** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**(MARKONE)**

 
| **x** | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|-------|------------|----------------------------------------------------------------------------------------------------|

 

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

 

**OR**

 
| **o** | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES 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 Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes  x  No o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer.  See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act).
| Large  accelerated filer o |                                         | Accelerated  filer o |
|---------------------------------|----------------------------------------------|---------------------------|
| Non-accelerated o          | (do  not check if smaller reporting company) |                      | Smaller  reporting company x |
|                                 |                                              |                           |  |

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).  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 of common stock, $0.01 par value per share, wereissued and outstanding as of July 31, 2008.

 

 

 

----

 

**CommunitySouthFinancial Corporation**

 

**Part I- Financial Information**

 

## **Item 1. FinancialStatements**.

## ** **

**CONSOLIDATEDBALANCE SHEETS**

** **
| ** **                                                                                                                                                                            | ** ** | **June 30, 2008** | ** **  | **December 31, 2007** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|-------------|---------------------------------|------------|
| ** **                                                                                                                                                                            | ** ** | **(Unaudited)**             | ** **  | **(Audited)**                   | ** ** |
| **Assets**                                                                                                                                                                            |       |                        |        |                            |       |
| Cash and cash  equivalents                                                                                                                                                            |       |                        |        |                            |       |
| Cash and due  from bank                                                                                                                                                               |       | $                           | 6,137,423   |                            | $          | 6,486,676 |   |
| Federal funds  sold                                                                                                                                                                   |       | 3,787,000                   |        | 33,665,005                      |       |
| Total cash and  cash equivalents                                                                                                                                                      |       | 9,924,423                   |        | 40,151,681                      |       |
| Investment  securities, available for sale                                                                                                                                            |       | 48,027,301                  |        | 24,844,007                      |       |
| Other  investments, at cost                                                                                                                                                           |       | 1,130,200                   |        | 446,800                         |       |
| Loans, net                                                                                                                                                                            |       | 309,022,814                 |        | 298,720,357                     |       |
| Accrued interest  receivable                                                                                                                                                          |       | 1,755,581                   |        | 2,092,066                       |       |
| Property and  equipment, net                                                                                                                                                          |       | 4,857,601                   |        | 5,073,685                       |       |
| Bank-owned life  insurance                                                                                                                                                            |       | 5,326,840                   |        | 5,226,806                       |       |
| Other assets                                                                                                                                                                          |       | 3,009,752                   |        | 1,311,799                       |       |
|                                                                                                                                                                                  |       |                        |        |                            |       |
| Total assets                                                                                                                                                                          |       | $                           | 383,054,512 |                            | $          | 377,867,201 |   |
|                                                                                                                                                                                  |       |                        |        |                            |       |
| **Liabilities and Shareholders’ Equity**                                                                                                                                         |       |                        |        |                            |       |
|                                                                                                                                                                                  |       |                        |        |                            |       |
| **Liabilities**                                                                                                                                                                       |       |                        |        |                            |       |
| Deposits                                                                                                                                                                              |       |                        |        |                            |       |
| Non-interest  bearing                                                                                                                                                                 |       | $                           | 25,255,575  |                            | $          | 24,464,433 |   |
| Interest bearing                                                                                                                                                                      |       | 282,546,423                 |        | 303,199,212                     |       |
| Total deposits                                                                                                                                                                        |       | 307,801,998                 |        | 327,663,645                     |       |
| Repurchase  agreements                                                                                                                                                                |       | 30,000,000                  |        | 15,000,000                      |       |
| FHLB advances                                                                                                                                                                         |       | 10,000,000                  |        | —                          |       |
| Accrued interest  payable                                                                                                                                                             |       | 3,530,389                   |        | 3,238,298                       |       |
| Accrued expenses                                                                                                                                                                      |       | 242,415                     |        | 427,380                         |       |
| Other  liabilities                                                                                                                                                                    |       | 1,649,088                   |        | 66,742                          |       |
|                                                                                                                                                                                  |       |                        |        |                            |       |
| Total  liabilities                                                                                                                                                                    |       | 353,223,890                 |        | 346,396,065                     |       |
|                                                                                                                                                                                  |       |                        |        |                            |       |
| **Shareholders’  Equity**                                                                                                                                                        |       |                        |        |                            |       |
| Preferred stock,  par value $.01 per share 10,000,000 shares authorized, no shares issued                                                                                             |       | —                      |        | —                          |       |
| Common stock,  par value $.01 per share 10,000,000 shares authorized, 4,698,697 and  4,698,697 issued and outstanding at June 30, 2008 and December 31,  2007, respectively |       | 46,987                      |        | 46,987                          |       |
| Additional  paid-in capital                                                                                                                                                           |       | 29,725,595                  |        | 29,691,467                      |       |
| Accumulated  other comprehensive income (loss)                                                                                                                                        |       | (473,657                    | )           | 152,050                         |       |
| Retained earnings                                                                                                                                                                     |       | 531,697                     |        | 1,580,632                       |       |
| Total  shareholders’ equity                                                                                                                                                      |       | 29,830,622                  |        | 31,471,136                      |       |
|                                                                                                                                                                                  |       |                        |        |                            |       |
| Total  liabilities and shareholders’ equity                                                                                                                                      |       | $                           | 383,054,512 |                            | $          | 377,867,201 |   |

 

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

 

2

----

 

**CommunitySouthFinancial Corporation**

 

**CONSOLIDATEDSTATEMENTS OF INCOME**

**(UNAUDITED)**

 
| ** **                                                 | ** ** | **Three months ended** | ** ** | **Three months ended** | ** ** |
|------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                 | ** ** | **June 30, 2008**      | ** ** | **June 30, 2007**      | ** ** |
| **Interest  income**                                       |       |                             |       |                             |       |
| Interest and fees  on loans                                |       | $                                | 5,004,394  |                             | $          | 5,192,585 |   |
| Interest and  dividends on investments                     |       | 671,554                          |       | 398,882                          |       |
| Total interest  income                                     |       | 5,675,948                        |       | 5,591,467                        |       |
|                                                       |       |                             |       |                             |       |
| **Interest  expense – deposits and other borrowings** |       | 3,337,152                        |       | 3,116,024                        |       |
| ** **                                                 |       |                             |       |                             |       |
| Net interest income                                        |       | 2,338,796                        |       | 2,475,443                        |       |
|                                                       |       |                             |       |                             |       |
| **Provision  for loan losses**                             |       | 2,579,000                        |       | 270,000                          |       |
| ** **                                                 |       |                             |       |                             |       |
| Net interest  income after provision for loan losses       |       | (240,204                         | )          | 2,205,443                        |       |
|                                                       |       |                             |       |                             |       |
| **Non-interest  income**                                   |       |                             |       |                             |       |
| Mortgage  origination fees                                 |       | 172,367                          |       | 276,276                          |       |
| Other                                                      |       | 203,965                          |       | 121,815                          |       |
| Total  non-interest income                                 |       | 376,332                          |       | 398,091                          |       |
| ** **                                                 |       |                             |       |                             |       |
| **Non-interest  expense**                                  |       |                             |       |                             |       |
| Salaries and  benefits                                     |       | 1,228,146                        |       | 1,047,241                        |       |
| Data processing                                            |       | 176,616                          |       | 138,154                          |       |
| Occupancy                                                  |       | 157,506                          |       | 112,226                          |       |
| Depreciation                                               |       | 180,132                          |       | 150,181                          |       |
| Equipment  maintenance and rental                          |       | 38,603                           |       | 23,091                           |       |
| Advertising                                                |       | 27,839                           |       | 42,771                           |       |
| Professional  fees                                         |       | 53,684                           |       | 80,800                           |       |
| Office supplies                                            |       | 19,399                           |       | 24,085                           |       |
| Telephone                                                  |       | 33,805                           |       | 32,278                           |       |
| FDIC assessment                                            |       | 54,000                           |       | 45,492                           |       |
| Other                                                      |       | 263,524                          |       | 182,239                          |       |
| Total  non-interest expense                                |       | 2,233,254                        |       | 1,878,558                        |       |
|                                                       |       |                             |       |                             |       |
| **Income  (loss) before income taxes**                     |       | (2,097,126                       | )          | 724,976                          |       |
|                                                       |       |                             |       |                             |       |
| **Income  tax expense (benefit)**                          |       | (706,700                         | )          | 262,847                          |       |
| ** **                                                 |       |                             |       |                             |       |
| **Net  income (loss)**                                     |       | $                                | (1,390,426 | )                                | $          | 462,129 |   |
| ** **                                                 |       |                             |       |                             |       |
| **Earnings  (losses) per share (1)**                       |       |                             |       |                             |       |
| Basic                                                      |       | $                                | (0.30      | )                                | $          | 0.10 |   |
| Diluted                                                    |       | $                                | (0.30      | )                                | $          | 0.09 |   |
|                                                       |       |                             |       |                             |       |
| **Weighted  average shares outstanding (1)**               |       |                             |       |                             |       |
| Basic                                                      |       | 4,698,697                        |       | 4,698,697                        |       |
| Diluted                                                    |       | 4,698,697                        |       | 5,159,460                        |       |

