**UNITED STATES SECURITIES AND EXCHANGECOMMISSION**Washington, D.C. 20549

**FORM 10-QSB**

 
| **(Mark One)**                                    |
|---------------------------------------------------|
| **x**                                             | ** ** | **QUARTERLY REPORT UNDER SECTION  13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |
| ** **                                        |
| **For the Quarterly Period Ended: June 30, 2006** |
| ** **                                        |
| **o**                                             | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**CommissionFile No. 00050921**

**SOUTHERN HERITAGE BANCSHARES, INC.**

(Exact Name of Small Business Issuer as Specified inits Charter)

 

| **Tennessee**                             |   | **42-1627829**                        |
|-------------------------------------------|--------|---------------------------------------|
| (State of  Incorporation)                 |   | (I.R.S. Employer  Identification No.) |
|                                      |   |                                  |
| **3020  Keith Street, N.W.**              |   | ** **                            |
| **Cleveland,  Tennessee**                 |   | **37312**                             |
| (Address of  Principal Executive Offices) |   | (Zip Code)                            |

 

**(423) 473-7980**(Issuer’s Telephone Number, Including Area Code)

**None**(Former Name, Address and Fiscal Year, if Changed Since LastReport)

Check whether the issuer(1) filed all reports required to be filed by Section 13 or 15(d) of theExchange Act during the past 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days

Yes  x     No  o

Indicate by check markwhether the registrant is a shell company (as defined in Exchange Act Rule12b-2).  Yes  o   No  x

State the outstandingnumber of shares of the issuer’s common stock as of July 31,2006:  1,164,776

Transitional Small Business Disclosure Format (checkone):

Yes  o     No  x

 

 

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**SOUTHERN HERITAGE BANCSHARES, INC.**

**FORM 10-QSB****Quarter ended June 30, 2006**

 
| ***PART I.***    | ** **     | ***FINANCIAL INFORMATION***                                                                                 |
|------------------|----------------|-------------------------------------------------------------------------------------------------------------|
| *** ***     | ** **     | *** ***                                                                                                |
| *** ***     | ***Item  1.*** | Financial Statements                                                                                        |
|             | ** **     |                                                                                                        |
|             | ** **     | Consolidated  Balance Sheets – June 30, 2006 (Unaudited) and December 31, 2005                         |
|             | ** **     |                                                                                                        |
|             | ** **     | Consolidated  Statements of Operations –Three and Six months ended June 30, 2006 and 2005  (Unaudited) |
|             | ** **     |                                                                                                        |
|             | ** **     | Consolidated Statements  of Cash Flows – Six months ended June 30, 2006 and 2005 (Unaudited)           |
|             | ** **     |                                                                                                        |
|             | ** **     | Notes to  Consolidated Financial Statements                                                                 |
|             | ** **     |                                                                                                        |
|             | ***Item 2.***  | Managements  Discussion And Analysis                                                                        |
|             | ** **     |                                                                                                        |
|             | ***Item 3.***  | Controls And Procedures                                                                                     |
| ** **       | ** **     |                                                                                                        |
| ***PART II.***   | *** ***   | ***OTHER INFORMATION***                                                                                     |
| ** **       | ** **     |                                                                                                        |
| ** **       | ***Item 1.***  | Legal Proceedings                                                                                           |
| ** **       | ** **     |                                                                                                        |
| ** **       | ***Item  2.*** | Unregistered  Sales of Equity Securities and Use of Proceeds                                                |
| ** **       | ** **     |                                                                                                        |
| ** **       | ***Item 3.***  | Defaults Upon Senior Securities                                                                             |
| ** **       | ** **     |                                                                                                        |
| ** **       | ***Item 4.***  | Submission of  Matters to a Vote of Security Holders                                                        |
| ** **       | ** **     |                                                                                                        |
| ** **       | ***Item 5.***  | Other Information                                                                                           |
| ** **       | ** **     |                                                                                                        |
| ** **       | ***Item 6.***  | Exhibits                                                                                                    |
| ** **       |           |                                                                                                        |
| ***Signatures*** |           |                                                                                                        |

 

 

 

2

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**Item 1.****FinancialStatements**

**SOUTHERNHERITAGE BANCSHARES, INC.Consolidated Balance Sheets**June 30, 2006

($ amounts in thousandsexcept share and earnings per share)

 
| ** **                                                                                                                       | ** ** | **(Unaudited)**         | ** **  | ** **                        | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|-------------|-----------------------------------|------------|
| ** **                                                                                                                       | ** ** | **June 30,  2006** | ** **  | **December 31,   2005** | ** ** |
| ***Assets***                                                                                                                     | ** ** | ** **              |        |                              |       |
| Cash and due from banks                                                                                                          | ** ** | **$**                   | **5,401**   |                              | 5,250      |   |
| Federal funds sold                                                                                                               | ** ** | **5,244**               |        | 1,828                             |       |
| ***Cash  and cash equivalents***                                                                                                 | ** ** | **10,645**              |        | 7,078                             |       |
| Securities  available-for-sale, at fair value                                                                                    | ** ** | **26,117**              |        | 24,736                            |       |
| Mortgage loans held for  sale                                                                                                    | ** ** | **1,519**               |        | 245                               |       |
| Loans                                                                                                                            | ** ** | **156,053**             |        | 151,131                           |       |
| Allowance for loan losses                                                                                                        | ** ** | **(1,962**              | **)**       | (2,036                            | )          |
| ***Loans,  net***                                                                                                                | ** ** | **154,091**             |        | 149,095                           |       |
| Premises and equipment                                                                                                           | ** ** | **5,293**               |        | 5,366                             |       |
| Restricted stock                                                                                                                 | ** ** | **519**                 |        | 515                               |       |
| Accrued income  receivable                                                                                                       | ** ** | **764**                 |        | 819                               |       |
| Other assets                                                                                                                     | ** ** | **1,672**               |        | 1,292                             |       |
| ** **                                                                                                                       | ** ** | **$**                   | **200,620** |                              | 189,146    |   |
|                                                                                                                             |       |                    |        |                              |       |
| ***Liabilities  and Shareholders’ Equity***                                                                                 |       |                    |        |                              |       |
| **Liabilities:**                                                                                                                 |       |                    |        |                              |       |
| **Deposits:**                                                                                                                    |       |                    |        |                              |       |
| Noninterest-bearing                                                                                                              | ** ** | **$**                   | **26,919**  |                              | 26,788     |   |
| Interest-bearing                                                                                                                 | ** ** | **148,271**             |        | 141,327                           |       |
| ***Total  deposits***                                                                                                            | ** ** | **175,190**             |        | 168,115                           |       |
| Repurchase  agreements                                                                                                           | ** ** | **346**                 |        | 300                               |       |
| FHLB cma advance                                                                                                                 | ** ** | **3,000**               |        | 0                                 |       |
| Accrued interest  payable                                                                                                        | ** ** | **1,024**               |        | 904                               |       |
| Subordinated  debentures                                                                                                         | ** ** | **5,155**               |        | 5,155                             |       |
| Other  liabilities                                                                                                               | ** ** | **704**                 |        | 501                               |       |
| ***Total  liabilities***                                                                                                         | ** ** | **185,419**             |        | 174,975                           |       |
| **Shareholders’ equity:**                                                                                                   |       |                    |        |                              |       |
| Preferred stock,  no par value. Authorized 1,000,000 shares; none issued                                                         | ** ** | **—**              |        | —                            |       |
| Common stock, $1  par value. Authorized 2,000,000 shares; issued 1,084,475 shares at Mar 31,  2006 and 1,082,675 at Dec 31, 2005 | ** ** | **1,139**               |        | 1,082                             |       |
| Additional  paid-in-capital                                                                                                      | ** ** | **12,653**              |        | 10,766                            |       |
| Retained  Earnings                                                                                                               | ** ** | **1,920**               |        | 2,696                             |       |
| Accumulated  other comprehensive income (loss)                                                                                   | ** ** | **(511**                | **)**       | (373                              | )          |
| ***Total  shareholders’ equity***                                                                                           | ** ** | **15,201**              |        | 14,171                            |       |
| ** **                                                                                                                       | ** ** | **$**                   | **200,620** |                              | 189,146    |   |

