**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

**Washington D.C. 20549**

 

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**FORM 10-KSB**

 

**ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**FOR THE FISCAL YEAR ENDED JUNE 30, 2003**

 

**Commission File No.: 000-25231**

 

| **NORTHERN STAR FINANCIAL, INC.**                                                                                      |
|------------------------------------------------------------------------------------------------------------------------|
| (Name of Small Business Issuer as specified  in its charter)                                                           |
|                                                                                                                   |   |   |
| **Minnesota**                                                                                                          |   | **41-1912467** |
| (State or other jurisdiction of  incorporation or organization)                                                        |   | (IRS Employer  Identification Number) |
|                                                                                                                   |   |   |
| **1650 Madison Avenue, Mankato, Minnesota  56001**                                                                     |
| Address of principal executive offices)  (Zip Code)                                                                    |
|                                                                                                                   |   |   |
| Issuer’s telephone number, including area  code:**(507) 387-2265**                                                |
|                                                                                                                   |   |   |
| Securities registered pursuant to Section  12(b) of the Exchange Act:  **None**                                   |
|                                                                                                                   |   |   |
| Securities registered pursuant to Section  12(g) of the Exchange Act:  **Common Stock, $.01 par value per share** |

 

Check whether the Issuer (1) has filed all reports required to be filedby Section 13 or 15 (d) of the Exchange Act during the past 12 months (or forsuch shorter period that the Registrant was required to file such reports), and(2) has been subject to such filing requirements for the past 90 days.  Yes ý           No o

 

Check if disclosure of delinquent filers in response to Item 405 ofRegulation S-B is not contained herein, and will not be contained, to the bestof Registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-KSB or any amendment tothis Form 10-KSB.  o

 

Issuer’s revenues for its most recent fiscal year:  **$2,880,317**.

 

The aggregate market value of the Common Stock held by nonaffiliates ofthe Registrant as of September 12, 2003 was approximately $1,187,859 based uponthe average high and low bid prices of the Registrant’s Common stock on suchdate.

 

There were 519,506 shares of Common Stock, $.01 par value, outstandingas of September 12, 2003.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Documents incorporated by reference pursuant to Rule 12b-23:  **Portionsof the Registrant’s Proxy Statement for its 2002 Annual Meeting are incorporatedby reference into Items 9, 10, 11 and 12 of Part III.**

 

Transitional Small Business Disclosure Format (check one).  Yes o         No ý

 

 

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INDEX

 
| **Description** |         |
|-----------------|--------------|
|            |         |
| PART I          |         |
|            |         |
|            | ITEM 1.      | DESCRIPTION  OF BUSINESS. |
|            |         |
|            | ITEM 2.      | DESCRIPTION  OF PROPERTY |
|            |         |
|            | ITEM 3.      | LEGAL  PROCEEDINGS |
|            |         |
|            | ITEM 4.      | SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS |
|            |         |
| PART II         |         |
|            |         |
|            | ITEM 5.      | MARKET  FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS |
|            |         |
|            | ITEM 6.      | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
|            |         |
|            | ITEM 7.      | FINANCIAL  STATEMENTS |
|            |         |
|            | ITEM 8.      | CHANGES  IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE |
|            |
|            | **ITEM 8a.** | **CONTROLS  AND PROCEDURES ** |
|            |
| PART  III       |         |
|            |         |
|            | ITEM 9.      | DIRECTORS,  EXECUTIVE OFFICERS, PROMOTORS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16  (a) OF THE EXCHANGE ACT |
|            |
|            | ITEM  10.    | EXECUTIVE  COMPENSATION |
|            |         |
|            | ITEM 11.     | SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER  MATTERS |
|            |         |
|            | ITEM  12.    | CERTAIN  RELATIONSHIPS AND RELATED TRANSACTIONS |
|            |         |
|            | ITEM  13.    | EXHIBITS  AND REPORTS ON FORM 8-K |
|                 |              |  |  |

 

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**PART I**

 

**ITEM 1.****                             DESCRIPTIONOF BUSINESS**

 

Certain statements in this Annual Report on Form 10-KSB includeforward-looking information within the meaning of Section 27A of the SecuritiesAct of 1933, as amended, and Section 21E of the Securities Exchange Act of1934, as amended, and are subject to the “safe harbor” created by thosesections. These forward-looking statements involve certain risks anduncertainties that could cause actual results to differ materially from thosein the forward-looking statements. Forward-looking statements, which are basedon certain assumptions and describe future plans, strategies, and expectations,are generally identifiable by the use of words such as “believe”, “expect”,“intend”, “anticipate”, “estimate”, “project”, “assume,” “plan,” “predict,”“forecast” or similar expressions. These forward-looking statements relate to,among other things, expectations of the business environment in which theCompany operates, projections of future performance, potential futureperformance, potential future credit experience, perceived opportunities in themarket, and statements regarding the Company’s mission and vision.

 

The Company’s actual results, performance, and achievements may differmaterially from the results, performance, and achievements expressed or impliedin such forward-looking statements due to a wide range of risks anduncertainties. Such risks and uncertainties include, but are not limited to,the following factors: competitive pressure in the banking industry; changes inthe interest rate environment; general economic conditions, either nationallyor regionally, becoming less favorable than expected and resulting in, amongother things, a deterioration in credit quality and an increase in the provisionfor possible loan losses; changes in the regulatory environment; monetary andfiscal policies of the United States Government; changes in real estatevaluations; changes in business conditions; volatility of rate sensitivedeposits; operational risks, including data processing system failures orfraud; asset/liability matching risks and liquidity risks; civil disturbancesor terrorist threats or acts; or apprehension about the possible futureoccurrences of acts of this type; the outbreak or escalation of hostilitiesinvolving the United States; and changes in the securities markets. Also,virtually all of the Company’s operations and customers are located inMinnesota. In addition, the potential for the occurrence of events similar tothose of September 11, 2001, have increased the uncertainty related to thenational and Minnesota economic outlook and could have an effect on the futureoperations of the Company or its customers, including borrowers.

 

The Company does not undertake, and specifically disclaims anyobligation, to update any forward-looking statements to reflect occurrences orunanticipated events or circumstances after the date of such statements.

 

**GENERAL**

 

Northern Star Financial, Inc. (the “Company”) was incorporated underthe laws of the State of Minnesota in January 1998 and operates principally asa bank holding company for its wholly owned subsidiary, Northern Star Bank,(the “Bank”). The Company is registered under the Bank Holding Company Act of1956, as amended. The Bank is the principal source of income for the Company.The Company holds all of the capital stock of its subsidiary. All referencesherein to the “Company” include the Bank unless the context otherwise requires.

 

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Our strategy is to establish de novo banks, branches, or representativeoffices in major retail centers located throughout Minnesota. By virtue ofrepresentative local ownership, management, and decision-making, we hope tobenefit from the continuing trend in the banking industry towards merger andconsolidation with the resulting loss of local control and personalizedservices. The Bank’s, business strategy and promotional activities emphasizeservice and responsiveness to local needs. In order to compete with other financial institutions in its primaryservice area, the Bank relies principally on local promotional activities,personal contacts by its officers, directors, employees and stockholders,extended hours and specialized services. The Bank’s promotional activitiesemphasize the advantages of dealing with a locally owned and headquarteredinstitution sensitive to the particular needs of the community. The Bank alsoassists customers in obtaining loans in excess of the Bank’s lending limit orservices not offered by the Bank by arranging such loans or services inparticipation with or through its correspondent banks.

 

The Bank is a community bank providing a broad range of commercial andretail banking services designed to meet the borrowing and depository needs ofsmall and medium sized businesses and consumers in the communities we serve.The Bank’s customer base consists primarily of small to medium-sized businessesand their owners, managers, and employees residing in Blue Earth, Nicollet,LeSueur, Benton, Sherburne and Stearns counties. Businesses served includemanufacturers, distributors, contractors, professional corporations andpartnerships, and service businesses. We offer a range of loans including commercial, real estate,construction, inventory and accounts receivable, and equipment loans.  We also accept checking, savings, and timedeposits; offer NOW and money market deposit accounts; and provide travelers’checks, safe deposit boxes, and other customary non-deposit banking services.We issue VISA and MasterCard credit cards as an agent of a correspondent bank.

 

The Bank’s principal sources of income are interest and gain on sale ofloans, interest and dividends collected on investments, gains on the sale ofloans, and service fees on deposit accounts. The Bank’s principal expenses areinterest paid on savings, time, NOW and money market deposits, loan lossprovision, employee compensation, office expenses, and other overhead expenses.

 

**MARKET AREA**

 

Our principal market area is the Minnesota counties of Blue Earth,Nicollet, LeSueur, Benton, Stearns, and Sherburne, which includes thecommunities of Mankato and St. Cloud, Minnesota, from which we are expected todraw a significant portion of our business. Approximately 85,000 people reside in Mankato and the surrounding areaand 191,000 people reside in St. Cloud and the surrounding area.  For calendar year 2002, median householdincome of residents living in our principal market areas was approximately $55,000.

 

**COMPETITION**

 

The banking business is highly competitive. The Bank competes withother commercial banks, savings and loan associations, and non-financialinstitutions in its primary service area. Recent legislation, regulatorychanges by the regulators of the various financial institutions, andcompetition from unregulated entities, has eliminated many traditionaldistinctions among commercial banks, thrift institutions and other providers offinancial services. Consequently,

 

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competition among all financial institutions is virtually unlimitedwith respect to their legal ability and authority to provide most financialservices.

 

Banks compete with other financial institutions through the bankingproducts and services they offer, the pricing of their services, the level ofservice provided, the convenience and availability of services, and the degreeof expertise and personal manner in which services are offered. Managementanticipates that the Bank will continue to face strong competition from thefinancial institutions in the Bank’s primary service area. In certain areas ofits banking business, the Bank also competes with credit unions, consumerfinance companies, insurance companies, money market mutual funds, non-banklenders and other financial institutions, some of which are not subject to thesame degree of regulation and restrictions imposed upon the Bank. Many of thesecompetitors have substantially greater resources and lending limits than theBank and offer certain products, such as international banking services, thatthe Bank does not provide.  We believethat competitive pricing, a hometown atmosphere and personalized service allowthe Bank to compete effectively in its primary service area.

 

**DEPOSITS**

 

We offer a full range of deposit services that are typically availablein most banks and savings associations, including checking accounts, commercialaccounts, savings accounts, and other time deposits of various types, rangingfrom daily money market accounts to longer-term certificates of deposit. Thetransaction accounts and time certificates are tailored to our principal marketareas at rates competitive to those offered in the Mankato and St. Cloud,Minnesota areas. In addition, we offer certain retirement account services, suchas Individual Retirement Accounts (IRAs), and sweep accounts.  The FDIC insures all of the funds ourcustomers place on deposit up to the maximum amount permitted by law.

 

**LENDING ACTIVITIES**

 

The Bank’s philosophy is to originate loans, taking into considerationthe interests of its stockholders, safety of the depositors’ funds,preservation of Bank liquidity, welfare of the community and adherence tofederal and state regulations. Loans will always be the major source of theBank’s income. Various elements of risk are associated with each category ofloan offered by the Bank. The economy plays an important part in lending risks,and these risks may be greater at times of economic downturns.

 

REAL ESTATE LOANS. The Bank originates multi-family and single-familyresidential construction loans. The Bank requires a first lien position on theconstruction site and offers these loans only to qualified residential buildingcontractors. Currently, the Bank requires that the builder obtain permanenttake-out financing for all multi-family construction loans prior to the startof construction.  Loan disbursementsrequire on-site inspections to assure the project is on budget and that theloan proceeds are being used in accordance with the plans, specifications and surveyfor the construction project. The loan-to-value ratio for such loans ispredominately 80% of the lower of the appraised value or project cost.  Loans for construction can present a highdegree of risk to the lender, depending on, among other things, whether thebuilder can sell the home to a buyer, whether the buyer can obtain permanentfinancing, whether the transaction produces income in the interim,

 

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and the nature of changing economic conditions. Almost all firstmortgage, single-family residential loans originated by the Bank are sold,servicing released, into the secondary market.

 

Additionally, the Bank offers first mortgage loans on commercial realestate and for owner-occupied or investment real estate having a loan-to-valueratio that does not exceed 80% with a maximum term of 30 years and call orre-pricing provisions every three to five years.  The increase in the Bank’s real estate loan portfolio is a resultof this lending activity related to the origination of multi-family residentialand commercial real estate. Commercial mortgage lending risks include: titledefects, fraud, general real estate market deterioration, inaccurateappraisals, violation of consumer protection laws, interest rate fluctuationsand financial deterioration of a borrower. Such loans typically carryadjustable interest rates.  The Bank isgenerally able to collect fees to the extent of the costs of underwriting theloan in connection with the origination of commercial and multi-familyresidential real estate loans.

 

COMMERCIAL NON-MORTGAGE LOANS. The Bank markets its commercialnon-mortgage loans to parties whose demand for funds falls within the Bank’slegal lending limits and who are existing or potential deposit customers of theBank. This category includes loans made to individual, partnership or corporateborrowers and obtained for a variety of purposes. Risks associated with theseloans can be significant. Risks include fraud, bankruptcy, economic downturn,deteriorated or non-existing collateral and changes in interest rates.

 

CONSUMER LOANS. The Bank originates consumer loans, consistingprimarily of installment loans to individuals for personal, family andhousehold purposes including loans for automobiles and investments. Risksassociated with these loans include fraud, deteriorated or non-existingcollateral, general economic downturn and customer financial problems.

 

LOAN APPROVAL AND REVIEW.  Ourloan approval policies provide for various levels of officer lending authority.When the amount of aggregate loans to a single borrower exceeds that individualofficer’s lending authority, the loan request will be considered and approvedby an officer with a higher lending limit. We have established a directors’ loancommittee that has lending limits, and any loan in excess of a lendingofficer’s lending limit will be approved by the directors’ loan committee. Ourlending policy does not permit us to make loans to any director, officer, oremployee of the Bank unless the loan is approved by the disinterested membersof the board of directors of the Bank and is made on terms not more favorableto such person than would be available to a person not affiliated with theBank.

 

LENDING LIMITS.** **Ourlending activities are subject to a variety of lending limits imposed by stateand federal law. While differing lending limits apply in certain circumstancesbased on the type of loan or the nature of the borrower (including theborrower’s relationship to the Bank), in general, we are subject to aloan-to-one-borrower limit. We generally may not make loans to one borrower andrelated entities in an amount which exceeds 15% of the Bank’s unimpairedcapital and surplus, although loans in an amount equal to an additional 10% ofunimpaired capital and surplus may be made to a borrower if the loans are fullysecured by readily marketable securities. Unless we are able to sellparticipation interests in our Bank’s loans to other financial institutions, wewill not be able to meet all of the lending needs of loan customers requiringaggregate extensions of credit above these limits.

 

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CREDIT RISK AND LOAN REVIEW. Credit risk represents the possibility that a customer may not performin accordance with contractual terms. The Bank incurs credit risk whenever itextends credit to or enters into other transactions with its customers.  The risks associated with extensions ofcredit include general risk, which is inherent in the lending business, andrisk specific to individual borrowers. Loan review and other loan monitoringpractices provide a means for our management to ascertain whether propercredit, underwriting and loan documentation policies, procedures and practicesare being followed by our loan officers and are being applied uniformlythroughout the Bank. Implementation and daily administration of loan reviewrests with the Chief Lending Officer and the President who approve loan officerrequests for changes in risk ratings. Loan officers are responsible forcontinually grading their loans so that individual credits properly reflect therisk inherent therein. The Board of Directors has made provisions for a thirdparty outside loan review of all loans that meet certain criteria that wereoriginated since the previous review. While we continue to review these andother related functional areas, there can be no assurance that the steps wehave taken to date will be sufficient to enable it to identify, measure,monitor and control all credit risk.

 

**OTHER BANKINGSERVICES**

 

Other services we provide include telephone banking, cash managementservices, safe deposit boxes, traveler’s checks, and direct deposit of payrolland social security checks. We are associated with a shared network of automatedteller machines that may be used by our customers throughout Minnesota andother regions and permit customers to access their funds 24 hours a day fromlocations outside our primary market area. As previously noted, we also offer MasterCard and VISA credit cardservices through a correspondent bank as an agent.

 

**INVESTMENT ACTIVITIES**

 

After establishing necessary cash reserves and funding loans, the Bankinvests its remaining liquid assets in investments allowed under banking lawsand regulations. The Bank invests primarily in obligations of the United Statesor obligations guaranteed as to principal and interest by the United States,and other taxable securities and in certain obligations of states andmunicipalities. The Bank also has federal funds transactions with its principalcorrespondent banks and primarily acts as a net seller of such funds. The saleof federal funds amounts to a short-term loan from the Bank to another bank.Risks associated with these investments include loss of value relative tointerest rate and maturities as compared to other investments.

 

**ASSET/LIABILITYMANAGEMENT**

 

The Bank’s objective is to manage its assets and liabilities to providea satisfactory, consistent level of profitability within the framework ofestablished cash, loan, investment, borrowing and capital policies. Variousofficers of the Bank are responsible for developing and monitoring policies andprocedures to insure an acceptable asset/liability mix. Management’s philosophyis to support asset growth primarily through growth of core deposits, whichinclude deposits of all categories made by individuals, partnerships andcorporations. Management of the Bank seeks to invest the largest portion of theBank’s assets in commercial and commercial real estate related loans. TheBank’s asset/liability mix is periodically monitored. Management prepares areport reflecting interest-sensitive assets and interest-sensitive liabilitiesfor the Bank’s Board of

 

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Directors on a quarterly basis.Our objective is to manage interest-sensitive assets and liabilities so as tominimize the impact of substantial movements in interest rates on the Bank’searnings.

 

**EMPLOYEES**

 

At June 30, 2003, the Bank employed 16 full-time employees and 3part-time employees. Various executive officers of the Bank also serve as theofficers of the Company. Other than our chief executive officer, the Companydoes not compensate any other officer or employees. Neither the Company nor theBank is a party to a collective bargaining agreement, and, in the opinion ofmanagement, the Bank enjoys satisfactory relations with its employees.

 

**SUPERVISION ANDREGULATION**

 

General

 

Commercial banking is highly regulated at both the federal and statelevel.  In addition to a variety ofgenerally applicable state and federal laws governing businesses and employers,the Company is extensively regulated by special laws applicable only tofinancial institutions.  Virtually allaspects of the Company’s operations are subject to specific requirements orrestrictions and general regulatory oversight. Deposits, reserves, capital, investments, loans, issuance of securities,payment of dividends, mergers and consolidations, electronic funds transfers,management practices, the scope of activities and other aspects of ouroperations are subject to regulation. With few exceptions, state and federal banking laws have as theirprincipal objective either the maintenance of the safety and soundness of thefinancial institution and the federal deposit insurance fund or the protectionof consumers or classes of consumers, rather than the specific protection ofour stockholders.

 

Set forth below is a summary of certain laws which relate to theregulation of the Company and the Bank. The description does not purport to becomplete and is qualified in its entirety by reference to the applicable lawsand regulations.

 

As a registered bank holding company, the Company is subject to thesupervision of, and to regular examination by, the Board of Governors of theFederal Reserve System (FRS). Historically the activities of bank holdingcompanies, such as the Company, have been limited by the Bank Holding CompanyAct (BHCA) to banking, managing or controlling banks, furnishing services to orperforming services for their subsidiaries, and other activities which the FRSdeems to be so closely related to banking or managing or controlling banks asto be a proper incident thereto. In making such determinations, the FRS isrequired to consider whether the performance of such activities by a bankholding company or its subsidiaries can reasonably be expected to producebenefits to the public such as greater convenience, increased competition, orgains in efficiency that outweigh the possible adverse effects, such as undueconcentration of resources, decreased or unfair competition, conflicts ofinterest, or unsound banking practices. Generally, bank holding companies arerequired to give notice to or obtain prior approval from FRS to engage in any newactivity or to acquire more than 5% of any class of voting stock of any bank.

 

The Company’s common stock is registered with the Securities andExchange Commission (“SEC”) under the Securities Exchange Act of 1934, asamended (the “Exchange Act”). As such, the

 

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Company is subject to theinformation, proxy solicitation, insider trading, and other requirements andrestrictions of the Exchange Act.

 

The Bank is a state bank chartered by and subject to supervision of theState of Minnesota and the Federal Deposit Insurance Corporation (FDIC).  Deposit accounts at the Banks are insured bythe FDIC, which currently insures deposits to a maximum of $100,000 perdepositor. For this protection, the Bank pays a semi-annual assessment and issubject to the rules and regulations of the FDIC pertaining to depositinsurance and other matters.

 

**PAYMENT OF DIVIDENDS**

 

Whether or not the Board of Directors will elect to pay stock dividendsor any cash dividends will be paid in the future depends upon theirconsideration of various factors.  The Company’s and the Bank’sprofitability and regulatory capital ratios in addition to other financialconditions will be key factors considered by the Board of Directors in makingsuch determinations regarding the payment of dividends. There are state andfederal statutory and regulatory requirements limiting the amount of dividendsthat may be paid to the Company by our Bank. Generally, the Bank may pay cash dividends out of current operatingearnings to the extent that the current rate of earnings retention isconsistent with the Bank’s capital needs, asset quality, and overall financialcondition.  The governing regulatoryagency has the authority to prohibit the Bank from engaging in businesspractices that the governing authority considers unsafe or unsound.  It is possible, depending upon the financialcondition of the Bank, that the governing regulatory agency may determine thatthe payment of dividends to the Company by the Bank might, under somecircumstances, be such an unsafe and unsound practice.

 

Since there are no current operatingearnings, no amounts are available for the payment of dividends.  Neither the Company nor the Bank has plansto pay any cash dividends to its stockholders in the foreseeable future.

 

**REGULATORY CAPITALREQUIREMENTS**

 

The Federal Reserve Board’s capital guidelines establish the followingminimum regulatory capital requirements for bank holding companies: (i) acapital leverage requirement expressed as a percentage of total assets, (ii) arisk-based requirement expressed as a percentage of total risk-weighted assets,and (iii) a Tier 1 leverage requirement expressed as a percentage of totalassets.  Tier 1 capital consists ofcommon stockholders’ equity, qualifying preferred stock, and minority interestsin the equity accounts of consolidated subsidiaries. The failure of a bankholding company to meet its risk-weighted capital ratios may result insupervisory action, as well as an inability to obtain approval of anyregulatory applications and, potentially, increased frequency ofexamination.  The federal bankregulators have proposed changes to capital requirements for bankingorganizations. The effect of any future change in the required capital ratioscannot be determined at this time.

 

Qualifying capital consists of two types of capital components: “corecapital elements” (“Tier 1” capital) and “supplementary capital elements”(“Tier 2” capital).  Tier 1 capital isgenerally defined as the sum of core capital elements less goodwill and otherintangibles.  Core capital

 

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elements consist of (i) commonstockholders’ equity, (ii) qualifying perpetual preferred stock, subject tocertain limitations, and (iii) minority interests in the equity accounts ofconsolidated subsidiaries. Supplementary capital (“Tier 2” capital) consists of such additionalcapital elements as (i) allowance for loan and lease losses (subject tolimitations); (ii) perpetual preferred stock which does not qualify as Tier 1capital (subject to certain conditions); (iii) hybrid capital instruments,perpetual debt and mandatory convertible debt securities; and (iv) termsubordinated debt and intermediate-term preferred stock (subject to limitations).  The maximum amount of Tier 2 capital thatmay be included in qualifying total capital is limited to 100% of Tier 1capital (net of goodwill).  Undercurrent capital adequacy standards, financial institutions must meet a minimumratio of qualifying capital to risk-weighted assets of 8%.  Of that ratio, at least half, or 4%, must bein the form of Tier 1 capital.  The Bankalso must maintain an allowable leverage ratio.  The leverage ratio is defined as the ratio of Tier 1 capital toaverage total assets. See Note 17 to the consolidated financial statements forinformation regarding more stringent leverage capital requirements placed onthe Bank as a result of litigation matters.

 

As a result of the FDIC Improvement Act of 1991, the federal bank regulatoryagencies were directed to adopt regulations defining banks as “wellcapitalized,” “adequately capitalized,” “undercapitalized,” “significantlyundercapitalized” and “critically undercapitalized.”  Under the law, depending upon the bank’s classification, a bankmay be directed to prepare and implement a capital restoration plan, to beguaranteed by its parent bank holding company. Further, banks are subject to increased restrictions upon activities andheightened regulatory supervision as capital classifications decline.

 

Generally, under regulations adopted by all of the bank federalregulatory agencies, “well capitalized” has been defined as an institution witha total capital to risk-based asset ratio of 10%, a Tier 1 capital torisk-based asset ratio of 6% and a Tier 1 leverage ratio of 5%.  The regulations further provide that an“adequately capitalized” institution must have a total capital to risk-basedasset ratio of at least 8%, a Tier 1 capital to risk-based asset ratio of 4%and a Tier 1 leverage ratio of 4%. Institutions not satisfying the requirements for “adequatelycapitalized” will be deemed “undercapitalized.”  Institutions with a total capital to risk-based asset ratio of 6%or less, a Tier 1 capital to risk-based asset ratio of 3% or less, or a Tier 1leverage ratio of 3% or less will be deemed “significantlyundercapitalized.”  Finally, theregulations provide that an institution with a Tier 1 leverage ratio of lessthan 2% will be deemed “critically undercapitalized.”  Federal bank regulatory agencies, including the FDIC, areauthorized to downgrade a financial institution from one capital category tothe next if they determine the asset quality, management, earnings or liquidityof that institution warrant such downgrade. Under the regulations, as of June 30, 2003 and 2002, the Bank isclassified as “well capitalized.”

 

**AFFILIATE TRANSACTIONLIMITATIONS**

 

Financial institutions are subject to certain restrictions imposed byfederal law on any extensions of credit to, or the issuance of a guarantee orletter of credit on behalf of, the Company or other affiliates, the purchase ofor investment in stock or other securities thereof, the taking of suchsecurities as collateral for loans and the purchase of assets from the Companyor other affiliates.  Such restrictionsprevent the Company and such other affiliates from borrowing from the Bank andany other subsequently acquired bank unless the loans are secured by marketableobligations of

 

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specified amounts.  Further, such secured loans, investments andother transactions between the Bank and the Company or any other affiliate arelimited to 10% of the Bank’s capital and surplus (as defined by federalregulations) and such secured loans, investments and other transactions arelimited, in the aggregate, to 20% of the Bank’s capital and surplus (as definedby federal regulations).  Suchtransactions must also comply with regulations prohibiting terms that would bepreferential to the Company or other affiliates of the Bank.  In fiscal year 2002, the Federal Reserveissued a new Regulation W to implement federal laws governing transactionsbetween affiliates.  Regulation Wrestricts loans by a depositor institution to its affiliates, asset purchasesby a depository institution from its affiliates and other transactions betweena depository institution and its affiliates.

