        |       |                            |       |
| Preferred stock, par value  $.01 per share 10,000,000 shares authorized, no shares issued                                                      |       | —                      |       | —                          |       |
| Common stock, par value  $.01 per share 35,000,000 shares authorized, 4,698,697 issued and outstanding  at June 30, 2010 and December 31, 2009 |       | 47                          |       | 47                              |       |
| Additional paid-in capital                                                                                                                     |       | 29,856                      |       | 29,824                          |       |
| Accumulated other  comprehensive income (loss)                                                                                                 |       | 452                         |       | (1,134                          | )          |
| Retained earnings                                                                                                                              |       | (24,372                     | )          | (20,066                         | )          |
| Total shareholders’ equity                                                                                                                |       | 5,983                       |       | 8,671                           |       |
|                                                                                                                                           |       |                        |       |                            |       |
| Total liabilities and  shareholders’ equity                                                                                               |       | $                           |       | 464,092                         |       | $ |   | 421,534 |   |

 

The accompanying notes arean integral part of the consolidated financial statements.

 

2

----

 

**CommunitySouthFinancial Corporation**

 

**CONSOLIDATED STATEMENTS OFOPERATIONS**

**(UNAUDITED)**

(dollars in thousands)

 
| ** **                                                              | ** ** | **Three months ended** | ** ** | **Three months ended** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                              | ** ** | **June 30, 2010**      | ** ** | **June 30, 2009**      | ** ** |
| **Interest income**                                                     |       |                             |       |                             |       |
| Interest and fees on loans                                              |       | $                                | 3,415      |                             | $          | 4,292 |   |
| Interest and dividends on  investments                                  |       | 683                              |       | 336                              |       |
| Total interest income                                                   |       | 4,098                            |       | 4,628                            |       |
|                                                                    |       |                             |       |                             |       |
| **Interest expense — deposits and  other borrowings**              |       | 2,524                            |       | 1,951                            |       |
| Net interest income                                                     |       | 1,574                            |       | 2,677                            |       |
| ** **                                                              |       |                             |       |                             |       |
| **Provision for loan losses**                                           |       | 1,000                            |       | 1,500                            |       |
| Net interest income after  provision for loan losses                    |       | 574                              |       | 1,177                            |       |
|                                                                    |       |                             |       |                             |       |
| **Non-interest income**                                                 |       |                             |       |                             |       |
| Mortgage origination  revenue                                           |       | 199                              |       | 243                              |       |
| Gain on sale of securities                                              |       | 424                              |       | —                           |       |
| Net gain on sale of other  real estate owned and repossessed Collateral |       | 8                                |       | —                           |       |
| Other                                                                   |       | 213                              |       | 198                              |       |
| Total non-interest income                                               |       | 844                              |       | 441                              |       |
| ** **                                                              |       |                             |       |                             |       |
| **Non-interest expense**                                                |       |                             |       |                             |       |
| Salaries and benefits                                                   |       | 1,275                            |       | 1,363                            |       |
| Data processing                                                         |       | 171                              |       | 249                              |       |
| Occupancy                                                               |       | 175                              |       | 168                              |       |
| Depreciation                                                            |       | 158                              |       | 182                              |       |
| Equipment maintenance and  rental                                       |       | 74                               |       | 36                               |       |
| Advertising                                                             |       | 38                               |       | 60                               |       |
| Professional fees                                                       |       | 353                              |       | 74                               |       |
| Office supplies                                                         |       | 16                               |       | 20                               |       |
| Telephone                                                               |       | 32                               |       | 38                               |       |
| FDIC assessment                                                         |       | 779                              |       | 271                              |       |
| Other                                                                   |       | 548                              |       | 376                              |       |
| Total non-interest expense                                              |       | 3,619                            |       | 2,837                            |       |
|                                                                    |       |                             |       |                             |       |
| **Loss before income taxes**                                            |       | (2,201                           | )          | (1,219                           | )          |
|                                                                    |       |                             |       |                             |       |
| **Income tax benefit**                                                  |       | —                           |       | (414                             | )          |
| ** **                                                              |       |                             |       |                             |       |
| **Net loss**                                                            |       | $                                | (2,201     | )                                | $          | (805 | ) |
| ** **                                                              |       |                             |       |                             |       |   |   |
| **Losses per share**                                                    |       |                             |       |                             |       |
| Basic                                                                   |       | $                                | (0.47      | )                                | $          | (0.17 | ) |
| Diluted                                                                 |       | $                                | (0.47      | )                                | $          | (0.17 | ) |
|                                                                    |       |                             |       |                             |       |
| **Weighted average shares  outstanding**                                |       |                             |       |                             |       |
| Basic                                                                   |       | 4,698,697                        |       | 4,698,697                        |       |
| Diluted                                                                 |       | 4,698,697                        |       | 4,698,697                        |       |

 

The accompanying notes arean integral part of the consolidated financial statements.

 

3

----

 

**CommunitySouthFinancial Corporation**

 

**CONSOLIDATED STATEMENTS OFOPERATIONS**

**(UNAUDITED)**

(dollars in thousands)

 
| ** **                                                              | ** ** | **Six months ended** | ** ** | **Six months ended** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|
| ** **                                                              | ** ** | **June 30, 2010**    | ** ** | **June 30, 2009**    | ** ** |
| **Interest income**                                                     |       |                 |       |                 |       |
| Interest and fees on loans                                              |       | $                    | 6,958      |                 | $          | 8,661 |   |
| Interest and dividends on  investments                                  |       | 1,357                |       | 899                  |       |
| Total interest income                                                   |       | 8,315                |       | 9,560                |       |
|                                                                    |       |                 |       |                 |       |
| **Interest expense — deposits and  other borrowings**              |       | 4,861                |       | 4,031                |       |
| Net interest income                                                     |       | 3,454                |       | 5,529                |       |
| ** **                                                              |       |                 |       |                 |       |
| **Provision for loan losses**                                           |       | 2,000                |       | 2,805                |       |
| Net interest income after  provision for loan losses                    |       | 1,454                |       | 2,724                |       |
| ** **                                                              |       |                 |       |                 |       |
| **Non-interest income**                                                 |       |                 |       |                 |       |
| Mortgage origination  revenue                                           |       | 363                  |       | 305                  |       |
| Gain on sale of securities                                              |       | 478                  |       | 519                  |       |
| Other                                                                   |       | 417                  |       | 431                  |       |
| Total non-interest income                                               |       | 1,258                |       | 1,255                |       |
| ** **                                                              |       |                 |       |                 |       |
| **Non-interest expense**                                                |       |                 |       |                 |       |
| Salaries and benefits                                                   |       | 2,670                |       | 2,603                |       |
| Data processing                                                         |       | 386                  |       | 471                  |       |
| Occupancy                                                               |       | 357                  |       | 339                  |       |
| Depreciation                                                            |       | 334                  |       | 361                  |       |
| Equipment maintenance and  rental                                       |       | 151                  |       | 79                   |       |
| Advertising                                                             |       | 74                   |       | 97                   |       |
| Professional fees                                                       |       | 707                  |       | 165                  |       |
| Office supplies                                                         |       | 39                   |       | 42                   |       |
| Telephone                                                               |       | 67                   |       | 75                   |       |
| FDIC assessment                                                         |       | 1,181                |       | 367                  |       |
| Net loss on sale of other  real estate owned and repossessed collateral |       | 8                    |       | —               |       |
| Other                                                                   |       | 1,044                |       | 654                  |       |
| Total non-interest expense                                              |       | 7,018                |       | 5,253                |       |
|                                                                    |       |                 |       |                 |       |
| **Loss before income taxes**                                            |       | (4,306               | )          | (1,274               | )          |
|                                                                    |       |                 |       |                 |       |
| **Income tax benefit**                                                  |       | —               |       | (433                 | )          |
| ** **                                                              |       |                 |       |                 |       |
| **Net loss**                                                            |       | $                    | (4,306     | )                    | $          | (841 | ) |
| ** **                                                              |       |                 |       |                 |       |
| **Losses per share**                                                    |       |                 |       |                 |       |
| Basic                                                                   |       | $                    | (0.92      | )                    | $          | (0.18 | ) |
| Diluted                                                                 |       | $                    | (0.92      | )                    | $          | (0.18 | ) |
|                                                                    |       |                 |       |                 |       |
| **Weighted average shares  outstanding**                                |       |                 |       |                 |       |
| Basic                                                                   |       | 4,698,697            |       | 4,698,697            |       |
| Diluted                                                                 |       | 4,698,697            |       | 4,698,697            |       |

 

The accompanying notes arean integral part of the consolidated financial statements.

 

4

----

 

**CommunitySouthFinancial Corporation**

 

**CONSOLIDATED STATEMENTS OFCHANGES IN SHAREHOLDERS’ EQUITY**

**AND COMPREHENSIVE INCOME**

**For the six month periods endedJune 30, 2010 and June 30, 2009**

**(UNAUDITED)**

(dollars in thousands,except share amounts)

** **
| ** **                                                         | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** **                            | **Additional  Paid-in**  | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Retained**                                  | ** ** | **Total  Shareholders’** | ** **    | **Total  Comprehensive** | ** ** |
|--------------------------------------------------------------------|------------|---------------------|------------|------------------|---------------------------------------|--------------------------|------------|---------------------------------------|------------|-----------------------------------------------|------------|-------------------------------|---------------|--------------------------|------------|
| ** **                                                         | ** ** | **Shares**          | ** ** | **Amount**       | ** **                            | **Shares**               | ** ** | **Amount**                            | ** ** | **Capital**                                   | ** ** | **Income**                    | ** **    | **Earnings**             | ** ** | **Equity** | ** ** | **Income** | ** ** |
| Balance at December 31, 2009                                       |       | —              |       | $                |       — |                     | 4,698,697  |                                  | $          | 47                                            |       | $                             |   29,824 |                     | $          | (1,134 | ) | $ |  (20,066 | ) | $ |  8,671 |   |   |   |
|                                                               |       |                |       |             |                                  |                     |       |                                  |       |                                          |       |                          |          |                     |       |   |   |   |   |
| Net loss                                                           |       | —              |       | —           |                                  | —                   |       | —                                |       | —                                        |       | —                        |          | (4,306                   | )          | (4,306 | ) | $ |   (4,306 | ) |
|                                                               |       |                |       |             |                                  |                     |       |                                  |       |                                          |       |                          |          |                     |       |   |   |   |   |
| Other comprehensive income:                                        |       |                |       |             |                                  |                     |       |                                  |       |                                          |       |                          |          |                     |       |   |   |   |   |
|                                                               |       |                |       |             |                                  |                     |       |                                  |       |                                          |       |                          |          |                     |       |   |   |   |   |
| Unrealized gains on securities, net of income tax of  $0           |       |  —        |       |  —     |                                  |  —             |       |  —                          |       |  —                                  |       |  1,351                   |          |  —             |       |  1,351 |   |  1,351 |   |
|                                                               |       |                |       |             |                                  |                     |       |                                  |       |                                          |       |                          |          |                     |       |   |   |   |   |
| Reclassification of realized losses                                |       |  —        |       |  —     |                                  |  —             |       |  —                          |       |  —                                  |       |  235                     |          |  —             |       |  235 |   |  235 |   |
|                                                               |       |                |       |             |                                  |                     |       |                                  |       |                                          |       |                          |          |                     |       |   |   |   |   |
| Total comprehensive loss                                           |       |                |       |             |                                  |                     |       |                                  |       |                                          |       |                          |          |                     |       |   |   | $ |   (2,720 | ) |
|                                                               |       |                |       |             |                                  |                     |       |                                  |       |                                          |       |                          |          |                     |       |   |   |   |   |
| Stock option compensation                                          |       | —              |       | —           |                                  | —                   |       | —                                |       | 32                                            |       | —                        |          | —                   |       | 32 |   |   |   |
|                                                               |       |                |       |             |                                  |                     |       |                                  |       |                                          |       |                          |          |                     |       |   |   |   |   |
| Balance at June 30, 2010                                           |       | —              |       | $                |      —       |                     | 4,698,697  |                                  | $          |         47 |       | $                             |  29,856  |                     | $          |  452 |   | $ |  (24,372 | ) | $ |   5,983 |   |   |   |
| ** **                                                         | ** ** | ** **          | ** ** | ** **       | ** **                            | ** **               | ** ** | ** **                            | ** ** | ** **                                    | ** ** | ** **                    | ** **    | ** **               | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                         | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** **                            | **Additional   Paid-in** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Retained**                                  | ** ** | **Total  Shareholders’** | ** **    | **Total  Comprehensive** | ** ** |
| ** **                                                         | ** ** | **Shares**          | ** ** | **Amount**       | ** **                            | **Shares**               | ** ** | **Amount**                            | ** ** | **Capital**                                   | ** ** | **Income**                    | ** **    | **Earnings**             | ** ** | **Equity** | ** ** | **Income** | ** ** |
| Balance at December 31, 2008                                       |       | —              |       | $                |  —                          |                     | 4,698,697  |                                  | $          |  47                                      |       | $                             |  29,760  |                     | $          |  491 |   | $ |  (1,770 | ) | $ |  28,528 |   |   |   |
|                                                               |       |                |       |             |                                  |                     |       |                                  |       |                                          |       |                          |          |                     |       |   |   |   |   |
| Net loss                                                           |       | —              |       | —           |                                  | —                   |       | —                                |       | —                                        |       | —                        |          | (841                     | )          | (841 | ) | $ | (841 | ) |
|                                                               |       |                |       |             |                                  |                     |       |                                  |       |                                          |       |                          |          |                     |       |   |   |   |   |
| Other comprehensive income (loss):                                 |       |                |       |             |                                  |                     |       |                                  |       |                                          |       |                          |          |                     |       |   |   |   |   |
|                                                               |       |                |       |             |                                  |                     |       |                                  |       |                                          |       |                          |          |                     |       |   |   |   |   |
| Unrealized gains on securities, net of income tax  benefit of $203 |       | —              |       | —           |                                  | —                   |       | —                                |       | —                                        |       | (449                          | )             | —                   |       | (449 | ) | (449 | ) |
|                                                               |       |                |       |             |                                  |                     |       |                                  |       |                                          |       |                          |          |                     |       |   |   |   |   |
| Total comprehensive loss                                           |       |                |       |             |                                  |                     |       |                                  |       |                                          |       |                          |          |                     |       |   |   | $ | (1,290 | ) |
|                                                               |       |                |       |             |                                  |                     |       |                                  |       |                                          |       |                          |          |                     |       |   |   |   |   |
| Stock option compensation                                          |       | —              |       | —           |                                  | —                   |       | —                                |       | 33                                            |       | —                        |          | —                   |       | 33 |   |   |   |
|                                                               |       |                |       |             |                                  |                     |       |                                  |       |                                          |       |                          |          |                     |       |   |   |   |   |
| Balance at June 30, 2009                                           |       | —              |       | $                | —                                |                     | 4,698,697  |                                  | $          | 47                                            |       | $                             | 29,793        |                     | $          | 42 |   | $ | (2,611 | ) | $ | 27,271 |   |   |   |

 

The accompanying notes arean integral part of the consolidated financial statements.

 

5

----

 

**CommunitySouthFinancial Corporation**

 

**CONSOLIDATED STATEMENTS OF CASHFLOWS**

**(UNAUDITED)**

(dollars in thousands)

 
| ** **                                                                                 | ** ** | **Six months ended** | ** ** | **Six months ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **                                                                                 | ** ** | **June 30, 2010**    | ** ** | **June 30, 2009**    | ** ** |
| **Operating  activities**                                                                  |       |                           |       |                           |       |
| Net loss                                                                                   |       | $                              | (4,306     | )                              | $          | (841 | ) |
| Adjustments to reconcile  net loss to net cash provided by (used in) operating activities: |       |                           |       |                           |       |
| Provision for loan losses                                                                  |       | 2,000                          |       | 2,805                          |       |
| Stock option compensation                                                                  |       | 32                             |       | 33                             |       |
| Appreciation of bank-owned  life insurance                                                 |       | —                         |       | (51                            | )          |
| Gain on sale of securities                                                                 |       | (478                           | )          | (519                           | )          |
| Depreciation                                                                               |       | 334                            |       | 361                            |       |
| Loss on disposal of  equipment                                                             |       | 3                              |       | —                         |       |
| Net loss on sale of other  real estate owned and repossessed collateral                    |       | 7                              |       | —                         |       |
| Deferred income tax  expense                                                               |       | —                         |       | 17                             |       |
| Income tax refund                                                                          |       | 978                            |       | —                         |       |
| Decrease in accrued  interest receivable                                                   |       | 438                            |       | 343                            |       |
| Decrease in accrued  interest payable                                                      |       | (11                            | )          | (188                           | )          |
| Increase in accrued  expenses                                                              |       | 238                            |       | 313                            |       |
| Decrease (increase) in  other assets                                                       |       | 197                            |       | (1,301                         | )          |
| Decrease in other  liabilities                                                             |       | —                         |       | (149                           | )          |
|                                                                                       |       |                           |       |                           |       |
| Net cash provided by (used  in) operating activities                                       |       | (568                           | )          | 823                            |       |
|                                                                                       |       |                           |       |                           |       |
| **Investing  activities**                                                                  |       |                           |       |                           |       |
| Net decrease in loans  outstanding                                                         |       | 23,857                         |       | 9,898                          |       |
| Sale of bank owned life  insurance                                                         |       | —                         |       | 5,488                          |       |
| Purchase of investment  securities                                                         |       | (244,951                       | )          | (60,153                        | )          |
| Sale/call/maturity of  investment securities                                               |       | 159,107                        |       | 64,890                         |       |
| Sale of FHLB stock                                                                         |       | —                         |       | 206                            |       |
| Disposal (purchase) of  property and equipment                                             |       | (18                            | )          | (201                           | )          |
| Sale of other real estate  owned and repossessed collateral                                |       | 1,709                          |       | —                         |       |
|                                                                                       |       |                           |       |                           |       |
| Net cash provided by (used  in) investing activities                                       |       | (60,296                        | )          | 20,128                         |       |
|                                                                                       |       |                           |       |                           |       |
| **Financing  activities**                                                                  |       |                           |       |                           |       |
| Net increase in deposit  accounts                                                          |       | 45,019                         |       | 26,845                         |       |
| Repayments to FHLB                                                                         |       | —                         |       | (25,000                        | )          |
| Repayment of note payable                                                                  |       | —                         |       | (1,570                         | )          |
|                                                                                       |       |                           |       |                           |       |
| Net cash provided by  financing activities                                                 |       | 45,019                         |       | 275                            |       |
|                                                                                       |       |                           |       |                           |       |
| Net increase (decrease) in  cash and cash equivalents                                      |       | (15,845                        | )          | 21,226                         |       |
|                                                                                       |       |                           |       |                           |       |
| **CASH AND CASH EQUIVALENTS,  BEGINNING OF PERIOD**                                        |       | 37,919                         |       | 9,876                          |       |
|                                                                                       |       |                           |       |                           |       |
| **CASH AND CASH EQUIVALENTS, END  OF PERIOD**                                              |       | $                              | 22,074     |                           | $          | 31,102 |   |
|                                                                                       |       |                           |       |                           |       |
| **SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION**                                      |       |                           |       |                           |       |
| Cash paid for (received  from):                                                            |       |                           |       |                           |       |
| Interest                                                                                   |       | $                              | 4,873      |                           | $          | 4,219 |   |
| Income taxes                                                                               |       | $                              | (978       | )                              | $          | 419 |   |
|                                                                                       |       |                           |       |                           |       |
| **Schedule  of non-cash transactions**                                                     |       |                           |       |                           |       |
| Unrealized gains /  (losses) on investment securities, net of income taxes                 |       | $                              | 1,586      |                           | $          | (449 | ) |
| Loans charged-off                                                                          |       | $                              | 3,362      |                           | $          | 1,205 |   |
| Transfers to other real  estate owned                                                      |       | $                              | 3,110      |                           | $          | 2,717 |   |

 

The accompanying notes arean integral part of the consolidated financial statements.

 

6

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**CommunitySouthFinancial Corporation**

 

**Notes to Unaudited ConsolidatedFinancial Statements**

 

**NOTE 1 — NATURE OF BUSINESS AND BASIS OF PRESENTATION**

 

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

 

The Bank began operations on January 18, 2005.  The Bank primarily is engaged in the businessof accepting deposits insured by the FDIC, and providing commercial, consumerand mortgage loans to the general public.