 

See accompanying notes toconsolidated financial statements.

3

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**SOUTHERNHERITAGE BANCHARES, INC.Consolidated Statements of OperationsSix Months Ended June 30(Unaudited)**

($ amounts in thousands except share andearnings per share)

 
| ** **                                                 | ** ** | **Three Months Ended June 30** | ** ** | **Six Months Ended June 30** | ** ** | ** **    |
|------------------------------------------------------------|------------|----------------------------------------------------|------------|--------------------------------------------------|------------|---------------|
| ** **                                                 | ** ** | **2006**                                           | ** ** | **2005**                                         | ** ** | **2006**      | ** ** | **2005** |   | ** ** |
| **Interest  income:**                                      |       |                                               |       |                                             |       |          |   |   |   |   |
| Loans, including fees                                      | ** ** | **$**                                              | **2,839**  | ** **                                       | 2,135      | ** **    | **$** | **5,485** |   | 4,170 |   |   |
| Securities                                                 | ** ** | **273**                                            | ** ** | 192                                              | ** ** | **515**       |   | 368 |   |   |
| Federal funds sold                                         | ** ** | **95**                                             | ** ** | 84                                               | ** ** | **175**       |   | 105 |   |   |
| ***Total interest income***                                | ** ** | **3,207**                                          | ** ** | 2,411                                            | ** ** | **6,175**     |   | 4,643 |   |   |
| **Interest  expense:**                                     |       |                                               |       |                                             |       |          |   |   |   |   |
| Deposits                                                   | ** ** | **1,274**                                          | ** ** | 784                                              | ** ** | **2,390**     |   | 1,466 |   |   |
| Other borrowed funds                                       | ** ** | **96**                                             | ** ** | 69                                               | ** ** | **183**       |   | 127 |   |   |
| ***Total interest expense***                               | ** ** | **1,370**                                          | ** ** | 853                                              | ** ** | **2,573**     |   | 1,593 |   |   |
| ***Net interest income***                                  | ** ** | **1,837**                                          | ** ** | 1,558                                            | ** ** | **3,602**     |   | 3,050 |   |   |
| **Provision  for loan losses**                             | ** ** | **117**                                            | ** ** | 58                                               | ** ** | **168**       |   | 187 |   |   |
| ***Net interest income after  provision for loan losses*** | ** ** | **1,720**                                          | ** ** | 1,500                                            | ** ** | **3,434**     |   | 2,863 |   |   |
| **Noninterest  income:**                                   |       |                                               |       |                                             |       |          |   |   |   |   |
| Service charges on deposit accounts                        | ** ** | **275**                                            | ** ** | 339                                              | ** ** | **554**       |   | 658 |   |   |
| Mortgage banking activities                                | ** ** | **204**                                            | ** ** | 116                                              | ** ** | **347**       |   | 203 |   |   |
| Gain (loss) on sale of securities                          | ** ** | **3**                                              | ** ** | (1                                               | )          | **13**        |   | (4 | ) |   |
| Other service charges, commissions and fees                | ** ** | **76**                                             | ** ** | 63                                               | ** ** | **156**       |   | 143 |   |   |
| ***Total noninterest income***                             | ** ** | **558**                                            | ** ** | 517                                              | ** ** | **1,070**     |   | 1,000 |   |   |
| **Noninterest  expenses:**                                 |       |                                               |       |                                             |       |          |   |   |   |   |
| Salaries and employee benefits                             | ** ** | **768**                                            | ** ** | 688                                              | ** ** | **1,484**     |   | 1,255 |   |   |
| Occupancy expense                                          | ** ** | **428**                                            | ** ** | 87                                               | ** ** | **192**       |   | 175 |   |   |
| Other operating expenses                                   | ** ** | **251**                                            | ** ** | 527                                              | ** ** | **1,123**     |   | 1,069 |   |   |
| ***Total noninterest expenses***                           | ** ** | **1,447**                                          | ** ** | 1,302                                            | ** ** | **2,799**     |   | 2,499 |   |   |
| ***Income before income taxes***                           | ** ** | **831**                                            | ** ** | 715                                              | ** ** | **1,705**     |   | 1,367 |   |   |
| **Income  taxes**                                          | ** ** | **283**                                            | ** ** | 238                                              | ** ** | **581**       |   | 472 |   |   |
| ***Net income***                                           | ** ** | **548**                                            | ** ** | 477                                              | ** ** | **1,124**     |   | 892 |   |   |
|                                                       |       |                                               |       |                                             |       |          |   |   |   |   |
| **Other  comprehensive income (loss):**                    |       |                                               |       |                                             |       |          |   |   |   |   |
| Unrealized gains/losses on securities                      | ** ** | **(150**                                           | **)**      | 144                                              | ** ** | **(511**      | **)** | (342 | ) |   |
|                                                       |       |                                               |       |                                             |       |          |   |   |   |   |
| **Comprehensive  income (loss)**                           | ** ** | **398**                                            | ** ** | 621                                              | ** ** | **613**       |   | 550 |   |   |
|                                                       |       |                                               |       |                                             |       |          |   |   |   |   |
| Basic earnings  per share                                  | ** ** | **$**                                              | **0.49**   | ** **                                       | $          | 0.44          | ** ** | **$** | **1.02** | ** ** | **$** | **0.84** |   |   |
| Diluted earnings  per share                                | ** ** | **$**                                              | **0.45**   | ** **                                       | $          | 0.40          | ** ** | **$** | **0.93** | ** ** | **$** | **0.77** |   |   |
|                                                       |       |                                               |       |                                             |       |          |   |   |   |   |
| Shares used in  computation of earnings per share          |       |                                               |       |                                             |       |          |   |   |   |   |
| Basic                                                      | ** ** | **1,120,675**                                      | ** ** | 1,095,892                                        | ** ** | **1,102,275** |   | 1,060,306 |   |   |
| Diluted                                                    | ** ** | **1,223,710**                                      | ** ** | 1,195,384                                        | ** ** | **1,205,310** |   | 1,159,798 |   |   |

 

See accompanyingnotes to consolidated financial statements.

