** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

** **

**(MARKONE)**

** **

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

** **

**For the Quarterly Period ended March 31, 2009**

** **

**OR**

** **

**o****        ****TRANSITION REPORT PURSUANT TO SECTION 13OR 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.) |

 

**6602Calhoun Memorial Highway**

**Easley,South Carolina 29640**

(Address of principal executive offices)

 

**(864) 306-2540**

(Registrant’s telephone number, including area code)

 

----

 

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

 

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

 

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

 

| Large accelerated filer o                                      |   | Accelerated filer o         |
|----------------------------------------------------------------|--------|-----------------------------|
|                                                           |   |                        |
| Non-accelerated o  (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, were issued and outstanding as of May 11, 2009.

 

 

 

----

 

**CommunitySouthFinancial Corporation**

 

**Part I- Financial Information**

 

## **Item 1. FinancialStatements**.

## ** **

**CONSOLIDATEDBALANCE SHEETS**

(dollars inthousands)

** **
| ** **                                                                                                                                                                             | ** ** | **March 31, 2009** | ** ** | **December 31, 2008** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                                                             | ** ** | **(Unaudited)**         | ** ** | **(Audited)**              | ** ** |
| **Assets**                                                                                                                                                                             | ** ** | ** **              | ** ** | ** **                 | ** ** |
|                                                                                                                                                                                   |       |                    |       |                       |       |
| Cash and cash  equivalents                                                                                                                                                             |       |                    |       |                       |       |
| Cash and due  from bank                                                                                                                                                                |       | $                       | 7,879      |                       | $          | 5,251 |   |
| Federal funds  sold                                                                                                                                                                    |       | 5,530                   |       | 4,625                      |       |
| Total cash and  cash equivalents                                                                                                                                                       |       | 13,409                  |       | 9,876                      |       |
| Investment  securities, available for sale                                                                                                                                             |       | 49,880                  |       | 47,602                     |       |
| Other  investments, at cost                                                                                                                                                            |       | 1,824                   |       | 1,805                      |       |
| Loans, net                                                                                                                                                                             |       | 307,216                 |       | 312,819                    |       |
| Accrued interest  receivable                                                                                                                                                           |       | 1,464                   |       | 1,628                      |       |
| Property and  equipment, net                                                                                                                                                           |       | 4,591                   |       | 4,618                      |       |
| Bank-owned life  insurance                                                                                                                                                             |       | 909                     |       | 5,437                      |       |
| Other assets                                                                                                                                                                           |       | 5,677                   |       | 4,031                      |       |
|                                                                                                                                                                                   |       |                    |       |                       |       |
| Total assets                                                                                                                                                                           |       | $                       | 384,970    |                       | $          | 387,816 |   |
|                                                                                                                                                                                   |       |                    |       |                       |       |
| **Liabilities and Shareholders’ Equity**                                                                                                                                          |       |                    |       |                       |       |
|                                                                                                                                                                                   |       |                    |       |                       |       |
| **Liabilities**                                                                                                                                                                        |       |                    |       |                       |       |
| Deposits                                                                                                                                                                               |       |                    |       |                       |       |
| Non-interest  bearing                                                                                                                                                                  |       | $                       | 22,138     |                       | $          | 22,162 |   |
| Interest bearing                                                                                                                                                                       |       | 299,287                 |       | 274,481                    |       |
| Total deposits                                                                                                                                                                         |       | 321,425                 |       | 296,643                    |       |
| Repurchase  agreements                                                                                                                                                                 |       | 30,000                  |       | 30,000                     |       |
| Federal Home  Loan Bank advances                                                                                                                                                       |       | —                  |       | 25,000                     |       |
| Note payable                                                                                                                                                                           |       | —                  |       | 1,570                      |       |
| Subordinated  debt                                                                                                                                                                     |       | 4,325                   |       | 4,325                      |       |
| Accrued interest  payable                                                                                                                                                              |       | 669                     |       | 1,406                      |       |
| Accrued expenses                                                                                                                                                                       |       | 242                     |       | 193                        |       |
| Other  liabilities                                                                                                                                                                     |       | 150                     |       | 151                        |       |
|                                                                                                                                                                                   |       |                    |       |                       |       |
| Total  liabilities                                                                                                                                                                     |       | 356,811                 |       | 359,288                    |       |
|                                                                                                                                                                                   |       |                    |       |                       |       |
| **Shareholders’  Equity**                                                                                                                                                         |       |                    |       |                       |       |
| Preferred stock,  par value $.01 per share 10,000,000 shares authorized, no shares issued                                                                                              |       | —                  |       | —                     |       |
| Common stock,  par value $.01 per share 10,000,000 shares authorized, 4,698,697 and  4,698,697 issued and outstanding at March 31, 2009 and December 31,  2008, respectively |       | 47                      |       | 47                         |       |
| Additional  paid-in capital                                                                                                                                                            |       | 29,777                  |       | 29,760                     |       |
| Accumulated  other comprehensive income                                                                                                                                                |       | 141                     |       | 491                        |       |
| Retained deficit                                                                                                                                                                       |       | (1,806                  | )          | (1,770                     | )          |
| Total  shareholders’ equity                                                                                                                                                       |       | 28,159                  |       | 28,528                     |       |
|                                                                                                                                                                                   |       |                    |       |                       |       |
| Total  liabilities and shareholders’ equity                                                                                                                                       |       | $                       | 384,970    |                       | $          | 387,816 |   |

 

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

 

2

----

 

**CommunitySouthFinancial Corporation**

 

**CONSOLIDATEDSTATEMENTS OF INCOME**

**(UNAUDITED)**

(dollars inthousands, except share data)

 
| ** **                                           | ** ** | **Three months ended**  | ** ** | **Three months ended**  | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                           | ** ** | **March 31, 2009** | ** ** | **March 31, 2008** | ** ** |
| **Interest  income**                                 |       |                    |       |                    |       |
| Interest and  fees on loans                          |       | $                       | 4,370      |                    | $          | 5,518 |   |
| Interest and  dividends on investments               |       | 563                     |       | 731                     |       |
| Total interest  income                               |       | 4,933                   |       | 6,249                   |       |
|                                                 |       |                    |       |                    |       |
| **Interest  expense**                                |       | 2,080                   |       | 3,653                   |       |
| ** **                                           |       |                    |       |                    |       |
| Net interest  income                                 |       | 2,853                   |       | 2,596                   |       |
|                                                 |       |                    |       |                    |       |
| **Provision  for loan losses**                       |       | 1,305                   |       | 125                     |       |
| ** **                                           |       |                    |       |                    |       |
| Net interest  income after provision for loan losses |       | 1,548                   |       | 2,471                   |       |
|                                                 |       |                    |       |                    |       |
| **Non-interest  income**                             |       |                    |       |                    |       |
| Mortgage  origination fees                           |       | 62                      |       | 163                     |       |
| Gain on sale of  securities                          |       | 520                     |       | —                  |       |
| Other                                                |       | 232                     |       | 207                     |       |
| Total  non-interest income                           |       | 814                     |       | 370                     |       |
| ** **                                           |       |                    |       |                    |       |
| **Non-interest  expense**                            |       |                    |       |                    |       |
| Salaries and  benefits                               |       | 1,239                   |       | 1,235                   |       |
| Data processing                                      |       | 222                     |       | 191                     |       |
| Occupancy                                            |       | 171                     |       | 162                     |       |
| Depreciation                                         |       | 180                     |       | 181                     |       |
| Equipment  maintenance and rental                    |       | 42                      |       | 48                      |       |
| Advertising                                          |       | 36                      |       | 11                      |       |
| Professional  fees                                   |       | 91                      |       | 78                      |       |
| Office supplies                                      |       | 23                      |       | 28                      |       |
| Telephone                                            |       | 37                      |       | 36                      |       |
| FDIC assessments                                     |       | 96                      |       | 53                      |       |
| Other                                                |       | 279                     |       | 294                     |       |
| Total non-interest  expense                          |       | 2,416                   |       | 2,317                   |       |
|                                                 |       |                    |       |                    |       |
| **Income  (loss) before income taxes**               |       | (54                     | )          | 524                     |       |
|                                                 |       |                    |       |                    |       |
| **Income  tax expense (benefit)**                    |       | (18                     | )          | 183                     |       |
| ** **                                           |       |                    |       |                    |       |
| **Net  income (loss)**                               |       | $                       | (36        | )                       | $          | 341 |   |
| ** **                                           |       |                    |       |                    |       |
| **Earnings  (loss) per share**                       |       |                    |       |                    |       |
| Basic                                                |       | $                       | (0.01      | )                       | $          | 0.07 |   |
| Diluted                                              |       | $                       | (0.01      | )                       | $          | 0.07 |   |
|                                                 |       |                    |       |                    |       |
| **Weighted  average shares outstanding**             |       |                    |       |                    |       |
| Basic                                                |       | 4,698,697               |       | 4,698,697               |       |
| Diluted                                              |       | 4,698,697               |       | 4,910,736               |       |

 

The accompanyingnotes are an integral part of the consolidated financial statements.