 

The Company sold 4,681,069 shares of common stock at $6.40 per share inan initial public offering that was completed on February 15, 2005 (asadjusted for all stock splits).  Theoffering raised $29,430,810, net of offering costs.  The directors and officers of the Companypurchased 659,531 shares at $6.40 per share for a total of $4,221,000.

 

**Basis of Presentation —**The accompanying financialstatements have been prepared in accordance with generally accepted accountingprinciples in the United States of America (“GAAP”) and to general practices inthe banking industry for interim financial information and with theinstructions to Form 10-Q. Accordingly, they do not include all the information and footnotesrequired by GAAP for complete financial statements.  In the opinion of management, all adjustments(consisting of normal recurring accruals) considered necessary for a fairpresentation have been included. Operating results for the three and six month periods ended June 30,2010 are not necessarily indicative of the results that may be expected for theyear ending December 31, 2010.  Forfurther information, refer to the audited consolidated financial statements andfootnotes included in the Company’s Form 10-K for the year ended December 31,2009 as filed with the Securities and Exchange Commission (the “SEC”).

 

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

 

**Principlesof Consolidation —**The consolidated financial statements include theaccounts of CommunitySouth Financial Corporation, the parent company, andCommunitySouth Bank and Trust, its wholly owned subsidiary, and All SeasonsProperties, LLC, a subsidiary of the Bank, which was formed in 2009 for thepurpose of holding and marketing repossessed assets. All significantintercompany items have been eliminated in the consolidated financialstatements.

 

**Management’s Estimates** — The preparation ofconsolidated financial statements in conformity with GAAP requires managementto make estimates and assumptions that affect the reported amounts of assetsand liabilities and disclosure of contingent assets and liabilities at the dateof the financial statements and the reported amounts of income and expensesduring the reporting period.  Actualresults could differ from those estimates.

 

**Disclosure RegardingSegments** — The Company reports as one operating segment, asmanagement reviews the results of operations of the Company as a singleenterprise.

 

**Cash and Cash Equivalents**— For purposesof reporting cash flows, cash and cash equivalents include cash on hand,amounts due from banks, short-term interest bearing deposits and federal fundssold.  Cash and cash equivalents have anoriginal maturity of three months or less.

 

**Concentrations of Credit Risk** — Financialinstruments, which potentially subject the Company to concentrations of creditrisk, consist principally of loans receivable, investment securities, federalfunds sold and amounts due from banks.

 

7

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The Company makes loans toindividuals and small businesses for various personal and commercial purposesprimarily in the upstate region of South Carolina.  The Company’s loan portfolio is notconcentrated in loans to any single borrower or to a relatively small number ofborrowers.  The Bank does, however, havea concentration of loans classified as commercial real estate. These loans areespecially susceptible to being adversely effected by the current economicdownturn. The current downturn in the real estate market has resulted in anincrease in loan delinquencies, defaults and foreclosures, and we believe thesetrends are likely to continue.  In somecases, this downturn has resulted in a significant impairment to the value ofour collateral and our ability to sell the collateral upon foreclosure, andthere is a risk that this trend will continue. The commercial real estate collateral in each case provides an alternatesource of repayment in the event of default by the borrower and may deterioratein value during the time the credit is extended.  If real estate values in our market areascontinue to decline, it is also more likely that we would be required toincrease our allowance for loan losses.

 

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 paymentincreases (e.g., principal deferral periods, loans with initial interest-onlyperiods, etc.), and loans with high loan-to-value ratios.  Additionally, there are industry practicesthat could subject the Company to increased credit risk should economicconditions change over the course of a loan’s life.  For example, the Company makes variable rateloans and fixed rate principal-amortizing loans with maturities prior to theloan being fully paid (i.e., balloon payment loans).  These loans are underwritten and monitored tomanage the associated risks.  Managementhas determined that there is no concentration of credit risk associated withits lending policies or practices.

 

The Company’s investment portfolio consists of both marketable andnon-marketable equity securities. Management believes credit risk associated with the equity securities isnot significant. The Company places its deposits and correspondent accountswith, and sells its federal funds to, high quality institutions.  Management believes credit risk associatedwith correspondent accounts is not significant.

 

**InvestmentSecurities** — The Company classifies investments in equity anddebt securities in three categories:

 

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

2.               *Held tomaturity securities*: These are investment securities that the Companyhas the ability and intent to hold until maturity.  These securities arestated at cost, adjusted for amortization of premiums and the accretion ofdiscounts.

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

 

Gains or losses on dispositions of investment securities are based onthe differences between the net proceeds and the adjusted carrying amount ofthe securities sold, using the specific identification method.  Premiums and discounts are amortized or accrued into interest income by amethod that approximates a level yield.

 

**Other Investments —**The Bank, as a memberinstitution, is required to own stock investments in the Federal Home Loan Bankof Atlanta (the “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 FHLB stock hashistorically been at par value.  At June 30,2010 and December 31, 2009, the Company’s investment in FHLB stock was$1,599,300.  The dividend received onthis stock is included in interest and dividends on investments.

 

**Loans Receivable** — Loans are stated at theirunpaid principal balance less an allowance for loan losses and net deferredloan origination fees.  Interest incomeis computed using the simple interest method and is recorded in the period earned.Loan origination fees collected and certain loan origination costs are deferredand the net amount is accreted as income using a method that approximates thelevel yield method over the life of the related loans.

 

8

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Loans are considered to be impaired when, in management’s judgment andbased on current information, the full collection of principal and interestbecomes doubtful according to the contractual terms of the loan agreement.  A loan is also considered impaired if itsterms are modified in a troubled debt restructuring.  Loans are generally placed on non-accrualstatus when principal or interest becomes 90 days past due, or when payment infull is not anticipated.  Additionally, impaired loans are typicallyplaced in non-performing status if it is determined that the entire balance of principaland interest of the loan cannot be repaid, and future payments are applied toprincipal until such time as collection of the obligation is no longerdoubtful. Interest accrual resumes only when loans return to performingstatus.  To return to performing status,loans must be fully current, and continued timely payments must be a reasonableexpectation.  When a loan is placed onnon-accrual status, interest accrued but not received is generally reversedagainst interest income.  Cash receipts on non-accrual loans are notrecorded as interest income, but are used to reduce principal.

 

The Company identifies impaired loans through its normal internal loanreview process.  Loans on the Company’spotential problem loan list are considered potentially impaired loans.  These loans are evaluated in determiningwhether all outstanding principal and interest are expected to becollected.  Loans are not consideredimpaired if a minimal payment delay occurs and all amounts due, includingaccrued interest at the contractual interest rate for the period of delay, areexpected to be collected.  Management hasdetermined that the Company had $68,124,000 and $34,158,000 in impaired loansat June 30, 2010 and December 31, 2009, 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 losses is evaluated on a regular basis bymanagement and is based upon management’s periodic review of the collectabilityof the loans in light of historical experiences, the nature and volume of theloan portfolio, adverse situations that may affect the borrower’s ability torepay, estimated value of any underlying collateral and prevailing economicconditions.  This evaluation isinherently subjective as it requires estimates that are susceptible tosignificant revision as more information becomes available.

 

The allowance consists of specific, general and unallocatedcomponents.  The specific component relatesto loans that are classified as either doubtful, substandard or specialmention.  For such loans that are alsoclassified as impaired, an allowance is established when the discounted cashflows (or collateral value or observable market price) of the impaired loan islower than the carrying value of the loan. The general component coversnon-classified loans and is based on historical loss experience adjusted forqualitative factors.  An unallocatedcomponent is maintained to cover uncertainties that could affect management’sestimate of probable losses.  Theunallocated component of the allowance reflects the margin of imprecisioninherent in the underlying assumptions used in the methodologies for estimatingspecific and general losses in the portfolio.

 

A loan is considered impaired when, based on current information andevents, it is probable that the Company will be unable to collect the scheduledpayments of principal or interest when due according to the contractual termsof the loan agreement.  Factorsconsidered by management in determining impairment include payment status,collateral value, and the probability of collecting scheduled principal andinterest payments due.  Loans thatexperience insignificant payment delays and payment shortfalls generally arenot classified as impaired.  Managementdetermines the significance of payment delays and payment shortfalls on acase-by-case basis, taking into consideration all of the circumstancessurrounding the loan and the borrower, including the length of the delay, thereasons for the delay, the borrower’s prior payment record and the amount ofthe shortfall in relation to the principal and interest owed.  Impairment is measured on a loan by loanbasis for commercial and construction loans by either the present value ofexpected future cash flows discounted at the loan’s effective interest rate,the loan’s obtainable market price, or the fair value of the collateral if theloan is collateral dependent.

 

Large groups of smaller balance homogeneous loans are collectivelyevaluated for impairment.  Accordingly,the Company does not separately identify individual consumer and residentialloans for impairment disclosures, unless such loans are the subject of arestructuring agreement.

 

**Bank-Owned Life Insurance** — As of June 30, 2010, the Company has no remaining bank-owned lifeinsurance policies.  The Companymade the decision to sell these policies in 2009 in order to help reduceassets, thereby improving the Bank’s risk based capital ratio. During the firstquarter of 2009, the Company began the process of divesting of its key employeelife insurance policies by selling policies at no gain or loss.  Income from these policies and changes in thenet cash surrender value were recorded in non-interest income. The final policywas sold in April 2009.

 

9

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**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.

 

**Property and Equipment** — Premises, furniture andequipment are stated at cost, less accumulated depreciation.  Depreciation expense is computed using thestraight-line method, based on the estimated useful lives for furniture andequipment of 5 to 10 years.  Leaseholdimprovements are amortized over the life of the lease.  Maintenance and repairs are charged tocurrent expense.  The costs of majorrenewals and improvements are capitalized.

 

**Mortgage Origination Revenue**— The Bank offers residential loan origination services to its customersin its immediate market area.  The loansare offered on terms and prices offered by the Bank’s correspondents and areclosed in the name of the Bank with preapproval from the correspondents.  The Bank receives fees for services itprovides in conjunction with the origination services it provides.  The fees are recognized at the time the loansare sold to the Bank’s correspondent.

 

**Income Taxes** — The consolidated financial statements have beenprepared on the accrual basis.  When income and expenses are recognized indifferent periods for financial reporting purposes versus for the purposes ofcomputing income taxes currently payable, deferred taxes are provided on suchtemporary differences.

 

The Company has analyzed filing positions in all of the federal andstate jurisdictions where it is required to file income tax returns, as well asall open tax years in these jurisdictions. The Company believes that its incometax filing positions taken or expected to be taken in an its tax returns willmore likely than not be sustained upon audit by the taxing authorities and doesnot anticipate any adjustments that will result in a material adverse impact onthe Company’s financial condition, results of operations, or cash flow.Therefore, no reserves for uncertain income tax positions have been recorded.

 

Deferred tax assets and liabilities are recognized for the expectedfuture tax consequences of events that have been recognized in the consolidatedfinancial statements or tax returns.  Income taxes are the sum of amountscurrently payable to taxing authorities and the net changes in income taxespayable or refundable in future years. Deferred tax assets and liabilities are measured using the enacted taxrates expected to apply to taxable income in the years in which those temporarydifferences are expected to be realized or settled.  Income taxes deferred to future years aredetermined utilizing an asset and liability approach.  This method gives consideration to the futuretax consequences associated with differences between financial accounting andtax bases of certain assets and liabilities which are principally the allowancefor loan losses, depreciable premises and equipment, and net operating losscarry-forwards.  As of June 30, 2010and December 31, 2009, due to the Company’s recent financial results, theuncertainty involved in projecting near-term profitability, and evaluation ofappropriate tax planning strategies, management has provided a 100% valuationallowance for these deferred tax assets. This valuation allowance reflects management’s estimate that thedeferred tax assets are not more-likely-than-not to be realized.

 

**Earnings (loss) Per Share** — Basic earnings (loss) pershare represents the net income (loss) allocated to shareholders divided by theweighted-average number of common shares outstanding during the period.  Diluted earnings per share reflect the impactof additional common shares that would have been outstanding if dilutivepotential common shares had been issued. Potential common shares that may be issued by the Company relate to bothoutstanding warrants and stock options, and are determined using the treasurystock method.

 

**Stock—based Compensation** — The Company has adoptedthe fair value recognition provisions to account for compensation costs underits stock option plans.  The Companypreviously utilized the intrinsic value method. Under the intrinsic value method, no compensation costs were recognizedfor the Company’s stock options because the option exercise price in its plansequaled the market price on the date of grant.

 

The Company elected to use the modifiedprospective method to account for the transition from the intrinsic valuemethod to 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-Balance Sheet Financial Instruments** — In theordinary course of business, the Company enters into off-balance sheetfinancial instruments consisting of commitments to extend credit and letters ofcredit.  These financial instruments arerecorded in the financial statements when they become payable by the customer.

 

**Recently Issued Accounting Standards —**The following is a summaryof recent authoritative pronouncements that could impact the accounting,reporting, and / or disclosure of financial information by the Company:

 

10

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Income Tax guidance was amended in April 2010 to reflect an SECStaff Announcement after the President signed the Health Care and EducationReconciliation Act of 2010 on March 30, 2010, which amended the PatientProtection and Affordable Care Act signed on March 23, 2010.   According to the announcement, although thebills were signed on separate dates, regulatory bodies would not object if thetwo Acts were considered together for accounting purposes. This view is basedon the SEC staff’s understanding that the two Acts together represent thecurrent health care reforms as passed by Congress and signed by thePresident.  The amendment had no impacton the financial statements.

 

Other accounting standards that have been issued or proposed by theFASB or other standards-setting bodies are not expected to have a materialimpact on the Company’s financial position, results of operations or cashflows.

 

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

 

The Company is subject to the regulations of various governmentalagencies.  These regulations can and dochange significantly from period to period. The Company also undergoes periodic examinations by the regulatoryagencies, which may subject it to further changes with respect to assetvaluations, amounts of required loss allowances and operating restrictions fromthe regulators’ judgments based on information available to them at the time oftheir examination.  On June 29,2009, the Bank entered into a Memorandum of Understanding (the “MOU”) with theSouth Carolina Board of Financial Institutions and the FDIC.  In addition, on February 23, 2010 the Bankentered into a Consent Order (the “Consent Order”) with these same regulatorswhich supersedes the MOU.  Additionally,on March 1, 2010, the Company entered into a memorandum of understandingwith the Federal Reserve Bank of Richmond, which contains provisions similar tothe articles in the Bank’s Consent Order with the South Carolina Board ofFinancial Institutions and the FDIC. Please see Note 3 for more details regarding these regulatoryagreements.

 

**Reclassifications** - Certain captions andamounts in the prior financial statements were reclassified to conform with the2010 presentation.  Suchreclassifications had no effect on previously reported net income (loss) orshareholders’ equity.

 

**NOTE 3 — REGULATORY ACTIONS AND GOING CONCERN CONSIDERATIONS**

 

***Memorandum of Understanding***

 

As a result of the issues stemming from the economic downturn, on June 29,2009 the Bank entered into the MOU with the South Carolina Board of FinancialInstitutions and the FDIC.  The MOUrequired the Bank to, among other things, (1) submit a capital plan to thesupervisory authorities for returning to a “well-capitalized” designation; (2) developspecific plans and proposals for the reduction and improvement of assets whichare subject to adverse classification and past due loans; (3) implement aplan to decrease the concentration of commercial real estate loans; (4) developand implement an adequate loan review program; and (5) review overallliquidity objectives and develop plans and procedures aimed at improvingliquidity and reducing reliance on volatile liabilities to fund longer-termassets.  In addition, the Bank may notpay dividends without the prior written consent of each supervisoryauthority.  Since entering into the MOU,the Bank has been actively pursuing the corrective actions required by the MOUin an effort to ensure that the requirements of the MOU are met in a timelymanner.  For additional information onthe MOU, including actions the Bank has taken in response to the MOU, see “Management’sDiscussion and Analysis of Financial Condition and Results of Operations**—**The Effect of the Current Economic Environment on ourBank — *Memorandum of Understanding*.”

 

In addition, in mid-February 2010 the Bank received a supervisoryletter from the FDIC dated February 11, 2010, which provided foradditional restrictions and mandatory actions to be taken by the Bank.  These restrictions and actions were allsubstantially addressed and superseded by the subsequent Consent Order discussedin the subsection below.  However, inorder to comply with the supervisory letter, the Bank was required to prepareand submit to the FDIC a capital restoration plan no later than April 2,2010, which submission date was sooner than a similar requirement under theConsent Order.  The Bank submitted itscapital restoration plan to the FDIC on April 2, 2010.

 

11

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***Consent Order***

 

Following the FDIC’s safety and soundness examination of the Bank inthe fourth quarter of 2009, the Bank entered into the Consent Order with theFDIC and the South Carolina Board of Financial Institutions on February 23,2010.  The Consent Order, whichsupersedes the MOU, conveys specific actions needed to address certain findingsfrom the FDIC’s Report of Examination and to address the Bank’s currentfinancial condition, primarily related to capital planning, liquidity/fundsmanagement, policy and planning issues, management oversight, loanconcentrations and classifications, and non-performing loans.  For additional information on the ConsentOrder, including actions the Bank has taken in response to the Consent Order,see “Management’s Discussion and Analysis of Financial Condition and Results ofOperations**—**The Effect of the Current EconomicEnvironment on our Bank — *Consent Order*.”

 

Additionally, on March 1, 2010, the Company entered into aninformal agreement with the Federal Reserve Bank of Richmond.  The informal agreement contains provisionssimilar to those in the Bank’s MOU with the FDIC and the South Carolina Boardof Financial Institutions, including a requirement that the Company obtain theprior written approval of the Federal Reserve Bank of Richmond before (1) declaringor paying any dividends, (2) directly or indirectly accepting dividends orany other form of payment representing a reduction in capital from the Bank, (3) makingany distributions of interest, principal or other sums on subordinateddebentures or trust preferred securities, (4) directly or indirectly,incurring, increasing or guaranteeing any debt, and (5) directly orindirectly, purchasing or redeeming any shares of its stock.  Pursuant to our plans to preserve capital andto inject more capital into the Bank, the Company has no plans to undertake anyof the foregoing activities.

 

***Going Concern Considerations***

 

Due to the conditions and events discussedin this Form 10-Q, substantial doubt exists as to our ability to continueas a going concern.  We have determinedthat significant additional sources of capital will be required for us tocontinue operations through 2010 and beyond. We also continue to monitor andaddress liquidity issues. As of June 30, 2010, we are deemed to be“significantly undercapitalized.”  Asdescribed below, we did not meet the Consent Order deadline to achieve andmaintain a “well-capitalized” designation, and therefore we submitted a revisedcapital plan to the FDIC and the South Carolina Board of Financial Institutionson July 28,  2010.

 

We have engaged financial advisors to assistthe Company in its efforts to raise additional capital, sell assets, andexplore other strategic alternatives to address our current and expectedliquidity and capital deficiencies.  Todate, those efforts have not yielded any significant results.  As a result of our financial condition, our regulatorsare continually monitoring our liquidity and capital adequacy.  In addition, our regulators have variousenforcement tools available to them, including the issuance of capitaldirectives, orders to cease engaging in certain business activities, theissuance of modified or additional orders or agreements, and the authority toclose the Bank.

 

Notwithstanding the above, accompanyingconsolidated financial statements have been prepared on a going concern basis,which contemplates the realization of assets and the discharge of liabilitiesin the normal course of business for the foreseeable future, and do not includeany adjustments to reflect the possible future effects on the recoverabilityand classification of assets, or the amounts and classification of liabilitiesthat may result should we be unable to continue as a going concern.

 

The Bank’s financial condition has suffered during 2009 and the firstsix months of 2010 from the extraordinary effects of what may ultimately be theworst economic downturn since the Great Depression. The effects of the currenteconomic environment are being felt across many industries, with financialservices and residential real estate being particularly hard hit. The effectsof the economic downturn have been particularly severe during the lastyear.  The Bank, with a loan portfolioconsisting of a concentration in commercial real estate loans includingresidential construction and development loans, has seen a decline in the valueof the collateral securing its portfolio as well as rapid deterioration in itsborrowers’ cash flow and ability to repay their outstanding loans to the Bank.As a result, the Bank’s level of nonperforming assets increased substantiallyduring 2009 and has continued to increase through the second quarter of 2010.As of June 30, 2010, our non-performing assets equaled $43.9 million, or9.5% of assets, as compared to $42.4 million, or 10.1% of assets, as ofDecember 31, 2009. In addition, our level of impaired loans increased to$68.1 million at June 30, 2010 compared to $34.2 million atDecember 31, 2009. For the year ended December 31, 2009 and for thesix months ended June 30, 2010, the Bank recorded a $17 million and a $2million provision, respectively, to increase the allowance for loan losses to alevel which, in management’s best judgment, adequately reflected the increasedrisk inherent in the loan portfolio as of the year and quarter end periods,respectively.  Nevertheless, given thecurrent economic climate, management recognizes the possibility of furtherdeterioration in the loan portfolio in the second half of 2010.  For the six months ended June 30, 2010,we recorded net loan charge-offs of $3.4 million, or 1.3% of average loans, ascompared to net loan charge-offs of $1.2 million, for the six months endedJune 30, 2009.