 

----

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

 

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

 

3

----

 

**CommunitySouthFinancial Corporation**

 

**CONSOLIDATEDSTATEMENTS OF INCOME**

**(UNAUDITED)**

 
| ** **                                                 | ** ** | **Six months ended** | ** ** | **Six months ended** | ** ** |
|------------------------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **                                                 | ** ** | **June 30, 2008**    | ** ** | **June 30, 2007**    | ** ** |
| **Interest  income**                                       |       |                           |       |                           |       |
| Interest and  fees on loans                                |       | $                              | 10,551,241 |                           | $          | 9,797,238 |   |
| Interest and  dividends on investments                     |       | 1,402,663                      |       | 709,038                        |       |
| Total interest  income                                     |       | 11,953,904                     |       | 10,506,276                     |       |
|                                                       |       |                           |       |                           |       |
| **Interest  expense – deposits and other borrowings** |       | 6,990,290                      |       | 5,880,587                      |       |
| ** **                                                 |       |                           |       |                           |       |
| Net interest  income                                       |       | 4,963,614                      |       | 4,625,689                      |       |
|                                                       |       |                           |       |                           |       |
| **Provision  for loan losses**                             |       | 2,704,000                      |       | 632,000                        |       |
| ** **                                                 |       |                           |       |                           |       |
| Net interest  income after provision for loan losses       |       | 2,259,614                      |       | 3,993,689                      |       |
|                                                       |       |                           |       |                           |       |
| **Non-interest  income**                                   |       |                           |       |                           |       |
| Mortgage  origination fees                                 |       | 335,262                        |       | 522,012                        |       |
| Other                                                      |       | 381,845                        |       | 220,762                        |       |
| Total  non-interest income                                 |       | 717,107                        |       | 742,774                        |       |
| ** **                                                 |       |                           |       |                           |       |
| **Non-interest  expense**                                  |       |                           |       |                           |       |
| Salaries and  benefits                                     |       | 2,462,731                      |       | 2,040,461                      |       |
| Data processing                                            |       | 367,398                        |       | 259,014                        |       |
| Occupancy                                                  |       | 320,040                        |       | 244,125                        |       |
| Depreciation                                               |       | 361,346                        |       | 281,228                        |       |
| Equipment  maintenance and rental                          |       | 86,227                         |       | 53,364                         |       |
| Advertising                                                |       | 39,002                         |       | 73,640                         |       |
| Professional  fees                                         |       | 131,788                        |       | 123,011                        |       |
| Office supplies                                            |       | 47,183                         |       | 76,267                         |       |
| Telephone                                                  |       | 69,863                         |       | 71,750                         |       |
| FDIC assessment                                            |       | 106,500                        |       | 53,884                         |       |
| Other                                                      |       | 557,178                        |       | 391,149                        |       |
| Total  non-interest expense                                |       | 4,549,256                      |       | 3,667,893                      |       |
|                                                       |       |                           |       |                           |       |
| **Income  (loss) before income taxes**                     |       | (1,572,535                     | )          | 1,068,570                      |       |
|                                                       |       |                           |       |                           |       |
| **Income tax  expense (benefit)**                          |       | (523,600                       | )          | 398,069                        |       |
| ** **                                                 |       |                           |       |                           |       |
| **Net  income (loss)**                                     |       | $                              | (1,048,935 | )                              | $          | 670,501 |   |
| ** **                                                 |       |                           |       |                           |       |
| **Earnings  (losses) per share (1)**                       |       |                           |       |                           |       |
| Basic                                                      |       | $                              | (0.22      | )                              | $          | 0.14 |   |
| Diluted                                                    |       | $                              | (0.22      | )                              | $          | 0.13 |   |
|                                                       |       |                           |       |                           |       |
| **Weighted  average shares outstanding (1)**               |       |                           |       |                           |       |
| Basic                                                      |       | 4,698,697                      |       | 4,698,570                      |       |
| Diluted                                                    |       | 4,698,697                      |       | 5,187,265                      |       |

 

----

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

 

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

 

4

----

 

**CommunitySouthFinancial Corporation**

 

**CONSOLIDATEDSTATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY**

**For thesix month periods ended June 30, 2008 and June 30, 2007**

**(UNAUDITED)**

 
| ** **                                                                      | ** ** | **Common Stock** | ** ** | **Additional  Paid-in** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Retained** | ** ** | **Total  Shareholders’** | ** ** | **Total  Comprehensive** | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|---------------------------------------|------------|--------------|------------|-------------------------------|------------|--------------------------|------------|
| ** **                                                                      | ** ** | **Shares (1)**   | ** ** | **Amount (1)**     | ** ** | **Capital (1)**                  | ** ** | **Income**   | ** ** | **Earnings**                  | ** ** | **Equity**               | ** ** | **Income** | ** ** |
| Balance at  December 31, 2007                                              |       | 4,698,697             |       | $                       | 46,987     |                                  | $          | 29,691,467   |       | $                             | 152,050    |                     | $          | 1,580,632 |   | $ | 31,471,136 |   |   |   |
|                                                                            |       |                  |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Net income  (loss)                                                              |       | —                |       | —                  |       | —                                |       | —       |       | (1,048,935                    | )          | (1,048,935               | )          | $ | (1,048,935 | ) |
|                                                                            |       |                  |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Other  comprehensive income:                                                    |       |                  |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
|                                                                            |       |                  |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Unrealized gains  (losses) on securities, net of income tax benefit of $369,000 |       | —                |       | —                  |       | —                                |       | (625,707     | )          | —                        |       | (625,707                 | )          | (625,707 | ) |
|                                                                            |       |                  |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Total  comprehensive income (loss)                                              |       |                  |       |                    |       |                                  |       |         |       |                          |       |                     |       | $ | (1,674,642 | ) |
|                                                                            |       |                  |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Stock option  compensation                                                      |       | —                |       | —                  |       | 34,128                                |       | —       |       | —                        |       | 34,128                   |       |   |   |
|                                                                            |       |                  |       |                    |       |                                  |       |         |       |                          |       |                     |       |   |   |
| Balance at  June 30, 2008                                                  |       | 4,698,697             |       | $                       | 46,987     |                                  | $          | 29,725,595   |       | $                             | (473,657   | )                        | $          | 531,697 |   | $ | 29,830,622 |   |   |   |

