**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**(MARKONE)**

 

**x****     ****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the Quarterly Period ended June 30, 2009**

 

**OR**

 

**o****        ****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the Transition Period from                  to                  **

 

**Commission File No. ****000-51896**

 

**COMMUNITYSOUTHFINANCIAL CORPORATION**

(Exact name of registrant as specified in its charter)

 

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

 

**6602 Calhoun Memorial Highway**

**Easley,South Carolina 29640**

(Address of principal executive offices)

 

**(864) 306-2540**

(Registrant’s telephone number, including area code)

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the 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 tosuch filing requirements for the past 90 days.  Yes x  No o

 

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

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated 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) |   |                             |

 

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

 

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

4,698,697 shares ofcommon stock, $0.01 par value pershare, were issued and outstanding as of August 4, 2009.

 

 

 

----

 

**CommunitySouthFinancial Corporation**

 

**Part I- Financial Information**

 

## **Item 1. FinancialStatements**.

 

**CONSOLIDATED BALANCE SHEETS**

(dollars in thousands)

 
| ** **                                                                                                                                                                           | ** ** | **June 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                                                           | ** ** | **(Unaudited)**        | ** ** | **(Audited)**              | ** ** |
| ** **                                                                                                                                                                           |       |                   |       |                       |       |
| **Assets**                                                                                                                                                                           |       |                   |       |                       |       |
|                                                                                                                                                                                 |       |                   |       |                       |       |
| Cash and cash  equivalents                                                                                                                                                           |       |                   |       |                       |       |
| Cash and due from bank                                                                                                                                                               |       | $                      | 10,030     |                       | $          | 5,251 |   |
| Federal funds sold                                                                                                                                                                   |       | 21,072                 |       | 4,625                      |       |
| Total cash and cash  equivalents                                                                                                                                                     |       | 31,102                 |       | 9,876                      |       |
| Investment securities,  available for sale                                                                                                                                           |       | 42,715                 |       | 47,602                     |       |
| Other investments, at  cost                                                                                                                                                          |       | 1,599                  |       | 1,805                      |       |
| Loans, net                                                                                                                                                                           |       | 297,399                |       | 312,819                    |       |
| Accrued interest  receivable                                                                                                                                                         |       | 1,285                  |       | 1,628                      |       |
| Property and equipment,  net                                                                                                                                                         |       | 4,458                  |       | 4,618                      |       |
| Bank-owned life  insurance                                                                                                                                                           |       | —                 |       | 5,437                      |       |
| Other real estate owned                                                                                                                                                              |       | 3,132                  |       | 415                        |       |
| Other assets                                                                                                                                                                         |       | 5,120                  |       | 3,616                      |       |
|                                                                                                                                                                                 |       |                   |       |                       |       |
| Total assets                                                                                                                                                                         |       | $                      | 386,810    |                       | $          | 387,816 |   |
|                                                                                                                                                                                 |       |                   |       |                       |       |
| **Liabilities and Shareholders’ Equity**                                                                                                                                        |       |                   |       |                       |       |
|                                                                                                                                                                                 |       |                   |       |                       |       |
| **Liabilities**                                                                                                                                                                      |       |                   |       |                       |       |
| Deposits                                                                                                                                                                             |       |                   |       |                       |       |
| Non-interest bearing                                                                                                                                                                 |       | $                      | 22,439     |                       | $          | 22,162 |   |
| Interest bearing                                                                                                                                                                     |       | 301,049                |       | 274,481                    |       |
| Total deposits                                                                                                                                                                       |       | 323,488                |       | 296,643                    |       |
| Repurchase agreements                                                                                                                                                                |       | 30,000                 |       | 30,000                     |       |
| Federal Home Loan Bank  advances                                                                                                                                                     |       | —                 |       | 25,000                     |       |
| Note payable                                                                                                                                                                         |       | —                 |       | 1,570                      |       |
| Subordinated debt                                                                                                                                                                    |       | 4,325                  |       | 4,325                      |       |
| Accrued interest  payable                                                                                                                                                            |       | 1,218                  |       | 1,406                      |       |
| Accrued expenses                                                                                                                                                                     |       | 506                    |       | 193                        |       |
| Other liabilities                                                                                                                                                                    |       | 2                      |       | 151                        |       |
|                                                                                                                                                                                 |       |                   |       |                       |       |
| Total liabilities                                                                                                                                                                    |       | 359,539                |       | 359,288                    |       |
|                                                                                                                                                                                 |       |                   |       |                       |       |
| **Shareholders’ Equity**                                                                                                                                                        |       |                   |       |                       |       |
| Preferred stock, par  value $.01 per share 10,000,000 shares authorized, no shares issued                                                                                            |       | —                 |       | —                     |       |
| Common stock, par value  $.01 per share 10,000,000 shares authorized, 4,698,697 and 4,698,697 issued and  outstanding at June 30, 2009 and December 31, 2008, respectively |       | 47                     |       | 47                         |       |
| Additional paid-in  capital                                                                                                                                                          |       | 29,793                 |       | 29,760                     |       |
| Accumulated other  comprehensive income                                                                                                                                              |       | 42                     |       | 491                        |       |
| Retained earnings                                                                                                                                                                    |       | (2,611                 | )          | (1,770                     | )          |
| Total shareholders’  equity                                                                                                                                                     |       | 27,271                 |       | 28,528                     |       |
|                                                                                                                                                                                 |       |                   |       |                       |       |
| Total liabilities and  shareholders’ equity                                                                                                                                     |       | $                      | 386,810    |                       | $          | 387,816 |   |

 

2

----

 

**CommunitySouthFinancial Corporation**

 

**CONSOLIDATED STATEMENTS OF INCOME**

**(UNAUDITED)**

(dollars in thousands)

 
| ** **                                                 | ** ** | **Three months ended** | ** ** | **Three months ended** | ** ** |
|------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                 | ** ** | **June 30, 2009** | ** ** | **June 30, 2008** | ** ** |
| **Interest income**                                        |       |                   |       |                   |       |
| Interest and fees on  loans                                |       | $                      | 4,292      |                   | $          | 4,980 |   |
| Interest and dividends  on investments                     |       | 336                    |       | 671                    |       |
| Total interest income                                      |       | 4,628                  |       | 5,651                  |       |
|                                                       |       |                   |       |                   |       |
| **Interest expense – deposits and  other borrowings** |       | 1,951                  |       | 3,337                  |       |
| ** **                                                 |       |                   |       |                   |       |
| Net interest income                                        |       | 2,677                  |       | 2,314                  |       |
|                                                       |       |                   |       |                   |       |
| **Provision for loan losses**                              |       | 1,500                  |       | 2,579                  |       |
| ** **                                                 |       |                   |       |                   |       |
| Net interest income  after provision for loan losses       |       | 1,177                  |       | (265                   | )          |
|                                                       |       |                   |       |                   |       |
| **Non-interest income**                                    |       |                   |       |                   |       |
| Mortgage origination  fees                                 |       | 243                    |       | 172                    |       |
| Other                                                      |       | 198                    |       | 228                    |       |
| Total non-interest  income                                 |       | 441                    |       | 400                    |       |
| ** **                                                 |       |                   |       |                   |       |
| **Non-interest expense**                                   |       |                   |       |                   |       |
| Salaries and benefits                                      |       | 1,363                  |       | 1,228                  |       |
| Data processing                                            |       | 249                    |       | 177                    |       |
| Occupancy                                                  |       | 168                    |       | 157                    |       |
| Depreciation                                               |       | 182                    |       | 180                    |       |
| Equipment maintenance  and rental                          |       | 36                     |       | 39                     |       |
| Advertising                                                |       | 60                     |       | 28                     |       |
| Professional fees                                          |       | 74                     |       | 54                     |       |
| Office supplies                                            |       | 20                     |       | 19                     |       |
| Telephone                                                  |       | 38                     |       | 33                     |       |
| FDIC assessment                                            |       | 271                    |       | 54                     |       |
| Other                                                      |       | 376                    |       | 263                    |       |
| Total non-interest  expense                                |       | 2,837                  |       | 2,233                  |       |
| ** **                                                 |       |                   |       |                   |       |
| **Loss before income taxes**                               |       | (1,219                 | )          | (2,097                 | )          |
| ** **                                                 |       |                   |       |                   |       |
| **Income tax benefit**                                     |       | (414                   | )          | (707                   | )          |
| ** **                                                 |       |                   |       |                   |       |
| **Net loss**                                               |       | $                      | (805       | )                      | $          | (1,390 | ) |
| ** **                                                 |       |                   |       |                   |       |
| **Losses per share**                                       |       |                   |       |                   |       |
| Basic                                                      |       | $                      | (0.17      | )                      | $          | (0.30 | ) |
| Diluted                                                    |       | $                      | (0.17      | )                      | $          | (0.30 | ) |
| ** **                                                 |       |                   |       |                   |       |
| **Weighted average shares  outstanding**                   |       |                   |       |                   |       |
| Basic                                                      |       | 4,698,697              |       | 4,698,697              |       |
| Diluted                                                    |       | 4,698,697              |       | 4,698,697              |       |

 

3

----

 

**CommunitySouthFinancial Corporation**

 

**CONSOLIDATED STATEMENTS OF INCOME**

**(UNAUDITED)**

(dollars in thousands)

 
| ** **                                           | ** ** | **Six months ended**   | ** ** | **Six months ended**   | ** ** |
|------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                           | ** ** | **June 30, 2009** | ** ** | **June 30, 2008** | ** ** |
| **Interest income**                                  |       |                   |       |                   |       |
| Interest and fees on  loans                          |       | $                      | 8,661      |                   | $          | 10,498 |   |
| Interest and dividends  on investments               |       | 899                    |       | 1,402                  |       |
| Total interest income                                |       | 9,560                  |       | 11,900                 |       |
|                                                 |       |                   |       |                   |       |
| **Interest expense deposits and  other borrowings**  |       | 4,031                  |       | 6,990                  |       |
| ** **                                           |       |                   |       |                   |       |
| Net interest income                                  |       | 5,529                  |       | 4,910                  |       |
|                                                 |       |                   |       |                   |       |
| **Provision for loan losses**                        |       | 2,805                  |       | 2,704                  |       |
| ** **                                           |       |                   |       |                   |       |
| Net interest income  after provision for loan losses |       | 2,724                  |       | 2,206                  |       |
|                                                 |       |                   |       |                   |       |
| **Non-interest income**                              |       |                   |       |                   |       |
| Mortgage origination  fees                           |       | 305                    |       | 335                    |       |
| Other                                                |       | 950                    |       | 436                    |       |
| Total non-interest  income                           |       | 1,255                  |       | 771                    |       |
|                                                 |       |                   |       |                   |       |
| **Non-interest expense**                             |       |                   |       |                   |       |
| Salaries and benefits                                |       | 2,603                  |       | 2,463                  |       |
| Data processing                                      |       | 471                    |       | 367                    |       |
| Occupancy                                            |       | 339                    |       | 320                    |       |
| Depreciation                                         |       | 361                    |       | 361                    |       |
| Equipment maintenance  and rental                    |       | 79                     |       | 86                     |       |
| Advertising                                          |       | 97                     |       | 39                     |       |
| Professional fees                                    |       | 165                    |       | 132                    |       |
| Office supplies                                      |       | 42                     |       | 47                     |       |
| Telephone                                            |       | 75                     |       | 70                     |       |
| FDIC assessment                                      |       | 367                    |       | 107                    |       |
| Other                                                |       | 654                    |       | 558                    |       |
| Total non-interest  expense                          |       | 5,253                  |       | 4,550                  |       |
| ** **                                           |       |                   |       |                   |       |
| **Loss before income taxes**                         |       | (1,274                 | )          | (1,573                 | )          |
| ** **                                           |       |                   |       |                   |       |
| **Income tax benefit**                               |       | (433                   | )          | (524                   | )          |
| ** **                                           |       |                   |       |                   |       |
| **Net loss**                                         |       | $                      | (841       | )                      | $          | (1,049 | ) |
| ** **                                           |       |                   |       |                   |       |
| **Losses per share**                                 |       |                   |       |                   |       |
| Basic                                                |       | $                      | (0.18      | )                      | $          | (0.22 | ) |
| Diluted                                              |       | $                      | (0.18      | )                      | $          | (0.22 | ) |
| ** **                                           |       |                   |       |                   |       |
| **Weighted average shares  outstanding**             |       |                   |       |                   |       |
| Basic                                                |       | 4,698,697              |       | 4,698,697              |       |
| Diluted                                              |       | 4,698,697              |       | 4,698,697              |       |

 

4

----

 

**CommunitySouthFinancial Corporation**

 

**CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’EQUITY**

**For the six month periods ended June 30, 2009and June 30, 2008**

**(UNAUDITED)**

(dollars in thousands, except share amounts)

 
| ** **                                                                  | ** ** | **Common Stock** | ** ** | **Additional  Paid-in** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Retained** | ** ** | **Total  Shareholders’** | ** ** | **Total  Comprehensive** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------|------------|-------------------------|------------|---------------------------------------|------------|--------------|------------|-------------------------------|------------|--------------------------|------------|
| ** **                                                                  | ** ** | **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:                                                |       |             |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
|                                                                        |       |             |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Unrealized gains  (losses) on securities, net of income tax benefit of $203 |       | —           |       | —                  |       | —                                |       | (449         | )          | —                        |       | (449                     | )          | (449 | ) |
|                                                                        |       |             |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Total comprehensive  income (loss)                                          |       |             |       |                    |       |                                  |       |         |       |                          |       |                     |       | $ | (1,290 | ) |
|                                                                        |       |             |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Stock option  compensation                                                  |       | —           |       | —                  |       | 33                                    |       | —       |       | —                        |       | 33                       |       |   |   |
|                                                                        |       |             |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Balance at June 30,  2009                                              |       | 4,698,697        |       | $                       | 47         |                                  | $          | 29,793       |       | $                             | 42         |                     | $          | (2,611 | ) | $ | 27,271 |   |   |   |

 
| ** **                                                                  | ** ** | **Common Stock** | ** ** | **Additional  Paid-in** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Retained** | ** ** | **Total  Shareholders’** | ** ** | **Total  Comprehensive** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------|------------|-------------------------|------------|---------------------------------------|------------|--------------|------------|-------------------------------|------------|--------------------------|------------|
| ** **                                                                  | ** ** | **Shares**       | ** ** | **Amount**              | ** ** | **Capital**                           | ** ** | **Income**   | ** ** | **Earnings**                  | ** ** | **Equity**               | ** ** | **Income** | ** ** |
| Balance at  December 31, 2007                                          |       | 4,698,697        |       | $                       | 47         |                                  | $          | 29,692       |       | $                             | 152        |                     | $          | 1,581 |   | $ | 31,472 |   |   |   |
|                                                                        |       |             |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Net income                                                                  |       | —           |       | —                  |       | —                                |       | —       |       | (1,049                        | )          | (1,049                   | )          | $ | (1,049 | ) |
|                                                                        |       |             |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Other comprehensive  income:                                                |       |             |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
|                                                                        |       |             |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Unrealized gains  (losses) on securities, net of income tax benefit of $369 |       | —           |       | —                  |       | —                                |       | (626         | )          | —                        |       | (626                     | )          | (626 | ) |
|                                                                        |       |             |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Total comprehensive  income                                                 |       |             |       |                    |       |                                  |       |         |       |                          |       |                     |       | $ | (1,675 | ) |
|                                                                        |       |             |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Stock option  compensation                                                  |       | —           |       | —                  |       | 34                                    |       | —       |       | —                        |       | 34                       |       |   |   |
|                                                                        |       |             |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Balance at June 30,  2008                                              |       | 4,698,697        |       | $                       | 47         |                                  | $          | 29,726       |       | $                             | (474       | )                        | $          | 532 |   | $ | 29,831 |   |   |   |

 

5

----

 

**CommunitySouthFinancial Corporation**

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(UNAUDITED)**

(dollars in thousands)

 
| ** **                                                                       | ** ** | **Six months  ended** | ** ** | **Six Months  ended** | ** ** |
|----------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                       | ** ** | **June 30,**     | ** ** | **June 30,**     | ** ** |
| ** **                                                                       | ** ** | **2009**              | ** ** | **2008**              | ** ** |
| **Operating activities**                                                         |       |                  |       |                  |       |
| Net loss                                                                         |       | $                     | (841       | )                     | $          | (1,049 | ) |
| Adjustments to  reconcile net loss to net cash provided by operating activities: |       |                  |       |                  |       |
| Provision for loan  losses                                                       |       | 2,805                 |       | 2,704                 |       |
| Stock option  compensation                                                       |       | 33                    |       | 34                    |       |
| Sale (appreciation) of  bank-owned life insurance                                |       | 5,437                 |       | (100                  | )          |
| Depreciation                                                                     |       | 361                   |       | 361                   |       |
| Deferred income tax  expense (benefit)                                           |       | 17                    |       | (886                  | )          |
| Decrease in accrued  interest receivable                                         |       | 343                   |       | 337                   |       |
| Increase (decrease) in  accrued interest payable                                 |       | (188                  | )          | 292                   |       |
| Increase (decrease) in  accrued expenses                                         |       | 313                   |       | (185                  | )          |
| Decrease (increase) in  other assets                                             |       | (1,301                | )          | 45                    |       |
| Increase (decrease) in  other liabilities                                        |       | (149                  | )          | 1,583                 |       |
|                                                                             |       |                  |       |                  |       |
| Net cash provided by  operating activities                                       |       | 6,830                 |       | 3,136                 |       |
|                                                                             |       |                  |       |                  |       |
| **Investing activities**                                                         |       |                  |       |                  |       |
| Net (increase) decrease  in loans outstanding                                    |       | 9,898                 |       | (13,511               | )          |
| Sale (purchases) of  investment securities                                       |       | 4,218                 |       | (24,178               | )          |
| Sale (purchases) of  FHLB stock                                                  |       | 206                   |       | (683                  | )          |
| Purchase of property  and equipment                                              |       | (201                  | )          | (129                  | )          |
|                                                                             |       |                  |       |                  |       |
| Net cash provided by  (used in) investing activities                             |       | 14,121                |       | (38,501               | )          |
|                                                                             |       |                  |       |                  |       |
| **Financing activities**                                                         |       |                  | ** ** |                  | ** ** |
| Net increase (decrease)  in deposit accounts                                     |       | 26,845                |       | (19,862               | )          |
| Advances (repayments)  from FHLB                                                 |       | (25,000               | )          | 10,000                |       |
| Increase in repurchase  agreements                                               |       | —                |       | 15,000                |       |
| Repayment of note  payable                                                       |       | (1,570                | )          | —                |       |
|                                                                             |       |                  |       |                  |       |
| Net cash provided by  financing activities                                       |       | 275                   |       | 5,138                 |       |
|                                                                             |       |                  |       |                  |       |
| Net increase (decrease)  in cash and cash equivalents                            |       | 21,226                |       | (30,227               | )          |
|                                                                             |       |                  |       |                  |       |
| **CASH AND CASH EQUIVALENTS,  BEGINNING OF PERIOD**                              |       | 9,876                 |       | 40,152                |       |
|                                                                             |       |                  |       |                  |       |
| **CASH AND CASH EQUIVALENTS, END  OF PERIOD**                                    |       | $                     | 31,102     |                  | $          | 9,925 |   |
|                                                                             |       |                  |       |                  |       |
| **SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION**                            |       |                  |       |                  |       |
| Cash paid for:                                                                   |       |                  |       |                  |       |
| Interest                                                                         |       | $                     | 4,219      |                  | $          | 6,696 |   |
| Income taxes                                                                     |       | $                     | 419        |                  | $          | 363 |   |
|                                                                             |       |                  |       |                  |       |
| **Schedule  of non-cash transactions**                                           |       |                  |       |                  |       |
| Unrealized gains /  (losses) on investment securities, net of income taxes       |       | $                     | (449       | )                     | $          | (626 | ) |

 

6

----

 

**Notes to Unaudited Consolidated FinancialStatements**

 

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

 

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

 

The Bank began operations on January 18, 2005.  The Bank primarily is engaged in the 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 financial statementshave been prepared in accordance with generally accepted accounting principlesin the United States of America and to general practices in the bankingindustry for interim financial information and with the instructions to Form 10-Q.  Accordingly, they do not include all theinformation and footnotes required by generally accepted accounting principlesfor complete financial statements.  Inthe opinion of management, all adjustments (consisting of normal recurringaccruals) considered necessary for a fair presentation have been included.  Operating results for the three and six monthperiods ended June 30, 2009 are not necessarily indicative of the resultsthat may be expected for the year ending December 31, 2009.  For further information, refer to the auditedconsolidated financial statements and footnotes dated December 31, 2008included in the Company’s Form 10-K for the year ended December 31,2008 as filed with the Securities and Exchange Commission.

 

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

 

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

 

**Management’s Estimates** — The preparation of consolidatedfinancial statements in conformity with generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of income and expenses during the reporting period.  Actual results could differ from thoseestimates.

 

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

 

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

 

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

 

The Company makes loans to individuals and small businesses for variouspersonal and commercial purposes primarily in the upstate region of SouthCarolina.  The Company’s loan portfoliois not concentrated in loans to any single borrower or to a relatively smallnumber of borrowers.  The Bank does 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 continue to decline, itis also more likely that we would be required to increase our allowance forloan losses.

 

7

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

 

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.

 

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

 

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

 

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

 

3.               *Trading securities*: These are securities that are boughtand held principally for the purpose of selling in the near future. Trading securities are reported at fair market value, and related unrealizedgains and losses are recognized in the income statement.  The Company hasno trading securities.

 

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 identificationmethod.  Premiums and discounts are amortized or accreted intointerest income by a method that approximates a level yield.

 

**Other Investments —**CommunitySouth Bank and Trust, as amember institution, is required to own stock investments in the Federal HomeLoan Bank of Atlanta(“FHLB”).  Investment in the FHLB is acondition of borrowing from the FHLB, and the stock is pledged to collateralizesuch borrowings.  No ready market existsfor the stock and it has no quoted market value.  However, redemption of these stocks hashistorically been at par value.  Thedividend received on this stock is included in interest and dividends oninvestments.

 

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

 

In accordance with SFAS No. 114, “Accounting by Creditors forImpairment of a Loan,” (“SFAS 114”), loans are considered to be impaired when,in management’s judgment and based on current information, the full collectionof principal and interest becomes doubtful. A loan is also considered impaired if its terms are modified in atroubled debt restructuring.  Impairedloans are placed in non-performing status, and future payments are applied toprincipal until such time as collection of the obligation is no longerdoubtful. Interest accrual resumes only when loans return to performingstatus.  To return to performing status,loans must be fully current, and continued timely payments must be a reasonableexpectation.  Loans are generally placedon non-accrual status when principal or interest becomes ninety days past due,or when payment in full is not anticipated.  When a loan is placed onnon-accrual status, interest accrued but not received is generally reversedagainst interest income.  Cash receipts on non-accrual loans are notrecorded as interest income, but are used to reduce principal.

 

8

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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 $23,097,000 and $13,172,000 in impaired loansat June 30, 2009 and December 31, 2008, respectively.

 

**Allowancefor Loan Losses** —The allowance for loan losses is established as losses are estimated to haveoccurred through a provision for loan losses charged to earnings.  Loan 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 componentrelates to 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 of expectedfuture cash flows discounted at the loan’s effective interest rate, the loan’sobtainable market price, or the fair value of the collateral if the loan iscollateral dependent.

 

Large groups of smaller balance homogeneous loans are collectively evaluatedfor impairment.  Accordingly, the Companydoes not separately identify individual consumer and residential loans forimpairment disclosures, unless such loans are the subject of a restructuringagreement.

 

**Bank-Owned Life Insurance** — The Company made the decision to sellthese policies in order to help reduce assets, thereby improving the Bank’srisk based capital ratio. During the first quarter of 2009, the Company beganthe process of divesting of its key employee life insurance policies by sellingpolicies at no gain or loss.  Income fromthese policies and changes in the net cash surrender value are currentlyrecorded in non-interest income. The final policy was sold in April 2009.

 

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

 

**Residential Loan Origination Fees** — The Companyoffers residential loan origination services to its customers in its immediatemarket area.  The loans are offered onterms and prices offered by the Company’s correspondents and are closed in thename of the correspondents.  The Companyreceives fees for services it provides in conjunction with the originationservices it provides.  The fees arerecognized at the time the loans are closed by the Company’s correspondent.

 

9

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

 

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

 

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

 

**Earnings (loss) Per Share** — Basic earnings (loss) per sharerepresents 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 adopted the fair valuerecognition provisions of the SFAS No. 123(R), “Share-Based Payment”,which is a revision of SFAS No. 123, “Accounting for Stock-BasedCompensation”, to account for compensation costs under its stock optionplans.  The Company previously utilizedthe intrinsic value method under Accounting Principles Board (“APB”) Opinion No. 25,“Accounting for Stock Issued to Employees (as amended)” (“APB 25”).  Under the intrinsic value method prescribedby APB 25, no compensation costs were recognized for the Company’s stockoptions because the option exercise price in its plans equaled the market priceon the date of grant.

