**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 30,2002**

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

** **

**NORTHERN STAR FINANCIAL, INC.**

(Name of SmallBusiness Issuer as specified in its charter)

 

| **Minnesota**                    |   | **41-1912467**          |
|----------------------------------|--------|-------------------------|
| (State or other  jurisdiction of |   | (IRS Employer           |
| incorporation or  organization)  |   | Identification  Number) |

 

**1650Madison Avenue, Mankato, Minnesota 56001**(Address of principalexecutive offices) (Zip Code)

 

Issuer’s telephone number, including area code:  **(507) 387-2265**

 

Securitiesregistered pursuant to Section 12(b) of the Exchange Act:  **None**

 

Securities registeredpursuant to Section 12(g) of the Exchange Act: Common Stock, $.0l par value pershare

 

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

 

Check if disclosure ofdelinquent filers in response to Item 405 of Regulation S-B is not containedherein, and will not be contained, to the best of Registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in PartIII of this Form 10-KSB or any amendment to this Form 10-KSB.  o

 

Issuer’s revenuesfor its most recent fiscal year: $2,742,800

 

The aggregate marketvalue of the Common Stock held by nonaffiliates of the Registrant as ofSeptember 12, 2002 was approximately $995,000 based upon the average high andlow bid prices of the Registrant’s Common Stock on such date.

 

There were 479,506shares of Common Stock, $.0l par value, outstanding as of September 12, 2002

 

**DOCUMENTSINCORPORATED BY REFERENCE**

 

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

 

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

 

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INDEX

 

 
| **Description**                                                                                                                 |   | **Page** |   |
|---------------------------------------------------------------------------------------------------------------------------------|--------|----------|--------|
|                                                                                                                            |   |     |   |
| 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                                                                                                   |   |     |   |
| INDEPENDENT AUDITOR’S  REPORT                                                                                              |   |     |   |
|                                                                                                                            |   |     |   |
| ITEM  8.  CHANGES IN AND DISAGREEMENTS WITH  ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                            |   |     |   |
|                                                                                                                            |   |     |   |
| 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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**PARTI**

 

**ITEM1.  DESCRIPTION OF BUSINESS**

 

This Report containsstatements which constitute forward-looking statements within the meaning ofSection 27A of the Securities Act of 1933 and the Securities Exchange Act of1934. These statements appear in a number of places in this Report and include allstatements regarding the intent, belief or current expectations of NorthernStar Financial, Inc. (the “Company”), its directors or its officers.  Such forward-looking statements involveknown and unknown risks, uncertainties and other factors that may cause theactual results, performance or achievements of the Company to be materiallydifferent from any future results, performance or achievements expressed orimplied by such forward-looking statements. Such factors include, among others,the following: general economic and business conditions in those areas in whichthe Company operates, demographic changes, competition, fluctuations ininterest rates, changes in business strategy or development plans, changes ingovernmental regulation, credit quality, the availability of capital to fundthe expansion of the Company’s business, as well as economic, political andglobal changes.

 

**GENERAL**

 

                The Company is a Minnesota corporation and a bankholding company.  It owns 100% of theoutstanding capital stock of Northern Star Bank, Mankato, Minnesota (the“Bank”).  Substantially all of theCompany’s revenues and income are derived solely from the Bank throughdividends and management fees.

 

                Our strategy is to establish de novo banks, branches,or representative offices in major retail centers located throughout Minnesota.By virtue of representative local ownership, management, and decision making,we hope to benefit from the continuing trend in the banking industry towardsmerger and consolidation with the resulting loss of local control andpersonalized services. The Bank’s, business strategy and promotional activitiesemphasize service and responsiveness to local needs.

 

The Bank is a community bank providing a broad rangeof commercial and retail banking services designed to meet the borrowing anddepository needs of small and medium sized businesses and consumers in thecommunities we serve. The Bank’s customer base consists primarily of small tomedium-sized businesses and their owners, managers, and employees residing inBlue Earth, Nicollet, Le Sueur, Benton, Sherburne and Stearns counties.Businesses served include manufacturers, distributors, contractors,professional corporations and partnerships, and service businesses.  We offer a range of loans, primarilycommercial, including real estate, construction, Small Business Administration(SBA), inventory and accounts receivable, and equipment loans.  We also accept checking, savings, and timedeposits; offer NOW and money market deposit accounts; and provides 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’sprincipal sources of income are interest and fees collected on loans, interestand dividends collected on investments, gains on the sale of loans, and servicefees on deposit accounts. The Bank’s principal expenses are interest paid onsavings, time, NOW and money market deposits, loan loss provision, employeecompensation, office expenses, and other overhead expenses.

 

**MARKET AREA**

 

                Our principal market area is the Minnesota countiesof Blue Earth, Nicollet, LeSueur, Benton, Stearns, and Sherburne, whichincludes the communities of Mankato and St. Cloud, Minnesota, from which we areexpected to draw a significant portion of our business.  Approximately 85,000 people reside 

 

 

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in Mankato and thesurrounding area and 191,000 people reside in St. Cloud and the surroundingarea.  For calendar year 2001, medianhousehold income of residents living in our principal market areas wasapproximately $55,000.

 

**COMPETITION**

 

The bankingbusiness is highly competitive. The Bank competes with other commercial banks,savings and loan associations, and non-financial institutions in its primaryservice area. Recent legislation, regulatory changes by the regulators of thevarious financial institutions, and competition from unregulated entities, haseliminated many traditional distinctions among commercial banks, thriftinstitutions and other providers of financial services. Consequently,competition among all financial institutions is virtually unlimited withrespect to their legal ability and authority to provide most financialservices.

 

Banks compete withother financial institutions through the banking products and services theyoffer, the pricing of their services, the level of service provided, theconvenience and availability of services, and the degree of expertise andpersonal manner in which services are offered. Management anticipates that theBank will continue to face strong competition from the financial institutionsin the Bank’s primary service area. In certain areas of its banking business,the Bank also competes with credit unions, consumer finance companies,insurance companies, money market mutual funds, non-bank lenders and otherfinancial institutions, some of which are not subject to the same degree ofregulation and restrictions imposed upon the Bank. Many of these competitors havesubstantially greater resources and lending limits than the Bank and offercertain products, such as international banking services, that the Bank doesnot provide.  We believe thatcompetitive pricing, a hometown atmosphere and personalized service allow theBank to compete effectively in its primary service area.

 

**DEPOSITS**

 

We offer a fullrange of deposit services that are typically available in most banks andsavings associations, including checking accounts, commercial accounts, savingsaccounts, and other time deposits of various types, ranging from daily moneymarket accounts to longer-term certificates of deposit. The transactionaccounts and time certificates are tailored to our principal market areas atrates competitive to those offered in the Mankato and St. Cloud, Minnesotaareas. In addition, we offer certain retirement account services, such asIndividual Retirement Accounts (IRAs), and sweep accounts.  All of the funds our customers place ondeposit are insured by the FDIC up to the maximum amount permitted by law.

 

**LENDING ACTIVITIES**

 

The Bank’sphilosophy is to make loans, taking into consideration the interests of itsshareholders, safety of the depositors’ funds, preservation of Bank liquidity,welfare of the community and adherence to federal and state regulations. Loanswill always be the major source of the Bank’s income. Various elements of riskare associated with each category of loan offered by the Bank. The economyplays an important part in lending risks, and these risks may be greater attimes of economic downturns.

 

REAL ESTATE LOANS.The Bank makes single-family residential construction loans for one- tofour-unit structures. The Bank requires a first lien position on theconstruction site and offers these loans only to qualified residential buildingcontractors. Loan disbursements require on-site inspections to assure theproject is on budget and that the loan proceeds are being used in accordancewith the plans, specifications and survey for the construction project. The loan-to-valueratio for such loans is predominately 75% of the lower of the appraised valueor project cost, and is a maximum of 80% if the loan is amortized. Loans forconstruction can present a high degree of risk to the lender, depending on, 

 

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among other things,whether the builder can sell the home to a buyer, whether the buyer can obtainpermanent financing, whether the transaction produces income in the interim,and the nature of changing economic conditions. Almost all first mortgage loansoriginated by the Bank are sold, servicing released, into the secondary market.

 

Additionally, theBank offers first mortgage loans on commercial real estate and forowner-occupied or investment real estate having a loan-to-value ratio that doesnot exceed 80% with a maximum term of 30 years and call or re-pricingprovisions every three to five years. Commercial mortgage lending risks include title defects, fraud, generalreal estate market deterioration, inaccurate appraisals, violation of consumerprotection laws, interest rate fluctuations and financial deterioration of aborrower. Such loans typically carry adjustable interest rates.

 

COMMERCIALNON-MORTGAGE LOANS. The Bank markets its commercial non-mortgage loans toparties whose demand for funds falls within the Bank’s legal lending limits andwho are existing or potential deposit customers of the Bank. This categoryincludes loans made to individual, partnership or corporate borrowers andobtained for a variety of purposes. Risks associated with these loans can besignificant. Risks include fraud, bankruptcy, economic downturn, deterioratedor non-existing collateral and changes in interest rates.

 

CONSUMER LOANS.The Bank makes consumer loans, consisting primarily of installment loans toindividuals for personal, family and household purposes including loans forautomobiles and investments. Risks associated with these loans include fraud,deteriorated or non-existing collateral, general economic downturn and customerfinancial problems.