 
| ** **                                           | ** ** | ** **              | ** ** | ** **          | ** ** | ** **           | ** ** | **Accumulated** | ** ** | ** **             | ** ** | ** **        | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|---------------------|------------|----------------------|------------|-----------------|------------|------------------------|------------|-------------------|------------|------------|------------|
| ** **                                           | ** ** | ** **              | ** ** | ** **          | ** ** | **Additional**       | ** ** | **Other**       | ** ** | ** **             | ** ** | **Total**         | ** ** | **Total**  | ** ** |
| ** **                                           | ** ** | **Common Stock**   | ** ** | **Paid-in**         | ** ** | **Comprehensive**    | ** ** | **Retained**    | ** ** | **Shareholders’** | ** ** | **Comprehensive** | ** ** |
| ** **                                           | ** ** | **Shares**** (1)** | ** ** | **Amount (1)** | ** ** | **Capital (1)** | ** ** | **Income**      | ** ** | **Eanrings**           | ** ** | **Equity**        | ** ** | **Income** | ** ** |
| Balance at  December 31, 2006                   |       | 4,697,697               |       | $                   | 46,977     |                 | $          | 29,635,458      |       | $                      | —     |              | $          | 12,520     |       | $ | 29,694,955 |   |   |   |
|                                                 |       |                    |       |                |       |                 |       |            |       |                   |       |              |       |       |       |
| Net income                                           |       | —                  |       | —              |       | —               |       | —          |       | 670,501                |       | 670,501           |       | $          | 670,501    |   |
|                                                 |       |                    |       |                |       |                 |       |            |       |                   |       |              |       |       |       |
| Other  comprehensive income:                         |       |                    |       |                |       |                 |       |            |       |                   |       |              |       |       |       |
|                                                 |       |                    |       |                |       |                 |       |            |       |                   |       |              |       |       |       |
| Unrealized gains  on securities, net of income taxes |       | —                  |       | —              |       | —               |       | —          |       | —                 |       | —            |       | —     |       |
|                                                 |       |                    |       |                |       |                 |       |            |       |                   |       |              |       |       |       |
| Total  comprehensive income                          |       |                    |       |                |       |                 |       |            |       |                   |       |              |       | $          | 670,501    |   |
|                                                 |       |                    |       |                |       |                 |       |            |       |                   |       |              |       |       |       |
| Stock option  compensation                           |       | —                  |       | —              |       | 23,622               |       | —          |       | —                 |       | 23,622            |       |       |       |
|                                                 |       |                    |       |                |       |                 |       |            |       |                   |       |              |       |       |       |
| Cash paid for  fractional shares                     |       | —                  |       | —              |       | (5,701               | )          | —          |       | —                 |       | (5,701            | )          |       |       |
|                                                 |       |                    |       |                |       |                 |       |            |       |                   |       |              |       |       |       |
| Stock options  exercised                             |       | 1,000                   |       | 10                  |       | 6,390                |       | —          |       | —                 |       | 6,400             |       |       |       |
|                                                 |       |                    |       |                |       |                 |       |            |       |                   |       |              |       |       |       |
| Balance at  June 30, 2007                       |       | 4,698,697               |       | $                   | 46,987     |                 | $          | 29,659,769      |       | $                      | —     |              | $          | 683,021    |       | $ | 30,389,777 |   |   |   |

 

----

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

 

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

 

5

----

 

**CommunitySouthFinancial Corporation**

 

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(UNAUDITED)**

 
| ** **                                                                         | ** ** | **Six months  ended** | ** ** | **Six Months  ended** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                                                         | ** ** | **June 30,**          | ** ** | **June 30,**          | ** ** |
| ** **                                                                         | ** ** | **2008**                   | ** ** | **2007**                   | ** ** |
| **Operating activities**                                                           |       |                       |       |                       |       |
| Net income  (loss)                                                                 |       | $                          | (1,048,935 | )                          | $          | 670,501 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                       |       |                       |       |
| Provision for  loan losses                                                         |       | 2,704,000                  |       | 632,000                    |       |
| Stock option  compensation                                                         |       | 34,128                     |       | 23,622                     |       |
| Appreciation of  bank-owned life insurance                                         |       | (100,034                   | )          | (111,024                   | )          |
| Depreciation                                                                       |       | 361,346                    |       | 281,228                    |       |
| Deferred income  tax benefit                                                       |       | (886,100                   | )          | —                     |       |
| Decrease  (increase) in accrued interest receivable                                |       | 336,485                    |       | (233,436                   | )          |
| Increase in  accrued interest payable                                              |       | 292,091                    |       | 265,931                    |       |
| Decrease in  accrued expenses                                                      |       | (184,965                   | )          | 35,774                     |       |
| Decrease in  other assets                                                          |       | 45,278                     |       | 331,852                    |       |
| Increase  (decrease) in other liabilities                                          |       | 1,582,346                  |       | (10,231                    | )          |
| Loss on disposal  of property and equipment                                        |       | —                     |       | 709                        |       |
|                                                                               |       |                       |       |                       |       |
| Net cash  provided by operating activities                                         |       | 3,135,640                  |       | 1,886,927                  |       |
|                                                                               |       |                       |       |                       |       |
| **Investing activities**                                                           |       |                       |       |                       |       |
| Net increase in  loans outstanding                                                 |       | (13,510,542                | )          | (46,234,762                | )          |
| Purchases of  investment securities                                                |       | (24,178,001                | )          | (176,000                   | )          |
| Purchases of  FHLB stock                                                           |       | (683,400                   | )          | —                     |       |
| Purchase of  property and equipment                                                |       | (129,308                   | )          | (487,130                   | )          |
|                                                                               |       |                       |       |                       |       |
| Net cash used in  investing activities                                             |       | (38,501,251                | )          | (46,897,892                | )          |
|                                                                               |       |                       |       |                       |       |
| **Financing activities**                                                           | ** ** | ** **                 | ** ** | ** **                 | ** ** |
| Net increase  (decrease) in deposit accounts                                       |       | (19,861,647                | )          | 70,564,586                 |       |
| Advances from  FHLB                                                                |       | 10,000,000                 |       | —                     |       |
| Increase in  repurchase agreements                                                 |       | 15,000,000                 |       | —                     |       |
| Cash paid for  fractional shares                                                   |       | —                     |       | (5,701                     | )          |
| Stock options  exercised                                                           |       | —                     |       | 6,400                      |       |
|                                                                               |       |                       |       |                       |       |
| Net cash  provided by financing activities                                         |       | 5,138,353                  |       | 70,565,285                 |       |
|                                                                               |       |                       |       |                       |       |
| Net increase  (decrease) in cash and cash equivalents                              |       | (30,227,258                | )          | 25,554,320                 |       |
|                                                                               |       |                       |       |                       |       |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                |       | 40,151,681                 |       | 21,041,070                 |       |
|                                                                               |       |                       |       |                       |       |
| **CASH  AND CASH EQUIVALENTS, END OF PERIOD**                                      |       | $                          | 9,924,423  |                       | $          | 46,595,390 |   |
|                                                                               |       |                       |       |                       |       |
| **SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION**                              |       |                       |       |                       |       |
| Cash paid for:                                                                     |       |                       |       |                       |       |
| Interest                                                                           |       | $                          | 6,696,005  |                       | $          | 2,374,279 |   |
| Income taxes                                                                       |       | $                          | 362,500    |                       | $          | 1,197 |   |
|                                                                               |       |                       |       |                       |       |
| **Schedule  of non-cash transactions**                                             |       |                       |       |                       |       |
| Unrealized gains  / (losses) on investment securities, net of income taxes         |       | $                          | (625,707   | )                          | $          | — |   |

 

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

 

6

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** **

**Notes toUnaudited Consolidated Financial Statements**

 

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

 

**Business Activity andOrganization –**CommunitySouthFinancial Corporation (the “Company”) is a South Carolina corporation organizedfor the purpose of owning and controlling all of the capital stock ofCommunitySouth Bank and Trust (the “Bank”). The Bank is a state chartered bank organized under the laws of SouthCarolina.  From inception on March 20,2004 through January 18, 2005, the Company engaged in organizational andpre-opening activities necessary to obtain regulatory approvals and to prepareits subsidiary, the Bank, to commence business as a financial institution.  The Company received approval from theFederal Deposit Insurance Corporation (“FDIC”), the Federal Reserve Board (“FRB”)and the State Board of Financial Institutions in January 2005.

 

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

 

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

 

**Basis of Presentation –**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 month periodended June 30, 2008 is not necessarily indicative of the results that maybe expected for the year ending December 31, 2008.  For further information, refer to the auditedconsolidated financial statements and footnotes dated December 31, 2007included in the Company’s Form 10-KSB for the year ended December 31,2007 as filed with the Securities and Exchange Commission.

 

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

 

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

 

**Management’sEstimates** – Thepreparation of consolidated financial statements in conformity with generallyaccepted accounting principles requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities and disclosureof contingent assets and liabilities at the date of the financial statementsand the reported amounts of income and expenses during the reportingperiod.  Actual results could differ fromthose estimates.

 

**Disclosure Regarding Segments** – The Company reports as one operatingsegment, as management reviews the results of operations of the Company as asingle enterprise.

 

**Cash and Cash Equivalents**– For purposes of reporting cash flows,cash and cash equivalents include cash on hand, amounts due from banks,short-term interest bearing deposits and federal funds sold.  Cash and cash equivalents have an originalmaturity of three months or less.

 

**Concentrationsof Credit Risk** –Financial instruments, which potentially subject the Company to concentrationsof credit risk, consist principally of loans receivable, investment securities,federal funds sold and amounts due from banks.

 

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

 

7

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

 

The Company’s investmentportfolio consists of both marketable and non-marketable equitysecurities.  Management believes creditrisk associated with the equity securities is not significant. The Companyplaces its deposits and correspondent accounts with and sells its federal fundsto high quality institutions.  Managementbelieves credit risk associated with correspondent accounts is not significant.