 

# **In adopting SFAS No. 123(R), the Companyelected to use the modified prospective method to account for the transitionfrom the intrinsic value method to the fair value recognition method.  Under the modified prospective method,compensation cost is recognized from the adoption date forward for all newstock options granted and for any outstanding unvested awards as if the fairvalue method had been applied to those awards as of the date of grant.**

# ** **

**Off-Balance Sheet FinancialInstruments** — Inthe ordinary 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 summary of recentauthoritative pronouncements that could impact the accounting, reporting, and /or disclosure of financial information by the Company

 

InJune 2009, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 168,“The *FASB Accounting Standards Codification*TM and the Hierarchy of Generally AcceptedAccounting Principles — a replacement of FASB Statement No. 162,” (“SFAS168”).  SFAS 168 establishes the *FASB Accounting Standards Codification*TM (“Codification”) as the source ofauthoritative generally accepted accounting principles (“GAAP”) fornongovernmental entities.  TheCodification does not change GAAP. Instead, it takes the thousands ofindividual pronouncements that currently comprise GAAP and reorganizes theminto approximately 90 accounting Topics, and displays all Topics using aconsistent structure.  Contents in eachTopic are further organized first by Subtopic, then Section and finallyParagraph. The Paragraph level is the only level that contains substantivecontent. Citing particular content in the Codification involves specifying theunique numeric path to the content through the Topic, Subtopic, Section andParagraph structure. FASB suggests that all citations begin with “FASB ASC,” 

 

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whereASC stands for *Accounting Standards Codification*.SFAS 168, (FASB ASC 105-10-05, 10, 15, 65, 70) is effective for interim andannual periods ending after September 15, 2009 and will not have an impacton the Company’s financial position but will change the referencing system foraccounting standards.  The followingpronouncements provide citations to the applicable Codification by Topic,Subtopic and Section in addition to the original standard type and number.

 

FSPEITF 99-20-1, “Amendments to the Impairment Guidance of EITF Issue No. 99-20,”(FASB ASC 325-40-65) (“FSP EITF 99-20-1”) was issued in January 2009.  Prior to the FSP, other-than-temporaryimpairment was determined by using either Emerging Issues Task Force (“EITF”)Issue No. 99-20, “Recognition of Interest Income and Impairment onPurchased Beneficial Interests and Beneficial Interests that Continue to beHeld by a Transferor in Securitized Financial Assets,” (“EITF 99-20”) or SFAS No. 115,“Accounting for Certain Investments in Debt and Equity Securities,” (“SFAS 115”)depending on the type of security.  EITF99-20 required the use of market participant assumptions regarding future cashflows regarding the probability of collecting all cash flows previouslyprojected.  SFAS 115 determinedimpairment to be other than temporary if it was probable that the holder wouldbe unable to collect all amounts due according to the contractual terms. Toachieve a more consistent determination of other-than-temporary impairment, theFSP amends EITF 99-20 to determine any other-than-temporary impairment based onthe guidance in SFAS 115, allowing management to use more judgment indetermining any other-than-temporary impairment.  The FSP was effective for reporting periodsending after December 15, 2008. Management has reviewed the Company’s security portfolio and evaluatedthe portfolio for any other-than-temporary impairments.

 

OnApril 9, 2009, the FASB issued three staff positions related to fair valuewhich are discussed below.

 

FSPSFAS 115-2 and SFAS 124-2 (FASB ASC 320-10-65), “Recognition and Presentationof Other-Than-Temporary Impairments,” (“FSP SFAS 115-2 and SFAS 124-2”)categorizes losses on debt securities available-for-sale or held-to-maturitydetermined by management to be other-than-temporarily impaired into losses dueto credit issues and losses related to all other factors.  Other-than-temporary impairment (“OTTI”)exists when it is more likely than not that the security will mature or be soldbefore its amortized cost basis can be recovered.  An OTTI related to credit losses should berecognized through earnings.  An OTTIrelated to other factors should be recognized in other comprehensiveincome.  The FSP does not amend existingrecognition and measurement guidance related to other-than-temporary impairmentsof equity securities.  Annual disclosuresrequired in SFAS 115 and FSP SFAS 115-1 and SFAS 124-1 are also required forinterim periods (including the aging of securities with unrealized losses).

 

FSPSFAS 157-4 (FASB ASC 820-10-65), “Determining Fair Value When the Volume andLevel of Activity for the Asset or Liability Have Significantly Decreased andIdentifying Transactions That are Not Orderly” recognizes that quoted pricesmay not be determinative of fair value when the volume and level of tradingactivity has significantly decreased. The evaluation of certain factors may necessitate that fair value bedetermined using a different valuation technique.  Fair value should be the price that would bereceived to sell an asset or paid to transfer a liability in an orderlytransaction, not a forced liquidation or distressed sale.  If a transaction is considered to not beorderly, little, if any, weight should be placed on the transaction price.  If there is not sufficient information toconclude as to whether or not the transaction is orderly, the transaction priceshould be considered when estimating fair value.  An entity’s intention to hold an asset orliability is not relevant in determining fair value.  Quoted prices provided by pricing services maystill be used when estimating fair value in accordance with SFAS 157; however,the entity should evaluate whether the quoted prices are based on currentinformation and orderly transactions. Inputs and valuation techniques are required to be disclosed in additionto any changes in valuation techniques.

 

FSPSFAS 107-1 and APB 28-1 (FASB ASC 825-10-65), “Interim Disclosures about FairValue of Financial Instruments” requires disclosures about the fair value offinancial instruments for interim reporting periods of publicly tradedcompanies as well as in annual financial statements and also requires thosedisclosures in summarized financial information at interim reporting periods  A publicly traded company includes any companywhose securities trade in a public market on either a stock exchange or in theover-the-counter market, or any company that is a conduit bond obligor.  Additionally, when a company makes a filingwith a regulatory agency in preparation for sale of its securities in a publicmarket it is considered a publicly traded company for this purpose.

 

Thethree staff positions are effective for periods ending after June 15,2009, with early adoption of all three permitted for periods ending after March 15,2009.  The Company adopted the staff positionsfor its second quarter 10-Q.  The staffpositions had no material impact on the financial statements.  Additional disclosures have been providedwhere applicable.

 

Alsoon April 1, 2009, the FASB issued FSP SFAS 141(R)-1 (FASB ASC 805-20-25,30, 35, 50), “Accounting for Assets Acquired and Liabilities Assumed in aBusiness Combination That Arise from Contingencies.”  The FSP requires that assets 

 

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acquiredand liabilities assumed in a business combination that arise from a contingencybe recognized at fair value.  If fairvalue cannot be determined during the measurement period as determined in SFAS141 (R), the asset or liability can still be recognized if it can be determinedthat it is probable that the asset existed or the liability had been incurredas of the measurement date and if the amount of the asset or liability can bereasonably estimated.  If it is notdetermined to be probable that the asset/liability existed/was incurred or noreasonable amount can be determined, no asset or liability is recognized. Theentity should determine a rational basis for subsequently measuring theacquired assets and assumed liabilities. Contingent consideration agreements should be recognized initially at fairvalue and subsequently reevaluated in accordance with guidance found inparagraph 65 of SFAS 141 (R).  The FSP iseffective for business combinations with an acquisition date on or after thebeginning of the Company’s first annual reporting period beginning on or after December 15,2008.  The Company will assess the impactof the FSP if and when a future acquisition occurs.

 

TheSecurities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”)No. 111 (FASB ASC 320-10-S99-1) on April 9, 2009 to amend Topic 5.M.,“Other Than Temporary Impairment of Certain Investments in Debt and EquitySecurities” and to supplement FSP SFAS 115-2 and SFAS 124-2.  SAB 111 maintains the staff’s previous viewsrelated to equity securities; however debt securities are excluded from itsscope.  The SAB provides that “other-than-temporary”impairment is not necessarily the same as “permanent” impairment and unlessevidence exists to support a value equal to or greater than the carrying valueof the equity security investment, a write-down to fair value should berecorded and accounted for as a realized loss. The SAB was effective upon issuance and had no impact on the Company’sfinancial position.

 

SFAS165 (FASB ASC 855-10-05, 15, 25, 45, 50, 55), “Subsequent Events,” (“SFAS 165”)was issued in May 2009 and provides guidance on when a subsequent eventshould be recognized in the financial statements.  Subsequent events that provide additionalevidence about conditions that existed at the date of the balance sheet shouldbe recognized at the balance sheet date. Subsequent events that provideevidence about conditions that arose after the balance sheet date but beforefinancial statements are issued, or are available to be issued, are notrequired to be recognized. The date through which subsequent events have beenevaluated must be disclosed as well as whether it is the date the financialstatements were issued or the date the financial statements were available tobe issued.  For nonrecognized subsequentevents which should be disclosed to keep the financial statements from beingmisleading, the nature of the event and an estimate of its financial effect, ora statement that such an estimate cannot be made, should be disclosed.  The standard is effective for interim orannual periods ending after June 15, 2009. See Note 10 for Management’s evaluation of subsequent events.

 

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

 

**Risks and Uncertainties** — In the normal course of its business,the Company encounters two significant types of risk: economic andregulatory.  There are three main componentsof economic risk:  interest rate risk,credit risk and market risk.  The Companyis subject to interest rate risk to the degree that its interest-bearingliabilities mature or reprice at different speeds, or on different bases, thanits interest-earning assets.  Credit riskis the risk of default on the Company’s loan portfolio that results from theborrower’s inability or unwillingness to make contractually requiredpayments.  Market risk reflects changesin the value of collateral underlying loans receivable and the valuation ofreal estate held by the 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.  As discussed in moredetail in Note 9, on June 29, 2009, the Bank entered into a Memorandum ofUnderstanding (the “MOU”) with the Commissioner of Banking of the SouthCarolina State Board of Financial Institutions and the Regional Director of theFDIC’s Atlanta Regional Office.

 

The Bank is subject to FDIC insurance premiums. Legislation hasrecently passed that imposed a one time FDIC insurance premium that equated toa $178,000 one time charge to the Bank in 2009. This was expensed in June 2009and will be paid September 30, 2009.

 

**Reclassifications** - Certain captions and amounts in theprior financial statements were reclassified to conform with the 2009presentation.  Such reclassifications hadno effect on previously reported net income or shareholders’ equity.

 

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**NOTE 3 — INVESTMENT SECURITIES**

 

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

 
| ** **                        | ** ** | **Amortized** | ** ** | **Gross  Unrealized** | ** ** | **Fair**   | ** ** |
|-----------------------------------|------------|---------------|------------|-----------------------|------------|------------|------------|
| **As of  June 30, 2009**     | ** ** | **Cost**      | ** ** | **Gains**             | ** ** | **Losses** | ** ** | **Value** | ** ** |
| **Available  for sale**           |       |          |       |                  |       |       |       |   |   |
| Government  sponsored enterprises |       | $             | —     |                  | $          | —     |       | $ | — |   | $ | — |   |
| Mortgage-backed                   |       | 42,551        |       | 175                   |       | 111        |       | 42,615 |   |
| Marketable  securities            |       | 100           |       | —                |       | —     |       | 100 |   |
| Total available  for sale         | ** ** | **$**         | **42,651** | ** **            | **$**      | **175**    | ** ** | **$** | **111** | ** ** | **$** | **42,715** | ** ** |

 

**NOTE 4 — LEASES**

 

The Company leases branch locations in Spartanburg,Mauldin, Anderson, Greer and Greenville as well as the loan operations centerin Easley. The initial lease terms range from three to ten years with variousrenewal options. The minimum future rental payments under non-cancelableoperating leases having remaining terms in excess of one year, for each of thenext five years and in the aggregate are (in thousands):

 
| 2009                                  |       | $     | 159       |       |
|---------------------------------------|------------|-------|-----------|------------|
| 2010                                  |       | 320   |      |
| 2011                                  |       | 332   |      |
| 2012                                  |       | 345   |      |
| 2013                                  |       | 351   |      |
| Thereafter                            |       | 938   |      |
| Total minimum future  rental payments | ** ** | **$** | **2,445** | ** ** |

 

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

 

**NOTE 5 — 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 6 —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. The Bank has a lease agreement for a pending branch location inSpartanburg. The completion of the branch is currently on hold due to the Bank’sbalance sheet restructuring. The Bank is in negotiations with the landlord toalter the lease agreement. The lease is not material to the Bank’s operations.

 

**NOTE 7 — 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.  Inaddition, the Company has adopted a stock option plan.  As of June 30, 2009 the Company has769,713 outstanding options to employees and directors. On January 16,2006 the Company adopted a resolution that terminated the “evergreen” provisionof the Company 2005 Stock Incentive Plan. As a result, the number of shares ofcommon stock issuable under the plan shall not be further increased inconnection with any future share issuances by the Company. The exercise priceof each option is equal to the market price of the Company’s stock on the dateof grant. The maximum term is ten years, and they typically vest in no greaterthan five years. When necessary, the Company may purchase shares on the openmarket to satisfy share option exercises. During the ensuing year, the Companyis expected to acquire no shares.