4

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** **

**SOUTHERNHERITAGE BANCSHARES, INC.Consolidated Statements of Cash FlowsSix Months Ended June 30(Unaudited)**

*($ amountsin thousands)*
| ** **                                                                                | ** ** | **2006**    | ** ** | **2005** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------|------------|----------|------------|
| **Cash  flows from operating activities:**                                                |       | ** **  |       |     |       |
| **Net income**                                                                            | ** ** | **$**       | **1,124**  |     | 892        |   |
| Adjustments to reconcile net income to net cash  provided (used) by operating activities: |       | ** **  |       |     |       |
| Depreciation and amortization                                                             | ** ** | **199**     |       | 199      |       |
| Provision for loan losses                                                                 | ** ** | **168**     |       | 187      |       |
| Gain (loss) on sale of securities available for sale                                      | ** ** | **13**      |       | 4        |       |
| FHLB stock dividends                                                                      | ** ** | **(7**      | **)**      | (5       | )          |
| Mortgage loans originated for sale                                                        | ** ** | **(16,926** | **)**      | (11,113  | )          |
| Proceeds from sale of mortgage loans                                                      | ** ** | **15,652**  |       | 11,688   |       |
| Decrease (increase) in accrued interest receivable                                        | ** ** | **55**      |       | (120     | )          |
| Increase (decrease) in accrued interest payable                                           | ** ** | **(120**    | **)**      | 180      |       |
| Other, net                                                                                | ** ** | **(28**     | **)**      | (8       | )          |
| ***Net cash provided by operating  activities***                                          | ** ** | **130**     |       | 1,904    |       |
| **Cash  flows from investing activities:**                                                |       | ** **  |       |     |       |
| Proceeds from maturities and redemptions of  securities available for sale                | ** ** | **529**     |       | 636      |       |
| Proceeds from sales of securities available for sale                                      | ** ** | **3,171**   |       | 4,408    |       |
| Purchases of securities available for sale                                                | ** ** | **(5,294**  | **)**      | (6,207   | )          |
| Purchases of restricted stock                                                             | ** ** | **(4**      | **)**      | (54      | )          |
| Net decrease (increase) in loans                                                          | ** ** | **(4,922**  | **)**      | (9,157   | )          |
| Purchases of premises and equipment                                                       | ** ** | **(184**    | **)**      | (92      | )          |
| ***Net cash used by investing  activities***                                              | ** ** | **(6,704**  | **)**      | (10,466  | )          |
| **Cash  flows from financing activities:**                                                |       | ** **  |       |     |       |
| Increase (decrease) in repurchase agreements                                              | ** ** | **46**      |       | (767     | )          |
| FHLB cma advance                                                                          | ** ** | **3,000**   |       | 0        |       |
| Proceeds from exercise of stock options                                                   | ** ** | **29**      |       | 0        |       |
| Dividends Paid                                                                            | ** ** | **(9**      | **)**      | 0        |       |
| Increase in deposits                                                                      | ** ** | **7,075**   |       | 20,168   |       |
| ***Net cash provided by financing  activities***                                          | ** ** | **10,141**  |       | 19,401   |       |
|                                                                                      |       | ** **  |       |     |       |
| ***Net increase (decrease) in cash***                                                     | ** ** | **3,567**   |       | 10,839   |       |
| **Cash  and cash equivalents, beginning of period**                                       | ** ** | **7,078**   |       | 5,093    |       |
|                                                                                      |       | ** **  |       |     |       |
| **Cash  and cash equivalents, end of period**                                             | ** ** | **$**       | **10,645** |     | 15,932     |   |
|                                                                                      |       | ** **  |       |     |       |
| **Cash  payments for interest**                                                           | ** ** | **$**       | **2,453**  |     | 1,413      |   |
| **Cash payments for income taxes**                                                        | ** ** | **697**     |       | 638      |       |

 

See accompanyingnotes to consolidated financial statements.

5

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** **

**SOUTHERNHERITAGE BANCSHARES, INC.Notes to Consolidated Financial StatementsJune 30, 2006(Unaudited)**

*Basis of Presentation*

The accompanyingfinancial statements have been prepared in accordance with generally acceptedaccounting principals for interim financial information and with theinstructions to Form 10-QSB. Accordingly they do not include allinformation and footnotes required by generally accepted accounting principalsfor complete financial statements.

The consolidatedfinancial statements include Southern Heritage Bancshares, Inc. and itswholly owned subsidiary, Southern Heritage Bank, together referred to as “theCompany”. Intercompany transactions and balances are eliminated inconsolidation.

Southern HeritageBancshares, Inc. is a one bank holding company that owns 100% of SouthernHeritage Bank (the Bank). Substantially all of the consolidated operations arethat of the Bank.

In the opinion ofmanagement, the financial statements contain all adjustments necessary tosummarize fairly the financial position of the Bank as of June 30, 2006,the results of operations for the six months ended June 30, 2006, and cashflows for the six months ended June 30, 2006. The interim financialstatements should be read in conjunction with the notes to the financialstatements presented in the Bank’s December 31, 2005, financial statements.The results for the interim periods are not necessary indicative of the resultsto be expected for the complete year.

*Allowance for Loan Losses*

Transactions in the allowance for loan losses were asfollows:
| ** **                       | ** ** | **Six Months  Ended  June 30, 2006** | ** ** | **Six Months  Ended  June 30, 2005** | ** ** |
|----------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                       | ** ** | **(In Thousands)**                             | ** ** | **(In Thousands)**                             | ** ** |
|                             | * *   | * *                                            | * *   | * *                                            | * *   |
| Balance  January 1          |       | $                                                   | 2,036      |                                                | $          | 1,723 |   |
|                             |       |                                                |       |                                                |       |
| Add (deduct):                    |       |                                                |       |                                                |       |
| Losses charged to allowance      |       | (259                                                | )          | (37                                                 | )          |
| Recoveries credited to allowance |       | 17                                                  |       | 13                                                  |       |
| Provision for loan losses        |       | 168                                                 |       | 187                                                 |       |
|                             |       |                                                |       |                                                |       |
| Balance June 30             |       | $                                                   | 1,962      |                                                | $          | 1,886 |   |

 