 

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

 

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

 

**Other Investments –**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.

 

**LoansReceivable** –Loans are stated at their unpaid principal balance less an allowance for loanlosses and net deferred loan origination fees. Interest income is computed using the simple interest method and isrecorded in the period earned. Loan origination fees collected and certain loanorigination costs are deferred and the net amount is accreted as income using amethod that approximates the level yield method over the life of the relatedloans.

 

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

 

8

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The Company identifiesimpaired loans through its normal internal loan review process.  Loans on the Company’s potential problem loanlist are considered potentially impaired loans. These loans are evaluated in determining whether all outstandingprincipal and interest are expected to be collected.  Loans are not considered impaired if aminimal payment delay occurs and all amounts due, including accrued interest atthe contractual interest rate for the period of delay, are expected to becollected.  Management has determinedthat the Company had $6.9 million and approximately $35,000 in impaired loansat June 30, 2008 and December 31, 2007, respectively.

 

**Allowance for Loan Losses** – The allowance for loan losses isestablished as losses are estimated to have occurred through a provision forloan losses charged to earnings.  Loanlosses are charged against the allowance when management believes the uncollectabilityof a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

 

The allowance for loanlosses is evaluated on a regular basis by management and is based uponmanagement’s periodic review of the collectability of the loans in light ofhistorical experiences, the nature and volume of the loan portfolio, adversesituations that may affect the borrower’s ability to repay, estimated value ofany underlying collateral and prevailing economic conditions.  This evaluation is inherently subjective asit requires estimates that are susceptible to significant revision as moreinformation becomes available.

 

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

 

A loan is consideredimpaired when, based on current information and events, it is probable that theCompany will be unable to collect the scheduled payments of principal orinterest when due according to the contractual terms of the loan agreement.  Factors considered by management indetermining impairment include payment status, collateral value, and theprobability of collecting scheduled principal and interest payments due.  Loans that experience insignificant paymentdelays and payment shortfalls generally are not classified as impaired.  Management determines the significance ofpayment delays and payment shortfalls on a case-by-case basis, taking intoconsideration all of the circumstances surrounding the loan and the borrower,including the length of the delay, the reasons for the delay, the borrower’sprior payment record and the amount of the shortfall in relation to theprincipal and interest owed.  Impairmentis measured on a loan by loan basis for commercial and construction loans byeither the present value of expected future cash flows discounted at the loan’seffective interest rate, the loan’s obtainable market price, or the fair valueof the collateral if the loan is collateral dependent.

 

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

 

**Bank-OwnedLife Insurance** – The Company has purchased life insurance policies oncertain key employees.  These policiesare recorded in other assets at their net cash surrender value, or the amountthat can be realized.  Income from thesepolicies and changes in the net cash surrender value are recorded innon-interest income.

 

**Advertising –** Advertising, promotional, and other businessdevelopment costs generally are expensed as incurred.  External costs incurred in producing mediaadvertising are expensed the first time the advertising takes place.  External costs relating to direct mailingcosts are expensed in the period in which the direct mailings are sent.

 

**Propertyand Equipment** –Premises, furniture and equipment are stated at cost, less accumulateddepreciation.  Depreciation expense is computedusing the straight-line method, based on the estimated useful lives forfurniture and equipment of 5 to 10 years. Leasehold improvements are amortized over the life of the lease.  Maintenance and repairs are charged tocurrent expense.  The costs of majorrenewals and improvements are capitalized.

 

**ResidentialLoan Origination Fees** – The Company offers residential loanorigination services to its customers in its immediate market area.  The loans are offered on terms and pricesoffered by the Company’s correspondents and are closed in the name of thecorrespondents.  The Company receivesfees for services it provides in conjunction with the origination services itprovides.  The fees are recognized at thetime 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 Per Share** – Basic earnings per share representsthe net income allocated to shareholders divided by the weighted-average numberof common shares outstanding during the period. Diluted earnings per share reflect the impact of additional commonshares that would have been outstanding if dilutive potential common shares hadbeen issued.  Potential common sharesthat may be issued by the Company relate to both outstanding warrants and stockoptions, and are determined using the treasury stock method.

 

**Stock–based Compensation** – On January 1, 2006, the Companyadopted the fair value recognition provisions of the Financial AccountingStandards Board’s (“FASB”) SFAS No. 123(R), “Share-Based Payment”, whichis a revision of SFAS No. 123, “Accounting for Stock-Based Compensation”,to account for compensation costs under its stock option plans.  The Company previously utilized the intrinsicvalue method under Accounting Principles Board (“APB”) Opinion No. 25, “Accountingfor 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.  Prior to January 1,2006, the Company only disclosed the pro forma effects on net income andearnings per share as if the fair value recognition provisions of SFAS No. 123(R) hadbeen utilized.

 

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

# ** **

**Off-BalanceSheet Financial Instruments** – In the ordinary course of business, the Companyenters into off-balance sheet financial instruments consisting of commitmentsto extend credit and letters of credit. These financial instruments are recorded in the financial statementswhen they become payable by the customer.

 

**Recently Issued AccountingStandards –**Thefollowing is a summary of recent authoritative pronouncements that could impactthe accounting, reporting, and / or disclosure of financial information by theCompany.

 

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

 

10

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

 
| Level 1 |   | Quoted prices in active  markets for identical assets or liabilities. Level 1 assets and liabilities  include debt and equity securities and derivative contracts that are traded  in an active exchange market, as well as U.S. Treasury, other U.S. Government  and agency mortgage-backed debt securities that are highly liquid and are  actively traded in over-the-counter markets.                                                                                                                                                                                                                                                                                                                                                         |
|---------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| Level 2 |   | Observable inputs other  than Level 1 prices such as quoted prices for similar assets or liabilities;  quoted prices in markets that are not active; or other inputs that are  observable or can be corroborated by observable market data for substantially  the full term of the assets or liabilities. Level 2 assets and liabilities  include debt securities with quoted prices that are traded less frequently  than exchange-traded instruments and derivative contracts whose value is  determined using a pricing model with inputs that are observable in the market  or can be derived principally from or corroborated by observable market data.  This category generally includes certain derivative contracts and impaired  loans. |
|    |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| Level 3 |   | Unobservable inputs  that are supported by little or no market activity and that are significant  to the fair value of the assets or liabilities. Level 3 assets and  liabilities include financial instruments whose value is determined using  pricing models, discounted cash flow methodologies, or similar techniques, as  well as instruments for which the determination of fair value requires  significant management judgment or estimation. For example, this category  generally includes certain private equity investments, retained residual  interests in securitizations, residential mortgage servicing rights, and  highly-structured or long-term derivative contracts.                                                       |

 

Available-for-saleinvestment securities (approximately $48.0 million at June 30, 2008) arethe only assets whose fair values are measured on a recurring basis using Level1 inputs (active market quotes).

 

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

 

The Company ispredominantly an asset-based lender with real estate serving as collateral on asubstantial majority of loans.  Loanswhich are deemed to be impaired are primarily valued on a non-recurring basisat the fair values of the underlying real estate collateral.  When practical, such fair values are obtainedusing independent appraisals, which the Company considers to be Level 2inputs.  The aggregate carrying amount ofimpaired loans at June 30, 2008 was $6.9 million.

 

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

 

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

 

Other accounting standardsthat have been issued or proposed by the FASB or other standards-setting bodiesare not expected to have a material impact on the Company’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 maincomponents of economic risk:  interestrate risk, credit risk and market risk. The Company is subject to interest rate risk to the degree that itsinterest-bearing liabilities mature or reprice at different speeds, or ondifferent bases, than its interest-earning assets.  Credit risk is the risk of default on theCompany’s loan portfolio that results from the borrower’s inability orunwillingness to make contractually required payments.  Market risk reflects changes in the value ofcollateral underlying loans receivable and the valuation of real estate held bythe Company.

 

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

 

**Reclassifications** - Certain captions and amounts in theprior financial statements were reclassified to conform with the 2008presentation.  Such reclassifications hadno effect on previously reported net income or shareholders’ equity.