 

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The table set forth below summarizes stock option activity for theCompany’s stock compensation plans for the period ended June 30, 2009 asadjusted for all stock splits.

 
| ** **                                 | ** ** | **Stock Options** | ** ** | **Warrants**  | ** ** |
|--------------------------------------------|------------|-------------------|------------|---------------|------------|
| ** **                                 | ** ** | ** **        | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **                                 | ** ** | ** **        | ** ** | **Average**   | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                 | ** ** | ** **        | ** ** | **Exercise**  | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                                 | ** ** | **Number**        | ** ** | **Price**     | ** ** | **Number** | ** ** | **Price** | ** ** |
| **Outstanding  at December 31, 2008** |       | 764,113           |       | $             | 7.08       |   | 171,404 |   | $ | 6.40 |   |
| Granted                                    |       | 13,900            |       | 2.74          |       | — |   | — |   |
| Forfeited                                  |       | 8,300             |       | 7.13          |       | — |   | — |   |
| Exercised                                  |       | —            |       | —        |       | — |   | — |   |
| **Outstanding  at June 30, 2009**     | ** ** | **769,713**       | ** ** | **7.00**      | ** ** | **171,404** | ** ** | **6.40** | ** ** |
|                                            |            |                   |            |               |            |  |  |  |  |  |  |

 

The table set forth below summarizes non-vested stockoptions as of June 30, 2009.

 
| ** **                                 | ** ** | ** ** | ** ** | **Fair**  | ** ** |
|--------------------------------------------|------------|------------|------------|-----------|------------|
| ** **                                 | ** ** | **Number** | ** ** | **Value** | ** ** |
| **Outstanding  at December 31, 2008** |       | 51,810     |       | $         | 5.33       |   |
| Granted                                    |       | 13,900     |       | 1.70      |       |
| Vested                                     |       | 8,006      |       | 6.07      |       |
| Forfeited                                  |       | 8,280      |       | 3.20      |       |
| **Outstanding  at June 30, 2009**     | ** ** | **49,424** | ** ** | **4.54**  | ** ** |
|                                            |            |            |            |           |            |  |

 

As of June 30, 2009, there was $192,072 in total unrecognizedcompensation cost related to non-vested share-based compensation arrangements,which is expected to be recognized over a weighted average period of 38 months.As of December 31, 2008, there was $223,689 in total unrecognizedcompensation cost related to non-vested share-based compensation arrangements,which was expected to be recognized over a weighted average period of 42months.

 

The fair value of each option granted is estimated on the grant dateusing the Black-Scholes option-pricing model with the following assumptions for2009:  dividend yield of 0%, expectedterm of 10 years, risk-free interest rate of 0.25%, expected life of 10 years,and expected volatility of 55%.  Thefollowing assumptions were used for the 2008 estimates:  dividend yield of 0%, expected term of 10years, risk-free interest rate of 5.0%, expected life of 10 years, and expectedvolatility of 20%.

 

The following table summarizes information about stockoptions outstanding under the Company’s plans at June 30, 2009 and December 31,2008.

 
| **June 30, 2009**           | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** |
|----------------------------------|------------|-----------------|------------|-----------------|------------|
| Number of options                |       | 769,713         |       | 720,289         |       |
| Weighted average  remaining life |       | 5.96 years      |       | 5.79 years      |       |
| Weighted average  exercise price |       | $               | 7.00       |            | $          | 6.81 |   |
| High exercise price              |       | $               | 16.80      |            | $          | 16.80 |   |
| Low exercise price               |       | $               | 2.50       |            | $          | 2.50 |   |

 
| **December 31, 2008**       | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** |
|----------------------------------|------------|-----------------|------------|-----------------|------------|
| Number of options                |       | 764,113         |       | 712,203         |       |
| Weighted average  remaining life |       | 6.42 years      |       | 6.26 years      |       |
| Weighted average  exercise price |       | $               | 7.08       |            | $          | 6.74 |   |
| High exercise price              |       | $               | 16.80      |            | $          | 16.80 |   |
| Low exercise price               |       | $               | 6.40       |            | $          | 6.40 |   |

 

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 2009 and 2008.

 

At June 30, 2009, all of the 171,404 warrants were exercisable andhad an average remaining life of 5.56 years. At December 31, 2008, all ofthe 171,404 warrants were exercisable and had an average remaining life of 6.05years.

 

14

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**NOTE 8 — FAIR VALUE OF FINANCIAL INSTRUMENTS**

 

SFAS No. 107, “Disclosures about Fair Value of FinancialInstruments” (“SFAS 107”), requires disclosure of fair value information,whether or not recognized in the consolidated balance sheets, when it ispractical to estimate the fair value. SFAS 107 defines a financial instrument as cash, evidence of anownership interest in an entity or contractual obligations, which require theexchange of cash, or other financial instruments.  Certain items are specifically excluded fromthe disclosure requirements, including the Company’s common stock, premises andequipment, accrued interest receivable and payable, and other assets andliabilities.

 

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 financialinstruments, 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 carrying amount is a reasonableestimate of fair value.

 

***Federal Funds Sold*** - Federal funds sold are for a term ofone day, and the carrying amount approximates the fair value.

 

***Investment Securities*** - The fair values of marketable equitysecurities are valued using quoted fair market prices.

 

***Other Investments*** - The carrying value of non-marketableequity securities approximates the fair value since no ready market exists forthe stocks.

 

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

 

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

# ** **

***Deposits*****- The fair value of demand deposits,savings, and money market accounts is the amount payable on demand at thereporting date.  The fair values ofcertificates of deposit are estimated using a discounted cash flow calculationthat applies current interest rates to a schedule of aggregated expected maturities.

 

***Repurchase Agreements*** - The carrying value of theseinstruments is a reasonable estimate of fair value.

 

***FHLB Advances -***The carrying value of these instrumentsis a reasonable estimate of fair value.

 

***Note Payable -***The carrying value of these instrumentsis a reasonable estimate of fair value.

 

***Subordinated Debt -***The carrying value of these instrumentsis a reasonable estimate of fair value.

 

15

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The carrying values and estimated fair values of theCompany’s financial instruments at June 30, 2009 are shown in thefollowing table.

 
| ** **                                                          | ** ** | **Carrying** | ** ** | **Estimated**   | ** ** |
|---------------------------------------------------------------------|------------|--------------|------------|-----------------|------------|
| **(Dollars in thousands)**                                          | ** ** | **Amount**   | ** ** | **Fair  Value** | ** ** |
| **June 30,  2009**                                             |       |         |       |            |       |
| **Financial  Assets**                                               |       |         |       |            |       |
| Cash and due  from banks                                            |       | $            | 10,030     |            | $          | 10,030 |   |
| Federal funds  sold                                                 |       | 21,072       |       | 21,072          |       |
| Investment  securities, available for sale                          |       | 42,715       |       | 42,715          |       |
| Other  investments                                                  |       | 1,599        |       | 1,599           |       |
| Loans, gross                                                        |       | 307,087      |       | 322,754         |       |
|                                                                |       |         |       |            |       |
| **Financial  Liabilities**                                          |       |         |       |            |       |
| Demand deposit,  interest-bearing transaction, and savings accounts |       | $            | 62,655     |            | $          | 62,655 |   |
| Certificates of  deposit and other time deposits                    |       | 260,833      |       | 261,944         |       |
| Repurchase  agreements                                              |       | 30,000       |       | 30,000          |       |
| Subordinated  debt                                                  |       | 4,325        |       | 5,479           |       |

 
| ** **                                   | ** ** | **June 30, 2009** | ** ** |
|----------------------------------------------|------------|------------------------|------------|
| **(Dollars in thousands)**                   | ** ** | **Notional  Amount**   | ** ** | **Estimated  Fair Value** | ** ** |
| **Off-Balance Sheet Financial Instruments:** |       |                   |       |   |   |
| ** **                                   |       |                   |       |   |   |
| Commitments  to extend credit                |       | $                      | 23,155     |   | $ | — |   |
| Standby  Letters of Credit                   |       | 1,412                  |       | $ | — |   |
|                                              |            |                        |            |  |  |  |  |

 

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

 

·                  Level 1:  Quotedmarket prices in active markets for identical assets or liabilities.

 

·                  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 determiningappropriate levels, the Company performs a detailed analysis of the assets andliabilities that are subject to SFAS No. 157.  At each reporting period, all assets andliabilities for which the fair value measurement is based on significantunobservable inputs are classified as Level 3.

 

The table below presentsthe balances of assets and liabilities measured at fair value on a recurringbasis by level within the hierarchy.

 
| ** **                                 | ** ** | **June 30, 2009** | ** ** |
|--------------------------------------------|------------|------------------------|------------|
| **(Dollars in thousands)**                 | ** ** | **Total**              | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Investment  securities, available for sale |       | $                      | 42,715     |   | $ | 42,715 |   | $ | — |   | $ | — |   |
|                                            |            |                        |            |  |  |  |  |  |  |  |  |  |  |

 

Certain assets andliabilities are measured at fair value on a nonrecurring basis; that is, theinstruments are not measured at fair value on an ongoing basis but are subjectto fair value adjustments in certain circumstances (for example, when there is

 

16

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evidence ofimpairment).  The following tablepresents the assets and liabilities carried on the balance sheet by caption andby level within the SFAS No. 157 valuation hierarchy (as described above) as ofJune 30, 2009 for which a nonrecurring change in fair value has been recordedduring the year ended June 30, 2009.

 
| ** **                 | ** ** | **Carrying Value at June 30, 2009** | ** ** |
|----------------------------|------------|-------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Total**                           | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Impaired  loans            |       | $                                   | 23,097     |   | $ | — |   | $ | 23,097 |   | $ | — |   |
| Other  real estate owned   |       | 3,132                               |       | — |   | 3,132 |   | — |   |
|                            |            |                                     |            |  |  |  |  |  |  |  |  |  |  |

 

**NOTE 9 – RECENT REGULATORYDEVELOPMENTS**

 

On June 29, 2009, the Bank entered into a MOU with theCommissioner of Banking of the South Carolina State Board of FinancialInstitutions and the Regional Director of the FDIC’s Atlanta RegionalOffice.  The MOU requires the Bank to,among other things, (1) submit a capital plan to the supervisory authoritiesfor maintaining a “well-capitalized” designation; (2) develop specific plansand proposals for the reduction and improvement of assets which are subject toadverse classification and past due loans; (3) implement a plan to decrease theconcentration of commercial real estate loans; (4) develop and implement animproved loan review program; and (5) review overall liquidity objectives anddevelop plans and procedures aimed at improving liquidity and reducing relianceon volatile liabilities to fund longer-term assets.  In addition, the Bank may not pay dividendswithout the prior written consent of each supervisory authority.

 

Since entering into theMOU, the Bank has been actively pursuing the corrective actions required by theMOU in an effort to ensure that the requirements of the MOU are met in a timelymanner.  The MOU is characterized by thesupervisory authorities as an informal action that is neither published normade publicly available by the supervisory authorities and is used whencircumstances warrant a milder form of action rather than a formal supervisoryaction.

 

**NOTE 10 – SUBSEQUENT EVENTS**

 

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

 

17

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

 

*The following discussion reviewsour results of operations and assesses our financial condition.  You should read the following discussion andanalysis in conjunction with the accompanying consolidated financial statements.  The commentary should be read in conjunctionwith the discussion of forward-looking statements, the financial statements,and the related notes and the other statistical information included in thisreport.*

 

**DISCUSSION OF FORWARD-LOOKING STATEMENTS**

 

This report containsstatements which constitute “forward-looking statements” within the meaning of Section27A of the Securities Act of 1933 and Section 21E of the Securities ExchangeAct of 1934.  Forward-looking statementsrelate to the financial condition, results of operations, plans, objectives,future performance, and business of our Company.  Forward-looking statements are based on manyassumptions and estimates and are not guarantees of future performance. Ouractual results may differ materially from those anticipated in anyforward-looking statements, as they will depend on many factors about which weare unsure, including many factors which are beyond 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 similar expressions, are meant to identify suchforward-looking statements.  Potentialrisks and uncertainties that could cause our actual results to differmaterially from those anticipated in our forward-looking statements include,without limitation, those described under the heading “Risk Factors” in ourAnnual Report on Form 10-K for the year ended December 31, 2008 as filed withthe Securities and Exchange Commission (the “SEC”) and the following:

 
|   | · | our rapid growth to date 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, increasing 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;                                                                                                                                                                            |
|   | · | our reliance on available secondary funding sources  such as Federal Home Loan Bank advances, Federal Reserve Bank discount window  borrowings, sales of securities and loans, federal funds lines of credit from  correspondent banks, and out-of-market time deposits, including in particular  brokered deposits, to meet our liquidity needs;      |
|   | · | our ability to raise capital or otherwise improve  our capital ratios;                                                                                                                                                                                                                                                                                 |
|   | · | our ability to comply with the terms of the MOU  between the Bank and its supervisory authorities within the timeframes  specified;                                                                                                                                                                                                                    |
|   | · | the opening of additional full-service branches and  the resulting pressure this could cause on our management team;                                                                                                                                                                                                                                   |
|   | · | significant increases in competitive pressure in the  banking and financial services industries;                                                                                                                                                                                                                                                       |
|   | · | changes in the interest rate environment which could  reduce anticipated or actual margins;                                                                                                                                                                                                                                                            |
|   | · | changes in political conditions or the legislative  or regulatory environment;                                                                                                                                                                                                                                                                         |
|   | · | general economic conditions, either nationally or  regionally and especially in our primary service area, becoming less  favorable than expected resulting in, among other things, a deterioration in  credit quality;                                                                                                                                 |
|   | · | changes occurring in business conditions and  inflation;                                                                                                                                                                                                                                                                                               |
|   | · | changes in technology;                                                                                                                                                                                                                                                                                                                                 |
|   | · | changes in deposits flows;                                                                                                                                                                                                                                                                                                                             |
|   | · | changes in monetary and tax policies;                                                                                                                                                                                                                                                                                                                  |
|   | · | the lack of seasoning of our loan portfolio,  especially given our rapid loan growth;                                                                                                                                                                                                                                                                  |
|   | · | the amount of our real estate based loans, and the  weakness in the commercial real estate market;                                                                                                                                                                                                                                                     |
|   | · | adequacy of the level of our allowance for loan  losses;                                                                                                                                                                                                                                                                                               |
|   | · | the rate of delinquencies and amounts of loans  charged-off;                                                                                                                                                                                                                                                                                           |
|   | · | 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;                                                                                                                                                                                                                                              |
|   | · | increased funding costs due to market illiquidity,  increased competition for funding, and/or regulatory requirements;                                                                                                                                                                                                                                 |
|   | · | our ability to retain our existing customers,  including our deposit relationships;                                                                                                                                                                                                                                                                    |
|   | · | adverse changes in asset quality and resulting  credit risk-related losses and expenses, including the risk of further  impairment to the value of our collateral on loans for which we have already  taken specific reserves;                                                                                                                         |
|   | · | loss of consumer confidence and economic disruptions  resulting from terrorist activities or other military actions;                                                                                                                                                                                                                                   |
|   | · | changes in the securities markets; and                                                                                                                                                                                                                                                                                                                 |
|   | · | other risks and uncertainties detailed from time to  time in our filings with the SEC.                                                                                                                                                                                                                                                                 |