 

**COMMUNITYREINVESTMENT ACT**

 

Pursuant to the Community Reinvestment Act of 1977 (CRA), the federalregulatory agencies that oversee the banking industry are required to use theirauthority to encourage financial institutions to help meet the credit needs ofthe local communities in which such institutions are located, consistent withsafe and sound banking practices.

 

When conducting an examination of financial institutions, such as theBank, the agencies assess the institution’s record of meeting the credit needsof its entire community, including low- and moderate-income neighborhoods. Thisrecord is taken into account in an agency’s evaluation of an application forcreation or relocation of domestic branches or for merger with anotherinstitution. Failure to address the credit needs of a bank’s community may alsoresult in the imposition of certain other regulatory sanctions, including arequirement that corrective action be taken.

 

The federal banking agencies determine a bank’s CRA rating byevaluating its performance on lending, service, and investment tests, with thelending test as the most important. The tests are to be applied in an“assessment context” that is developed by the agency for a particularinstitution. The assessment context takes into account demographic data aboutthe community, the community’s characteristics and needs, the institution’scapacities and constraints, the institution’s product offerings and businessstrategy, the institution’s prior performance, and data on similarly situatedlenders. Since the assessment context is developed by the regulatory agencies,a particular bank will not know until it is examined whether its CRA programsand efforts have been sufficient.

 

Larger institutions are required to compile and report certain data ontheir lending activities in order to measure performance. Some of this data isalso required under other laws, such as the Equal Credit Opportunity Act. Smallinstitutions (those institutions with less than $250 million in assets) are nowbeing examined on a “streamlined assessment method.” The streamlined methodfocuses on the institution’s loan to deposit ratio, degree of local lending,record of lending to borrowers and neighborhoods of differing income levels,and record of responding to complaints. Large and small institutions have theoption of being evaluated for CRA purposes in relation to their own pre-approvedstrategic plan. Such a strategic plan must be submitted to the institution’sregulator three months before its effective date and be published for publiccomment.

 

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**CONSUMER PROTECTION**

 

Banks are subject to a variety of federal and state laws andregulations promulgated to provide consumer protection.  These laws can be grouped into three generalcategories: disclosure laws, civil rights laws, and laws designed to providesafeguards against specific abuses in the extension, collection, and reportingof consumer credit.  Examples ofdisclosure laws are the Truth in Lending Act and the Federal Reserve’sRegulation Z, the Consumer Leasing Act of 1976 and the Federal Reserve’sRegulation M, the Real Estate Settlement Procedures Act of 1974 and RegulationX of the Department of Housing and Urban Development, the Electronic FundTransfer Act and Federal Reserve Regulation E, the Expedited Funds AvailabilityAct of 1987 and Federal Reserve Regulation CC, and the Truth in Savings Act andthe Federal Reserve’s Regulation DD.

 

The second category of laws, the civil rights laws, are aimed ateliminating invidious discrimination. Under the laws, lenders are not allowed to make lending decisions on anyfactors that are unrelated to a person’s creditworthiness.  These laws include the Equal CreditOpportunity Act and the Federal Reserve’s Regulation B, the Fair Housing Act of1968, the Home Mortgage Disclosure Act of 1975 and the Federal Reserve’sRegulation C, and the Community Reinvestment Act of 1977 discussed above.

 

The third category of laws addresses problems that arise in particularaspects of credit transactions.  Theselaws include the Fair Credit Reporting Act of 1970, the Fair Debt CollectionPractices Act of 1977, the Right to Financial Privacy Act of 1978, and theNational Flood Insurance Act.

 

In addition to federal consumer protection laws, Company and Bank aresubject to state consumer laws that govern interest rates, advertising, andtrade practices.

 

**FINANCIAL PRIVACY**

 

Significant consumer legislation was passed by Congress in 1999 as partof the Gramm-Leach-Bliley Act (“GLBA”). Title V of GLBA contains new privacy requirements.  Under GLBA and regulations implemented bythe federal banking regulators, a financial institution must (i) provideconsumers and customers with a notice of the financial institution’s privacypolicies and practices; (ii) provide customers, during the continuation of acustomer relationship, with an annual privacy notice; and (iii) provideconsumers and customers with an opportunity to opt-out of having theirnonpublic personal financial information shared with nonaffiliated thirdparties if disclosure does not fit within one of the exceptions contained inthe law.

 

**USA PATRIOT ACT**

 

The terrorist attacks in September, 2001 impacted the financialservices industry and led to the Uniting and Strengthening America by ProvidingAppropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the“USA PATRIOT Act”).

 

The USA PATRIOT Act authorizes the Secretary of the Treasury, inconsultation with the heads of other government agencies, to adopt specialmeasures applicable to banks, bank holding

 

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companies, and/or otherfinancial institutions. These measures may include enhanced record keeping andreporting requirements for certain financial transactions that are of primarymoney laundering concern, due diligence requirements concerning the beneficialownership of certain types of accounts, and restrictions or prohibitions oncertain types of accounts with foreign financial institutions.

 

Among its other provisions, USA PATRIOT Act requires each financialinstitution to: (i) establish an anti-money laundering program; (ii) establishdue diligence policies, procedures and controls with respect to its privatebanking accounts and correspondent banking accounts involving foreignindividuals and certain foreign banks; and (iii) avoid establishing,maintaining, administering, or managing correspondent accounts in the UnitedStates for, or on behalf of, a foreign bank that does not have a physicalpresence in any country. In addition, USA PATRIOT Act contains a provisionencouraging cooperation among financial institutions, regulatory authoritiesand law enforcement authorities with respect to individuals, entities andorganizations engaged in, or reasonably suspected of engaging in, terroristacts or money laundering activities. USA Patriot Act expands the circumstancesunder which funds in a bank account may be forfeited and requires coveredfinancial institutions to respond under certain circumstances to requests forinformation from federal banking agencies within 120 hours. USA PATRIOT Actalso amends the Bank Holding Company Act and the Bank Merger Act to require thefederal banking agencies to consider the effectiveness of a financialinstitution’s anti-money laundering activities when reviewing an applicationunder these acts.

 

A number of the USA PATRIOT Act provisions became effective October 26,2001. Additional regulations were adopted during 2002 and 2003 to implementminimum standards to verify customer identity, to encourage cooperation amongfinancial institutions, federal banking agencies, and law enforcement authoritiesregarding possible money laundering or terrorist activities, to prohibit theanonymous use of “concentration accounts,” and to require all covered financialinstitutions to have in place a Bank Secrecy Act compliance program.

 

The Company has established policies and procedures to ensurecompliance with the USA PATRIOT Act. As of the date of this filing, the Companydoes not believe that USA PATRIOT Act will have a significant adverse impact onthe Company’s operations.

 

**SARBANES-OXLEY**

 

The Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley”) implementedlegislative reforms intended to address corporate and accounting fraud. Inaddition to the establishment of a new accounting oversight board that willenforce auditing, quality control and independence standards and will be fundedby fees from all publicly traded companies, Sarbanes-Oxley places certainrestrictions on the scope of services that may be provided by accounting firmsto their public company audit clients. Any non-audit services being provided toa public company audit client will require pre-approval by the company’s auditcommittee. In addition, Sarbanes-Oxley makes certain changes to therequirements for accounting firm partner rotation after a period of time.Sarbanes-Oxley requires chief executive officers and chief financial officers,or their equivalent, to certify to the accuracy of periodic reports filed withthe SEC, subject to civil and criminal penalties if they knowingly or willinglyviolate the certification requirement. In addition, under Sarbanes-Oxley,

 

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counsel are required to reportevidence of a material violation of the securities laws or a breach offiduciary duty by a company to its chief executive officer or its chief legalofficer, and, if such officer does not appropriately respond, to report suchevidence to the audit committee or other similar committee of the board ofdirectors or to the board itself.

 

Under Sarbanes-Oxley, longer prison terms will apply to corporate executiveswho violate federal securities laws; the period during which certain types ofsuits can be brought against a company or its officers is extended; and bonusesissued to top executives prior to restatement of a company’s financialstatements are subject to disgorgement if the restatement was due to corporatemisconduct. Executives are also prohibited from insider trading duringretirement plan “blackout” periods, and loans to company executives (other thanloans by financial institutions permitted by federal rules and regulations) arerestricted. In addition, a provision directs that civil penalties levied by theSEC as a result of any judicial or administrative action under Sarbanes-Oxleybe deposited to a fund for the benefit of harmed investors. The legislationaccelerates the time frame for disclosures by public companies, as they mustimmediately disclose any material changes in their financial condition oroperations. Directors and executive officers must also provide information formost changes in ownership in a company’s securities generally within twobusiness days of the change.

 

Sarbanes-Oxley also increases responsibilities and codifies certainrequirements relating to audit committees of public companies and how theyinteract with the company’s “registered public accounting firm.” AuditCommittee members must be independent and are absolutely barred from acceptingconsulting, advisory or other compensatory fees from the issuer. In addition,companies must disclose whether at least one member of the committee is a“financial expert” (as defined by the SEC) and if not, why not. A company’spublic accounting firm is prohibited from performing audit services for thecompany if the company’s chief executive officer, chief financial officer, comptroller,chief accounting officer or any person serving in equivalent positions had beenemployed by the auditor and participated in the company’s audit during the yearpreceding the audit initiation date. Sarbanes-Oxley also prohibits any officeror director of a company or any other person acting under their direction fromtaking any action to fraudulently influence, coerce, manipulate or mislead anyindependent accountant engaged in the audit of the company’s financialstatements for the purpose of rendering the financial statements materiallymisleading. Sarbanes-Oxley requires the SEC to prescribe rules requiringinclusion of any internal control report and assessment by management in theannual report to stockholders. Sarbanes-Oxley also requires the publicaccounting firm that issues a company’s audit report to attest to and report onmanagement’s assessment of the company’s internal controls.

 

Although the Company anticipates that it will incur additional expensein complying with the provisions of Sarbanes-Oxley, management does not expectthat compliance will have a material impact on the Company’s financialcondition or results of operations.

 

**ITEM 2.****                             DESCRIPTIONOF PROPERTY**

 

The Company and Bank’s office is located at 1650 Madison Avenue,Mankato, Minnesota.  The Bank hasentered into a 10-year lease agreement with Colonial Square Partners, Inc. tolease approximately 5,000 square feet. Dean Doyscher, a director and principal shareholder of the Company was,but no longer is, a partner of Colonial Square Partners, Inc.  Pursuant to the lease

 

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agreement, the Bank paysmonthly rent of approximately $6,042 during the first three years of the lease,$6,250 a month for the next three years and $6,458 per month for the last fouryears of the lease term.  The Bankcurrently pays monthly rent of $6,384 a month. The Bank has the option to extend the lease term for two consecutivefive-year periods with a right of first refusal on any additional space that becomesavailable.  The Bank’s office includes ateller line with three tellers, two platform positions, two drive-throughlanes, an ATM drive-through lane and executive and administrative offices.

 

The Bank also maintains a banking facility that is located at 300 EastSt. Germain Street in St. Cloud, Minnesota. On March 7, 2001 the Bank has entered into a 10-year lease agreementwith Five Star Properties of St. Cloud, LLC to rent approximately 3,100 squarefeet.  James H. Illies, a director ofthe Company and Bank, is an owner of Five Star Properties of St. Cloud,LLC.  Pursuant to the lease agreement,the Bank pays monthly rent of approximately $4,801 month.  Rents are scheduled to escalate at the rateof $1.00 per square foot annually during the next three years.  Under the terms of the lease the Bank willpay $20.00 per square foot during years six through ten.  The Bank has the option to extend the leaseterm for one consecutive five-year period with a right of first refusal on anyadditional space that becomes available. The Bank’s office includes a teller line with three tellers, twoplatform positions, two drive-through lanes, an ATM drive-through lane andexecutive and administrative offices.

 

Under the terms of both of the above referenced leases, the landlordpays building insurance, taxes, assessments and all utilities excepttelephone.  Real estate tax increasesover the base year of the lease are to be pro-rated based upon square footage.  These facilities are in good condition andmeet our current needs.

 

**ITEM 3.****                             LEGALPROCEEDINGS**

 

The Bank was a defendant in a complaint filed on February 23, 2002in United States District Court, District of South Dakota Southern Division byBridge Lenders, LLC; Jim Perry; Larry Ticknor; Doug English; Rollyn H. Samp;Courtney Anderson; Henry Carlson, Jr.; Michael M. Samp; Ernest Olson; DonDavis; Jerry Landerville; Allen Lewis; Gary Viger; Glen Jamtgaard and SteveHerman (“Plaintiffs”).  The complaintarose out of a series of loans that the Bank made to Plaintiffs in 2000.  Plaintiffs used the proceeds of the loans tomake an investment in Bridge Lenders, LLC, and Bridge Lenders, LLC in turn usedthe funds to make an investment in Phenix Biocomposites, which has defaulted inits obligations to Plaintiffs.  The Bankwas a defendant in this action due to the fact that its former director, FrankGazzola, was also a director of Phenix Biocomposites.  The Plaintiffs alleged that Mr. Gazzola failed to inform thePlaintiffs that their investment in Phenix Biocomposites was not secured.  The Plaintiffs claim that the Bank had afiduciary duty to the Plaintiffs because of Mr. Gazzola’s dual role as adirector of both the Bank and Phenix Biocomposites, that the Bank violated thisfiduciary duty and a separate implied covenant of good faith and fair dealingwhen Mr. Gazzola allegedly provided false information to Plaintiffs, and thatthe false information allegedly provided by Mr. Gazzola constituted intentionalor unintentional fraud by the Bank. Plaintiffs seek compensatory, general, special and punitivedamages.  The Bank denied thePlaintiffs’ allegations and brought a motion to dismiss all claims for lack ofpersonal jurisdiction. On July 22, 2003, the court dismissed the complaint basedupon the failure of the plaintiffs to enjoin Mr. Gazzola.  On July 28, 2003, the Bank initiated legalaction in the Blue Earth

 

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county court of the State ofMinnesota to compel payment on the notes. On July 29, 2003, the Plaintiffs filed a revised complaint in UnitedStates District Court, District of Minnesota, re-asserting their earlierallegations.  The Bank denies thePlaintiffs’ allegations and intends to vigorously defend itself in this actionwhile seeking repayment of its loans.

 

The Companywas a defendant and third party plaintiff in a complaint originally filed onMarch 22, 2002 in the United States District Court for the WesternDistrict of Wisconsin by Catalytic Combustion Corporation 401(k) Profit SharingPlan and Catalytic Combustion Corporation (“Plaintiffs”).  On March 31, 2003, the Company, the thirdparty defendant, and the plaintiffs entered into a confidential final andbinding mutual release of all claims and settlement agreement.  All expenses incurred in connection with thesettlement have been expensed in the amount of $22,000.

 

During 1999 and 2000, the Bank made a series of loans to Frank Gazzola,then a Director of the Company, in various amounts at market rates of interestand for terms of various lengths of time. Mr. Gazzola defaulted on the loansand the Bank foreclosed on the collateral for the loans. The bankruptcy courtclaimed that since certain of the collateral was conveyed to the Bank withinone year of Gazzola’s bankruptcy filing and since he was an insider, they werepreferential transfers and must be reversed. On June 12, 2003, in an out of court settlement, the court approved asettlement agreement where-in the Bank agreed to pay the bankruptcy court asettlement fee for which the Bank retained a claim against the unsecured assetsof Mr. Gazzola’s bankruptcy estate and a release by the court of all claims tothe collateral held by the Bank.  Allexpenses incurred in connection with the settlement have been expensed in theamount of $144,400.

 

**ITEM 4.****                             SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

** **

There were nomatters submitted to a vote of stockholders of the Company during the fourthquarter of fiscal year 2003.

 

**PART II**

 

**ITEM 5.****                             MARKETFOR COMMON EQUITY****AND RELATED STOCKHOLDER MATTERS**

 

Our common stock has been quoted on the OTC Bulletin Board under thesymbol “NSBK” since February 2, 1999. Quotations in the following table represent inter-dealer prices, withoutretail markup, markdown or commission, and do not necessarily represent actualtransactions.

 
|                     |   | **Common  Stock** |   |
|--------------------------|--------|-------------------|--------|
| **Fiscal Quarter Ended** |   | **High Bid**      |   | **Low Bid** |   |
|                     |   |              |   |   |   |
| September 30, 2001       |   | 6.00              |   | 6.00 |   |
| December 31, 2001        |   | 3.00              |   | 3.00 |   |
| March 31, 2002           |   | 6.75              |   | 6.75 |   |
| June 30, 2002            |   | 5.75              |   | 5.75 |   |
| September 30, 2002       |   | 7.25              |   | 6.50 |   |
| December 31, 2002        |   | 6.50              |   | 5.75 |   |
| March 31, 2003           |   | 7.00              |   | 4.75 |   |
| June 30, 2003            |   | 6.50              |   | 4.75 |   |
|                          |        |                   |        |  |  |  |

 

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At July 30, 2003, the last sale price for the Company’s common stockwas $4.90 per share.  At June 30, 2003,there were issued and outstanding 519,506 shares of common stock of the Companyheld by 55 stockholders of record. Record ownership includes ownership by nominees who may hold formultiple owners.

 

The Company has paid no dividends on its common stock and does not anticipatepaying any such dividends in the foreseeable future.

 

In the fourth quarter of fiscal year 2003, the Company sold $100,000 ofunsecured convertible subordinated notes to an accredited investor.  The note bears an interest rate of 7.0% perannum and is convertible into common stock of the Company at the rate of $9.00per share.  In connection with the saleof the note the Company relied on the exemption from registration provided bySection 4(2) of the Securities Act of 1933. The investor has taken the note for investment purposes, and the notescontain a restrictive securities legend.

 

Generally, the Bank may pay cash dividends out of current operatingearnings or retained earnings to the extent that the current rate of earningsretention is consistent with the Bank’s capital needs, asset quality, andoverall financial condition.  Thegoverning regulatory agency has the authority to prohibit the Bank fromengaging in business practices that the governing authority considers unsafe orunsound.  It is possible, depending uponthe financial condition of the Bank, that the governing regulatory agency maydetermine that the payment of dividends to the Company by the Bank might, undersome circumstances, be such an unsafe and unsound practice.

 

**ITEM 6.****                             MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.**

 

This section presents management’s review of the operating results andfinancial condition of Northern Star Financial, Inc. (the “Company”) and itssubsidiary, Northern Star Bank (the “Bank”). This section provides informationwhich management believes may not be otherwise apparent from the ConsolidatedStatements of Financial Condition, Operations, Stockholders’ Equity and CashFlows and is intended to assist readers in understanding the Company’sperformance and financial condition.

 

**THIS ANNUAL REPORT ONFORM 10-KSB CONTAINS FORWARD-LOOKING INFORMATION AND ACTUAL RESULTS MAY DIFFER**

 

Statements that Northern Star Financial may publish, including those inthis Annual Report on Form 10-KSB that are not strictly historical are “forwardlooking” statements made under the safe harbor provisions of the PrivateSecurities Litigation Reform Act of 1995. These include statements about the Company’s plans, objectives,expectations and intentions that are not historical facts. When used in thisAnnual Report, the words “expects”, “anticipates”, “plans”, “believes”,“seeks”, “estimates”, and similar expressions are generally intended toidentify forward-looking

 

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statements.  Statements made in this Annual Reportregarding the Company’s beliefs and expectations that (i) it expects to be ableto maintain or slightly improve its net interest margin in a declining rateenvironment; (ii) loan demand is expected to remain satisfactory in the nearfuture with any growth a function of local and national economic conditions;(iii) the present loan allowance is adequate; (iv) the Company maintainsoverall liquidity sufficient to satisfy its depositors’ requirements and meetits customers’ credit needs; and (v) it expects a decrease in the overall costof money during fiscal 2004 are “forward looking” statements which involveknown and unknown risks and uncertainties that may cause the actual results todiffer materially from those expected and stated in this announcement.  Actual results could differ as a result of:(i) a further slowdown of economic growth in the United States, particularly inthe Company’s market areas; (ii) an increase in loan defaults; (iii) changes inconsumer behavior resulting from the September 11, 2001 attack on the UnitedStates and changes in federal and state laws; (iv) increased competitions fromother financial and non-financial institutions; (v) the failure of the Companyto successfully implement its growth strategy; and (vi) costs and expensesincurred in defending the Company and Bank in connection with pendinglitigation and payment of damages and settlement costs associated with suchlitigation.

 

**BUSINESS**

 

We are a bank holding company. Our subsidiary, Northern Star Bank, is a state-chartered commercial bankproviding a broad range of commercial and retail banking services designed tomeet the borrowing and depository needs of small and mid-sized businesses and consumersin the Cities of Mankato and St. Cloud as well as the counties of Blue Earth,Nicollet, LeSueur, Benton, Stearns and Sherburne.  We offer a full range of lending services including commercial,real estate and consumer loans. Unless indicated otherwise the results ofoperation of the Company include the results of operation of the Bank.

 

Our principal business consists of attracting deposits from the generalpublic and using these deposits, together with borrowings and other funds, tooriginate commercial, commercial real estate, residential, agricultural,automobile and other consumer loans.  Wealso originate construction loans and invest in securities.  Our results of operations are primarilydependent on our interest rate spread, which is the difference (“spread”)between the average yield on interest-earning assets, such as loans, andinvestment securities and short-term interest bearing deposits and the averagerate paid on interest-bearing liabilities, such as deposits and borrowings. Thespread is affected by regulatory, economic and competitive factors thatinfluence interest rates, loan demand and deposit flows. In addition to creditrisk, we are subject to interest rate risk to the degree that ourinterest-earning assets mature or re-price at different times, or on adifferent basis, than our interest-bearing liabilities.

 

Our results of operations also depend upon, among other things, thelevel of fee income, gains or losses on the sale of loans and other assets,provisions for possible loan losses, income derived from subsidiary andinvestment activities, operating expenses and income taxes.  Our operating expenses principally consistof employee compensation and benefits, occupancy expenses, federal depositinsurance premiums and other general and administrative expenses.

 

We are affected by prevailing economic conditions, including federalmonetary and fiscal policies, as well as by federal regulation of financialinstitutions. Deposit balances are influenced by

 

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a number of factors, includinginterest rates paid on competing personal investments and the level of personalincome and savings within the institution’s market area. In addition, depositbalances are influenced by the perceptions of customers regarding the stabilityof the financial markets and financial services industry.  We expect to retain a significant portion ofexisting deposit balances by offering competitive rates on such deposits.  We have adopted a strategy of employingFederal Home Loan Bank (FHLB) advances to supplement deposits. FHLB advancesare expected to augment the liquidity necessary to fund lending operations andinvestment opportunities. Lending activities are influenced by demand forhousing, consumer and commercial loans as well as competition from otherlending institutions. The primary sources of funds for lending activitiesinclude deposits, loan payments, borrowings, the sale of loans and other assetsand funds provided from operations.

 

**RESULTS OF OPERATIONS**

 

**Net Income (Loss)**

The Company’s net operating loss totaled $232,816 for the fiscal yearended June 30, 2003, resulting in an improvement of $855,500 over the$1,088,316 net operating loss of the prior fiscal year ended June 30,2002.  The basic loss per share infiscal year 2003 was $0.47, compared to a basic loss of $2.27 and $0.21 in 2002and 2001, respectively.  The net lossesincurred during the fiscal year included $144,400 in settlement expensesincurred in connection with the litigation associated with the Gazzolabankruptcy (see Item 3. Legal Proceedings). The net losses incurred during the fiscal year 2003 also included a$373,937 addition to the Bank’s reserve for loan losses.

 

During fiscal year 2003, the Company experienced increases in bothearning assets and deposits. As a result of an increase in interest income of$137,517 and a decrease of $378,686 in interest expense, the Company realizedan increase in net interest income of $516,203 as compared to $109,923 in 2002.This represents an increase of $403,280 or 367%.  The yield on interest earningassets decreased to 6.42% for the fiscal year ended June 30, 2003 compared to6.62% on interest earning assets for the fiscal year ended June 30, 2002.

 

We maintain an allowance for loan losses that is intended to absorbinherent losses in the loan portfolio. Loans are charged against the allowance when management believescollection of the principal is unlikely. Management is continually analyzing its loan portfolio in an effort torecognize and resolve its problem assets as quickly and efficiently aspossible.  As a result of an evaluationof the existing loans in our loan portfolio as well as the addition of newloans to the portfolio, the Company made provisions for loan losses of $373,937during fiscal year 2003.

 

The Bank was successful in collecting interest totaling $12,687 on aloan that had previously been written off. Interest forgone on non-accrual loans amounted to $74,936 during fiscalyear 2003 compared to $70,894 during fiscal year 2002.

 

During the fiscal year ended June 30, 2003, the Bank’s loan portfolioincluding loans held for sale increased 18.64%.  The lower interest rate environment during fiscal year 2003, whencompared to fiscal year 2002 resulted in a reduction in the Bank’s interestincome, as shown in the rate column of the Rate/Volume Analysis table.

 

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The lower interest rate environment during fiscal year 2003, ascompared to fiscal year 2002, also resulted in a decrease in the Company’stotal interest expense. The reduction in interest expense occurred primarily asa result of a decrease in the overall interest rate paid for deposits which waspartially offset by an increase in total deposits.

 

Non-interest income totaled $1,087,177 for the year ending June 30,2003 representing an increase of $639,712, or 142.96% over the prior year. Theincrease resulted primarily from gains on the sale of investment securities andloans, increased other fees and service charge revenue, which resulted from theincrease in total deposits, increased mortgage lending activity arising out ofrefinancing activity associated with the comparatively low interest rateenvironment. Total non-interest expense increased $711,553, or 42.19% from$1,686,506 in 2002 to $2,398,059 during 2003 primarily as a result of thelitigation settlement expenses, pay increases for existing staff as well asadditions to our staff and to overall increases in the cost of operationsassociated with an increase in the number of deposit and loan accounts.