 

11

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**NOTE 3 – INVESTMENT SECURITIES**

 

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

 
| ** **                                  | ** ** | **Amortized** | ** **     | **Gross Unrealized** | ** ** | **Fair**    | ** ** |
|---------------------------------------------|------------|---------------|----------------|---------------------------|------------|-------------|------------|
| **As of June 30, 2008** | ** ** | **Cost**      | ** **     | **Gains**                 | ** ** | **Losses**  | ** ** | **Value** | ** ** |
| **Available  for sale**                     |       |          |           |                      |       |        |       |   |   |
| Government  sponsored enterprises           |       | $             | 24,494,677     |                      | $          | 103,458     |       | $ | 165,000 |   | $ | 24,433,135 |   |
| Mortgage-backed                             |       | 24,186,081    |           | 77,668                    |       | 769,583     |       | 23,494,166 |   |
| Marketable  securities                      |       | 100,000       |           | —                    |       | —      |       | 100,000 |   |
| Total available  for sale                   | ** ** | **$**         | **48,780,758** | ** **                | **$**      | **181,126** | ** ** | **$** | **934,583** | ** ** | **$** | **48,027,301** | ** ** |

 

**NOTE 4 – LEASES**

 

The Company leases branchlocations in Spartanburg, Mauldin, Anderson, Greer and Greenville as well asthe loan operations center in Easley. The initial lease terms range from threeto ten years with various renewal options. The minimum future rental paymentsunder non-cancelable operating leases having remaining terms in excess of oneyear, for each of the next five years and in the aggregate are:

 
| 2008                                  |       | $         | 173,536       |       |
|---------------------------------------|------------|-----------|---------------|------------|
| 2009                                  |       | 353,771   |          |
| 2010                                  |       | 332,364   |          |
| 2011                                  |       | 331,862   |          |
| 2012                                  |       | 345,471   |          |
| Thereafter                            |       | 1,288,756 |          |
| Total minimum  future rental payments | ** ** | **$**     | **2,825,760** | ** ** |

 

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

 

**NOTE 5 – RELATED PARTYTRANSACTIONS**

 

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

 

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

### ** **

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

 

**NOTE 7 – STOCK-BASED COMPENSATION**

 

Upon completion of theoffering, the Company agreed to issue warrants to the organizing directors forthe purchase of one share of common stock at $6.40 per share for every twoshares purchased in the stock offering, up to a maximum of 15,625 warrants perdirector. The warrants were fully vested 120 days after January 18, 2005 andwill expire on January 18, 2015. Warrants held by directors of the Company will expire 90 days after thedirector ceases to be a director or officer of the Company (365 days if due todeath or disability). The Company issued a total of 171,404 warrants.  In addition, the Company has adopted a stockoption plan.  As of June 30, 2008the Company has 770,837 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.

 

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

 

12

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| ** **                                 | ** ** | **Stock Options** | ** ** | **Warrants**  | ** ** |
|--------------------------------------------|------------|------------------------|------------|---------------|------------|
| ** **                                 | ** ** | ** **             | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **                                 | ** ** | ** **             | ** ** | **Average**   | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                 | ** ** | ** **             | ** ** | **Exercise**  | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                                 | ** ** | **Number**             | ** ** | **Price**     | ** ** | **Number** | ** ** | **Price** | ** ** |
| **Outstanding  at December 31, 2007** |       | 761,493                |       | $             | 7.17       |   | 171,404 |   | $ | 6.40 |   |
| Granted                                    |       | 18,550                 |       | 8.80          |       | — |   | — |   |
| Forfeited                                  |       | 9,206                  |       | 14.14         |       | — |   | — |   |
| Exercised                                  |       | —                 |       | —        |       | — |   | — |   |
| **Outstanding  at June 30, 2008**     | ** ** | **770,837**            | ** ** | **7.13**      | ** ** | **171,404** | ** ** | **6.40** | ** ** |
|                                            |            |                        |            |               |            |  |  |  |  |  |  |

 

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

 
| ** **                                 | ** ** | ** ** | ** ** | **Fair**  | ** ** |
|--------------------------------------------|------------|------------|------------|-----------|------------|
| ** **                                 | ** ** | **Number** | ** ** | **Value** | ** ** |
| **Outstanding  at December 31, 2007** |       | 42,273     |       | $         | 6.79       |   |
| Granted                                    |       | 18,550     |       | 3.95      |       |
| Vested                                     |       | 6,298      |       | 7.06      |       |
| Forfeited                                  |       | 4,300      |       | 7.69      |       |
| **Outstanding  at June 30, 2008**     | ** ** | **50,225** | ** ** | **5.73**  | ** ** |
|                                            |            |            |            |           |            |  |

 

As of June 30, 2008,there was $246,900 in total unrecognized compensation cost related tonon-vested share-based compensation arrangements, which is expected to berecognized over a weighted average period of 47 months. As of December 31,2007, there was $255,917 in total unrecognized compensation cost related tonon-vested share-based compensation arrangements, which was expected to berecognized over a weighted average period of 49 months.

 

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

 

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

 
| **June 30, 2008**      | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** |
|----------------------------------|------------|-----------------|------------|-----------------|------------|
| Number of  options               |       | 770,837         |       | 720,612         |       |
| Weighted average  remaining life |       | 6.77 years      |       | 6.76 years      |       |
| Weighted average  exercise price |       | $               | 7.13       |            | $          | 6.74 |   |
| High exercise  price             |       | $               | 16.80      |            | $          | 16.80 |   |
| Low exercise  price              |       | $               | 6.40       |            | $          | 6.40 |   |

 
| **December 31, 2007**  | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** |
|----------------------------------|------------|-----------------|------------|-----------------|------------|
| Number of  options               |       | 761,493         |       | 719,220         |       |
| Weighted average  remaining life |       | 7.35 years      |       | 7.25 years      |       |
| Weighted average  exercise price |       | $               | 7.17       |            | $          | 6.71 |   |
| High exercise  price             |       | $               | 16.80      |            | $          | 16.80 |   |
| Low exercise  price              |       | $               | 6.40       |            | $          | 6.40 |   |

 

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

 

At June 30, 2008,all of the 171,404 warrants were exercisable and had an average remaining lifeof 6.55 years. At December 31, 2007, all of the 171,404 warrants wereexercisable and had an average remaining life of 7.05 years.

 

13

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**Item 2.  Management’sDiscussion and Analysis or Plan of Operation.**

 

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

 

**DISCUSSION OF FORWARD-LOOKINGSTATEMENTS**

 

This report contains “forward-lookingstatements” relating to, without limitation, future economic performance, plansand objectives of management for future operations, and projections of revenuesand other financial items that are based on the beliefs of management, as wellas assumptions made by and information currently available to management.  The words “may,” “will,” “anticipate,” “should,”“would,” “believe,” “contemplate,” “expect,” “estimate,” “continue,” and “intend,”as well as other similar words and expressions of the future, are intended toidentify forward-looking statements.  Ouractual results may differ materially from the results anticipated in theforward-looking statements as a result of, and our operating performance eachquarter is subject to, various risks and uncertainties that include, withoutlimitation, those described under the heading “Risk Factors” in our AnnualReport on Form 10-KSB for the year ended December 31, 2007 as filedwith the Securities and Exchange Commission and the following:

 

·                  our rapid growthto date and short operating history;

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

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

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

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

·                  changes inpolitical conditions or the legislative or regulatory environment;

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

·                  changesoccurring in business conditions and inflation;

·                  changes intechnology;

·                  changes indeposits flows;

·                  changes inmonetary and tax policies;

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

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

·                  the level ofallowance for loan losses;

·                  the rate ofdelinquencies and amounts of charge-offs;

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

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

·                  changes in thesecurities markets; and

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

 

All forward-looking statements in this report are based on informationavailable to us as of the date of this report. We undertake no obligation to publicly update or otherwise revise anyforward-looking statements, whether as a result of new information, futureevents, or otherwise.

 

# **Overview**

 

CommunitySouth Financial Corporation is a bank holding companyheadquartered in Easley, South Carolina. Our subsidiary, CommunitySouth Bank and Trust, 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 of2007.  We anticipate continued branchexpansion in the Upstate region as opportunities arise.  The Bank provides banking services todomestic markets, principally in the Upstate of South Carolina.  The deposits of the Bank are insured by theFederal Deposit Insurance Corporation. All share and per share information in this report has been adjusted forthe 5-for-4 stock splits effected in the form of a stock dividend paid on January 16,2007 and January 16, 2006 to shareholders of record as of December 15,2006 and December 15, 2005, respectively.

 

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Like mostcommunity banks, we derive most of our income from interest we receive on ourloans and investments.  Our primarysource of funds for making these loans and investments is our deposits, on whichwe pay interest.  Consequently, one ofthe key measures of our success is our amount of net interest income, or thedifference between the income on our interest-earning assets, such as loans andinvestments, and the expense on our interest-bearing liabilities, such asdeposits.  Another key measure is thespread between the yield we earn on these interest-earning assets and the ratewe pay on our interest-bearing liabilities.