 

The Company and the Bank operate in a highlyregulated industry and must plan for the liquidity needs of each entityseparately. A variety of sources of liquidity are available to the Bank to meetits short-term and long-term funding needs. Although a number of these sourceshave been limited following execution of the Consent Order with the FDIC andthe South Carolina Board of Financial Institutions, management has preparedforecasts of these sources of funds and the Bank’s projected uses of fundsduring 2010 in an effort to ensure that the sources available are sufficient tomeet the Bank’s projected liquidity needs for this period.

 

The Company relies on dividends from theBank as its primary source of liquidity. The Company is a legal entity separateand distinct from the Bank. Various legal limitations restrict the Bank fromlending or otherwise supplying funds to the Company to meet its obligations,including paying dividends. In addition, the terms of the Consent Orderdescribed in greater detail under “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations — The Effect of the CurrentEconomic Environment on our Bank — Consent Order” will further limit the Bank’sability to pay dividends to the Company to satisfy its funding needs.

 

12

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The Company will also need to raiseadditional capital to increase capital levels to meet the standards set forthby the FDIC as  described in greater detailunder “Management’s Discussion and Analysis of Financial Condition and Resultsof Operations — The Effect of the Current Economic Environment on our Bank —Consent Order”. As a result of the recent downturn in the financial markets,the availability of many sources of capital (principally to financial servicescompanies) has become significantly restricted or has become increasinglycostly as compared to the prevailing market rates prior to the volatility.Management cannot predict when or if the capital markets will return to morefavorable conditions or whether the Company will be able to raise a sufficientamount of capital to continue operations. Management is actively evaluating anumber of capital sources, asset reductions and other balance sheet managementstrategies in an effort to ensure that the Bank’s projected level of regulatorycapital can support its balance sheet.

 

There can be no assurances that the Companywill be successful in its efforts to raise additional capital. An equityfinancing transaction would result in substantial dilution to the Company’scurrent shareholders and could adversely affect the market price of theCompany’s common stock. It is difficult to predict if these efforts will besuccessful, either on a short-term or long-term basis. Should these efforts beunsuccessful, due to the regulatory restrictions which exist that restrict cashpayments between the Bank and the Company, the Company may be unable to realizeits assets and discharge its liabilities in the normal course of business.

 

As a result of management’s assessment ofthe Company’s ability to continue as a going concern, the accompanyingconsolidated financial statements for the Company have been prepared on a goingconcern basis, which contemplates the realization of assets and the dischargeof liabilities in the normal course of business for the foreseeable future, anddoes not include any adjustments to reflect the possible future effects on therecoverability or classification of assets.

 

**NOTE 4 — INVESTMENT SECURITIES**

 

The amortized costs andfair values of investment securities are as follows (in thousands):

 
| ** **                   | ** ** | **Amortized** | ** **  | **Gross Unrealized** | ** ** | **Fair**   | ** ** |
|------------------------------|------------|---------------|-------------|----------------------|------------|------------|------------|
| **As of June 30, 2010** | ** ** | **Cost**      | ** **  | **Gains**            | ** ** | **Losses** | ** ** | **Value** | ** ** |
| **Available for sale**       |       |          |        |                 |       |       |       |   |   |
| US Treasury                  |       | $             | 149,971     |                 | $          | 4          |       | $ | — |   | $ | 149,975 |   |
| Mortgage-backed              |       | 41,023        |        | 448                  |       | —     |       | 41,471 |   |
| Marketable securities        |       | 100           |        | —               |       | —     |       | 100 |   |
| Total available for sale     | ** ** | **$**         | **191,094** | ** **           | **$**      | **452**    | ** ** | **$** | — | ** ** | **$** | **191,546** | ** ** |

 
| ** **                       | ** ** | **Amortized** | ** **  | **Gross Unrealized** | ** ** | **Fair**   | ** ** |
|----------------------------------|------------|---------------|-------------|----------------------|------------|------------|------------|
| **As of December 31, 2009** | ** ** | **Cost**      | ** **  | **Gains**            | ** ** | **Losses** | ** ** | **Value** | ** ** |
| **Available for sale**           |       |          |        |                 |       |       |       |   |   |
| Mortgage-backed                  |       | 104,672       |        | 77                   |       | (1,211     | )          | 103,538 |   |
| Marketable securities            |       | 100           |        | —               |       | —     |       | 100 |   |
| Total available for sale         | ** ** | **$**         | **104,772** | ** **           | **$**      | **77**     | ** ** | **$** | (1,211 | ) | **$** | **103,638** | ** ** |
|                                  |            |               |             |                      |            |            |            |  |  |  |  |  |  |

 

**NOTE 5 — LOANS RECEIVABLE**

 

Major classifications of loans receivable are summarized as follows:

 
| **(dollar amounts in thousands)** | ** ** | **June 30, 2010** | ** **  | **December 31, 2009** | ** ** |
|--------------------------------------------------|------------|-----------------------------|-------------|---------------------------------|------------|
| Real estate - construction                       |       | $                           | 68,514      |                            | $          | 81,128 |   |
| Real estate - mortgage                           |       | 154,414                     |        | 167,296                         |       |
| Commercial and industrial                        |       | 20,665                      |        | 25,028                          |       |
| Consumer and other                               |       | 1,183                       |        | 1,652                           |       |
| Total loans, gross                               |       | 244,776                     |        | 275,104                         |       |
| Less allowance for loan  losses                  |       | (11,601                     | )           | (12,963                         | )          |
| Total loans, net                                 | ** ** | **$**                       | **233,175** | ** **                      | **$**      | **262,141** | ** ** |

 

Loans are stated net of deferred fees and costs.

 

13

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The Bank had $30.1 million and $29.4 million of loans classified asnon-accrual status as of June 30, 2010 and December 31, 2009,respectively.  At June 30, 2010 andDecember 31, 2009, loans past due 30 days or more, excluding non-accrualloans amounted to $6.8 million and $4.8 million, respectively.  Changes in the allowance for loan losses forwere as follows (dollars in thousands):

 
| ** **                      | ** ** | **Six-months ended  June 30, 2010** | ** ** | **Six-months ended  June 30, 2009** | ** ** |
|---------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|
| Balance, beginning of  period   |       | $                                        | 12,963     |                                     | $          | 8,088 |   |
| Provision charged to operations |       | 2,000                                    |       | 2,805                                    |       |
| Net collections  (charge-offs)  |       | (3,362                                   | )          | (1,205                                   | )          |
| Balance, end of period          | ** ** | **$**                                    | **11,601** | ** **                               | **$**      | **9,688** | ** ** |

 
| ** **                                                 | ** ** | **Six-months ended June 30,** | ** ** |
|------------------------------------------------------------|------------|------------------------------------|------------|
| **Impaired Loans:**                                        | ** ** | **2010**                           | ** ** | **2009** | ** ** |
| No valuation allowance  required                           |       | $                                  | 36,860     |   | $ | 10,569 |   |
| Valuation allowance required                               |       | 31,264                             |       | 12,528 |   |
| Total impaired loans                                       | ** ** | **$**                              | **68,124** | ** ** | **$** | **23,097** | ** ** |
| ** **                                                 | ** ** | ** **                         | ** ** | ** ** | ** ** |
| Allowance for loan losses  on impaired loans at period end | ** ** | **$**                              | **6,366**  | ** ** | **$** | **2,681** | ** ** |

 

**NOTE 6 — LEASES**

 

The Company leases branch locations in Spartanburg, Mauldin, Anderson,Greer and Greenville, South Carolina as well as the loan operations center inEasley, South Carolina. The initial lease terms range from three to ten yearswith various renewal options. The minimum future rental payments undernon-cancelable operating leases having remaining terms in excess of one year,for each of the next five years and in the aggregate are (in thousands):

 
| Remaining six months of  2010         |       | $     | 182       |       |
|---------------------------------------|------------|-------|-----------|------------|
| 2011                                  |       | 365   |      |
| 2012                                  |       | 343   |      |
| 2013                                  |       | 348   |      |
| 2014                                  |       | 353   |      |
| Thereafter                            |       | 606   |      |
| Total minimum future  rental payments | ** ** | **$** | **2,197** | ** ** |

 

Theloan operations center in Easley is leased from a partnership in which aCompany director has a partnership interest.

 

**NOTE 7 — RELATED PARTY TRANSACTIONS**

 

Certain parties (principally certain directors and executive officersof the Company, their immediate families and business interests) (“affiliates”)are loan customers in the normal course of business with the Bank.  These loans are made on substantially thesame terms, including interest rates and collateral, as those prevailing at thetime for comparable transactions with unrelated persons and do not involve morethan the normal risk of collectability.

 

**NOTE 8 — COMMITMENTS AND CONTINGENCIES**

 

The Company is subject to claims and lawsuits which arise primarily inthe ordinary course of business. Management is not aware of any legal proceedings which would have amaterial adverse effect on the financial position or operating results of theCompany.

 

14

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**NOTE 9 — STOCK-BASED COMPENSATION**

 

Upon completion of its initial public offering in 2005, the Companyagreed to issue warrants to the organizing directors for the purchase of oneshare of common stock at $6.40 per share for every two shares purchased in thestock offering, up to a maximum of 15,625 warrants per director. The warrantswere fully vested 120 days after January 18, 2005 and will expire on January 18,2015.  Warrants held by directors of theCompany will expire 90 days after the director ceases to be a director orofficer of the Company (365 days if due to death or disability). The Companyissued a total of 171,404 warrants.  Asof June 30, 2010 the Company has 155,799 outstanding warrants to directorsand officers.  In addition, the Companyhas adopted a stock option plan.  As of June 30,2010 the Company has 728,635 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 below summarizes stock option activity for theCompany’s stock compensation plans for the period ended June 30, 2010 asadjusted for all stock splits.

 
| ** **                                 | ** ** | **Stock Options** | ** ** | **Warrants**  | ** ** |
|--------------------------------------------|------------|-------------------|------------|---------------|------------|
| ** **                                 | ** ** | ** **        | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **                                 | ** ** | ** **        | ** ** | **Average**   | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                 | ** ** | ** **        | ** ** | **Exercise**  | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                                 | ** ** | **Number**        | ** ** | **Price**     | ** ** | **Number** | ** ** | **Price** | ** ** |
| **Outstanding  at December 31, 2009** |       | 756,033           |       | $             | 6.99       |   | 171,404 |   | $ | 6.40 |   |
| Granted                                    |       | 1,350             |       | 0.97          |       | — |   | — |   |
| Forfeited                                  |       | 28,748            |       | 8.40          |       | 15,625 |   | 6.40 |   |
| Exercised                                  |       | —            |       | —        |       | — |   | — |   |
| **Outstanding  at June 30, 2010**     | ** ** | **728,635**       | ** ** | **6.92**      | ** ** | **155,779** | ** ** | **6.40** | ** ** |
|                                            |            |                   |            |               |            |  |  |  |  |  |  |

 

The table set forth below summarizes non-vested stock options as of June 30,2010.

 
| ** **                                 | ** ** | ** ** | ** ** | **Fair**  | ** ** |
|--------------------------------------------|------------|------------|------------|-----------|------------|
| ** **                                 | ** ** | **Number** | ** ** | **Value** | ** ** |
| **Outstanding  at December 31, 2009** |       | 48,423     |       | $         | 4.32       |   |
| Granted                                    |       | 1,350      |       | 0.68      |       |
| Vested                                     |       | 10,292     |       | 5.11      |       |
| Forfeited                                  |       | 2,551      |       | 2.37      |       |
| **Outstanding  at June 30, 2010**     | ** ** | **36,930** | ** ** | **4.10**  | ** ** |
|                                            |            |            |            |           |            |  |

 

As of June 30, 2010, there was $123,038 in total unrecognizedcompensation cost related to non-vested share-based compensation arrangements,which is expected to be recognized over a weighted average period of 26 months.As of December 31, 2009, there was $159,989 in total unrecognizedcompensation cost related to non-vested share-based compensation arrangements,which was expected to be recognized over a weighted average period of 32months.

 

The fair value of each option granted is estimated on the grant dateusing the Black-Scholes option-pricing model with the following assumptions for2010:  dividend yield of 0%, expectedterm of 10 years, risk-free interest rate equal to the 10-year treasury rate onthe respective grant date, expected life of 10 years, and expected volatilityranging from 53% to 57%.  The followingassumptions were used for the 2009 estimates: dividend yield of 0%, expected term of 10 years, risk-free interest rateequal to the 10-year treasury rate on the respective grant date, and expectedlife of 10 years.  Volatility assumed foroptions granted during 2009 ranged from 38% to 51%.

 

15

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The following table summarizes information about stock optionsoutstanding under the Company’s plans at June 30, 2010 and December 31,2009.

 
| **June 30, 2010**           | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** |
|----------------------------------|------------|-----------------|------------|-----------------|------------|
| Number of options                |       | 728,635         |       | 691,705         |       |
| Weighted average remaining  life |       | 4.97 years      |       | 4.82 years      |       |
| Weighted average exercise  price |       | $               | 6.92       |            | $          | 6.82 |   |
| High exercise price              |       | $               | 16.80      |            | $          | 16.80 |   |
| Low exercise price               |       | $               | 0.56       |            | $          | 2.50 |   |

 
| **December 31, 2009**       | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** |
|----------------------------------|------------|-----------------|------------|-----------------|------------|
| Number of options                |       | 756,033         |       | 707,610         |       |
| Weighted average remaining  life |       | 5.47 years      |       | 5.29 years      |       |
| Weighted average exercise  price |       | $               | 6.99       |            | $          | 6.83 |   |
| High exercise price              |       | $               | 16.80      |            | $          | 16.80 |   |
| Low exercise price               |       | $               | 1.75       |            | $          | 4.55 |   |

 

There were no options exercised during the quarter and thus no cash wasreceived related to this type of transaction. There was no intrinsic value ofoptions exercised during 2010 or 2009.

 

At June 30, 2010, all of the 155,779 warrants were exercisable andhad an average remaining life of 4.55 years. At December 31, 2009, all ofthe 171,404 warrants were exercisable and had an average remaining life of 5.05years.

 

**NOTE 10 — FAIR VALUE OF FINANCIAL INSTRUMENTS**

 

GAAP requires disclosure of fair value information, whether or notrecognized in the consolidated balance sheets, when it is practical to estimatethe fair value.  GAAP defines a financialinstrument as cash, evidence of an ownership interest in an entity orcontractual obligations, which require the exchange of cash, or other financialinstruments.  Certain items arespecifically excluded from the disclosure requirements, including the Company’scommon stock, premises and equipment, accrued interest receivable and payable,and other assets and liabilities.

 

The fair value of a financial instrument is the amount at which theasset or obligation could be exchanged in a current transaction between willingparties, other than in a forced or liquidation sale.  Fair value estimates are made at a specificpoint in time based on relevant market information and information about thefinancial instruments.  Because no marketvalue exists for a significant portion of the financial instruments, fair valueestimates are based on judgments regarding future expected loss experience,current economic conditions, risk characteristics of various financial instruments,and other factors.

 

The Company has used management’s best estimate of fair value based onthe above assumptions.  Thus, the fairvalues presented may not be the amounts, which could be realized, in animmediate sale or settlement of the instrument. In addition, any income taxesor other expenses, which would be incurred in an actual sale or settlement, arenot taken into consideration in the fair values presented.

 

The following methods and assumptions were used to estimate the fairvalue of significant financial instruments:

 

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

 

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

 

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

 

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

 

***LoansReceivable*****-** For certain categories of loans, such asvariable rate loans which are repriced frequently and have no significantchange in credit risk, fair values are based on the carrying amounts.  The fair value of other types of loans isestimated by discounting the future cash flows using the current rates at whichsimilar loans would be made to borrowers with similar credit ratings and forthe same remaining maturities.  In orderto capture the change in credit risk, the current allowance for loan losses isalso considered when determining fair value of loans receivable.

 

16

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

 

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

 

***Subordinated Debt*** — The fairvalue of subordinated debt is estimated using a discounted cash flowcalculation that applies prevailing market rates for comparableinstruments.  Due to diminishing cashavailable at the holding company level, we only paid the June 2010interest payments to subordinated debt holders that were not officers ordirectors of the Company.  If we areunable to raise additional capital, we may have to discontinue paying intereston the subordinated debentures to all holders due to lack of funds, and ourfair value calculation reflects this.

 

The carrying values andestimated fair values of the Company’s financial instruments at June 30,2010 and December 31, 2009 are shown in the following table (dollars inthousands).

 
| ** **                                                          | ** ** | **Carrying** | ** ** | **Estimated**  | ** ** |
|---------------------------------------------------------------------|------------|--------------|------------|----------------|------------|
| ** **                                                          | ** ** | **Amount**   | ** ** | **Fair Value** | ** ** |
| **June 30, 2010**                                         |       |         |       |           |       |
| **Financial Assets**                                                |       |         |       |           |       |
| Cash and due from banks                                             |       | $            | 7,109      |           | $          | 7,109 |   |
| Federal funds sold                                                  |       | 14,965       |       | 14,965         |       |
| Investment securities,  available for sale                          |       | 191,546      |       | 191,546        |       |
| Other investments                                                   |       | 1,599        |       | 1,599          |       |
| Loans, gross                                                        |       | 244,776      |       | 237,464        |       |
|                                                                |       |         |       |           |       |
| **Financial Liabilities**                                           |       |         |       |           |       |
| Demand deposit,  interest-bearing transaction, and savings accounts |       | $            | 104,856    |           | $          | 104,856 |   |
| Certificates of deposit  and other time deposits                    |       | 316,726      |       | 318,690        |       |
| Repurchase agreements                                               |       | 30,000       |       | 32,703         |       |
| Subordinated debt                                                   |       | 4,325        |       | 1,915          |       |
|                                                                |       |         |       |           |       |
| **December 31, 2009**                                          |       |         |       |           |       |
| **Financial Assets**                                                |       |         |       |           |       |
| Cash and due from banks                                             |       | $            | 6,876      |           | $          | 6,876 |   |
| Federal funds sold                                                  |       | 31,043       |       | 31,043         |       |
| Investment securities,  available for sale                          |       | 103,638      |       | 103,638        |       |
| Other investments                                                   |       | 1,599        |       | 1,599          |       |
| Loans, gross                                                        |       | 275,104      |       | 260,894        |       |
|                                                                |       |         |       |           |       |
| **Financial Liabilities**                                           |       |         |       |           |       |
| Demand deposit,  interest-bearing transaction, and savings accounts |       | $            | 122,712    |           | $          | 122,712 |   |
| Certificates of deposit  and other time deposits                    |       | 253,851      |       | 254,930        |       |
| Repurchase agreements                                               |       | 30,000       |       | 31,558         |       |
| Subordinated debt                                                   |       | 4,325        |       | 2,062          |       |

 
| ** **                                    | ** ** | **June 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| **(Dollars in thousands)**                    | ** ** | **Notional  Amount**   | ** ** | **Estimated  Fair Value**  | ** ** | **Notional  Amount** | ** ** | **Estimated  Fair Value** | ** ** |
|                                          |       |                   |       |                       |       |   |   |   |   |
| **Off-Balance Sheet Financial  Instruments:** |       |                   |       |                       |       |   |   |   |   |
|                                          |       |                   |       |                       |       |   |   |   |   |
| Commitments to extend  credit                 |       | $                      | 10,864     |                       | $          | — |   | $ | 15,451 |   | $ | — |   |
| Standby Letters of Credit                     |       | $                      | 1,413      |                       | $          | — |   | $ | 1,525 |   | $ | — |   |

 

GAAP requires new disclosure that establishes a framework for measuringfair value, and expands disclosure about fair value measurements.  This disclosure enables the reader of thefinancial statements to assess the inputs used to develop those measurements byestablishing a hierarchy for ranking the quality and reliability of theinformation used to determine fair values. Assets and liabilities carried at fair value will be classified anddisclosed in one of the following three categories:

 

17

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·                  Level 1: Quoted market prices in active markets for identical assets orliabilities.

 

·                  Level 2: Observable market based inputs or unobservable inputs that arecorroborated by market data.