 

18

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We have based our forward-looking statements on ourcurrent expectations about future events. Although we believe that theexpectations reflected in our forward-looking statements are reasonable, wecannot guarantee you that these expectations will be achieved. We undertake noobligation to publicly update or otherwise revise any forward-lookingstatements, whether as a result of new information, future events, orotherwise.

 

These risks are exacerbated by the recent developmentsin national and international financial markets, and we are unable to predictwhat effect these uncertain market conditions will have on us.  During 2008 and 2009, the capital and creditmarkets have experienced extended volatility and disruption.  There can be no assurance that theseunprecedented recent developments will not continue to materially and adverselyaffect our business, financial condition and results of operations, as well asour ability to raise capital or other funding for liquidity and businesspurposes.

 

# **Overview**

 

CommunitySouth FinancialCorporation (the “Company”) is a bank holding company headquartered in Easley,South Carolina.  Our subsidiary,CommunitySouth Bank and Trust (the “Bank”), opened for business on January 18,2005.  In addition to the main office inEasley, the Bank has five branch locations in the upstate region of SouthCarolina.  We opened our Mauldin branchin the fourth quarter of 2005, our Spartanburg branch in the first quarter of2006, our Anderson branch in the third quarter of 2006, our Greer branch in thefourth quarter 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 communitybanks, we derive most of our income from interest we receive on our loans andinvestments.  Our primary source of fundsfor making these loans and investments is our deposits, on which we payinterest.  Consequently, one of the keymeasures of our success is our amount of net interest income, or the differencebetween the income on our interest-earning assets, such as loans andinvestments, and the expense on our interest-bearing liabilities, such asdeposits.  Another key measure is thespread between the yield we earn on these interest-earning assets and the ratewe pay on our interest-bearing liabilities.

 

We have approximately$41.5 million of acquisition and development (A&D) loans outstanding at June30, 2009.  A&D loans are typicallycomprised of loans to borrowers for real estate to be developed (intoproperties such as sub-divisions or spec houses).  Normally, these loans are repaid with theproceeds from the sale of the developed property.  Collateral for these types of loans normallyconsists of real estate.

 

Our outstanding A&Dloans are located primarily in the Upstate of South Carolina and Western NorthCarolina.  The current economicenvironment in our market area has resulted in a downturn in the real estatemarket, which has placed greater pressure on our borrowers’ repaymentcapabilities.  We are experiencing higherlevels of loan delinquencies, defaults and foreclosures.  Further, the downturn in the real estatemarket has adversely impacted the value of the underlying collateral (realestate) for the A&D loans.  Thegreater degree of strain on these types of loans and the significance to ouroverall loan portfolio has caused us to apply a greater degree of scrutiny inanalyzing the ultimate collectability of amounts due.  Our analysis has resulted in a significantprovision expense in order to meet the estimated allowance for loan lossreserve requirement.

 

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

 

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

 

The Bank is currentlyrestructuring its balance sheet to reduce its risk weighted assets and improvecapital ratios.  Since December 31, 2008,the Bank has converted all of its 20% risk weighted securities into 0% riskweighted securities, sold its 100% risk weighted BOLI policies, and implementeda loan reduction policy with regards to the loan portfolio. The Bank is strictlylimiting new lending which, combined with normal payoffs and principalamortization, has resulted in a decrease in the loan portfolio of $13.2 millionfrom December 31, 2008 to June 30, 2009. The effect of all of these actions hasbeen to reduce risk weighted assets by $35 million from December 31, 2008 to June30, 2009. Because the Bank is required to keep a 

 

19

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minimum of 10% capital torisk weighted assets to remain well capitalized, this equates to $3.5 millionin capital improvement.

 

**RecentLegislative and Regulatory Initiatives to Address Financial and Economic Crises**

 

Marketsin the United States and elsewhere have experienced extreme volatility anddisruption for more than 12 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 Economic Stabilization Act of 2008  (“EESA”), approved by Congress and signed by President Bush on October 3,  2008, which, among other provisions, allowed the U.S. Treasury to purchase up  to $700 billion of mortgages, mortgage-backed securities and certain other  financial instruments from financial institutions for the purpose of  stabilizing and providing liquidity to the U.S. financial markets.  EESA also temporarily raised the basic  limit of FDIC deposit insurance from $100,000 to $250,000 through December 31,  2013;                                                                                                                                                                                                                                                                                                                                        |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   | · | On October 7, 2008, the FDIC approved a plan to  increase the rates banks pay for deposit insurance;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   | · | On October 14, 2008, the U.S. Treasury announced the  creation of a new program, the Troubled Asset Relief Program (the “TARP”)  Capital Purchase Program (the “CPP”) that encourages and allows financial  institutions to build capital through the sale of senior preferred shares to  the U.S. Treasury on terms that are non-negotiable;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   | · | On October 14, 2008, the FDIC announced the creation  of the Temporary Liquidity Guarantee Program (the “TLGP”), which seeks to  strengthen confidence and encourage liquidity in the banking system.  The TLGP has two primary components that are  available on a voluntary basis to financial institutions:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | · | The Transaction Account Guarantee Program (“TAGP”),  which provides unlimited deposit insurance coverage through December 31, 2009  for noninterest-bearing transaction accounts (typically business checking  accounts) and certain funds swept into noninterest-bearing savings  accounts.  Institutions participating  in the TLGP pay a 10 basis points fee (annualized) on the balance of each  covered account in excess of $250,000, while the extra deposit insurance is  in place; |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |   |   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | · | The Debt Guarantee Program (“DGP”), under which the  FDIC guarantees certain senior unsecured debt of FDIC-insured institutions  and their holding companies.  The  unsecured debt must be issued on or after October 14, 2008 and not later than  June 30, 2009, and the guarantee is effective through the earlier of the  maturity date or June 30, 2012.  The  DGP coverage limit is generally 125% of the eligible entity’s eligible debt  outstanding on September 30, 2008 and scheduled to mature on or before June 30,  2009 or, for certain insured institutions, 2% of their liabilities as of September  30, 2008.  Depending on the term of the  debt maturity, the nonrefundable DGP fee ranges from 50 to 100 basis points  (annualized) for covered debt outstanding until the earlier of maturity or June  30, 2012.  The TAGP and DGP are in  effect for all eligible entities, unless the entity opted out on or before December  5, 2008. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   | · | On February 17, 2009 President Obama signed into law  The American Recovery and Reinvestment Act of 2009 (“ARRA”), more commonly  known as the economic stimulus or economic recovery package. ARRA includes a  wide variety of programs intended to stimulate the economy and provide for  extensive infrastructure, energy, health, and education needs.  In addition, ARRA imposes certain new  executive compensation and corporate expenditure limits on all current and  future TARP recipients, including our Company, that are in addition to those  previously announced by the U.S. Treasury. These new limits are in place  until the institution has repaid the Treasury, which is now permitted under  ARRA without penalty and without the need to raise new capital, subject to  the Treasury’s consultation with the recipient institution’s appropriate  regulatory agency. |

 

20

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|   | · | On March 23, 2009, the U.S. Treasury, in conjunction  with the FDIC and the Federal Reserve, announced the Public-Private  Partnership Investment Program for Legacy Assets which consists of two  separate plans, addressing two distinct asset groups: |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                     | · | The Legacy Loan Program, in which the primary  purpose will be to facilitate the sale of troubled mortgage loans by eligible  institutions, which include FDIC-insured federal or state banks and savings  associations. Eligible assets may not be strictly limited to loans; however,  what constitutes an eligible asset will be determined by participating banks,  their primary regulators, the FDIC and the Treasury. Additionally, the Loan  Program’s requirements and structure will be subject to notice and comment rulemaking,  which may take some time to complete. |
|   |   |                                                                                                                                                                                                                                                     |   |   |
|   |   |                                                                                                                                                                                                                                                     | · | The Securities Program, which will be administered  by the Treasury, involves the creation of public-private investment funds to  target investments in eligible residential mortgage-backed securities and  commercial mortgage-backed securities issued before 2009 that originally were  rated AAA or the equivalent by two or more nationally recognized statistical  rating organizations, without regard to rating enhancements (collectively,  “Legacy Securities”). Legacy Securities must be directly secured by actual mortgage  loans, leases or other assets, and may be purchased only from financial  institutions that meet TARP eligibility requirements. |

 

Itis likely that further regulatory actions may arise as the Federal governmentcontinues to attempt to address the economic situation.

 

Weare participating in both components 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 2009.  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.

 

**Resultsof Operations**

 

*Three Months ended June 30, 2009and 2008*

 

*Overview*

 

Our net loss was $805,000for the three months ended June 30, 2009 as compared to net loss of $1,390,000for the three months ended June 30, 2008. Our net loss for the quarter is primarily due to an additional $1.5million in provision for loan losses. For the three months ended June 30, 2009, we realized $4,628,000 ininterest income, of which $336,000 was from investment activities and$4,292,000 was from loan activities.  Forthe three months ended June 30, 2008, we realized $5,676,000 in interestincome, of which $672,000 was from investment activities and $5,004,000 wasfrom loan activities.  The primary sourceof funding for our loan portfolio is deposits that are acquired both locallyand via the national brokered certificate market.  We incurred interest expense of $1,951,000and $3,337,000 for the three months ended June 30, 2009 and June 30, 2008,respectively.  This decrease in ourinterest expense was a result of a decreased interest rate environment.  We have experienced an increase in our netinterest margin to 2.87% from 2.54% for the quarters ended June 30, 2009 and2008, respectively.  The increase was aresult of declining deposit costs.

 

*Provision for Loan Losses*

 

Our provision for loanlosses for the three months ended June 30, 2009 was $1,500,000 compared to$2,579,000 for the comparable prior year period.  The prior period provision included aspecific reserve allocation of $2.5 million for a real estate developmentproject on Lake Keowee, South Carolina. Net of this specific allocation, the loan loss provision has increaseddue to continued deterioration in the overall quality of the loan portfolio,which is primarily a result of the downturn in the economy.

 

*Non-interest Income*

 

We had non-interestincome of $441,000 and $376,000 for the three months ended June 30, 2009 and2008, respectively.  Mortgage originationfee income for the three months ended June 30, 2009 was $243,000.  We had $172,000 in mortgage origination feeincome in the second quarter of 2008.

 

21

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*Non-interest Expense*

 

We incurred non-interestexpense of $2,837,000 during the three months ended June 30, 2009.  Included in the expense was $1,363,000 ofsalaries and employee benefits, $249,000 of data processing expense, $74,000 ofprofessional fees expense, $60,000 of advertising expense, $20,000 of expenserelated to office supplies, $38,000 of telephone expense and $271,000 ofassessments related to FDIC.  Legislationhas recently passed that imposed a one time FDIC insurance premium that equatedto a $178,000 one time charge to the Bank in 2009.  This was expensed in June 2009 and will bepaid September 30, 2009.   Thenon-interest expense incurred in the three months ended June 30, 2008 was$2,233,000.  Included in the expense was$1,228,000 of salaries and employee benefits, $177,000 of data processingexpense, $54,000 of professional fee expense, $28,000 of advertising expense,$19,000 of expense related to office supplies, $33,000 of telephone expense and$54,000 of assessments related to FDIC.