The following tablepresents various categories of loans contained in the Company’s loan portfoliofor the periods indicated and the total amount of all loans for such period:
| ** **                               | ** ** | **As of**                 | ** ** |
|------------------------------------------|------------|--------------------------------|------------|
| ** **                               | ** ** | **June 30, 2006**    | ** ** | **December 31, 2005** | ** ** |
| **Domestic:**                            | ** ** | **($ in thousands)** | ** ** |
|                                     |       |                           |       |   |   |
| Commercial,  financial and agricultural  |       | $                              | 45,049     |   | $ | 43,499 |   |
| Real estate -  construction              |       | 29,522                         |       | 27,212 |   |
| Real estate - 1  to 4 family residential |       | 24,564                         |       | 25,692 |   |
| Real estate -  commercial                |       | 48,446                         |       | 46,614 |   |
| Consumer                                 |       | 8,472                          |       | 8,114 |   |
| Total loans                              |       | 156,053                        |       | 151,131 |   |
| Allowance for  loan losses               |       | (1,962                         | )          | (2,036 | ) |
|                                     |       |                           |       |   |   |
| Total (net of  allowance)                |       | $                              | 154,091    |   | $ | 149,095 |   |

 

6

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** **

**SOUTHERNHERITAGE BANCSHARES, INC.Notes to Consolidated Financial StatementsJune 30, 2006(Unaudited)**

** **

The following tablepresents information regarding nonaccrual, past due and restructured loans atthe dates indicated:
| ** **                                                                                                                          | ** ** | **As of**                 | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                          | ** ** | **June 30, 2006**    | ** ** | **December 31, 2005** | ** ** |
| ** **                                                                                                                          | ** ** | **($ in thousands)** | ** ** |
| Loans accounted  for on a non-accrual basis:                                                                                        |       |                           |       |   |   |
| Number                                                                                                                              |       | 3                              |       | 1 |   |
| Amount                                                                                                                              |       | $                              | 426        |   | $ | 27 |   |
|                                                                                                                                |       |                           |       |   |   |
| Accruing loans  (including consumer loans) which are contractually past due 90 days or more  as to principal and interest payments: |       |                           |       |   |   |
| Number                                                                                                                              |       | 1                              |       | — |   |
| Amount                                                                                                                              |       | $                              | 78         |   | — |   |
|                                                                                                                                     |            |                                |            |  |  |  |  |

 

Management’sdetermination of the appropriate level of the provision for loan losses and theadequacy of the allowance for loan losses is based, in part on an evaluation ofspecific loans, as well as other factors considered by management, includingthe composition of the loan portfolio, current economic conditions, and thecreditworthiness of the Bank’s borrowers and other related factors.

At June 30,2006, the Bank had three loans totaling $426,000 in nonaccrual status; one loanaccounts for $416,000 of this total. This compares with December 31, 2005,where there were two loans for $27,000 in nonaccrual. The Bank had one loan fora total of $78,000 that was more than 90 days delinquent on June 30, 2006compared to no loans that were delinquent as of December 31, 2005. In thefirst six months of 2006, loans totaling $259,000 were charged off (one loanrepresents $192,000 of the total) and $17,000 was recovered on loans previouslycharged off. Management does not believe that the two problem loan issues (onecharge-off of $192,000 and one nonaccrual of $426,000) is indicative of anunfavorable trend developing. Based on historical low chargeoff levels, fiveyear average is .07%, a lower level of allowance relative to total loans iswarranted and is reflected in the allowance for June 30, 2006 and theprovision for the six months then ended.

*StockDividend*

The Companydeclared a stock dividend of one share for each 20 shares owned forshareholders of record as of May 18, 2006. The effect of this stockdividend have been reflected in earnings per share and shares used in thecomputation of earnings per share for all periods presented as well as theshared data presented in the summary of option activity table.

*Stock Compensation*

The Companyestablished an Incentive Stock Option Plan (ISO) for officers and employees anda Non-Employee Directors’ Non-Qualified Stock Option Plan (NQO), which wasshareholder approved, effective August 8, 2000, allowing for the grantingof share options and shares to its employees and directors up to 153,543 sharesof common stock. The Company believes that such awards better align theinterests of its employees and directors with those of its shareholders. Optionawards are generally granted with an exercise price equal to the market priceof the Company’s stock at the date of grant; those option awards generally vest20% every two years based on 10 years of continuous service. Certain option andshare awards provide for accelerated vesting if there is a change in control(as defined in the Plan).

The fair value ofeach option grant is estimated on the date of grant using the Black-Scholesoption-pricing model. Expected volatilities are based on historical exercisepatterns, employee terminations and historical stock prices. The expected lifeof options granted represents the period of time that options granted areexpected to be outstanding. The U.S. Treasury 10 year constant maturity rate ineffect at the date of the grant is used to derive the risk-free interest ratefor the contractual period of the options.There were no options granted in2006.

7

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** **

**SOUTHERNHERITAGE BANCSHARES, INC.Notes to Consolidated Financial StatementsJune 30, 2006(Unaudited)**

** **

A summary ofoption activity under the Plan as of June 30, 2006, and changes during thesix months then ended is presented below:

 
| **Options**                          | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Weighted  Average  Intrinsic  Value** | ** ** |
|--------------------------------------|------------|------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                           | ** ** | ** ** | ** ** | ** **                             | ** ** | ** **                                          | ** ** | **(In thousands)**                 | ** ** |
| Outstanding at  January 1, 2006 |       | 157,457    |       | $                                      | 11.57      |                                                |       |                                    |       |   |
|                                 |       |       |       |                                   |       |                                                |       |                                    |       |
| Granted                              |       | —     |       | —                                 |       |                                                |       |                                    |       |
|                                 |       |       |       |                                   |       |                                                |       |                                    |       |
| Exercised                            |       | (2,461     | )          | 11.90                                  |       |                                                |       |                                    |       |
|                                 |       |       |       |                                   |       |                                                |       |                                    |       |
|                                 |       |       |       |                                   |       |                                                |       |                                    |       |
| Outstanding at  June 30, 2006   |       | 154,996    |       | $                                      | 11.56      |                                                | 4.90       |                                    | $          | 3,633 |   |
|                                 |       |       |       |                                   |       |                                                |       |                                    |       |
| Exercisable at  June 30, 2006   |       | 52,726     |       | $                                      | 10.37      |                                                | 3.88       |                                    | $          | 1,299 |   |

 

The totalintrinsic value of options exercised during the six months ended June 30,2006 was $56,849.

8

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** **

**SOUTHERNHERITAGE BANCSHARES, INC.Notes to Consolidated Financial StatementsJune 30, 2006(Unaudited)**

** **

As of June 30,2006, there was $277,000 of total unrecognized compensation cost related tononvested share-based compensation arrangements granted under the Plan. Thatcost is expected to be recognized over a weighted-average period ofapproximately 5 years. The options under the Plan vest every other year andnone have vested in 2006. However, the compensation cost is recorded on aprorata basis over the entire vesting period resulting total compensation costof $24,000 for the six months ended June 30, 2006, based on the fair valueof the options.