 

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

 

In determining appropriate levels, the Company performs a detailedanalysis of the assets and liabilities that are subject to fair valuemeasurement.  At each reporting period,all assets and liabilities for which the fair value measurement is based onsignificant unobservable inputs are classified as Level 3.

 

The tables below present the balances of assets and liabilitiesmeasured at fair value on a recurring basis by level within the valuation hierarchy(as described above) as of June 30, 2010.

 
| ** **                                 | ** ** | **June 30, 2010** | ** ** |
|--------------------------------------------|------------|------------------------|------------|
| **(Dollars in thousands)**                 | ** ** | **Total**              | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Investment securities,  available for sale |       | $                      | 191,546    |   | $ | — |   | $ | 191,546 |   | $ | — |   |
|                                            |            |                        |            |  |  |  |  |  |  |  |  |  |  |

 

Certain assets and liabilities are measured at fair value on anonrecurring basis; that is, the instruments are not measured at fair value onan ongoing basis but are subject to fair value adjustments in certaincircumstances (for example, when there is evidence of impairment).  The following tables present the assets andliabilities carried on the balance sheet by caption and by level within thevaluation hierarchy (as described above) as of June 30, 2010 for which anonrecurring change in fair value has been recorded during the six months endedJune 30, 2010.

 
| ** **                                        | ** ** | **Carrying Value at June 30,  2010** | ** ** |
|---------------------------------------------------|------------|-------------------------------------------|------------|
| **(Dollars in thousands)**                        | ** ** | **Total**                                 | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Impaired loans, net of  allowance for loan losses |       | $                                         | 61,758     |   | $ | — |   | $ | — |   | $ | 61,758 |   |
| Other real estate owned                           |       | 8,272                                     |       | — |   | — |   | 8,272 |   |
| Repossessed collateral                            |       | 767                                       |       | — |   | — |   | 767 |   |
|                                                   |            |                                           |            |  |  |  |  |  |  |  |  |  |  |

** **
| ** **                           | ** ** | **Fair Value Measurements Using  Significant Unobservable Inputs** | ** ** |
|--------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                           | ** ** | **(Level 3)**                                                      | ** ** |
| **(Dollars in thousands)** | ** ** | **Impaired  Loans**                                                | ** ** | **Other Real  Estate Owned** | ** ** | **Repossessed  Collateral** | ** ** | **Total** | ** ** |
| Beginning balance                    |       | $                                                                  | 34,158     |   | $ | 6,703 |   | $ | 942 |   | $ | 41,803 |   |
| Gains/(losses) included in  earnings |       | —                                                             |       | (7 | ) | (1 | ) | (8 | ) |
| Net additions                        |       | 27,600                                                             |       | 1,576 |   | (174 | ) | 29,002 |   |
| Transfers in/(out) of  level 3       |       | —                                                             |       | — |   | — |   | — |   |
| Ending balance                       |       | $                                                                  | 61,758     |   | $ | 8,272 |   | $ | 767 |   | $ | 70,797 |   |

 

**NOTE 11 — SUBSEQUENT EVENTS**

 

The Bank has evaluated events and transactions through our filing datefor potential recognition or disclosure in the consolidated financialstatements, and has determined there are no subsequent events to disclose.

 

18

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**Item 2.  Management’s Discussionand Analysis of Financial Condition and Results of Operations.**

 

*Thefollowing discussion reviews our results of operations and assesses ourfinancial condition.  You should read thefollowing discussion and analysis in conjunction with the accompanyingconsolidated financial statements.  Thecommentary should be read in conjunction with the discussion of forward-lookingstatements, the financial statements, and the related notes and the otherstatistical information included in this report.  For further information, refer to Management’sDiscussion and Analysis of Financial Condition and Results of Operationsappearing in our Annual Report on Form 10-K for the year ended December 31,2009.*

 

**DISCUSSIONOF FORWARD-LOOKING STATEMENTS**

 

This Report, including information included or incorporated byreference in this document, contains statements which constituteforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934. Forward-looking statements relate to the financial condition, results ofoperations, plans, objectives, future performance, and business of the Company.Forward-looking statements are based on many assumptions and estimates and arenot guarantees of future performance. Our actual results may differ materiallyfrom those anticipated in any forward-looking statements, as they will dependon many factors about which we are unsure, including many factors which arebeyond our control. The words “may,” “would,” “could,” “should,” “will,” “expect,”“anticipate,” “predict,” “project,” “potential,” “continue,” “assume,” “believe,”“intend,” “plan,” “forecast,” “goal,” and “estimate,” as well as similarexpressions, are meant to identify such forward-looking statements. Potentialrisks and uncertainties that could cause our actual results to differmaterially from those anticipated in our forward-looking statements include,but are not limited to, those described under the heading “Risk Factors” in ourAnnual Report on Form 10-K for the year ended December 31, 2009 asfiled with the SEC and the following:

 
| ·     | our  efforts to raise capital or otherwise increase our regulatory capital ratios;                                                                                                                                                                                                                                                                      |
|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ·     | the  effects of our efforts to raise capital on our balance sheet, liquidity,  capital, and profitability;                                                                                                                                                                                                                                              |
| ·     | our  ability to retain our existing customers, including our deposit  relationships;                                                                                                                                                                                                                                                                    |
| ·     | our  ability to comply with the terms of the enforcement actions between our  Company, Bank, and our regulatory authorities within the time frames  specified;                                                                                                                                                                                          |
| ·     | the  rate of delinquencies and amounts of loans charged-off;                                                                                                                                                                                                                                                                                            |
| **·** | our  ability to maintain sufficient liquidity to repay our brokered deposits as  they become due;                                                                                                                                                                                                                                                       |
| ·     | our  rapid growth through 2008 and short operating history;                                                                                                                                                                                                                                                                                             |
| ·     | reduced  earnings due to higher credit losses generally and specifically because  losses in the sectors of our loan portfolio secured by real estate are  greater than expected due to economic factors, including declining real  estate values, decreasing interest rates, increasing unemployment, or changes  in payment behavior or other factors; |
| ·     | reduced  earnings due to higher credit losses because our loans are concentrated by  loan type, industry segment, borrower type, or location of the borrower or  collateral;                                                                                                                                                                            |
| ·     | the  amount of our real estate based loans, and the weakness in the commercial  real estate market;                                                                                                                                                                                                                                                     |
| ·     | our  reliance on available secondary funding sources such as Federal Reserve  Discount Window borrowings, sales of securities and loans, and secured  federal funds lines of credit from correspondent banks, to meet our liquidity  needs;                                                                                                             |
| ·     | significant  increases in competitive pressure in the banking and financial services  industries;                                                                                                                                                                                                                                                       |
| ·     | changes  in the interest rate environment which could reduce anticipated or actual  margins;                                                                                                                                                                                                                                                            |
| ·     | changes in political conditions or the legislative or regulatory  environment, including the effect of recent financial reform legislation on  the banking industry;                                                                                                                                                                                    |
| ·     | general  economic conditions, either nationally or regionally and especially in our  primary service area, becoming less favorable than expected resulting in,  among other things, a deterioration in credit quality;                                                                                                                                  |
| ·     | changes  occurring in business conditions and inflation;                                                                                                                                                                                                                                                                                                |
| ·     | changes  in technology;                                                                                                                                                                                                                                                                                                                                 |
| ·     | changes  in deposits flows;                                                                                                                                                                                                                                                                                                                             |
| ·     | changes  in monetary and tax policies;                                                                                                                                                                                                                                                                                                                  |
| ·     | the  lack of seasoning of our loan portfolio, especially given our rapid loan  growth through 2008;                                                                                                                                                                                                                                                     |
| ·     | adequacy  of the level of our allowance for loan losses;                                                                                                                                                                                                                                                                                                |
| ·     | increased  funding costs due to market illiquidity, increased competition for funding,  and/or regulatory requirements;                                                                                                                                                                                                                                 |
| ·     | the  effect of final rules amending Regulation E that prohibit financial  institutions from charging consumer fees for paying overdrafts on ATM and  one-time debit card transactions, unless the consumer consents or opts-in to  the overdraft service for those types of transactions;                                                          |
| ·     | adverse  changes in asset quality and resulting credit risk-related losses and  expenses, including the risk of further impairment to the value of our  collateral on loans for which we have already taken specific reserves;                                                                                                                          |
| ·     | loss  of consumer confidence and economic disruptions resulting from terrorist  activities or other military actions;                                                                                                                                                                                                                                   |

 

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| · | changes  in the securities markets; and                                                 |
|--------|-----------------------------------------------------------------------------------------|
| · | other  risks and uncertainties detailed from time to time in our filings with the  SEC. |

 

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

 

These risks are exacerbated by the recent developments in national andinternational financial markets, and we are unable to predict what impact theseuncertain market conditions will have on us. During 2008 and 2009 and thus far in 2010, the capital and creditmarkets continued to experience extended volatility and disruption.  There can be no assurance that theseunprecedented recent developments will not continue to materially and adverselyimpact our business, financial condition, and results of operations, as well asour ability to raise capital or other funding for liquidity and businesspurposes.

 

**Overview**

 

Thefollowing discussion describes our results of operations for the six monthsended June 30, 2010 and also analyzes our financial condition as of June 30,2010.  We received approvals from theFDIC, the FRB, and the South Carolina Board of Financial Institutions duringJanuary 2005, and commenced business on January 18, 2005.

 

The Company is a bank holding company headquartered in Easley, SouthCarolina.  Our subsidiary, the Bank,opened for business on January 18, 2005. All Seasons Properties, LLC, a subsidiary of the Bank, was formed in2009 for the purpose of holding and marketing repossessed assets.  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.  The Bank provides banking services todomestic markets, principally in the Upstate of South Carolina.  The deposits of the Bank are insured by theFDIC.

 

Like most community banks, we derive most of our income from interestwe receive on our loans and investments. Our primary source of funds for making these loans and investments isour deposits, on which we pay interest. Consequently, one of the key measures of our success is our amount ofnet interest income, or the difference between the income on ourinterest-earning assets, such as loans and investments, and the expense on ourinterest-bearing liabilities, such as deposits. Another key measure is the spread between the yield we earn on theseinterest-earning assets and the rate we pay on our interest-bearingliabilities.

 

**Current Economic Environment**

 

Markets in the United States, including our market areas, haveexperienced extreme volatility and disruption for more than the past 24months.  According to the National Bureauof Economic Research, the United States entered into an economic recession inDecember 2007.  Dramatic slowdownsin the residential housing industry with falling home prices, increasingforeclosures, and rising unemployment levels have created strains on the loanportfolios of many financial institutions. Median home sales continued to decline during 2009 and in the first sixmonths of 2010 nationally and in our primary market area, South Carolina.  As a result, the level of foreclosures onhomebuilders and homeowners continued to increase.

 

As a result of the current economic recession, many borrowers areunable to repay their loans, and the collateral securing these loans has, insome cases, declined below the loan balance with the drop in real estatevalues, making it difficult for financial institutions to fully recover theprincipal and interest owed.  Inaddition, the rapidly deteriorating economic conditions in our country haveevolved into a crisis of confidence in the safety and soundness of largerfinancial institutions, brokerage firms, and insurance companies, resulting inextreme liquidity pressure throughout the United States financial system forall financial companies including community financial institutions such asours.  This pressure has caused many banksto tighten lending standards, which has constrained the ability of businessesand consumers to obtain credit.  Anxietyover liquidity and credit risk has grown in recent months and banks have curbedlending to each other, further limiting liquidity sources available tofinancial institutions.

 

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**The Effect of the Current Economic Environment on our Bank**

 

Like many financial institutions across the United States and in SouthCarolina, our operations have been adversely affected by the current economiccrisis.  Beginning in 2008 and continuingthrough the first six months of 2010, we recognized that construction,acquisition, and development real estate projects were slowing, guarantors werebecoming financially stressed, and increasing credit losses weresurfacing.  During the first six monthsof 2010, delinquencies over 90 days continued to increase, resulting in anincrease in non-accrual loans indicating significant credit qualitydeterioration and probable losses.  Inparticular, loans secured by real estate, including acquisition, construction,and development projects, demonstrated stress given reduced cash flows ofindividual borrowers, limited bank financing and credit availability, and slowproperty sales.  This deteriorationmanifested itself in our borrowers in the following ways: (i) the cashflows from underlying properties supporting the loans decreased (e.g., slowerproperty sales for development type projects or lower occupancy rates or rentalrates for operating properties); (ii) cash flows from the borrowersthemselves and guarantors were under pressure given illiquid personal balancesheets and drainage by investing additional personal capital in the projects;and (iii) fair values of real estate related assets declined, resulting inlower cash proceeds from sales or fair values declining to the point thatborrowers were no longer willing to sell the assets at such deep discounts.

 

As of June 30, 2010, approximately 91.1% of our loans had real estateas a primary or secondary component of collateral. The Bank had approximately90.3% of such loans at December 31, 2009. Included in our loans secured by real estate, we have approximately$31.7 million of acquisition and development (“A&D”) loans as of June 30,2010, most of which are on properties located in the Upstate of South Carolinaand Western North Carolina.  A&D loans are typically comprised ofloans to borrowers for real estate to be developed (into properties such assub-divisions or spec houses).  Normally, these loans are repaid with the proceeds from the sale of thedeveloped property.  The greater degree of strain on these types of loansand the significance to our overall loan portfolio has caused us to apply agreater degree of scrutiny in analyzing the ultimate collectability of amountsdue.  The majority of these borrowers are having financialdifficulties.  Our analysis has resultedin a significant provision expense in order to meet the estimated allowance forloan loss reserve requirement.

 

Included in our loans secured by real estate, we have approximately$35.7 million of acreage and finished or buildable lot loans as of June 30,2010.  The Bank had approximately $40.6million of such loans at December 31, 2009. These loans are comprised ofloans to borrowers for raw land and lots in subdivisions that have utilitiesand are ready to be built on individually but not as part of an entiredevelopment project.  These loans aregenerally repaid with the proceeds from the sale of the property.  As with our A&D loans, many of theseborrowers are also experiencing financial difficulties and the greater degreeof strain on these types of loans and the significance to our overall loanportfolio has caused us to apply a greater degree of scrutiny in analyzing theultimate collectability of amounts due. Our analysis has resulted in a significant provision expense in order tomeet the estimated allowance for loan loss reserve requirement.

 

The result of the above has been an increase in the level of ournon-performing assets over the past two years, although the amount of theincrease slowed during the first six months of 2010.  As of June 30, 2010, our non-performingassets equaled $43.9 million, or 9.5% of assets, as compared to $42.4 million,or 10.1% of assets, as of December 31, 2009.  For the six months ended June 30, 2010,we recorded a provision for loan losses of $2 million and net loan charge-offsof $3.4 million, or 1.3% of average loans, as compared to a $2.8 millionprovision for loan losses and net loan losses of $1.2 million, for the sixmonths ended June 30, 2009.  Inaddition, our net interest margin decreased to 1.61% for the six months ended June 30,2010 from 2.96% for the six months ended June 30, 2009.  In total, the above reduced our earnings forthe six months ended June 30, 2010 by $3.5 million compared to the sameperiod in 2009.  As a result, as of June 30,2010, we are deemed to be “significantly undercapitalized.”

 

The adverse economic environment has also placed greater pressure onour deposits, as we have been taking steps to decrease our reliance on brokereddeposits, while at the same time the competition for local deposits among banksin our market has been increasing in the past years.  Prior to the third quarter of 2009, wegenerally obtained out-of-market time deposits of $100,000 or more throughbrokers with whom we maintain ongoing relationships.  As of June 30, 2010, we had brokereddeposits of $174.6 million, representing 41.41% of our total deposits, of which$79.7 million are scheduled to mature in the third quarter of 2010 and $94.9million are scheduled to mature in the fourth quarter of 2010.  As a result of the limitations on brokereddeposits imposed by the Consent Order and our “significantly undercapitalized”designation, we must find other sources of liquidity to replace these depositsas they mature.  At the end of the fourthquarter of 2009, the Bank started using an internet based certificate ofdeposit gathering service.  This producthas provided a source of funds to replace our brokered deposits.  The Bank’s internet based deposits haveincreased from $1.8 million at December 31, 2009 to $70.0 million as of June 30,2010.  Secondary sources of liquidity mayinclude proceeds from FHLB advances and federal funds lines of credit fromcorrespondent banks.  However, the FHLBhas informed us that due to our financial condition we are not currentlypermitted to receive any more advances. At June 30, 2010, we had federal funds lines of credit with unrelatedbanks totaling $5.0 

 

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million.  These lines areavailable for general corporate purposes but may be terminated at any timebased on our financial condition.  Thus,we can make no assurances that this funding source will continue to beavailable to us.  As a result, we mustlimit our growth, raise additional capital, or sell assets, which couldmaterially and adversely affect our financial condition and results ofoperations.  Additionally, deposit levelsmay be affected by a number of factors, including rates paid by competitors,general interest rate levels, regulatory capital requirements, returnsavailable to customers on alternative investments and general economicconditions.  Because the Bank is not wellcapitalized, it would normally be restricted from offering an effective yieldon deposits of more than 75 basis points over the national rates published bythe FDIC weekly on its website.  However,on April 1, 2010, we applied for and received a determination from theFDIC that our market areas were all high interest rate areas.  As a result, we have permission to paydeposit rates of up to 75 basis points over the local rates (assuming the localrates exceed the applicable non-local rates) and on non-local deposits gatheredin our normal market area even if these rates exceed non-local rates by morethan 75 basis points.  Nevertheless, ifwe are unable to attract sufficient deposits to meet our liquidity needs, thenthe Bank may be placed into a federal conservatorship or receivership by theFDIC, with the FDIC appointed as conservator or receiver.

 

***Memorandum of Understanding***

 

As a result of the issues stemming from the economic downturn, on June 29,2009 the Bank entered into the MOU with the Commissioner of Banking of theSouth Carolina Board of Financial Institutions and the Regional Director of theFDIC’s Atlanta Regional Office.  The MOUrequired the Bank to, among other things, (1) submit a capital plan to thesupervisory authorities for returning to a “well-capitalized” designation; (2) developspecific plans and proposals for the reduction and improvement of assets whichare subject to adverse classification and past due loans; (3) implement aplan to decrease the concentration of commercial real estate loans; (4) developand implement an adequate loan review program; and (5) review overallliquidity objectives and develop plans and procedures aimed at improvingliquidity and reducing reliance on volatile liabilities to fund longer-termassets.  In addition, the Bank may notpay dividends without the prior written consent of each supervisory authority.

 

In addition, in mid-February 2010 the Bank received a supervisoryletter from the FDIC dated February 11, 2010, which provided foradditional restrictions and mandatory actions to be taken by the Bank.  These restrictions and actions were allsubstantially addressed and superseded by the subsequent Consent Orderdiscussed in the subsection below. However, in order to comply with the supervisory letter, the Bank wasrequired to prepare and submit to the FDIC a capital restoration plan no laterthan April 2, 2010, which submission date was sooner than a similarrequirement under the Consent Order.  TheBank submitted its capital restoration plan to the FDIC on April 2, 2010.As discussed above, the plan was rejected due to the Bank’s inability to meetthe June 23, 2010 deadline to achieve and maintain a “well-capitalized”designation.  The Bank submitted arevised capital plan to the FDIC on July 28, 2010.