 

LOAN APPROVAL ANDREVIEW.  Our loan approval policiesprovide for various levels of officer lending authority. When the amount ofaggregate loans to a single borrower exceeds that individual officer’s lendingauthority, the loan request will be considered and approved by an officer witha higher lending limit. We have established directors’ loan committee that haslending limits, and any loan in excess of a lending officers lending limit willbe approved by the directors’ loan committee. Our lending policy does notpermit us to make loans to any director, officer, or employee of the Bankunless the loan is approved by the board of directors of the Bank and is madeon terms not more favorable to such person than would be available to a personnot affiliated with the Bank.

 

LENDING LIMITS.** **Our lending activities aresubject to a variety of lending limits imposed by state and federal law. Whilediffering lending limits apply in certain circumstances based on the type ofloan or the nature of the borrower (including the borrower’s relationship tothe Bank), in general, we are subject to a loan-to-one-borrower limit. Sincethe enactment of the Financial Institutions Reform, Recovery and EnforcementAct (“FIRREA”) in 1989, 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.

 

CREDIT RISK AND LOANREVIEW.  Credit risk represents thepossibility that a customer may not perform in accordance with contractualterms. The Bank incurs credit risk whenever it extends credit to or enters intoother transactions with its customers. The risks associated with extensions of credit include general risk,which is inherent in the lending business, and risk specific to individualborrowers. Loan review and other loan monitoring practices provide a means forour management to ascertain whether proper credit, underwriting and loandocumentation policies, procedures and practices are being followed by our loanofficers and are being applied uniformly throughout the Company. Implementationand daily administration of loan review rests with the Chief Lending Officerand the President who 

 

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approve loan officer requests for changes in riskratings. Loan officers are responsible for continually grading their loans so thatindividual credits properly reflect the risk inherent therein. The Board ofDirectors has made provisions for a third party outside loan review of allloans that meet certain criteria that were originated since the previousreview. While we continue to review these and other related functional areas,there can be no assurance that the steps we have taken to date will besufficient to enable it to identify, measure, monitor and control all creditrisk.

 

**OTHER BANKING SERVICES**

** **

Other services weprovide include telephone banking, cash management services, safe depositboxes, traveler’s checks, and direct deposit of payroll and social securitychecks. We are associated with a shared network of automated teller machinesthat may be used by our customers throughout Minnesota and other regions andpermit customers to access their funds 24 hours a day from locations outsideour primary market area.  As previouslynoted, we also offer MasterCard and VISA credit card services through acorrespondent bank as an agent.

 

**INVESTMENT ACTIVITIES**

 

After establishingnecessary cash reserves and funding loans, the Bank invests its remainingliquid assets in investments allowed under banking laws and regulations. TheBank invests primarily in obligations of the United States or obligationsguaranteed as to principal and interest by the United States, and other taxablesecurities and in certain obligations of states and municipalities. The Bankalso has federal funds transactions with its principal correspondent banks andprimarily acts as a net seller of such funds. The sale of federal funds amountsto a short-term loan from the Bank to another bank. Risks associated with theseinvestments include loss of value relative to interest rate and maturities ascompared to other investments.

 

**ASSET/LIABILITY MANAGEMENT**

 

The Bank’sobjective is to manage its assets and liabilities to provide a satisfactory,consistent level of profitability within the framework of established cash,loan, investment, borrowing and capital policies. Various officers of the Bankare responsible for developing and monitoring policies and procedures to insurean acceptable asset/liability mix. Management’s philosophy is to support assetgrowth primarily through growth of core deposits, which include deposits of allcategories made by individuals, partnerships and corporations. Management ofthe Bank seeks to invest the largest portion of the Bank’s assets in commercialand commercial real estate related loans. The Bank’s asset/liability mix ismonitored on a timely basis. Management prepares a report reflectinginterest-sensitive assets and interest-sensitive liabilities for the Bank’sBoard of Directors on a quarterly basis. Our objective is to manageinterest-sensitive assets and liabilities so as to minimize the impact ofsubstantial movements in interest rates on the Bank’s earnings.

 

**EMPLOYEES**

 

At June 30, 2002, the Bank employed 14 full-timeemployees and 2 part-time employees. Various executive officers of the Bankalso serve as the officers of the Company. Other than our chief executiveofficer, we do not have compensated employees. Neither the Company nor the Bankis a party to a collective bargaining agreement, and, in the opinion ofmanagement, the Bank enjoys satisfactory relations with its employees

 

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**COMPETITION**

 

The business of operating a community bank is highlycompetitive. We compete with community and national banks, credit unions,thrifts, and non-financial institutions such as insurance companies andinvestment banks. Our principal market areas, the Minnesota counties of BlueEarth, Nicollet, Benton and Stearns are served by 41 different banks, threefederal savings banks and twelve credit unions. Most, if not all, of ourcompetitors have substantially greater financial resources than we do.  We believe our competitive strength will liein providing long-term, relationship-oriented banking services by managementand employees with strong ties to the Mankato and St. Cloud areas. We expect totarget all residents of our principal market areas, especially local businessesand homeowners.

 

**RECENTDEVELOPMENTS**

 

The Companyinjected $400,000 of additional capital into the Bank on June 28, 2002.  The capital was raised through the sale ofconvertible subordinated unsecured notes. The notes were issued for a three-year term and bear interest at therate of seven percent per annum payable quarterly.  Investors in the notes were granted the right to convert theirinvestment into shares of Northern Star Financial, Inc. common stock at therate of $9.00 per share any time prior to maturity.

 

Mr. Gerald Eick has been appointed to serve as adirector of Northern Star Bank and of the bank holding company, Northern StarFinancial, Inc.  Mr. Eick, a CertifiedPublic Accountant, has been a Mankato area resident for the past 34 years.During this time, he has served as a director and advisor to numerous private,professional, civic and charitable organizations.

 

**SUPERVISION AND REGULATION**

 

**General**

 

                Commercial banking is highly regulated at both thefederal and state level.  In addition toa variety of generally applicable state and federal laws governing businessesand employers, we are extensively regulated by special laws applicable only tofinancial institutions.  Virtually allaspects of our operations are subject to specific requirements or restrictionsand 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 systems or theprotection of consumers or classes of consumers, rather than the specificprotection of our shareholders.

 

                Bank holding companies and banks are extensively regulatedunder both federal and state law. This regulation is intended primarily for theprotection of depositors and the deposit insurance fund and not for the benefitof stockholders of the Company. Set forth below is a summary of certain lawswhich relate to the regulation of the Company and the Bank. The descriptiondoes not purport to be complete and is qualified in its entirety by referenceto the applicable laws and regulations.

 

As a registeredbank holding company, the Company is subject to the supervision of, and toregular examination by, the Federal Reserve Board (FRB). Historically theactivities of bank holding companies such as the Company have been limited bythe Bank Holding Company Act (BHCA) to banking, managing or controlling banks,furnishing services to or performing services for their subsidiaries, and otheractivities which the FRB deems to be so closely related to banking or managingor controlling banks as to be a proper incident thereto. In making suchdeterminations, the FRB is required to consider whether the performance of suchactivities by a bank holding company or its subsidiaries can 

 

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reasonably be expected toproduce benefits to the public such as greater convenience, increasedcompetition, or gains in efficiency that outweigh the possible adverse effects,such as undue concentration of resources, decreased or unfair competition,conflicts of interest, or unsound banking practices. Generally, bank holdingcompanies are required to give notice to or obtain prior approval from FRB toengage in any new activity or to acquire more than 5% of any class of votingstock of any bank.

 

The Company’scommon stock is registered with the Securities and Exchange Commission (“SEC”)under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Assuch, the Company is subject to the information, proxy solicitation, insidertrading, and other requirements and restrictions of the Exchange Act.

 

The Bank is astate bank chartered by and subject to supervision of the State of Minnesotaand the FDIC.

 

Deposit accountsat the Banks are insured by the Federal Deposit Insurance Corporation (FDIC),which currently insures deposits to a maximum of $100,000 per depositor. Forthis protection, the Banks pay a semi-annual assessment and are subject to therules and regulations of the FDIC pertaining to deposit insurance and othermatters.

 

**PAYMENT OF DIVIDENDS BY THE COMPANY**

 

The FederalReserve Board has indicated that banking organizations should generally paycash dividends out of current operating earnings and the current rate ofearnings retention should be consistent with the organization’s capital needs,asset quality and overall financial condition. The Federal Reserve Board policy strongly discourages a bank holdingcompany from declaring or paying a cash dividend which would impose unduepressure on the capital of subsidiary banks or would be funded only throughborrowings or other arrangements that might adversely affect the holding company’sfinancial position.  The Federal Reservemay, and in certain circumstances must, prohibit a bank holding company frommaking any capital distributions without prior approval of the Federal ReserveBoard, if the subsidiary institution is undercapitalized.  The Federal Reserve Board also may imposelimitations on the payment of dividends as a condition to its approval ofcertain applications, including applications for approval of mergers oracquisitions.

 

In addition to therestrictions on dividends imposed by the Federal Reserve, under the MinnesotaBusiness Corporation Act, the discretion of the Company’s Board of Directors isconstrained by Minnesota Statutes, section 302A.551.  Under that section, the Board may only authorize a dividend if ingood faith, in a manner that the directors reasonably believe to be in the bestinterests of the corporation, and with the care an ordinarily prudent person ina like position would exercise under similar circumstances, the boarddetermines that the corporation will be able to pay its debts in the ordinarycourse of business after making a distribution.