 

For the three monthsended June 30, 2009, we incurred other fixed asset expenses of $182,000 indepreciation and $36,000 in equipment maintenance and rental.  For the three months ended June 30, 2008, weincurred other fixed asset expenses of $180,000 in depreciation and $39,000 inequipment maintenance and rental.  Weincurred $168,000 and $158,000 in occupancy expense related to all of ouroffice locations for the three months ended June 30, 2009 and 2008,respectively.

 

The increase innon-interest expense is the result of the increased administrative expensesincluding FDIC assessments, advertising, professional fees, and dataprocessing, resulting from an increase in customer volume.

 

*Six Months ended June 30, 2009and 2008*

 

*Overview*

 

Our net loss was $841,000for the six months ended June 30, 2009 as compared to net loss of $1,049,000for the six months ended June 30, 2008. Our net loss for the six months ended June 30, 2009 is primarily due toan additional $2.8 million in provision for loan losses.  For the six months ended June 30, 2009, werealized $9,560,000 in interest income, of which $899,000 was from investmentactivities and $8,661,000 was from loan activities.  For the six months ended June 30, 2008, werealized $11,900,000 in interest income, of which $1,402,000 was frominvestment activities and $10,498,000 was from loan activities.  The primary source of funding for our loanportfolio is deposits that are acquired both locally and via the nationalbrokered certificate market.  We incurredinterest expense of $4,031,000 and $6,990,000 for the six months ended June 30,2009 and June 30, 2008, respectively. This decrease in our interest expense was a result of a decreasedinterest rate environment.  We haveexperienced an increase in our net interest margin to 2.96% from 2.68% for thesix months ended June 30, 2009 and 2008, respectively.

 

*Rate/VolumeAnalysis*

Net interest income canbe analyzed in terms of the impact of changing interest rates and changingvolumes.  The following tables set forththe effect which the varying levels of interest-earning assets andinterest-bearing liabilities and the applicable rates have had on changes inthe net interest income for the periods presented.

 
| ** **                 | ** ** | **Six Months Ended June 30, 2009 vs. 2008** | ** ** |
|----------------------------|------------|---------------------------------------------|------------|
| ** **                 | ** ** | **Increase (decrease) Due to**              | ** ** |
| ** **                 | ** ** | ** **                                  | ** ** | ** ** | ** ** | **Rate /** | ** ** | ** ** | ** ** |
| **(Dollars in thousands)** | ** ** | **Volume**                                  | ** ** | **Rate** | ** ** | **Volume** | ** ** | **Total** | ** ** |
| Interest  Income           |       |                                        |       |   |   |   |   |   |   |
| Loans                      |       | $                                           | 201        |   | $ | (1,999 | ) | $ | (38 | ) | $ | (1,836 | ) |
| Investment  securities (1) |       | 2                                           |       | (316 | ) | (1 | ) | (315 | ) |
| Federal  funds             |       | 2                                           |       | (189 | ) | (2 | ) | (189 | ) |
| Total  Interest Income     | ** ** | **$**                                       | **205**    | ** ** | **$** | **(2,504** | **)** | **$** | **(41** | **)** | **$** | **(2,340** | **)** |
|                       |       |                                        |       |   |   |   |   |   |   |
| Interest  Expense          |       |                                        |       |   |   |   |   |   |   |
| Deposits                   |       | $                                           | 170        |   | $ | 194 |   | $ | 92 |   | $ | 456 |   |
| Other  borrowings          |       | (53                                         | )          | (3,389 | ) | 27 |   | (3,415 | ) |
| Total  Interest Expense    | ** ** | **$**                                       | **117**    | ** ** | **$** | **(3,195** | **)** | **$** | **119** | ** ** | **$** | **(2,959** | **)** |
|                       |       |                                        |       |   |   |   |   |   |   |
| Net  Interest Income       | ** ** | **$**                                       | **88**     | ** ** | **$** | **691** | ** ** | **$** | **(160** | **)** | **$** | **619** | ** ** |

 

----

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

 

22

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*AverageBalances, Income and Expenses and Rate*

 

The following table setsforth, for the six months ended June 30, 2009 and 2008, information related tothe Company’s average balance sheet and its average yields on earning assetsand average costs of interest-bearing liabilities.  Such yields are derived by dividing income orexpense by the average balance of the corresponding earning assets orinterest-bearing liabilities.  Averagebalances have been derived from the daily balances throughout the periodsindicated.

 
| ** **                                      | ** ** | **Six Months Ended June 30, 2009** | ** **  | **Six Months Ended June 30, 2008** | ** ** |
|-------------------------------------------------|------------|------------------------------------|-------------|------------------------------------|------------|
| ** **                                      | ** ** | **Average**                        | ** **  | **Income /**                       | ** ** | **Yield/** | ** ** | **Average** | ** ** | **Income /** | ** ** | **Yield /** | ** ** |
| **(Dollars in thousands)**                      | ** ** | **Balance**                        | ** **  | **Expense**                        | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Expense** | ** ** | **Rate** | ** ** |
| **Assets**                                      |       |                               |        |                               |       |   |   |   |   |   |   |   |   |
| Earning assets:                                 |       |                               |        |                               |       |   |   |   |   |   |   |   |   |
| Loans (1)                                       |       | $                                  | 315,912     |                               | $          | 8,661 |   | 5.53 | % | $ | 309,990 |   | $ | 10,498 |   | 6.83 | % |
| Investment securities (2)                       |       | 48,353                             |        | 881                                |       | 3.67 | % | 48,264 |   | 1,195 |   | 4.99 | % |
| Federal funds sold and other                    |       | 11,809                             |        | 18                                 |       | 0.31 | % | 11,678 |   | 207 |   | 3.57 | % |
| Total earning assets                            |       | 376,074                            |        | 9,560                              |       | 5.13 | % | 369,932 |   | 11,900 |   | 6.49 | % |
| Cash and due from banks                         |       | 7,217                              |        |                               |       |   |   | 5,361 |   |   |   |   |   |
| Premises and equipment                          |       | 4,579                              |        |                               |       |   |   | 4,996 |   |   |   |   |   |
| Other assets                                    |       | 9,384                              |        |                               |       |   |   | 10,450 |   |   |   |   |   |
| Allowance for loan losses                       |       | (8,240                             | )           |                               |       |   |   | (4,252 | ) |   |   |   |   |
| Total assets                                    | ** ** | **$**                              | **391,456** |                               |       |   |   | ** ** | **$** | **386,487** |   |   |   |   |   |
| ** **                                      |       |                               |        |                               |       |   |   |   |   |   |   |   |   |
| **Liabilities**                                 |       |                               |        |                               |       |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                   |       |                               |        |                               |       |   |   |   |   |   |   |   |   |
| Repurchase agreements                           |       | $                                  | 30,000      |                               | 486        |   | 3.27 | % | $ | 27,033 |   | 307 |   | 2.29 | % |
| Federal funds purchased                         |       | 441                                |        | 1                                  |       | 0.46 | % | 283 |   | 2 |   | 1.43 | % |
| Federal Home Loan Bank advances                 |       | 10,856                             |        | 72                                 |       | 1.34 | % | 3,846 |   | 46 |   | 2.41 | % |
| Note Payable                                    |       | 497                                |        | 7                                  |       | 2.84 | % | 95 |   | 2 |   | 4.25 | % |
| Subordinated Debt                               |       | 4,325                              |        | 247                                |       | 11.50 | % | — |   | — |   | — | % |
| Interest-bearing transaction accounts           |       | 18,534                             |        | 107                                |       | 1.16 | % | 15,892 |   | 108 |   | 1.37 | % |
| Savings deposits                                |       | 15,981                             |        | 118                                |       | 1.49 | % | 21,506 |   | 201 |   | 1.88 | % |
| Time deposits                                   |       | 256,027                            |        | 2,993                              |       | 2.36 | % | 255,458 |   | 6,324 |   | 4.99 | % |
| Total interest-bearing liabilities              |       | 336,661                            |        | 4,031                              |       | 2.41 | % | 324,113 |   | 6,990 |   | 4.35 | % |
| Demand deposits                                 |       | 22,416                             |        |                               |       |   |   | 23,403 |   |   |   |   |   |
| Accrued interest and other liabilities          |       | 1,214                              |        |                               |       |   |   | 4,793 |   |   |   |   |   |
| Total liabilities                               |       | 360,291                            |        |                               |       |   |   | 352,309 |   |   |   |   |   |
| Shareholders’ equity                       |       | 31,165                             |        |                               |       |   |   | 34,178 |   |   |   |   |   |
| Total liabilities and shareholders’ equity | ** ** | **$**                              | **391,456** |                               |       |   |   | ** ** | **$** | **386,487** |   |   |   |   |   |
| ** **                                      |       |                               |        |                               |       |   |   |   |   |   |   |   |   |
| Net interest income                             |       |                               | ** **  | **$**                              | **5,529**  |   |   |   |   | ** ** | **$** | **4,910** |   |   |   |
| Net interest spread                             |       |                               |        |                               | ** ** | **2.72** | **%** |   |   |   | ** ** | **2.14** | **%** |
| Net interest margin                             |       |                               |        |                               | ** ** | **2.96** | **%** |   |   |   | ** ** | **2.68** | **%** |

 

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(1)          There were$22.8 million and $6.9 million of loans in non-accrual status as of June 30,2009 and 2008, respectively.  The effectof fees collected on loans for the six months ended June 30, 2009 and 2008totaled $91,000 and $113,000, respectively, and increased the annualized yieldon loans by 6 basis points from 5.47% for June 30, 2009 and by 7 basis pointsfrom 6.76% for June 30, 2008.  The effectof such fees on the annualized yield on earning assets was an increase of 5basis points from 5.08% for June 30, 2009 and an increase of 6 basis pointsfrom 6.43% for June 30, 2008.  Theeffects of such fees on net interest spread were an increase of 5 basis pointsfrom 2.67% for June 30, 2009 and an increase of 6 basis points from 2.08% for June30, 2008.  The effects of such fees onnet interest margin were an increase of 4 basis points from 2.92% for June 30,2009 and an increase of 7 basis points from 2.61% for June 30, 2008.

 

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

 

23

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*Provision for Loan Losses*

 

Our provision for loanlosses for the six months ended June 30, 2009 was $2,805,000 compared to$2,704,000 for the comparable prior year period. Charges to our provision forloan losses have remained stable compared to the six months ended June 30,2008. The prior period provision included a specific reserve allocation of $2.5million for a real estate development project on Lake Keowee, SC.  Net of this specific allocation, the loanloss provision has increased due to continued deterioration in the overallquality of the loan portfolio, which is primarily a result of the downturn inthe economy.

 

*Non-interest Income*

 

We had non-interestincome of $1,255,000 and $771,000 for the six months ended June 30, 2009 and2008, respectively.  Mortgage originationfee income for the six months ended June 30, 2009 was $305,000.  We had $335,000 in mortgage origination feeincome in the first two quarters of 2008. The decrease is due to our decreased volume in mortgage loanoriginations due to the current economic conditions and departmentalrestructuring.  We also had a gain onsale of available for sale securities of $520,000 for the six months ended June30, 2009.

 

*Non-interest Expense*

 

We incurred non-interestexpense of $5,253,000 during the six months ended June 30, 2009.  Included in the expense was $2,603,000 ofsalaries and employee benefits, $471,000 of data processing expense, $165,000of professional fees expense, $97,000 of advertising expense, $42,000 ofexpense related to office supplies, $75,000 of telephone expense and $367,000of assessments related to FDIC.  Legislationhas recently passed that imposed a one time FDIC insurance premium that equatedto a $178,000 one time charge to the Bank in 2009.  This was expensed in June 2009 and will bepaid September 30, 2009.  Thenon-interest expense incurred in the six months ended June 30, 2008 was$4,550,000.  Included in the expense was$2,463,000 of salaries and employee benefits, $367,000 of data processingexpense, $132,000 of professional fee expense, $39,000 of advertising expense,$47,000 of expense related to office supplies, $70,000 of telephone expense and$107,000 of assessments related to FDIC.

 

For the six months ended June30, 2009, we incurred other fixed asset expenses of $361,000 in depreciationand $79,000 in equipment maintenance and rental.  For the six months ended June 30, 2008, weincurred other fixed asset expenses of $361,000 in depreciation and $86,000 inequipment maintenance and rental.  Weincurred $339,000 and $320,000 in occupancy expense related to all of ouroffice locations for the six months ended June 30, 2009 and 2008, respectively.

 

The increase innon-interest expense is the result of the increased administrative expensesincluding FDIC assessments, advertising, professional fees, and dataprocessing, resulting from an increase in customer volume.