 

***Consent Order***

 

Following the FDIC’s safety and soundness examination of the Bank inthe fourth quarter of 2009, the Bank entered into the Consent Order with theFDIC and the South Carolina Board of Financial Institutions onFebruary 23, 2010.  The ConsentOrder, which supersedes the MOU, conveys specific actions needed to addresscertain findings from the FDIC’s Report of Examination and to address theBank’s current financial condition, primarily related to capital planning,liquidity/funds management, policy and planning issues, management oversight,loan concentrations and classifications, and non-performing loans.  A summary of the requirements of the ConsentOrder and the Bank’s status on complying with the Consent Order is as follows:

 

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| **Requirements of the Consent Order**                                                                                                                                                                                  | ** ** | **Bank’s  Compliance Status**                                                                                                                                                                                                                                                                                                                                                                                            |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                                                             | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                    |
| Establish, within 30 days from the effective date of the Consent  Order, a plan to monitor compliance with the Consent Order, which shall be  monitored by the Bank’s board of directors.                         |       | A plan to monitor compliance with the Consent Order was established  by the Bank’s board of directors at a meeting held on March 16, 2010.  Pursuant to the plan, the board created and appointed four of its members to  serve on a consent order compliance committee to monitor the Bank’s  compliance with the Consent Order. The committee has met four times since its  creation on March 16, 2010. |
|                                                                                                                                                                                                                   |       |                                                                                                                                                                                                                                                                                                                                                                                                                          |
| Ensure the Bank has qualified management in  place to carry out the policies of the Bank’s board of directors and operate  the Bank in a safe and sound manner.                                                   |       | A management plan, which includes  organizational structure and management assessment, was approved by the  Bank’s board of directors and submitted to the supervisory authorities on  April 12, 2010. The Bank has also taken steps to implement this  management plan.                                                                                                                                            |
|                                                                                                                                                                                                                   |       |                                                                                                                                                                                                                                                                                                                                                                                                                          |
| Achieve and maintain, within 120 days from  the effective date of the Consent Order, Total Risk Based capital at least  equal to 10% of risk-weighted assets and Tier 1 capital at least equal to 8%  of total assets. |       | The Bank did not meet this deadline. The  Bank submitted a revised written plan to the FDIC on July 28, 2010  describing the means and timing by which the Bank will seek to increase such  ratios up to or in excess of the established minimums.                                                                                                                                                                       |

 

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| Develop, within 45 days from the effective  date of the Consent Order, a written analysis and assessment of the Bank’s  management and staffing needs.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |   | The Bank prepared a written analysis and  assessment of its management and staffing needs and submitted this analysis  to the supervisory authorities on April 12, 2010.                                                                                                                                                                                                   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |   |                                                                                                                                                                                                                                                                                                                                                                            |
| Establish, within 60 days from the  effective date of the Consent Order, a comprehensive policy for determining  the adequacy of the Bank’s allowance for loan and lease losses, which must  provide for a review of the Bank’s allowance for loan and lease losses at  least once each calendar quarter.                                                                                                                                                                                                                                                                                                                                       |   | The Bank’s board of directors and consent  order compliance committee reviewed and approved a comprehensive policy for  determining the adequacy of the Bank’s allowance for loan and lease losses,  and this policy was submitted to the supervisory authorities prior to the  April 27, 2010 deadline.                                                         |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |   |                                                                                                                                                                                                                                                                                                                                                                            |
| Enhance, within 60 days from the effective  date of the Consent Order, the Bank’s written plan for the reduction of  classified assets, which shall include, among other things, a reduction of  the Bank’s risk position in each asset in excess of $250,000 that is  classified as “Substandard” or “Doubtful.”                                                                                                                                                                                                                                                                                                           |   | A plan to reduce the Bank’s classified  assets was reviewed and approved by the Bank’s board of directors and consent  order compliance committee on April 20, 2010. The plan was submitted to  the supervisory authorities on the April 27, 2010 deadline.                                                                                                 |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |   |                                                                                                                                                                                                                                                                                                                                                                            |
| Not extend any additional credit to any  borrower who has a loan or other extension of credit from the Bank that has  been charged off or classified, in whole or in part, “loss” or “doubtful” and  is uncollected. In addition, the Bank may not extend any additional credit to  any borrower who has a loan or other extension of credit from the Bank that  has been classified, in whole or in part, “substandard” and is uncollected,  unless the Bank’s board of directors determines that failure to extend  further credit to a particular borrower would be detrimental to the best  interests of the Bank. |   | The Bank has not knowingly extended,  directly or indirectly, any additional credit to, or for the benefit of, any  borrower who was a loan or other extension of credit from the Bank that has  been charged off or classified, in whole or in part, “loss” or “doubtful” and  is uncollected.                                                             |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |   |                                                                                                                                                                                                                                                                                                                                                                            |
| Perform, within 45 days from the effective  date of the Consent Order, a risk segmentation analysis with respect to the  Bank’s Concentrations of Credit and a written plan to systematically reduce  any segment of the portfolio that is an undue concentration of credit.                                                                                                                                                                                                                                                                                                                                                                         |   | The Bank performed a risk segmentation  analysis with respect to its concentrations of credit, and this analysis was  reviewed and approved by the consent order compliance committee on  April 6, 2010 and by the Bank’s board of directors on April 8,  2010. This analysis was submitted to the supervisory authorities by the  April 12, 2010 deadline. |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |   |                                                                                                                                                                                                                                                                                                                                                                            |
| Revise, within 60 days from the effective  date of the Consent Order, the Bank’s internal loan review and grading system  to provide for the periodic review of the Bank’s loan portfolio in order to  identify and categorize the Bank’s loans, and other extensions of credit which  are carried on the Bank’s books as loans, on the basis of credit quality.                                                                                                                                                                                                                                                                      |   | The Bank revised and updated its internal  loan review plan, which was reviewed and approved by the Bank’s board of  directors and the consent order compliance committee on April 20, 2010.  The plan was submitted to the supervisory authorities prior to the  April 27, 2010 deadline.                                                                       |

 

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| Formulate and implement, within 60 days from the effective date of  the Consent Order, a profit plan and comprehensive budget for all categories  of income and expense, which must address, at minimum, goals and strategies  for improving and sustaining the earnings of the Bank, the major areas in and  means by which the Bank will seek to improve the Bank’s operating  performance, and the operating assumptions that form the basis for and  adequately support major projected income and expense components of the plan. |   | The Bank created profit plan and budget for all categories of income  and expense, which includes adjustments where the Bank either exceeded budget  or had budget shortfalls in order to provide realistic projections going  forward. The profit plan and budget were reviewed and approved by the Bank’s  board of directors on April 20, 2010 and were submitted to the  supervisory authorities prior to the April 27, 2010 deadline. |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| Enhance, within 60 days from the effective date of the Consent Order,  the Bank’s written funds management plan addressing liquidity, contingent  funding, and asset liability management.                                                                                                                                                                                                                                                                                                                                             |   | The Bank’s funds management plan, which addresses liquidity,  contingent funding, and asset liability management, was reviewed and approved  by the Bank’s board of directors and the consent order compliance committee  on April 20, 2010 and was submitted to the supervisory authorities prior  to the April 27, 2010 deadline.                                                                                                   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| Not accept, renew, or rollover any brokered deposits. The Bank must  develop and submit to the FDIC, within 30 days from the effective date of the  Consent Order, a plan for eliminating its reliance on brokered deposits.                                                                                                                                                                                                                                                                                                                |   | A plan was approved by the Bank’s board of directors and consent  order compliance committee on March 24, 2010 and was submitted to the  FDIC on March 25, 2010. Since entering into the Consent Order, the Bank  has not accepted, renewed, or rolled-over any brokered deposits and has  repaid $28.2 million during 2010.                                                                                                               |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| Not offer an effective yield in excess of 75 basis points over  interest paid on deposits (including brokered deposits, if approval is  granted for the Bank to accept them) of comparable size and maturity in  either the Bank’s normal market area or in the market area in which such  deposits would otherwise be accepted.                                                                                                                                                                                                       |   | On April 1, 2010, we applied for and received a determination  from the FDIC that our market areas were all high interest rate areas. As a  result, we have permission to pay deposit rates of up to 75 basis points over  the local rates (assuming the local rates exceed the applicable non-local  rates) and on non-local deposits gathered in our normal market area even if  these rates exceed non-local rates by more than 75 basis points.  |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| Not declare or pay any dividends or bonuses  or make any distributions of interest, principal, or other sums on  subordinated debentures without the prior approval of the supervisory  authorities.                                                                                                                                                                                                                                                                                                                                        |   | Since entering into the Consent Order, the  Bank has not declared or paid any dividends or bonuses or made any  distributions of interest, principal, or other sums on subordinated  debentures.                                                                                                                                                                                                                                                          |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| Furnish, within 45 days from the effective  date of the Consent Order and within 45 days of the end of each quarter  thereafter, written progress reports to the supervisory authorities detailing  the form and manner of any actions taken to secure compliance with the  Consent Order. The Bank has furnished written progress reports to the  supervisory authorities as required by the Consent Order.                                                                                                                                |   | The Bank has furnished written progress  reports to the supervisory authorities as required by the Consent Order.                                                                                                                                                                                                                                                                                                                                         |

 

Since entering into the MOU and continuing after entering into theConsent Order, the Bank has been actively pursuing the corrective actionsrequired first by the MOU and then by Consent Order in an effort to ensure thatthe requirements of these regulatory actions are met in a timely manner.  For example:

 

·                  As of June 30, 2010, we are deemed to be“significantly undercapitalized.”  Asdescribed above, we did not meet the Consent Order deadline to achieve andmaintain a “well-capitalized” designation, therefore, we submitted a revisedcapital plan to the FDIC and the South Carolina Board of Financial Institutionson July 28,  2010.  Our capital plan outlines how we will seek toreturn our Bank’s risk-based capital ratio level over 10% by (i) reducingour overall amount of assets and, in particular, our amount of risk-basedassets and (ii) raising additional capital.  To reduce our amount of assets, we have soldassets such as our bank-owned life insurance and some of our available for salesecurities.  In addition, we are activelyseeking buyers for part of our loan portfolio. As a result of these steps, we decreased our amount of risk-based assetsby $45.9 million from December 31, 2009 to June 30, 2010.  We are also exploring additional financingalternatives to strengthen the capital levels of the Bank. However, there canbe no assurances that the Company will be successful in its efforts to raiseadditional capital.

 

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

 

·                  We have implemented a plan to decrease theconcentration of our commercial real estate loans.  Since January 2009, we have effectivelyceased making any new commercial real estate loans and we are decreasing theexisting level of these loans through the normal sale of real estate byborrowers and by encouraging borrowers who are not full relationship clients ofthe Bank to seek other financing when their loans mature.  We are also actively seeking secondary marketpermanent financing for recently completed residential constructionprojects.  As a result of these efforts,our amount of commercial real estate loans decreased from $151.6 million atDecember 31, 2008 to $106.4 million at June 30, 2010.

 

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

 

·                  On September 10, 2009, we submitted tothe FDIC and the South Carolina Board of Financial Institutions a revised FundsManagement Policy to reflect our plan to continue to improve liquidity levelsand reduce our reliance on brokered deposits and other non-core funding sourcesover the next 18 months.  We grew rapidlyin our initial years of operations, which we funded with a combination of localdeposits and wholesale funding, including brokered deposits.  As of June 30, 2010, we are deemed to be“significantly undercapitalized” and, as a result, can no longer accept, renewor roll over brokered deposits.  Thus, weare actively focused on eliminating brokered deposits on our balancesheet.  We improved the Bank’s liquidityposition by raising approximately $45.0 million in new deposits, net of a $28.2million decrease in brokered deposits, through the use of an internet baseddeposit gathering system along with growth of local deposits from December 31,2009 to June 30, 2010.

 

Additionally, on March 1, 2010, the Company entered into aninformal agreement with the Federal Reserve Bank of Richmond.  The informal agreement contains provisionssimilar to those in the Bank’s MOU with the FDIC and the South Carolina Boardof Financial Institutions, including a requirement that the Company obtain theprior written approval of the Federal Reserve Bank of Richmond before (1) declaringor paying any dividends, (2) directly or indirectly accepting dividends orany other form of payment representing a reduction in capital from the Bank, (3) makingany distributions of interest, principal or other sums on subordinateddebentures or trust preferred securities, (4) directly or indirectly,incurring, increasing or guaranteeing any debt, and (5) directly orindirectly, purchasing or redeeming any shares of its stock.  Pursuant to our plans to preserve capital andto inject more capital into the Bank, the Company has no plans to undertake anyof the foregoing activities.

 

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** **

***Going Concern Considerations***

 

Due to the conditions and events discussedin this Form 10-Q, substantial doubt exists as to our ability to continueas a going concern.  We have determinedthat significant additional sources of capital will be required for us tocontinue operations through 2010 and beyond. We also continue to monitor andaddress liquidity issues. As of June 30, 2010, we are deemed to be“significantly undercapitalized.”  Asdescribed above, we did not meet the Consent Order deadline to achieve andmaintain a “well-capitalized” designation, and therefore we submitted a revisedcapital plan to the FDIC and the South Carolina Board of Financial Institutionson July 28,  2010.

 

We have engaged financial advisors to assistthe Company in its efforts to raise additional capital, sell assets, andexplore other strategic alternatives to address our current and expectedliquidity and capital deficiencies.  Todate, those efforts have not yielded any significant results.  As a result of our financial condition, ourregulators are continually monitoring our liquidity and capital adequacy.  In addition, our regulators have variousenforcement tools available to them, including the issuance of capitaldirectives, orders to cease engaging in certain business activities, theissuance of modified or additional orders or agreements, and the authority toclose the Bank.

 

Notwithstanding the above, accompanyingconsolidated financial statements have been prepared on a going concern basis,which contemplates the realization of assets and the discharge of liabilitiesin the normal course of business for the foreseeable future, and do not includeany adjustments to reflect the possible future effects on the recoverabilityand classification of assets, or the amounts and classification of liabilitiesthat may result should we be unable to continue as a going concern.

 

The Bank’s financial condition has suffered during 2009 and the firstsix months of 2010 from the extraordinary effects of what may ultimately be theworst economic downturn since the Great Depression. The effects of the currenteconomic environment are being felt across many industries, with financialservices and residential real estate being particularly hard hit. The effectsof the economic downturn have been particularly severe during the lastyear.  The Bank, with a loan portfolioconsisting of a concentration in commercial real estate loans includingresidential construction and development loans, has seen a decline in the valueof the collateral securing its portfolio as well as rapid deterioration in itsborrowers’ cash flow and ability to repay their outstanding loans to the Bank.As a result, the Bank’s level of nonperforming assets increased substantiallyduring 2009 and has continued to increase through the second quarter of 2010.As of June 30, 2010, our non-performing assets equaled $43.9 million, or9.5% of assets, as compared to $42.4 million, or 10.1% of assets, as ofDecember 31, 2009. In addition, our level of impaired loans increased to$68.1 million at June 30, 2010 compared to $34.2 million at December 31,2009. For the year ended December 31, 2009 and for the six months endedJune 30, 2010, the Bank recorded a $17 million and a $2 million provision,respectively, to increase the allowance for loan losses to a level which, inmanagement’s best judgment, adequately reflected the increased risk inherent inthe loan portfolio as of the year and quarter end periods, respectively.  Nevertheless, given the current economicclimate, we recognize the possibility of further deterioration in the loanportfolio in the second half of 2010. For the six months ended June 30, 2010, we recorded net loancharge-offs of $3.4 million, or 1.3% of average loans, as compared to net loancharge-offs of $1.2 million, for the six months ended June 30, 2009.

 

The Company and the Bank operate in a highlyregulated industry and must plan for the liquidity needs of each entityseparately. A variety of sources of liquidity are available to the Bank to meetits short-term and long-term funding needs. Although a number of these sourceshave been limited following execution of the Consent Order with the FDIC andthe South Carolina Board of Financial Institutions, management has preparedforecasts of these sources of funds and the Bank’s projected uses of fundsduring 2010 in an effort to ensure that the sources available are sufficient tomeet the Bank’s projected liquidity needs for this period.

 

The Company relies on dividends from theBank as its primary source of liquidity. The Company is a legal entity separateand distinct from the Bank. Various legal limitations restrict the Bank fromlending or otherwise supplying funds to the Company to meet its obligations,including paying dividends. In addition, the terms of the Consent Orderdescribed above and in greater detail under “Management’s Discussion andAnalysis of Financial Condition and Results of Operations — The Effect of theCurrent Economic Environment on our Bank — Consent Order” will further limitthe Bank’s ability to pay dividends to the Company to satisfy its fundingneeds.

 

The Company will also need to raiseadditional capital to increase capital levels to meet the standards set forthby the FDIC as  described in greaterdetail under “Management’s Discussion and Analysis of Financial Condition andResults of Operations — The Effect of the Current Economic Environment on ourBank — Consent Order”. As a result of the recent downturn in the financialmarkets, the availability of many sources of capital (principally to financialservices companies) has become significantly restricted or has becomeincreasingly costly as compared to the prevailing market rates prior to thevolatility. Management cannot predict when or if the capital markets willreturn to more favorable conditions or whether the Company will be able toraise a sufficient amount of capital to continue operations. Management isactively evaluating a number of capital sources, asset reductions and otherbalance sheet management strategies in an effort to ensure that the Bank’sprojected level of regulatory capital can support its balance sheet.

 

There can be no assurances that the Companywill be successful in its efforts to raise additional capital. An equityfinancing transaction would result in substantial dilution to the Company’scurrent shareholders and could adversely affect the market price of theCompany’s common stock. It is difficult to predict if these efforts will besuccessful, either on a short-term or long-term basis. Should these efforts beunsuccessful, due to the regulatory restrictions which exist that restrict cashpayments between the Bank and the Company, the Company may be unable to realizeits assets and discharge its liabilities in the normal course of business.

 

As a result of management’s assessment ofthe Company’s ability to continue as a going concern, the accompanyingconsolidated financial statements for the Company have been prepared on a goingconcern basis, which contemplates the realization of assets and the discharge ofliabilities in the normal course of business for the foreseeable future, anddoes not include any adjustments to reflect the possible future effects on therecoverability or classification of assets.

 

**Current Business Strategy**

 

In addition to the actions required by the MOU, we have been activelypursuing the corrective actions required by the Consent Order in an effort toensure that the requirements of the Consent Order are met in a timelymanner.  Specifically, we are currentlyfocusing our efforts in the following areas:

 

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·                  **Increasingand Strengthening Our Capital Position.**

As of June 30, 2010,the Bank is deemed to be “significantly undercapitalized.”  Management has developed a plan to increase andpreserve our capital with the goal of returning to and maintaining a “well-capitalized”status. These initiatives include, among other things, restructuring the Bank’sbalance sheet by limiting new loan activity and aggressively attempting to sellcertain real estate-related loans and other assets, and raising additionalcapital through a stock offering. Additionally, we are actively evaluating a number of capital sources andbalance sheet management strategies to ensure that our projected level of regulatorycapital can support our balance sheet and meet or exceed minimum requirements.

 

·                  **Managingand Improving Asset Quality.**

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

 

·                  In February of2009, we restructured the credit administration and loan operations departmentsand hired a skilled chief credit officer to oversee the enhancement of ourprocesses and procedures in this area.

 

·                  In June of2009, we established an improving problem asset committee to assist Bankmanagement in policy development, management strategy, and/or liquidation ofproblem assets. We are currently proactively seeking avenues to sell bank-ownedproperties and problem assets to outside investors.

 

·                  In January of2009, we implemented a process for the continuous review of all classifiedloans, watch loans, past due loans, relationships over $500,000, and any otherpotential risky loans and applied conservative risk grades.

 

·                  Throughout 2009and 2010, we conducted disciplined watch loan meetings to track and monitorprogress, including the execution of workout plans, obtainment of currentfinancial data, and detailed progress updates.

 

·                  Throughout 2009and through June 30, 2010, we maintained what we believe is an adequate reservefor loan losses given the risk profile of our Bank.

 

·                  In May of2009, we implemented a risk-focused internal and external loan review program.

 

·                  During thefirst six months of 2010, we updated our policies and procedures and enhancedstaffing related to loan work-outs and collection processes.

 

·                  **DecreasingConcentrations in Our Loan Portfolio.**

We are focused on reducingour concentrations in commercial real estate (CRE), specifically acquisitiondevelopment and construction loans, and residential construction loans.  Since January 2009, we have effectivelyceased making any new CRE loans while proactively decreasing the level of theseexisting loan types.  We have worked todecrease our concentration by various means, including (1) through thenormal sale of real estate by borrowers, (2) by seeking avenues to sell aportion of the CRE portfolio to outside investors, (3) by proactivelyseeking secondary market permanent financing for recently completed residentialconstruction projects, and (4) by encouraging transactional CRE customersto seek other financing when their loans mature.  As a result of these efforts, our amount ofCRE loans decreased 29.8% from $151.6 million of our total loan portfolio at December 31,2008 to $106.4 million of our loan portfolio at June 30, 2010.  We have also reduced our residentialconstruction portfolio 96.4% from $33.8 million at December 31, 2008 to$1.2 million at June 30, 2010.  Weexpect commercial real estate loan portfolio balances to continue to decreasein 2010 through the continued successful implementation of the plans outlinedabove.

 

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·                  **ReducingOperating Expenses.**

We have always focused oncontrolling expenses and managing efficient overhead.  During 2010, management intends to furtherreduce costs in a manner which does not impact the quality of our customerservice.  Given the prolonged economicrecession, we have embarked on an extremely aggressive expense reductioncampaign.  Management has already reducedsalary and benefits expenses by reducing staffing levels, freezing salaries at2008 levels, and reducing compensation in several positions.  Additionally, we will continue to seek torenegotiate vendor contracts and implement several other cost-saving measuresto reduce noninterest expenses.  Reducing our level of nonperformingassets will also lower our operating costs.