 

3

----

 

**CommunitySouthFinancial Corporation**

 

**CONSOLIDATEDSTATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY**

**For thethree-month periods ended March 31, 2009 and March 31, 2008**

**(UNAUDITED)**

(dollars inthousands, except share amounts)

** **
| ** **                                                 | ** ** | **Common Stock** | ** ** | **Additional  Paid-in** | ** ** | **Accumulated   Other   Comprehensive** | ** ** | **Retained  Earnings** | ** ** | **Total  Shareholders’** | ** ** | **Total Comprehensive** | ** ** |
|------------------------------------------------------------|------------|------------------|------------|-------------------------|------------|-----------------------------------------|------------|------------------------|------------|-------------------------------|------------|-------------------------|------------|
| ** **                                                 | ** ** | **Shares**       | ** ** | **Amount**              | ** ** | **Capital**                             | ** ** | **Income**             | ** ** | **(Defecit)**                 | ** ** | **Equity**              | ** ** | **Income (Loss)** | ** ** |
| Balance at  December 31, 2008                         |       | 4,698,697        |       | $                       | 47         |                                    | $          | 29,760                 |       | $                             | 491        |                    | $          | (1,770 | ) | $ | 28,528 |   |   |   |
|                                                       |       |             |       |                    |       |                                    |       |                   |       |                          |       |                    |       |   |   |
| Net income  (loss)                                         |       | —           |       | —                  |       | —                                  |       | —                 |       | (36                           | )          | (36                     | )          | $ | (36 | ) |
|                                                       |       |             |       |                    |       |                                    |       |                   |       |                          |       |                    |       |   |   |
| Other  comprehensive income:                               |       |             |       |                    |       |                                    |       |                   |       |                          |       |                    |       |   |   |
|                                                       |       |             |       |                    |       |                                    |       |                   |       |                          |       |                    |       |   |   |
| Unrealized loss  on securities, net of income taxes of $63 |       | —           |       | —                  |       | —                                  |       | (692                   | )          | —                        |       | (692                    | )          | (692 | ) |
|                                                       |       |             |       |                    |       |                                    |       |                   |       |                          |       |                    |       |   |   |
| Reclassification  of realized losses                       |       | —           |       | —                  |       | —                                  |       | 342                    |       | —                        |       | 342                     |       | 342 |   |
|                                                       |       |             |       |                    |       |                                    |       |                   |       |                          |       |                    |       |   |   |
| Total  comprehensive income (loss)                         |       |             |       |                    |       |                                    |       |                   |       |                          |       |                    |       | $ | (386 | ) |
|                                                       |       |             |       |                    |       |                                    |       |                   |       |                          |       |                    |       |   |   |
| Stock option  compensation                                 |       | —           |       | —                  |       | 17                                      |       | —                 |       | —                        |       | 17                      |       |   |   |
|                                                       |       |             |       |                    |       |                                    |       |                   |       |                          |       |                    |       |   |   |
| Balance at  March 31, 2009                            |       | 4,698,697        |       | $                       | 47         |                                    | $          | 29,777                 |       | $                             | 141        |                    | $          | (1,806 | ) | $ | 28,159 |   |   |   |

 
| ** **                                                  | ** ** | **Common Stock** | ** ** | **Additional  Paid-in** | ** ** | **Accumulated   Other   Comprehensive** | ** ** | **Retained** | ** ** | **Total  Shareholders’** | ** ** | **Total Comprehensive** | ** ** |
|-------------------------------------------------------------|------------|------------------|------------|-------------------------|------------|-----------------------------------------|------------|--------------|------------|-------------------------------|------------|-------------------------|------------|
| ** **                                                  | ** ** | **Shares**       | ** ** | **Amount**              | ** ** | **Capital**                             | ** ** | **Income**   | ** ** | **Earnings**                  | ** ** | **Equity**              | ** ** | **Income** | ** ** |
| Balance at  December 31, 2007                          |       | 4,698,697        |       | $                       | 47         |                                    | $          | 29,691       |       | $                             | 152        |                    | $          | 1,581 |   | $ | 31,471 |   |   |   |
|                                                        |       |             |       |                    |       |                                    |       |         |       |                          |       |                    |       |   |   |
| Net income                                                  |       | —           |       | —                  |       | —                                  |       | —       |       | 341                           |       | 341                     |       | $ | 341 |   |
|                                                        |       |             |       |                    |       |                                    |       |         |       |                          |       |                    |       |   |   |
| Other  comprehensive income:                                |       |             |       |                    |       |                                    |       |         |       |                          |       |                    |       |   |   |
|                                                        |       |             |       |                    |       |                                    |       |         |       |                          |       |                    |       |   |   |
| Unrealized gain  on securities, net of income taxes of $139 |       | —           |       | —                  |       | —                                  |       | 86           |       | —                        |       | 86                      |       | 86 |   |
|                                                        |       |             |       |                    |       |                                    |       |         |       |                          |       |                    |       |   |   |
| Total  comprehensive income                                 |       |             |       |                    |       |                                    |       |         |       |                          |       |                    |       | $ | 427 |   |
|                                                        |       |             |       |                    |       |                                    |       |         |       |                          |       |                    |       |   |   |
| Stock option  compensation                                  |       | —           |       | —                  |       | 18                                      |       | —       |       | —                        |       | 18                      |       |   |   |
|                                                        |       |             |       |                    |       |                                    |       |         |       |                          |       |                    |       |   |   |
| Balance at  March 31, 2008                             |       | 4,698,697        |       | $                       | 47         |                                    | $          | 29,709       |       | $                             | 238        |                    | $          | 1,922 |   | $ | 31,916 |   |   |   |

 

The accompanyingnotes are an integral part of the consolidated financial statements.