 

**Assets and Liabilities**

 

*General*

 

At June 30, 2009, totalassets decreased 0.3% to $386.8 million as compared to $387.8 million at December31, 2008.  Gross loans decreased $13.8million, or 4.3%, during the first six months of 2009.  As described below, federal funds soldincreased to $21.1 million at June 30, 2009 compared to $4.6 million at December31, 2008.  Cash and cash equivalentsincreased $21.2 million, or 214.9%, since December 31, 2008.  As described below, deposits increased $26.8million, or 9.0%, during the first six months of 2009.  At June 30, 2009, shareholders’ equity was$27.3 million.

 

*Investment Securities*

 

Investments available forsale decreased by $4.9 million, or 10.27%, since December 31, 2008 due toportfolio restructuring.

 

*Other Investments*

 

Other investmentsdecreased by $206,000 since December 31, 2008 due to the sale of FHLBstock.  All of the FHLB stock is used tocollateralize advances from the FHLB.

 

24

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*Loans*

 

Since loans typicallyprovide higher interest yields than other types of interest earning assets, weallocate the majority of our earning assets to our loan portfolio.  Gross loans decreased by $13.8 million, or4.3%, during the first six months of 2009. Loan demand has slowed during the first two quarters of 2009 due togeneral economic conditions and the real estate market, along with management’sdecision to shrink the size of the Bank’s loan portfolio, to help improve theBank’s risk based capital ratios.****We expect thistrend to continue during the next quarter.

 

Balances within majorloan categories are as follows:

 
| **(dollar amounts in thousands)** | ** ** | **June 30, 2009** | ** **  | **December 31, 2008** | ** ** |
|-----------------------------------|------------|-------------------|-------------|-----------------------|------------|
| Real  estate - construction       |       | $                 | 97,378      |                  | $          | 129,777 |   |
| Real  estate - mortgage           |       | 178,518           |        | 154,838               |       |
| Commercial  and industrial        |       | 28,685            |        | 33,303                |       |
| Consumer  and other               |       | 2,506             |        | 2,989                 |       |
| Total  loans, gross               |       | 307,087           |        | 320,907               |       |
| Less  allowance for loan losses   |       | (9,688            | )           | (8,088                | )          |
| Total  loans, net                 | ** ** | **$**             | **297,399** | ** **            | **$**      | **312,819** | ** ** |

 

We discontinue accrual of interest on a loan when we conclude it is doubtful that we will be able to collect principal and/or interest from the borrower.  We reach this conclusion by taking into account factors such as the borrower’s financial condition, economic and business conditions, and the results of our previous collection efforts.  Generally, we place a delinquent loan in non-accrual status when the loan becomes 90 days or more past due.  When we place a loan in non-accrual status, we reverse all interest which has been accrued on the loan but remains unpaid and we deduct this interest from earnings as a reduction of reported interest income.  We do not accrue any additional interest on the loan balance until we conclude the collection of both principal and interest is reasonably certain.  At June 30, 2009, there were $22.8 million in loans that were non-accruing and $1.9 million in loans that were 30 days past due, excluding non-accrual loans.  At December 31, 2008, there were $9.9 million in loans that were non-accruing and $2.4 million in loans that were 30 days past due, excluding non-accrual loans.

 

The increase of $12.9million in non-performing loans from December 31, 2008 to June 30, 2009 isrelated primarily to continued deterioration in the Bank’s overall acquisitionand development (A&D) loan portfolio. The number of loans on non-accrualstatus increased from 30 at December 31, 2008 to 64 at June 30, 2009. Theaverage non-accrual loan balance is $330,000 and $356,000 as of December 31,2008 and June 30, 2009, respectively.  AtJune 30, 2009, 93% of the non-accrual loans were secured by real estate and$2.7 million of the allowance for loan loss has been specifically allocated tothese relationships. This increase in non-performing loans is a direct resultof the poor economic environment, as noted below, taking a toll on numerousborrowers’ ability to pay as scheduled. At this time, management is unable todetermine the length of the economic downturn and therefore unable to determinethe ultimate impact on the Bank’s A&D portfolio.

 

We have approximately$41.5 of A&D loans outstanding at June 30, 2009.  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 the developedproperty.  Collateral for these types ofloans normally consists of real estate.

 

Our outstanding A&Dloans are located primarily in the Upstate of South Carolina and Western NorthCarolina.  The current economicenvironment in our market area has resulted in a downturn in the real estatemarket, which has placed greater pressure on our borrowers’ repaymentcapabilities.  We are experiencing higherlevels of loan delinquencies, defaults and foreclosures.  Further, the downturn in the real estatemarket has adversely impacted the value of the underlying collateral (realestate) for the A&D loans.  Thegreater degree of strain on these types of loans and the significance to ouroverall loan portfolio has caused us to apply a greater degree of scrutiny inanalyzing the ultimate collectability of amounts due.  Our analysis has resulted in a significantprovision expense in order to meet the estimated allowance for loan lossreserve requirement.  Nevertheless, giventhe current economic environment, there is a risk of further impairment to thevalue of our collateral on these loans, which would require even furtherincreases to our allowance for loan losses and in the corresponding expensecharged to our provision for loan losses.

 

25

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*Impaired Loans*

 

The Company identifies impaired loans through its normal internal loan review process.  Loans on the Company’s potential problem loan list are considered potentially impaired loans.  These loans are evaluated in determining whether all outstanding principal and interest are expected to be collected.  Loans are not considered impaired if a minimal payment delay occurs and all amounts due, including accrued interest at the contractual interest rate for the period of delay, are expected to be collected.  Management has determined that the Company had $23.1 million and $13.2 million in impaired loans at June 30, 2009 and December 31, 2008, respectively.

 

*Potential Problem Loans*

 

Potential problem loans are loans that are not included in impaired loans (non-accrual loans or loans past due 90 days or more and still accruing), but about which management has become aware of information about possible credit problems of the borrowers that causes concern about their ability to comply with current repayment terms.  At June 30, 2009 and December 31, 2008, the Company had identified $18.1 million and $4.4 million, respectively, of potential problem loans through its internal review procedures.  The results of this internal review process are considered in determining management’s assessment of the adequacy of the allowance for loan losses.

 

*Provision and Allowance for Loan Losses*

 

The Company has developedpolicies and procedures for evaluating the overall quality of its creditportfolio and the timely identification of potential problem loans.  On a quarterly basis, the Company’s Board ofDirectors reviews and approves the appropriate level for the Company’sallowance for loan losses based upon management’s recommendations, the resultsof the internal monitoring and reporting system, and an analysis of economicconditions in its market.

 

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

 

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

 

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

 

26

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Although impaired loanshave increased $12.9 million since December 31, 2008, the loan provisionfor the six months ended June 30, 2009 only increased $100,000 to $2.8million compared to the six months ended June 30, 2008. However, while thecurrent year provision is designated for overall portfolio deterioration, theprior year period contained a specific provision of $2.5 million for a singlereal estate development project on Lake Keowee, South Carolina.

 

*Deposits*

 

Our primary source of funds for loans and investments is ourdeposits.  We have chosen to obtain aportion of our certificates of deposit from areas outside of our market, whichare brokered deposits. The deposits obtained outside of our market area generallyhave been below those being offered for comparable certificates of deposit inour local market. Because of this, even though brokered deposits are interestsensitive, they have been considered a desirable source of funds. We cannot beassured that we will continue to have access to such funds. See furtherdiscussion in the liquidity section. As of June 30, 2009, total depositshad increased by $26.8 million, or 9.0%, from December 31, 2008.  The largest percentage increase was inbrokered deposits, which increased $16.6 million, or 8.9%, from December 31,2008 to June 30, 2009. This was due to the replacement of FHLB advances asnoted below.

 

Balances within the major deposit categories are asfollows:

 
| **(dollar  amounts in thousands)** | ** ** | **June 30,  2009** | ** **  | **December 31,  2008** | ** ** |
|------------------------------------|------------|-------------------------|-------------|-----------------------------|------------|
| Non-interest  bearing demand       |       | $                       | 22,439      |                        | $          | 22,162 |   |
| Interest bearing  demand           |       | 22,779                  |        | 16,449                      |       |
| Savings                            |       | 17,437                  |        | 14,461                      |       |
| Time deposits  less than $100,000  |       | 31,760                  |        | 32,112                      |       |
| Time deposits of  $100,000 or over |       | 26,153                  |        | 25,161                      |       |
| Brokered  deposits                 |       | 202,920                 |        | 186,298                     |       |
| Total deposits                     | ** ** | **$**                   | **323,488** | ** **                  | **$**      | **296,643** | ** ** |

 

During the period between December 31,2008 and June 30, 2009, as brokered deposits matured, the Bank moved allbrokered deposits from 3 month maturities into 15 to 18 month maturities inorder to lock in funding sources. This extension of maturities removed thepossibility of funding issues related to brokered deposits for the next 15months. Given the current economic environment, management believes this wasprudent liquidity management. At the time, due to downward market rate changes,this funding design resulted in a slight decrease in interest expense relatedto brokered deposits. The average cost of brokered funds in the quarter ending June 30,2009 was 1.97%.

 

Maturities of Certificatesof 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,  2009**                            | ** ** | ** ** | ** ** | ** **  | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Brokered  deposits                                 |       | $          | 6,879      |        | $          | —      |       | $          | 21,269     |       | $          | 174,772 |   | $ | 202,920 |   |
| Other  certificates of deposit of $100,000 or more |       | 6,831      |       | 11,338      |       | 7,008       |       | 977        |       | 26,153     |       |
| Total                                              |       | $          | 13,710     |        | $          | 11,338      |       | $          | 28,777     |       | $          | 175,749 |   | $ | 229,073 |   |
|                                               |       |       |       |        |       |        |       |       |       |       |       |
| **December 31,  2008**                        | ** ** | ** ** | ** ** | ** **  | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Brokered  deposits                                 |       | $          | 186,298    |        | $          | —      |       | $          | —     |       | $          | — |   | $ | 186,298 |   |
| Other  certificates of deposit of $100,000 or more |       | 1,782      |       | 11,231      |       | 10,494      |       | 1,655      |       | 25,162     |       |
| Total                                              |       | $          | 188,080    |        | $          | 11,231      |       | $          | 10,494     |       | $          | 1,655 |   | $ | 211,460 |   |

 

Of the Company’s time deposits of $100,000 or over as of June 30,2009 and December 31, 2008, 5.98% and 88.95% are scheduled maturitieswithin three months, respectively. As of June 30, 2009 and December 31,2008, 23.50% and 99.22%, respectively, of the Company’s time deposits of$100,000 or over had maturities within twelve months.

 

27

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*Advances from Federal Home Loan Bank (“FHLB”)*

 

Advances from FHLB are a source of funding that theBank uses depending on the current level of deposits and the availability ofcollateral to secure FHLB borrowings.  AtJune 30, 2009, the Bank had no outstanding advances from FHLB. The Bankreplaced $25 million of outstanding FHLB advances with an average maturity oftwo months and average cost of 1.49% as of December 31, 2008 with brokeredcertificates of deposit with an average maturity of 14 months and cost of 2.25%as of June 30, 2009 in order to extend maturities and remove the risk ofthe borrowings being called.

 

*Repurchase Agreements*

 

At June 30, 2009, the Bank had sold $30.0 millionof securities under agreements to repurchase with brokers with a weightedaverage rate of 3.24% and an average maturity of 84 months.  The maximum amount outstanding at anymonth-end was $30.0 million.  Theseagreements were secured with approximately $36.1 million of investmentsecurities.

 

*Subordinated Debt*

 

At June 30, 2009, the Company had subordinated debt totaling $4.3million.  The subordinated notes weresold during the third quarter of 2008 to a limited number of purchasers in aprivate offering, 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.

 

**Liquidity**

 

Liquidity  is the  ability  to  meet  current  and  future  obligations  through liquidation or maturity of existing  assets or the  acquisition of  liabilities.  We manage both assets and liabilities to achieve appropriate levels of liquidity.  Cash, federal funds and investments available for sale are our primary sources of asset liquidity. These funds provide a cushion against short-term fluctuations in cash flow from both deposits and loans.  Historically, individual and commercial deposits have been our primary source of funds for credit activities. These include brokered deposits, which comprised 63% of our deposit base as of June 30, 2009. These have proven to be a reliable source of funds. However, access to the brokered deposit market could be curtailed if the Bank were to fall to a “less than well capitalized” status unless we are able to obtain FDIC approval to renew the brokered deposits, which is unlikely given the current regulatory environment. This would not have any liquidity impact in the short term due to the extended maturities of the brokered deposits, but it could cause long term funding issues. If access to the brokered deposit market were to become unavailable, the Bank would be required to replace those funds with the combination of FHLB advances, Federal Reserve Discount Window borrowings and local deposits. The Federal Reserve and FHLB borrowings would require pledging additional collateral. At this time, we believe these are viable alternatives. The Bank is currently reducing the loan portfolio which is helping to increase liquidity. Loans have decreased by $13.8 million from December 31, 2008 to June 30, 2009 primarily due to payoffs and amortization. We expect this trend to continue during the coming year. See the section entitled “Overview” for more information on the risk weighted asset restructuring policy. Deposit balances, net of brokered deposits, have increased $10.2 million from December 31, 2008 to June 30, 2009. We expect this trend to continue due to our change in focus from loan growth to deposit growth. However, this cannot be assured. We anticipate that our funding cost and funding mix will remain stable.