 

**REGULATORY CAPITAL REQUIREMENTS**

 

The FederalReserve Board’s capital guidelines establish the following minimum regulatorycapital requirements for bank holding companies: (i) a capital leveragerequirement expressed as a percentage of total assets, (ii) a risk-basedrequirement expressed as a percentage of total risk-weighted assets, and (iii)a Tier 1 leverage requirement expressed as a percentage of total assets.  Tier 1 capital consists of commonstockholders’ equity, qualifying preferred stock, and minority interests in theequity accounts of consolidated subsidiaries. The failure of a bank holdingcompany to meet its risk-weighted capital ratios may result in supervisoryaction, as well as an inability to obtain approval of any regulatoryapplications and, potentially, increased frequency of examination.  The federal bank regulators have 

 

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proposed changes tocapital requirements for banking organizations. The effect of any future changein the required capital ratios cannot be determined at this time.

 

Qualifying capitalconsists of two types of capital components: “core capital elements” (“Tier 1”capital) and “supplementary capital elements” (“Tier 2” capital).  Tier 1 capital is generally defined as thesum of core capital elements less goodwill and other intangibles.  Core capital elements consist of (i) commonshareholders’ 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 tolimitations).  The maximum amount ofTier 2 capital that may be included in qualifying total capital is limited to100% of Tier 1 capital (net of goodwill). Under current capital adequacy standards, financial institutions mustmeet a minimum ratio 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.

 

As a result of the FDICImprovement Act of 1991, the federal bank regulatory agencies were directed toadopt regulations defining banks as “well capitalized,” “adequatelycapitalized,” “undercapitalized,” “significantly undercapitalized” and“critically undercapitalized.”  Underthe law, depending upon the bank’s classification, a bank may be directed toprepare and implement a capital restoration plan, to be guaranteed by itsparent bank holding company.  Further,banks are subject to increased restrictions upon activities and heightenedregulatory supervision as capital classifications decline. See Note 14 to theconsolidated financial statements for information regarding more stringentleverage capital requirements placed on the Bank as a result of litigationmatters.

 

Generally, underregulations adopted by all of the bank federal regulatory agencies, “wellcapitalized” has been defined as an institution with a total capital to risk-basedasset ratio of 10%, a Tier 1 capital to risk-based asset ratio of 6% and a Tier1 leverage ratio of 5%.  The regulationsfurther provide that an “adequately capitalized” institution must have a totalcapital to risk-based asset ratio of at least 8%, a Tier 1 capital torisk-based asset ratio of 4% and a Tier 1 leverage ratio of 4%.  Institutions not satisfying the requirementsfor “adequately capitalized” will be deemed “undercapitalized.”  Institutions with a total capital torisk-based asset ratio of 6% or less, a Tier 1 capital to risk-based assetratio of 3% or less, or a Tier 1 leverage ratio of 3% or less will be deemed“significantly undercapitalized.” Finally, the regulations provide that an institution with a Tier 1leverage ratio of less than 2% will be deemed “criticallyundercapitalized.”  Federal bankregulatory agencies, including the FDIC, are authorized to down-grade afinancial institution from one capital category to the next if they determinethe asset quality, management, earnings or liquidity of that institutionwarrant such down-grade.  Under theregulations, as of June 30, 2002 the Bank is classified as “well capitalized.”

 

**AFFILIATE TRANSACTION LIMITATIONS**

 

Financialinstitutions are subject to certain restrictions imposed by federal law on anyextensions of credit to, or the issuance of a guarantee or letter of credit onbehalf of, the Company or other affiliates, the purchase of or investment instock or other securities thereof, the taking of such securities as collateralfor loans and the purchase of assets from the Company or other affiliates.  Such restrictions prevent the Company andsuch other affiliates from borrowing from the Bank and any other subsequentlyacquired bank unless the loans are secured by marketable obligations ofspecified amounts.  Further, suchsecured loans, investments and other transactions between the Bank and theCompany or any other affiliate are limited to 10% of the Bank’s capital andsurplus (as defined by federal regulations) and such secured loans, investmentsand other transactions are limited, in the aggregate, to 20% of the Bank’scapital and 

 

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surplus (as defined byfederal regulations).  Such transactionsmust also comply with regulations prohibiting terms that would be preferentialto the Company or other affiliates of the Bank.  Early in fiscal year 2001, the Federal Reserve issued, for publiccomment, a new Regulation W to implement federal laws governing transactionsbetween affiliates.

 

**COMMUNITY REINVESTMENT ACT**

 

Pursuant to theCommunity Reinvestment Act of 1977, the federal regulatory agencies thatoversee the banking industry are required to use their authority to encouragefinancial institutions to help meet the credit needs of the local communitiesin which such institutions are located, consistent with safe and sound bankingpractices.

 

When conducting anexamination of a financial institution such as the Bank, the agencies assessthe institution’s record of meeting the credit needs of its entire community,including low- and moderate-income neighborhoods. This record is taken intoaccount in an agency’s evaluation of an application for creation or relocationof domestic branches or for merger with another institution. Failure to addressthe credit needs of a bank’s community may also result in the imposition ofcertain other regulatory sanctions, including a requirement that correctiveaction be taken.

 

The federalbanking agencies determine a bank’s CRA rating by evaluating its performance onlending, service, and investment tests, with the lending test as the mostimportant. The tests are to be applied in an “assessment context” that isdeveloped by the agency for a particular institution. The assessment contexttakes into account demographic data about the community, the community’scharacteristics and needs, the institution’s capacities and constraints, theinstitution’s product offerings and business strategy, the institution’s priorperformance, and data on similarly situated lenders.

 

Largerinstitutions are required to compile and report certain data on their lendingactivities in order to measure performance. Some of this data is also requiredunder other laws, such as the Equal Credit Opportunity Act. Small institutions(those institutions with less than $250 million in assets) are now beingexamined on a “streamlined assessment method.” The streamlined method focuseson the institution’s loan to deposit ratio, degree of local lending, record oflending to borrowers and neighborhoods of differing income levels, and recordof responding to complaints. Large and small institutions have the option ofbeing 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.

 

**CONSUMER PROTECTION**

 

Banks are subjectto a variety of federal and state laws and regulations promulgated to provideconsumer protection.  These laws can begrouped into three general categories: disclosure laws, civil rights laws, andlaws designed to provide safeguards against specific abuses in the extension,collection, and reporting of consumer credit. Examples of disclosure laws are the Truth in Lending Act and the FederalReserve’s Regulation Z, the Consumer Leasing Act of 1976 and the FederalReserve’s Regulation M, the Real Estate Settlement Procedures Act of 1974 andRegulation X of the Department of Housing and Urban Development, the ElectronicFund Transfer Act and Federal Reserve Regulation E, the Expedited FundsAvailability Act of 1987 and Federal Reserve Regulation CC, and the Truth inSavings Act and the Federal Reserve’s Regulation DD.

 

The secondcategory of laws, the civil rights laws, are aimed at eliminating invidiousdiscrimination.  Under the laws, lendersare not allowed to make lending decisions on any factors that are unrelated toa person’s creditworthiness.  These lawsinclude the Equal Credit Opportunity Act and the Federal Reserve’s RegulationB, the Fair Housing Act of 1968, the Home Mortgage Disclosure Act of 

 

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1975 and the FederalReserve’s Regulation C, and the Community Reinvestment Act of 1977 discussedabove.

 

The third categoryof laws address problems that arise in particular aspects of credittransactions.  These laws include theFair Credit Reporting Act of 1970, the Fair Debt Collection Practices Act of1977, the Right to Financial Privacy Act of 1978, and the National FloodInsurance Act.

 

 In addition to the above described federalconsumer protection laws, Company and Bank are subject to state consumer lawsthat govern interest rates, advertising, and trade practices.

 

**FINANCIAL PRIVACY**

 

Significantconsumer legislation was passed by Congress in 1999 as part of theGramm-Leach-Bliley Act (“GLBA”).  TitleV of GLBA contains new privacy requirements. Under GLBA and regulations implemented by the federal bankingregulators, a financial institution must (i) provide consumers and customerswith a notice of the financial institution’s privacy policies and practices;(ii) provide customers, during the continuation of a customer relationship,with an annual privacy notice; and (iii) provide consumers and customers withan opportunity to opt-out of having their nonpublic personal financialinformation shared with nonaffiliated third parties if disclosure does not fitwithin one of the exceptions contained in the law.  Financial institutions must also have programs to safeguardcustomer information.

 

**USA PATRIOT ACT**

 

The terroristattacks on September 11, 2001, have impacted the financial services industryand have already led to federal legislation that attempts to address certainissues involving financial institutions. On October 26, 2001, President Bush signed into law the Uniting andStrengthening America by Providing Appropriate Tools Required to Intercept andObstruct Terrorism Act of 2001 (the “USA Patriot Act”).

 

Similar to the Gramm-Leach-Bliley Act, the Patriot Act applies to abroad range of “financial institutions”: banks; broker/dealers; currency exchanges; issuers, redeemers or cashersof travelers’ checks, checks, money orders, or similar instruments; insurancecompanies; loan finance companies; dealers in precious metals, stones or jewels; travel agencies; licensedsenders of money; businesses engaged in vehicle sales, including automobiles,airplanes and boats; persons involved in real estate closings and settlements;casinos; etc.