 

Of course, thereare risks inherent in all loans, so we maintain an allowance for loan losses toabsorb probable losses on existing loans that may become uncollectible.  We establish and maintain this allowance bycharging a provision for loan losses against our operating earnings.  In the following section we have included adetailed discussion of this process.

 

In addition toearning interest on our loans and investments, we earn income through fees andother expenses we charge to our customers. We describe the various components of this non-interest income, as wellas our non-interest expense, in the following discussion.

 

**Results of Operations**

 

*Three Months ended June 30, 2008 and 2007*

 

*Overview*

 

Our net loss was $1,390,426 for the three months ended June 30,2008 as compared to net income of $462,129 for the three months ended June 30,2007.  Since we began operations in thefirst quarter of 2005, we have experienced significant growth, which has led toa substantial increase in revenues and expenses.  Our net loss for the quarter is primarily dueto an additional $2.5 million in provision for loan losses.  For the three months ended June 30,2008, we realized $5,675,948 in interest income, of which $671,554 was frominvestment activities and $5,004,394 was from loan activities.  For the three months ended June 30,2007, we realized $5,591,467 in interest income, of which $398,882 was frominvestment activities and $5,192,585 was from loan activities.  Although we have grown rapidly to date, givencurrent industry and market conditions, asset growth is not currently a primarygoal for our company.  Our currentstrategic objectives are to preserve capital, manage loan growth, reduceportfolio concentration of construction and land development loans, manageportfolio risk, enhance credit management practices, improve margins, and lowerour overall funding costs, primarily through the growth of core deposits.  As a result of our current focus, ourinterest and fees on loans decreased modestly during the quarter ended June 30,2008 from the quarter ended June 30, 2007.

 

The primary source of funding for our loan portfolio is deposits thatare acquired both locally and via the national brokered certificatemarket.  We incurred interest expense of$3,337,152 and $3,116,024 for the three months ended June 30, 2008 and June 30,2007, respectively.  This increase in ourinterest expense was a result of increased levels of interest bearingdeposits.  We have experienced a declinein our net interest margin to 2.54% from 3.49% for the quarters ended June 30,2008 and 2007, respectively.  The declinewas due to the competitive pressure on commercial loan pricing and on depositpricing, as well as changes in the overall interest rate environment.  On September 18, 2007, the FederalReserve began to decrease short-term rates with an initial 50 basis pointreduction and continued the decrease with an additional 275 basis pointsthrough the end of 2007 and the first six months of 2008.  We had more assets, such as loans, thanliabilities, such as deposits, that repriced down during the three months endedJune 30, 2008, which contributed to the decline in our net interestmargin.

 

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*Provision for Loan Losses*

 

Our provision for loan losses for the three months ended June 30,2008 was $2,579,000 compared to $270,000 for the comparable prior year period.The $2.3 million increase in 2008 compared to the same period in 2007 was theresult of the financing of purchases for several residential lots and theconstruction of several houses in a real estate development project on LakeKeowee, South Carolina (Oconee County) called Sweetwater.  The Bankhas determined that these loans have been over-disbursed and that theassociated houses on these properties will not be completed on schedule. Although the construction loans are nearly fully funded, the houses are invarious stages of completion.  The Bank has approximately $4.9 million insecured loans to 11 borrowers in this development.  The Bank hasclassified this entire $4.9 million as non-accrual and reversed the accruedinterest, and the Bank has reserved a total of $3.0 million for possible lossesrelated to these loans.  The Bank has notyet taken any charge-offs but anticipates it will likely do so over the nextseveral quarters. The Bank has engaged a builder to provide a cost estimate tocomplete each of the houses and is obtaining new appraisals on each of theloans.  We are investigating whether fraud was involved in these loans andhave filed a notice of loss with our Financial Institution Bond, though we cangive no assurances that we will obtain any recovery on this claim.  We are also continuing to investigate otherpotential recovery alternatives.  Theincrease in gross loans outstanding was $6.1 million for the second quarter of2008 as compared to an increase of $19.5 million for the second quarter of2007.

 

*Non-interest Income*

 

We had non-interest income of $376,332 and $398,091 for the threemonths ended June 30, 2008 and 2007, respectively.  Mortgage origination fee income for the threemonths ended June 30, 2008 was $172,367. We had $276,276 in mortgage origination fee income in the second quarterof 2007.  The decrease was the result ofthe overall decline in the demand for home mortgages due to the currenteconomic conditions.  Further, changes instate and federal laws regarding the oversight of mortgage brokers and lenderscould increase our costs of operations and affect our mortgage originationvolume which could negatively impact our non-interest income in the future.

 

*Non-interest Expense*

 

We incurred non-interest expense of $2,233,254 during the three monthsended June 30, 2008.  Included inthe expense was $1,228,146 of salaries and employee benefits, $176,616 of dataprocessing expense, $53,684 of professional fees expense, $27,839 of advertisingexpense, $19,399 of expense related to office supplies, $33,805 of telephoneexpense and $54,000 of assessments related to FDIC.  The non-interest expense incurred in thethree months ended June 30, 2007 was $1,878,558.  Included in the expense was $1,047,241 ofsalaries and employee benefits, $138,154 of data processing expense, $80,800 ofprofessional fee expense, $42,771 of advertising expense, $24,085 of expenserelated to office supplies, $32,278 of telephone expense and $45,492 ofassessments related to FDIC.

 

For the three months ended June 30, 2008, we incurred other fixedasset expenses of $180,132 in depreciation and $38,603 in equipment maintenanceand rental.  For the three months ended June 30,2007, we incurred other fixed asset expenses of $150,181 in depreciation and$23,091 in equipment maintenance and rental. We incurred $157,506 and $112,226 in occupancy expense related to all ofour office locations for the three months ended June 30, 2008 and 2007,respectively.

 

The increase in non-interest expense is the result of the addition of anew branch and personnel over the past year as well as expense related tocustomer growth at the new and existing branches.

 

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*Six Months ended June 30, 2008 and 2007*

 

*Overview*

 

Our net loss was $1,048,935 for the six months ended June 30, 2008as compared to net income of $670,501 for the six months ended June 30,2007.  Since we began operations in thefirst quarter of 2005, we have experienced significant growth, which has led toa substantial increase in revenues and expenses.  Our net loss for the six months ended June 30,2008 is primarily due to an additional $2.1 million in provision for loanlosses.  For the six months ended June 30,2008, we realized $11,953,904 in interest income, of which $1,402,663 was frominvestment activities and $10,551,241 was from loan activities.  For the six months ended June 30, 2007,we realized $10,506,276 in interest income, of which $709,038 was frominvestment activities and $9,797,238 was from loan activities.   As discussed above, although we have grownrapidly to date, given current industry and market conditions, asset growth isnot currently a primary goal for our company. Our current strategic objectives are to preserve capital, manage loangrowth, reduce portfolio concentration of construction and land developmentloans, manage portfolio risk, enhance credit management practices, improvemargins, and lower our overall funding costs, primarily through the growth ofcore deposits.  As a result of ourcurrent focus, our interest and fees on loans decreased modestly during the sixmonths ended June 30, 2008 from the quarter ended June 30, 2007.

 

The primary source of funding for our loan portfolio is deposits thatare acquired both locally and via the national brokered certificatemarket.  We incurred interest expense of$6,990,290 and $5,880,587 for the six months ended June 30, 2008 and June 30,2007, respectively.  This increase in ourinterest expense was a result of increased levels of interest bearingdeposits.  We have experienced a declinein our net interest margin to 2.69% from 3.46% for the six months ended June 30,2008 and 2007, respectively. As discussed above, the decline was due to thecompetitive pressure on commercial loan pricing and on deposit pricing, as wellas that fact that in response to the Federal Reserve’s decreases to short termrates more of our rate-sensitive liabilities repriced than our rate-sensitiveassets during the twelve month period ended June 30, 2008.

 

*Provision for Loan Losses*

 

Our provision for loan losses for the six months ended June 30,2008 was $2,704,000 compared to $632,000 for the comparable prior year period.The $2.1 million increase in 2008 compared to the same period in 2007 was theresult of the financing of purchases for several residential lots and theconstruction of several houses in a real estate development project on LakeKeowee, South Carolina (Oconee County) called Sweetwater.  The Bankhas determined that these loans have been over-disbursed and that theassociated houses on these properties will not be completed on schedule. Although the construction loans are nearly fully funded, the houses are invarious stages of completion.  The Bank has approximately $4.9 million insecured loans to 11 borrowers in this development.  The Bank has not yettaken any charge-offs but anticipates it will likely do so over the nextseveral quarters. The Bank has engaged a builder to provide a cost estimate tocomplete each of the houses and is obtaining new appraisals on each of theloans.  The Bank has designated $3.0 million of the allowance for loanlosses to cover any potential loss associated with this matter.  The increase in gross loans outstanding was$12.8 million for the first two quarters of 2008 as compared to an increase of$46.2 million for the first two quarters of 2007.