 

**Net Interest Income**

Net interest income increased $516,203, or 55.16% to $1,452,003 in 2003after increasing 13.31% in 2002. While the yield on average earning assetsdeclined to 6.42% in 2003 as compared to 6.62% in 2002, the cost of funds foraverage earning assets also decreased to 3.34% in 2003 from 4.71% in 2002. Theamount of the increase in net interest income in 2003 is attributable to anincrease of 8.30% in average earning assets, which was offset, by an 11.32%increase in average interest bearing liabilities.  The Bank’s interest rate spread improved to 3.08% from 1.91% atJune 30, 2003 and 2002, respectively. The Bank’s net interest margin increased from 2.26% during fiscal year2002 to 3.24% and during fiscal year 2003.

 

The Bank’s net interest margin increased 98 basis points during fiscalyear 2003 after decreasing 46 basis points in fiscal year 2002. This increasein 2003 was the result of several key items:

 

•      Interestforgone on nonaccrual loans during fiscal year 2003 totaled $74,936 as comparedto $70,894 during fiscal year 2002. This was a $4,042 deterioration year to year and reduced the yield onloans by 21 basis points and the net interest margin by 16 basis points.

 

•      Interestcollected on loans that had previously been charged off or on nonaccrual statustotaled $12,687.

 

•      Changes in themix of the investment portfolio during fiscal year 2003 resulted in a decreaseof 92 basis points in the average yield earned on investments securities.

 

•      The generaldecrease in the interest rate environment during 2003 resulted in a decrease of142 basis points in the average yield earned on federal funds sold.

 

•      The decreasein interest rates during 2003 also resulted in a decrease of 153 basis pointsin the cost of average certificates of deposit.

 

•      During fiscalyear 2002, the Company adopted provisions to its lending policies establishinga floor rate of interest for new and renewing loans.

 

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During fiscal year 2003, average loans increased $6.70 million, or22.68%, while investment securities decreased $3.44 million, or 34.87%,compared to fiscal year end 2002. Average interest bearing deposits increased$3.13 million, or 9.56% during 2003 and other borrowings increased $1.21million, primarily as a result of a $700,000 increase in Federal Home Loan Bankadvances and a $200,000 increase in the amount of convertible subordinatednotes issued and outstanding.

 

Net interest income increased $109,923 or 13.31% during fiscal year2002 after increasing 32.35% during fiscal year 2001. The increase in fiscalyear 2002 is attributable to an increase of 36.34% in average interest earningassets combined with a 32.74% increase in average interest bearing deposits. Inaddition, during fiscal year 2002, the Company adopted provisions to itslending policies establishing a floor rate of interest for new and renewingloans.

 

The mix of earning assets at June 30, 2002 changed as compared to June30, 2001 as a result of year-over-year loan growth of 41.98% during fiscal year2002 as compared to 43.14% in fiscal year 2001.  Average interest bearing deposits increased  $8.08 million, or 32.74%.

 

Net interest margin decreased 46 basis points in 2002 after decreasing by167 basis points in 2001. This improvement in 2002 was the result of severalkey items:

 

•      Interestforgone on nonaccrual loans during 2002 totaled $70,894. This reduced the yieldon loans by 24 basis points and the net interest margin by 17 basis points.

 

•      No interestwas collected on loans that had previously been on nonaccrual status.

 

•      The generaldecrease in interest rates during 2002 resulted in a decrease of 260 basispoints in the average yield earned on federal funds sold.

 

•      The decreasein interest rates during 2002 also resulted in a decrease of 139 basis pointsin the average cost of certificates of deposit.

 

The volume variances for total interest income in 2003 compared to 2002was comprised of an increase in average loans of 22.68% together with decreasesin average investment securities and federal funds sold of 27.35%, combined fora net increase in interest income of $138,000. The continued decline of theinterest rate environment offset by an increase in demand during fiscal year 2003increased interest income $138,000, as compared to the prior year, with$173,000 of the decrease resulting from a 20 basis point decline in the yieldearned on loans; a $252,000 decrease resulting from a 92 basis points declinein the yield earned on investment securities and a $27,000 decrease resultingfrom a 142 basis points decline in the yield earned on federal funds sold.  While average interest bearing liabilitiesincreased 11.32% during 2003, the average rate paid on interest bearingliabilities declined 137 basis points resulting in a net decrease in totalinterest expense of $378,000.

 

**Provision for LoanLosses**

The provisionfor loan losses decreased $411,138 or 52.37% to $373,937 during the fiscal yearended June 30, 2003 as compared to $785,075 for the fiscal year endedJune 30, 2002.  The decrease in theprovision for loan losses is primarily in response to the decrease in loangrowth during fiscal year 2003 as compared to fiscal year 2002 and to theresolution of the litigation associated with the Gazzola bankruptcy.

 

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During fiscalyear 2002, the Bank made a $204,095 provision for loan losses associated withthe Bank’s loans to Mr. Gazzola and an additional provision of $406,775associated with our assessment of the risk of loss inherent in the loanssubject to litigation (see Item 3. Legal Proceedings).

 

During fiscalyear 2003, the Bank made a $287,114 provision for loan losses associated withthe risk of loss inherent in one commercial loan with an outstanding balance ofapproximately $600,000. The Bank does not have any other credits associatedwith the related industry and type of loan and, as a result, management doesnot believe the deterioration in this credit represents an adverse trend in thequality of our loan portfolio.

 

The provisionfor loan losses represents the current period expense associated withmaintaining an appropriate allowance for credit losses. The provision for loanlosses and level of allowance for each period is dependent upon many factors,including loan growth, net charge-offs, changes in the composition of the loanportfolio, delinquencies, management’s assessment of the quality of the loanportfolio, the valuation of problem loans and the general economic conditionsin the Bank’s market area. Periodic fluctuations in the provision for loanlosses result from management’s assessment of the adequacy of the allowance forloan losses; however, actual loan losses may vary from current estimates.

 

Netcharge-offs during 2003 totaled $5,526 and represents a decrease of $353,368,or 98.5% over 2002.  During 2002, theBank charged off $282,874 of principal and prior period interest in connectionwith the loans subject to the litigation noted above.  The Bank has not modified or significantly changed itsunderwriting standards or estimation methods and assumptions affecting theallowance for loan losses.

 

**Non-Interest Income**

Non-interest income increased 142.96% and 71.33% in 2003 and 2002,respectively. The primary components of noninterest income consist of: servicecharges, gain on sale of loans, and other noninterest income.

 

Other fees and service charge revenue increased 61.36% in 2003 comparedto 2002 and 47.17% in 2002 compared to 2001. These increases are primarily theresult of continued growth in demand deposits. While average total depositsincreased 13.95% in 2003 and 35.43% in 2002, average noninterest-bearing demanddeposits increased 73.98% and 78.74% and NOW and money market accountsincreased 11.73% during 2003 as compared to 2002.

 

The Company experienced increased mortgage lending activity for bothnew loans and refinancing of existing loans due to the continued decline inmortgage lending rates during 2003. The increased lending activity resulted inan increase in the Company’s gain on sale of loans totaling $616,102, or246.96% from 2002 to 2003 and $131,912, or 112.20% in 2002 as compared to 2001.

 

The Company realized gains on the sale of investment securitiestotaling $3,504 and $62,827 in 2003 and 2002, respectively.

 

**Non-Interest Expenses**

Non-interest expenses increased 42.19% in 2003 compared to 2002 and52.58% in 2002

 

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compared to 2001. The increasein non-interest expense during 2003 was primarily a result of litigationsettlement expenses, increases in the number of full-time equivalent employees,and the cost of employee benefits, marketing and occupancy expenditures. During2003, the Company experienced increases in salaries and employee benefits as aresult of increases in the number of full time equivalent employees combinedwith increases in the salaries of officers and employees.  In addition, during 2003, the Companyincurred $167,078 of expenses associated with the litigation arising out of thepersonal business affairs of former director Gazzola.

 

Noninterest expense is broken down into four primary categories each ofwhich is discussed in this section.

 

***Salaries and Employee Benefits***

 

The number of full-time equivalent employees increased to 17 in 2003compared to 15 in 2002 and 14 in 2001. Total salaries and benefits expenseincreased 28.84% in 2003 compared to 2002 and 64.25% in 2002 compared to 2001.The average total payroll and benefits per full-time equivalent employeeincreased 13.68% in 2003 compared to 2002 and increased 61.38% in 2002 comparedto 2001. The increase in fiscal year 2002 was a result of opening a branch inSt. Cloud, MN.

 

Incentive compensation includes compensation in the form of bonusawards to employees under the Incentive Compensation Plan and matchingcontributions to the Simple Individual Retirement Account Plan. The IncentiveCompensation Plan pays incentive compensation to officers and employees basedupon the achievement of specific performance goals within their area ofresponsibility combined with the achievement of company-wide performance goals.Matching contributions to the employee Simple Individual Retirement AccountPlan are made at the rate of 2% of the employee’s base compensation.

 

***Occupancy Expense***

 

Occupancy expenses increased 15.90% in 2003 compared to 2002 and169.11% in 2002 compared to 2001. The primary reasons for the increases in 2003and 2002 are the expansion to St. Cloud and general increases in themaintenance of the Mankato and St. Cloud Office.

 

***Other Non-interest Expense***

 

Other non-interest expense increased 28.21% in 2003 as compared to 2002and increased 37.81% in 2002 compared to 2001.

 

Third party data processing increased 40.71% during 2003. As a resultof an increase in fees paid to a third party data processing service providers.As of June 30, 2003, third party data processing expenses increased $44,277,compared to 2002. Professional fees increased 350.25% during 2003 as a resultof expenses related to on-going litigation, utilizing a third party firm toexpand the internal audit function, and utilization of a third party humanresource service provider.

 

During 2003, the Company expensed $101,500 for director fees. There wasan increase of 11.23% in director fees when compared to 2002. The increase isattributable to an increase in the

 

23

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total number of outsidedirectors.

 

During 2003, the Company expensed $236,884 in costs associated with theresolution of non-performing loans. Included in these costs are amounts paidfor legal representation, security and other asset preservation expenses. Thesecurity and other property maintenance expenses were incurred by the Companyin order to protect and preserve the quality of assets pledged as collateralfor the non-performing loans.

 

***Income Taxes***

 

The effective income tax rate for the Company was 0% for the fiscalyear ended June 30, 2003 and 2002 because the tax benefit of the net operatingloss is reduced by a deferred tax asset valuation allowance in accordance withgenerally accepted accounting principles. The Company’s deferred tax assets have been reduced by a valuationaccount due to the uncertainty of the Company’s ability to make use of the underlyingnet operating loss carry forwards.

 

**FINANCIAL CONDITIONAS OF JUNE 30, 2003**

 

Average total assets increased 12.72% in 2003 compared to 2002 and37.22% in 2002 as compared to 2001. Year-end asset at June 30, 2003 reached$51.3 million and represented an increase of 5.52% over June 30, 2002. Theincrease in 2003 and 2002 is a function of deposit growth in both the Mankatoand St Cloud markets, as average deposits increased 13.95% and 35.43%,respectively.

 

During 2003, average gross loans increased 22.68%. This increase wasfunded by the growth in deposits combined with a 34.87% reduction in investmentsecurities and 8.92% increase in federal funds sold.

 

Average non-interest earning assets at June 30, 2003 and 2002 increased93.64% and 55.53% as compared to June 30, 2002 and 2001, respectively. Theincrease in average non-interest earning assets is attributable to the increasein loans held for sale.

 

**Investment Securities**

The available for sale investment portfolio decreased $3.49 million or36.31%, at June 30, 2003 as compared to June 30, 2002 and decreased $25,442, or0.26%, at June 30, 2002 as compared to June 30, 2001. The decrease in theinvestment portfolio during 2003 and 2002 occurred as a result of cash requiredto fund the loan grown not obtained by deposit growth.  The funds obtained through the sale ofinvestments funded this loan growth. During 2003 and 2002, proceeds received from sale and prepaymentsinvestment securities totaled $5.97 million and $14.26 million, respectively,and proceeds from the maturity of investment securities totaled $1.76 millionand $1.59 million, respectively. Proceeds from the sale of investmentsecurities resulted in gains totaling $3,504 and $62,827 for the years endedJune 30, 2003 and 2002, respectively.

 

**Loans**

Gross loans outstanding as of June 30, 2003 and 2002 exceeded thecomparable prior year-end totals by 15.90% and 43.53%, respectively. Thereduced interest rate environment combined with increased business developmentefforts were the foundation for the growth in both years. The

 

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entry into the St Cloud marketarea in August 2001 substantially enhanced the bank’s loan generatingcapabilities.

 

The most significant segment of the loan portfolio is multi-family andcommercial real estate loans, which represented 46.52% and 38.86% of the totalportfolio at June 30, 2003 and 2002, respectively. Commercial and agriculturalloans represent 17.55% and 19.28% of our loan receivables as of June 30, 2003and 2002 respectively.  Loans made toindividual consumers represented 24.69% and 34.41% of our loan portfolio as ofJune 30, 2003 and 2002, respectively.

 

Loans maturing after one year are approximately 69.02% of the loanportfolio and have a fixed rate of interest as of June 30, 2003, while approximately82.35% of the portfolio matures within five years.

 

**Deposits**

Average deposits increased approximately 13.95% and 35.43% in 2003 and2002, respectively. Due to a decreasing interest rate environment during 2003and 2002, the average rate decreased 144 basis points and 150 basis points whencomparing 2003 to 2002 and 2002 to 2001, respectively. Account growth at boththe Mankato and St. Cloud banking facilities resulted in the deposit growth in2003 and 2002. The growth was the result of business development efforts in thelending area as well as a continued influx of bank customers seeking a higherlevel of customer service than that experienced at major financialinstitutions. Certificates of deposit contain regular and individual retirementaccount balances. Certificates of $100,000 or more represent approximately21.93% and 18.19% of the certificate of deposit portfolio at June 30, 2003 and2002, respectively.

 

**Short Term Borrowings**

The Bank has a line of credit with a correspondent bank totaling $600,000at June 30, 2003 and 2002. The current interest rate on this note is prime +1.00%, with a maturity date of March 31, 2004, interest due quarterly.

 

**Asset Quality**

The Company’s nonaccrual policy is discussed in Note 1 to theconsolidated financial statements. Interest income recorded on these nonaccrualloans was approximately $153,578 and $201,158 in 2003 and 2002, respectively. Interest income foregone orreversed on these loans was approximately $74,936 and $70,894 in 2003 and 2002,respectively.

 

Non-performing loans increased $45,815 or 2.52%, in 2003. Portfoliodelinquency decreased to 5.36% in 2003 from 6.06% in 2002, from 1.27% and .05%in 2001 and 2000, respectively. The dollar amount of the allowance for loanlosses increased $368,411 during 2003 and increased $426,181 during 2002. Thereasons for the decrease in the provision for loan losses in 2003 as comparedto 2002 is explained in the “Provision for Loan Losses” section above.

 

When a loan becomes impaired as a result of adeterioration in credit quality to the extent that the bank no longer hasreasonable assurance of timely collection of the full amount of principal andinterest, the carrying value of the loan is reduced. The reduction in thecarrying amount is recognized as a charge to earnings in the period in whichimpairment is identified.

 

25

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When a loan has been identified as impairedits carrying value is reduced to its estimated realizable value.  When estimating the realizable value thebank considers: 1) the fair value of the collateral after holding and sellingcosts, 2) the value the bank would receive if the loan were sold, and 3) thepresent value of the discounted expected cash flow the bank will receive forthe remaining life of the loan.

 

The Bank has established a methodology forthe determination of provisions for loan losses.  The methodology is setforth in a formal policy and takes into consideration the need for an overallallowance for loan losses as well as specific allowances that are tied toindividual loans.  The Bank’s methodology for assessing theappropriateness of the allowance consists of several key elements, whichinclude the formula allowance and a specific allowance for identified problemloans.

 

In originating loans, the Bank recognizesthat losses will be experienced and that the risk of loss will vary with, amongother things, the type of loan being made, the creditworthiness of the borrowerover the term of the loan, general economic conditions and, in the case of asecured loan, the quality of the collateral securing the loan.  Theallowance is increased by provisions charged against earnings and reduced bynet loan charge-offs.  Loans are charged off when they are deemed to beuncollectible, or partially charged off when portions of a loan are deemed tobe uncollectible.   Recoveries are generally recorded only when cashpayments are received.

 

The allowance for loan losses is maintainedto cover losses inherent in the loan portfolio.  The responsibility forthe review of the Bank’s assets and the determination of the adequacy of thegeneral valuation allowance lies with the director’s loan committee.  Thiscommittee assigns the loss reserve ratio for each type of asset and reviews theadequacy of the allowance at least quarterly based on an evaluation of theportfolio, past experience, prevailing market conditions, amount of governmentguarantees, concentration in loan types and other relevant factors. Specific valuation allowances are established to absorb losses on loans forwhich full collectibility may not be reasonably assured.  The amount ofthe specific allowance is based on the estimated value of the collateralsecuring the loans and other analyses pertinent to each situation.  Estimatesof identifiable losses are reviewed continually and, generally, a provision forlosses is charged against operations on a monthly basis as necessary tomaintain the allowance at an appropriate level.  Management presents ananalysis of the allowance for loan losses to the Bank’s board of directors on aquarterly basis.

 

The directors’ loan committee meets quarterlyto review and monitor conditions in the portfolio and to determine theappropriate allowance for loan losses.  To the extent that any of theseconditions are evidenced by identifiable problem credit or portfolio segment asof the evaluation date, the committee’s estimate of such condition may bereflected as a specific allowance applicable to such credit or portfoliosegment.  By assessing the probable estimated losses inherent in the loanportfolio on a quarterly basis, the Bank is able to adjust specific andinherent loss estimates based upon the most recent information that has becomeavailable.

 

**Market Risk**

Market risk is the risk to a company’s financial position resultingfrom adverse changes in market rates or prices, such as interest rates, foreignexchange rates or equity prices. The Company has no exposure to foreigncurrency exchange risk or any specific exposure to commodity price risk.

 

26

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The Company’s major area ofmarket risk exposure is interest rate risk (“IRR”). The Company’s exposure toIRR can be explained as the potential for change in its reported earningsand/or the market value of the Company’s net worth. Variations in interestrates affect earnings by changing net interest income and the level of otherinterest-sensitive income and operating expenses. Interest rate changes alsoaffect the underlying economic value of the Company’s assets, liabilities andoff-balance sheet items. These changes arise because the present value offuture cash flows, and often the cash flows themselves, change with theinterest rates. The effects of the changes in these present values reflect thechange in the Company’s underlying economic value and provide a basis for theexpected change in future earnings related to the interest rate. IRR isinherent in the role of banks as financial intermediaries, however a bank witha high IRR level may experience lower earnings, impaired liquidity and capitalpositions, and most likely, a greater risk of insolvency. Therefore, theCompany and Bank must carefully evaluate IRR to promote safety and soundness intheir activities.

 

The responsibility for the Company’s market risk sensitivity managementhas been delegated to the Asset/Liability Committee (“ALCO”). Specifically,ALCO utilizes computerized modeling techniques to monitor and attempt tocontrol the influence that market changes have on rate sensitive assets (“RSA”)and rate sensitive liabilities (“RSL”).

 

Market risk continues to be a major focal point of regulatory emphasis.In accordance with regulation, each bank is required to develop its own IRRmanagement program depending on its structure, including certain fundamentalcomponents, which are mandatory to ensure sound IRR management. These elementsinclude appropriate regulatory and management oversight as well as acomprehensive risk management process that effectively identifies, measures,monitors and controls risk. Should a bank have material weaknesses in its riskmanagement process or high exposure relative to its capital, the regulatoryagencies will take action to remedy these shortcomings. Moreover, the level ofa bank’s IRR exposure and the quality of its risk management process is adetermining factor when evaluating a bank’s capital adequacy.

 

At June 30, 2003, the Bank held federal funds sold of $482,000 with ayield of 1.41% and available for sale investment securities totaling $6.11million with a weighted-average, tax-equivalent yield of 4.70%, which was adecrease of $.55 million over June 30 2002 balance of $1,037,000 with aweighted-average, tax equivalent yield of 5.62%. In addition, gross loanstotaling $39.77 million with a weighted-average yield of 7.03% were scheduledto mature within the same time frame. Overall, average interest-earning assetsof $44.9 million have a weighted-average yield of 6.42%, which $10.9 millionare scheduled to mature within one year.

 

As of June 30,2003, interest-bearing liabilities including NOW accounts, money market andsavings deposits of $13.3 million with a weighted-average cost of 1.71% werescheduled to mature within one year. Certificates of deposit totaling $16.4 million have a weighted-averagecost of 3.99%, which $16.4 million are scheduled to mature within oneyear.  In addition, short-termborrowings totaling $2.6 million with a weighted-average cost of 3.09% werealso scheduled to mature within one year. In aggregate, total interest-bearing liabilities of $42.7 million have aweighted-average cost of 3.34%, which $32.3 million are schedule to maturewithin one year.

 

Historical withdrawal patterns with respect to interest-bearing andnoninterest-bearing transaction accounts are not necessarily indicative offuture performance as the volume of cash flows

 

27

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may increase or decrease. Loaninformation is presented based on payment due dates, which may materiallydiffer from actual results due to prepayments caused by changes in interestrates, sociological conditions, demographics, and the economic climate.

 

Models that consider repricing frequencies of RSA and RSL in additionto maturity distributions are also used to monitor IRR. One such technique utilizesa static gap report, which attempts to measure the Company’s interest rateexposure by calculating the net amount of RSA and RSL that reprice withinspecific time intervals.

 

The Company’s interest rate sensitivity gap position, illustrating RSAand RSL at their related carrying values, is summarized in the Interest RateSensitivity Analysis Table. The distributions in the table are based on acombination of maturities; call provisions, repricing frequencies andprepayment patterns. Adjustable-rate assets are distributed based on therepricing frequency of the instrument.

 

The interest rate gaps reported in the table arise when assets arefunded with liabilities having different repricing intervals. Since these gapsare actively managed and change daily as adjustments are made in interest rateforecasts and market outlook, positions at the end of any period may not bereflective of the Company’s interest rate sensitivity in subsequent periods.Active management dictates that longer-term economic views are balanced againstprospects for short-term interest rate changes in all repricing intervals. Forpurposes of the above analysis, repricing of fixed-rate instruments is basedupon the contractual maturity of the applicable instruments. In addition, repricingof assets and liabilities is assumed in the first available repricing period.Actual payment patterns may differ from contractual payment patterns, and ithas been management’s experience that repricing does not always correlatedirectly with market changes in the yield curve.

 

Fluctuations in interest rates can also impact the market value ofassets and liabilities either favorably or adversely depending upon the natureof the rate fluctuations as well as the maturity and repricing structure of theunderlying financial instruments. To the extent that financial instruments areheld to contractual maturity, market value fluctuations related to interestrate changes are realized only to the extent that future net interest margin iseither higher or lower than comparable market rates for the period. To theextent that liquidity management dictates the need to liquidate certain assetsprior to contractual maturity, changes in market value from fluctuatinginterest rates will be realized in income to the extent of any gain or lossincurred upon the liquidation of the related assets.

 

**Liquidity**

The Company’s primary sources of liquidity are the sale of commonstock, borrowings, and dividends from the Bank. In fiscal year 2003, theCompany sold 40,000 shares of stock with proceeds from these shares of$220,000, there were no sales of stock in fiscal year 2002. It is the Company’sgeneral policy to maintain liquidity levels at the parent which managementbelieves to be consistent with the safety and soundness of the Company as awhole. Federal regulatory agencies have the authority to prohibit the paymentof dividends by the Bank to the Company if a finding is made that such paymentwould constitute an unsafe or unsound practice or if the Bank would beundercapitalized as a result. Currently the Company’s primary uses of liquidityis associated with payment of operating expenses.

 

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The Bank’s liquidity is managed on a daily basis by maintaining cash,federal funds sold, and short-term investments at levels commensurate with theestimated requirements for loan demand and fluctuations in deposits. Loandemand and deposit fluctuations are affected by a number of factors, includingeconomic conditions, seasonality of the borrowing and deposit bases, and thegeneral level of interest rates. The Bank maintains two lines of credit withcorrespondent banks, as a supplemental source of short-term liquidity in theevent that saleable investment securities and loans or available new depositsare not adequate to meet liquidity needs. Furthermore, the Bank may also borrowon a short-term basis from the Federal Reserve in the event that otherliquidity sources are not adequate.

 

At June 30, 2003, liquidity was considered adequate, and fundsavailable in the local deposit market combined with scheduled maturities andprepayments of available for sale investment securities and borrowingfacilities are considered sufficient to meet both the short and long-termliquidity needs and commitments. Compared to 2002, the Bank’s liquiditydecreased in 2003.  As a result, theBank sought to lower its cost of funds while growing its loan portfolio.

 

**Capital Resources**

Consolidated capital decreased $9,530, or 0.50%, during 2003. Thedecrease was due primarily to our net operating loss of $232,816. Capital wasincreased by $220,000 as a result of a private placement of 40,000 shares ofthe Company’s common stock. The consolidated capital to assets ratio decreased23 basis points during the fiscal year ended June 30, 2003.

 

The Bank’s total risk-based and leverage capital ratios were 11.60% and8.04%, respectively, at June 30, 2003 compared to 11.5% and 8.70%,respectively, at June 30, 2002. The total risk-based and leverage capitalratios at June 30, 2003, are in excess of the required regulatory minimums of10% and 5%, respectively, for well-capitalized institutions.

 

**Effectsof Inflation and Changing Prices**

Theaccompanying consolidated financial statements have been prepared in accordancewith generally accepted accounting principles in the United States of America,which require the measurement of financial position and operating results interms of historical dollars without considering the change in the relativepurchasing power of money over time due to inflation.  Unlike most industrial companies, interest rates generally have amore significant impact on the performance of a financial institution than theeffects of general levels of inflation. Although interest rates do not necessarily move in the same direction orto the same extent as the prices of goods and services, increases in inflationgenerally have resulted in increased interest rates.  In addition, inflation affects financial institutions’ increasedcost of goods and services purchased, the cost of salaries and benefits,occupancy expense, and similar items. Inflation and related increases in interest rates generally decrease themarket value of investments and loans held and may adversely affect liquidity,earnings, and stockholders’ equity. Commercial and other loan originations and re-financings tend to slow asinterest rates increase, and can reduce the Company’s earnings from suchactivities.