 

The USA Patriot Act,among other things:

 

•                  Requires the Secretary of the Treasury (“Treasury”) to adoptregulations to encourage financial institutions, their regulators, and lawenforcement authorities to share information regarding individuals, entitiesand organizations engaged in terrorist acts or money laundering;

•                  Allows the Treasury to require increased record keeping and reportingby financial institutions;

•                  Requires the Treasury to issue regulations regarding minimum standardsfor financial institutions regarding the identity of customers openingaccounts;

•                  Requires financial institutions to establish anti-money launderingprograms that include (i) development of internal policies; (ii) designation ofa compliance officer; (iii) ongoing employee training programs; and (iv) anindependent audit function;

•                  Requires financial institutions to establish due diligence policies andprocedures to detect suspected money laundering through private bankingaccounts of foreign persons and correspondent accounts;

•                  Prohibits financial institutions, including broker-dealers, frommaintaining or administering correspondent accounts with unaffiliated foreignshell banks;

 

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•                  Authorizes the Treasury to regulate concentration accounts;

•                  Applies the Bank Secrecy Act to credit unions, futures commissionmerchants, commodity trading advisors and commodity pool operators;

•                  Requires registered brokers and dealers to file suspicious activityreports;

•                  Requires consumer-reporting agencies to furnish consumer reports to agovernment agency for intelligence and counter-intelligence activities relatedto international terrorism;

•                  Allows forfeiture of funds from US interbank accounts up to the amountof funds deposited in a foreign bank with no requirement that the governmentestablish that the funds are directly traceable to the funds that weredeposited into the foreign bank;

•                  Makes it a Federal crime to operate a money transmitter businesswithout an appropriate state license; and

•                  Requires banking regulators to consider a financial institution’srecord of combating money laundering in connection with bank merger andacquisition applications filed after December 31, 2001.

 

A number of the Act’s requirements became effective on October 26,2001.  Additional implementingregulations are expected in the next 12 months.

 

**ITEM2.  DESCRIPTION OF PROPERTY**

** **

The Company andBank’s office is located at 1650 Madison Avenue, Mankato, Minnesota.  The Bank has entered into a 10 year leaseagreement with Colonial Square Partners, Inc. to lease approximately 5,000square feet.  Dean Doyscher, a directorand principal shareholder of the Company is a partner of Colonial SquarePartners, Inc.  Pursuant to the leaseagreement, the Bank pays monthly rent of approximately $6,042 during the firstthree years of the lease, $6,250 a month for the next three years and $6,458per month for the last four years of the lease term.  The Bank currently pays monthly rent of $6,250 a month.  The Bank has the option to extend the leaseterm for two consecutive five-year periods 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.

 

The Bank alsomaintains a banking facility which is located at 300 East St. Germain Street inSt. Cloud, Minnesota.  The Bank hasentered into a 10-year lease agreement with INH Property Management, Inc. to rentapproximately 3,100 square feet.  JamesH. Illies is a director of the Company and Bank is an owner of INH PropertyManagement, Inc.  Pursuant to the leaseagreement, the Bank pays monthly rent of approximately $3,358 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 ofboth of the above referenced leases, the landlord pays building insurance,taxes, assessments and all utilities except telephone.  Real estate tax increases over the base yearof the lease are to be pro-rated based upon square footage.

 

**ITEM3.   LEGAL PROCEEDINGS**

** **

**               **As of September 13, 2001, the Company andthe Bank are subject to pending legal proceedings that arose out of thebusiness affairs of former Company Chief Financial Officer, and Company andBank Director Frank L. Gazzola.  TheCompany and the Bank deny the Plaintiff’s allegations and intend to vigorouslydefend themselves in these actions.

 

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                The Company and the Bank, are defendants in civilactions.  The Company is a defendant ina complaint filed on March 22, 2002 in the United States District Courtfor the Western District of Wisconsin by Catalytic Combustion Corporation401(k) Profit Sharing Plan and Catalytic Combustion Corporation (“Plaintiffs”).  According to the complaint, Plaintiffs seekto rescind the purchase of 30,000 shares of Company common stock purchased inconnection with the Company’s initial public offering in 1998 and 1999.  Plaintiffs allege that the Company sold theshares to Catalytic Combustion Corporation 401(k) Profit Sharing Plan inviolation of Wisconsin securities laws, and therefore, Plaintiffs are entitledto rescind the purchase according to Wisconsin securities laws.  The Plaintiffs seek damages in the amount ofapproximately $210,714, plus interest from March 23, 1999 and all actualand reasonable attorney’s fees.  TheCompany denies the allegations in the complaint and has brought a third partycomplaint against its agent, Diamond Hill Securities, Inc., f/k/a Banc StockFinancial Services for indemnification and/or contribution for any and allamounts which may be adjudged against it in the case, and for its costs ofdefending the Plaintiff’s lawsuit.  TheCompany intends to aggressively defend itself in this action.

 

                The Bank is 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 is a Plaintiff in this action dueto the fact that its former director, Frank Gazzola, was also a director ofPhenix Biocomposites.  The Plaintiffsallege that Mr. Gazzola failed to inform the Plaintiffs that their investmentin Phenix Biocomposites was not secured. The Plaintiffs claim that the Bank had a fiduciary duty to the Plaintiffs because of Mr. Gazzola’sdual role as a director of both the Bank and Phenix Biocomposites, that Northern Star 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 denies thePlaintiffs’ allegations and intends to vigorously defend itself in this action.

 

During 1999 through 2000, the Bank made a series ofloans to Frank Gazzola, then a Director of the Company, in various amounts atmarket rates of interest and for terms of various lengths of time.  As of the fiscal year ending June 30, 2002,two loans remained unpaid with principal balances totaling $492,000.  The loans were secured by 32,000 shares ofCommon Stock of the Company, 41,000 shares of Common Stock of DMC StratexNetworks and shares of Common Stock representing 32% of a privately heldcompany.  Mr. Gazzola defaulted on theloans and the Bank foreclosed on the collateral for the loans. The bankruptcycourt claims that since certain of the collateral was conveyed to the Bankwithin one year of Gazzola’s bankruptcy filing and since he was an insider,they are preferential transfers and must be reversed.  The effect of a successful outcome by the bankruptcy court wouldincrease the risk of loss to the Bank

 

**ITEM4.  SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

 

Therewere no matters submitted to a vote of shareholders of the Company during thefourth quarter of fiscal 2002.

 

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**PARTII**

 

**ITEM5.  MARKET FOR COMMON EQUITY****AND RELATED STOCKHOLDER MATTERS**

 

Our Common Stockhas been quoted on the OTC Bulletin Board under the symbol “NSBK” sinceFebruary 2, 1999.  Quotations in thefollowing table represent inter-dealer prices, without retail markup, markdownor commission, and do not necessarily represent actual transactions.

 
|                     |   | **Common  Stock** |   |
|--------------------------|--------|-------------------|--------|
| **Fiscal Quarter Ended** |   | **High Bid**      |   | **Low Bid** |   |
| September 30,  2000      |   | 10.50             |   | 6.43 |   |
| December 31,  2000       |   | 6.50              |   | 6.00 |   |
| March 31, 2001           |   | 10.50             |   | 7.00 |   |
| June 30, 2001            |   | 10.50             |   | 10.00 |   |
|                     |   |              |   |   |   |
| 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 |   |

 

At August 13,2002, the last sale price for the Company’s Common Stock was $5.75 pershare.  At June 30, 2002, there wereissued and outstanding 479,506 shares of Common Stock of the Company held by 50shareholders of record.  Recordownership includes ownership by nominees who may hold for multiple owners.

 

The Company haspaid no dividends on its Common Stock and does not anticipate paying any suchdividends in the foreseeable future.

 

On June 28, 2002, the Company sold an aggregate of$400,000 of unsecured convertible subordinated notes to five accreditedinvestors.  The notes bear interest atthe rate of 7% per annum and are convertible into common stock of the Companyat the rate of $9.00 per share.  Inconnection with the sale of such notes the Company relied on the exemption fromregistration provided by Section 4(2) of the Securities Act of 1933.  The investors have taken the notes forinvestment purposes, and the notes contain a restrictive securities legend.

 

The following table provides information as of June30, 2002 about the Company’s equity compensation plans.

 
|                                                        |   | **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     |   | 86,800                                                                                              |   | $                                                                                   | 8.85   |                                                                                                                                                 | 29,900 |   |
| Equity  compensation plans not approved by security holders |   | 30,800                                                                                              |   | $                                                                                   | 10.00  |                                                                                                                                                 | 0      |   |

 

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

** **

This sectionpresents management’s review of the operating results and financial conditionof Northern Star Financial, Inc. (the “Company”) and its subsidiary, NorthernStar Bank (the “Bank”). This section provides information which is nototherwise apparent from the Consolidated Statements of Financial Condition,Operations, Stockholders’ Equity and Cash Flows and is intended to assistreaders in understanding the Company’s performance and financial condition.