 

4

----

 

**CommunitySouthFinancial Corporation**

 

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(UNAUDITED)**

(in thousands)

 
| ** **                                                                                           | ** ** | **Three Months  ended** | ** ** | **Three Months  ended** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                                                           | ** ** | **March 31,**      | ** ** | **March 31,**      | ** ** |
| ** **                                                                                           | ** ** | **2009**                | ** ** | **2008**                | ** ** |
| **Operating activities**                                                                             |       |                    |       |                    |       |
| Net income  (loss)                                                                                   |       | $                       | (36        | )                       | $          | 341 |   |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                    |       |                    |       |
| Provision for  loan losses                                                                           |       | 1,305                   |       | 125                     |       |
| Stock option  compensation                                                                           |       | 17                      |       | 18                      |       |
| Appreciation of  bank-owned life insurance                                                           |       | (48                     | )          | (56                     | )          |
| Gain on sale of  securities                                                                          |       | (520                    | )          | —                  |       |
| Depreciation                                                                                         |       | 180                     |       | 181                     |       |
| Deferred income  tax benefit                                                                         |       | (10                     | )          | (29                     | )          |
| Decrease in  accrued interest receivable                                                             |       | 164                     |       | 332                     |       |
| Increase  (decrease) in accrued interest payable                                                     |       | (737                    | )          | 1,489                   |       |
| Increase  (decrease) in accrued expenses                                                             |       | 49                      |       | (173                    | )          |
| Increase in  other assets                                                                            |       | (1,699                  | )          | (34                     | )          |
| Increase  (decrease) in other liabilities                                                            |       | (1                      | )          | 8                       |       |
|                                                                                                 |       |                    |       |                    |       |
| Net cash  provided by (used in) operating activities                                                 |       | (1,336                  | )          | 2,202                   |       |
|                                                                                                 |       |                    |       |                    |       |
| **Investing activities**                                                                             |       |                    |       |                    |       |
| Net (increase)  decrease in loans outstanding                                                        |       | 4,298                   |       | (7,111                  | )          |
| Sale of bank  owned life insurance                                                                   |       | 4,576                   |       | —                  |       |
| Purchases of  investment securities, net                                                             |       | (2,045                  | )          | (29,202                 | )          |
| Purchases of  FHLB stock                                                                             |       | (19                     | )          | (459                    | )          |
| Purchase of  property and equipment                                                                  |       | (153                    | )          | (79                     | )          |
|                                                                                                 |       |                    |       |                    |       |
| Net cash  provided by (used in) investing activities                                                 |       | 6,657                   |       | (36,851                 | )          |
|                                                                                                 |       |                    |       |                    |       |
| **Financing activities**                                                                             | ** ** | ** **              | ** ** | ** **              | ** ** |
| Net increase  (decrease) in deposit accounts                                                         |       | 24,782                  |       | (17,292                 | )          |
| Advances from  FHLB                                                                                  |       | —                  |       | 5,000                   |       |
| Repayment of  FHLB                                                                                   |       | (25,000                 | )          | —                  |       |
| Increase in  repurchase agreements                                                                   |       | —                  |       | 15,000                  |       |
| Repayment of  Bank of Tennessee advance                                                              |       | (1,570                  | )          | —                  |       |
|                                                                                                 |       |                    |       |                    |       |
| Net cash  provided by (used in) financing activities                                                 |       | (1,788                  | )          | 2,708                   |       |
|                                                                                                 |       |                    |       |                    |       |
| Net increase  (decrease) in cash and cash equivalents                                                |       | 3,533                   |       | (31,941                 | )          |
|                                                                                                 |       |                    |       |                    |       |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                                  |       | 9,876                   |       | 40,152                  |       |
|                                                                                                 |       |                    |       |                    |       |
| **CASH  AND CASH EQUIVALENTS, END OF PERIOD**                                                        |       | $                       | 13,409     |                    | $          | 8,211 |   |
|                                                                                                 |       |                    |       |                    |       |
| **SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION**                                                |       |                    |       |                    |       |
| Cash paid for:                                                                                       |       |                    |       |                    |       |
| Interest                                                                                             |       | $                       | 1,343      |                    | $          | 2,165 |   |
| Income taxes                                                                                         |       | $                       | —     |                    | $          | 213 |   |
|                                                                                                 |       |                    |       |                    |       |
| **Schedule  of non-cash transactions**                                                               |       |                    |       |                    |       |
| Unrealized gains  (losses) on investment securities, net of income taxes                             |       | $                       | (692       | )                       | $          | 86 |   |
| Loans  charged-off (recovered)                                                                       |       | $                       | (20        | )                       | $          | 50 |   |

 

The accompanyingnotes are an integral part of the consolidated financial statements.

 

5

----

 

**CommunitySouthFinancial Corporation**

 

**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 March 31, 2009 is not necessarily indicative of the results that maybe expected for the year ending December 31, 2009.  For further information, refer to the auditedconsolidated financial statements and footnotes included in the Company’s Form 10-Kfor the year ended December 31, 2008 as filed with the Securities andExchange 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 anddisclosure of contingent assets and liabilities at the date of the financialstatements and 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.

 

6

----

 

**CommunitySouthFinancial Corporation**

 

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.  The bank does have aconcentration of loans classified as commercial real estate. These loans areespecially susceptible to being adversely effected by the current economicdownturn. The current downturn in the real estate market has resulted in anincrease in loan delinquencies, defaults and foreclosures, and we believe thesetrends are likely to continue.  In somecases, this downturn has resulted in a significant impairment to the value ofour collateral and our ability to sell the collateral upon foreclosure, andthere is a risk that this trend will continue. The commercial real estate collateral in each case provides an alternatesource of repayment in the event of default by the borrower and may deterioratein value during the time the credit is extended.  If real estate values continue to decline, itis also more likely that we would be required to increase our allowance forloan losses.

 

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 sale securities*: These are securities that are notclassified as either held to maturity or as trading securities.  Thesesecurities are reported at fair market value.  Unrealized gains and lossesare reported, net of income taxes, as separate components of shareholders’equity (accumulated other comprehensive income).

 

2.               *Held to maturity securities*: These are investment securities thatthe Company has the ability and intent to hold until maturity.  Thesesecurities are stated at cost, adjusted for amortization of premiums and theaccretion 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 areamortized or accrued into interest income by a method that approximates a levelyield.

 

**Other Investments —**The Bank, as a member institution, isrequired to own stock investments in the Federal Home Loan Bank of Atlanta (the“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.

 

7

----

 

**CommunitySouthFinancial Corporation**

 

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.

 

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 $18,090,000 and $13,172,000 million in impaired loans at March 31,2009 and December 31, 2008, 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 theuncollectability of a loan balance is confirmed.  Subsequent recoveries, if any, are creditedto 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 is establishedwhen the discounted cash flows (or collateral value or observable market price)of the impaired loan is lower than the carrying value of the loan. The generalcomponent covers non-classified loans and is based on historical lossexperience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that couldaffect management’s estimate of probable losses.  The unallocated component of the allowancereflects the margin of imprecision inherent in the underlying assumptions usedin the methodologies for estimating specific and general losses in theportfolio.

 

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

 

Large groups of 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 made the decision to sell these policiesin order to help reduce assets, thereby improving the bank’s risk based capitalratio. During the quarter, the Company began the process of divesting of itskey employee life insurance policies by selling policies at no gain orloss.  Income from these policies andchanges in the net cash surrender value are currently recorded in non-interestincome. The remaining policy which was sold in April is recorded in otherassets at its net cash surrender value, or the amount that can be realized.

 

**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.

 

8

----

 

**CommunitySouthFinancial Corporation**

 

**Propertyand Equipment** —Premises, furniture and equipment are stated at cost, less accumulateddepreciation.  Depreciation expense iscomputed using the straight-line method, based on the estimated useful livesfor furniture 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.

 

**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** —The Company has adopted the fair valuerecognition provisions of the Financial Accounting Standards Board’s (“FASB”)SFAS No. 123(R), “Share-Based Payment”, which is a revision of SFAS No. 123,“Accounting for Stock-Based Compensation”, to account for compensation costsunder its stock option plans.  TheCompany previously utilized the intrinsic value method under AccountingPrinciples Board (“APB”) Opinion No. 25, “Accounting for Stock Issued toEmployees (as amended)” (“APB 25”). Under the intrinsic value method prescribed by APB 25, no compensationcosts were recognized for the Company’s stock options because the optionexercise price in its plans equaled the market price on the date of grant.

 

# **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 any outstandingunvested awards as if the fair value method had been applied to those awards asof 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.