 

*Non-interest Income*

 

We had non-interest income of $717,107 and $742,774 for the six monthsended June 30, 2008 and 2007, respectively.  Mortgage origination fee income for the sixmonths ended June 30, 2008 was $335,262. We had $522,012 in mortgage origination fee income in the first twoquarters of 2007.  The decrease was theresult of the overall decline in the demand for home mortgages due to thecurrent economic conditions.  Further,changes in state and federal laws regarding the oversight of mortgage brokersand lenders could increase our costs of operations and affect our mortgageorigination volume which could negatively impact our non-interest income in thefuture.

 

*Non-interest Expense*

 

We incurred non-interest expense of $4,549,256 during the six monthsended June 30, 2008.  Included inthe expense was $2,462,731 of salaries and employee benefits, $367,398 of dataprocessing expense, $131,788 of professional fees expense, $39,002 ofadvertising expense, $47,183 of expense related to office supplies, $69,863 oftelephone expense and $106,500 of assessments related to FDIC.  The non-interest expense incurred in the sixmonths ended June 30, 2007 was $3,667,893. Included in the expense was $2,040,461 of salaries and employeebenefits, $259,014 of data processing expense, $123,011 of professional feeexpense, $73,640 of advertising expense, $76,267 of expense related to officesupplies, $71,750 of telephone expense and $53,884 of assessments related toFDIC.

 

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For the six months ended June 30, 2008, we incurred other fixedasset expenses of $361,346 in depreciation and $86,227 in equipment maintenanceand rental.  For the six months ended June 30,2007, we incurred other fixed asset expenses of $281,228 in depreciation and$53,364 in equipment maintenance and rental. We incurred $320,040 and $244,125 in occupancy expense related to all ofour office locations for the six months ended June 30, 2008 and 2007,respectively.

 

The increase in non-interest expense is the result of the addition of anew branch and personnel over the past year as well as expense related tocustomer growth at the new and existing branches.

 

**Assets and Liabilities**

 

*General*

 

At June 30, 2008, total assets increased 1.55% to$383.1 million as compared to $377.9 million at December 31, 2007.  Gross loans increased $12.8 million, or4.24%, during the first six months of 2008. As described below, federal funds sold decreased to $3.8 million at June 30,2008 compared to $33.7 million at December 31, 2007.  Cash and cash equivalents decreased $30.2million, or 75.28%, since December 31, 2007.  As described below, deposits decreased $19.9million, or 6.06%, during the first six months of 2008.  At June 30, 2008, shareholders’ equitywas $29.8 million.

 

*Investment Securities*

 

Investments available for sale increased by $23.2 million, or 93.32%,since December 31, 2007 due to the purchase and the related appreciationof government agency bonds and mortgaged-backed securities.  Since December 31, 2007 the rationalefor the general change of investing in federal funds to investing in securitiesavailable for sale was to take advantage of higher earning rates and longerterms on the Bank’s investable funds.

 

*Other Investments*

 

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

 

*Loans*

 

Since loans typically provide higher interest yields than other typesof interest earning assets, we allocate the majority of our earning assets toour loan portfolio.  Gross loansincreased by $12.8 million, or 4.24%, during the first six months of 2008.  Loan demand has slowed during the first twoquarters of 2008 due to general economic conditions and the real estatemarket.  We expect this trend to continueduring the next several quarters.

 

Balances within major loan categories are as follows:

 
| **(dollar amounts in thousands)** | ** ** | **June 30, 2008** | ** **  | **December 31, 2007** | ** ** |
|--------------------------------------------------|------------|-----------------------------|-------------|---------------------------------|------------|
| Real estate -  construction                      |       | $                           | 130,338     |                            | $          | 124,016 |   |
| Real estate -  mortgage                          |       | 150,923                     |        | 149,370                         |       |
| Commercial and  industrial                       |       | 31,593                      |        | 26,095                          |       |
| Consumer and other                               |       | 2,914                       |        | 3,453                           |       |
| Total loans,  gross                              |       | 315,768                     |        | 302,934                         |       |
| Less allowance  for loan losses                  |       | (6,745                      | )           | (4,214                          | )          |
| Total loans, net                                 | ** ** | **$**                       | **309,023** | ** **                      | **$**      | **298,720** | ** ** |

 

We discontinue accrual of interest on a loan when we conclude it is doubtful that we will be able to collect interest from the borrower.  We reach this conclusion by taking into account factors such as the borrower’s financial condition, economic and business conditions, and the results of our previous collection efforts.  Generally, we place a delinquent loan in non-accrual status when the loan becomes 90 days or more past due.  When we place a loan in non-accrual status, we reverse all interest which has been accrued on the loan but remains unpaid and we deduct this interest from earnings as a reduction of reported interest income.  We do not accrue any additional interest on the loan balance until we conclude the collection of both principal and interest is reasonably certain.  At June 30, 2008, there were $6.6 million in loans that were non-accruing and $3.8 million in loans that were 30 days past due and still accruing.  At December 31, 2007, there were approximately $35,000 in loans that were non-accruing and about $725,000 in loans that were 30 days past due and still accruing.

 

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*Potential ProblemLoans*

 

Potential problem loans are loans that are not included in impaired loans (non-accrual loans or loans past due 90 days or more and still accruing), but about which management has become aware of information about possible credit problems of the borrowers that causes doubt about their ability to comply with current repayment terms.  At June 30, 2008 and December 31, 2007, the Company had identified $9.2 million and $1.6 million, respectively, of potential problem loans through its internal review procedures.  The results of this internal review process are considered in determining management’s assessment of the adequacy of the allowance for loan losses.

 

*Provision andAllowance for Loan Losses*

 

The Company has developed policies and procedures for evaluating theoverall quality of its credit portfolio and the timely identification ofpotential problem loans.  On a quarterlybasis, the Company’s Board of Directors reviews the appropriate level for theCompany’s allowance for loan losses as determined by management based on theresults of the internal monitoring and reporting system and an analysis ofeconomic conditions in its market.

 

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

 

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

 

In addition, the recent downturn in the real estate market has resultedin an increase in loan delinquencies, defaults and foreclosures, and we believethese trends are likely to continue.  Insome cases, this downturn has resulted in a significant impairment to the valueof our collateral and our ability to sell the collateral upon foreclosure, andthere is a risk that this trend will continue. The real estate collateral in each case provides an alternate source ofrepayment in the event of default by the borrower and may deteriorate in valueduring the time the credit is extended. If real estate values continue to decline, it is also more likely thatwe would be required to increase our allowance for loan losses.  Based on present information and an ongoingevaluation, management considers the allowance for loan losses to be adequateto meet presently known and inherent losses in the loan portfolio.  Management’s judgment about the adequacy ofthe allowance is based upon a number of assumptions about future events whichit believes to be reasonable but which may or may not be accurate.  Thus, there can be no assurance thatcharge-offs in future periods will not exceed the allowance for loan losses orthat additional increases in the allowance for loan losses will not be required.  The Company does not allocate the allowancefor loan losses to specific categories of loans but evaluates the adequacy onan overall portfolio basis utilizing a risk grading system.

 

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*Deposits*

 

Our primary source of funds for loans and investments is ourdeposits.  We have chosen to obtain aportion of our certificates of deposits from areas outside of our market, whichare brokered deposits. The deposits obtained outside of our market areagenerally have rates comparable to those being offered for certificates ofdeposits in our local market.  As of June 30,2008, total deposits had decreased by $19.9 million, or 6.06%, from December 31,2007.  The largest percentage decreasewas in brokered deposits which decreased $20.0 million, or 12.66%, from December 31,2007 to June 30, 2008.  The secondlargest percentage decrease in deposits was in savings which decreased $2.6million, or 10.55%, from December 31, 2007 to June 30, 2008.  This was primarily the result of a run-off ofmoney market accounts that had been established as temporary holding accountsfor IRS section 1031 exchange transactions. The decline in deposits was also affected by certain Bank deposit pricingmethods that resulted in a decline in certificates and allowed us to shift aportion of our funding to FHLB advances and repurchase agreements, whichtogether increased $25 million since December 31, 2007.  We anticipate that future deposit growth willbe positive and will be sufficient to fund our anticipated loan growth.