 

**THIS ANNUAL REPORT ON FORM 10-KSB CONTAINSFORWARD-LOOKING INFORMATION AND ACTUAL RESULTS MAY DIFFER**

 

Statements thatNorthern Star Financial  may publish,including those in this Annual Report on Form 10-KSB that are not strictlyhistorical are “forward looking” statements made under the safe harborprovisions of the Private Securities Litigation Reform Act of 1995.  These include statements about the Company’splans, objectives, expectations and intentions that are not historical facts.When used in this Annual Report, the words “expects”, “anticipates”, “plans”,“believes”, “seeks”, “estimates”, and similar expressions are generallyintended to identify forward-looking statements.  Statements made in this Annual Report regarding the Company’sbeliefs and expectations that (i) it expects to be able to maintain or slightlyimprove its net interest margin in a declining rate environment; (ii) loandemand is expected to remain satisfactory in the near future with any growth afunction of local and national economic conditions; (iii) the present loanallowance is adequate; (iv) the Company maintains overall liquidity sufficientto satisfy its depositors’ requirements and meet its customers’ credit needs; and(v) it expects a decrease in the overall cost of money during 2002 are “forwardlooking” statements which involve known and unknown risks and uncertaintiesthat may cause the actual results to differ materially from those expected andstated in this announcement.  Actualresults could differ as a result of: (i) a further slowdown of economic growthin the United States, particularly in the Company’s market areas; (ii) anincrease in loan defaults; (iii) changes in consumer behavior resulting fromthe September 11, 2001 attack on the United States and changes in federal andstate laws; (iv) increased competitions from other financial and non-financialinstitutions; (v) the failure of the Company to successfully implement itsgrowth strategy; (vi) costs and expenses incurred in defending the Company andBank in connection with pending litigation and payment of damages andsettlement costs associated with such litigation; and (i) an increase inoperating expenses due to the Company’s expansion into St. Cloud, Minnesota.

 

**BUSINESS**

 

We are a bankholding company.  Our subsidiary,Northern Star Bank, is a state-chartered commercial bank providing a broadrange of commercial and retail banking services designed to meet the borrowingand depository needs of small and mid-sized businesses and consumers in theCities 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 principalbusiness consists of attracting deposits from the general public and usingthese deposits, together with borrowings and other funds, to originatecommercial, commercial real estate, 

 

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residential,agricultural, automobile and other consumer loans.  We also originate construction loans and invest insecurities.  Our results of operationsare primarily dependent on our interest rate spread, which is the difference(“spread”) between the average yield on interest-earning assets, such as loans,and investment securities and short-term interest bearing deposits and theaverage rate paid on interest-bearing liabilities, such as deposits andborrowings. The spread is affected by regulatory, economic and competitivefactors that influence interest rates, loan demand and deposit flows. Inaddition to credit risk, we are subject to interest rate risk to the degreethat our interest-earning assets mature or re-price at different times, or on adifferent basis, than our interest-bearing liabilities.

 

Our results ofoperations also depend upon, among other things, the level of fee income, gainsor losses on the sale of loans and other assets, provisions for possible loanlosses, income derived from subsidiary and investment activities, operatingexpenses and income taxes.  Ouroperating expenses principally consist of employee compensation and benefits,occupancy expenses, federal deposit insurance premiums and other general andadministrative expenses.

 

We are affected byprevailing economic conditions, including federal monetary and fiscal policies,as well as by federal regulation of financial institutions. Deposit balancesare influenced by a number of factors, including interest rates paid oncompeting personal investments and the level of personal income and savingswithin the institution’s market area. In addition, deposit balances are influencedby the perceptions of customers regarding the stability of the financialmarkets and financial services industry. We expect to retain a significant portion of existing deposit balancesby offering competitive rates on such deposits.  We have adopted a strategy of employing Federal Home Loan Bank(FHLB) advances to supplement deposits. FHLB advances are expected to augmentthe liquidity necessary to fund lending operations and investmentopportunities. Lending activities are influenced by demand for housing,consumer and commercial loans as well as competition from other lendinginstitutions. The primary sources of funds for lending activities includedeposits, loan payments, borrowings, the sale of loans and other assets andfunds provided from operations.

 

**RESULTS OF OPERATIONS**

 

**Net Income**

 

                TheCompany’s net operating loss for the fiscal year ended June 30, 2002 was$(1,088,316) or $(2.27) per share compared to a net operating loss of $(91,015)or $(0.21) per share for the fiscal year ended June 30, 2001.  Net losses incurred during fiscal year 2002include $121,000 associated with charges to earnings as a result of reversing$96,000 of accrued interest and $25,000 of legal expenses incurred inconnection with loans subject to legal proceeding (see *Item III. Legal Proceedings*)and $785,075 in additions to the Bank’s reserve for loan losses.* *Without these charges, the netloss would have been $(0.33) per share for the fiscal year ended June 30, 2002.

 

The Company’s return onaverage assets (“ROA”) and return on average equity (“ROE”) for the fiscal yearended June 30, 2002 were (2.48)% and (44.37)%, as compared to the ROA and ROEof (0.29)% and (3.15)% for the fiscal year ended June 30, 2001.

 

                Netoperating losses increased $997,301 to $(1,088,316) for the fiscal year endedJune 30, 2002, compared to $(91,015) for the same period during fiscal year2001.  Net interest income andnon-interest income increased by a combined amount of approximately $300,000,which was offset by an increase of approximately $383,000 in non-interestexpenses associated with our expansion into the St. Cloud, Minnesota market andby the $785,075 provision for loan losses.

 

                Theimprovement in net interest income was primarily due to an increase in averageinterest earning assets resulting from a growth in lending activities and froma lower cost of interest bearing 

 

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liabilities as a result of a general decline ininterest rates.  The increase innon-interest income was a result of an increase in loan and deposit relatedactivities and other miscellaneous fees, due to the overall growth of the loanand deposit portfolios.

 

**Net Interest Income/Margin**

 

                Netinterest income consists of interest income generated by earning assets, lessinterest expense.  Net interest incomeincreased $109,923 or 13.31% to $935,800 during the fiscal year ended June 30,2002 compared to $825,877 for the fiscal year ended June 30, 2001.  The $109,923 increase was a combination of a$227,740 increase in interest income offset by a $117,817 increase in interestexpense.

 

                Averageinterest earning assets increased $11.0 million to $41.4 million during thefiscal year ended June 30, 2002, compared to $30.4 million for the fiscal yearended June 30, 2001.  Comparing thesesame two periods, the yield on average interest earning assets decreased from8.27% in fiscal year 2001 to 6.62% in fiscal year 2002.  The increase in volume had a positive effecton the change in interest income ($920,000 volume variance).  The decrease in yields had a negative effecton the change in interest income ($531,000 rate variance).  The net result was a $226,000 increase ininterest income.

 

                Averageinterest bearing liabilities increased $10.9 million to $38.4 million duringthe fiscal year ended June 30, 2002, compared to $27.5 million for the fiscalyear ended June 30, 2001.  Comparingthese same two periods, the cost of average interest bearing liabilitiesdecreased from 6.15% in fiscal year 2001 to 4.71% in fiscal year 2002.  The increase in volume resulted in anincrease in interest expense ($680,000 volume variance), and the decrease inyields resulted in a decrease in interest expense ($405,000 rate variance).  The result was a net increase of $117,000 ininterest expense.

 

**Provision and Allowance for Loan Losses**

 

                Ourpolicy is to maintain the allowance for loan losses at a level sufficient toabsorb inherent losses in the loan portfolio. The allowance is increased by the provision for loan losses, which is acharge to current period earnings and decreased by charge-offs net ofrecoveries on prior loan charge-offs. In determining the adequacy of thereserve for loan losses, management considers those levels maintained byconditions of individual borrowers, the historical loan loss experience, thegeneral economic environment and the overall portfolio composition.  As these factors change, the level of loanloss provision changes.

 

                Theprovision for loan loss expense increased $727,561 to $785,075 during thefiscal year ended June 30, 2002, as compared to $57,514 for the fiscal yearended June 30, 2001.  At June 30, 2002,the allowance for loan losses totaled $661,170 or 1.93%, of total loansoutstanding, compared to $234,989, or 1.00% of total loans outstanding at June30, 2001.

 

                Theallowance for loan losses increased $426,181 or 181.4% during fiscal year2002.  The net charge-offs for fiscalyear 2002 was $358,894 compared to $4,025 during fiscal year 2001.  Net charge-offs to average loans outstandingwas 1.22% for fiscal year 2002 and .02% for fiscal year 2001.  The growth in the allowance for loan lossesis primarily due to $1.8 million of loans subject to adverse risk ratingsclassifications associated with legal proceedings and to a $10.6 millionoverall growth in loans outstanding. Loans outstanding grew $10.6 or 43.3% to$35.1 million at June 30, 2002 from $24.5 at fiscal year end June 30, 2001.

 

                Impairedloans at June 30, 2002 totaled $1.8 million and had related specific reservesof $442,000 that was part of the allowance for loan losses.  We believethat the Bank’s allowance for loan losses is adequate at June 30, 2002.

 

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**Non-Interest Income**

 

                Non-interestincome for fiscal year 2002 increased by $186,297, or 71.3%, to $447,465 ascompared to $261,168 for the fiscal year ending June 30, 2001.  The net increase was primarily comprised ofapproximately $132,000 increase in fees earned on residential mortgages sold.  The remaining $54,000 net increase wasprimarily the result of increases in other service charges and depositoryfees.  The overall increase is due tothe increase in volume as the Bank has grown, as well as management’s endeavorsto raise fees whenever the market allows.

 

**Non-InterestExpense**

 

                Non-interestexpense increased $581,180, or 52.6%, to $1.7 million for the fiscal year endedJune 30, 2002, compared to $1.1 million for the fiscal year ended June 30,2001.  The increase was a result ofapproximately $295,000 increase in compensation and related employee benefits,approximately $69,000 increase in occupancy and related equipment expenses, andapproximately $19,000 increase in data processing expenses.  The Bank opened a new branch on August 15,2001 which accounted for approximately $383,000 of these increases.