 

9

----

 

**CommunitySouthFinancial Corporation**

 

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

 

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

 

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

 

FSPSFAS 115-2 and SFAS 124-2, “Recognition and Presentation ofOther-Than-Temporary Impairments,” (“FSP SFAS 115-2 and SFAS 124-2”)categorizes losses on debt securities available-for-sale or held-to-maturitydetermined by management to be other-than-temporarily impaired into losses dueto credit issues and losses related to all other factors.  Other-than-temporary impairment (OTTI) existswhen it is more likely than not that the security will mature or be sold beforeits amortized cost basis can be recovered. An OTTI related to credit losses should be recognized throughearnings.  An OTTI related to otherfactors should be recognized in other comprehensive income.  The FSP does not amend existing recognitionand measurement guidance related to other-than-temporary impairments of equitysecurities.  Annual disclosures requiredin SFAS 115 and FSP SFAS 115-1 and SFAS 124-1 are also required for interimperiods (including the aging of securities with unrealized losses).

 

FSPSFAS 157-4, “Determining Fair Value When the Volume and Level of Activity forthe Asset or Liability Have Significantly Decreased and IdentifyingTransactions That are Not Orderly” recognizes that quoted prices may not bedeterminative of fair value when the volume and level of trading activity hassignificantly decreased.  The evaluationof certain factors may necessitate that fair value be determined using adifferent valuation technique.  Fairvalue should be the price that would be received to sell an asset or paid totransfer a liability in an orderly transaction, not a forced liquidation ordistressed sale.  If a transaction isconsidered to not be orderly, little, if any, weight should be placed on thetransaction price.  If there is not sufficientinformation to conclude as to whether or not the transaction is orderly, thetransaction price should be considered when estimating fair value.  An entity’s intention to hold an asset orliability is not relevant in determining fair value.  Quoted prices provided by pricing servicesmay still be used when estimating fair value in accordance with SFAS 157;however, the entity should evaluate whether the quoted prices are based oncurrent information and orderly transactions. Inputs and valuation techniques are required to be disclosed in additionto any changes in valuation techniques.

 

FSPSFAS 107-1 and APB 28-1, “Interim Disclosures about Fair Value of FinancialInstruments” requires disclosures about the fair value of financial instrumentsfor interim reporting periods of publicly traded companies as well as in annualfinancial statements and also requires those disclosures in summarizedfinancial information at interim reporting periods  A publicly traded company includes anycompany whose securities trade in a public market on either a stock exchange orin the over-the-counter market, or any company that is a conduit bondobligor.  Additionally, when a companymakes a filing with a regulatory agency in preparation for sale of itssecurities in a public market it is considered a publicly traded company forthis purpose.

 

Thethree staff positions are effective for periods ending after June 15,2009, with early adoption permitted for periods ending after March 15,2009, in which case all three must be adopted. The Company will adopt the staff positions for its second quarter 10-Qbut does not expect the staff positions to have a material impact on theconsolidated financial statements.

 

TheSecurities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”)No. 111 on April 9, 2009 to amend Topic 5.M., “Other Than TemporaryImpairment of Certain Investments in Debt and Equity Securities” and tosupplement FSP SFAS 115-2 and SFAS 124-2. SAB 111 maintains the staff’s previous views related to equitysecurities; however debt securities are excluded from its scope.  The SAB provides that “other-than-temporary”impairment is not necessarily the same as “permanent” impairment and unlessevidence exists to support a value equal to or greater than the 

 

10

----

 

**CommunitySouthFinancial Corporation**

 

carryingvalue of the equity security investment, a write-down to fair value should berecorded and accounted for as a realized loss. The SAB was effective upon issuance and had no impact on the Company’sfinancial position.

 

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

 

**Risks and Uncertainties** — In the normal course of its business,the Company encounters two significant types of risk: economic andregulatory.  There are three 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.

 

The bank is subject toFDIC insurance premiums. Legislation has recently passed that will increase FDICinsurance premiums as well as implement an estimated $300,000 one time chargeto the bank in 2009. It is unknown at this time if these charges will increaseor decrease from their current proposed levels.

 

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

 

**NOTE 3 — INVESTMENT SECURITIES**

** **

# **The amortized costs and fair values of investment securities are asfollows (in thousands):**

 
| ** **                        | ** ** | **Amortized** | ** **       | **Gross Unrealized** | ** ** | **Fair**      | ** ** |
|-----------------------------------|------------|---------------|------------------|----------------------|------------|---------------|------------|
| **As of March 31, 2009**     | ** ** | **Cost**      | ** **       | **Gains**            | ** ** | **Losses**    | ** ** | **Value** | ** ** |
| **Available  for sale**           |       |          |             |                 |       |          |       |   |   |
| Government  sponsored enterprises |       | $             |  5,000      |                 | $          |  4       |       | $ |  — |   | $ |  5,004 |   |
| Mortgage-backed                   |       | 44,576        |             | 200                  |       | —        |       | 44,776 |   |
| Marketable  securities            |       | 100           |             | —               |       | —        |       | 100 |   |
| Total available  for sale         | ** ** | **$**         | ** 49,676** | ** **           | **$**      | ** 204** | ** ** | **$** | ** —** | ** ** | **$** | ** 49,880** | ** ** |

 

**NOTE 4 — LEASES**

** **

The Company leases branchlocations in Spartanburg, Mauldin, Anderson, Greer and Greenville as well as theloan operations center in Easley. The initial lease terms range from three toten 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 (dollars inthousands):

 
| 2009                                  |       | $     | 313             |       |
|---------------------------------------|------------|-------|-----------------|------------|
| 2010                                  |       | 428   |            |
| 2011                                  |       | 428   |            |
| 2012                                  |       | 441   |            |
| 2013                                  |       | 447   |            |
| Thereafter                            |       | 1,507 |            |
| Total minimum  future rental payments | ** ** | **$** | ** 3,564** | ** ** |

 

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 comparable transactionswith unrelated persons and do not involve more than the normal risk ofcollectability.

 

11

----

 

**CommunitySouthFinancial Corporation**

 

### **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. The bank has a lease agreement fora pending branch location in Spartanburg. The completion of the branch iscurrently on hold due to the bank’s balance sheet restructuring and no growthpolicy. The bank is in negotiations with the landlord to alter the leaseagreement. The lease is not material to the bank’s operations.

 

**NOTE 7 — STOCK-BASED COMPENSATION**

** **

Upon completion of theoffering, the Company agreed to issue warrants to the organizing directors forthe purchase of one share of common stock at $6.40 per share for every twoshares purchased in the stock offering, up to a maximum of 15,625 warrants perdirector. The warrants were fully vested 120 days after January 18, 2005and will expire on January 18, 2015. Warrants held by directors of the Company will expire 90 days after thedirector ceases to be a director or officer of the Company (365 days if due todeath or disability). The Company issued a total of 171,404 warrants.  In addition, the Company has adopted a stockoption plan.  As of March 31, 2009the Company has 756,463 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 in connectionwith any future share issuances by the Company. The exercise price of eachoption is equal to the market price of the Company’s stock on the date ofgrant. 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 March 31, 2009 as adjusted for all stock splits.

 
| ** **                                 | ** ** | **Stock Options** | ** ** | **Warrants**  | ** ** |
|--------------------------------------------|------------|-------------------|------------|---------------|------------|
| ** **                                 | ** ** | ** **        | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **                                 | ** ** | ** **        | ** ** | **Average**   | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                 | ** ** | ** **        | ** ** | **Exercise**  | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                                 | ** ** | **Number**        | ** ** | **Price**     | ** ** | **Number** | ** ** | **Price** | ** ** |
| **Outstanding  at December 31, 2008** |       | 764,113           |       | $             |  7.08 |   | 171,404 |   | $ |  6.40 |   |
| Granted                                    |       | 650               |       | 2.50          |       | — |   | — |   |
| Forfeited                                  |       | 8,300             |       | 7.13          |       | — |   | — |   |
| Exercised                                  |       | —            |       | —        |       | — |   | — |   |
| **Outstanding  at March 31, 2009**    | ** ** | **756,463**       | ** ** | **7.08**      | ** ** | **171,404** | ** ** | **6.40** | ** ** |
|                                            |            |                   |            |               |            |  |  |  |  |  |  |

 

The table set forth belowsummarizes non-vested stock options as of March 31, 2009.

 
| ** **                                 | ** ** | ** ** | ** ** | **Fair**  | ** ** |
|--------------------------------------------|------------|------------|------------|-----------|------------|
| ** **                                 | ** ** | **Number** | ** ** | **Value** | ** ** |
| **Outstanding  at December 31, 2008** |       | 51,810     |       | $         |  5.33 |   |
| Granted                                    |       | 650        |       | 1.49      |       |
| Vested                                     |       | 2,037      |       | 6.34      |       |
| Forfeited                                  |       | 8,280      |       | 3.20      |       |
| **Outstanding  at March 31, 2009**    | ** ** | **42,143** | ** ** | **5.62**  | ** ** |
|                                            |            |            |            |           |            |  |

 

As of March 31,2009, there was $190,806 in total unrecognized compensation cost related tonon-vested share-based compensation arrangements, which is expected to berecognized over a weighted average period of 38 months. As of December 31,2008, there was $223,689 in total unrecognized compensation cost related tonon-vested share-based compensation arrangements, which was expected to berecognized over a weighted average period of 42 months.