 

The level of liquidity is measured by the cash, cash equivalents and securities available for sale-to-total assets ratio, which was at 8.41% at June 30, 2009. We anticipate that this will increase with the combination of deposit growth and shrinkage of assets.

 

In addition to our on balance sheet sources of funds, we also rely on off-balance sheet lines of credit. At June 30, 2009, we had lines of credit with unrelated banks totaling $14.5 million.  These lines, $9.5 million of which are unsecured, are available on a one-to-seven day basis for general corporate purposes.  These lines may be terminated at any time based on our financial condition, although we believe that not to be the case. As members of the FHLB, we have credit availability of up to 15% of the Bank’s total assets. Advances under this credit facility are subject to qualifying collateral**.**Advances may be terminated and called at any time by the FHLB, although we believe that not to be the case. We also have credit availability through the Federal Reserve Discount Window.  As of June 30, 2009, $23.9 million was available, based on qualifying collateral. Availability of the Federal Reserve Discount Window may be terminated at any time by the Federal Reserve, although we believe that not to be the case.

 

We believe our liquidity sources are adequate to meet our short and long term operating needs.

 

28

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**Impactof Off-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, 2009, we had issued commitments to extend credit of$24.6 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 tablesummarizes our off-balance-sheet financial instruments whose contract amountsrepresent credit risk:

 
| **(dollar amounts in thousands)** | ** ** | **June 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|-----------------------------------|------------|------------------------|------------|----------------------------|------------|
|                              |       |                   |       |                       |       |
| Commitments to extend  credit     |       | $                      | 23,155     |                       | $          | 36,260 |   |
|                              |       |                   |       |                       |       |
| Letters of credit                 |       | $                      | 1,412      |                       | $          | 3,488 |   |

 

**Capital Resources**

 

Total shareholders’ equity decreased from $28.5 million at December 31,2008 to $27.3 million at June 30, 2009. The decrease is principally due to the net unrealized losses onsecurities available for sale of $449,000 (net of income taxes) and to the netloss for the six months ended June 30, 2009 of $841,000.

 

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

 

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

 

The Bank is also required to maintain capital at a minimum level basedon quarterly average assets, which is known as the leverage ratio.  Only the strongest banks are allowed tomaintain capital at the minimum requirement of 3%.  All others are subject to maintaining ratiosat least 1% to 2% above the minimum.

 

29

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The Bank exceeded the regulatory capital requirements at June 30,2009 and December 31, 2008 as set forth in the following table (dollars inthousands).

 
| ** **                                | ** ** | **June 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|-------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                | ** ** | **Amount**              | ** ** | **Ratio**                   | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
|                                      |       |                    |       |                        |       |   |   |   |   |
| Tier 1 capital  (to risk-weighted assets) |       | $                       | 29,352     |                        | 9.46       | % | $ | 30,836 |   | 8.92 | % |
| Total capital  (to risk-weighted assets)  |       | 33,304                  |       | 10.73                       |       | 35,205 |   | 10.18 |   |
| Tier 1 capital  (to average assets)       |       | 29,352                  |       | 7.57                        |       | 30,836 |   | 7.98 |   |
|                                           |            |                         |            |                             |            |  |  |  |  |  |  |

 

The Bank’s capital ratioshave improved primarily through balance sheet restructuring as noted in theOverview section.

 

The Company did apply forTARP as outlined above in the Recent Legislative and Regulatory Initiatives toAddress Financial and Economic Crises section. However, after consideration ofrequirements, the Company withdrew its application. The Bank is seeking tocontinue to improve its capital ratios through the restructuring of its balancesheet, reduction of classified assets and investigation of external capitalsources.

 

**RecentRegulatory Developments**

 

On June 29, 2009, the Bank entered into a MOUwith the Commissioner of Banking of the South Carolina State Board of FinancialInstitutions and the Regional Director of the FDIC’s Atlanta RegionalOffice.  The MOU requires the Bank to,among other things, (1) submit a capital plan to the supervisoryauthorities for maintaining 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 improved loan review program; and (5) review overallliquidity objectives and develop plans and procedures aimed at improvingliquidity and reducing reliance on volatile liabilities to fund longer-termassets.  In addition, the Bank may notpay dividends without the prior written consent of each supervisory authority.

 

Since entering into theMOU, the Bank has been actively pursuing the corrective actions required by theMOU in an effort to ensure that the requirements of the MOU are met in a timelymanner.  The MOU is characterized by thesupervisory authorities as an informal action that is neither published normade publicly available by the supervisory authorities and is used whencircumstances warrant a milder form of action rather than a formal supervisoryaction.

 

**Critical Accounting Policies**

 

We have adopted various accounting policies thatgovern the application of accounting principles generally accepted in theUnited States of America and with general practices within the banking industryin the preparation of our financial statements. Our significant accounting policies are described in Note 1 to thefinancial statements in Item 1.

 

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 judgment and assumptions we use are basedon historical experience and other factors, which we believe to be reasonableunder the circumstances.  Because of thenature of the judgments and assumptions we make, actual results could differfrom these judgments and estimates that could have a material impact on thecarrying values of our assets and liabilities and our results of operations.

 

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

 

Some of the more criticaljudgments supporting the amount of our allowance for loan losses includejudgments about the creditworthiness of borrowers, the estimated value of theunderlying collateral, cash flow assumptions, the determination of loss factorsfor estimating credit losses, the impact of current events, and other factorsimpacting the level of probable 

 

30

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inherentlosses.  Under different conditions or using different assumptions,the actual amount of credit losses incurred by us may be different frommanagement’s estimates provided in our consolidated financialstatements.  Please see “Allowance for Loan Losses” for a morecomplete discussion of our processes and methodology for determining ourallowance for loan losses.

 

*Allowancefor Loan Losses*

 

The allowance for loanlosses represents an amount that we believe will be adequate to absorb probablelosses on existing loans that may become uncollectible. Assessing theadequacy of the allowance for loan losses is a process that requiresconsiderable judgment. Our judgment in determining the adequacy of theallowance is based on evaluations of the collectability of loans, includingconsideration of factors such as the balance of impaired loans; the quality,mix and size of our overall loan portfolio; economic conditions that may affectthe borrower’s ability to repay; the amount and quality of collateral securingthe loans; our historical loan loss experience; and a review of specificproblem loans. We adjust the amount of the allowance periodically based onchanging circumstances as a component of the provision for loan losses. Wecharge recognized losses against the allowance and add subsequent recoveriesback to the allowance.

 

We calculate theallowance for loan losses for specific types of loans (excluding mortgage loansheld for sale) and evaluate the adequacy on an overall portfolio basisutilizing our credit grading system which we apply to each loan.  We combineour estimates of the reserves needed for each component of the portfolio,including loans analyzed on a pool basis and loans analyzed individually. The allowance is divided into two portions: (1) an amount forspecific allocations on significant individual credits and (2) a generalreserve amount.

 

*SpecificReserve*

 

We analyze individualloans within the portfolio and make allocations to the allowance based on eachindividual loan’s specific factors and other circumstances that affect thecollectability of the credit in accordance with SFAS No. 114, “Accountingby Creditors for Impairment of a Loan.” Significant individual creditsclassified as doubtful or substandard/special mention within our credit gradingsystem require both individual analysis and specific allocation.

 

Loans in the substandardcategory are characterized by deterioration in quality exhibited by any numberof well-defined weaknesses requiring corrective action such as declining ornegative earnings trends and declining or inadequate liquidity.  Loans inthe doubtful category exhibit the same weaknesses found in the substandardloan; however, the weaknesses are more pronounced.  These loans,however, are not yet rated as loss because certain events may occur which couldsalvage the debt such as injection of capital, alternative financing, orliquidation of assets.

 

In these situations wherea loan is determined to be impaired (primarily because it is probable that allprincipal and interest due according to the terms of the loan agreement willnot be collected as scheduled), the loan is excluded from the general reservecalculations described below and is assigned a specific reserve.  Wecalculate specific reserves on those impaired loans exceeding$250,000.  These reserves are based on a thorough analysis of themost probable source of repayment which is usually the liquidation of theunderlying collateral, but may also include discounted future cash flows or, inrare cases, the market value of the loan itself.

 

Generally, for larger collateraldependent loans, current market appraisals are ordered to estimate the currentfair value of the collateral.  However, in situations where a currentmarket appraisal is not available, management uses the best availableinformation (including recent appraisals for similar properties, communicationswith qualified real estate professionals, information contained in reputabletrade publications and other observable market data) to estimate the currentfair value.  The estimated costs to sell the subject property arethen deducted from the estimated fair value to arrive at the “net realizablevalue” of the loan 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.

 

*GeneralReserve*

 

We calculate our generalreserve based on a percentage allocation for each of the categories of thefollowing unclassified loan types such as:  real estate, commercial,consumer, A&D/construction and mortgage.  We apply our historicaltrend loss factors to each category and adjust these percentages forqualitative or environmental factors, as discussed below.  Thegeneral estimate is then added to the specific allocations made to determinethe amount of the total allowance for loan losses.

 

31

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We also maintain ageneral reserve in accordance with December 2006 regulatory interagencyguidance in our assessment of the loan loss allowance.  This generalreserve considers qualitative or environmental factors that are likely to causeestimated credit losses including, but not limited to:  changes indelinquent loan trends, trends in risk grades and net chargeoffs, concentrationsof credit, trends in the nature and volume of the loan portfolio, general andlocal economic trends, collateral valuations, the experience and depth oflending management and staff, lending policies and procedures, the quality ofloan review systems, and other external factors.

 

**Item 3. Quantitative and Qualitative DisclosuresAbout Market Risk.**

 

Not applicable.

 

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

 

As of the end of theperiod covered by this report, we carried out an evaluation, under thesupervision and with the participation of our management, including our ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of ourdisclosure controls and procedures as defined in Exchange Act Rule 13a-15(e).  Based upon that evaluation, our Chief ExecutiveOfficer and Chief Financial Officer have concluded that our current disclosurecontrols and procedures are effective as of June 30, 2009.  There have been no significant changes in ourinternal controls over financial reporting during the fiscal quarter ended June 30,2009 that have materially affected, or are reasonably likely to materiallyaffect, our internal controls over financial reporting.

 

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

 

**Part II - Other Information**

 

**Item 1. Legal Proceedings.**

 

Not Applicable.

 

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

 

Not applicable.

 

**Item 3. Defaults Upon SeniorSecurities.**

 

Not applicable.

 

**Item 4. Submission of Mattersto Vote of Security Holders.**

 

There was one mattersubmitted to a vote of security holders during the three months ended June 30,2009 at our annual meeting of shareholders held on May 19, 2009.

 

***Proposal #1 — Election of Class IIDirectors***

 

Our board ofdirectors is divided into three classes with each class to be as nearly equalin number as possible.  The three classesof directors have staggered terms, so that the terms of only approximatelyone-third of the board members will expire at each annual meeting ofshareholders.  The current Class Idirectors are C. Allan Ducker, III, W. Michael Riddle, R. Wesley Hammondand David W. Edwards.  The current Class IIdirectors are David A. Miller, David L. Brotherton, Arnold J. Ramsey and J.Neal Workman, Jr.  The current Class IIIdirectors are G. Dial DuBose, Joanne Rogers, B. Lynn Spencer, Daniel E.Youngblood and John W. Hobbs.

 

The Class IIdirectors were up for reelection at this year’s annual meeting held on May 19,2009.  Each of the existing Class IIdirectors were re-elected at the annual meeting for a three-year term expiringat the 2012 annual meeting of shareholders. For Mr. Miller, 2,798,984 votes were cast in favor of hisreelection as director with 14,721 abstained. For Mr. Brotherton, 2,797,365 votes were cast in favor of hisreelection as director with 16,340 abstained. For Mr. Ramsey, 2,686,180 votes were cast in favor of hisreelection as director with 127,525 abstained. For Mr. Workman, 2,798,984votes were cast in favor of his election as a director with 14,721abstained.  The terms of the Class IIIdirectors will expire at the 2010 annual shareholders meeting, and the terms ofthe Class I directors will expire at the 2011 annual shareholders meeting.

 

32

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**Item 5. Other Information.**

 

Not applicable.

 

**Item 6. Exhibits.**

 
| 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.                                           |

 

33

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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 14, 2009 | By:                                          | /s/ C. Allan Ducker, III |
|---------------------------------|----------------------------------------------|-------------------------------|
|                            | C. Allan Ducker, III                    |
|                            | Chief Executive Officer                      |
|                            | (Principal Executive Officer)                |
|                            |                                         |
| Date: August 14, 2009 | By:                                          | /s/ John W. Hobbs             |
|                            | John W. Hobbs                                |
|                            | Chief Financial Officer                      |
|                            | (Principal Financial and Accounting Officer) |

 

34

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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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