 

Excluding thenon-interest expenses associated with the Bank’s expansion into the St. Cloudmarket, non-interest expenses would have increased by approximately $198,000 or17.9%.

 

**Overview**

 

                Asof June 30, 2002, we had total assets of $48.6 million, compared to$39.1 million as of June 30, 2001. As of June 30, 2002 total netloans were $33.8 million and total deposits were $39.6 million,compared to $23.4 million and $32.8 million, respectively, as of June30, 2001.

 

**Loans**

 

                Lending-relatedincome is the most important component of the Company’s net interest income andis a major contributor to profitability. The loan portfolio is the largestcomponent of earning assets, and it therefore generates the largest portion ofrevenues. The absolute volume of loans and the volume of loans as a percentageof earning assets is an important determinant of net interest margin as loansare expected to produce higher yields than securities and other earning assets.Average loans during the fiscal year ended June 30, 2002, were 29.5 million, or71.3% of earning assets, as compared to $22.0 million, or 72.3% of earningassets, at June 30, 2001.  Total loans,net of unearned fees and cost, at fiscal year end June 30, 2002 and fiscal yearend June 30, 2001 were $35.1 million and $24.5 million, respectively. Thisrepresents a loan to total asset ratio of 72.3% and 62.6% and a loan to depositratio of  88.7% and 74.7%, at fiscalyear end June 30, 2002 and fiscal year end June 30, 2001 respectively, and anincrease of $10.6 million from fiscal year end 2001 to fiscal year end 2002, oran increase of 43.3%.  The growth inloans during this period was mainly due to the general growth in the market.

 

                Totalreal estate mortgage loans totaled $14.0 million making up nearly 40% of theloan portfolio as of June 30, 2002. Construction loans totaled $2.4 million, or6.8% of the loan portfolio. Commercial loans totaled $6.6 million, or 18.9% ofthe loan portfolio. Installment and consumer loans totaled $11.8 million, or 33.8%of the loan portfolio.

 

 

**Credit Quality**

 

                Wemaintain an allowance for loan losses to absorb inherent losses in the loanportfolio. The loans are charged against the allowance when management believescollection of the principal is unlikely. 

 

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The allowance consists of amounts established forspecific loans and is also based on historical loan loss experience.  The specific reserve element is the resultof a regular analysis of all loans and commitments based on credit ratingclassifications.  The historical loanloss element represents an assessment of potential credit problems and isdetermined using industry and Bank loan loss experience for each loan type.  Management also weighs general economic conditions,the risk characteristics of various classifications of loans, credit record ofits borrowers, the fair market value of underlying collateral and otherfactors.  We are committed to the earlyrecognition of problems and to maintaining a sufficient allowance.  At June 30, 2002, the allowance for loanlosses was $661,170 or 1.92% of total loans outstanding, net of loans held forsale, compared to $234,989, or 1.00%, at fiscal year end June 30, 2001.

 

                Non-performingassets consist of non-accrual loans, loans past due 90 days or more andstill accruing interest, and other real estate owned.  Loans are placed on a non-accrual status when they are past due90 days and management believes the borrower’s financial condition, aftergiving consideration to economic conditions and collection efforts, is suchthat collection of interest is doubtful. When a loan is placed on non-accrual status, interest accruals cease anduncollected interest is reversed and charged against current income.  Subsequent collections reduce the principalbalance of the loan until the loan is returned to accrual status.  At June 30, 2002 non-accrual loans totaled$1.8 million.  No loans were in non-accrualas of year ended June 30, 2001.

 

                AtJune 30, 2002 repossessed assets other than real estate totaled $8,000.  We had no repossessed real estate owned atJune 30, 2002.

 

                Managementis continually analyzing its loan portfolio in an effort to recognize andresolve its problem assets as quickly and efficiently as possible. While managementbelieves it uses the best information available at the time to make adetermination with respect to allowance for loan losses, management recognizesthat many factors can adversely impact various segments of its market, andsubsequent adjustments in the allowance may be necessary if future economicindications or other factors differ from the assumptions used in making theinitial determination or if regulatory policies change.  As such management continuously focuses itsattention on promptly identifying and providing for potential problem loans, asthey arise.  Although the totalallowance for loan losses is available to absorb losses from all loans,management allocates the reserve among the general loan portfolio categoriesfor informational and regulatory reporting purposes. Interest income notrecognized on non accrual loans was approximately $99,000 at fiscal year endJune 30, 2002.

 

**Deposits**

 

Total depositsincreased $6.8 million, or 20.6%, to $39.6 million as of June 30, 2002,compared to $32.8 million at June 30, 2001. The generation of deposits withinour market area serves as our primary source of funds to be invested largely inloans made to individuals and businesses located in or doing business inMinnesota.

 

**Securities**

 

Investments to be heldfor indefinite periods of time and not intended to be held to maturity areclassified as available for sale and are carried at fair value.  Unrealized holding gains and losses areincluded as a separate component of stockholders’ equity net of the effect ofdeferred income taxes. Realized gains and losses on investment securitiesavailable for sale are computed using the specific identification method.

 

                Securitiesthat management has the intent and the Bank has the ability to hold untilmaturity are classified as investment securities held to maturity.  Securities in this category are carried atamortized cost adjusted for accretion of discounts and amortization of premiumsusing the level yield method over 

 

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the estimated life of the securities.  If a security has a decline in fair valuebelow its amortized cost that is other than temporary, then the security willbe written down to its new cost basis by recording a loss in the statement ofoperations.  The Company does not engagein trading activities as defined in Statement of Financial Accounting StandardNumber 115.

 

                Ouravailable for sale portfolio totaled $9.6 million at June 30, 2002 and  June 30, 2001, or 19.7% and 24.6%,respectively, of total assets.  TheCompany did not have any investments in its held to maturity portfolio atfiscal year end June 30, 2002.

 

                Weuse our securities portfolio primarily as a source of liquidity.  When the Bank’s liquidity position exceedsexpected loan demand, other investments are considered by management as asecondary earnings alternative. Typically, management remains short-term (under 5 years) in itsdecision to invest in certain securities. As these investments mature, they will be used to meet cash needs orwill be reinvested to maintain a desired liquidity position.  We have designated substantially all of oursecurities as available for sale to provide flexibility, in case an immediateneed for liquidity arises.  Thecomposition of the portfolio offers management full flexibility in managing itsliquidity position and interest rate sensitivity, without adversely impactingits regulatory capital levels.  Theavailable for sale portfolio is carried at fair market value and had a netunrealized gain of approximately $52,700 on June 30, 2002, and a netunrealized gain of approximately $26,300 on June 30, 2001.

 

                Weinvest primarily in direct obligations of the United States, obligationsguaranteed as to the principal and interest by the United States and obligationsof agencies of the United States. In addition, we enter into federal fundstransactions with our principal correspondent banks, and acts as a net sellerof such funds.

 

**Liquidity and Interest Rate Sensitivity**

 

                Marketand public confidence in the financial strength of the Bank and financialinstitutions in general will largely determine our access to appropriate levelsof liquidity. This confidence is significantly dependent on the Bank’s abilityto maintain sound asset quality and appropriate levels of capital reserves.

 

                The Company’sfinancial strength was severely tested in fiscal year 2002.  The Company’s cash flows from operationswere not adequate to fund its operations. The Company received $1,400,000 from the sale of convertible notes toprovide the Company with liquidity.  TheCompany and Bank are parties to litigation and are incurring legal expenses andcosts. See “Item 3 — Legal Proceedings.” The Company and Bank intend to use cash from operations to fund suchexpenses.  In connection with theCompany’s litigation with Catalytic Combustion Corporation 401(k) ProfitSharing Plan and Catalytic Combustion Corporation, the Plaintiffs are seekingrescission of the purchase of 30,000 shares of Company Common Stock.  The Plaintiffs seek damages of approximately$210,714 plus interest expenses and attorney fees.  The Company may have to pay all or a portion of the damages thePlaintiffs seek.  The Company expects touse funds from operations to pay such damages if required.  The Company and Bank are uncertain as to theBank’s financial exposure in connection with the Bank’s defense in a Complaintfiled on February 23, 2002 by a group of lenders.  Each of the suits is significant to the Company and could have adetrimental impact on the future of the Company.  A significant loss could result in the Company falling below theminimum regulatory capital requirements. Failure to meet regulatory requirements can initiate certain mandatoryand possible discretionary actions by the regulators that, if taken, could havea detrimental material adverse effect on the Company’s consolidated financialstatements.  See Note 14 to theconsolidated financial statements for information regarding more stringentleverage capital requirements placed on the Bank as a result of litigationmatters.  In the event the Company doesnot have adequate funds to pay its litigation expenses and damages, if any, itplans to raise equity through the private placement of its securities or borrowfunds from available sources.  There isno assurance the Company 

 

20

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will be able to raise any capital from the sale of securities or borrowfunds.

 

                Liquidityis defined as the ability to meet anticipated customer demands for funds undercredit commitments and deposit withdrawals at a reasonable cost and on a timelybasis. Management measures the liquidity position by giving consideration toboth on- and off-balance sheet sources of and demands for funds on a daily andweekly basis.

 

                Shortterm sources of funding and liquidity include cash and cash equivalents, net offederal requirements to maintain reserves against deposit liabilities;investment securities eligible for pledging to secure borrowings from dealersand customers pursuant to securities sold under repurchase agreements; loanrepayments; loan sales; deposits and certain interest rate-sensitive deposits;and borrowings under overnight federal fund lines available from correspondentbanks. In addition to interest rate-sensitive deposits, the primary demand forliquidity is anticipated loan extensions under credit commitments tocustomers.  We do not use off balancesheet financing. We believe that it is reasonably likely these funding sourceswill be available in the future.