Cash received fromoptions exercised for the six months ended June 30, 2006 was $29,300. Allof these options were ISO’s, resulting in no tax benefit for the Company. TheCompany’s policy is to issue new shares to satisfy option exercises.

In 2005 and prior,employee compensation expense under stock options was reported using theintrinsic value method. No stock-based compensation cost was reflected in netincome; as all options granted had an exercise price equal to or greater thanthe market price of the underlying common stock at date of grant. The followingtable illustrates the effect on net income and earnings per share if expensewas measured using the fair value recognition provisions of FASB Satement No. 123,Accounting for Stock-Based Compensation.

 
| ** **                                                                         | ** ** | **Three Months  Ended  June 30, 2005** | ** ** | **Six Months  Ended  June 30, 2005** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
|                                                                               |       |                                                  |       |                                                |       |
| Net income as  reported                                                            |       | 477                                                   |       | $                                                   | 892        |   |
| Deduct:  Stock-based compensation expense determined under fair value based method |       | 12                                                    |       | 24                                                  |       |
|                                                                               |       |                                                  |       |                                                |       |
| Pro Forma net  income                                                              |       | 465                                                   |       | $                                                   | 868        |   |
|                                                                               |       |                                                  |       |                                                |       |
| Basic earnings  per share as reported                                              |       | .44                                                   |       | $                                                   | .84        |   |
| Pro Forma basic  earnings per share                                                |       | .42                                                   |       | .82                                                 |       |
|                                                                               |       |                                                  |       |                                                |       |
| Diluted earnings  per share as reported                                            |       | .40                                                   |       | .77                                                 |       |
| Pro Forma diluted  earnings per share                                              |       | .39                                                   |       | .75                                                 |       |

 

9

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** **

**SOUTHERNHERITAGE BANCSHARES, INC.Notes to Consolidated Financial StatementsJune 30, 2006(Unaudited)**

** **

Earnings Per ShareAmounts:  Basicearnings per share is computed using the weighted average number of commonshares outstanding during the period and excludes any dilutive effects ofoptions. Diluted earnings per share is computed using the weighted averagenumber of common and common stock equivalent shares outstanding during theperiod; common stock equivalent shares are excluded from the computation iftheir effect is antidilutive. The effect of these options on earnings percommon share was to increase average shares outstanding by 103,035 and 99,492in 2006 and 2005 and decrease earnings per share by $.09 and $.07. No shareswere antidilutive at June 30, 2006 and 2005.

 

10

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**Item 2. Management’s Discussion and Analysis**

# **OVERVIEW**

Thefollowing discussion compares the financial condition of Southern HeritageBancshares, Inc. (the “Company”) at June 30, 2006, to December 31, 2005, andthe results of operations for the six months ended June 30, 2006 and 2005.  Reasons for changes in the quarterly resultsare the same as those for the year to date results.  The Company is a one bank holding companythat owns 100% of Southern Heritage Bank (the “Bank”). Substantially all of theconsolidated operations are that of the Bank. This discussion should be read inconjunction with the interim financial statements and footnotes includedherein.

Certainstatements contained in this report that are not historical facts are forwardlooking statements that are subject to certain risks and uncertainties. Whenused herein, the terms “anticipates,” “plans,” “expects,” “believes,” andsimilar expressions as they relate to the Company or its management areintended to identify such forward looking statements. The Company’s actualresults, performance or achievements may materially differ from those expressedor implied in the forward-looking statements. Risks and uncertainties thatcould cause or contribute to such material differences include, but are notlimited to, general economic conditions, the interest rate environment,competitive conditions in the financial services industry, changes in law,governmental policies and regulations, and rapidly changing technologyaffecting financial services.

# **FINANCIALCONDITION**

Totalassets as of June 30, 2006 increased 6.1%, or $11,474,000, to $200,620,000,compared with $189,146,000 at December 31, 2005. The increase in total assetswas funded primarily by an increase in total deposits of $7,075,000 and a FHLBCMA Advance of $3,000,000. Cash and cash equivalents increased $3,567,000 to$10,645,000 at June 30, 2006 from $7,078,000 at December 31, 2005. Securitiesincreased $1,381,000 to $26,117,000 at June 30, 2006 compared to $24,736,000 atDecember 31, 2005.

Loansare the principal component of the Company’s assets and the primary source ofincome. Total loans at June 30, 2006, were $156,053,000 compared to$151,131,000 at December 31, 2005, an increase of $4,922,000. The increase inloans in the first six months of 2006 was as follows: construction real estateloans increased $2,310,000, commercial loans secured by real estate increased$1,832,000, commercial loans which increased $1,697,000; other loans increased$132,000, consumer loans increased $79,000, and loans secured by 1-4 familyresidential real estate decreased $1,128,000. As of June 30, 2006, $48,446,000 or 31% of total loans were commercialloans secured by real estate. Commercial loans were $44,745,000 or 29% of totalloans. Loans secured by 1-4 family residential real estate were $24,564,000 or16% of total loans. Construction loans secured by real estate were $29,522,000or 19% of total loans. Consumer loans were $4,180,000 or 2% of total loans.Other loans were $4,596,000 or 3% of total loans. Of the total loans,$102,453,000 or 65.6% mature or reprice within 12 months. Only $2,304,000 or1.5% mature or reprice over five years.

Therewas $1,519,000 in mortgage loans held for sale at June 30, 2006, compared with$245,000 at December 31, 2005. The increase in mortgage loans held for sale wasprimarily due to timing issues related to secondary market investor funding.

11

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Managementanticipates that loan demand will be moderate in the near future. Theloan-to-deposit ratio as of June 30, 2006, was 89.1%, compared to 89.9% atDecember 31, 2005, and the loan-to-assets ratio was 77.8% at June 30, 2006,compared to 79.9% at December 31, 2005. Management expects that theloan-to-deposit ratio for the remainder of 2006 will remain in the range ofapproximately 85% - 90% and the loans-to-assets ratio will be between 75% -80%.

Thesecurities portfolio provides a balance to interest rate and credit risk whileproviding a vehicle for investing available funds, furnishing liquidity, andsupplying securities to pledge as required for certain deposits and borrowedfunds. All securities are classified as “available for sale”. We have no plansto liquidate a significant amount of the securities portfolio.  As of June 30, 2006, the Company owned$26,117,000 of securities available-for-sale, an increase of $1,381,000 or5.6%.