 

The fair value of eachoption granted is estimated on the grant date using the Black-Scholesoption-pricing model with the following assumptions for 2009:  dividend yield of 0%, expected term of 10years, risk-free interest rate of 0.25%, expected life of 10 years, andexpected volatility of 52%.  Thefollowing assumptions were used for the 2008 estimates:  dividend yield of 0%, expected term of 10years, risk-free interest rate of 5.0%, expected life of 10 years, and expectedvolatility of 20%.

 

12

----

 

**CommunitySouthFinancial Corporation**

 

The following tablesummarizes information about stock options outstanding under the Company’splans at March 31, 2009 and December 31, 2008.

 
| **March 31, 2009**          | ** ** | **Outstanding** | ** **  | **Exercisable** | ** ** |
|----------------------------------|------------|-----------------|-------------|-----------------|------------|
| Number of  options               |       | 756,463         |        | 714,320         |       |
| Weighted average  remaining life |       | 6.15 years      |        | 6.02 years      |       |
| Weighted average  exercise price |       | $               |  7.08  |            | $          |  6.76 |   |
| High exercise  price             |       | $               |  16.80 |            | $          |  16.80 |   |
| Low exercise  price              |       | $               |  2.50  |            | $          |  6.40 |   |

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

 

There were no optionsexercised during the quarter and thus no cash was received related to this typeof transaction. There was no intrinsic value of options exercised during 2009and 2008.

 

At March 31, 2009,all of the 171,404 warrants were exercisable and had an average remaining lifeof 5.80 years. At December 31, 2008, all of the 171,404 warrants were exercisableand had an average remaining life of 6.05 years.

 

**NOTE 8 — FAIR VALUE OF FINANCIALINSTRUMENTS**

** **

# **TheCompany adopted Statement No. 157 at the beginning of our 2008 fiscalyear.  SFAS No. 157 applies to allassets and liabilities that are being measured and reported on a fair valuebasis.  SFAS No. 157 requires newdisclosure that establishes a framework for measuring fair value in GAAP, andexpands disclosure about fair value measurements.  This statement enables the reader of thefinancial statements to assess the inputs used to develop those measurements byestablishing a hierarchy for ranking the quality and reliability of theinformation used to determine fair values. The statement requires that assets and liabilities carried at fair valuewill be classified and disclosed in one of the following three categories:**

# ** **

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

 

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

 

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

 

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

 

13

----

 

**CommunitySouthFinancial Corporation**

 

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

 
| ** **                                 | ** ** | **March, 31, 2009** | ** **   |
|--------------------------------------------|------------|---------------------|--------------|
| **(Dollars in thousands)**                 | ** ** | **Total**           | ** **   | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Investment  securities, available for sale |       | $                   |  49,880 |   | $ |  49,880 |   | $ |  — |   | $ |  — |   |
|                                            |            |                     |              |  |  |  |  |  |  |  |  |  |  |

 

Certain assets andliabilities are measured at fair value on a nonrecurring basis; that is, theinstruments are not measured at fair value on an ongoing basis but are subjectto fair value adjustments in certain circumstances (for example, when there isevidence of impairment).  The followingtable presents the assets and liabilities carried on the balance sheet bycaption and by level within the SFAS No. 157 valuation hierarchy (asdescribed above) as of March 31, 2009 for which a nonrecurring change infair value has been recorded during the year ended March 31, 2009.

 
| ** **                 | ** ** | **Carrying Value at March, 31, 2009** | ** **   |
|----------------------------|------------|---------------------------------------|--------------|
| **(Dollars in thousands)** | ** ** | **Total**                             | ** **   | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** |
| Impaired loans             |       | $                                     |  16,675 |   | $ |  — |   | $ |  16,675 |   | $ |  — |   |
| Other real  estate owned   |       | $                                     |  1,685  |   | $ |  — |   | $ |  1,685 |   | $ |  — |   |

 

14

----

 

**CommunitySouthFinancial Corporation**

 

**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 discussed in theforward-looking statements, and our operating performance each quarter issubject to various risks and uncertainties that include, without limitation,those described under the heading “Risk Factors” in our Annual Report on Form 10-Kfor the year ended December 31, 2008 as filed with the Securities andExchange Commission (the “SEC”) and the following:

 

·      ourrapid growth to date and short operating history;

·      theopening of additional full-service branches and the resulting pressure thiscould cause on our management team;

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

·      changesin the interest rate environment which could reduce anticipated or actualmargins;

·      changesin political conditions or the legislative or regulatory environment;

·      generaleconomic conditions, either nationally or regionally and especially in ourprimary service area, becoming less favorable than expected resulting in, amongother things, a deterioration in credit quality;

·      changesoccurring in business conditions and inflation;

·      changesin technology;

·      changesin deposits flows;

·      changesin monetary and tax policies;

·      thelack of seasoning of our loan portfolio, especially given our rapid loangrowth;

·      theamount of our real estate based loans, and the weakness in the commercial realestate market;

·      thelevel of allowance for loan losses;

·      therate of delinquencies and amounts of charge-offs;

·      adversechanges in asset quality and resulting credit risk-related losses and expenses;

·      lossof consumer confidence and economic disruptions resulting from terroristactivities;

·      changesin the securities markets; and

·      otherrisks and uncertainties detailed from time to time in our filings with the SEC.

 

The above risks are exacerbated by the recent developments in nationaland international financial markets, and we are unable to predict what effectthese uncertain market conditions will have on our Company.  During 2008 and thus far in 2009, the capitaland credit markets have experienced extended volatility and disruption.  There can be no assurance that theseunprecedented recent developments will not materially and adversely affect ourbusiness, financial condition and results of operations.

 

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 (the “Company”) is a bank holdingcompany headquartered in Easley, South Carolina.  Our subsidiary, CommunitySouth Bank and Trust(the “Bank”), opened for business on January 18, 2005.  In addition to the main office in Easley, theBank has five branch locations in the upstate region of South Carolina.  We opened our Mauldin branch in the fourthquarter of 2005, our Spartanburg branch in the first quarter of 2006, ourAnderson branch in the third quarter of 2006, our Greer branch in the fourthquarter of 2006 and our Greenville branch in the third quarter of 2007.  The Bank provides banking services todomestic markets, principally in the Upstate of South Carolina.  The deposits of the Bank are insured by theFDIC.

 

15

----

 

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

 

We have approximately$45.5 million of acquisition and development (A&D) loans outstanding at March 31,2009.  A&D loans are typicallycomprised of loans to borrowers for real estate to be developed (intoproperties such as sub-divisions or spec houses).  Normally, these loans are repaid with theproceeds from the sale of the developed property.  Collateral for these types of loans normallyconsists of real estate.

 

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

 

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.