 

                Interestrate sensitivity refers to the responsiveness of interest-earning assets andinterest-bearing liabilities to changes in market interest rates.  The rate sensitive position, or gap, is thedifference in the volume of rate-sensitive assets and liabilities, at a giventime interval, including both floating rate instruments and instruments whichare approaching maturity.  Themeasurement of our interest rate sensitivity, or gap, is one of the principaltechniques used in asset and liability management.

 

                Wegenerally attempt to maintain a balance between rate-sensitive assets andliabilities as the exposure period is lengthened to minimize overall interestrate risks.

 

                Theasset mix of the balance sheet is evaluated continually in terms of severalvariables: yield, credit quality, appropriate funding sources and liquidity.Management of the liability mix of the balance sheet focuses on expanding thevarious funding sources.

 

                Ourgap and liquidity positions are reviewed periodically to determine whether or notchanges in policies and procedures are necessary to achieve financial goals. AtJune 30, 2002, approximately 41.2% of total gross loans were adjustable rate oreither repricing or maturing in less than one year.  Deposit liabilities consisted of approximately $7.7 million inNOW and money market accounts, $4.5 million in savings accounts, $22.8 million in time deposits and $4.6 million innon-interest bearing demand accounts. At June 30, 2001, approximately 39.3% of total gross loans wereadjustable rate or either repricing or maturing in less than one year.  Deposit liabilities consisted ofapproximately $3.5 million in NOW and money market accounts, $4.7 million insavings accounts, $23.1 million in time deposits, and $1.5 million innon-interest bearing demand accounts.

 

We have prepared a tablewhich presents the market risk associated with financial instruments held bythe Company.  In the “Rate SensitivityAnalysis” table, rate sensitive assets and liabilities are shown by maturity orre-pricing periods, separating fixed and variable interest rates. The estimatedfair value of each instrument category is also shown in the table.  While these estimates of fair value arebased on management’s judgment of the most appropriate factors, there is noassurance that, if we had to dispose of such instruments at June 30, 2002, theestimated fair values would necessarily have been achieved at that date, sincemarket values may differ depending on various circumstances.  The estimated fair values at June 30, 2002,should not necessarily be considered to apply at subsequent dates.

 

21

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**PrimarySources and Uses of Funds**

 

                Theprimary source of funds during the fiscal year ended June 30, 2002, includedproceeds from financing activities ($10.6 million), including an increase indeposits ($6.8 million), and the maturity/sale of investments net of purchases($69,546),.

 

The primary uses of fundsduring the period included an increase in net loans outstanding ($11.2 million),decrease in federal funds sold ($2.4 million), increase in premises andequipment ($242,065), and investments ($15.8 million).

 

**Capital Resources**

 

                Totalshareholders’ equity at June 30, 2002 was $1.9 million compared to $3.0 millionat June 30, 2001.

 

                TheMinnesota Department of Commerce — Financial Institution Division and theFederal Deposit Insurance Corporation has established risk-based capitalrequirements for state chartered banks. These guidelines are intended toprovide an additional measure of a bank’s capital adequacy by assigningweighted levels of risk to asset categories. Banks are also required tosystematically maintain capital against such “off-balance sheet” activities asloans sold with recourse, loan commitments, guarantees and standby letters ofcredit. These guidelines are intended to strengthen the quality of capital byincreasing the emphasis on common equity and restricting the amount of loanloss reserves and other forms of equity such as preferred stock that may beincluded in capital. The Company’s subsidiary bank’s goal is to maintain itscurrent status as a “well-capitalized institution” as that term is defined byits regulators.

 

                Underthe terms of the guidelines, banks must meet minimum capital adequacy basedupon both total assets and risk adjusted assets. All banks are required tomaintain a minimum ratio of total capital to risk-weighted assets of 8% and aminimum ratio of Tier 1 capital to risk-weighted assets of 4%. Adherence tothese guidelines has not had an adverse impact on the Company.

 

**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 industrialcompanies, virtually all of the assets and liabilities of a financialinstitution are monetary in nature. As a result, interest rates generally havea more significant impact on the performance of a financial institution thanthe effects of general levels of inflation. Although interest rates do not necessarilymove in the same direction or to the same extent as the prices of goods andservices, increases in inflation generally have resulted in increased interestrates. In addition, inflation affects financial institutions’ increased cost ofgoods and services purchased, the cost of salaries and benefits, occupancyexpense, and similar items. Inflation and related increases in interest ratesgenerally decrease the market value of investments and loans held and mayadversely affect liquidity, earnings, and shareholders’ equity. Commercial andother loan originations and re-financings tend to slow as interest ratesincrease, and can reduce the Company’s earnings from such activities.

 

**RecentAccounting Developments**

 

SFAS No. 133, “Accountingfor Derivative Instruments and Hedging Activities,” is effective for all fiscalyears beginning after June 15, 2001. SFAS No. 133, as amended and interpreted, establishes accounting andreporting standards for derivative instruments, including certain derivativeinstruments 

 

22

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embedded in other contracts and for hedgingactivities. Under SFAS No. 133, certain contracts that were not formerlyconsidered derivatives may now meet the definition of a derivative.  We adopted SFAS No. 133 effective January 1,2001. The adoption of SFAS No. 133 did not have a significant impact on ourfinancial position, results of operations, or cash flows.

 

SFAS No. 140, “Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities,” revises the standards for accounting for securitizations andother transfers of financial assets and collateral and requires certaindisclosures, but carries over most of the provisions of SFAS No. 125 withoutreconsideration. SFAS No. 140 is effective for transfers and servicing offinancial assets and extinguishments of liabilities occurring after March 31,2001.  The Statement is effective forrecognition and reclassification of collateral and for disclosures relating tosecuritization transactions and collateral for fiscal years ending afterDecember 15, 2001.  The adoption of SFASNo. 140 did not have a material effect on our financial position, results ofoperations or cash flows.

 

SFAS No. 141, “BusinessCombinations,” requires that all business combinations be accounted for by asingle method — the purchase method. The provisions of this SFAS No. 141 apply to all business combinationsinitiated after June 30, 2001.  SFAS No.141 also applies to all business combinations accounted for using the purchasemethod for which the date of acquisition is July 1, 2001, or later.  The adoption of the provisions of SFAS No.141 did not have a material impact on our financial condition, results of operationsor cash flows.

 

SFAS No. 142, “Goodwilland Other Intangible Assets,” requires that, upon its adoption, amortization ofgoodwill will cease and instead, the carrying value of goodwill will beevaluated for impairment on an annual basis. Identifiable intangible assetswill continue to be amortized over their useful lives and reviewed forimpairment in accordance with SFAS No. 121, “Accounting for the Impairment ofLong-Lived Assets and for Long-Lived Assets to be Disposed Of” (“SFAS No.121”). SFAS No. 142 will be effective for fiscal years beginning after December15, 2001.  We have determined that thisstatement will not have a material impact on our financial condition, resultsof operations or cash flows.

 

SFAS No. 143, “Accountingfor Asset Retirement Obligations,” requires that the fair value of a liabilityfor an asset retirement obligation be recognized in the period in which it isincurred, if a reasonable estimate of fair value can be made.  The associated asset retirement cost wouldbe capitalized as part of the carrying amount of the long-lived asset. SFAS No.143 will be effective for fiscal years beginning after June 15, 2002.  We have determined that this statement willnot have a material impact on our financial condition, results of operations orcash flows.

 

SFAS No. 144, “Accountingfor the Impairment or Disposal of Long Lived Assets,” replaces SFAS No. 121.SFAS No. 144 requires that long-lived assets be measured at the lower ofcarrying amount or fair value less cost to sell, whether reported in continuingoperations or in discontinued operations. SFAS No. 144 also broadens thereporting of discontinued operations to include all components of an entitywith operations that can be distinguished from the rest of the entity and thatwill be eliminated from the ongoing operations of the entity in a disposaltransaction.  The provisions of SFAS No.144 are effective for financial statements issued for fiscal years beginningafter December 15, 2001.  We havedetermined that this statement will not have a material impact on our financialcondition, results of operations or cash flows.

 

**SECONDARYSTOCK OFFERING AND ISSUANCE OF CONVERTIBLE SUBORDINATED DEBENTURES**

 

In September of2000, we undertook an offering of a minimum of 50,000 and a maximum of 300,000shares of common stock.  On the closingdate of the offering, April 11, 2001, the Company 

 

23

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issued 51, 906 shares ata price of $10.50 per share.  Net ofexpenses of $325,000, the offering provided us with $220,000 of additional equity.  Following the close of the offering, weinjected $400,000 of additional capital into the Bank to support its continuedgrowth and development.

 

In July andAugust, 2001, we raised $1.0 million through the sale of convertiblesubordinated unsecured notes, and from June to August, 2002 the Company raisedan additional $500,000 through the sale of similar notes.  The notes were issued for a three-year termand bear interest at the rate of eight percent per annum (as to the 2001 notes)and seven percent per annum (as to the 2002 notes), payable quarterly.  Investors in the notes were granted theright to convert their investment into shares of Northern Star Financial, Inc.common 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).