 

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**SECONDARY STOCKOFFERING AND ISSUANCE OF CONVERTIBLE SUBORDINATED DEBENTURES**

 

During the second and fourth quarters of fiscal year 2003, the Board ofDirectors of the Company authorized a private placement of 40,000 and 20,000shares respectively, of its common stock at a price of $5.50 per share.  In July 2003, the Board of Directors of theCompany amended its original motion of 20,000 shares be increased to 50,000shares.  The Company did not incur anyunderwriting or placement expenses in connection with these offerings.  As of July 31, 2003, subscriptions to all ofthe authorized shares had been received. As of June 30, 2003, payment for 40,000 shares had been received.  The proceeds will be used to support ouron-going operations.

 

In July and August 2001, the Company raised $1.0 million through thesale of convertible subordinated unsecured notes, and from June to August, 2002the Company raised an additional $500,000 through the sale of similarnotes.  The notes were issued for athree-year term and bear interest at the rate of eight percent per annum (as tothe 2001 notes) and seven percent per annum (as to the 2002 notes), payablequarterly.  Investors in the notes weregranted the right to convert their investment into shares of the Company’scommon stock any time prior to maturity at the rate of $10.50 per share (as tothe 2001 notes) and $9.00 per share (as to the 2002 notes).  In April 2003, the Company raised anadditional $100,000 through the sale of similar notes to a director.  The notes sold in April 2003 were issued fora seven month term and bear interest at the rate of seven percent per annumpayable quarterly.  Investors in thenotes were given the right to convert their investment into shares of theCompany’s common stock any time prior to maturity at the rate of $9.00 pershare.

 

**Average Balances,Yields and Rates**

 

The following table summarizes our weightedaverage yields earned, weighted average rates paid, interest rate spread andnet yield on earning assets and interest-bearing liabilities.

 
|                                                                              |   | **For the  Year Ended** |       |
|-----------------------------------------------------------------------------------|--------|-------------------------|------------|
|                                                                              |   | **June 30,  2003**      |       | **June 30,  2002** |   |
|                                                                              |   | **Average  Balance**    |       | **Interest** |   | **Average  Yield or  Rates Paid** |   | **Average  Balance** |   | **Interest** |   | **Average  Yield or  Rates Paid** |   |
| **Assets**                                                                        |   |                    |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable                                                                  |   | $                       | 36,226,724 |   | $ | 2,547,014 |   | 7.03 | % | $ | 29,529,396 |   | $ | 2,130,429 |   | 7.21 | % |
| Investment securities                                                             |   | 6,426,373               |       | 302,030 |   | 4.70 | % | 9,866,372 |   | 554,514 |   | 5.62 | % |
| Federal funds sold                                                                |   | 2,225,827               |       | 31,273 |   | 1.41 | % | 2,043,466 |   | 57,857 |   | 2.83 | % |
| Total interest-earning assets                                                     |   | 44,878,924              |       | 2,880,317 |   | 6.42 | % | 41,439,234 |   | 2,742,800 |   | 6.62 | % |
| Non-interest-earning assets                                                       |   | 4,378,059               |       |   |   |   |   | 2,260,896 |   |   |   |   |   |
| Total assets                                                                      |   | $                       | 49,256,983 |   |   |   |   |   | $ | 43,700,130 |   |   |   |   |   |
| **Liabilities and Stockholders’  Equity**                                    |   |                    |       |   |   |   |   |   |   |   |   |   |   |
| Interest bearing deposits                                                         |   | $                       | 35,891,511 |   | 1,130,416 |   | 3.15 | % | $ | 32,760,283 |   | 1,504,181 |   | 4.59 | % |
| Other liabilities                                                                 |   | 6,820,266               |       | 297,898 |   | 4.37 | % | 5,606,850 |   | 302,819 |   | 5.40 | % |
| Total interest-bearing liabilities                                                |   | 42,711,777              |       | 1,428,314 |   | 3.34 | % | 38,367,133 |   | 1,807,000 |   | 4.71 | % |
| Non-interest-bearing liabilities                                                  |   | 4,514,078               |       |   |   |   |   | 2,826,075 |   |   |   |   |   |
| Total liabilities                                                                 |   | 47,225,855              |       |   |   |   |   | 41,193,208 |   |   |   |   |   |
| Stockholders’ Equity                                                         |   | 2,031,128               |       |   |   |   |   | 2,506,922 |   |   |   |   |   |
| Total liabilities and stockholders’ equity                                   |   | $                       | 49,256,983 |   |   |   |   |   | $ | 43,700,130 |   |   |   |   |   |
| Net interest spread                                                               |   |                    |       |   |   | 3.08 | % |   |   |   |   | 1.91 | % |
| Net interest income/margin                                                        |   |                    |       | $ | 1,452,003 |   | 3.24 | % |   |   | $ | 935,800 |   | 2.26 | % |
| Ratio of average interest-earning assets to average  interest-bearing liabilities |   | 1.05                    | x          |   |   |   |   | 1.08 | x |   |   |   |   |

 

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**Rate/Volume Analysis**

 

The tablebelow sets forth certain information regarding changes in interest income andinterest expense of the Bank for the periods indicated.  For each category of interest-earning andinterest-bearing liabilities, information is provided on changes attributableto (i) changes in volume (change in average volume multiplied by old rate);(ii) changes in rates (changes in rate multiplied by old average volume);  (iii) changes in rate-volume (changes inrate multiplied by the change in average volume)

 
|                                |   | **Year  Ended June 30, 2003**   |       |
|-------------------------------------|--------|---------------------------------|------------|
|                                |   | **2003 vs  2002**               |       |
|                                |   | **Increase  (decrease) due to** |       |
|                                |   | **(dollars  in thousands)**     |       |
|                                |   | **Volume**                      |       | **Rate** |   | **Rate/Volume** |   | **Net** |   |
| Interest income:                    |   |                            |       |   |   |   |   |   |   |
| Loans receivable                    |   | $                               | 482        |   | $ | (53 | ) | $ | (12 | ) | $ | 417 |   |
| Investment securities               |   | (193                            | )          | (91 | ) | 32 |   | (252 | ) |
| Federal funds sold                  |   | 5                               |       | (29 | ) | (3 | ) | (27 | ) |
| Other interest-earning  assets      |   | —                          |       | — |   | — |   | — |   |
| Total interest-earning  assets      |   | 294                             |       | (173 | ) | 17 |   | 138 |   |
| Interest expense:                   |   |                            |       |   |   |   |   |   |   |
| Deposit accounts                    |   | 144                             |       | (473 | ) | (45 | ) | (374 | ) |
| Other liabilities                   |   | 66                              |       | (58 | ) | (12 | ) | (4 | ) |
| Total interest-bearing  liabilities |   | 210                             |       | (531 | ) | (57 | ) | (378 | ) |
| Net change in net  interest income  |   | $                               | 84         |   | $ | 358 |   | $ | 74 |   | $ | 516 |   |
|                                |   |                            |       |   |   |   |   |   |   |   |   |   |   |
|                                |   | **Year Ended June 30, 2002**    |       |
|                                |   | **2002 vs 2001**                | ** ** |
|                                |   | **Increase (decrease) due to**  | ** ** |
|                                |   | **(dollars in thousands)**      | ** ** |
|                                |   | **Volume**                      |       | **Rate** |   | **Rate/Volume** |   | **Net** |   |
| Interest income:                    |   |                            |       |   |   |   |   |   |   |
| Loans receivable                    |   | $                               | 685        |   | $ | (409 | ) | $ | (141 | ) | $ | 135 |   |
| Investment securities               |   | 266                             |       | (54 | ) | (38 | ) | 174 |   |
| Federal funds sold                  |   | (31                             | )          | (68 | ) | 16 |   | (83 | ) |
| Other interest-earning  assets      |   | —                          |       | — |   | — |   | — |   |
| Total interest-earning  assets      |   | 920                             |       | (531 | ) | (163 | ) | 226 |   |
| Interest expense:                   |   |                            |       |   |   |   |   |   |   |
| Deposit accounts                    |   | 492                             |       | (370 | ) | (121 | ) | 1 |   |
| Other liabilities                   |   | 188                             |       | (35 | ) | (37 | ) | 116 |   |
| Total interest-bearing  liabilities |   | 680                             |       | (405 | ) | (158 | ) | 117 |   |
|                                |   |                            |       |   |   |   |   |   |   |
| Net change in net  interest income  |   | $                               | 240        |   | $ | (126 | ) | $ | (5 | ) | $ | 109 |   |

 

## **InvestmentPortfolio**

 

At June 30,2003, our available for sale investments securities portfolio representedapproximately 13.2% of our interest earning assets of $46 million.  We also held investments in stock of theFederal Home Loan Bank and United Bankers Bank in the amount of $367,100, and

 

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securities held for trading inthe amount of $115,862, which are not included in the table below.

 

At June 30,2002, our securities portfolio represented approximately 21.06% of our interestearning assets of $46 million.

 
|                        |   | **June 30, 2003**       |      |
|-----------------------------|--------|-------------------------|-----------|
|                        |   | **One Year****or Less** |      | **Yield** |   | **After one  year thru  five years** |   | **Yield** |   | **After five  years thru  ten years** |   | **Yield** |   | **After 10  years** |   | **Yield** |   | **Total** |   | **Yield** |   |
| U.S. Agencies               |   | $                       | —    |   | 0.00 | % | $ | 507,656 |   | 3.31 | % | $ | 1,259,828 |   | 4.11 | % | $ | 499,255 |   | 4.02 | % | $ | 2,266,739 |   | 3.91 | % |
| Mortgage-back  securities   |   | —                  |      | 0.00 | % | 164,558 |   | 5.75 | % | 985,332 |   | 5.27 | % | 2,168,540 |   | 5.74 | % | 3,318,430 |   | 5.60 | % |
| Corporate  bonds            |   | —                  |      | 0.00 | % | 527,919 |   | 6.06 | % | — |   | 0.00 | % | — |   | 0.00 | % | 527,919 |   | 6.06 | % |
| Mutual  fund                |   | —                  |      | 0.00 | % | — |   | 0.00 | % | — |   | 0.00 | % | — |   | 0.00 | % | — |   | 0.00 | % |
|                        |   | $                       | —    |   | 0.00 | % | $ | 1,200,133 |   | 4.85 | % | $ | 2,245,160 |   | 4.62 | % | $ | 2,667,795 |   | 5.42 | % | $ | 6,113,088 |   | 5.01 | % |
|                        |   |                    |      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                        |   | **June  30, 2002**      |      |
|                        |   | **One  Year  or Less**  |      | **Yield** |   | **After  one  year thru  five years** |   | **Yield** |   | **After  five  years thr  ten years** |   | **Yield** |   | **After  10  years** |   | **Yield** |   | **Total** |   | **Yield** |   |
| U.S.  Agencies              |   | $                       | —    |   | 0.00 | % | $ | 249,378 |   | 4.63 | % | $ | 1,003,677 |   | 4.94 | % | $ | — |   | 0.00 | % | $ | 1,253,055 |   | 4.88 | % |
| Mortgage-backed  securities |   | 20,847                  |      | 7.02 | % | — |   | 0.00 | % | 542,747 |   | 5.77 | % | 4,767,437 |   | 5.75 | % | 5,331,031 |   | 5.76 | % |
| Corporate  bonds            |   | —                  |      | 0.00 | % | 511,920 |   | 6.06 | % | — |   | 0.00 | % | — |   | 0.00 | % | 511,920 |   | 6.06 | % |
| Mutual  fund                |   | 2,502,514               |      | 3.14 | % | — |   | 0.00 | % | — |   | 0.00 | % | — |   | 0.00 | % | 2,502,514 |   | 3.14 | % |
|                        |   | $                       | 2,523,361 |   | 3.17 | % | $ | 761,298 |   | 5.59 | % | $ | 1,546,424 |   | 5.77 | % | $ | 4,767,437 |   | 5.75 | % | $ | 9,598,520 |   | 4.98 | % |

 

Contractual maturities and yields on the Bank’s available for saleinvestments are summarized in the above table. Expected maturities may differ from contractual maturities becauseissuers may have the right to call or prepay obligations with or without callor prepayment penalties.  Short-terminvestments in the amount of $482,000 and $1.0 million at June 30, 2003 and2002, respectively, were funds invested in Federal Funds sold on an overnightbasis, which are considered cash equivalents.

 

32

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**Interest Rate Sensitivity Analysis**

The Company continually evaluates the asset mix of our balance sheet interms of several variables:  yields,credit quality, appropriate funding sources and liquidity.  To effectively manage the liability mix ofthe balance sheet, the Company focuses on expanding various fundingsources.  The interest rate sensitivityposition at June 30, 2003 and 2002 is summarized in the following tables.  The difference between rate sensitive assetsand rate sensitive liabilities, or the interest rate sensitivity gap, for eachperiod is show at the bottom of each table. Since all interest rates and yields do not adjust at the same velocity,the gap is only a general indicator of rate sensitivity.  The tables may not be indicative of our ratesensitivity position at other points in time.

 
|                                                                   |   | **As of June 30, 2003**               |       |
|------------------------------------------------------------------------|--------|---------------------------------------|------------|
|                                                                   |   | **Within  Three  Months**             |       | **After Three  but within  Twelve Months** |   | **After Twelve  but within  Five Years** |   | **After  Five Years** |   | **Total** |   |
|                                                                   |   | **(Dollars in Thousands)**            |       |
| Interest earning assets                                                |   |                                  |       |   |   |   |   |   |   |   |   |
| Federal funds sold                                                     |   | $                                     | 482        |   | $ | — |   | $ | — |   | $ | — |   | $ | 482 |   |
| Investment securities                                                  |   | —                                |       | — |   | 1,200 |   | 4,913 |   | 6,113 |   |
| Loans receivable                                                       |   | 5,368                                 |       | 5,061 |   | 22,323 |   | 7,021 |   | 39,773 |   |
| Total earning assets                                                   |   | $                                     | 5,850      |   | $ | 5,061 |   | $ | 23,523 |   | $ | 11,934 |   | $ | 46,368 |   |
| Interest bearing liabilities                                           |   |                                  |       |   |   |   |   |   |   |   |   |
| NOW and money market                                                   |   | $                                     | 8,624      |   | $ | — |   | $ | — |   | $ | — |   | $ | 8,624 |   |
| Savings                                                                |   | 4,631                                 |       | — |   | — |   | — |   | 4,631 |   |
| Time deposits                                                          |   | 3,449                                 |       | 12,902 |   | 6,732 |   | — |   | 23,083 |   |
| Borrowed funds                                                         |   | —                                |       | 2,675 |   | 4,200 |   | 700 |   | 7,575 |   |
| Total interest bearing liabilities                                     |   | $                                     | 16,704     |   | $ | 15,577 |   | $ | 10,932 |   | $ | 700 |   | $ | 43,913 |   |
|                                                                   |   |                                  |       |   |   |   |   |   |   |   |   |
| Interest sensitivity gap                                               |   | (10,854                               | )          | (10,516 | ) | 12,591 |   | 11,234 |   | 2,455 |   |
| Cumulative interest sensitivity gap                                    |   | (10,854                               | )          | (21,370 | ) | (8,779 | ) | 2,455 |   | 2,455 |   |
| Ratio of interest sensitivity gap to  total earning assets             |   | -23.41                                | %          | -22.68 | % | 27.15 | % | 24.23 | % | 5.29 | % |
| Ratio of cumulative interest  sensitivity gap to total earning  assets |   | -23.41                                | %          | -46.09 | % | -18.93 | % | 5.29 | % | 5.29 | % |
|                                                                   |   |                                  |       |   |   |   |   |   |   |   |   |
|                                                                   |   | **As  of June 30, 2002**              | ** ** |
|                                                                   |   | **Within********Three********Months** |       | **After  Three  but within********Twelve Months** |   | **After  Twelve  but within********Five Years** |   | **After********Five Years** |   | **Total** |   |
|                                                                   |   | **(Dollars  in Thousands)**           | ** ** |
| Interest earning assets                                                |   |                                  |       |   |   |   |   |   |   |   |   |
| Federal funds sold                                                     |   | $                                     | 1,037      |   | $ | — |   | $ | — |   | $ | — |   | $ | 1,037 |   |
| Investment securities                                                  |   | 2,524                                 |       | — |   | 761 |   | 6,314 |   | 9,599 |   |
| Loans receivable                                                       |   | 3,772                                 |       | 6,581 |   | 19,144 |   | 5,446 |   | 34,943 |   |
| Total earning assets                                                   |   | $                                     | 7,333      |   | $ | 6,581 |   | $ | 19,905 |   | $ | 11,760 |   | $ | 45,579 |   |
| Interest bearing liabilities                                           |   |                                  |       |   |   |   |   |   |   |   |   |
| NOW and money market                                                   |   | $                                     | 7,718      |   | $ | — |   | $ | — |   | $ | — |   | $ | 7,718 |   |
| Savings                                                                |   | 4,533                                 |       | — |   | — |   | — |   | 4,533 |   |
| Time deposits                                                          |   | 2,649                                 |       | 13,025 |   | 7,090 |   | — |   | 22,764 |   |
| Borrowed funds                                                         |   | 1,650                                 |       | 2,250 |   | 2,075 |   | 700 |   | 6,675 |   |
| Total Interest bearing liabilities                                     |   | $                                     | 16,550     |   | $ | 15,275 |   | $ | 9,165 |   | $ | 700 |   | $ | 41,690 |   |
|                                                                   |   |                                  |       |   |   |   |   |   |   |   |   |
| Interest sensitivity gap                                               |   | (9,217                                | )          | (8,694 | ) | 10,740 |   | 11,060 |   | 3,889 |   |
| Cumulative interest sensitivity gap                                    |   | (9,217                                | )          | (17,911 | ) | (7,171 | ) | 3,889 |   | 3,889 |   |
| Ratio of interest sensitivity gap to  total earning assets             |   | -20.22                                | %          | -19.07 | % | 23.56 | % | 24.27 | % | 8.53 | % |
| Ratio of cumulative interest  sensitivity gap to total earning  assets |   | -20.22                                | %          | -39.30 | % | -15.73 | % | 8.53 | % | 8.53 | % |

 

33

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## **LoanPortfolio**

 

Since loanstypically provide higher interest yields than do other types of earning assets,our intent is to channel a substantial percentage of our earning assets intothe loan category.  The gross loansoutstanding, at June 30, 2003 and 2002 were $39,881,709 and $34,497,862,respectively.  This table excludes loansheld for sale as of June 30, 2003 and 2002 of $2,035,176 and $625,735,respectively.  Loans held for sale arecomprised of real estate mortgages. The following table summarizes thecomposition of our loan portfolio.

 
|                           |   | **June 30, 2003** |       | **June 30, 2002** |   |
|--------------------------------|--------|-------------------|------------|-------------------|--------|
|                           |   | **Amount**        |       | **%****of Total** |   | **Amount** |   | **%****of Total** |   |
| Commercial & agricultural  |   | $                 | 6,979,307  |              | 17.55  | % | $ | 6,616,193 |   | 19.28 | % |
| Real estate - construction     |   | 4,433,072         |       | 11.15             | %      | 2,375,318 |   | 6.92 | % |
| Real estate - mortgages        |   | 18,504,208        |       | 46.52             | %      | 13,336,761 |   | 38.86 | % |
| Consumer loans                 |   | 9,821,027         |       | 24.69             | %      | 11,809,464 |   | 34.41 | % |
| Lease financing                |   | 35,673            |       | 0.09              | %      | 179,995 |   | 0.53 | % |
| Total loans                    |   | $                 | 39,773,287 |              | 100.00 | % | $ | 34,317,731 |   | 100.00 | % |
| Net deferred loan fees/(costs) |   | 108,422           |       |              |   | 180,131 |   |   |   |
| Less: allowance for loan loss  |   | (1,029,581        | )          |              |   | (661,170 | ) |   |   |
| Total net loans                |   | $                 | 38,852,128 |              |   |   | $ | 33,836,692 |   |   |   |

 

Loansin nonaccrual, past due and restructured loans are listed below:

 
|                           |   | **June 30** |      |
|--------------------------------|--------|-------------|-----------|
|                           |   | **2003**    |      | **2002** |   |
| Non-accrual loans              |   | $           | 1,844,911 |   | $ | 1,814,504 |   |
|                           |   |        |      |   |   |
| Accruing > 90 days past due |   | $           | —    |   | $ | — |   |
|                           |   |        |      |   |   |
| Troubled debt restructured     |   | $           | —    |   | $ | — |   |

 

## **Maturitiesand Sensitivity of Loans to Changes in Interest Rates**

 

Theinformation in the following tables is based on the contractual maturities ofindividual loans, including loans, which may have been subject to renewal attheir contractual maturity.  Renewal ofthese loans is subject to review and credit approval, as well as modificationsin terms upon their maturity.  Actualrepayments of loans may differ from maturities reflected below becauseborrowers have the right to prepay obligations with or without prepaymentpenalties.  The following tablessummarize loan maturities, by type, and related interest rate characteristics:

 
|                               |   | **As of June 30, 2003** |       |
|------------------------------------|--------|-------------------------|------------|
|                               |   | **One Year  or Less**   |       | **After One but  within Five Years** |   | **After  Five Years** |   | **Total** |   |
| Commercial & agricultural      |   | $                       | 2,613,798  |   | $ | 2,597,750 |   | $ | 1,767,759 |   | $ | 6,979,307 |   |
| Real estate - construction         |   | 3,496,939               |       | 936,133 |   | — |   | 4,433,072 |   |
| Real estate - mortgages            |   | 2,034,243               |       | 12,075,344 |   | 4,394,621 |   | 18,504,208 |   |
| Consumer loans                     |   | 2,283,747               |       | 6,678,656 |   | 858,624 |   | 9,821,027 |   |
| Lease financing                    |   | —                  |       | 35,673 |   | — |   | 35,673 |   |
| Total                              |   | $                       | 10,428,727 |   | $ | 22,323,556 |   | $ | 7,021,004 |   | $ | 39,773,287 |   |
| Loans maturing after one year with |   |                    |       |   |   |   |   |   |   |
| Fixed interest rate                |   | $                       | 27,452,321 |   |   |   |   |   |   |   |
| Floating interest rates            |   | $                       | 1,892,239  |   |   |   |   |   |   |   |

 

34

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|                               |   | **As  of June 30, 2002** |       |
|------------------------------------|--------|--------------------------|------------|
|                               |   | **One  Year  or Less**   |       | **After  One but  within Five Years** |   | **After  Five Years** |   | **Total** |   |
| Commercial & agricultural      |   | $                        | 2,728,795  |   | $ | 2,252,871 |   | $ | 1,634,527 |   | $ | 6,616,193 |   |
| Real estate - construction         |   | 2,108,064                |       | 267,254 |   | — |   | 2,375,318 |   |
| Real estate - mortgages            |   | 2,295,594                |       | 9,126,974 |   | 1,914,193 |   | 13,336,761 |   |
| Consumer loans                     |   | 3,169,551                |       | 7,367,969 |   | 1,271,944 |   | 11,809,464 |   |
| Lease financing                    |   | 51,438                   |       | 128,557 |   | — |   | 179,995 |   |
| Total                              |   | $                        | 10,353,442 |   | $ | 19,143,625 |   | $ | 4,820,664 |   | $ | 34,317,731 |   |
| Loans maturing after one year with |   |                     |       |   |   |   |   |   |   |
| Fixed interest rate                |   | $                        | 19,929,853 |   |   |   |   |   |   |   |
| Floating interest rates            |   | $                        | 4,034,436  |   |   |   |   |   |   |   |

 

## **Provisionand Allowance for Loan Losses**

 

We have developed policies and procedures for evaluating the overallquality of our credit portfolio and the timely identification of potentialcredit problems.  Additions to theallowance for loan losses will be made periodically to maintain the allowancein an appropriate level based on our analysis of the potential risk in the loanportfolio.