 

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

 

Marketsin the United States and elsewhere have experienced extreme volatility and disruptionfor more than 12 months.  Thesecircumstances have exerted significant downward pressure on prices of equitysecurities and virtually all other asset classes, and have resulted insubstantially increased market volatility, severely constrained credit andcapital markets, particularly for financial institutions, and an overall lossof investor confidence.  Loan portfolioperformances have deteriorated at many institutions resulting from, among otherfactors, a weak economy and a decline in the value of the collateral supportingtheir loans.  Dramatic slowdowns in thehousing industry, due in part to falling home prices and increasingforeclosures and unemployment, have created strains on financial institutions.  Many borrowers are now unable to repay theirloans, and the collateral securing these loans has, in some cases, declinedbelow the loan balance.   In response tothe challenges facing the financial services sector, several regulatory andgovernmental actions have recently been announced including:

 

·      TheEmergency Economic Stabilization Act of 2008 (“EESA”), approved by Congress andsigned by President Bush on October 3, 2008, which, among otherprovisions, allowed the U.S. Treasury to purchase up to $700 billion ofmortgages, mortgage-backed securities and certain other financial instrumentsfrom financial institutions for the purpose of stabilizing and providingliquidity to the U.S. financial markets. EESA also temporarily raised the basic limit of FDIC deposit insurancefrom $100,000 to $250,000; the legislation contemplated a return to the$100,000 limit on December 31, 2009;

 

·      OnOctober 7, 2008, the FDIC approved a plan to increase the rates banks payfor deposit insurance;

 

·      OnOctober 14, 2008, the U.S. Treasury announced the creation of a newprogram, the Troubled Asset Relief Program (the “TARP”) Capital PurchaseProgram (the “CPP”) that encourages and allows financial institutions to buildcapital through the sale of senior preferred shares to the U.S. Treasury onterms that are non-negotiable;

 

16

----

 

·      OnOctober 14, 2008, the FDIC announced the creation of the TemporaryLiquidity Guarantee Program (the “TLGP”), which seeks to strengthen confidenceand encourage liquidity in the banking system.  The TLGP has two primarycomponents that are available on a voluntary basis to financial institutions:

 

·      TheTransaction Account Guarantee Program (“TAGP”), which provides unlimiteddeposit insurance coverage through December 31, 2009 fornoninterest-bearing transaction accounts (typically business checking accounts)and certain funds swept into noninterest-bearing savings accounts.  Institutions participating in the TLGP pay a10 basis points fee (annualized) on the balance of each covered account inexcess of $250,000, while the extra deposit insurance is in place;

 

·      TheDebt Guarantee Program (“DGP”), under which the FDIC guarantees certain seniorunsecured debt of FDIC-insured institutions and their holding companies.  The unsecured debt must be issued on or afterOctober 14, 2008 and not later than June 30, 2009, and the guaranteeis effective through the earlier of the maturity date or June 30,2012.  The DGP coverage limit isgenerally 125% of the eligible entity’s eligible debt outstanding on September 30,2008 and scheduled to mature on or before June 30, 2009 or, for certaininsured institutions, 2% of their liabilities as of September 30,2008.  Depending on the term of the debtmaturity, the nonrefundable DGP fee ranges from 50 to 100 basis points(annualized) for covered debt outstanding until the earlier of maturity or June 30,2012.  The TAGP and DGP are in effect forall eligible entities, unless the entity opted out on or before December 5,2008.

 

·      On February 17, 2009 President Obama signed intolaw The American Recovery and Reinvestment Act of 2009 (“ARRA”), more commonlyknown as the economic stimulus or economic recovery package. ARRA includes awide variety of programs intended to stimulate the economy and provide forextensive infrastructure, energy, health, and education needs.  In addition, ARRA imposes certain newexecutive compensation and corporate expenditure limits on all current andfuture TARP recipients, including our Company, that are in addition to thosepreviously announced by the U.S. Treasury. These new limits are in place untilthe institution has repaid the Treasury, which is now permitted under ARRAwithout penalty and without the need to raise new capital, subject to the Treasury’sconsultation with the recipient institution’s appropriate regulatory agency.

 

·      On March 23, 2009, the U.S. Treasury, inconjunction with the FDIC and the Federal Reserve, announced the Public-PrivatePartnership Investment Program for Legacy Assets which consists of two separateplans, addressing two distinct asset groups:

 

·      The Legacy Loan Program, in which the primary purposewill be to facilitate the sale of troubled mortgage loans by eligibleinstitutions, which include FDIC-insured federal or state banks and savingsassociations. Eligible assets may not be strictly limited to loans; however,what constitutes an eligible asset will be determined by participating banks,their primary regulators, the FDIC and the Treasury. Additionally, the Loan Program’srequirements and structure will be subject to notice and comment rulemaking,which may take some time to complete.

 

·      The Securities Program, which will be administered bythe Treasury, involves the creation of public-private investment funds totarget investments in eligible residential mortgage-backed securities andcommercial mortgage-backed securities issued before 2009 that originally wererated AAA or the equivalent by two or more nationally recognized statisticalrating organizations, without regard to rating enhancements (collectively, “LegacySecurities”). Legacy Securities must be directly secured by actual mortgageloans, leases or other assets, and may be purchased only from financialinstitutions that meet TARP eligibility requirements.

 

It is likely that furtherregulatory actions may arise as the Federal government continues to attempt toaddress the economic situation.

 

17

----

 

**Results of Operations**

 

*Three Months ended March 31, 2009 and 2008*

 

*Overview*

 

Our net loss was $36,000 for the three months ended March 31, 2009as compared to net income of $341,000 for the three months ended March 31,2008.  For the three months ended March 31,2009, we realized $4,933,000 in interest income, of which $563,000 was frominvestment activities and $4,370,000 was from loan activities.  For the three months ended March 31,2008, we realized $6,249,000 in interest income, of which $731,000 was frominvestment activities and $5,518,000 was from loan activities.  The primary source of funding for our loanportfolio is deposits that are acquired both locally and via the national brokeredcertificate market.  We incurred interestexpense of $2,080,000 and $3,653,000 for the three months ended March 31,2009 and March 31, 2008, respectively. We have experienced an increase in our net interest margin to 3.05% from2.81% for the quarters ended March 31, 2009 and 2008, respectively. Theincrease was a result of declining deposit costs.

 

*Provision for Loan Losses*

 

Our provision for loanlosses for the three months ended March 31, 2009 was $1,305,000 comparedto $125,000 for the comparable prior year period. This was a result of thegeneral weakening of the economy and an analysis of our loan portfolio. ** **As noted earlier, wehave approximately $45.5 of acquisition and development (A&D) loansoutstanding at March 31, 2009.  Weare experiencing higher levels of loan delinquencies, defaults andforeclosures.  Further, the downturn inthe real estate market has adversely impacted the value of the underlyingcollateral (real estate) for the A&D loans. The greater degree of strain on these types of loans and thesignificance to our overall loan portfolio has caused us to apply a greaterdegree of scrutiny in analyzing the ultimate collectability of amountsdue.  Our analysis has resulted insignificant increases to our allowance for loan losses and significantincreases in the corresponding expense charged to our provision for loanlosses.  Charges to our provision forloan losses have increased $1.2 million (or 944%) compared to the first quarterof 2008 as a result of our evaluation of the deterioration in our assetquality.

 

*Non-interest Income*

 

We had non-interest income of $814,000 and $370,000 for the threemonths ended March 31, 2009 and 2008, respectively.  Mortgage origination fee income for the threemonths ended March 31, 2009 was $62,000.  We had $163,000 in mortgage origination feeincome in the first quarter of 2008.  Thedecrease is due to our decreased volume in mortgage loan originations due tothe current economic conditions and departmental restructuring.  We also had a gain on sale of available forsale securities of $520,000 for the three months ended March 31, 2009.