 

·                  **EnhancingFunds Management and Liquidity.**

We grew rapidly from ourinception through 2008, and have historically funded our asset growth with acombination of local deposits and wholesale funding, specifically brokereddeposits. As of June 30, 2010, we had brokered deposits of $174.6 million,representing 41.41% of our total deposits, of which $79.7 million are scheduledto mature in the third quarter of 2010 and $94.9 million are scheduled tomature in the fourth quarter of 2010.  Because of the limitations onbrokered deposits imposed by the Consent Order and our significantlyundercapitalized status, the Bank may no longer accept, renew, or roll overbrokered deposits.  Thus, we must findother sources of liquidity to replace these deposits as they mature. We haveamended our funds management policy to reflect our plan to continue to improveliquidity levels and reduce our use of brokered deposits and other non-corefunding sources. Our funds management policy also includes our plan to reduceassets, certain loans, and other bank-owned real estate. We plan to reduce ourbrokered deposit usage by executing on our comprehensive deposit acquisitionprogram, which creates an environment of consistent deposit growth based onrelationship-based banking, advocate-based selling and an aggressive, focusedcalling program combined with offering internet based certificates of deposit.Our experienced team of bankers is actively cross-selling core deposits to ourlocal depositors and borrowers, and is held accountable for production throughtwice-weekly sales meetings. Production is enhanced by our relationship-basedculture training, which includes advanced customer service techniques andone-on-one coaching. We also plan to generate core deposits through acombination of competitive products and pricing, customer service excellence,and targeted marketing campaigns

 

·                  **EnhancingOur Bank’s Relationship Culture.**

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

 

·                  implementingconsistent customer service and communication standards in all areas of theBank;

 

·                  training andcertifying the non-negotiables of relationship banking to all employees;

 

·                  ensuring allemployees are engaged and motivated while enabling management to measure theenhancement of the culture by conducting quarterly employee engagement surveys;

 

·                  implementingconsistent management standards for all supervisors resulting in internal andexternal advocacy;

 

·                  refining theBank’s customer experience measurements, including branch mystery shopping andcustomer survey programs; and ensuring all programs evaluate and measure theBank’s expectations and areas of focus.

 

The Bank will continue to serve customers in all areas, includingprocessing banking transactions, paying competitive rates on deposits, andproviding access to lines of credit.  Allcustomer deposits are fully insured to the highest limits set by the FDIC,which are $250,000 for individually titled accounts and $250,000 forindividually titled IRA accounts. In addition, the Bank participates in theFDIC Transaction Account Guarantee Program (the “TAGP”). Under this program,all non-interest bearing transaction accounts are fully guaranteed by the FDICfor the entire amount of the account. The guarantee also applies to interestbearing transaction accounts with interest rates of 0.25% or less. On April 13,2010, the FDIC approved an interim 

 

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rule that extends the TAGP to December 31, 2010. We haveelected to continue our voluntary participation in the program.  This program is in addition to and separatefrom the coverage available under the FDIC general deposit insurancerules.  We believe participation in theprogram is enhancing our ability to retain customer deposits.

 

However, should the Bank fail to comply with the capital and liquidityfunding requirements in the Consent Order, or suffer a continued deteriorationin our financial condition, the Bank may be subject to being placed into afederal conservatorship or receivership by the FDIC, with the FDIC appointed asconservator or receiver.

 

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

 

Marketsin the United States and elsewhere have experienced extreme volatility anddisruption for more than 24 months. These circumstances have exerted significant downward pressure on pricesof equity securities and virtually all other asset classes, and have resultedin substantially increased market volatility, severely constrained credit andcapital markets, particularly for financial institutions, and an overall lossof investor confidence.  Loan portfolioperformances have deteriorated at many institutions resulting from, among otherfactors, a weak economy and a decline in the value of the collateral supportingtheir loans.  Dramatic slowdowns in thehousing industry, due in part to falling home prices and increasingforeclosures and unemployment, have created strains on financialinstitutions.  Many borrowers are nowunable to repay their loans, and the collateral securing these loans has, insome cases, declined below the loan balance.  In response to the challenges facing the financial services sector,several regulatory and governmental actions have recently been announcedincluding:

 

·                  The Emergency EconomicStabilization Act, approved by Congress and signed by President Bush on October 3,2008, which, among other provisions, allowed the U.S. Treasury to purchasetroubled assets from banks, authorized the SEC to suspend the application ofmarked-to-market accounting, and raised the basic limit of FDIC depositinsurance from $100,000 to $250,000 through December 31, 2013.

 

·                  On October 7, 2008, theFDIC approved a plan to increase the rates banks pay for deposit insurance.

 

·                  On October 14, 2008,the U.S. Treasury announced the creation of a new program, the Capital PurchaseProgram, that encourages and allows financial institutions to build capitalthrough the sale of senior preferred shares to the U.S. Treasury on terms thatare non-negotiable.

 

·                  On October 14, 2008,the FDIC announced the creation of the Temporary Liquidity Guarantee Program (“TLGP”),which seeks to strengthen confidence and encourage liquidity in the bankingsystem.  The TLGP has two primarycomponents that are available on a voluntary basis to financial institutions:

 

·                                      Guarantee of newly-issuedsenior unsecured debt; the guarantee would apply to new debt issued on orbefore October 31, 2009 and would provide protection until December 31,2012; issuers electing to participate would pay a 75 basis point fee for theguarantee; and

 

·                                      Unlimited deposit insurancefor non-interest bearing deposit transaction accounts; financial institutionselecting to participate will pay a 10 basis point premium in addition to theinsurance premiums paid for standard deposit insurance.

 

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

 

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

 

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

 

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

 

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institutions;and

 

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

 

·                  On February 17, 2009, the AmericanRecovery and Reinvestment Act (the “Recovery Act”) was signed into law in aneffort to, among other things, create jobs and stimulate growth in the UnitedStates economy.  The Recovery Actspecifies appropriations of approximately $787 billion for a wide range ofFederal programs and will increase or extend certain benefits payable under theMedicaid, unemployment compensation, and nutrition assistance programs.  The Recovery Act also reduces individual andcorporate income tax collections and makes a variety of other changes to taxlaws.  The Recovery Act also imposescertain limitations on compensation paid by participants in the U.S. Treasury’sTroubled Asset Relief Program (“TARP”).

 

·                  On March 23,2009, the U.S. Treasury, in conjunction with the FDIC and the Federal Reserve,announced the Public-Private Partnership Investment Program for Legacy Assetswhich consists of two separate plans, addressing two distinct asset groups:

 

·                  The first planis the Legacy Loan Program, which has a primary purpose to facilitate the saleof troubled mortgage loans by eligible institutions, including FDIC-insuredfederal or state banks and savings associations. Eligible assets are notstrictly limited to loans; however, what constitutes an eligible asset will bedetermined by participating banks, their primary regulators, the FDIC and theTreasury.

 

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

 

·                  On May 22, 2009, the FDIC levied aone-time special assessment on all banks due on September 30, 2009.

 

·                  On November 12, 2009, the FDIC issued afinal rule to require banks to prepay their estimated quarterly risk-basedassessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012and to increase assessment rates effective on January 1, 2011.

 

·                  On February 2, 2010, the U.S. Presidentcalled on the U.S. Congress to create a new Small Business Lending Fund.  Under this proposal, $30 billion in TARPfunds would be transferred to a new program outside of TARP to support smallbusiness lending.  As proposed, onlysmall- and medium-sized banks would qualify to participate in the program.

 

·                  On July 21, 2010, the U.S. Presidentsigned into a law the Dodd-Frank Wall Street Reform and Consumer Protection Actof 2010, a comprehensive regulatory framework that will affect every financialinstitution in the U.S.  U.S. financialregulators will begin the rulemaking process over the next 6 to 18 months whichwill set the parameters of the new regulatory framework and provide a clearerunderstanding of the legislation’s effect on banks.

 

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It is likely that further regulatory actions may arise as the Federalgovernment continues to attempt to address the economic situation.

 

We are participating in the TAGP component of the TLGP.  As a result of the enhancements to depositinsurance protection and the expectation that there will be demands on the FDIC’sdeposit insurance fund, our deposit insurance costs have increased and willcontinue to increase significantly throughout the remainder of 2010.  We have elected not to participate in theCPP.  Regardless of our lack ofparticipation, governmental intervention and new regulations under theseprograms could materially and adversely affect our business, financialcondition and results of operations.  Thefollowing discussion and analysis describes our performance in this challengingeconomic environment.

 

**Results of Operations**

 

*Three Months ended June 30, 2010 and 2009*

 

*Overview*

 

Our net loss was $2.2 million for the three months ended June 30,2010 as compared to a net loss of $805,000 for the three months ended June 30,2009.  The increase of $1.4 million in netloss for 2010 was primarily the result of $1.1 million lower net interestincome and $795,000 higher non-interest expense. We have experienced a decreasein our net interest margin to 1.41% from 2.87% for the quarters ended June 30,2010 and 2009, respectively, which was the primary reason for the drop in netinterest income.  This decrease is due toan increased volume of non-performing assets as well as increased liquidity inanticipation of repayment of brokered deposits maturing in 2010. For the threemonths ended June 30, 2010, we realized $4,098,000 in interest income, ofwhich $683,000 was from investment activities and $3,415,000 was from loanactivities.  For the three months ended June 30,2009, we realized $4,628,000 in interest income, of which $336,000 was frominvestment activities and $4,292,000 was from loan activities.  The primary source of funding for our loanportfolio is deposits that are acquired both locally, via the national brokeredcertificate market, and internet obtained certificates of deposit. We incurredinterest expense of $2,525,000 and $1,951,000 for the three months ended June 30,2010 and June 30, 2009, respectively.

 

*Provision for Loan Losses*

 

Our provision for loan losses for the three months ended June 30,2010 was $1,000,000 compared to $1,500,000 for the comparable prior yearperiod. Although our 2010 provision was less than the prior year, we are stillexperiencing deterioration of our loan portfolio. ** **As noted earlier, we haveapproximately $31.7 million of acquisition and development (A&D) loansoutstanding at June 30, 2010.  Weare experiencing increased levels of loan delinquencies, defaults andforeclosures with these loans.  Further,the downturn in the real estate market has adversely impacted the value of theunderlying collateral (real estate) for the A&D loans.  The greater degree of strain on these typesof loans and the significance to our overall loan portfolio has caused us toapply a greater degree of scrutiny in analyzing the ultimate collectability ofamounts due.  As a result of thesefactors, we recognize there may be further deterioration in our loan portfolioin the second half of 2010.

 

*Non-interest Income*

 

We had non-interest income of $858,000 and $441,000 for the threemonths ended June 30, 2010 and 2009, respectively.  The increase was mainly due to a $424,000gain on sale of securities for the three months ended June 30, 2010. Therewas no such gain for the three months ended June 30, 2009. Mortgageorigination revenue for the three months ended June 30, 2010 was$235,000.  We had $198,000 in mortgageorigination revenue in the second quarter of 2009.  This increase is due to an increased salesstaff.

 

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*Non-interest Expense*

 

We incurred non-interest expense of $3,633,000 during the three monthsended June 30, 2010, which was an increase of $796,000 over the threemonths ended June 30, 2009. Included in the expense was $1,275,000 of salaries and employeebenefits, $171,000 of data processing expense, $353,000 of professional feesexpense, $38,000 of advertising expense, $16,000 of expense related to officesupplies, $32,000 of telephone expense and $779,000 of assessments related tothe FDIC.  The non-interest expenseincurred in the three months ended June 30, 2009 was $2,837,000.  Included in the expense was $1,363,000 ofsalaries and employee benefits, $249,000 of data processing expense, $74,000 ofprofessional fee expense, $60,000 of advertising expense, $20,000 of expenserelated to office supplies, $38,000 of telephone expense and $271,000 ofassessments related to the FDIC. Included in the FDIC assessments for the three months ended June 30,2009 was a one time FDIC insurance premium that equated to a $178,000 one timecharge to the Bank in 2009.  This wasexpensed in June 2009 and paid September 30, 2009.

 

For the three months ended June 30, 2010, we incurred otherproperty and equipment expenses of $158,000 in depreciation and $74,000 inequipment maintenance and rental.  Forthe three months ended June 30, 2009, we incurred other property andequipment expenses of $182,000 in depreciation and $36,000 in equipmentmaintenance and rental.  We incurred$175,000 and $168,000 in occupancy expense related to all of our officelocations for the three months ended June 30, 2010 and 2009, respectively.

 

The increase in non-interest expense is the result of the increasedadministrative expenses including an increase in professional fees of $279,000,increased assessments related to the FDIC of $508,000, and an increase in loanexpenses of $67,000 resulting from the increased cost of problem loans andforeclosures. The higher professional fees were related to a stock offeringthat was abandoned during the quarter ended June 30, 2010.

 

*Six Months ended June 30, 2010 and 2009*

 

*Overview*

 

Our net loss was $4.3 million for the six months ended June 30,2010 as compared to net loss of $841,000 for the six months ended June 30,2009.  For the six months ended June 30,2010, we realized $8,315,000 in interest income, of which $1,357,000 was frominvestment activities and $6,958,000 was from loan activities.  For the six months ended June 30, 2009,we realized $9,560,000 in interest income, of which $899,000 was frominvestment activities and $8,661,000 was from loan activities.  The primary source of funding for our loanportfolio is deposits that are acquired locally, via the national brokeredcertificate market, and internet obtained certificates of deposit.  We incurred interest expense of $4,861,000and $4,031,000 for the six months ended June 30, 2010 and June 30,2009, respectively.  We have experienceda decrease in our net interest margin to 1.61% from 2.96% for the six monthsended June 30, 2010 and 2009, respectively.  This decrease is due to an increased volumeof non-performing assets as well as increased liquidity in anticipation ofrepayment of brokered deposits maturing in 2010.  Due to the large volume of brokered depositsmaturing in the third and fourth quarters of 2010, the Bank has had to steadilyincrease other deposits through the first six months of 2010 to be able toreplace the maturing brokered deposits.

 

*Rate/Volume Analysis*

 

Net interest income can be analyzed in terms of the impact of changinginterest rates and changing volumes.  Thefollowing tables set forth the effect which the varying levels ofinterest-earning assets and interest-bearing liabilities and the applicablerates have had on changes in the net interest income for the periods presented.

 
| ** **                           | ** ** | **Six Months Ended June 30,  2010 vs. 2009** | ** ** |
|--------------------------------------|------------|---------------------------------------------------|------------|
| ** **                           | ** ** | **Increase (decrease) Due to**                    | ** ** |
| ** **                           | ** ** | ** **                                        | ** ** | ** ** | ** ** | **Rate /** | ** ** | ** ** | ** ** |
| **(Dollars in thousands)** | ** ** | **Volume**                                        | ** ** | **Rate** | ** ** | **Volume** | ** ** | **Total** | ** ** |
| Interest Income                      |       |                                              |       |   |   |   |   |   |   |
| Loans                                |       | $                                                 | (1,527     | ) | $ | (214 | ) | $ | 38 |   | $ | (1,703 | ) |
| Investment securities (1)            |       | 1,204                                             |       | (332 | ) | (455 | ) | 417 |   |
| Federal funds                        |       | 70                                                |       | (6 | ) | (23 | ) | 41 |   |
| Total Interest Income                | ** ** | **$**                                             | **(253**   | **)** | **$** | **(552** | **)** | **$** | **(440** | **)** | **$** | **(1,245** | **)** |
|                                 |       |                                              |       |   |   |   |   |   |   |
| Interest Expense                     |       |                                              |       |   |   |   |   |   |   |
| Deposits                             |       | $                                                 | 949        |   | $ | (117 | ) | $ | (34 | ) | $ | 798 |   |
| Other borrowings                     |       | (208                                              | )          | 323 |   | (83 | ) | 32 |   |
| Total Interest Expense               | ** ** | **$**                                             | **741**    | ** ** | **$** | **206** | ** ** | **$** | **(117** | **)** | **$** | **830** | ** ** |
|                                 |       |                                              |       |   |   |   |   |   |   |
| Net Interest Income                  | ** ** | **$**                                             | **(994**   | **)** | **$** | **(758** | **)** | **$** | **(323** | **)** | **$** | **(2,075** | **)** |

 

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

 

*Average Balances, Income and Expenses and Rate*

 

The following table sets forth, for the six months ended June 30,2010 and 2009, information related to the Company’s average balance sheet andits average yields on earning assets and average costs of interest-bearingliabilities.  Such yields are derived bydividing income or expense by the average balance of the corresponding earningassets or interest-bearing liabilities. Average balances have been derived from the daily balances throughoutthe periods indicated.

 
| ** **                                         | ** ** | **Six Months Ended June 30,  2010** | ** **  | **Six Months Ended June 30,  2009** | ** ** |
|----------------------------------------------------|------------|------------------------------------------|-------------|------------------------------------------|------------|
| ** **                                         | ** ** | **Average**                              | ** **  | **Income /**                             | ** ** | **Yield/** | ** ** | **Average** | ** ** | **Income /** | ** ** | **Yield /** | ** ** |
| **(Dollars in thousands)**                         | ** ** | **Balance**                              | ** **  | **Expense**                              | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Expense** | ** ** | **Rate** | ** ** |
| **Assets**                                         |       |                                     |        |                                     |       |   |   |   |   |   |   |   |   |
| Earning assets:                                    |       |                                     |        |                                     |       |   |   |   |   |   |   |   |   |
| Loans (1)                                          |       | $                                        | 260,220     |                                     | $          | 6,958 |   | 5.39 | % | $ | 315,912 |   | $ | 8,661 |   | 5.53 | % |
| Investment securities (2)                          |       | 114,442                                  |        | 1,298                                    |       | 2.29 | % | 48,353 |   | 881 |   | 3.67 | % |
| Federal funds sold and  other                      |       | 57,684                                   |        | 59                                       |       | 0.21 | % | 11,809 |   | 18 |   | 0.31 | % |
| Total earning assets                               |       | 432,346                                  |        | 8,315                                    |       | 3.88 | % | 376,074 |   | 9,560 |   | 5.13 | % |
| Cash and due from banks                            |       | 7,775                                    |        |                                     |       |   |   | 7,217 |   |   |   |   |   |
| Premises and equipment                             |       | 3,720                                    |        |                                     |       |   |   | 4,579 |   |   |   |   |   |
| Other assets                                       |       | 11,635                                   |        |                                     |       |   |   | 8,926 |   |   |   |   |   |
| Allowance for loan losses                          |       | (12,403                                  | )           |                                     |       |   |   | (8,240 | ) |   |   |   |   |
| Total assets                                       | ** ** | **$**                                    | **443,073** |                                     |       |   |   | ** ** | **$** | **388,556** |   |   |   |   |   |
|                                               |       |                                     |        |                                     |       |   |   |   |   |   |   |   |   |
| **Liabilities**                                    |       |                                     |        |                                     |       |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:                     |       |                                     |        |                                     |       |   |   |   |   |   |   |   |   |
| Repurchase agreements                              |       | $                                        | 30,000      |                                     | 598        |   | 4.02 | % | $ | 30,000 |   | 486 |   | 3.27 | % |
| Federal funds purchased                            |       | —                                   |        | —                                   |       | — | % | 441 |   | 1 |   | 0.46 | % |
| Federal Home Loan Bank  advances                   |       | —                                   |        | —                                   |       | — | % | 10,856 |   | 72 |   | 1.34 | % |
| Note Payable                                       |       | —                                   |        | —                                   |       | — | % | 497 |   | 7 |   | 2.84 | % |
| Subordinated Debt                                  |       | 4,325                                    |        | 247                                      |       | 11.50 | % | 4,325 |   | 247 |   | 11.50 | % |
| Interest-bearing  transaction accounts             |       | 18,283                                   |        | 55                                       |       | 0.61 | % | 18,534 |   | 107 |   | 1.16 | % |
| Savings deposits                                   |       | 68,647                                   |        | 862                                      |       | 2.53 | % | 15,981 |   | 118 |   | 1.49 | % |
| Time deposits                                      |       | 289,316                                  |        | 3,099                                    |       | 2.16 | % | 256,027 |   | 2,993 |   | 2.36 | % |
| Total interest-bearing  liabilities                |       | 410,571                                  |        | 4,861                                    |       | 2.39 | % | 336,661 |   | 4,031 |   | 2.41 | % |
| Demand deposits                                    |       | 22,804                                   |        |                                     |       |   |   | 22,416 |   |   |   |   |   |
| Accrued interest and other  liabilities            |       | 1,979                                    |        |                                     |       |   |   | 1,214 |   |   |   |   |   |
| Total liabilities                                  |       | 435,354                                  |        |                                     |       |   |   | 360,291 |   |   |   |   |   |
| Shareholders’ equity                          |       | 7,719                                    |        |                                     |       |   |   | 28,265 |   |   |   |   |   |
| Total liabilities and****shareholders’ equity |       | **$**                                    | **443,073** |                                     |       |   |   |   | **$** | **388,556** |   |   |   |   |   |
|                                               |       |                                     |        |                                     |       |   |   |   |   |   |   |   |   |
| Net interest income                                |       |                                     | ** **  | **$**                                    | **3,454**  |   |   |   |   | ** ** | **$** | **5,529** |   |   |   |
| Net interest spread                                |       |                                     |        |                                     | ** ** | **1.49** | **%** |   |   |   | ** ** | **2.72** | **%** |
| Net interest margin                                |       |                                     |        |                                     | ** ** | **1.61** | **%** |   |   |   | ** ** | **2.96** | **%** |

 

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(1)          There were$30.1 million and $22.8 million of loans in non-accrual status as of June 30,2010 and 2009, respectively.  The effectof fees collected on loans for the six months ended June 30, 2010 and 2009totaled $20,000 and $91,000, respectively, and increased the annualized yieldon loans by 1 basis point from 5.38% for June 30, 2010 and by 6 basispoints from 5.47% for June 30, 2009. The effect of such fees on the annualized yield on earning assets was anincrease of 1 basis point from 3.87% for June 30, 2010 and an increase of5 basis points from 5.08% for June 30, 2009.  The effects of such fees on net interestspread were an increase of 1 basis point from 1.48% for June 30, 2010 andan increase of 5 basis points from 2.67% for June 30, 2009.  The effects of such fees on net interestmargin were an increase of 1 basis point from 1.60% for June 30, 2010 andan increase of 4 basis points from 2.92% for June 30, 2009.