 

The following table summarizes our Bank’s loan loss experience and theallowance for possible loan losses.

 
|                                                                                       |   | **Year Ended**   |      |
|--------------------------------------------------------------------------------------------|--------|------------------|-----------|
|                                                                                       |   | **June 30,2003** |      | **June 30, 2002** |   |
| Balance at beginning of period                                                             |   | $                | 661,170   |   | $ | 234,989 |   |
|                                                                                       |   |             |      |   |   |
| Charge-offs:                                                                               |   |             |      |   |   |
| Commercial & agricultural                                                              |   |             |      | (49,146 | ) |
| Consumer loans                                                                             |   | (14,680          | )         | (310,605 | ) |
|                                                                                       |   | (14,680          | )         | (359,751 | ) |
|                                                                                       |   |             |      |   |   |
| Recoveries:                                                                                |   |             |      |   |   |
| Commercial & agricultural                                                              |   | 7,930            |      |   |   |
| Consumer loans                                                                             |   | 1,224            |      | 857 |   |
|                                                                                       |   | 9,154            |      | 857 |   |
|                                                                                       |   |             |      |   |   |
| Net charge offs                                                                            |   | (5,526           | )         | (358,894 | ) |
| Provision charged to operations                                                            |   | 373,937          |      | 785,075 |   |
|                                                                                       |   |             |      |   |   |
| Balance at end of period                                                                   |   | $                | 1,029,581 |   | $ | 661,170 |   |
|                                                                                       |   |             |      |   |   |
| Ratio of net charge-offs during the period  to average loans outstanding during the period |   | 0.02             | %         | 1.22 | % |

 

35

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The allowance for loan losses was allocated as follows:

 
|                          |   | **June 30, 2003** |      | **June 30, 2002**                                      |   |
|-------------------------------|--------|-------------------|-----------|--------------------------------------------------------|--------|
|                          |   | **Amount**        |      | **Percent of Loans  in Each Category  of Total Loans** |   | **Amount** |   | **Percent of Loans  in Each Category  of Total Loans** |   |
| Commercial & agricultural |   | $                 | 341,993   |                                                   | 17.55  | % | $ | 42,318 |   | 19.28 | % |
| Real estate - construction    |   | 26,896            |      | 11.15                                                  | %      | 17,815 |   | 6.92 | % |
| Real estate - mortgages       |   | 151,417           |      | 46.52                                                  | %      | 85,373 |   | 38.86 | % |
| Consumer loans                |   | 509,007           |      | 24.69                                                  | %      | 514,123 |   | 34.41 | % |
| Lease financing               |   | 268               |      | 0.09                                                   | %      | 1,541 |   | 0.53 | % |
| Total                         |   | $                 | 1,029,581 |                                                   | 100.00 | % | $ | 661,170 |   | 100.00 | % |

 

## **Depositsand Other Interest-Bearing Liabilities**

 

As of June 30,2003, interest bearing deposits were 82.75% of interest-bearing liabilitiescompared to 82.99% for the same period ending June 30, fiscal year 2002.  The following tables summarize deposits bycategory.

 
|                              |   | **As  of June 30, 2003**  |       |
|-----------------------------------|--------|---------------------------|------------|
|                              |   | **Ending********Balance** |       | **Percentage********of Total********Deposits** |   | **Average********Balance** |   | **Percentage********of Total********Average   Deposits** |   | **Average****Rate********Paid** |   |
| Demand deposit                    |   | $                         | 5,090,364  |   | 12.29 | % | $ | 4,166,918 |   | 10.40 | % | 0.00 | % |
| Now and money market              |   | 8,623,932                 |       | 20.82 | % | 8,676,758 |   | 21.66 | % | 1.72 | % |
| Savings                           |   | 4,630,763                 |       | 11.18 | % | 4,530,948 |   | 11.31 | % | 1.70 | % |
| Time accounts less than $100,000  |   | 18,021,479                |       | 43.50 | % | 18,096,268 |   | 45.17 | % | 3.98 | % |
| Time accounts of $100,000 or more |   | 5,062,172                 |       | 12.21 | % | 4,587,528 |   | 11.46 | % | 4.02 | % |
| Total deposits                    |   | $                         | 41,428,710 |   | 100.00 | % | $ | 40,058,420 |   | 100.00 | % |   |   |
|                              |   |                      |       |   |   |   |   |   |   |   |   |
|                              |   | **As  of June 30, 2002**  |       |
|                              |   | **Ending********Balance** |       | **Percentage********of Total********Deposits** |   | **Average********Balance** |   | **Percentage********of Total********Average   Deposits** |   | **Average****Rate********Paid** |   |
| Demand deposit                    |   | $                         | 4,574,282  |   | 11.55 | % | $ | 2,395,080 |   | 6.81 | % | 0.00 | % |
| Now and money market              |   | 7,718,574                 |       | 19.50 | % | 5,734,695 |   | 16.31 | % | 2.67 | % |
| Savings                           |   | 4,533,290                 |       | 11.45 | % | 4,620,632 |   | 13.14 | % | 2.41 | % |
| Time accounts less than $100,000  |   | 18,622,280                |       | 47.04 | % | 18,763,158 |   | 53.37 | % | 5.48 | % |
| Time accounts of $100,000 or more |   | 4,141,303                 |       | 10.46 | % | 3,641,798 |   | 10.37 | % | 5.80 | % |
| Total deposits                    |   | $                         | 39,589,729 |   | 100.00 | % | $ | 35,155,363 |   | 100.00 | % |   |   |
|                                   |        |                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

As of June 30, 2003, the Bank had deposits classified as brokereddeposit totaling $2.18 million.  TheBank does not rely on brokered deposits. Core deposits, excluding time deposits of $100,000 or more, provide arelatively stable funding source for our loan portfolio and other earningassets.  Our loan to deposit ratio was96.27% at June 30, 2003 and 87.14% at June 30, 2002.  The maturity distribution of our time deposits is as follows.

 

36

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|                              |   | **June 30,  2003**    |      |
|-----------------------------------|--------|-----------------------|-----------|
|                              |   | **3 months  or less** |      | **Over 3  months  thru 6 months** |   | **Over 6  months  thru 12 months** |   | **Over  12 months** |   | **Total** |   |
| Time accounts less than  $100,000 |   | $                     | 2,939,671 |   | $ | 5,615,341 |   | $ | 4,475,488 |   | $ | 4,990,979 |   | $ | 18,021,479 |   |
| Time accounts of $100,00  or more |   | 509,409               |      | 1,986,830 |   | 824,491 |   | 1,741,442 |   | 5,062,172 |   |
| Total                             |   | $                     | 3,449,080 |   | $ | 7,602,171 |   | $ | 5,299,979 |   | $ | 6,732,421 |   | $ | 23,083,651 |   |
|                              |   |                  |      |   |   |   |   |   |   |   |   |
|                              |   | **June 30, 2002**     |      |
|                              |   | **3 months  or less** |      | **Over 3 months  thru 6 months** |   | **Over 6 months  thru 12 months** |   | **Over  12 months** |   | **Total** |   |
| Time accounts less than  $100,000 |   | $                     | 2,248,843 |   | $ | 6,116,940 |   | $ | 4,659,090 |   | $ | 5,597,407 |   | $ | 18,622,280 |   |
| Time accounts of $100,00  or more |   | 400,000               |      | 1,843,086 |   | 405,750 |   | 1,492,467 |   | 4,141,303 |   |
| Total                             |   | $                     | 2,648,843 |   | $ | 7,960,026 |   | $ | 5,064,840 |   | $ | 7,089,874 |   | $ | 22,763,583 |   |

 

**RETURN ON EQUITY AND ASSETS**

 

The followingtable shows the return (loss) on average assets (net loss divided by averagetotal assets), return on average equity (net loss divided by average equity),and equity to assets ratio (average equity divided by average total assets) forfiscal year 2003 and 2002.  Since itsinception, we have not paid any cash dividends.  The payment of dividends by the Bank is subject to limitationsimposed by law and governmental regulations.

 
|                            |   | **For the  Year Ended  June 30, 2003** |   | **For the  Year Ended  June 30, 2002** |   |
|---------------------------------|--------|----------------------------------------|--------|----------------------------------------|--------|
| Return (loss) on average assets |   | (0.47                                  | )%     | (2.48                                  | )%     |
|                            |   |                                   |   |                                   |   |
| Return (loss) on average equity |   | (12.13                                 | )%     | (44.37                                 | )%     |
|                            |   |                                   |   |                                   |   |
| Equity to assets ratio          |   | 3.84                                   | %      | 5.59                                   | %      |

 

## **BORROWINGS**

 

Deposits arethe primary source of funds for the Bank’s lending and investment activitiesand for its general business purposes. If the need arises, the Bank may rely upon advances from the FederalHome Loan Bank of Des Moines to supplement its supply of lendable funds and tomeet ending and deposit withdrawal requirements.  Advances from the FHLB are typically secured by a portion of theBank’s security portfolio.  In additionto borrowings from FHLB, we have had a fully advanced line of credit in theamount of $600,000 with a correspondent bank in Minneapolis, Minnesota.

 
|                     |   | **As of and  for the fiscal year Ended June 30** |      |
|--------------------------|--------|--------------------------------------------------|-----------|
|                     |   | **2003**                                         |      | **2002** |   |
| Maximum balance          |   | $                                                | 7,575,000 |   | $ | 6,675,000 |   |
|                     |   |                                             |      |   |   |
| Average balance          |   | 6,820,266                                        |      | 5,606,850 |   |
|                     |   |                                             |      |   |   |
| Balance at end of period |   | 7,575,000                                        |      | 6,675,000 |   |
|                     |   |                                             |      |   |   |
| Weighted average rate:   |   |                                             |      |   |   |
| at end of period         |   | 4.03                                             | %         | 5.41 | % |
| during the period        |   | 4.37                                             | %         | 5.40 | % |
|                          |        |                                                  |           |  |  |  |  |

# ** **

37

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# **ITEM 7.**          FINANCIAL STATEMENTS

# ** **

**NorthernStar Financial, Inc.**

**AndSubsidiary**

 

 

**ConsolidatedFinancial Report**

 

 

**June30, 2003**

 
| Reports  of Independent Auditors                                                                 |
|--------------------------------------------------------------------------------------------------|
|                                                                                             |
| Consolidated Statements of Financial  Condition  as of June 30, 2003 and 2002                    |
|                                                                                             |
| Consolidated Statements of Operations  for the Years Ended June 30, 2003 and 2002                |
|                                                                                             |
| Consolidated Statements of Stockholders’ Equity  for the Years Ended June 30, 2003 and 2002 |
|                                                                                             |
| Consolidated Statements of Cash Flows  for the Years Ended June 30, 2003 and 2002                |
|                                                                                             |
| Notes to Consolidated Financial Statements                                                       |

 

38

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REPORTOF INDEPENDENT AUDITORS

 

To the Board of Directors and

Stockholders of Northern StarFinancial, Inc.

Mankato, MN

 

We have audited theaccompanying consolidated statement of financial condition of Northern StarFinancial, Inc and Subsidiary as of June 30, 2003, and the related consolidatedstatements of operations, stockholders’ equity, and cash flows for the yearthen ended.  These consolidatedfinancial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these consolidated financial statements based on our audit.

 

We conducted our audit inaccordance with auditing standards generally accepted in the United States ofAmerica. Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the consolidated financial statements arefree of material misstatement. An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the consolidated financialstatements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation. We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Northern Star Financial, Inc andSubsidiary as of June 30, 2003, and the results of their operations and theircash flows for the year then ended in conformity with accounting principlesgenerally accepted in the United States of America.

 

 
|   | /s/ Boulay,  Heutmaker, Zibell & Co. P.L.L.P |   |
|--------|--------------------------------------------------|--------|
|   | Certified Public Accountants                     |   |

 

Minneapolis, MN

August 8, 2003

 

39

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INDEPENDENT AUDITOR’S REPORT

 

To the Board of Directors

Northern Star Financial, Inc. and Subsidiary

Mankato, Minnesota

 

We have audited the accompanying consolidated balance sheet of NorthernStar Financial, Inc. and Subsidiary as of June 30, 2002, and the relatedconsolidated statements of operations, stockholders’ equity, and cash flows forthe year then ended. These financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on thesefinancial statements based on our audit.

 

We conducted our audit in accordance with auditing standards generallyaccepted in the United States of America. Those standards require that we planand perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudit provides a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position of NorthernStar Financial, Inc. and Subsidiary as of June 30, 2002, and the results oftheir operations and their cash flows for the year then ended in conformitywith accounting principles generally accepted in the United States of America.

 

As explained in Note 20 to theconsolidated financial statements, the Company is a defendant in significantlitigation matters.

 

 
|   | /s/    | McGladrey & Pullen, L.L.P. |   |
|--------|--------|--------------------------------|--------|
|   |   | Certified Public Accountants   |

 

Minneapolis, Minnesota

August 14, 2002

 

40

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**NORTHERNSTAR FINANCIAL, INC. AND SUBSIDIARY**

**CONSOLIDATEDSTATEMENTS OF FINANCIAL CONDITION**

 
|                                                                                                                         |   | **June 30** |       |
|------------------------------------------------------------------------------------------------------------------------------|--------|-------------|------------|
|                                                                                                                         |   | **2003**    |       | **2002** |   |
| **ASSETS**                                                                                                                   |   |        |       |   |   |
|                                                                                                                         |   |        |       |   |   |
| Cash and cash equivalents                                                                                                    |   | $           | 2,377,132  |   | $ | 2,348,081 |   |
| Federal funds sold                                                                                                           |   | 482,000     |       | 1,037,000 |   |
| Securities available for sale, at fair value                                                                                 |   | 6,113,088   |       | 9,598,520 |   |
| Securities held for trading, at fair value                                                                                   |   | 115,862     |       | — |   |
| Federal Home Loan Bank and United Bankers Bank stock, at cost                                                                |   | 367,100     |       | 238,800 |   |
| Loans held for sale                                                                                                          |   | 2,035,176   |       | 625,735 |   |
| Loans receivable, net of allowance for loan and lease losses of  $1,029,581 and $661,170                                     |   | 38,852,128  |       | 33,836,692 |   |
| Accrued interest receivable                                                                                                  |   | 282,416     |       | 276,166 |   |
| Premise and equipment, net of depreciation                                                                                   |   | 503,397     |       | 535,938 |   |
| Other assets                                                                                                                 |   | 124,363     |       | 75,605 |   |
| **Total Assets**                                                                                                             |   | $           | 51,252,662 |   | $ | 48,572,537 |   |
|                                                                                                                         |   |        |       |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                |   |        |       |   |   |
| **Liabilities:**                                                                                                             |   |        |       |   |   |
| Demand deposits                                                                                                              |   | $           | 5,090,364  |   | $ | 4,574,282 |   |
| NOW and money market                                                                                                         |   | 8,623,932   |       | 7,718,574 |   |
| Savings                                                                                                                      |   | 4,630,763   |       | 4,533,290 |   |
| Time deposits                                                                                                                |   | 23,083,651  |       | 22,763,583 |   |
| Total deposits                                                                                                               |   | 41,428,710  |       | 39,589,729 |   |
| Notes payable and other borrowings                                                                                           |   | 5,975,000   |       | 5,275,000 |   |
| Convertible subordinated notes payable                                                                                       |   | 1,600,000   |       | 1,400,000 |   |
| Accrued interest payable and other                                                                                           |   | 334,818     |       | 384,144 |   |
| Total Liabilities                                                                                                            |   | 49,338,528  |       | 46,648,873 |   |
|                                                                                                                         |   |        |       |   |   |
| **Stockholders’ Equity:**                                                                                               |   |        |       |   |   |
| Common stock, $.01 par value, 15,000,000 shares authorized; 519,506  and 479,506 shares issued and outstanding, respectively |   | 5,195       |       | 4,795 |   |
| Undesignated stock, par value $.01per share; 5,000,000 shares  authorized, no shares issued                                  |   | —      |       | — |   |
| Additional paid in capital                                                                                                   |   | 4,378,104   |       | 4,158,504 |   |
| Accumulated deficit                                                                                                          |   | (2,513,175  | )          | (2,280,359 | ) |
| Unearned stock compensation                                                                                                  |   | (8,005      | )          | (12,004 | ) |
| Accumulated other comprehensive income                                                                                       |   | 52,015      |       | 52,728 |   |
| **Total Stockholders’ Equity**                                                                                          |   | 1,914,134   |       | 1,923,664 |   |
| **Total Liabilities and Stockholders’ Equity**                                                                          |   | $           | 51,252,662 |   | $ | 48,572,537 |   |

 

See Notes toConsolidated Financial Statements

 

41

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**NORTHERNSTAR FINANCIAL, INC. AND SUBSIDIARY**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

 
|                                                            |   | **For the  Year Ended June 30** |      |
|-----------------------------------------------------------------|--------|---------------------------------|-----------|
|                                                            |   | **2003**                        |      | **2002** |   |
| **Interest income:**                                            |   |                            |      |   |   |
| Loans receivable                                                |   | $                               | 2,547,014 |   | $ | 2,130,429 |   |
| Securities available for sale                                   |   | 302,030                         |      | 554,514 |   |
| Federal funds sold                                              |   | 31,273                          |      | 57,857 |   |
| Total interest income                                           |   | 2,880,317                       |      | 2,742,800 |   |
|                                                            |   |                            |      |   |   |
| **Interest expense:**                                           |   |                            |      |   |   |
| Deposits                                                        |   | 1,130,416                       |      | 1,504,181 |   |
| Borrowed funds                                                  |   | 297,898                         |      | 302,819 |   |
| Total interest expense                                          |   | 1,428,314                       |      | 1,807,000 |   |
|                                                            |   |                            |      |   |   |
| Net interest income                                             |   | 1,452,003                       |      | 935,800 |   |
| Provision for loan losses                                       |   | 373,937                         |      | 785,075 |   |
|                                                            |   |                            |      |   |   |
| Net interest income after provision for loan loss               |   | 1,078,066                       |      | 150,725 |   |
|                                                            |   |                            |      |   |   |
| **Non-interest income:**                                        |   |                            |      |   |   |
| Other fees and service charges                                  |   | 218,092                         |      | 135,159 |   |
| Gain on sale of securities                                      |   | 3,504                           |      | 62,827 |   |
| Gain on sale of loans held for sale                             |   | 865,581                         |      | 249,479 |   |
| Total non-interest income                                       |   | 1,087,177                       |      | 447,465 |   |
|                                                            |   |                            |      |   |   |
| **Non-interest expense:**                                       |   |                            |      |   |   |
| Compensation and employee benefits                              |   | 1,022,991                       |      | 794,026 |   |
| Board fees                                                      |   | 101,500                         |      | 91,250 |   |
| Occupancy                                                       |   | 178,890                         |      | 154,350 |   |
| Printing & supplies                                         |   | 78,576                          |      | 78,112 |   |
| Property and equipment depreciation                             |   | 75,282                          |      | 73,474 |   |
| Data processing                                                 |   | 153,039                         |      | 108,762 |   |
| Professional fees                                               |   | 408,554                         |      | 90,740 |   |
| Other                                                           |   | 379,227                         |      | 295,792 |   |
| Total non-interest expense                                      |   | 2,398,059                       |      | 1,686,506 |   |
|                                                            |   |                            |      |   |   |
| **Income (loss) before income tax benefit**                     |   | (232,816                        | )         | (1,088,316 | ) |
| Income tax benefit                                              |   | —                          |      | — |   |
|                                                            |   |                            |      |   |   |
| **Net income (loss)**                                           |   | $                               | (232,816  | ) | $ | (1,088,316 | ) |
|                                                            |   |                            |      |   |   |
| **Net income (loss) per common share**                          |   |                            |      |   |   |
| Basic and diluted income   (loss) per share of comon stock |   | $                               | (0.47     | ) | $ | (2.27 | ) |

 

See Notes to Consolidated Financial Statements

 

42

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### **NORTHERNSTAR FINANCIAL, INC AND SUBIDIARY**

### **CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY**

**Years Ended June 30, 2003 and 2002**

 
|                          |   | **Comprehensive  Income  (Loss)** |       | **Common  Stock  Par Value** |   | **Additional  Paid-In  Capital** |   | **Accumulated  Deficit** |       | **Unearned  Stock  Compensation** |       | **Accumulated  Other  Comprehensive  Income (loss)** |   | **Total** |       |
|-------------------------------|--------|-----------------------------------|------------|------------------------------|--------|----------------------------------|--------|--------------------------|------------|-----------------------------------|------------|------------------------------------------------------|--------|-----------|------------|
| Balance, June 30, 2001        |   |                              |       | $                            | 4,795  |                             | $      | 4,158,504                |       | $                                 | (1,192,043 | )                                                    | $      | (16,000   | )          | $ | 26,328 |   | $ | 2,981,584 |   |
|                          |   |                              |       |                         |   |                             |   |                     |       |                              |       |                                                 |   |      |       |
| Comprehensive income (loss):  |   |                              |       |                         |   |                             |   |                     |       |                              |       |                                                 |   |      |       |
| Net loss                      |   | $                                 | (1,088,316 | )                            | — |                             | — |                     | (1,088,316 | )                                 | —     |                                                 | — |      | (1,088,316 | ) |
|                          |   |                              |       |                         |   |                             |   |                     |       |                              |       |                                                 |   |      |       |
| Unrealized gain on securities |   | 26,400                            |       | —                       |   | —                           |   | —                   |       | —                            |       | 26,400                                               |   | 26,400    |       |
|                          |   | $                                 | (1,061,916 | )                            |   |                             |   |                     |       |                              |       |                                                 |   |      |       |   |
| Restricted stock earned       |   |                              |       | —                       |   | —                           |   | —                   |       | 3,996                             |       | —                                               |   | 3,996     |       |
|                          |   |                              |       |                         |   |                             |   |                     |       |                              |       |                                                 |   |      |       |
| Balance, June 30, 2002        |   |                              |       | 4,795                        |   | 4,158,504                        |   | (2,280,359               | )          | (12,004                           | )          | 52,728                                               |   | 1,923,664 |       |
|                          |   |                              |       |                         |   |                             |   |                     |       |                              |       |                                                 |   |      |       |
| Comprehensive income (loss):  |   |                              |       |                         |   |                             |   |                     |       |                              |       |                                                 |   |      |       |
| Net loss                      |   | $                                 | (232,816   | )                            | — |                             | — |                     | (232,816   | )                                 | —     |                                                 | — |      | (232,816   | ) |
|                          |   |                              |       |                         |   |                             |   |                     |       |                              |       |                                                 |   |      |       |
| Unrealized loss on securities |   | (713                              | )          | —                       |   | —                           |   | —                   |       | —                            |       | (713                                                 | )      | (713      | )          |
|                          |   | $                                 | (233,529   | )                            |   |                             |   |                     |       |                              |       |                                                 |   |      |       |   |
| Restricted stock earned       |   |                              |       |                         |   |                             |   |                     |       | 3,999                             |       |                                                 |   | 3,999     |       |
|                          |   |                              |       |                         |   |                             |   |                     |       |                              |       |                                                 |   |      |       |
| Issuance of common stock      |   |                              |       | 400                          |   | 219,600                          |   | —                   |       | —                            |       | —                                               |   | 220,000   |       |
|                          |   |                              |       |                         |   |                             |   |                     |       |                              |       |                                                 |   |      |       |
| Balance, June 30, 2003        |   |                              |       | $                            | 5,195  |                             | $      | 4,378,104                |       | $                                 | (2,513,175 | )                                                    | $      | (8,005    | )          | $ | 52,015 |   | $ | 1,914,134 |   |

 

See Notes to Consolidated Financial Statements

 

43

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**NORTHERN STAR FINANCIAL, INC. AND SUBSIDIARY**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

** **
|                                                                      |   | **Years  Ended June 30** |       |
|---------------------------------------------------------------------------|--------|--------------------------|------------|
|                                                                      |   | **2003**                 |       | **2002** |   |
| Cash flows from operating activities:                                     |   |                     |       |   |   |
| RECONCILIATION OF NET LOSS TO NET CASH PROVIDED BY OPERATING  ACTIVITIES  |   |                     |       |   |   |
| Net income (loss)                                                         |   | $                        | (232,816   | ) | $ | (1,088,316 | ) |
| Adjustments:                                                              |   |                     |       |   |   |
| Depreciation                                                              |   | 89,676                   |       | 87,654 |   |
| Provision for loan losses                                                 |   | 373,937                  |       | 785,075 |   |
| Accretion and (amortization) of premiums and discounts, net               |   | 14,356                   |       | 62,725 |   |
| Stock compensation earned                                                 |   | 3,999                    |       | 3,996 |   |
| Gain on sale of investments                                               |   | (3,504                   | )          | (62,827 | ) |
| Originations of loans held for sale                                       |   | (59,812,028              | )          | (17,116,084 | ) |
| Proceeds from sales of loans held for sale                                |   | 58,402,589               |       | 17,315,998 |   |
| Other                                                                     |   | (32,151                  | )          | (36,337 | ) |
| Net cash used in operating activities                                     |   | $                        | (1,195,942 | ) | $ | (48,116 | ) |
|                                                                      |   |                     |       |   |   |
| Cash flows from investing activities:                                     |   |                     |       |   |   |
| Purchases of available-for-sale securities                                |   | (4,256,624               | )          | (15,781,310 | ) |
| Proceeds from maturities of available-for-sale securities                 |   | 1,760,797                |       | 1,588,621 |   |
| Proceeds from sales of available-for-sale securities                      |   | 5,969,220                |       | 14,262,235 |   |
| Purchase of FHLB and UBB stock                                            |   | (128,300                 | )          | (100,000 | ) |
| Net decrease in federal funds sold                                        |   | 555,000                  |       | 2,401,000 |   |
| Loan originations and principal payments on loans, net                    |   | (5,576,945               | )          | (11,175,082 | ) |
| Purchase of premise and equipment                                         |   | (57,136                  | )          | (242,065 | ) |
| Net cash used in investing activities                                     |   | (1,733,988               | )          | (9,046,601 | ) |
|                                                                      |   |                     |       |   |   |
| Cash flows from financing activities:                                     |   |                     |       |   |   |
| Net increase in non-interest bearing demand and savings deposit  accounts |   | 1,524,165                |       | 6,218,870 |   |
| Net increase in time deposits                                             |   | 314,816                  |       | 553,795 |   |
| Proceeds from other borrowings                                            |   | 3,850,000                |       | 2,500,000 |   |
| Repayments of other borrowings                                            |   | (3,150,000               | )          | (100,000 | ) |
| Proceeds from issuance of convertible subordinated notes                  |   | 400,000                  |       | 1,400,000 |   |
| Repayment of convertible subordinated notes                               |   | (200,000                 | )          | — |   |
| Proceeds from sale of common stock                                        |   | 220,000                  |       | — |   |
| Net cash provided by financing activities                                 |   | 2,958,981                |       | 10,572,665 |   |
| Net increase in cash and cash equivalents                                 |   | 29,051                   |       | 1,477,948 |   |
| Cash and cash equivalents at beginning of year                            |   | 2,348,081                |       | 870,133 |   |
| Cash and cash equivalents at end of year                                  |   | $                        | 2,377,132  |   | $ | 2,348,081 |   |
|                                                                      |   |                     |       |   |   |
| Supplemental disclosure of cash flow information:                         |   |                     |       |   |   |
| Cash paid for interest                                                    |   | $                        | 1,513,535  |   | $ | 1,899,553 |   |
|                                                                      |   |                     |       |   |   |
| Non-cash investing and financing activities:                              |   |                     |       |   |   |
| Stock acquired in settlement of loan                                      |   | $                        | 115,862    |   | $ | — |   |

 

See Notes to Consolidated Financial Statements

 

44

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**NORTHERNSTAR FINANCIAL, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED****FINANCIAL STATEMENTS**

 

**Note 1.           Summaryof Significant Accounting Policies**

 

The followingsummarizes the significant accounting policies Northern Star Financial, Inc.(the Company) follows in presenting its financial statements.

 

*Principles of Consolidation*– The consolidated financial statements include the accounts of the Company andits wholly owned subsidiary, Northern Star Bank (the Bank).  All significant intercompany transactionsand balances are eliminated in consolidation.

 

*Nature of business* –****The Company is a bank holding companywhose subsidiary provides financial services. The Bank’s business is that of a financial intermediary and consistsprimarily of attracting deposits from the general public and using suchdeposits, together with borrowings and other funds, to make secured andunsecured loans to business and professional concerns and mortgage loanssecured by residential real estate and other consumer loans.  At June 30, 2003 and 2002, the Bank operatedone retail banking office in Mankato, Minnesota and a full service branchoffice in St. Cloud, Minnesota. The Bank is subject to significant competitionfrom other financial institutions, and is also subject to regulation by certainfederal and state agencies and undergoes periodic examinations by thoseregulatory authorities.