 

*Non-interest Expense*

 

We incurred non-interest expense of $2,416,000 during the three monthsended March 31, 2009.  Included inthe expense was $1,239,000 of salaries and employee benefits, $222,000 of dataprocessing expense, $91,000 of professional fees expense, $36,000 ofadvertising expense, $23,000 of expense related to office supplies, $37,000 oftelephone expense and $96,000 of assessments related to FDIC.  The non-interest expense incurred in thethree months ended March 31, 2008 was $2,317,000.  Included in the expense was $1,235,000 ofsalaries and employee benefits, $191,000 of data processing expense, $78,000 ofprofessional fee expense, $11,000 of advertising expense, $28,000 of expenserelated to office supplies, $36,000 of telephone expense and $53,000 ofassessments related to FDIC.

 

For the three months ended March 31, 2009, we incurred otherproperty and equipment expenses of $180,000 in depreciation and $42,000 inequipment maintenance and rental.  Forthe three months ended March 31, 2008, we incurred other property andequipment expenses of $181,000 in depreciation and $48,000 in equipmentmaintenance and rental.  We incurred$171,000 and $162,000 in occupancy expense related to all of our officelocations for the three months ended March 31, 2009 and 2008,respectively.

 

The increase in non-interest expense is the result of the increasedadministrative expenses including FDIC assessments, advertising, professionalfees, and data processing, resulting from an increase in customer volume.

 

18

----

 

**Assets and Liabilities**

 

*General*

 

At March 31, 2009, total assets decreased 0.7% to$385.0 million as compared to $387.8 million at December 31, 2008.  Gross loans decreased $4.3 million, or 1.3%,during the first three months of 2009. As described below, federal funds sold increased to $5.5 million at March 31,2009 compared to $4.6 million at December 31, 2008.  Cash and cash equivalents increased $3.5million, or 35.8%, since December 31, 2008.  As described below, deposits increased $24.8million, or 8.4%, during the first three months of 2009.  At March 31, 2009, shareholders’ equitywas $28.2 million.

 

*Investment Securities*

 

Investments available for sale increased by $2.3 million, or 4.8%,since December 31, 2008 due to the purchase of and the appreciationrelated to government agency bonds and mortgaged-backed securities.

 

*Other Investments*

 

Other investments increased by $19,000 since December 31, 2008 dueto the purchase of additional FHLB stock. All of the FHLB stock is used to collateralize advances with the FHLB.

 

*Loans*

 

Since loans typically provide higher interest yields than other typesof interest earning assets, we allocate the majority of our earning assets toour loan portfolio.  Gross loansdecreased by $4.3 million, or 1.3%, during the first three months of 2009.  Loan demand has slowed during the firstquarter of 2009 due to general economic conditions and the real estate market,along with management’s decision to shrink the size of the bank’s loanportfolio, to help improve the bank’s risk based capital ratios.****We expect this trend to continue during the next quarter.

 

Balances within major loan categories are as follows:

 
| **(dollar amounts in thousands)** | ** ** | **March 31, 2009** | ** **  | **December 31, 2008** | ** ** |
|-----------------------------------|------------|-------------------------|-------------|----------------------------|------------|
| Real estate -  construction       |       | $                       | 125,397     |                       | $          | 129,777 |   |
| Real estate -  mortgage           |       | 156,116                 |        | 154,838                    |       |
| Commercial and  industrial        |       | 32,209                  |        | 33,303                     |       |
| Consumer and  other               |       | 2,908                   |        | 2,989                      |       |
| Total loans,  gross               |       | 316,630                 |        | 320,907                    |       |
| Less allowance  for loan losses   |       | (9,414                  | )           | (8,088                     | )          |
| Total loans, net                  | ** ** | **$**                   | **307,216** | ** **                 | **$**      | **312,819** | ** ** |

 

We discontinue accrual of interest on a loan when we conclude it is doubtful that we will be able to collect principal and/or interest from the borrower.  We reach this conclusion by taking into account factors such as the borrower’s financial condition, economic and business conditions, and the results of our previous collection efforts.  Generally, we place a delinquent loan in non-accrual status when the loan becomes 90 days or more past due.  When we place a loan in non-accrual status, we reverse all interest which has been accrued on the loan but remains unpaid and we deduct this interest from earnings as a reduction of reported interest income.  We do not accrue any additional interest on the loan balance until we conclude the collection of both principal and interest is reasonably certain.  At March 31, 2009, there were $16.7 million in loans that were non-accruing and $7.3 million in loans that were 30 days past due, excluding non-accrual loans.  At December 31, 2008, there were $9.9 million in loans that were non-accruing and $2.4 million in loans that were 30 days past due, excluding non-accrual loans.

 

We have approximately$45.5 of acquisition and development (A&D) loans outstanding at March 31,2009.  A&D loans are typicallycomprised of loans to borrowers for real estate to be developed (intoproperties such as sub-divisions or spec houses).  Normally, these loans are repaid with theproceeds from the sale of the developed property.  Collateral for these types of loans normallyconsists of real estate.

 

Our outstanding A&Dloans are located primarily in the Upstate of South Carolina and Western NorthCarolina.  The current economicenvironment in our market area has resulted in a downturn in the real estatemarket, which has placed greater pressure on our borrowers’ repaymentcapabilities.  We are experiencing higherlevels of loan delinquencies, defaults and foreclosures.  Further, the downturn in the real estatemarket has adversely impacted the value of the underlying collateral 

 

19

----

 

(real estate) for theA&D loans.  The greater degree ofstrain on these types of loans and the significance to our overall loanportfolio has caused us to apply a greater degree of scrutiny in analyzing theultimate collectability of amounts due. Our analysis has resulted in significant increases to our allowance forloan losses and significant increases in the corresponding expense charged toour provision for loan losses.

 

Changes in the allowance for loan losses for were asfollows (dollars in thousands):

 
| ** **                       | ** ** | **Three-months ended  March 31, 2009** | ** ** | **Three-months ended  March 31, 2008** | ** ** |
|----------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| Balance,  beginning of period    |       | $                                           | 8,088      |                                        | $          | 4,214 |   |
| Provision  charged to operations |       | 1,305                                       |       | 125                                         |       |
| Net collections  (charge-offs)   |       | 20                                          |       | (50                                         | )          |
| Balance, end of  period          | ** ** | **$**                                       | **9,413**  | ** **                                  | **$**      | **4,289** | ** ** |

 

In April 2009, conditions warranted the bank to charged-off  $1.4 million of loans which had been previously identified and reserved for in the above allowance for loan losses as of March 31, 2009.

 

*Impaired Loans*

 

The Company identifies impaired loans through its normal internal loan review process.  Loans on the Company’s potential problem loan list are considered potentially impaired loans.  These loans are evaluated in determining whether all outstanding principal and interest are expected to be collected.  Loans are not considered impaired if a minimal payment delay occurs and all amounts due, including accrued interest at the contractual interest rate for the period of delay, are expected to be collected.  Management has determined that the Company had $18,090,000 and $13,172,000 million in impaired loans at March 31, 2009 and December 31, 2008, respectively.

 

*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 March 31, 2009 and December 31, 2008, the Company had identified $1.9 million and $424,844, 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 and approves the appropriatelevel of the Company’s allowance for loan losses based upon management’srecommendations, the results of the internal monitoring and reporting system,and an analysis of economic conditions in its market.

 

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.

 

20

----

 

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

 

In addition, the current downturn in the real estate market hasresulted in an increase in loan delinquencies, defaults and foreclosures, andwe believe these trends are likely to continue. In some cases, this downturn has resulted in a significant impairment tothe value of our collateral and our ability to sell the collateral uponforeclosure, and there is a risk that this trend will continue.  The real estate collateral in each caseprovides an alternate source of repayment in the event of default by theborrower and may deteriorate in value during the time the credit isextended.  If real estate values continueto decline, it is also more likely that we would be required to increase ourallowance for loan losses.  Based onpresent information and an ongoing evaluation, management considers theallowance for loan losses to be adequate to meet presently known and inherentlosses in the loan portfolio.  Management’sjudgment about the adequacy of the allowance is based upon a number ofassumptions about future events which it believes to be reasonable but whichmay or may not be accurate.  Thus, therecan be no assurance that charge-offs in future periods will not exceed theallowance for loan losses or that additional increases in the allowance forloan losses will not be required, especially considering the overall weaknessin the commercial real estate market in our market areas.