 

Balances within the major deposit categories are asfollows:

 
| **(dollar amounts in thousands)** | ** ** | **June 30, 2008** | ** **  | **December 31, 2007** | ** ** |
|--------------------------------------------------|------------|-----------------------------|-------------|---------------------------------|------------|
| Non-interest  bearing demand                     |       | $                           | 25,256      |                            | $          | 24,464 |   |
| Interest bearing  demand                         |       | 17,655                      |        | 13,721                          |       |
| Savings                                          |       | 22,035                      |        | 24,634                          |       |
| Time deposits  less than $100,000                |       | 55,163                      |        | 59,528                          |       |
| Time deposits of  $100,000 or over               |       | 49,515                      |        | 47,118                          |       |
| Brokered  deposits                               |       | 138,178                     |        | 158,199                         |       |
| Total deposits                                   | ** ** | **$**                       | **307,802** | ** **                      | **$**      | **327,664** | ** ** |

 

*Advances from 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, 2008, the Bank had received advances of $10.0 million from FHLB.

 

*Repurchase Agreements*

 

At June 30, 2008, the Bank had sold $30.0 millionof securities under agreements to repurchase with brokers with a weightedaverage rate of 2.21% and an average maturity of 96 months.  The maximum amount outstanding at any month-endwas $30.0 million.  These agreements weresecured with approximately $34.2 million of investment securities.

 

**Liquidity**

 

Liquidity  is the  ability  to  meet  current  and  future  obligations  through liquidation or maturity of existing  assets or the  acquisition of  liabilities.  We manage both assets and liabilities to achieve appropriate levels of liquidity.  Cash and short-term investments are our primary sources of asset liquidity.  These funds provide a cushion against short-term fluctuations in cash flow from both deposits and loans.  Individual and commercial deposits and borrowings are our primary source of funds for credit activities.  At June 30, 2008, we had lines of credit with unrelated banks totaling $15.5 million.  These lines, which are unsecured, are available on a one-to-seven day basis for general corporate purposes.  We believe our liquidity sources are adequate to meet our operating needs as well as our construction commitments.  The level of liquidity is measured by the cash, cash equivalents and securities available for sale-to-total assets ratio, which was at 15.13% at June 30, 2008.

 

As members of the Federal Home Loan Bank of Atlanta, we have credit availability of up to 10% of the Bank’s total assets, which meant $38.3 million was available as of June 30, 2008.  Advances under this credit facility are subject to qualifying collateral.

 

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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, 2008, we had issued commitments to extend credit of$51.6 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, 2008** | ** ** | **December 31, 2007** | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
|                                             |       |                        |       |                            |       |
| Commitments to  extend credit                    |       | $                           | 47,548     |                            | $          | 49,343 |   |
|                                             |       |                        |       |                            |       |
| Standby letters  of credit                       |       | $                           | 4,006      |                            | $          | 3,177 |   |

 

**Capital Resources**

 

Total shareholders’ equity decreased from $31.5 million at December 31,2007 to $29.8 million at June 30, 2008. The decrease is principally due to the net unrealized losses onsecurities available for sale of $625,707 (net of income taxes) and to the netloss for the six months ended June 30, 2008 of $1,048,935.

 

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 is registeredunder Section 12 of the Securities Exchange Act, we believe that becauseour stock is not listed on any exchange or otherwise actively traded, theFederal Reserve Board will interpret its new guidelines to mean that we qualifyas a small bank holding company. Nevertheless, our Bank remains subject to these capitalrequirements.  Failure to meet minimumcapital requirements can initiate certain mandatory and possibly additionaldiscretionary actions by regulators that, if undertaken, could have a directmaterial effect on the Bank’s financial statements.  Under capital adequacy guidelines and theregulatory framework for prompt corrective action, the Bank must meet specificcapital guidelines that involve quantitative measures of the Bank’s assets, liabilitiesand certain off-balance sheet items as calculated under regulatory accountingpractices.  The Bank’s capital amountsand classifications 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 capitaladequacy guidelines, regulatory capital is classified into two tiers.  These guidelines require an institution tomaintain a certain level of Tier 1 and Tier 2 capital to risk-weightedassets.  Tier 1 capital consists ofcommon shareholders’ equity, excluding the unrealized gain or loss onsecurities available for sale, minus certain intangible assets.  In determining the amount of risk-weightedassets, all assets, including certain off-balance sheet assets, are multipliedby a risk-weight factor of 0% to 100% based on the risks believed to beinherent in the type of asset.  Tier 2capital consists of Tier 1 capital plus the general reserve for loan losses,subject to certain limitations.  We arealso required to maintain capital at a minimum level based on total averageassets, which is known as the Tier 1 leverage ratio.

 

The Bank is also 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.

 

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

 
| ** **                                | ** ** | **June 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|-------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ** **                                | ** ** | **Amount**                  | ** ** | **Ratio**                       | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
|                                      |       |                        |       |                            |       |   |   |   |   |
| Tier 1 capital  (to risk-weighted assets) |       | $                           | 31,413,000 |                            | 9.01       | % | $ | 30,102,000 |   | 8.92 | % |
| Total capital  (to risk-weighted assets)  |       | 35,802,000                  |       | 10.26                           |       | 34,316,000 |   | 10.17 |   |
| Tier 1 capital  (to average assets)       |       | 31,413,000                  |       | 8.16                            |       | 30,102,000 |   | 8.26 |   |
|                                           |            |                             |            |                                 |            |  |  |  |  |  |  |

 

We currently anticipate raising additional capital, likely in the formof subordinated notes, to bolster our capital and to support anticipatedgrowth.  We cannot be certain that wewill be able to do so on acceptable terms, if at all.

 

**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.

 

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

 

Not applicable.

 

**Item 4.Controls and Procedures.**

 

As of the end of theperiod covered by this report, we carried out an evaluation, under thesupervision and with the participation of our management, including our ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of ourdisclosure controls and procedures as defined in Exchange Act Rule 13a-15(e).  Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer have concluded that our currentdisclosure controls and procedures are effective as of June 30, 2008.  There have been no significant changes in ourinternal controls over financial reporting during the fiscal quarter ended June 30,2008 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.

 

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**Part II- Other Information**

 

**Item 1. LegalProceedings.**

 

Not Applicable.

 

**Item 2. UnregisteredSales of Equity Securities and Use of Proceeds.**

 

Not applicable.

 

**Item 3. DefaultsUpon Senior Securities.**

 

Not applicable.

 

**Item 4. Submissionof Matters to Vote of Security Holders.**

 

There was one mattersubmitted to a vote of security holders during the three months ended June 30,2008 at our annual meeting of shareholders held on May 20, 2008.

 

***Election of Class I Directors***

 

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 Idirectors were up for reelection at this year’s annual meeting held on May 20,2008.  Each of the existing Class Idirectors were re-elected at the annual meeting for a three-year term expiringat the 2011 annual meeting of shareholders. For Mr. Ducker, 2,969,593 votes were cast in favor of hisreelection as director with 5,827 abstained. For Dr. Riddle, 2,965,687 votes were cast in favor of hisreelection as director with 9,733 abstained. For Mr. Hammond, 2,969,593 votes were cast in favor of hisreelection as director with 5,827 abstained. For Mr. Edwards, 2,967,641votes were cast in favor of his election as a director with 7,779abstained.  The terms of the Class IIdirectors will expire at the 2009 annual shareholders meeting, and the terms ofthe Class III directors will expire at the 2010 annual shareholdersmeeting.

 

**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.                                           |

 

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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, 2008 | By:                                          | /s/ C. Allan Ducker, III |
|----------------------------|----------------------------------------------|-------------------------------|
|                       | C. Allan Ducker, III                    |
|                       | Chief Executive Officer                      |
|                       | (Principal Executive Officer)                |
|                       |                                         |
| Date: August 14, 2008 | By:                                          | /s/ John W. Hobbs             |
|                       | John W. Hobbs                                |
|                       | Chief Financial Officer                      |
|                       | (Principal Financial and Accounting Officer) |

 

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**EXHIBIT INDEX**

 
| **Exhibit** | ** ** | ** **                                                                  |
|-------------|------------|-----------------------------------------------------------------------------|
| **Number**  | ** ** | **Description**                                                             |
|        |       |                                                                        |
| 31.1        |       | Rule 13a-14(a) Certification of the  Principal Executive Officer. |
|        |       |                                                                        |
| 31.2        |       | Rule 13a-14(a) Certification of the  Principal Financial Officer. |
|        |       |                                                                        |
| 32          |       | Section 1350 Certifications.                                           |

 

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