 

*Use of estimates -*In preparing the consolidated financial statements, management is required tomake estimates and assumptions that affect the reported amounts of assets andliabilities as of the date of the statement of financial condition, and incomeand expenses for the period.  Actualresults could differ from those estimates. Material estimates that are particularly susceptible to significantchange related to the determination of the allowance for losses on loans, thevaluation of real estate acquired in connection with foreclosures or insatisfaction of loans, and the valuation allowance for deferred taxes.  In connection with the determination of theallowance for losses on loans and foreclosed real estate, management obtainsindependent appraisals for significant properties.

 

Whilemanagement uses available information to recognize losses on loans andforeclosed assets, future additions to the allowance may be necessary based onchanges in local economic conditions. In addition, regulatory agencies, as an integral part of theirexamination process, periodically review the Bank’s allowance for losses onloans and foreclosed real estate.  Suchagencies may require the Bank to recognize additions to the allowance based ontheir judgment about information available to them at the time of theirexamination.

 

*Cash equivalents -*****For purposes of reporting cash flows, cashincludes cash on hand and non-interest bearing balances due from banks.

 

*Securities*–**Securities classified asavailable-for-sale are those debt securities that the Company intends to holdfor an indefinite period of time, but not necessarily to maturity.

 

45

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Any decisionto sell a security classified as available-for-sale would be based on variousfactors, including significant movements in interest rates, changes in thematurity mix of the Company’s assets and liabilities, liquidity needs,regulatory capital considerations, and other similar factors.  Securities available for sale are carried atfair value.  Unrealized gains or losses,net of the related deferred tax effect, are reported as a separate component ofother comprehensive income.  Realizedgains or losses, determined on the basis of the cost of specific securitiessold, are included in earnings.

 

Marketablesecurities that are acquired and held principally for the purpose of sellingthem in the near term are classified as trading securities and are reported atfair value, with unrealized gains and losses recognized in earnings.

 

Premium and discountson all investment securities are accreted (deducted) and amortized (added),respectively, to interest income on the straight-line and interest methods overthe period of the maturity of the related security.

 

*Restricted Stock -*TheBank, as a member of the Federal Home Loan Bank System, is required to maintainan investment in capital stock of the Federal Home Loan Bank of DesMoines.  Because no ready market existsfor this stock, and it has no quoted market value, the Bank’s investment inthis stock is carried at cost.

 

*Loans Held for Sale*– Mortgage loans originated and intended for sale in the secondary market arecarried at the lower cost or estimated market value in the aggregate.  Net unrealized losses are recognized througha valuation allowance by charges to income. Gains or losses on the sale of loans are recorded in non-interestincome, based on the net proceeds received and the recorded investment in theloan.

 

*Loans Receivable* –Loans receivable that management has the intent and ability to hold for theforeseeable future or until maturity or pay-off are reported at theiroutstanding principal balance adjusted for any charge-off, the allowance ofloan losses, and any deferred fees or costs on originated loans and unamortizedpremiums or discounts on purchased loans. Discounts and premiums on purchased residential real estate loans areamortized to income using the interest method over the remaining period tocontractual maturity, adjusted for anticipated prepayments.  Discounts and premiums on purchased consumerloans are recognized over the expected lives of the loans using the level yieldmethod.

 

A loan isimpaired when it is probable the Bank will be unable to collect all principaland interest payments due in accordance with the terms of the loanagreement.  Impaired loans are measuredbased on the present value of expected future cash flows or, alternatively, theobservable market price or the fair value of the collateral if the loan iscollateral dependent.  The amount ofimpairment, if any, and any subsequent changes are included in the allowancefor loan losses.

 

The allowancefor loan losses was established by a charge to income based on management’sevaluation of the known and inherent risks in the loan portfolio, adversesituations that may affect the borrower’s ability to repay, the estimated valueof any underlying collateral, and

 

46

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currenteconomic conditions. While management uses the best information available tomakes its evaluation, future adjustments to the allowance may be necessary ifthere are significant changes in economic conditions.

 

Uncollectibleinterest on loans contractually past due for three months is charged off or anallowance is established based on management’s periodic evaluation.  The allowance is established by a charge tointerest income equal to all interest previously accrued and income issubsequently recognized only to the extent cash payments are received or until,in management’s judgment, the borrower’s ability to make periodic interest andprincipal payments returns to normal, in which case the loan is returned toaccrual status.

 

Loanorigination fees and certain direct origination costs are capitalized with thenet fee or cost recognized as an adjustment to interest income using theinterest method.

 

*Premises and Equipment –*Leasehold improvements, furniture and equipment are carried at the lower ofcost less accumulated depreciation or fair market value.  Depreciation is computed by the straight-linemethod over the estimated useful lives of the assets, which range from three toseven years on furniture and equipment and five to twenty years on leaseholdimprovements.

 

*Advertising* – TheCompany expenses all advertising costs as incurred. Advertising costs of$52,562 and $42,589 are included in other non-interest expense for the yearsended June 30, 2003 and 2002, respectively.

 

*Income Taxes*–Deferred income taxes are recognized for the tax consequences of temporarydifferences by applying enacted statutory tax rates applicable to future yearsto differences between the financial statement carrying amounts and the taxbasis of existing assets and liabilities. The effect on deferred taxes of a change in tax rates is recognized inincome in the period that includes the enactment date.  Deferred tax assets are reduced by avaluation allowance if, based on the weight of available evidence, it is morelikely than not that some portion or all of the benefits will not berealized.  The effect of a change in thebeginning-of-the-year balance of a valuation allowance that results from achange in judgment about the realizability of deferred tax assets is includedin income.

 

The Companyfiles consolidated income tax returns with the Bank and they have entered intoa tax sharing agreement which provides that the Bank will pay to the Company,or receive a refund from the Company, as if the Bank portion of income taxliability or benefit was separately determined based on the Bank’s taxableincome or loss.

 

*Salary Reduction*–*SIMPLE IRA plan*–**The Company provides a salary reductionplan, which covers substantially all of the Company’s employees who areeligible as to age and length of service. A participant may elect to make contributions of up to the maximumamount eligible by law.  The Companymakes contributions of 2 percent of each participant’s compensation andcomplies with the requirements of the plan agreement.

 

47

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*Earnings (Loss) Per Share*–Basic income (loss) per share amounts are computed by dividing net income(loss) by weighted average number of common shares outstanding.  Diluted income (loss) per share amounts arecomputed by dividing net income (loss), adjusted for the effect of assumedconversions, by the weighted average number of common shares outstanding plusdilutive potential common shares calculated for stock options outstanding usingthe treasury method.

 

Nonvestedrestricted stock compensation is to be considered outstanding as of its issuancedate for computing diluted EPS even though it is contingent upon futuretime-related vesting and is not included in basic EPS until the time-basedvesting restriction has lapsed.

 

*Stock Based Compensation*- At June 30, 2003, the Company has a stock-based employee compensation plan,which is described more fully in Note 10. The Company accounts for the plan under the recognition and measurementprinciples of APB Opinion No. 25, Accounting for Stock Issued**to Employees and relatedInterpretations.  No stock basedemployee compensation cost is reflected in net income (loss), as all optionsgranted under those plans had an exercise price equal to the market value ofthe underlying common stock on the date of grant.  The following table illustrates the effect on net income (loss)and earnings (loss) per share if the Company had applied the fair valuerecognition provisions of FASB Statement No. 148, Accounting for Stock-BasedCompensation-Transition and Disclosure, to stock-based employee compensation.

 
|                                                                                                                                         |   | **Year Ended  June 30** |     |
|----------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|----------|
|                                                                                                                                         |   | **2003**                |     | **2002** |   |
| Net income (loss), as reported                                                                                                               |   | $                       | (232,816 | ) | $ | (1,088,316 | ) |
| Deduct: Total stock-based employee compensation expense determined  under fair value based method for all awards, net of related tax effects |   | (23,694                 | )        | (47,022 | ) |
|                                                                                                                                         |   |                    |     |   |   |
| Pro forma net income (loss)                                                                                                                  |   | $                       | (256,510 | ) | $ | (1,135,338 | ) |
|                                                                                                                                         |   |                    |     |   |   |
| Earnings (loss) per share:                                                                                                                   |   |                    |     |   |   |
| Basic–as reported                                                                                                                       |   | $                       | (0.47    | ) | $ | (2.27 | ) |
| Basic–pro forma                                                                                                                         |   | $                       | (0.52    | ) | $ | (2.37 | ) |
|                                                                                                                                         |   |                    |     |   |   |
| Stock based compensation included in net loss as reported (see Note  11)                                                                     |   | $                       | 3,999    |   | $ | 3,996 |   |

 

*Fair Values of Financial Instruments -*SFAS No. 107, Disclosure about Fair Value of Financial Instruments, requiresdisclosure of fair value information about financial instruments, whether ornot recognized in the statement of financial condition.  In cases where quoted market prices are notavailable, fair values are based on estimates using present value or othervaluation techniques.  Those techniquesare significantly affected by the assumptions used, including the discount rateand estimates of future cash flows.  Inthat regard, the derived fair value estimated cannot be substantiated bycomparison to independent markets and, in many cases, could not be realized inimmediate settlement of the

 

48

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instruments.  SFAS No. 107 excludes certain financialinstruments and all nonfinancial assets and liabilities from its disclosurerequirements. Accordingly, the aggregate fair value amounts presented to do notrepresent the underlying value of the Company.

 

The followingmethods and assumptions were used by the Company in estimating its fair valuedisclosures, presented in Note 15, for financial instruments:

 

*Cash and cash equivalents:*The carrying amounts reported in the statements of financial condition for cashand cash equivalents equal their fair values.

 

*Debt and equity securities:*  Fair values for debt and equity securitiesare based on quoted market prices, where available.  If quoted market prices are not available, fair values are basedon quoted market prices of comparable instruments.

 

*FHLB and UBB stock:*The carrying amount of FHLB and UBB stock approximates fair value.

 

*Loans held for sale*:  Fair values are based on quoted marketprices of similar loans sold on the secondary market.  Net unrealized losses are recognized through a valuationallowance by charges to income.  Gainsor losses on the sale of loans are recorded in non-interest income, based onthe net proceeds received and the recorded investment in the loan.

 

*Loans:* Forvariable-rate loans that reprice frequently with no significant change incredit risk, fair values are based on carrying amounts.  The fair values for other loans (forexample, fixed rate commercial real estate, rental property mortgage loans, andcommercial and industrial loans) are estimated using discounted cash flowanalyses, based on interest rates currently being offered for loans withsimilar terms to borrowers of similar credit quality giving consideration toestimated prepayment and credit loss factors. Loan fair value estimates include judgments regarding future expectedloss experience and risk characteristics. Fair values for impaired loans are estimated using discounted cash flowanalysis or underlying collateral values, where applicable.

 

*Accrued interest receivable*:  The carrying amount of accrued interestreceivable approximates fair value.

 

*Deposits*: The fairvalues disclosed for demand deposits are, by definition, equal to the amountpayable on demand at the reporting date (that is, their carrying amounts).  Fair values for time deposits are estimatedusing a discounted cash flow calculation that applies interest rates currentlyoffered on certificates to a schedule of aggregated expected monthly maturitieson time deposits.  The carrying amountof accrued interest payable approximates fair value.

 

*Notes payable, other borrowings, andconvertible subordinated notes payable: *The fair values of the Company’s long-termborrowings (other than deposits) are

 

49

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estimatedusing discounted cash flow analyses, based on the Company’s current incrementalborrowing rates for similar types of borrowing arrangements.

 

*Accrued interest payable*:  The carrying amount of accrued interest payableapproximates fair value.

 

*Loan commitments*:Commitments to extend credit were evaluated and fair value was estimated usingthe fees currently charged to enter into similar agreements, taking intoaccount the remaining terms of the agreements and the present creditworthinessof the counterparties.  For fixed-rateloan commitments, fair value also considers the difference between currentlevels of interest rates and the committed rates. The carrying value and fairvalue of commitments to extend credit are not considered material fordisclosure.

 

*Reclassifications* -Certain amounts in the financial statements for the prior year have beenreclassified to conform to current financial statement presentation. Thesereclassifications had no effect on net loss, total assets, or total liabilitiesand stockholders’ equity as previously reported.

 

*RecentAccounting Developments -*In April 2002, FASB issuedSFAS No. 145. Statement No. 145 rescinds SFAS No. 4, which requires all gainsand losses from extinguishment of debt to be aggregated and, if material,classified as an extraordinary item, net of related income tax effect. As aresult, the criteria in Opinion No. 30 will now be used to classify those gainsand losses. SFAS No. 64 amended SFAS No. 4, and is no longer necessary becauseSFAS No. 4 has been rescinded. The accounting, disclosure and financialstatements provision of SFAS No. 145 was effective for our fiscal yearbeginning July 1, 2002.  Any gain orloss on extinguishment of debt that was classified as an extraordinary item inprior periods presented that does not meet the criteria in Opinion No. 30 forclassification as an extraordinary item shall be reclassified. Theimplementation had no impact to the consolidated financial statements of theCompany.

 

In June 2002, the FASB issued SFAS 146, Accounting for Costs Associatedwith Exit or Disposal Activities.  ThisStatement addresses financial accounting and reporting for costs associatedwith exit or disposal activities and nullifies Emerging Issues Task Force IssueNo. 94-3, Liability Recognition for Certain Employee Termination Benefitsand Other Costs to Exit an Activity. The provisions of this Statement are effective for exit or disposalactivities that are initiated after December 31, 2002.  The implementation of this Statement doesnot impact the consolidated financial statements.

 

In October 2002, the FASB issued SFAS 147, which removes certainacquisitions of financial institutions (other than transactions between two ormore mutual enterprises) from the scope of SFAS 72, Accounting for CertainAcquisitions of Banking or Thrift Institutions, and FASB Interpretation 9,Applying APB Opinions 16 and 17 When a Savings and Loan or a SimilarInstitution Is Acquired in a Business Combination Accounted for by the PurchaseMethod. These types of transactions are now accounted for under SFAS 141 and142. In addition, this Statement amends SFAS 144, Accounting for the Impairmentor Disposal of Long-Lived Assets, to include in its scope long-term customer relationshipintangible assets

 

50

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of financial institutions. The provisions of this Statement wereeffective October 1, 2002, with earlier adoption permitted. The implementationof Statement No. 147 does not impact the consolidated financial statements ofthe Company.

 

In December 2002, the FASB issued SFAS 148, which provides alternativemethods of transition for a voluntary change to the fair value based method ofaccounting for stock-based compensation. In addition, this Statement amends thedisclosure requirements of SFAS 123 to require prominent disclosures in bothannual and interim financial statements about the method of accounting forstock-based employee compensation and the effect of the method used on reportedresults. Finally, this Statement amends APB Opinion 28, Interim FinancialReporting, to require disclosure about those effects in interim financialinformation. This Statement is effective for fiscal and interim periods endingafter December 15, 2002. Management does not expect this Statement to have amaterial impact to the consolidated financial statements. See Note 1 to theconsolidated financial statements for stock based compensation disclosures.

 

The FASBissued Statement No. 149, Amendment ofStatement 133 on Derivative Instruments and Hedging Activities.* *The Statement changes andclarifies accounting for derivative instruments, including certain derivativeinstruments embedded in other contracts, and for hedging activities underStatement 133.  The Statement iseffective for contracts entered into or modified after June 30, 2003.  Management does not expect this Statement tohave a material impact on the consolidated financial statements.

 

The FASBrecently issued Statement No. 150, Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity.  The Statement improvesthe accounting for certain financial instruments which, under previousguidance; issuers could account for as equity. The new Statement requires that those instruments be classified asliabilities in statements of financial position.  Most of the guidance is effective for all financial instrumentsentered into or modified after May 31, 2003. The implementation of Statement of 150 does not impact the consolidatedfinancial statements of the Company.

 

The FinancialAccounting Standards Board Interpretation 45 expands the information requiredto be disclosed by guarantors for obligations under certain types ofguarantees.  It also requires initialrecognition at fair value of liability for such guarantees but does notgenerally address subsequent measurement of the liability.  In addition, Interpretation 34, Disclosure of Indirect Guarantees of Others*,*is rescinded, though the guidance contained therein has been carried forwardinto Interpretation 45 without modification. The recognition and measurement provisions are applied prospectively forguarantees issued or modified after December 31, 2002 and the disclosurerequirements are effective for the current year’s financial statements.  Implementation of this Standard does nothave an impact on the consolidated financial statements.

 

In January 2003, the FASB issued FIN 46, which clarifies theapplication of Accounting Research Bulletin (ARB) 51, Consolidated FinancialStatements, to certain entities (called variable interest entities) in whichequity investors do not have the characteristics of a controlling financialinterest or do not have sufficient equity at risk for the entity to finance

 

51

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its activities without additional subordinated financial support fromother parties. The disclosure requirements of this Interpretation are effectivefor all financial statements issued after January 31, 2003. The consolidationrequirements apply to all variable interest entities created after January 31,2003. In addition, public companies must apply the consolidation requirementsto variable interest entities that existed prior to February 1, 2003 and remainin existence as of the beginning of annual or interim periods beginning afterJune 15, 2003. Management is currently assessing the impact of FIN 46, and doesnot expect this Interpretation to have a material impact to the consolidatedfinancial statements.

 

**Note2.   Securities – Available for sale andheld for trading**

 

The amortizedcosts and approximate fair values of debt and equity securities are summarizedas follows:

 
| **June 30, 2003**                   |   | **Amortized  Cost** |      | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Fair  Value** |   |
|-------------------------------------|--------|---------------------|-----------|------------------------------|--------|-------------------------------|--------|-----------------|--------|
| Debt securities available for sale: |   |                |      |                         |   |                          |   |            |   |
| US agency obligations               |   | $                   | 2,249,496 |                         | $      | 17,243                        |   | $               | — |   | $ | 2,266,739 |   |
| Mortgage-backed securities          |   | 3,275,935           |      | 48,489                       |   | (5,994                        | )      | 3,318,430       |   |
| Corporate bonds                     |   | 500,962             |      | 26,957                       |   | —                        |   | 527,919         |   |
|                                |   | 6,026,393           |      | 92,689                       |   | (5,994                        | )      | 6,113,088       |   |
| Securities held for trading:        |   |                |      |                         |   |                          |   |            |   |
| Common stock                        |   | 115,862             |      | —                       |   | —                        |   | 115,862         |   |
| Total                               |   | $                   | 6,142,255 |                         | $      | 92,689                        |   | $               | (5,994 | ) | $ | 6,228,950 |   |

 
| **June 30, 2002**                   |   | **Amortized  Cost** |      | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Fair  Value** |   |
|-------------------------------------|--------|---------------------|-----------|------------------------------|--------|-------------------------------|--------|-----------------|--------|
| Debt securities available for sale: |   |                |      |                         |   |                          |   |            |   |
| US agency obligations               |   | $                   | 1,246,295 |                         | $      | 7,302                         |   | $               | (542   | ) | $ | 1,253,055 |   |
| Mortgage-backed securities          |   | 5,263,117           |      | 67,914                       |   | —                        |   | 5,331,031       |   |
| Corporate bonds                     |   | 501,227             |      | 10,693                       |   | —                        |   | 511,920         |   |
| Mutual fund                         |   | 2,500,000           |      | 2,514                        |   | —                        |   | 2,502,514       |   |
| Total                               |   | $                   | 9,510,639 |                         | $      | 88,423                        |   | $               | (542   | ) | $ | 9,598,520 |   |

 

Proceeds from the sale of securities for the year ended June 30, 2003and 2002 were $5,969,220 and $14,262,235 respectively.  Net gains for the year ended June 30, 2003and 2002 of $3,504 and $62,827, respectively, were realized on these sales.

 

52

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The amortized cost and estimated market value of debt securities atJune 30, 2003, by contractual maturity, are shown below.

 
|                       |   | **June 30, 2003**   |      |
|----------------------------|--------|---------------------|-----------|
|                       |   | **Amortized  Cost** |      | **Estimated  Fair Value** |   |
| Due in one year or less    |   | $                   | —    |   | $ | — |   |
| Due from one to five years |   | 1,002,239           |      | 1,035,574 |   |
| Due from five to ten years |   | 1,248,964           |      | 1,259,829 |   |
| Due after ten years        |   | 499,255             |      | 499,255 |   |
|                       |   | 2,750,458           |      | 2,794,658 |   |
|                       |   |                |      |   |   |
| Mortgage-backed securities |   | 3,275,935           |      | 3,318,430 |   |
|                       |   | $                   | 6,026,393 |   | $ | 6,113,088 |   |

 

Anticipated maturities on mortgage-backed securities are not readilydeterminable since they may be prepaid without penalty.

 

Pledged securities:  Availablefor sale securities with an approximate carrying value of $2,800,000 and$3,200,000 at June 30, 2003 and 2002, respectively, were pledged to secureborrowings and for other purposes as required or permitted by law.

 

Changes in the unrealized gain (loss) on available for sale securities:

 
|                                                                       |   | **Years  Ended June 30** |   |
|----------------------------------------------------------------------------|--------|--------------------------|--------|
|                                                                       |   | **2003**                 |   | **2002** |   |
| Balance, beginning                                                         |   | $                        | 52,728 |   | $ | 26,328 |   |
| Unrealized gain during the year                                            |   | 3,033                    |   | 74,264 |   |
| Less reclassification adjustments for gains realized in net income  (loss) |   | (4,220                   | )      | (30,262 | ) |
| Deferred tax effect related to unrealized gain                             |   | 474                      |   | (17,602 | ) |
| Balance, ending                                                            |   | $                        | 52,015 |   | $ | 52,728 |   |

 

## **Note 3.   Loans Receivable**

 

Loansreceivable consist of the following:

 
|                           |   | **June 30, 2003** |       | **June 30, 2002** |   |
|--------------------------------|--------|-------------------|------------|-------------------|--------|
|                           |   | **Amount**        |       | **%****of Total** |   | **Amount** |   | **%****of Total** |   |
| Commercial & agricultural  |   | $                 | 6,979,307  |              | 17.55  | % | $ | 6,616,193 |   | 19.28 | % |
| Real estate - construction     |   | 4,433,072         |       | 11.15             | %      | 2,375,318 |   | 6.92 | % |
| Real estate - mortgages        |   | 18,504,208        |       | 46.52             | %      | 13,336,761 |   | 38.86 | % |
| Consumer loans                 |   | 9,821,027         |       | 24.69             | %      | 11,809,464 |   | 34.41 | % |
| Lease financing                |   | 35,673            |       | 0.09              | %      | 179,995 |   | 0.53 | % |
| Total loans                    |   | $                 | 39,773,287 |              | 100.00 | % | $ | 34,317,731 |   | 100.00 | % |
| Net deferred loan fees/(costs) |   | 108,422           |       |              |   | 180,131 |   |   |   |
| Less: allowance for loan loss  |   | (1,029,581        | )          |              |   | (661,170 | ) |   |   |
| Total net loans                |   | $                 | 38,852,128 |              |   |   | $ | 33,836,692 |   |   |   |

 

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A summary ofthe activity in the allowance for loan losses is as follows:

 
|                            |   | **Years  Ended June 30** |      |
|---------------------------------|--------|--------------------------|-----------|
|                            |   | **2003**                 |      | **2002** |   |
| Balance, beginning of period    |   | $                        | 661,170   |   | $ | 234,989 |   |
| Charge-offs                     |   | (14,680                  | )         | (359,751 | ) |
| Recoveries                      |   | 9,154                    |      | 857 |   |
| Provision charged to operations |   | 373,937                  |      | 785,075 |   |
| Balance, end of period          |   | $                        | 1,029,581 |   | $ | 661,170 |   |

 

In the ordinary course of business, the Bank has granted loans tocertain executive officers, directors and their related interest.  Loan activity in these accounts for the yearended June 30, is as follows:

 
|                |   | **2003**  |      | **2002**  |   |
|---------------------|--------|-----------|-----------|-----------|--------|
| Beginning balance   |   | $         | 3,957,000 |      | $      | 1,233,234 |   |
| New loans           |   | 5,769,954 |      | 3,217,938 |   |
| Participations sold |   | 4,691,500 |      | 210,750   |   |
| Less: Repayments    |   | 1,746,837 |      | 283,422   |   |
|                |   |      |      |      |   |
| Ending balance      |   | $         | 3,288,617 |      | $      | 3,957,000 |   |

 

Interest income from related parties was approximately $250,000 and$187,000 as of June 30, 2003 and 2002, respectively.

 

*Impaired loans:*** **Informationabout impaired loans as of and for the year ended June 30, 2003 is as follows:

 
| Loans receivable at year end, all of which  have related allowance for credit loss |   | $ | 3,111,421 |   |
|------------------------------------------------------------------------------------|--------|---|-----------|--------|
| Average impaired loans (based on quarter  end balances)                            |   | $ | 2,333,336 |   |
| Related allowance for credit losses at year  end                                   |   | $ | 806,954   |   |
| Interest income recognized on impaired  loans                                      |   | $ | 29,584    |   |

 

Informationabout impaired loans as of and for the year ended June 30, 2002 is as follows:

 
| Loans receivable at year end, all of which  have related allowance for credit loss |   | $ | 1,838,000 |   |
|------------------------------------------------------------------------------------|--------|---|-----------|--------|
| Average impaired loans (based on quarter  end balances)                            |   | $ | 824,000   |   |
| Related allowance for credit losses at year  end                                   |   | $ | 441,700   |   |
| Interest income recognized on impaired loans                                       |   | $ | 56,000    |   |

 

Loans receivable on non-accrual status for which interest income hasnot been recognized were $1,844,911 and $1,814,504 at June 30, 2003 and 2002,respectively.  The interest income notrecognized on these loans was $145,830 and $70,894, respectively.