 

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

 

*Provision for Loan Losses*

 

Our provision for loan losses for the six months ended June 30,2010 was $2,000,000 compared to $2,805,000 for the comparable prior yearperiod. Although the provision was lower for 2010, we are still experiencingdeterioration of our loan portfolio. ** **As noted earlier, we haveapproximately $31.7 million of acquisition and development (A&D) loansoutstanding at June 30, 2010.  Weare experiencing increased levels of loan delinquencies, defaults andforeclosures with these loans.  Further,the downturn in the real estate market has adversely impacted the value of theunderlying collateral (real estate) for the A&D loans.  The greater degree of strain on these typesof loans and the significance to our overall loan portfolio has caused us toapply a greater degree of scrutiny in analyzing the ultimate collectability ofamounts due.  As a result of thesefactors, we recognize there may be further deterioration in our loan portfolioin the second half of 2010.

 

*Non-interest Income*

 

We had non-interest income of $1,280,000 and $1,255,000 for the sixmonths ended June 30, 2010 and 2009, respectively.  Gain on sale of securities was $478,000 and$519,000 for the six months ended June 30, 2010 and 2009,respectively.  Mortgage originationrevenue for the six months ended June 30, 2010 was $363,000.  We had $305,000 in mortgage originationrevenue for the six months ended June 30, 2009.  This increase is due to an increased salesstaff.

 

*Non-interest Expense*

 

We incurred non-interest expense of $7,040,000 during the six monthsended June 30, 2010, an increase of $1.8 million over the six months endedJune 30, 2009. Included in the expense was $2,670,000 of salaries andemployee benefits, $386,000 of data processing expense, $707,000 ofprofessional fees expense, $74,000 of advertising expense, $39,000 of expenserelated to office supplies, $67,000 of telephone expense and $1,181,000 of assessmentsrelated to FDIC.  The non-interestexpense incurred in the six months ended June 30, 2009 was$5,253,000.  Included in the expense was$2,603,000 of salaries and employee benefits, $471,000 of data processingexpense, $165,000 of professional fee expense, $97,000 of advertising expense,$42,000 of expense related to office supplies, $75,000 of telephone expense and$367,000 of assessments related to FDIC. Included in the FDIC assessments forthe six months ended June 30, 2009 was a one time FDIC insurance premiumthat equated to a $178,000 one time charge to the Bank in 2009.  This was expensed in June 2009 and paid September 30,2009.

 

For the six months ended June 30, 2010, we incurred other propertyand equipment expenses of $334,000 in depreciation and $151,000 in equipmentmaintenance and rental.  For the sixmonths ended June 30, 2009, we incurred other property and equipmentexpenses of $361,000 in depreciation and $79,000 in equipment maintenance andrental.  We incurred $357,000 and $339,000in occupancy expense related to all of our office locations for the six monthsended June 30, 2010 and 2009, respectively.

 

The increase in non-interest expense is the result of the increasedadministrative expenses including an increase in professional fees of $542,000,increased assessments related to the FDIC of $814,000, and an increase in loanexpenses of $333,000 resulting from the increased cost of problem loans andforeclosures. The increase in FDIC assessments for 2010 was the result ofhigher assessment rates and increased deposit balances.

 

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**Assets and Liabilities**

 

*General*

 

At June 30, 2010, total assets increased 10.1% to $464.1 millionas compared to $421.5 million at December 31, 2009, primarily a result ofan increase in investments of $87.9 million, or 84.8%, offset by a decrease infederal funds sold of $16.1 million, or 51.8%, and a decrease of $30.3 millionin gross loans, or 11.0%, during the first six months of 2010.  As described below, federal funds solddecreased to $15.0 million at June 30, 2010 compared to $31.0 million at December 31,2009.  Cash and cash equivalentsdecreased $15.8 million, or 41.8%, since December 31, 2009.  As described below, deposits increased $45.0million, or 12.0%, during the first six months of 2010.  At June 30, 2010, shareholders’ equitywas $6.0 million.

 

*Investment Securities*

 

Investments available for sale increased by $87.9 million, or 84.8%,since December 31, 2009 due to the purchase of US treasury securities of$150 million coupled with the sale of $63.6 million of mortgage backedsecurities.  This general increase in securitiesis due to our efforts to increase liquidity in anticipation of repayment ofbrokered deposits scheduled to mature in 2010.

 

*Other Investments*

 

Other investments, consisting of FHLB stock, were $1.6 million for bothJune 30, 2010 and December 31, 2009. All of the FHLB stock is used to collateralize advances with the FHLB.

 

*Loans*

 

Since loans typically provide higher interest yields than other typesof interest earning assets, we allocate the majority of our earning assets toour loan portfolio.  Gross loansdecreased by $30.3 million, or 11.0%, during the first six months of 2010.  Loan demand has slowed during the first sixmonths of 2010 due to general economic conditions and the real estate market,along with management’s decision to shrink the size of the Bank’s loanportfolio to help improve the Bank’s risk profile.****Weexpect this trend to continue during the next quarter.

 

Balances within major loan categories are as follows:

 
| **(dollar amounts in thousands)** | ** ** | **June 30, 2010** | ** **  | **December 31, 2009** | ** ** |
|-----------------------------------|------------|------------------------|-------------|----------------------------|------------|
| Real estate - construction        |       | $                      | 68,514      |                       | $          | 81,128 |   |
| Real estate - mortgage            |       | 154,414                |        | 167,296                    |       |
| Commercial and industrial         |       | 20,665                 |        | 25,028                     |       |
| Consumer and other                |       | 1,183                  |        | 1,652                      |       |
| Total loans, gross                |       | 244,776                |        | 275,104                    |       |
| Less allowance for loan  losses   |       | (11,601                | )           | (12,963                    | )          |
| Total loans, net                  | ** ** | **$**                  | **233,175** | ** **                 | **$**      | **262,141** | ** ** |

 

Generally,we place a delinquent loan in non-accrual status when the loan becomes 90 daysor more past due.  Additionally, wediscontinue accrual of interest on a loan when we conclude it is doubtful thatwe will be able to collect the full amount of principal and interest from theborrower.  We reach this conclusion bytaking into account factors such as the borrower’s financial condition,economic and business conditions, value of the collateral underlying the loan,and the results of our previous collection efforts.  When we place a loan in non-accrual status,we reverse all interest which has been accrued on the loan but remains unpaidand we deduct this interest from earnings as a reduction of reported interestincome.  We do not accrue any additionalinterest on the loan balance until we conclude the collection of both principaland interest is reasonably certain.  At June 30,2010, there were $30.1 million in loans that were non-accruing and $6.8 millionin loans that were 30 days past due, excluding non-accrual loans.  At December 31, 2009, there were $29.4million in loans that were non-accruing and $4.8 million in loans that were 30days past due, excluding non-accrual loans.

 

The increase of $681,000 in non-accrual loans from December 31,2009 to June 30, 2010 is related primarily to continued deterioration inthe Bank’s overall Commercial Real Estate loan portfolio. The number of loanson non-accrual has increased from 79 to 83 since December 31, 2009. Theaverage non-accrual loan balance is $372,000 and $362,000 as of December 31,2009 and June 30, 2010, respectively. At June 30, 2010, 94.1% of the non-accrual loans were secured byreal estate. At this time, management is unable to determine the length of theeconomic downturn and therefore unable to determine the ultimate impact on theBank’s Commercial Real Estate portfolio.

 

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We have approximately $31.7 million of A&D loans as of June 30,2010, most of which are on properties located in the Upstate of South Carolinaand Western North Carolina.  A&Dloans are typically comprised of loans to borrowers for real estate to be developed(into properties such as sub-divisions or spec houses).  Normally, these loans are repaid with theproceeds from the sale of the developed property.  The greater degree of strain on these typesof loans and the significance to our overall loan portfolio has caused us toapply a greater degree of scrutiny in analyzing the ultimate collectability ofamounts due.  The majority of theseborrowers are having financial difficulties. Our analysis has resulted in a significant provision expense in order tomeet the estimated allowance for loan loss reserve requirement.

 

Included in our loans secured by real estate, we have approximately$35.7 million of acreage and finished or buildable lot loans as of June 30,2010.  These loans are comprised of loansto borrowers for raw land and lots in subdivisions that have utilities and areready to be built on individually but not as part of an entire developmentproject.  These loans are generallyrepaid with the proceeds from the sale of the property.  Many of these borrowers are also experiencingfinancial difficulties.

 

The current economic environment in our market area has resulted in adownturn in the real estate market, which has placed greater pressure on ourborrowers’ repayment capabilities.  Weare experiencing higher levels of loan delinquencies, defaults andforeclosures.  Further, the downturn inthe real estate market has adversely impacted the value of the underlying realestate securing the loans.  The greaterdegree of strain on these types of loans and the significance to our overallloan portfolio has caused us to apply a greater degree of scrutiny in analyzingthe ultimate collectability of amounts due. Our analysis has resulted in a significant provision expense recorded in2009, and an additional $2,000,000 recorded in the first six months of 2010, inorder to meet the estimated allowance for loan loss reserve requirement.  Nevertheless, given the current economicenvironment, there is a risk of further impairment to the value of ourcollateral on these loans, which would require even further increases to ourallowance for loan losses and in the corresponding expense charged to ourprovision for loan losses.

 

Changes in the allowance forloan losses for were as follows (dollars in thousands):

 
| ** **                       | ** ** | **Six-months ended  June 30, 2010** | ** ** | **Six-months ended  June 30, 2009** | ** ** |
|----------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|
| Balance, beginning of  period    |       | $                                        | 12,963     |                                     | $          | 8,088 |   |
| Provision charged to  operations |       | 2,000                                    |       | 2,805                                    |       |
| Net collections  (charge-offs)   |       | (3,362                                   | )          | (1,205                                   | )          |
| Balance, end of period           | ** ** | **$**                                    | **11,601** | ** **                               | **$**      | **9,688** | ** ** |

 

*ImpairedLoans*

 

TheCompany identifies impaired loans through its normal internal loan reviewprocess.  Loans are considered to beimpaired when, in management’s judgment and based on current information, thefull collection of principal and interest becomes doubtful according to thecontractual terms of the loan agreement. A loan is also considered impaired if its terms are modified in atroubled debt restructuring.  These loansare evaluated in determining whether all outstanding principal and interest areexpected to be collected.  Loans are notconsidered impaired if a minimal payment delay occurs and all amounts due,including accrued interest at the contractual interest rate for the period ofdelay, are expected to be collected. Management has determined that the Company had $68.1 million and $34.2million in impaired loans at June 30, 2010 and December 31, 2009,respectively.  $6.4 million and $2.0million of the allowance for loan loss has been specifically allocated to theserelationships at June 30, 2010 and December 31, 2009, respectively.

 

*PotentialProblem Loans*

 

Potentialproblem loans are loans that are not included in impaired loans, but aboutwhich management has become aware of information about possible credit problemsof the borrowers that causes doubt about their ability to comply with currentrepayment terms.  Loans on the Company’spotentially problem loan list are considered potentially impaired loans.  At June 30, 2010 and December 31,2009, the Company had identified $0 and $15.9 million, respectively, ofpotential problem loans through its internal review procedures.  The results of this internal review processare considered in determining management’s assessment of the adequacy of theallowance for loan losses.

 

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*Provisionand Allowance for Loan Losses*

 

The Company has developed policies and procedures for evaluating theoverall quality of its credit portfolio and the timely identification ofpotential problem loans.  On a quarterlybasis, the Company’s Board of Directors reviews and approves the appropriatelevel for the Company’s allowance for loan losses based upon management’srecommendations, the results of the internal monitoring and reporting system,and an analysis of economic conditions in its market.  In 2009, the Company developed and began toimplement an improved loan review program, which included the hiring of a newinternal loan review officer and the engagement of a new external loan reviewfirm and the establishment of a new system for tracking borrower financialstatements and the structure of our watch reports.

 

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

 

Portions of the allowance for loan losses may be allocated for specificloans or portfolio segments.  However,the entire allowance for loan losses is available for any loan that, inmanagement’s judgment, should be charged-off. While management utilizes the best judgment and information available toit, the ultimate adequacy of the allowance for loan losses depends on a varietyof factors beyond the Company’s control, including the performance of theCompany’s loan portfolio, the economy, changes in interest rates, and the viewof the regulatory authorities toward loan classifications.

 

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

 

The Company’s allowance for loan losses is based upon judgments andassumptions about risk elements in the portfolio, future economic conditions,and other factors affecting borrowers. The process includes identification and analysis of loss potential invarious portfolio segments utilizing a credit risk grading process and specificreviews and evaluations of significant problem credits.  However, there is no precise method ofestimating credit losses, since any estimate of loan losses is necessarilysubjective and the accuracy depends on the outcome of future events.  In addition, due to our rapid growth over thepast several years and our limited operating history, a large portion of theloans 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.

 

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The current downturn in the real estate market has resulted in anincrease in loan delinquencies, defaults and foreclosures, and we believe thesetrends are likely to continue.  In somecases, this downturn has resulted in a significant impairment to the value ofour collateral and our ability to sell the collateral upon foreclosure, andthere is a risk that this trend will continue. The real estate collateral ineach case provides an alternate source of repayment in the event of default bythe borrower and may deteriorate in value during the time the credit isextended.  If real estate values continueto decline in our market areas, it is also more likely that we would berequired to increase our allowance for loan losses.  We determine the value of real estatecollateral by using a current appraisal. Contrary to any other relevant informationan appraisal is considered current if it is less than 12 months old except wheneconomic or market changes have caused values to rise or fall significantly.If a current appraisal is not maintained, the Bank will generally order a newappraisal prior to accepting theproperty as a result of a deed in lieu of foreclosure or completion of aforeclosure action. Commercial appraisals generally take less than fourweeks to complete.  A specific impairment is made as soon as possible upon receipt of the appraisal.  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 thatcharge-offs in future periods will not exceed the allowance for loan losses orthat additional increases in the allowance for loan losses will not berequired, especially considering the overall weakness in the commercial realestate market in our market areas.

 

*Deposits*

 

Our primary source of funds for loans and investments is ourdeposits.  As of June 30, 2010,total deposits increased by $45.0 million, or 12.0%, from December 31,2009.  The largest percentage increasewas in time deposits less than $100,000, which increased $96.3 million, or320.4%, from December 31, 2009 to June 30, 2010, of which $68.2million were through internet obtained deposits.   The internet obtained deposits are fromother financial institutions, have been offered at or below the national ratecap and at this time are considered to be renewable.

 

We have chosen to obtain a portion of our certificates of deposit fromareas outside of our market, which are brokered deposits. The deposits obtainedoutside of our market area generally have been below those being offered forcomparable certificates of deposit in our local market. Because of this, even thoughbrokered deposits are interest sensitive, they have been considered a desirablesource of funds. As of June 30, 2010, we had brokered deposits of $174.6million, representing 41.41% of our total deposits, of which $79.7 million arescheduled to mature in the third quarter of 2010 and $94.9 million arescheduled to mature in the fourth quarter of 2010.  Because of the limitations on brokereddeposits imposed by the MOU, the Consent Order, and our “significantlyundercapitalized” status, we must find other sources of liquidity to replacethese deposits as they mature or the Bank could be placed into receivershipwith the FDIC.  Secondary sources ofliquidity may include proceeds from FHLB advances and federal funds lines ofcredit from correspondent banks. However, FHLB has informed us that due to our financial condition we arenot currently permitted to receive any more advances.  As a result, we must limit our growth, raiseadditional capital, or sell assets, which could materially and adversely affectour financial condition and results of operations.  During the first six months of 2010, werepaid $28.2 million of our brokered deposits.

 

Balances within the major deposit categories are as follows:

 
| **(dollar amounts in thousands)**  | ** ** | **June 30, 2010** | ** **  | **December 31, 2009** | ** ** |
|------------------------------------|------------|------------------------|-------------|----------------------------|------------|
| Non-interest bearing  demand       |       | $                      | 22,750      |                       | $          | 21,829 |   |
| Interest bearing demand            |       | 17,204                 |        | 18,588                     |       |
| Savings                            |       | 64,902                 |        | 82,295                     |       |
| Time deposits less than  $100,000  |       | 126,338                |        | 30,054                     |       |
| Time deposits of $100,000  or over |       | 15,830                 |        | 21,014                     |       |
| Brokered deposits                  |       | 174,558                |        | 202,783                    |       |
| Total deposits                     | ** ** | **$**                  | **421,582** | ** **                 | **$**      | **376,563** | ** ** |

 

Included in time deposits less than $100,000 are $70 million and $2million of internet obtained certificates of deposit for June 30, 2010 andDecember 31, 2009, respectively.

 

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

 
| ** **                                         | ** ** | ** ** | ** ** | **After**   | ** ** | **After**   | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------------|------------|------------|------------|-------------|------------|-------------|------------|------------|------------|------------|------------|
| ** **                                         | ** ** | ** ** | ** ** | **Three**   | ** ** | **Six**     | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                         | ** ** | **Within** | ** ** | **Through** | ** ** | **Through** | ** ** | **After**  | ** ** | ** ** | ** ** |
| ** **                                         | ** ** | **Three**  | ** ** | **Six**     | ** ** | **Twelve**  | ** ** | **Twelve** | ** ** | ** ** | ** ** |
| **(Dollars  in thousands)**                        | ** ** | **Months** | ** ** | **Months**  | ** ** | **Months**  | ** ** | **Months** | ** ** | **Total**  | ** ** |
| **June 30,  2010**                            |       |       | ** ** | ** **  | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Brokered  deposits                                 |       | $          | 79,704     |        | $          | 94,854      |       | $          | —     |       | $          | — |   | $ | 174,558 |   |
| Other  certificates of deposit of $100,000 or more |       | 5,283      |       | 2,544       |       | 2,487       |       | 5,516      |       | 15,830     |       |
| Total                                              |       | $          | 84,987     |        | $          | 97,398      |       | $          | 2,487      |       | $          | 5,516 |   | $ | 190,388 |   |
|                                               |       |       |       |        |       |        |       |       |       |       |       |
| **December 31,  2009**                        |       |       | ** ** | ** **  | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Brokered  deposits                                 |       | $          | 6,800      |        | $          | 21,269      |       | $          | 174,714    |       | $          | — |   | $ | 202,783 |   |
| Other  certificates of deposit of $100,000 or more |       | 4,692      |       | 7,868       |       | 6,624       |       | 1,830      |       | 21,014     |       |
| Total                                              |       | $          | 11,492     |        | $          | 29,137      |       | $          | 181,338    |       | $          | 1,830 |   | $ | 223,797 |   |

 

Of the Company’s time deposits of $100,000 or over as of June 30,2010 and December 31, 2009, 44.64% and 5.14% are scheduled maturitieswithin three months, respectively. As of June 30, 2010 and December 31,2009, 97.10% and 99.18%, respectively, of the Company’s time deposits of$100,000 or over had maturities within twelve months.