Depositswhich are the Company’s primary source of funds, totaled $175,190,000 at June30, 2006, for an increase of $7,075,000, or 4.2%, compared to $168,115,000 atDecember 31, 2005. Deposits at June 30, 2006 consisted of $26,919,000 or 15.3%in non-interest bearing demand deposits, $36,976,000 or 21.1% ininterest-bearing demand deposits, $104,043,000 or 59.4% in time certificates ofdeposit and $7,252,000 or 4.2% in savings accounts. There was $20,712,000 inbrokered CDs at June 30, 2006 compared to $19,263,000 at December 31, 2005. TheCompany has targeted local consumers, professionals, and small businesses asits central clientele. These customers are being offered various depositinstruments such as demand deposits, savings accounts, money market accounts,certificates of deposit and IRAs. Rates paid on such instruments are set basedon various factors such as liquidity needs and market conditions. The Companybelieves it has a competitive advantage by being a locally owned financialinstitution which will contribute to increased market share. However, noassurance of market growth can be given.

Themajority of the deposits continue to be CDs, which increased $8,083,000 in thefirst six months of 2006. At June 30, 2006, the weighted average rate on CDswas 4.04% compared to 3.12% for the six months ended June 30, 2005. The Companyhas time deposits maturing within one year of $79,004,000 or 75.9% of totaltime deposits. Time deposits maturing greater than one year is $25,039,000 or24.1% of total time deposits. Interest-bearing accounts, other than CDs,decreased $1,147,000 in the first six months of 2006. Noninterest bearingdeposits increased $131,000 for the six months ended June 30, 2006. The weightedaverage cost of all deposit accounts during the first six months of 2006 was2.92% compared to 2.09% for the same period in 2005.

Totalshareholders’ equity increased $1,030,000, to $15,201,000 at June 30, 2006,from $14,171,000 at December 31, 2005. This increase was due to the Company’snet income of $1,124,000 for the first six months of 2006 along with a netincrease in unrealized losses on securities available for sale of $138,000 netof tax. Stock options totaling $29,000 were exercised during the year. Therewas a $24,000 increase in additional paid in capital related to stock optioncompensation according to FASB 123R.  The5% stock dividend declared on May 18, 2006 resulted in $9,000 paid forfractional shares.

As ofJune 30, 2006 the Bank is categorized as well capitalized under the regulatoryframework for prompt corrective action. The total capital to risk-weightedassets ratio was 13.02%. Tier-1 to risk-weighted assets ratio was 11.88% andTier-1 to average asset ratio was 10.38%.

12

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# **RESULTSOF OPERATIONS**

Forthe first six months of 2006, net income after tax was $1,124,000, compared to$892,000 for the same period in 2005, an increase of 26.0%. The increase inearnings over the previous year was primarily a result of the increase in netinterest income as a result of the overall growth of the Company. Net interestincome before the provision for loan losses for the first six months of 2006was $3,602,000, an increase of $552,000 or 18.1% from $3,050,000 for the firstsix months of 2005. The net interest margin for June 30, 2006 was 3.99%,compared to June 30, 2005 at 3.90%.

Interestand fee income on loans for the first six months of 2006 was $5,485,000, anincrease of $1,315,000 or 31.5% from $4,170,000 for the six months ended June30, 2005. The increase in interest and fee income on loans is primarily due toincreased volume in commercial loans as well as construction and commercialreal estate loans along with the increase in rates following the FederalReserve’s efforts to increase short term rates. The yield on all loansincreased 95 basis points to 7.36% at June 30, 2006 compared to 6.41% at June30, 2005. Total loans outstanding at June 30, 2006 were $156,053,000 comparedto $135,082,000 at June 30, 2005.

Interestincome from securities and short-term funds totaled $515,000 for the first sixmonths of 2006, an increase of $147,000 over the same period of 2005. Theincrease in 2006 was due to an increase in the average dollar amount ofsecurities and short-term funds outstanding; $31,829,000 at June 30, 2006compared to $26,328,000 at June 30, 2005 and the increase in short term rates.The yield on securities and short-term funds increased to 4.32% at June 30,2006 compared to 3.60% at June 30, 2005.

Interestexpense totaled $2,573,000 in the first six months of 2006, compared to$1,593,000 for the same period of 2005. The increase in interest expense in2006 was due to the significant growth of deposits and an increase in shortterm rates. The Company’s cost of funds increased to 2.92% at June 30, 2006compared to 2.09% at June 30, 2005. Total deposits outstanding at June 30, 2006were $175,190,000 compared to $157,527,000 at June 30, 2005.

TheCompany’s net interest margin for the first six months of 2006 was 3.99% ascompared to June 30, 2005 at 3.90%.

TheCompany’s yield on earning assets has increased to 6.83%, for the first sixmonths of 2006 compared to 5.94% for the same period of 2005. The cost ofinterest-bearing funds has followed the same trend, increasing to 3.45% for thefirst six months of 2006, up from 2.49% for the six months ended June 30, 2005.

Theallowance for loan losses is maintained by management at a level consideredadequate to cover probable incurred losses in the Company’s loan portfolio.Management’s determination of the appropriate level of the provision for loanlosses and the adequacy of the allowance for loan losses is based, in part, onthe consideration of loss histories of other similar community financialinstitutions which management believes are representative of the probableexpected loss experience of the Company. Other factors considered by managementinclude the composition of the loan portfolio, current economic conditions, thecreditworthiness of the Company’s borrowers and other related factors. TheCompany’s net charge-off experience has historically been low; therefore thefirst six months of 2006, the Company provided $168,000 for loan lossescompared to $187,000 for the same period of 2005. The net charge-offs for thefirst six months of 2006 were $242,000 compared to $24,000 for the same periodin 2005. This compares to net chargeoffs of $61,000 and $101,000 for the yearsended December 31, 2005 and 2004.  The$242,000 net chargeoffs for 2006 includes one loan for $192,000.  Management believes that the level of netchargeoffs for the six months ended June 30, 2006 will not be sustained for theentire year. At June 30, 2006, the Company had three loans totaling $426,000 innonaccrual status.  The $426,000 primarilyconsists of one loan totaling $416,000. This compares with December 31, 2005, where there were two loanstotaling $27,000 in nonaccrual. At June 30, 2006 one loan totaling $78,000 ismore than 90 days delinquent. At June 30, 2006, the allowance for loan losseswas 1.25% compared to 1.39% at December 31, 2005.  Management does not believe that the twoproblem loan issues (one charge-off of $192,000 and one nonaccrual of $426,000)is indicative of an unfavorable trend developing.  Based on historical low chargeoff levels,five year average is .07%, a lower level of allowance relative to total loansis warranted and is reflected in the allowance for June 30, 2006 and theprovision for the six months then ended.