 

54

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## **Note 4.   Accrued Interest Receivable**

Accruedinterest receivable is summarized as follows:

 
|                  |   | **June 30** |    |
|-----------------------|--------|-------------|---------|
|                  |   | **2003**    |    | **2002** |   |
| Investment securities |   | $           | 50,096  |   | $ | 43,913 |   |
| Loans receivable      |   | 232,320     |    | 232,253 |   |
|                  |   |        |    |   |   |
| Total                 |   | $           | 282,416 |   | $ | 276,166 |   |

## ** **

## **Note 5.   Premises and Equipment**

 

Premises andequipment consists of the following:

 
|                          |   | **June 30** |    |
|-------------------------------|--------|-------------|---------|
|                          |   | **2003**    |    | **2002** |   |
| Leasehold improvements        |   | $           | 270,189 |   | $ | 250,009 |   |
| Furniture and equipment       |   | 567,926     |    | 530,970 |   |
| Total                         |   | 838,115     |    | 780,979 |   |
|                          |   |        |    |   |   |
| Less accumulated depreciation |   | 334,718     |    | 245,041 |   |
|                          |   |        |    |   |   |
| Premises and equipment, net   |   | $           | 503,397 |   | $ | 535,938 |   |

## ** **

## **Note 6.   Deposits**

 
|                              |   | **June 30** |       |
|-----------------------------------|--------|-------------|------------|
|                              |   | **2003**    |       | **2002** |   |
| Demand deposit                    |   | $           | 5,090,364  |   | $ | 4,574,282 |   |
| Now and money market              |   | 8,623,932   |       | 7,718,574 |   |
| Savings                           |   | 4,630,763   |       | 4,533,290 |   |
| Time accounts less than $100,000  |   | 18,021,479  |       | 18,622,280 |   |
| Time accounts of $100,000 or more |   | 5,062,172   |       | 4,141,303 |   |
| Total deposits                    |   | $           | 41,428,710 |   | $ | 39,589,729 |   |

 

The scheduled maturities oftime deposits are as follows:

 
| Years ending June 30: |   |      |       |
|-----------------------|--------|-----------|------------|
| 2004                  |   | $         | 16,351,229 |   |
| 2005                  |   | 3,679,253 |       |
| 2006                  |   | 2,247,967 |       |
| 2007                  |   | 597,191   |       |
| 2008                  |   | 208,011   |       |
| Total                 |   | $         | 23,083,651 |   |

 

The amount of deposit accounts reclassified to the loan category was$27,348 and $5,097 as of June 30, 2003 and 2002, respectively.

 

55

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Interest expense by category follows:

 
|                              |   | **June 30** |      |
|-----------------------------------|--------|-------------|-----------|
|                              |   | **2003**    |      | **2002** |   |
| Demand deposit                    |   | $           | —    |   | $ | — |   |
| Now and money market              |   | 148,974     |      | 152,983 |   |
| Savings                           |   | 77,077      |      | 111,256 |   |
| Time accounts less than $100,000  |   | 719,918     |      | 1,028,611 |   |
| Time accounts of $100,000 or more |   | 184,447     |      | 211,331 |   |
| Total                             |   | $           | 1,130,416 |   | $ | 1,504,181 |   |

 

Deposits by related parties were approximately $6,617,000 and$6,144,000 as of June 30, 2003 and 2002, respectively.  Interest expense paid to related parties wasapproximately $208,000 and $282,000 as of June 30, 2003 and 2002,respectively.  Of the related partydeposits, approximately $5,496,000 and $6,144,000 as of June 30, 2003 and 2002,respectively, were from two individuals and their corresponding businesses.

 

## **Note 7.   Notes Payable and Other Borrowings**

## ** **

Fixed-rate advances from the Federal Home Loan Bank of Des Moines(FHLB), interest payable monthly (1.44% to 5.36%), due at varying dates through2011, secured by securities with a carrying value of approximately $2,800,000and $3,200,000, and residential real estate loans with a carrying value of$6,600,000 and 3,957,000 as of June 30, 2003 and 2002, respectively.  A $500,000 advance from the Federal HomeLoan Bank with a maturity date of October 2010 is callable quarterly.

 

Note payable to a bank, in the amount of $600,000, interest payablequarterly, variable interest rate of Prime + 1.00% at June 30, 2003 and 2002,secured by common stock of Northern Star Bank, matures March 31, 2004.

 

In connection with the note payable to the bank, the Company hasagreed, among other things, to maintain certain financial ratios.  The agreement also has restrictions on thepayment of dividends and limits future borrowing by the Company.

 
|            |   | **June 30** |      |
|-----------------|--------|-------------|-----------|
|            |   | **2003**    |      | **2002** |   |
| FHLB Borrowing  |   | $           | 5,375,000 |   | $ | 4,675,000 |   |
| Note Payable    |   | 600,000     |      | 600,000 |   |
| Total borrowing |   | $           | 5,975,000 |   | $ | 5,275,000 |   |

 

56

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At June 30, 2003, scheduled maturities, based on contractual maturitydates of the Company’s borrowings, including convertible subordinated notespayable were as follows:

 
| Years ending June 30: |   |      |      |
|-----------------------|--------|-----------|-----------|
| 2004                  |   | $         | 2,675,000 |   |
| 2005                  |   | 3,350,000 |      |
| 2006                  |   | 750,000   |      |
| 2007                  |   | 100,000   |      |
| 2008                  |   | —    |      |
| Thereafter            |   | 700,000   |      |
|                  |   | $         | 7,575,000 |   |
|                       |        |           |           |  |  |

 

## **Note 8.   Convertible Subordinated Notes Payable**

 

The Company has completed two issuances of three-year, unsecuredconvertible subordinated notes payable and one issuance of seven-month, unsecuredconvertible subordinated notes payable. The holders of the notes have the right to convert at any time prior tomaturity all or any part of the notes into shares of common stock of theCompany at the conversion rate.  Theconversion rate is adjustable if the number of outstanding shares changes.  A summary of the convertible subordinatednotes payable follows:

 
|                        |   | **First  Issue**       |      | **Second  Issue** |   | **Third  Issue** |   |
|-----------------------------|--------|------------------------|-----------|-------------------|--------|------------------|--------|
| Total Authorized            |   | $                      | 1,000,000 |              | $      | 500,000          |   | $ | 100,000 |   |
| Principal Outstanding       |   | 1,000,000              |      | 500,000           |   | 100,000          |   |
| Interest Rate               |   | 8.0                    | %         | 7.0               | %      | 7.0              | %      |
| Maturity Date               |   | July  thru August 2004 |      | June  2005        |   | December  2003   |   |
| Conversion rate (per share) |   | $                      | 10.50     |              | $      | 9.00             |   | $ | 9.00 |   |
| Conversion Shares           |   | 95,238                 |      | 55,555            |   | 11,111           |   |

 

Convertiblesubordinated notes payable totaling $850,000 and $1,050,000 were issued torelated parties as of June 30, 2003 and 2002, respectively. Interest expensepaid to related parties was approximately $61,000 and $36,000 as of June 30,2003 and 2002, respectively.

 

## **Note 9.   Income Taxes**

The Company and the Bank incurred no current tax expense becausetaxable income was offset by net operating loss carry forwards.  A reconciliation of income taxes computed atthe federal statutory income tax rate to total income taxes is as follows:

 
|                                                |   | **Years  Ended June 30** |    |
|-----------------------------------------------------|--------|--------------------------|---------|
|                                                |   | **2003**                 |    | **2002** |   |
|                                                |   |                     |    |   |   |
| Computed “expected” tax expense (benefit) |   | $                        | (81,000 | ) | $ | (380,000 | ) |
|                                                |   |                     |    |   |   |
| Increase (decrease) in income tax resulting from:   |   |                     |    |   |   |
| State income taxes, net of federal tax benefit      |   | (15,000                  | )       | (69,000 | ) |
| Other                                               |   | 36,000                   |    | 13,000 |   |
| Change in valuation allowance                       |   | 60,000                   |    | 436,000 |   |
|                                                |   |                     |    |   |   |
| Net income tax expense (benefit)                    |   | $                        | —  |   | $ | — |   |

 

57

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Temporary differences between financial statement carrying amounts and thetax basis of assets and liabilities that create deferred tax assets andliabilities are as follows:

 
|                                             |   | **June 30** |    |
|--------------------------------------------------|--------|-------------|---------|
|                                             |   | **2003**    |    | **2002** |   |
| Deferred tax assets:                             |   |        |    |   |   |
| Loan loss allowance                              |   | $           | 417,000 |   | $ | 268,000 |   |
| Net operating loss carryover                     |   | 616,000     |    | 708,000 |   |
| Other                                            |   | 21,000      |    | 37,000 |   |
|                                             |   | 1,054,000   |    | 1,013,000 |   |
|                                             |   |        |    |   |   |
| Less: valuation allowance                        |   | (932,000    | )       | (872,000 | ) |
| Total deferred tax assets                        |   | 122,000     |    | 141,000 |   |
|                                             |   |        |    |   |   |
| Deferred tax liability:                          |   |        |    |   |   |
| Property and equipment                           |   | 32,000      |    | 25,000 |   |
| Unrealized gain on available for sale securities |   | 35,000      |    | 35,000 |   |
| Deferred loan fees and costs                     |   | 55,000      |    | 81,000 |   |
| Total deferred tax liabilities                   |   | 122,000     |    | 141,000 |   |
|                                             |   |        |    |   |   |
| Net deferred tax asset (liability)               |   | $           | —  |   | $ | — |   |

 

During the years ended June 30, 2003 and 2002, the Company increasedthe valuation allowance by $60,000 and $436,000, respectively.  Management reviews the estimate of thisvaluation account on a regular basis, and it is reasonably possible that its estimatewill change in the next year.

 

At June 30, 2003, the Company has a cumulative net operating losscarryover for tax purposes of approximately $1,522,000 available for futureperiods.  The loss carry forwards willbegin to expire in 2019.

## ** **

## **Note 10. Stock Options**

 

In August 1998, the Company adopted the 1998 Equity Incentive Plan (the“Plan”) and reserved 41,700 shares of common stock for issuance pursuant to thePlan to certain employees and directors of the Company and its subsidiary.  In addition, the Company granted to itsorganizing directors options to purchase an aggregate of 30,800 shares outsidethe Plan.  These plans provide for thegranting of incentive stock options as defined in Section 422 of the InternalRevenue Code as well as nonqualified stock options (collectively stock options).

 

In October 1999, the Company amended the Plan and reserved anadditional 75,000 shares of its common stock for issuance.  The options vest over a period ranging fromimmediate to 3 years and must be exercised within 10 years of grant date.

 

58

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The followingsummarizes the stock option activity:

 
|             |   | **Shares  Available  for Grant** |   | **Options  Shares  Outstanding** |   | **Weighted  Avg.  Exercise Price** |   |
|------------------|--------|----------------------------------|--------|----------------------------------|--------|------------------------------------|--------|
| At June 30, 2001 |   | 42,900                           |   | 104,600                          |   | $                                  | 9.75   |   |
|             |   |                             |   |                             |   |                               |   |
| Granted          |   | (22,000                          | )      | 22,000                           |   | 6.50                               |   |
|             |   |                             |   |                             |   |                               |   |
| Exercised        |   | —                           |   | —                           |   | —                             |   |
|             |   |                             |   |                             |   |                               |   |
| At June 30, 2002 |   | 20,900                           |   | 126,600                          |   | 9.19                               |   |
|             |   |                             |   |                             |   |                               |   |
| Granted          |   | (25,600                          | )      | 25,600                           |   | 5.57                               |   |
|             |   |                             |   |                             |   |                               |   |
| Shares cancelled |   | 9,000                            |   | (9,000                           | )      | (9.66                              | )      |
|             |   |                             |   |                             |   |                               |   |
| At June 30, 2003 |   | 4,300                            |   | 143,200                          |   | $                                  | 8.51   |   |

 

A summary of the status ofthe stock options as of and for the year ended June 30, 2003 is presentedbelow:

 
|        |   | **Shares** |   | **Weighted  Avg.  Exercise Price** |   |
|-------------|--------|------------|--------|------------------------------------|--------|
|        |   |       |   |                               |   |
| Granted     |   | 143,200    |   | $                                  | 8.51   |   |
| Outstanding |   | 143,200    |   | $                                  | 8.51   |   |
| Exercisable |   | 130,095    |   | $                                  | 8.76   |   |

 
| **Stock options  Issued** |   | **Weighted  average  fair value** |   | **Weighed  average contractual  life of options outstanding** |   |
|---------------------------|--------|-----------------------------------|--------|---------------------------------------------------------------|--------|
| 1999                      |   | $                                 | 4.33   |                                                          | 5.3    |   |
| 2000                      |   | $                                 | 3.06   |                                                          | 6.4    |   |
| 2001                      |   | $                                 | 2.15   |                                                          | 7.4    |   |
| 2002                      |   | $                                 | 0.47   |                                                          | 8.4    |   |
| 2003                      |   | $                                 | 0.57   |                                                          | 9.4    |   |
| overall                   |   |                              |   | 7.0                                                           |   |

 

Statement of Financial Accounting Standards No. 123, Accounting forStock-Based Compensation (SFAS 123), provides for companies to recognizecompensation expense associated with stock-based compensation plans over theanticipated service period based on the fair value of the award on the date ofgrant.  However, SFAS 123 allowscompanies to continue to measure compensation costs prescribed by AccountingPrinciples Board Opinion No. 25, Accounting for Stock Issued to Employees (APB25).

 

The Company elected to follow APB 25 and related Interpretations inaccounting for its employee stock options. Under APB 25, the exercise price of the Company’s employee stock optionsequal the market price of the underlying stock on the date of grant, and,therefore, no compensation expense is recognized.

 

Proforma information regarding net income (loss) and earnings (loss)per share is required by SFAS No. 148 Accounting for Stock-BasedCompensation-Transition and

 

59

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Disclosure,and has been determined as if the Company had accounted for its employee stockoption under the fair value method of that statement. Proforma net income(loss) and earnings (loss) per share for the fiscal year end 2003 and 2002follows:

 
|                                                          |   | **2003** |     | **2002** |   |
|---------------------------------------------------------------|--------|----------|----------|----------|--------|
| Net income (loss)                                             |   |     |     |     |   |
| As reported                                                   |   | $        | (232,816 | )        | $      | (1,088,316 | ) |
| Pro forma                                                     |   | $        | (256,510 | )        | $      | (1,135,338 | ) |
|                                                          |   |     |     |     |   |
| Earnings (loss) per common  share and common share equivalent |   |     |     |     |   |
| As reported                                                   |   | (0.47    | )        | (2.27    | )      |
| Pro forma                                                     |   | (0.52    | )        | (2.37    | )      |

 

The above-disclosed pro forma effects of applying SFAS No. 123 tocompensation costs may not be representative of the effects on reported proforma net income (loss) for future years.

 

The fair value for each option grant is estimated on the date of thegrant using the Black Scholes Model. The model incorporates the followingassumptions:

 
|                    |   | **Options  Issued** |   |
|-------------------------|--------|---------------------|--------|
|                    |   | **Fiscal  2003**    |   | **Fiscal  2002** |   |
| Risk-free interest rate |   | 4.35                | %      | 5.34 | % |
| Expected life           |   | 10  Yrs.            |   | 5  Yrs. |   |
| Expected volatility     |   | 77.00               | %      | 81.00 | % |
| Expected dividends      |   | None                |   | None |   |

 

# **Note 11. Employee Benefits**

 

In December 1999, the Bank adopted a salary reduction plan (Simple IRA)which covers substantially all full time employees.  The cost to the Bank for this plan was approximately $14,000 and$12,000 for the years ended June 30, 2003, and 2002, respectively.

 

On December 22, 1999, the Company granted its Chief Executive Officer arestricted stock award of 2,000 shares of the Company’s common stock. Theshares are subject to a vesting period ranging from three to five years.  The unearned compensation, measured by thequoted price of the stock on the award date ($10 per share), is shown as aseparate reduction of the stockholders’ equity.  The unearned compensation will be accounted for as expense overthe vesting period. Unearned compensation and compensation expense was $8,005and $3,999 and $12,004 and $3,996 at June 30, 2003 and 2002, respectively.

 

# **Note 12. Commitments**

 

At June 30, 2003, the Bank was obliged under operating leases foroffice space and equipment.  The Bank’sSt. Cloud office space is leased from a lesser entity in which a Companystockholder has a significant interest. Minimum lease payments under the operating leases are as follows:

 

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| **For the Year  Ended** |   | **Mankato  Office  lease** |    | **St. Cloud  Office  lease** |   | **Equipment  lease** |   |
|-------------------------|--------|----------------------------|---------|------------------------------|--------|----------------------|--------|
| 2004                    |   | $                          | 79,212  |                         | $      | 61,679               |   | $ | 13,925 |   |
| 2005                    |   | 80,292                     |    | 66,111                       |   | 9,821                |   |
| 2006                    |   | 81,804                     |    | 70,543                       |   | 3,542                |   |
| 2007                    |   | 81,804                     |    | 87,163                       |   |                 |   |
| 2008                    |   | 81,804                     |    | 88,640                       |   |                 |   |
| Thereafter              |   | 47,719                     |    | 265,920                      |   |                 |   |
| Total                   |   | $                          | 452,635 |                         | $      | 640,056              |   | $ | 27,288 |   |

 

The Bank has an option to renew the Mankatooffice lease for two additional five-year terms and the St. Cloud office leasefor an additional five-year term.  Rentexpense for the fiscal year 2003 and 2002 was approximately $132,000 and$117,000, respectively.  Rent expense torelated parties for fiscal year 2003 and 2002 was approximately $119,000 and$110,000, respectively.

 

# **Note 13.  Stock Warrants**

 

On October 9, 1998, the Company entered intoan agency agreement to sell the Company’s common stock.  In accordance with the agreement, warrantswere issued to the underwriters to acquire 10,000 shares of the Company’s stockat $12.00 per share at any time prior to October 9, 2003.

 

On April 11, 2001, the Company entered intoan agency agreement to sell the Company’s common stock.  In accordance with the agreement, warrantswere issued to the underwriters to acquire 5,190 shares of the Company’s stockat $12.60 per share any time during the period of April 11, 2002 and April 11,2006.

 

# **Note 14.  Financial Instruments With Off-Balance SheetRisk**

 

The Bank is a party to financial instrumentswith off-balance sheet risk in the normal course of business to meet thefinancing needs of its customers.  Thesefinancial instruments are commitments to extend credit and involve, to varyingdegrees, elements of credit risk in excess of the amount recognized in thebalance sheet. The Bank’s exposure to credit loss in the event ofnonperformance by the other party to the financial instrument for commitmentsto extend credit is represented by the contractual amount of thoseinstruments.  The Bank uses the samecredit policies in making commitments as it does for on-balance sheetinstruments. The Bank had outstanding commitments for additional borrowings asfollows:

 
|                                                         |   | **At June 30** |      |
|--------------------------------------------------------------|--------|----------------|-----------|
|                                                         |   | **2003**       |      | **2002** |   |
| Revolving, open-end secured by 1-4 family  residential       |   | $              | 1,438,965 |   | $ | 1,454,257 |   |
| Commercial real estate, construction and land  development   |   | 1,453,467      |      | 1,620,977 |   |
| Other, agricultural real estate, unsecured and  check credit |   | 1,888,010      |      | 1,210,985 |   |
| Total outstanding commitments and additional  borrowings     |   | $              | 4,780,442 |   | $ | 4,286,219 |   |

 

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Commitments to extend credit are agreementsto lend to a customer as long as there is no violation of any conditionestablished in the contract. Commitments generally have fixed expiration dates or other terminationclauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawnupon, the total commitments amounts do not necessarily represent future cashrequirements. The Bank examines each customer’s creditworthiness on acase-by-case basis. The amount and type of collateral obtained, if deemednecessary by the Bank upon extension of credit, varies and is based onmanagement’s credit evaluation of the counterparty.

 

Commitments to sell loans amounted to$2,035,176 at June 30, 2003 and $625,735 at June 30, 2002.

 

# **Note 15.  Fair Value of Financial Instruments**

 

The estimated fair values of the Company’s and the Bank’s financialinstruments are as follows:

 
|                                   |   | **June 30,  2003**   |   | **June 30,  2002** |   |
|----------------------------------------|--------|----------------------|--------|--------------------|--------|
|                                   |   | **Carrying  Amount** |   | **Fair  Value**    |   | **Carrying  Amount** |   | **Fair  Value** |   |
| Financial assets:                      |   |                 |   |               |   |   |   |   |   |
| Cash and cash equivalents              |   | 2,377,132            |   | 2,377,132          |   | 2,348,081 |   | 2,348,081 |   |
| Federal funds sold                     |   | 482,000              |   | 482,000            |   | 1,037,000 |   | 1,037,000 |   |
| Securities available for sale          |   | 6,113,088            |   | 6,113,088          |   | 9,598,520 |   | 9,598,520 |   |
| Securities held for trading            |   | 115,862              |   | 115,862            |   | — |   | — |   |
| Investment in FHLB and UBB stock       |   | 367,100              |   | 367,100            |   | 238,800 |   | 238,800 |   |
| Loans held for sale                    |   | 2,035,176            |   | 2,035,176          |   | 625,735 |   | 625,735 |   |
| Loans                                  |   | 38,852,128           |   | 39,900,355         |   | 33,836,692 |   | 34,673,000 |   |
| Accrued interest receivable            |   | 282,416              |   | 282,416            |   | 276,166 |   | 276,166 |   |
| Financial liabilities;                 |   |                 |   |               |   |   |   |   |   |
| Deposits                               |   | 41,428,710           |   | 41,787,398         |   | 39,589,729 |   | 40,121,000 |   |
| Notes payable and other borrowing      |   | 5,975,000            |   | 6,049,138          |   | 5,275,000 |   | 5,300,000 |   |
| Convertible subordinated notes payable |   | 1,600,000            |   | 1,607,774          |   | 1,400,000 |   | 1,421,000 |   |
| Accrued interest payable               |   | 266,708              |   | 266,708            |   | 321,546 |   | 321,546 |   |

 

*Interest Rate Risk:* The Company and the Bank assume interest raterisk (the risk that general interest rate levels will change) as a result oftheir normal operations.  As a result,the fair values of the Company’s and Bank’s financial instruments will changewhen rate levels change, and that change may be either favorable or unfavorableto the Company and the Bank.  Managementattempts to match maturities of assets and liabilities to the extent believednecessary to minimize interest rate risk. However, borrowers with fixed-rate obligations are less likely to prepayin a rising-rate environment and more likely****toprepay in a falling-rate environment. Conversely, depositors who are receivingfixed rates are more likely to withdraw funds before maturity in a rising-rateenvironment and less likely to do so in a falling-rate environment.  Management monitors rates and maturities ofassets and liabilities and attempts to minimize interest rate risk by adjustingterms of new loans and

 

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deposits andby investing in securities with terms that mitigate the Company’s and theBank’s overall interest rate risk.

 

# **Note 16.  Concentration of Credit Risk**

 

*Concentration over insured limits: *The nature of theBank’s business requires that it maintain amounts due from banks, which, attimes, may exceed federally insured limits. The Bank has not experienced any losses in such accounts.

 

*Concentration by geographic location: *The Bank makescommercial, real estate, and consumer loans to its customers primarily in theBank’s primary trade areas of Mankato and St. Cloud, Minnesota.  Although the Bank’s loan portfolio isdiversified, a substantial portion of the Bank’s customers’ ability to honortheir contracts is dependent upon the local business economy, which is takeninto consideration by management in determining the allowance for loan losses.

 

# **Note 17.  Stockholders’ Equity and Regulatory Matters**

 

The Bank is subject to various regulatorycapital requirements administered by the Federal Deposit Insurance Corporation(FDIC). Failure to meet minimum capital requirements can initiate certainmandatory and possible additional discretionary actions by regulators that, ifundertaken, could have a direct material effect on the Bank’s financialstatements.  Under capital adequacyguidelines and the regulatory framework for prompt corrective action, the Bankmust meet specific capital guidelines that involve quantitative measures of theBank’s assets, liabilities and certain off-balance sheet items as calculatedunder regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitativejudgments by the regulators about components, risk weightings, and otherfactors.

 

Quantitative measures established byregulation to ensure capital adequacy require the Bank to maintain minimumratios (set forth in the table below) of total and Tier I capital torisk-weighted assets, and of Tier I capital to average assets (all as definedin the regulations).  Managementbelieves, as of June 30, 2003, that the Bank meets all capital adequacyrequirements to which it is subject.

 

As of June 30, 2003, the most recentnotification for the Bank’s primary regulator (FDIC) categorized the Bank aswell capitalized under the regulatory framework for prompt correctiveaction.  To be categorized as wellcapitalized, the Bank must maintain minimum total risk-based, Tier Irisk-based, and Tier I leverage ratios as set forth in the table below.

 

Banking regulations restrict the amount ofdividends that may be paid by the Bank without prior approval of banksupervisory authorities.

 

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|                                                  |   | **Actual** |      | **For  Capital  Adequacy Purposes** |   | **To Be Well  Capitalized  Under Prompt Corrective  Action Provision** |   |
|-------------------------------------------------------|--------|------------|-----------|-------------------------------------|--------|------------------------------------------------------------------------|--------|
|                                                  |   | **Amount** |      | **Percent**                         |   | **Amount**                                                             |   | **Percent** |   | **Amount** |   | **Percent** |   |
| As  of June 30, 2003                                  |   |       |      |                                |   |                                                                   |   |   |   |   |   |   |   |
| Total Capital   (to Risk Weighted Assets)             |   | $          | 4,518,323 |                                | 11.60  | %                                                                      | $      | 3,117,680 |   | >8.00 | % | $ | 3,897,110 |   | >10.0 | % |
|                                                  |   |       |      |                                |   |                                                                   |   |   |   |   |   |   |   |
| Tier I Capital   (to Risk Weighted Assets)            |   | $          | 4,024,323 |                                | 10.33  | %                                                                      | $      | 1,558,840 |   | >4.00 | % | $ | 2,338,260 |   | >6.00 | % |
|                                                  |   |       |      |                                |   |                                                                   |   |   |   |   |   |   |   |
| Leverage Ratio   Tier I Captial   (to Average Assets) |   | $          | 4,024,323 |                                | 8.04   | %                                                                      | $      | 2,002,560 |   | >4.00 | % | $ | 2,503,200 |   | >5.00 | % |
|                                                  |   |       |      |                                |   |                                                                   |   |   |   |   |   |   |   |
| As of June 30, 2002                                   |   |       |      |                                |   |                                                                   |   |   |   |   |   |   |   |
| Total Capital   (to Risk Weighted Assets)             |   | $          | 4,298,000 |                                | 11.50  | %                                                                      | $      | 2,990,000 |   | >8.00 | % | $ | 3,737,000 |   | >10.0 | % |
|                                                  |   |       |      |                                |   |                                                                   |   |   |   |   |   |   |   |
| Tier I Capital   (to Risk Weighted Assets)            |   | $          | 3,827,000 |                                | 10.20  | %                                                                      | $      | 1,496,000 |   | >4.00 | % | $ | 2,245,000 |   | >6.00 | % |
|                                                  |   |       |      |                                |   |                                                                   |   |   |   |   |   |   |   |
| Leverage Ratio   Tier I Captial   (to Average Assets) |   | $          | 3,827,000 |                                | 8.70   | %                                                                      | $      | 1,760,000 |   | >4.00 | % | $ | 2,199,000 |   | >5.00 | % |

 

The Bank may not declare or pay cashdividends to the Company if the effect would be to reduce capital belowapplicable regulatory requirements or if such declaration and payment wouldotherwise violate regulatory requirements. Since there are no current operating earnings or retained earnings, noamounts are available for the payment of dividends.