 

*Subordinated Debt*

 

During the third quarter of 2008, we commenced a subordinated debtoffering to enhance and strengthen the levels of capital and liquidity at theholding company such that we could improve the levels of regulatory capital atthe Bank. We raised $4.325 million in additional capital before we closed theoffering on October 15, 2008.  Thesubordinated notes were sold to a limited number of purchasers in a privateoffering, bear an interest rate of 11.5%, are callable after September 30,2011, at a premium, and mature in 2018. The subordinated debt has beenstructured to fully count as Tier 2 regulatory capital on a consolidated basis.  At June 30, 2010, the Company hadsubordinated debt totaling $4.3 million.

 

Due to diminishing cash available at the holding company level, we onlypaid the June 2010 interest payments to subordinated debt holders who werenot officers or directors of the Company. If we are unable to raise additional capital, we may have to discontinuepaying interest on the subordinated debentures to all holders due to lack offunds.

 

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*Federal Home Loan Bank Advances, Fed Funds Lines of Credit, FederalReserve Discount Window, and Securities Sold Under Agreements to Repurchase*

 

Our other borrowings have traditionally included proceeds from FHLBadvances, federal funds lines of credit from correspondent banks, andsecurities sold under agreements to repurchase. As of June 30, 2010 the FHLB has informed us that due to ourfinancial condition we are not currently permitted to receive any moreadvances. At June 30, 2010, we had federal funds lines of credit withunrelated banks totaling $5 million. These lines are available for general corporate purposes.  These lines may be terminated at any timebased on our financial condition. We also have credit availability through theFederal Reserve Discount Window.  As of June 30,2010, $5.1 million was available, based on qualifying collateral.  The Federal Reserve Discount Window borrowingcapacity has been curtailed to only overnight terms, contingent upon creditapproval for each transaction. Availability of the Federal Reserve Discount Window may be terminated atany time by the Federal Reserve, and we can make no assurances that thisfunding source will continue to be available to us.  At June 30, 2010, the Bank had $30.0million of securities under agreements to repurchase with brokers with aweighted average rate of 4.16% and an average maturity of 72 months.  The maximum amount outstanding at anymonth-end was $30.0 million.  Theseagreements were secured with approximately $37.6 million of investmentsecurities.  In addition, the Bank was indefault under a $15.0 million repurchase agreement due to the Bank’s “significantlyundercapitalized” designation.  However,the broker elected to amend the agreement and waive its right to terminatebased on this issue through December 31, 2010 in exchange for the Bankproviding an additional 7% of collateral based on the outstanding balance.

 

**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 toachieve appropriate levels of liquidity. Cash, federal funds and investments available for sale are our primarysources of asset liquidity.  These fundsprovide a cushion against short-term fluctuations in cash flow from bothdeposits and loans.  Historically,individual and commercial deposits have been our primary source of funds forcredit activities.  These include brokereddeposits, which comprise 41.41% of our deposit base as of June 30,2010.  These have proven to be a reliablesource of funds.  However, pursuant tothe Consent Order and our current financial condition, our ability to accessbrokered deposits through the wholesale funding market is restricted.  Specifically, the Consent Order restricts theBank’s ability to accept, renew, or rollover brokered deposits.  Management believes that this will not haveany liquidity impact through the fourth quarter of 2010 due to the extendedmaturities of the brokered deposits and the amount of short-term investmentsand federal funds sold at June 30, 2010. With access to the brokered deposit market unavailable, the Bank mustreplace those funds with core deposits. Deposit balances, net of brokered deposits, have increased $73.2 millionfrom December 31, 2009 to June 30, 2010.  This was due to intentional restructuring toreplace brokered deposits with local and internet obtained deposits.  We believe internet deposits may be obtainedwithout restriction under the guidelines of the Consent Order.  We anticipate that our funding cost andfunding mix will now remain stable through the maturity of the brokereddeposits through the fourth quarter of 2010. We anticipate that the Bank will be able to replace all brokereddeposits through local and internet obtained deposits.

 

In addition to our on balance sheet sources of funds, we also rely onoff-balance sheet lines of credit.  At June 30,2010, we had lines of credit with a correspondent bank totaling $5million.  This line is available forgeneral corporate purposes.  This linemay be terminated at any time based on our financial condition. We also havecredit availability through the Federal Reserve Discount Window.  As of June 30, 2010, $5.1 million wasavailable, based on qualifying collateral. The Federal Reserve Discount Window borrowing capacity has beencurtailed to only overnight terms, contingent upon credit approval for eachtransaction.  Availability of the FederalReserve Discount Window may be terminated at any time by the Federal Reserve,and we can make no assurances that this funding source will continue to beavailable to us.  In addition, the FHLBhas informed us that due to our financial condition we are not currentlypermitted to receive any more advances.

 

Following the execution of the Consent Order with the FDIC and theSouth Carolina Board of Financial Institutions, we revised our comprehensiveliquidity risk management program.  Thisprogram assesses our current and projected funding needs to ensure thatsufficient funds or access to funds exist to meet those needs.  The program includes effective methods toachieve and maintain sufficient liquidity and to measure and monitor liquidityrisk including the preparation and submission of liquidity reports on a regularbasis to the FDIC.  The program containsa contingency funding plan that forecasts funding needs and funding sourcesunder different stress scenarios.  Ourplan details how the Bank is complying with the restrictions in the ConsentOrder, including the restriction against brokered deposits, as well asproviding reports detailing all funding sources and obligations under best caseand worse case scenarios.

 

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The level of liquidity is measured by the cash, cash equivalents and unpledgedsecurities available for sale to total assets ratio, which was at 36.5% at June 30,2010, compared to 23.8% at December 31, 2009. We anticipate that this willcontinue to increase with the combination of deposit growth and shrinkage ofassets until the brokered deposits are paid off or mature during the remainderof 2010.

 

We believe our liquidity sources are adequate to meet our needs throughthe fourth quarter of 2010.  See section “Maturitiesof Certificates of Deposit of $100,000 or More (Including Brokered Deposits)”above.  If we are unable to meet ourliquidity needs during the fourth quarter of 2010, then the Bank may be placedinto a federal conservatorship or receivership by the FDIC, with the FDICappointed as conservator or receiver.

 

**Impact ofOff-Balance Sheet Instruments**

 

Through the operations of our Bank, we have made contractualcommitments to extend credit in the ordinary course of our businessactivities.  These commitments arelegally binding agreements to lend money to our customers at predeterminedinterest rates for a specified period of time. At June 30, 2010, we had issued commitments to extend credit of$12.3 million through various types of lending arrangements.  We evaluate each customer’s credit worthinesson a case-by-case basis.  The amount ofcollateral obtained, if deemed necessary by us upon extension of credit, isbased on our credit evaluation of the borrower. Collateral varies but may include accounts receivable, inventory,property, plant and equipment, commercial and residential real estate.  We manage the credit risk on thesecommitments by subjecting them to normal underwriting and risk managementprocesses.  The following table summarizesour off-balance-sheet financial instruments whose contract amounts representcredit risk:

 
| **(dollar amounts in thousands)** | ** ** | **June 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|-----------------------------------|------------|------------------------|------------|----------------------------|------------|
|                              |       |                   |       |                       |       |
| Commitments to extend  credit     |       | $                      | 10,864     |                       | $          | 14,451 |   |
|                              |       |                   |       |                       |       |
| Letters of credit                 |       | $                      | 1,413      |                       | $          | 1,525 |   |

 

**CapitalResources**

 

Total shareholders’ equity decreased from $8.7 million at December 31,2009 to $6.0 million at June 30, 2010. The decrease is principally due to the net loss for the six months endedJune 30, 2010 of $4.3 million offset partially by an increase in marketvalue of available for sale securities.

 

The FRB and bank regulatory agencies require bank holding companies andfinancial institutions to maintain capital at adequate levels based on apercentage of assets and off-balance sheet exposures, adjusted for risk weightsranging from 0% to 100%.

 

The FRB guidelines contain an exemption from the capital requirementsfor “small bank holding companies” to cover most bank holding companies withless than $500 million in total assets that do not have a material amount ofdebt or equity securities outstanding registered with the SEC.  Although our class of common stock isregistered under Section 12 of the Securities Exchange Act, we believethat because our stock is not listed on any exchange or otherwise activelytraded, the FRB will interpret its new guidelines to mean that we qualify as asmall bank holding company. Nevertheless, our Bank remains subject to these capitalrequirements.  Failure to meet minimumcapital requirements can initiate certain mandatory and possibly additionaldiscretionary actions by regulators that, if undertaken, could have a directmaterial effect on the Bank’s financial statements.  Under capital adequacy guidelines and theregulatory framework for prompt corrective action, the Bank must meet specificcapital guidelines that involve quantitative measures of the Bank’s assets,liabilities, and certain off-balance sheet items as calculated under regulatoryaccounting practices.  The Bank’s capitalamounts and classifications are also subject to qualitative judgments by theregulators about components, risk weightings, and other factors.

 

Under the capital adequacy guidelines, regulatory capital is classifiedinto two tiers.  These guidelines requirean institution to maintain a certain level of Tier 1 and Tier 2 capital torisk-weighted assets.  Tier 1 capitalconsists of common shareholders’ equity, excluding the unrealized gain or losson securities 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.

 

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At the Bank level, we are subject to various regulatory capital requirementsadministered by the federal banking agencies. Under the regulations adopted by the federal regulatory authorities, abank will be categorized as:

 

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

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

·                  Undercapitalized if the institutionhas a total risk-based capital ratio that is less than 8.0%, a Tier 1risk-based capital ratio of less than 4.0%, or a leverage ratio of less than4.0%.

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

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

 

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

 

If a bank is not well capitalized, it cannot accept brokered depositswithout prior FDIC approval.  Inaddition, a bank that is not well capitalized cannot offer an effective yieldin excess of 75 basis points over interest paid on deposits of comparable sizeand maturity in such institution’s normal market area for deposits acceptedfrom within its normal market area, or national rate paid on deposits ofcomparable size and maturity for deposits accepted outside the Bank’s normalmarket area.  Moreover, the FDICgenerally prohibits a depository institution from making any capitaldistributions (including payment of a dividend) or paying any management fee toits parent holding company if the depository institution would thereafter be categorizedas undercapitalized. Undercapitalized institutions are subject to growthlimitations (an undercapitalized institution may not acquire anotherinstitution, establish additional branch offices or engage in any new line ofbusiness unless determined by the appropriate federal banking agency to beconsistent with an accepted capital restoration plan, or unless the FDICdetermines that the proposed action will further the purpose of promptcorrective action) and are required to submit a capital restoration plan. Theagencies may not accept a capital restoration plan without determining, amongother things, that the plan is based on realistic assumptions and is likely tosucceed in restoring the depository institution’s capital. In addition, for acapital restoration plan to be acceptable, the depository institution’s parentholding company must guarantee that the institution will comply with thecapital restoration plan. The aggregate liability of the parent holding companyis limited to the lesser of an amount equal to 5.0% of the depositoryinstitution’s total assets at the time it became categorized asundercapitalized or the amount that is necessary (or would have been necessary)to bring the institution into compliance with all capital standards applicablewith respect to such institution as of the time it fails to comply with theplan. If a depository institution fails to submit an acceptable plan, it iscategorized as significantly undercapitalized.

 

Significantly undercapitalized categorized depository institutions maybe subject to a number of requirements and restrictions, including orders tosell sufficient voting stock to become categorized as adequately capitalized,requirements to reduce total assets, and cessation of receipt of deposits fromcorrespondent banks.  The appropriatefederal banking agency may take any action authorized for a significantlyundercapitalized institution if an undercapitalized institution fails to submitan acceptable capital restoration plan or fails in any material respect toimplement a plan accepted by the agency. A critically undercapitalized institution is subject to having areceiver or conservator appointed to manage its affairs and for loss of itscharter to conduct banking activities.

 

An insured depository institution may not pay a management fee to abank holding company controlling that institution or any other person havingcontrol of the institution if, after making the payment, the institution wouldbe undercapitalized.  In addition, aninstitution cannot make a capital distribution, such as a dividend or otherdistribution, that is in substance a distribution of capital to the owners ofthe institution if following such a distribution the institution would beundercapitalized.  Thus, if payment ofsuch a management fee or the making of such would cause a bank to becomeundercapitalized, it could not pay a management fee or dividend to the bankholding company.

 

At June 30, 2010, the Bank was categorized as “significantlyundercapitalized” under the regulatory framework.  As of December 31, 2009, the Bank wascategorized “undercapitalized” under the regulatory framework.

 

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The Bank’s regulatory capital ratios are set forth in the followingtable (dollars in thousands).

 
| ** **                                | ** ** | **June 30, 2010** | ** ** | **December 31, 2009** | ** ** |
|-------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                | ** ** | **Amount**             | ** ** | **Ratio**                  | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
|                                      |       |                   |       |                       |       |   |   |   |   |
| Tier 1 capital (to  risk-weighted assets) |       | $                      | 9,788      |                       | 4.06       | % | $ | 13,643 |   | 4.96 | % |
| Total capital (to  risk-weighted assets)  |       | 12,904                 |       | 5.36                       |       | 17,201 |   | 6.25 |   |
| Tier 1 capital (to average  assets)       |       | 9,788                  |       | 2.13                       |       | 13,643 |   | 3.12 |   |
|                                           |            |                        |            |                            |            |  |  |  |  |  |  |

 

Our losses for 2009 and the first six months of 2010 have adverselyimpacted our capital. As a result, we have been pursuing a plan to increase ourcapital ratios in order to strengthen our balance sheet and satisfy thecommitments required under the Consent Order that we entered into with the FDICand the South Carolina Board of Financial Institutions on February 23,2010. In addition, the Consent Order requires us to achieve and maintain, by June 23,2010, Total Risk Based capital at least equal to 10% of risk-weighted assetsand Tier 1 capital at least equal to 8% of total assets. We did not meet thatrequirement and have submitted a revised capital plan to the FDIC on July 28,2010.  If we continue to fail to meet the capital requirements in the ConsentOrder in a timely manner, then this would result in additional regulatoryactions, which could ultimately lead to the Bank being taken into receivershipby the FDIC.  Our auditors havenoted that the uncertainty of our ability to obtain sufficient capital oraddress our upcoming liquidity needs raises substantial doubt about our abilityto continue as a going concern.

 

**CriticalAccounting Policies**

 

We have adopted various accounting policies that govern the applicationof GAAP and with general practices within the banking industry in thepreparation of our financial statements. Our significant accounting policies are described in Note 2 to thefinancial statements.

 

Certain accounting policies involve significant judgments andassumptions by us that have a material impact on the carrying value of certainassets and liabilities.  We considerthese accounting policies to be critical accounting policies.  The judgments and assumptions we use arebased on historical experience and other factors, which we believe to bereasonable under the circumstances. Because of the nature of the judgments and assumptions we make, actualresults could differ from these judgments and estimates that could have amaterial impact on the carrying values of our assets and liabilities and ourresults of operations.

 

We believe the allowance for loan losses is the critical accountingpolicy that requires the most significant judgments and estimates used inpreparation of our consolidated financial statements.  Some of the more critical judgmentssupporting the amount of our allowance for loan losses include judgments aboutthe credit worthiness of borrowers, the estimated value of the underlyingcollateral, the assumptions about cash flows, the determination of loss factorsfor estimating credit losses, the impact of current events, and conditions, andother factors impacting the level of probable inherent losses.  Under different conditions or using differentassumptions, the actual amount of credit losses incurred by us may be differentfrom management’s estimates provided in our consolidated financialstatements.  Refer to the portion of thisdiscussion that addresses our allowance for loan losses for a more completediscussion of our processes and methodology for determining our allowance forloan losses.

 

*Allowance for Loan Losses*

 

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

 

We calculate the allowance for loan losses for specific types of loansand evaluate the adequacy on an overall portfolio basis utilizing our creditgrading system which we apply to each loan.  We combine our estimates ofthe reserves needed for each component of the portfolio, including loansanalyzed on a pool basis and loans analyzed individually.  The allowanceis divided into two portions: (1) an amount for specific allocationson significant individual credits that are considered impaired and (2) ageneral reserve amount.

 

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*Specific Reserve*

 

We analyze individual loans within the portfolio and make allocationsto the allowance based on each individual loan’s specific factors and othercircumstances that affect the collectability of the credit. Significantindividual credits classified as impaired within our credit grading systemrequire both individual analysis and specific allocation.

 

In these situations where a loan is determined to be impaired(primarily because it is probable that all principal and interest due accordingto the terms of the loan agreement will not be collected as scheduled), theloan is excluded from the general reserve calculations described below and isassigned a specific reserve.  We calculate specific reserves on thoseimpaired loans exceeding $250,000.  These reserves are based on athorough analysis of the most probable source of repayment which is usually theliquidation of the underlying collateral, but may also include discountedfuture cash flows or, in rare cases, the market value of the loan itself.

 

Generally, for larger collateral dependent loans, current marketappraisals are ordered to estimate the current fair value of thecollateral.  However, in situations where a current market appraisalis not available, management uses the best available information (includingrecent appraisals for similar properties, communications with qualified realestate professionals, information contained in reputable trade publications andother observable market data) to estimate the current fairvalue.  The estimated costs to sell the subject property are then deductedfrom the estimated fair value to arrive at the “net realizable value” of theloan and to determine the specific reserve on each impaired loanreviewed.  The credit risk management group periodically reviews thefair value assigned to each impaired loan and adjusts the specific reserveaccordingly.

 

*General Reserve*

 

We calculate our general reserve based on a percentage allocation foreach of the categories of the following unclassified loan types such as: real estate, commercial, consumer, A&D/construction and mortgage.  Weapply historical trend loss factors to each category and adjust thesepercentages for qualitative or environmental factors, as discussedbelow.  The general estimate is then added to the specificallocations made to determine the amount of the total allowance for loanlosses.

 

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

 

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

 

*Other Real Estate Owned*

 

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

 

**Item 3. Quantitative and Qualitative Disclosures About Market Risk.**

 

Not applicable.

 

**Item 4. Controls and Procedures****.**

 

As of the end of the period covered by this report, we carried out anevaluation, under the supervision and with the participation of our management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of our disclosure controls and procedures as defined in ExchangeAct Rule 13a-15(e).  Based upon thatevaluation, our Chief Executive Officer and Chief Financial Officer haveconcluded that our current disclosure controls and procedures are effective asof June 30, 2010.  There have beenno significant changes in our internal controls over financial reporting duringthe fiscal quarter ended June 30, 2010 that have materially affected, orare reasonably likely to materially affect, our internal controls overfinancial reporting.

 

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The design of any system of controls and procedures is based in partupon certain assumptions about the likelihood of future events.  There can be no assurance that any designwill succeed in achieving its stated goals under all potential future conditions,regardless of how remote.

 

**Part II - Other Information**

 

**Item 1.Legal Proceedings.**

 

NotApplicable.

 

**Item1A. Risk Factors.**

 

NotApplicable.

 

**Item 2.Unregistered Sales of Equity Securities and Use of Proceeds.**

 

Notapplicable.

 

**Item 3.Defaults Upon Senior Securities.**

 

Notapplicable.

 

**Item 4.(Removed and Reserved).**

 

**Item 5.Other Information.**

 

Notapplicable.

 

**Item 6. Exhibits.**

 

31.1         Rule 13a-14(a) Certificationof the Principal Executive Officer.

 

31.2         Rule 13a-14(a) Certificationof the Principal Financial Officer.

 

32            Section 1350Certifications.

 

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**SIGNATURES**

 

In accordance with the requirements of the Securities Exchange Act of1934, the Registrant caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 

 
| Date: August 2, 2010 | By:                                          | /s/ C. Allan Ducker, III |
|----------------------|----------------------------------------------|-------------------------------|
|                 | C. Allan Ducker, III                    |
|                 | Chief Executive Officer                      |
|                 | (Principal Executive Officer)                |
|                 |                                         |                          |
| Date: August 2, 2010 | By:                                          | /s/ John W. Hobbs             |
|                 | John W. Hobbs                                |
|                 | Chief Financial Officer                      |
|                 | (Principal Financial and Accounting Officer) |

 

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**EXHIBIT INDEX**

 
| **Exhibit** | ** ** | ** **                                                                  |
|-------------|------------|-----------------------------------------------------------------------------|
| **Number**  | ** ** | **Description**                                                             |
|        |       |                                                                        |
| 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.                                           |

 

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