13

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Totalnoninterest income for the first six months of 2006 was $1,070,000 compared to$1,000,000 for the same period in 2005. The largest single source ofnoninterest income is service charges on deposit accounts. Service charges ondeposits totaled $554,000 in 2006 compared to $658,000 in 2005. The decrease isdue primarily to lower NSF and overdraft protection fee income realized duringthe period. Mortgage banking income was $347,000 for the six months ended June30, 2006 compared to $203,000 for the same period in 2005. For the six monthsended June 30, 2006, the Company originated for subsequent sale, 99 loans for$15,652,000 compared to 89 loans for $11,688,000 for the same period in 2005.The average loan closed increased $27,000 to $158,000 from $131,000 in theprevious year. Net securities gains or losses reflected a gain of $13,000 in2006 compared to a loss of $4,000 in 2005. Other service charges, commissionsand fees were $156,000 as of June 30, 2006 as compared to $143,000 for the sameperiod in 2005. This includes safe deposit box rent, ATM interchange andsurcharges, credit card interchange income, and the sale of checks todepositors.

Noninterestexpenses were $2,799,000 for the first six months of 2006 compared with$2,499,000 for the same period of 2005; an increase of $300,000 or 12.0%. Theincrease in noninterest expenses in the first six months of 2006 isattributable primarily to the increase in salaries and benefits expense; anincrease of $229,000 or 18.2% compared to 2005, and occupancy expense whichincreased $17,000 or 9.7%.

As ofJune 30, 2006, the Company had 51 full-time equivalent employees compared to 45for the same period of 2005.  Mortgagecommissions total $78,000 for 2006 as compared to $55,000 for 2005. There wasan additional $24,000 charge for stock option compensation as required by FASB123R in 2006 compared to no charge in 2005. The increased staff includes two highly compensated positions that wereadded during 2005; senior commercial lender (May) and human resources director(August) accounts for $82,000 of the increase. Employee incentive programs increased $28,000 at June 30, 2006 over theprior year.

The increase inoccupancy expense was due to increases in property taxes of $6,000, utilities$4,000, janitorial $4,000, and grounds maintenance $2,000.

Other operatingexpenses had a slight increase of $54,000 in the first six months of 2006 ascompared to the same period in 2005. With the growth of the Company there were increases in some areas suchas marketing $28,000, ATM $25,000, postage/freight $11,000, telephone $6,000,dues/subscriptions $6,000, data processing $5,000, and human resources $5,000.The increases were offset with decreases in other areas such as  accounting/audit fess $16,000, and consultingfees $16,000.

TheCompany booked income tax expense of $581,000 for the period ended June 30,2006 compared to $472,000 for the same period in 2005. The effective tax ratefor the six months ended June 30, 2006 is 34.1% compared to 34.6% for the sameperiod ended 2005.

# **LIQUIDITYAND CAPITAL RESOURCES**

Liquidityrefers to the Company’s ability to fund loan demand, meet deposit customers’withdrawal needs and provide for operating expenses. As summarized in theStatement of Cash Flows, the Company’s main source of cash flow is fromreceiving deposits from its customers, and to a lesser extent, repayment ofloan principal and interest income on loans and investments. The primary usesof cash are lending to the Company’s borrowers, and investing in securities andshort-term interest-earning assets.

In thefirst six months of 2006, deposit growth has exceeded loan growth; however,this is more of a timing issue and is not expected to continue. Other potentialsources of liquidity include the sale of available-for-sale securities from theCompany’s portfolio, the sale of loans, the purchase of federal funds, orrepurchase agreements. The Company currently has $20,712,000 in brokeredcertificates of deposit, compared to $19,263,000 at December 31, 2005.

14

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AtJune 30, 2006 and December 31, 2005, the Bank’s risk-based capital ratios andthe minimums to be considered well-capitalized under the Federal Reserve Board’sprompt corrective action guidelines were as follows:

 
| ** **                              | ** ** | **June 30, 2006** | ** ** | **Dec. 31, 2005** | ** ** | **Well-capitalized** | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|----------------------|------------|
|                                    |       |                        |       |                        |       |                 |       |
| Tier 1 capital  to risk-weighted assets |       | 11.88                       | %          | 11.80                       | %          | 6.0                  | %          |
| Total capital to  risk-weighted assets  |       | 13.02                       | %          | 13.04                       | %          | 10.0                 | %          |
| Tier 1 leverage ratio                   |       | 10.38                       | %          | 10.38                       | %          | 5.0                  | %          |

 

As discussedabove, total shareholders’ equity increased $1,030,000, to $15,201,000 at June30, 2006 from $14,171,000 at December 31, 2005. This increase was due to theCompany’s net income of $1,124,000 for the first six months of 2006 along witha net increase in unrealized losses on securities available for sale of$138,000, net of tax. Stock options totaling $29,000 were exercised during theyear. There was a $24,000 increase in additional paid in capital related tostock option compensation according to FASB 123R.  The 5% stock dividend declared on May 18,2006 resulted in $9,000 paid for fractional share.

The payment of dividends by the Company depends to a great extent onthe ability of the Bank to pay dividends to the Company. The Company is subjectto the Tennessee Banking Act, which provides that the Bank may not declaredividends in any calendar year that exceeds the total of its net income of thatyear combined with its retained net income of the preceding two years withoutthe approval of the TDFI. Thereafter, 10% of net profits must be transferred tocapital surplus prior to payment of dividends until capital surplus equalscapital stock. The Bank is also subject to the minimum capital requirements ofthe FDIC which impact the Bank’s ability to pay dividends. If the Bank fails tomeet these standards, it may not be able to pay dividends or to acceptadditional deposits because of regulatory requirements.

If, in the opinion of the applicable federal bank regulatory authority,a depository institution is engaged in or is about to engage in an unsafe orunsound practice (which, depending on the financial condition of the depositoryinstitution, could include the payment of dividends), such authority mayrequire that such institution cease and desist from such practice. The federalbanking agencies have indicated that paying dividends that deplete a depositoryinstitution’s capital base to an inadequate level would be such an unsafe andunsound banking practice. Moreover, the Federal Reserve Board, the Comptrollerof the Currency and the FDIC have issued policy statements which provide thatbank holding companies and insured depository institutions generally shouldonly pay dividends out of current earnings.

# **INTERESTRATE SENSITIVITY**

Financialinstitutions are subject to interest rate risk to the degree that theirinterest-bearing liabilities (consisting principally of customer deposits)mature or reprice more or less frequently than their interest-earning assets(generally consisting of loans and investment securities). The match betweenthe scheduled repricing and maturities of earning assets and liabilities withindefined time periods is referred to as “gap” analysis. At June 30, 2006 thecumulative one-year gap was a negative (or liability sensitive) $16,839,000 or8.9% of earning assets compared to an evenly matched or slightly negative gapof $71,000 or .1% of earning assets at December 31, 2005.

One ofmanagement’s objectives in managing the Company’s balance sheet for interestrate sensitivity is to reduce volatility in the net interest margin bymatching, as closely as possible, the timing of the repricing of its interestrate sensitive assets with interest rate sensitive liabilities. During thefirst six months of 2006 the Company experienced four rate increases aftereight such increases during 2005. Management believes that interest rates willlevel off and possibly decline within the next two years. The Company’sstrategy of being in a slight negative one year gap position should result instable net interest margin as rates level off or decline. The Company hadmaintained a positive gap for most of 2005 and moved to a balanced or slightlynegative position during the fourth quarter of 2005. This position into thesecond quarter of 2006 was significant in improving the net interest margin to3.99% compared to 3.89% at December 31, 2005. Many of the Company’s loans are commercial real estate loans with ratesthat are tied to New York Prime or that are fixed for up to three years, andthis strategy allows the Company to match longer-term funding with these loans,thus minimizing volatility in the net interest margin.