 

During the second and fourth quarters offiscal year 2003, the Board of Directors of the Company authorized a privateplacement of 40,000 and 20,000 shares respectively, of its common stock at aprice of $5.50 per share.  In July 2003,the Board of Directors of the Company amended its original motion of 20,000shares be increased to 50,000 shares. The Company did not incur any underwriting or placement expenses inconnection with these offerings.  As ofJuly 31, 2003, subscriptions to all of the authorized shares had beenreceived.  As of June 30, 2003, paymentfor 40,000 shares had been received. The proceeds will be used to support our on-going operations.

 

**Note 18. Earnings (Loss) Per Share**

 

The basic earnings (loss) per share amountswere computed using the weighted-average number of shares outstanding duringthe years presented.  For the yearsended June 30, 2003 and 2002, the weighted-average number of shares outstandingfor basic and diluted earnings (loss) per share were 495,084 and 479,506,respectively.  Common stock sharesissuable upon the conversion of subordinated debt (Note 8) and from the exerciseof stock options (Note 10) and warrants issued (Note 13) totaling 307,189 and269,039 shares at June 30, 2003 and 2002 respectively, were not used in thecalculation of diluted earnings (loss) per share because they wereanti-dilutive

 

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**Note 19. Parent Only Condensed Financial Information**

 

CONDENSED STATEMENTS OF FINANCIAL CONDITION

 
|                                      |   | **June 30** |      |
|-------------------------------------------|--------|-------------|-----------|
|                                      |   | **2003**    |      | **2002** |   |
| Assets                                    |   |        |      |   |   |
|                                      |   |        |      |   |   |
| Cash on deposit with subsidiary bank      |   | $           | 68,178    |   | $ | 71,993 |   |
| Investment in subsidiary                  |   | 4,076,339   |      | 3,879,824 |   |
|                                      |   | $           | 4,144,517 |   | $ | 3,951,817 |   |
| Liabilities and Stockholders’ Equity |   |        |      |   |   |
|                                      |   |        |      |   |   |
| Note payable to bank                      |   | $           | 600,000   |   | $ | 600,000 |   |
| Convertible subordinated notes payable    |   | 1,600,000   |      | 1,400,000 |   |
| Other liabilities                         |   | 30,383      |      | 28,153 |   |
|                                      |   | 2,230,383   |      | 2,028,153 |   |
|                                      |   |        |      |   |   |
| Stockholders’ equity                 |   | 1,914,134   |      | 1,923,664 |   |
|                                      |   | $           | 4,144,517 |   | $ | 3,951,817 |   |

 

CONDENSED STATEMENTS OF OPERATIONS

 
|                                                 |   | **Years Ended June 30** |     |
|------------------------------------------------------|--------|-------------------------|----------|
|                                                 |   | **2003**                |     | **2002** |   |
| Interest income                                      |   | $                       | 411      |   | $ | 8,505 |   |
| Equity in undistributed income (loss) of  subsidiary |   | 197,227                 |     | (811,791 | ) |
|                                                 |   | 197,638                 |     | (803,286 | ) |
|                                                 |   |                    |     |   |   |
| Interest expense                                     |   | 145,201                 |     | 110,631 |   |
| Non-interest expense                                 |   | 285,253                 |     | 174,399 |   |
|                                                 |   | 430,454                 |     | 285,030 |   |
|                                                 |   |                    |     |   |   |
| Loss before income taxes                             |   | (232,816                | )        | (1,088,316 | ) |
|                                                 |   |                    |     |   |   |
| Income tax expense (benefit)                         |   | —                  |     | — |   |
| Net loss                                             |   | $                       | (232,816 | ) | $ | (1,088,316 | ) |

 

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CONDENSED STATEMENTS OF CASH FLOWS

 
|                                                              |   | **Years  Ended June 30** |     |
|-------------------------------------------------------------------|--------|--------------------------|----------|
|                                                              |   | **2003**                 |     | **2002** |   |
| Cash flows from operating activities:                             |   |                     |     |   |   |
| Net loss                                                          |   | $                        | (232,816 | ) | $ | (1,088,316 | ) |
| Adjustments:                                                      |   |                     |     |   |   |
| Equity in undistributed (income) loss of  subsidiary              |   | (197,227                 | )        | 811,791 |   |
| Earned stock compensation                                         |   | 3,999                    |     | 3,996 |   |
| Other                                                             |   | 2,229                    |     | 24,344 |   |
|                                                              |   | (423,815                 | )        | (248,185 | ) |
|                                                              |   |                     |     |   |   |
| Cash flows from investing activities:                             |   |                     |     |   |   |
| Capital contributed to subsidiary bank                            |   | —                   |     | (1,600,000 | ) |
|                                                              |   |                     |     |   |   |
| Cash flows from financing activities:                             |   |                     |     |   |   |
| Proceeds from issuance of common stock, net                       |   | 220,000                  |     | — |   |
| Proceeds from issuance of convertible  subordinated notes payable |   | 400,000                  |     | 1,400,000 |   |
| Repayment of convertible subordinated notes  payable              |   | (200,000                 | )        | — |   |
| Proceeds from notes payable and other  borrowing                  |   | —                   |     | 500,000 |   |
|                                                              |   | 420,000                  |     | 1,900,000 |   |
|                                                              |   |                     |     |   |   |
| Net increase (decrease) in cash                                   |   | (3,815                   | )        | 51,815 |   |
|                                                              |   |                     |     |   |   |
| Cash, beginning                                                   |   | 71,993                   |     | 20,178 |   |
| Cash, ending                                                      |   | $                        | 68,178   |   | $ | 71,993 |   |

 

**Note 20. Litigation Matters**

 

The Bank was a defendant in a complaint filed onFebruary 23, 2002 in United States District Court, District of SouthDakota Southern Division by Bridge Lenders, LLC; Jim Perry; Larry Ticknor; DougEnglish; Rollyn H. Samp; Courtney Anderson; Henry Carlson, Jr.; Michael M.Samp; Ernest Olson; Don Davis; Jerry Landerville; Allen Lewis; Gary Viger; GlenJamtgaard and Steve Herman (“Plaintiffs”). The complaint arose out of a series of loans that the Bank made toPlaintiffs in 2000.  Plaintiffs used theproceeds of the loans to make an investment in Bridge Lenders, LLC, and BridgeLenders, LLC in turn used the funds to make an investment in PhenixBiocomposites, which has defaulted in its obligations to Plaintiffs.  The Bank was a defendant in this action dueto the fact that its former director, Frank Gazzola, was also a director ofPhenix Biocomposites.  The Plaintiffsalleged that Mr. Gazzola failed to inform the Plaintiffs that their investmentin Phenix Biocomposites was not secured. The Plaintiffs claimed that the Bank had a fiduciary duty to thePlaintiffs because of Mr. Gazzola’s dual role as a director of both the Bankand Phenix Biocomposites, that Northern Star Bank violated this fiduciary dutyand a separate implied covenant of good faith and fair dealing when Mr. Gazzolaallegedly provided false information to Plaintiffs, and that the falseinformation allegedly provided by Mr. Gazzola constituted intentional or 

 

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unintentional fraud by theBank.  Plaintiffs sought compensatory,general, special and punitive damages.

 

On July 22, 2003, the District Court for theDistrict of South Dakota dismissed all claims against the Bank.  The dismissal was based on the Court’sdetermination that Mr. Gazzola is an indispensable party-defendant; and on thefact that Plaintiffs failed to comply with the Court’s June 5, 2003 orderdirecting Plaintiffs to join Mr. Gazzola. The dismissal of the Plaintiff’s claim is without prejudice.

 

On July 31, 2003, the Plaintiffs filed a newcomplaint in the United States District Court for the District ofMinnesota.  In the new complaint, thePlaintiffs assert claims against the Bank that are substantially the same asthe claims they had asserted in the complaint that was dismissed in SouthDakota.  The Plaintiffs addedMr. Gazzola as named defendant in the new complaint.  The Bank denies the Plaintiffs’ allegationsand intends to vigorously defend itself in this action.  On August 26, 2003, the Bank served andfiled a motion to dismiss the new complaint.

 

The Bank has commenced separate collection actionsin Minnesota State Court against some of the Plaintiffs who are in defaultunder the terms of their outstanding notes to the Bank.

 

The Company was a defendant and third partyplaintiff in a complaint originally filed on March 22, 2002 in the UnitedStates District Court for the Western District of Wisconsin by CatalyticCombustion Corporation 401(k) Profit Sharing Plan and Catalytic CombustionCorporation (“Plaintiffs”).  On March31, 2003, the Company, the third party defendant, and the plaintiffs enteredinto a confidential final and binding mutual release of all claims andsettlement agreement.  All expensesincurred in connection with the settlement have been expensed in the amount of$22,000.

 

During 1999 and 2000, the Bank made a seriesof loans to Frank Gazzola, then a Director of the Company, in various amountsat market rates of interest and for terms of various lengths of time. Mr.Gazzola defaulted on the loans and the Bank foreclosed on the collateral forthe loans. The bankruptcy court claimed that since certain of the collateralwas conveyed to the Bank within one year of Gazzola’s bankruptcy filing andsince he was an insider, they were preferential transfers and must bereversed.  On June 12, 2003, in an outof court settlement, the court approved a settlement agreement where-in theBank agreed to pay the bankruptcy court a settlement fee for which the Bankretained a claim against the unsecured assets of Mr. Gazzola’s bankruptcyestate and a release by the court of all claims to the collateral held by theBank.  All expenses incurred inconnection with the settlement have been expensed in the amount of $144,400.

 

Of the litigation, neither management nor theCompany’s legal counsel can determine the likelihood of loss or an estimatedamount.  Accordingly, no accrual, otherthan certain specific reserves for loan losses noted above, has been made forthe potential loss related to this claim.

 

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This suit is significant to the Bank and theCompany and could have a detrimental impact on the future of the Bank and theCompany.  A significant loss couldresult in the Bank and the Company falling below the minimum regulatory capitalrequirements.  Failure to meet minimumregulatory requirements can initiate certain mandatory and possiblediscretionary actions by the regulators that, if taken, could have a directmaterial adverse effect on the Bank’s and the Company’s consolidated financialstatements.

 

The Bank’s and the Company’s plan withregards to this potential loss is to raise additional equity capital to fundoperations, should the need arise. There is, however, no assurance that the Bank and the Company would besuccessful in raising additional capital should the need arise.

 

**ITEM8****.          CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

On September 15, 2001, the Company dismissed Bertram Cooper & Co.,LLP, the independent accountant which had been engaged by the Company for priorfiscal years. There were not any disagreements with Bertram Cooper & Co.,LLP, on any matter of accounting principles or practices, financial statementdisclosure, or auditing scope or procedure which, if not resolved to BertramCooper & Co., LLP’s satisfaction, would have cause it to make reference tothe subject matter of the disagreement in connection with its report, nor has BertramCooper & Co., LLP’s report on the financial statements of the Company forthe past two years contained an adverse opinion or disclaimer of opinion orbeen qualified as to uncertainty, audit scope or accounting principles, nor arethere any events requiring disclosure under Item 304(a)(1)(iv)(B) of RegulationS-B.

 

On September15, 2001, the Company’s Audit Committee and Board of Directors approvedMcGladrey & Pullen, L.L. P. to serve as the Company’s independent auditorsfor the 2002 fiscal year.  During thetwo most recent fiscal years prior to September 15, 2001, the Company had notconsulted with McGladrey & Pullen, L. L. P. on items which  (i) involve the application of accountingprinciples to specified transactions either completed or proposed, or involvedthe type of audit opinion which might be rendered upon the Company’s financialstatements, or (ii) concern the subject matter of a disagreement or reportableevent with the former auditor.

 

On September24, 2002, the Company dismissed McGladrey & Pullen, LLP, the independentaccountant, which had been engaged by the Company for the fiscal year endedJune 30, 2002. There was not any disagreements with McGladrey & Pullen,LLP, the independent accountant engaged by the Company for 2002 on any matterof accounting principles or practices, financial statement disclosure, orauditing scope or procedure which, if not resolved to McGladrey & Pullen,LLP’s satisfaction, would have cause it to make reference to the subject matterof the disagreement in connection with its report, nor did McGladrey &Pullen, LLP’s report on the financial statements of the Company for the pastyear contain an adverse opinion or disclaimer of opinion or was modified as touncertainty, audit scope or accounting principles, nor are there any eventsrequiring disclosure under Item 304(a)(1)(iv)(B) of Regulation S-B.  McGladrey & Pullen, LLP’s opinion didinclude an explanatory paragraph regarding significant litigation matters.

 

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On October 28,2002, the Company’s Audit Committee and Board of Directors approved Boulay,Heutmaker, Zibell, & Co. P.L.L.P. to serve as the Company’s independentauditors for the 2003 fiscal year. During the two most recent fiscal years prior to October 28, 2002, theCompany had not consulted with Boulay, Heutmaker, Zibell, & Co. P.L.L.P. onitems which:  (i) involve theapplication of accounting principles to specified transaction either completedor proposed, or involved the type of audit opinion which might be rendered uponthe Company’s financial statements, or (ii) concern the subject matter of adisagreement or reportable event with the former auditor.

 

## **ITEM 8A**.       CONTROLS AND PROCEDURES

 

Evaluation of Disclosure Controls Procedures

As of the endof the period covered by this report, the Company conducted an evaluation underthe supervision and with the participation of the company’s management,including the Company’s Chief Executive Officer and Principal FinancialOfficer, regarding the effectiveness of the design and operation of theCompany’s disclosure controls and procedures pursuant to Rules 13a-15(b) of theSecurities Exchange Act of 1934 (the “Exchange Act”).  Based upon that evaluation, the Chief Executive Officer andPrincipal Financial Officer concluded that the Company’s disclosure controlsand procedures are effective to ensure that information that is required to bedisclosed by the Company in reports that it files under the Exchange Act isrecorded, processed, summarized and reported within the time period specifiedin the rules of the Securities Exchange Commission.

 

Changes in Internal Controls

There were no changes in the Company’s internal control over financialreporting that occurred during the period covered by this report that havematerially affected, or are reasonably likely to materially affect, theCompany’s internal control over financial reporting.

 

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**PARTIII**

 

## **ITEM 9**.          DIRECTORS, EXECUTIVE OFFICERS,PROMOTERS AND CONTROL

**PERSONS; COMPLIANCE WITH SECTION 16(a) OF THEEXCHANGE ACT**

 

The names andages of the executive officers of the Registrant and their positions andoffices held are as follows:

 
| **Name**             |   | **Age** |   | **Position  with Company**                                                                                                                                                                                                                                                                                    |   |
|----------------------|--------|---------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                 |   |    |   |                                                                                                                                                                                                                                                                                                          |   |
| Thomas P. Stienessen |   | 57      |   | Chief  Executive Officer, President and a Director of the Registrant since its  formation.  From January 1991 to  January 1998, Chief Executive Officer and President of SGL, Inc., a holding  company for Family Bank, and Chairman, Chief Executive Officer, President and  a Director of Family Bank. |   |
|                 |   |    |   |                                                                                                                                                                                                                                                                                                          |   |
| Gerald W. Eick       |   | 50      |   | Chief  Financial Officer and Treasurer of the Registrant since August 2002, and a  Director of the Registrant since May 2002.   Was a certified public accountant with Abdo, Eick and Meyers, LLP from  1974 to 2002.  Since June 2002, CFO  for Weerts Companies.                                  |   |

 

Theinformation required by Item 9 relating to directors, family relationships andcompliance with Section 16(a) of the Exchange Act is incorporated herein byreference to the sections labeled “Election of Directors” and “Section 16(a)Beneficial Ownership Reporting Compliance”, respectively, which appear in theCompany’s definitive Proxy Statement for its 2003 Annual Meeting ofStockholders.

 

## **ITEM 10**.       EXECUTIVE COMPENSATION

 

Theinformation required by Item 10 is incorporated herein by reference to thesection labeled “Executive Compensation” which appears in the Registrantsdefinitive Proxy Statement for its 2003 Annual Meeting of Stockholders.

 

## **ITEM 11**.       SECURITY OWNERSHIP OF CERTAIN BENEFICIALOWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

 

Theinformation required by Item 11 relating to security ownership of certainbeneficial owners and management is incorporated herein by reference to thesection labeled “Shareholdings of Principal Stockholders and Management,” whichappears in the Registrant’s definitive Proxy Statement for its 2003 AnnualMeeting of Stockholders.

 

The following table provides information as of June 30, 2003 and 2002about the Company’s equity compensation plans.

 

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| **June 30,  2003**                                          |   | **Number of  securities  to be issued upon  exercise of outstanding  options, warrants and  rights** |   | **Weighted  average  exercise price of  outstanding  options, warrants  and rights** |   | **Number of  securities remaining   available for future issuance  under equity compensation plans (excluding securities reflected  in column (a))** |   |
|-------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------|--------|--------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                        |   | **(a)**                                                                                              |   | **(b)**                                                                              |   | **(c)**                                                                                                                                                   |   |
| Equity compensation plans approved by  security holders     |   | 112,400                                                                                              |   | $                                                                                    | 8.23   |                                                                                                                                                      | 4,300  |   |
|                                                        |   |                                                                                                 |   |                                                                                 |   |                                                                                                                                                      |   |   |
| Equity compensation plans not approved by  security holders |   | 30,800                                                                                               |   | $                                                                                    | 10.00  |                                                                                                                                                      | 0      |   |
|                                                        |   |                                                                                                 |   |                                                                                 |   |                                                                                                                                                      |   |   |
| Total                                                       |   | 143,200                                                                                              |   |                                                                                 |   | 4,300                                                                                                                                                     |   |

 

## **ITEM 12**.       CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS

 

Theinformation required by Item 12 is incorporated by reference to the sectionlabeled “Certain Transactions” which appears in the Registrant’s definitiveProxy Statement for its 2003 Annual Meeting of Stockholders.

 

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## **ITEM 13**.       EXHIBITS AND REPORTS ONFORM 8-K

 

(a)          Exhibits.

 

Exhibits are numbered in accordance with Item 601 of RegulationS-B.  See “Exhibit Index” immediatelyfollowing the signature page of this Form 10-KSB.

 

(b)         Reports on Form 8-K

 

On May 14, 2003, the Registrant issued a press release announcingresults for the Company and its wholly owned subsidiary Northern Star Bank forthe third quarter of the fiscal year ending June 30, 2003.

 

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**SIGNATURES**

 

In accordancewith Section 13 or 15(d) of the Exchange Act, the registrant caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

 
|   | NORTHERN  STAR FINANCIAL, INC.                |
|--------|-----------------------------------------------|
|   |                                          |   |
| Dated: | September 22, 2003                            | by: | /s/ Thomas P. Stienessen |   |
|   | Thomas P. Stienessen, Chief Executive Officer |
|        |                                               |  |  |  |  |

 

In accordancewith the Exchange Act, the following persons on behalf of the registrant and inthe capacities and on the dates indicated have signed this Report.

 

(POWER OF ATTORNEY)

 

Each personwhose signature appears below constitutes and appoints THOMAS P. STIENESSEN andGERALD W. EICK as true and lawful attorneys-in-fact and agents, each actingalone, with full power of substitution and resubstitution, for him and in hisname, place and stead, in any and all capacities, to sign any or all amendmentsto this Annual Report on Form 10-KSB and to file the same, with all exhibitsthereto, and other documents in connection thereto, and other documents inconnection therewith, with the Securities and Exchange Commission, grantingunto said attorneys-in-fact- and agents, each acting alone, full power andauthority to do and perform each and every act and thing requisite andnecessary to be done in and about the premises, as fully to all intents andpurposes as he might or could do in person, hereby ratifying and confirming allsaid attorneys-in-fact and agents, each acting alone, or his substitute orsubstitutes, may lawfully do or cause to be done by virtue thereof.

 
| **Signature  and Title**                              |   | **Date** |
|-------------------------------------------------------|--------|----------|
|                                                  |   |     |
| /s/ Thomas P. Stienessen                              |   |     | September 22, 2003 |
| Thomas P. Stienessen,  Chief  Executive Officer, |   |     |
| President,  and Director                         |   |     |
| (Principal Executive Officer)                         |   |     |
|                                                  |   |     |
| /s/ Dean M. Doyscher                                  |   |     | September 22, 2003 |
| Dean M. Doyscher,  Director                      |   |     |
|                                                  |   |     |
| /s/ Robert H. Dittrich                                |   |     | September 22, 2003 |
| Robert H. Dittrich, Director                          |   |     |
|                                                  |   |     |
| /s/ Gerald W. Eick                                    |   |     | September 22, 2003 |
| Gerald W. Eick, Treasurer and Director                |   |     |
| (Principal Financial and Accounting Officer)          |   |     |
|                                                  |   |     |
| /s/ James H. Illies                                   |   |     | September 22, 2003 |
| James H Illies, Director                              |   |     |
|                                                  |   |     |
| /s/ Steven A Loehr                                    |   |     | September 22, 2003 |
| Steven A Loehr, Director                              |   |     |
|                                                  |   |     |
| /s/ Michael P. Reynolds                               |   |     | September 22, 2003 |
| Michael P. Reynolds, Director                         |   |     |
|                                                  |   |     |
| /s/ Thomas J. Reynolds                                |   |     | September 22, 2003 |
| Thomas J. Reynolds, Director                          |   |     |

 

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NORTHERN STAR FINANCIAL, INC.

 

EXHIBIT INDEX TO FORM 10-KSB

 
| **Exhibit  Number** |   | **Description**                                                                                                                                                                                                                                                                                                  |
|---------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |   |                                                                                                                                                                                                                                                                                                             |
| 3.1                 |   | Amended and Restated Articles of Incorporation, as amended to  date.  (Incorporated by reference to  Exhibit 2.1 to the Company’s Registration Statement on Form SB-1, Reg. No.  333-61655)*                                                                                                           |
|                |   |                                                                                                                                                                                                                                                                                                             |
| 3.2                 |   | By-Laws, as amended to date. (Incorporated by reference to Exhibit  2.2 to the Company’s Registration Statement on Form SB-2, Reg. No.  333-61655)*                                                                                                                                                         |
|                |   |                                                                                                                                                                                                                                                                                                             |
| 10.1                |   | Lease Agreement between Northern Star Bank (the “Bank”) and Colonial  Square Partners relating to the space located at 1650 Madison Avenue,  Mankato, Minnesota.  (Incorporated by  reference to Exhibit 6.1 to the Company’s Registration Statement on Form  SB-1, Reg. No. 333-61655)*     |
|                |   |                                                                                                                                                                                                                                                                                                             |
| 10.2**              |   | Employment Agreement between the Bank and Thomas P. Stienessen.  (Incorporated by reference to Exhibit 6.2  to the Company’s Registration Statement on Form SB-1, Reg. No. 333-61655)*                                                                                                                 |
|                |   |                                                                                                                                                                                                                                                                                                             |
| 10.3**              |   | 1998 Equity Incentive Plan, including specimen of Incentive Stock  Option Agreement and Nonqualified Stock Option Agreement.  (Incorporated by reference to Exhibit 6.5  to the Company’s Registration Statement on Form SB-1, Reg. No. 333-61655)*                                                    |
|                |   |                                                                                                                                                                                                                                                                                                             |
| 10.4**              |   | Form of Nonqualified Stock Option Agreement governing options granted  to Organizers. (Incorporated by reference to Exhibit 6.6 to the Company’s Registration  Statement on Form SB-1, Reg. No. 333-61655)*                                                                                                 |
|                |   |                                                                                                                                                                                                                                                                                                             |
| 10.5                |   | Lease Agreement between Northern Star Bank (the “Bank”) and Five Star  Properties of St. Cloud, LLC relating to the space located at 300 East St.  Germain Street, St. Cloud, Minnesota. (Incorporated by reference to Exhibit  10.5 to the Company's Form 10-KSB for the period ended June 30, 2002.) |
|                |   |                                                                                                                                                                                                                                                                                                             |
| 10.6                |   | Form and amounts of Convertible Subordinated Unsecured Notes issued  by the Registrant to certain of its directors in July and August, 2001. (Incorporated  by reference to Exhibit 10.6 to the Company's Form 10-KSB for the period  ended June 30, 2002.)                                                      |
|                |   |                                                                                                                                                                                                                                                                                                             |
| 10.7                |   | Form and amounts of Convertible Subordinated Unsecured Notes issued  by the Registrant to certain of its directors in June, 2002. (Incorporated by  reference to Exhibit 10.7 to the Company's Form 10-KSB for the period ended  June 30, 2002.)                                                                 |

 

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| 11     |   | Statement re: Computation of Earning (Loss) Per Share (included in  Notes to Financial Statements) |
|--------|--------|----------------------------------------------------------------------------------------------------|
|   |   |                                                                                               |
| 21     |   | Subsidiaries of the Registrant:                                                                    |
|   |   |                                                                                               |
|   |   | **Name**                                                                                           |   | **State of Organization** |
|   |   | Northern Star Bank, Inc.                                                                           |   | Minnesota |
|   |   |                                                                                               |
| 24     |   | Power of Attorney from Certain Directors (See Signature Page)                                      |
|   |   |                                                                                               |
| 31.1   |   | Certification of CEO Pursuant to Sec. 302 of the Sarbanes-Oxley Act  of 2002                       |
|   |   |                                                                                               |
| 31.2   |   | Certification of CFO Pursuant to Sec. 302 of the Sarbanes-Oxley Act  of 2002                       |
|   |   |                                                                                               |
| 32     |   | Certification of the CEO and CFO Pursuant to Sec. 906 of The  Sarbanes-Oxley Act. of  2002    |

 

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**Indicates a management contract or compensatory plan or arrangementrequired to be filed as an exhibit to this form 10-KSB.

 

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