 

Loans charged off as wellas charges to our provision for loan losses adversely impact our regulatorycapital levels.  Significant futurecharge-offs and charges to the provision for loan losses could cause us to fallbelow the level required to remain considered “well capitalized” under theappropriate regulatory standards.

 

*Deposits*

 

Our primary source of funds for loans and investments is ourdeposits.  We have chosen to obtain aportion of our certificates of deposit from areas outside of our market, whichare brokered deposits. The deposits obtained outside of our market area generallyhave rates comparable to those being offered for certificates of deposit in ourlocal market.  As of March 31, 2009,total deposits had increased by $24.8 million, or 8.4%, from December 31,2008.  The largest percentage increasewas in brokered deposits, which increased $15.7 million, or 8.4%, from December 31,2008 to March 31, 2009. This was due to the replacement of FHLB advancesas noted below.

 

Balances within the major deposit categories are asfollows:

 
| **(dollar amounts in thousands)**  | ** ** | **March 31, 2009** | ** **  | **December 31, 2008** | ** ** |
|------------------------------------|------------|-------------------------|-------------|----------------------------|------------|
| Non-interest  bearing demand       |       | $                       | 22,138      |                       | $          | 22,162 |   |
| Interest bearing  demand           |       | 21,360                  |        | 16,449                     |       |
| Savings                            |       | 16,522                  |        | 14,461                     |       |
| Time deposits  less than $100,000  |       | 32,589                  |        | 32,112                     |       |
| Time deposits of  $100,000 or over |       | 26,799                  |        | 25,161                     |       |
| Brokered  deposits                 |       | 202,017                 |        | 186,298                    |       |
| Total deposits                     | ** ** | **$**                   | **321,425** | ** **                 | **$**      | **296,643** | ** ** |

 

21

----

 

*Advances from Federal Home Loan Bank (FHLB)*

 

Advances from FHLB are a source of funding that theBank uses depending on the current level of deposits and the availability ofcollateral to secure FHLB borrowings.  AtMarch 31, 2009, the Bank had no outstanding advances from FHLB. The bankreplaced its outstanding FHLB advances with brokered certificates of deposit inorder to extend maturities and remove the risk of the borrowings being called.

 

*Repurchase Agreements*

 

At March 31, 2009, the Bank had $30.0 million ofsecurities under agreements to repurchase with brokers with a weighted averagerate of 3.24% and an average maturity of 87 months.  The maximum amount outstanding at anymonth-end was $30.0 million.  Theseagreements were secured with approximately $36.1 million of investmentsecurities.

 

*Subordinated Debt*

 

At March 31, 2009, the Company had subordinated debt totaling $4.3million.  The subordinated notes weresold during the third quarter of 2008 to a limited number of purchasers in aprivate offering, bear an interest rate of 11.5%, are callable after September 30,2011, at a premium, and mature in 2018. The subordinated debt has beenstructured to fully count as Tier 2 regulatory capital on a consolidated basis.

 

**Liquidity**

 

Liquidity  is the  ability  to  meet  current  and  future  obligations  through liquidation or maturity of existing  assets or the  acquisition of  liabilities.  We manage both assets and liabilities to achieve appropriate levels of liquidity.  Cash 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 March 31, 2009, we had lines of credit with unrelated banks totaling $14.5 million.  These lines are available on a one-to-twenty day basis for general corporate purposes. These lines may be terminated at any time. We believe our liquidity sources are adequate to meet our operating needs.  The level of liquidity is measured by the cash, cash equivalents and securities available for sale divided by total assets and half of any outstanding loan commitments.  The Bank’s liquidity ratio at March 31, 2009 was 5.23%.

 

As members of the FHLB, we have credit availability of up to 15% of the Bank’s total assets. Advances under this credit facility are subject to qualifying collateral**.**Advances may be terminated and called at any time by the FHLB.

 

We also have credit availability through the Federal Reserve Discount Window.  As of March 31, 2009, $31.9 million was available, based on qualifying collateral. Availability of the Federal Reserve Discount Window may be terminated at any time by the Federal Reserve.

 

**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 March 31, 2009, we had issued commitments to extend credit of$31.1 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)** | ** ** | **March 31, 2009** | ** ** | **December 31, 2008** | ** ** |
|-----------------------------------|------------|-------------------------|------------|----------------------------|------------|
|                              |       |                    |       |                       |       |
| Commitments to  extend credit     |       | $                       | 28,085     |                       | $          | 36,260 |   |
|                              |       |                    |       |                       |       |
| Standby letters  of credit        |       | $                       | 3,000      |                       | $          | 3,488 |   |

 

22

----

 

**Capital Resources**

 

Total shareholders’ equity decreased from $28.5 million at December 31,2008 to $28.2 million at March 31, 2009. The decrease is principally due to the net loss for the period of$36,000 and changes in market value of available for sale securities.

 

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

 

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

 

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

 

The Bank exceeded theregulatory capital requirements at March 31, 2009 and December 31,2008 as set forth in the following table (dollars in thousands).

 
| ** **                                | ** ** | **March 31, 2009** | ** ** | **December 31, 2008** | ** ** |
|-------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                                | ** ** | **Amount**              | ** ** | **Ratio**                  | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
|                                      |       |                    |       |                       |       |   |   |   |   |
| Tier 1 capital  (to risk-weighted assets) |       | $                       | 30,903     |                       | 9.43       | % | $ | 30,836 |   | 8.92 | % |
| Total capital  (to risk-weighted assets)  |       | 35,066                  |       | 10.70                      |       | 35,205 |   | 10.18 |   |
| Tier 1 capital  (to average assets)       |       | 30,903                  |       | 7.85                       |       | 30,836 |   | 7.98 |   |
|                                           |            |                         |            |                            |            |  |  |  |  |  |  |

 

The Company did apply forTARP as outlined above in the Recent Legislative and Regulatory Initiatives toAddress Financial and Economic Crises section. However, after consideration ofrequirements, the Company withdrew its application. The bank is seeking toimprove its capital ratios through the restructuring of its balance sheet,reduction of classified assets and investigation of external capital sources.

 

**Critical Accounting Policies**

 

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

 

23

----

 

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 judgment 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 judgment 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, 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 DisclosuresAbout Market Risk.**

 

Not applicable.

 

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

 

As of the end of theperiod covered by this report, we carried out an evaluation, under thesupervision and with the participation of our management, including our ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of ourdisclosure controls and procedures as defined in Exchange Act Rule 13a-15(e).  Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer have concluded that our currentdisclosure controls and procedures are effective as of March 31,2009.  There have been no significantchanges in our internal controls over financial reporting during the fiscalquarter ended March 31, 2009 that have materially affected, or arereasonably likely to materially affect, our internal controls over financialreporting.

 

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

 

**Part II - Other Information**

 

**Item 1. LegalProceedings.**

 

Not Applicable.

 

**Item 1A. Risk Factors.**

 

Not Applicable.

 

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

 

Not applicable.

 

**Item 3. Defaults UponSenior Securities.**

 

Not applicable.

 

**Item 4. Submission ofMatters to Vote of Security Holders.**

 

Not applicable.

 

**Item 5. OtherInformation.**

 

Not applicable.

 

24

----

 

**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.                                           |

 

25

----

 

# **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: May 15, 2009 | By:                                          | /s/ C. Allan Ducker, III |
|-------------------------|----------------------------------------------|-------------------------------|
|                    | C. Allan Ducker, III                    |
|                    | Chief Executive Officer                      |
|                    | (Principal Executive Officer)                |
|                    |                                         |
| Date: May 15, 2009 | By:                                          | /s/ John W. Hobbs             |
|                    | John W. Hobbs                                |
|                    | Chief Financial Officer                      |
|                    | (Principal Financial and Accounting Officer) |

 

26

----

 

**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.                                           |

 

27

----