**OFF-BALANCE SHEET ARRANGEMENTS**

We are a party tofinancial instruments with off-balance sheet risk in the normal course ofbusiness to meet the financing needs of its consumers.  At June 30, 2006, we had unfunded loancommitments outstanding of $40.3 million and standby letters of credit of $3.1million.  These financial instrumentsinclude commitments to extend credit and standby letters of credit.  Those instruments involve, to varyingdegrees, elements of credit risk in excess of the amount recognized in thebalance sheet.  The contract or notionalamounts of those instruments reflect the extent of our involvement in thoseparticular financial instruments.  We usethe same credit policies in making commitments and conditional obligations asit does for on-balance sheet instruments.

Because thesecommitments generally have fixed expiration dates and many will expire withoutbeing drawn upon, the total commitment level does not necessarily representfuture cash requirements.  If needed, wecan liquidate Federal funds sold or securities available for sale or borrow andpurchase Federal funds from other financial institutions where we haveavailable federal funds lines totaling $13.3 million.

15

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**Item 3. Controls and Procedures**

As ofJune 30, 2006, an evaluation was carried out under the supervision and with theparticipation of the registrant’s management, including our President and ChiefFinancial Officer, of the effectiveness of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934 (the “Exchange Act”)). Based on their evaluation, ourPresident and Chief Financial Officer have concluded that the registrant’sdisclosure controls and procedures are effective to ensure that informationrequired to be disclosed by the registrant in reports that it files or submitsunder the Exchange Act is recorded, processed, summarized and reported withinthe time periods specified in Securities and Exchange Commission rules andforms.

Therehave been no changes in the registrant’s internal controls over financialreporting or in other factors that has materially affected, or is reasonablylikely to materially affect, the registrant’s internal control over financialreporting.

16

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**PART II - OTHER INFORMATION**

**Item 1. Legal Proceedings**

None

**Item 2. Unregistered Sales of EquitySecurities and Use of Proceeds**

(a)                             Sharesof the Company’s common stock were issued to Employees pursuant to the Company’sStock Option Plan as follows:

 

| Date of Sale | ** ** | **Number of Shares of  Common Stock Sold** | ** ** | **Price Per Share** | ** ** |
|------------------------|------------|---------------------------------------------------------------------|------------|-------------------------------|------------|
| June 16, 2006          |       | 441                                                                 |       | $                             | 9.07       |   |
| June 16, 2006          |       | 220                                                                 |       | $                             | 16.33      |   |

 

The aggregate proceeds ofthe shares sold were $7,592.

There were no underwriters and no underwritingdiscounts or commissions. All sales were for cash.

The Company believes thatan exemption from registration of these shares was available to the Company inthat the issuance thereof did not constitute a public offering of securitieswithin the meaning of the Securities Act of 1933, as amended. The Companyrelied on the exemption provided by Section 4(2) of the Securities Act of 1933.

The common stock is not convertible or exchangeableinto other equity securities.

The proceeds of the sales are being used by theCompany for general corporate purposes.

(b)                            Notapplicable.

(c)                             Norepurchases for our securities were made during the quarter ended June 30,2006.

17

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**Item 3. Default Upon SeniorSecurities**

None

**Item 4. Submission of Matters to aVote of Security Holders**

(a)                               The annual meeting of the Bank’sstockholders was held May 18, 2006.

(b)                              The following members of the board ofdirectors were each re-elected as Class I directors to serve for 

additional three year terms or until their respectivesuccessors are duly elected and qualified.

 

Danny Hays, MDSteve LedbetterHank SmithJim Workman

The term of office forthe following members of the board of directors continued after themeeting:  Eddie N. Duncan, M.D., Roger E.Jenne, Esq., Larry S. McDaniel and J. Lee Stewart (Class II); Len D. Graham,Clyde A. Kyle, Jr. M.D., Lester T. Simerville, Sr., and James F. Williams, Jr.(Class III).

(c)           (1)   The followingdirectors were elected by the following tabulation:

|                 | ** ** | **Number of shares voting** | ** ** | **For** | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker Non-Votes** | ** ** |
|-----------------|------------|--------------------------------------------|------------|---------|------------|-------------|------------|-------------|------------|---------------------------|------------|
| Danny Hayes, MD |       | 671,464                                    |       | 669,259 |       | 0           |       | 2,205       |       | 0                         |       |
| Steve Ledbetter |       | 671,464                                    |       | 669,823 |       | 0           |       | 1,641       |       | 0                         |       |
| Hank Smith      |       | 671,464                                    |       | 663,730 |       | 0           |       | 7,734       |       | 0                         |       |
| Jim Workman     |       | 671,464                                    |       | 663,141 |       | 0           |       | 8,323       |       | 0                         |       |

 

(2)   Theratification of the appointment of Crowe, Chizek and Company, LLP asindependent auditors for the Company for the fiscal year 2006 was as follows:

| Number of shares voting | ** ** | **For** | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker Non-Votes** |
|-------------------------|------------|---------|------------|-------------|------------|-------------|------------|----------------------|
| 671,464                 |       | 665,689 |       | 1,050       |       | 0           |       | 0                    |

 

**Item 5. Other Information**

None

**Item 6. Exhibits**

31.1                           Rule 13a-14(a)/15d-15(e) Certification ofthe President.

31.2                           Rule 13a-14(a)/15d-15(e) Certification ofthe Chief Financial Officer.

32.1                           Section 1350 Certification of thePresident.

32.2                           Section 1350 Certification of the ChiefFinancial Officer.

 

18

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**SOUTHERNHERITAGE BANCSHARES, INC.**

**FORM10-QSB**

Quarter ended June30, 2006

# **SIGNATURES**

Pursuantto the requirements of the Securities and Exchange Act of 1934, the Registranthas duly caused this report to be signed on its behalf by the undersignedthereunto duly authorized.

 
|         |   | Southern Heritage  Bancshares, Inc. |   |
|--------------|--------|-------------------------------------|--------|
|         |   | (Registrant)                        |   |
|         |   |                                |   |
| Aug 14, 2006 |   | /s/ J. Lee Stewart                  |   |
| (Date)       |   | J. Lee Stewart                      |   |
|         |   | President                           |   |
|         |   |                                |   |
| Aug 14, 2006 |   | /s/ Steven W. Ledbetter             |   |
| (Date)       |   | Steven W. Ledbetter,                |   |
|         |   | Chief Financial Officer             |   |

 

19

 

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