 

**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 years 2002 and 2001.  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, 2002** |   | **For the  Year Ended  June 30, 2001** |   |
|----------------------------------|--------|----------------------------------------|--------|----------------------------------------|--------|
| Return (loss) on  average assets |   | (2.48                                  | )%     | (.29                                   | )%     |
| Return (loss) on  average equity |   | (44.37                                 | )%     | (3.49                                  | )%     |
| Equity to assets  ratio          |   | 5.59                                   | %      | 8.19                                   | %      |

 

**BORROWINGS**

 

Deposits are theprimary source of funds for the Bank’s lending and investment activities andfor its general business purposes.  Ifthe need arises, the Bank may rely upon advances from the Federal Home LoanBank of Des Moines to supplement its supply of lendable funds and to meetlending and deposit withdrawal requirements. Advances from the FHLB are typically secured by a portion of the Bank’ssecurity portfolio.  In addition toborrowings from FHLB, we have had a fully advanced line of credit in the amountof $600,000 with a correspondent bank in Minneapolis, Minnesota.

 
|                      |   | **As of and  for the fiscal year Ended June 30,** |      |
|---------------------------|--------|---------------------------------------------------|-----------|
|                      |   | **2002**                                          |      | **2001** |   |
| Maximum Balance           |   | $                                                 | 6,675,000 |   | $ | 2,875,000 |   |
| Average Balance           |   | 5,606,850                                         |      | 2,789,559 |   |
| Balance at end  of period |   | 6,675,000                                         |      | 2,875,000 |   |
| Weighted average  rate:   |   |                                              |      |   |   |
| at end of the  period     |   | 5.41                                              | %         | 5.54 | % |
| during the  period        |   | 5.40                                              | %         | 6.67 | % |
|                           |        |                                                   |           |  |  |  |  |

 

 

24

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**CAPITAL ADEQUACY**

 

There are now twoprimary measures of capital adequacy for banks and bank holding companies: (i)risk-based capital guidelines and (ii) leverage ratio.

 

The risk basedcapital guidelines measure the amount of a bank’s required capital in relationto the degree of risk perceived in its assets and its off-balance sheetitems.  Under the risk-based capitalguidelines, capital is divided into two “tiers.”  Tier 1 capital consists of common stockholders’ equity,non-cumulative and cumulative perpetual preferred stock (bank holding companiesonly) and minority interest.  Goodwillis subtracted from the total.  Tier 2capital consists of the allowance for loan loss, hybrid capital instruments,and term subordinated debt and intermediate term preferred stock.  Banks are required to maintain a minimumrisk-based capital ratio of 8.0% with at least 4.0% consisting of Tier 1capital.

 

The second measureof capital adequacy relates to the leverage ratio.  The Federal Deposit Insurance Corporation has established a 3.0%minimum leverage ratio requirement.  Notethat the leverage ratio is computed by dividing Tier 1 capital into averageassets.  For all banks, except thehighest rated banks, the minimum leverage ratio should be 3.0% plus anadditional cushion of at least 1 to 2 percent, depending upon risk profiles andother factors.

 

The FederalReserve Board and the FDIC rules add a measure of interest rate risk to thedetermination of supervisory capital adequacy. In connection with this rule, the agencies have adopted a measurementprocess to measure interest rate risk. Under this rule, all items reported on the balance sheet, as well asoff-balance sheet items, are reported according to maturity, re-pricing datesand cash flow characteristics.  A bank’sweighted position is used in assessing capital adequacy.  The objective of this complex rule is todetermine the sensitivity of banks to various rising and declining interestrate scenarios.

 

The FederalDeposit Insurance Corporation Improvement Act (“FDICIA”), as well as otherrequirements, established five capital tiers: well-capitalized, adequatelycapitalized, under capitalized, significantly under capitalized, and criticallyunder capitalized.  A depositoryinstitution’s capital tier depends on its capital levels in relation to variousrelevant capital measures and certain other factors.  Depository institutions that are not classified as wellcapitalized are subject to various restrictions regarding capitaldistributions, payment of management fees, acceptance of brokered deposits andother operating activities.

 

Thetable below illustrates the Bank’s regulatory capital and ratios at June 30,2002:

 
|                                      |   | **Actual** |      | **For Capital  Adequacy Purposes** |   | **To Be Well Capitalized  Under Prompt Corrective  Action Provision** |   |
|-------------------------------------------|--------|------------|-----------|------------------------------------|--------|-----------------------------------------------------------------------|--------|
|                                      |   | **Amount** |      | **Percent**                        |   | **Amount**                                                            |   | **Percent** |   | **Amount** |   | **Percent** |   |
| As of June 30, 2002:                      |   |       |      |                               |   |                                                                  |   |   |   |   |   |   |   |
| Total Capital  (to Risk Weighted Assets)  |   | $          | 4,298,000 |                               | 11.5   | %                                                                     | $      | 2,990,000 |   | >=  8.0 | % | $ | 3,737,000 |   | >=  10.0 | % |
| Tier I Capital  (to Risk Weighted Assets) |   | $          | 3,827,000 |                               | 10.2   | %                                                                     | $      | 1,496,000 |   | >=  4.0 | % | $ | 2,245,000 |   | >=  6.0 | % |
| Leverage Ratio                            |   |       |      |                               |   |                                                                  |   |   |   |   |   |   |   |
| Tier I Capital  (to Average Assets)       |   | $          | 3,827,000 |                               | 8.7    | %                                                                     | $      | 1,760,000 |   | >=  4.0 | % | $ | 2,199,000 |   | >=  5.0 | % |

 

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                At June 30, 2002 the Bank is classified aswell-capitalized and is in compliance with all regulatory capitalrequirements.  Management anticipatesthe Bank will continue to be classified as well-capitalized.

 

As of June 30, 2002, there were no significantcommitments outstanding for capital expenditures.

 

**INDUSTRY DEVELOPMENTS**

 

From time to time,various bills are introduced in the United States Congress with respect to theregulation of financial institutions. Certain of these proposals, if adopted, could significantly change theregulation of banks and the financial services industry.  The Company cannot predict whether any ofthese proposals will be adopted or, if adopted, how these proposals wouldaffect the Company.

 

**AverageBalances, Yields and Rates**

 

                The following table summarizesour weighted average yields earned, weighted average rates paid, interest ratespread and net yield on earning assets and interest-bearing liabilities.

 
|                                                                              |   | **For the  Year Ended** |       |
|-----------------------------------------------------------------------------------|--------|-------------------------|------------|
|                                                                              |   | **June 30,  2002**      |       | **June 30,  2001** |   |
| **Assets**                                                                        |   | **Average  Balance**    |       | **Interest** |   | **Average  Yield or  Rates** |   | **Average  Balance** |   | **Interest** |   | **Average  Yield or  Rates** |   |
| Loans receivable                                                                  |   | $                       | 29,529,396 |   | $ | 2,130,429 |   | 7.21 | % | $ | 21,972,800 |   | $ | 1,993,140 |   | 9.07 | % |
| Investment  securities                                                            |   | 9,866,372               |       | 554,514 |   | 5.62 | % | 5,797,613 |   | 379,551 |   | 6.55 | % |
| Federal funds  sold                                                               |   | 2,043,466               |       | 57,857 |   | 2.83 | % | 2,623,853 |   | 142,369 |   | 5.43 | % |
| Total  interest-earning assets                                                    |   | 41,439,234              |       | 2,742,800 |   | 6.62 | % | 30,394,266 |   | 2,515,060 |   | 8.27 | % |
| Non-interest-earning  assets                                                      |   | 2,260,896               |       |   |   |   |   | 1,453,626 |   |   |   |   |   |
| Total assets                                                                      |   | $                       | 43,700,130 |   |   |   |   |   | $ | 31,847,892 |   |   |   |   |   |
| **Liabilities  and Stockholders’ Equity**                                    |   |                    |       |   |   |   |   |   |   |   |   |   |   |
| Interest Bearing  Deposits                                                        |   | $                       | 32,760,283 |   | 1,504,181 |   | 4.59 | % | $ | 24,680,140 |   | 1,503,011 |   | 6.09 | % |
| Other  liabilities                                                                |   | 5,606,850               |       | 302,819 |   | 5.40 | % | 2,789,559 |   | 186,172 |   | 6.67 | % |
| Total  interest-bearing liabilities                                               |   | 38,367,133              |       | 1,807,000 |   | 4.71 | % | 27,469,699 |   | 1,689,183 |   | 6.15 | % |
| Non-interest-bearing  liabilities                                                 |   | 2,826,075               |       |   |   |   |   | 1,771,549 |   |   |   |   |   |
| Total  liabilities                                                                |   | 41,193,208              |       |   |   |   |   | 29,241,248 |   |   |   |   |   |
| Stockholders’  Equity                                                        |   | 2,506,922               |       |   |   |   |   | 2,606,644 |   |   |   |   |   |
| Total  liabilities and stockholders’ equity                                  |   | $                       | 43,700,130 |   |   |   |   |   | $ | 31,847,892 |   |   |   |   |   |
| Net Interest  Spread                                                              |   |                    |       |   |   | 1.91 | % |   |   |   |   | 2.12 | % |
| Net Interest  Income/Margin                                                       |   |                    |       | $ | 935,800 |   | 2.26 | % |   |   | $ | 825,877 |   | 2.72 | % |
| Ratio of average  interest-earning assets to average interest-bearing liabilities |   | 1.08x                   |       |   |   |   |   | 1.11x |   |   |   |   |   |
|                                                                                   |        |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

26

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**Rate/VolumeAnalysis**

 

The table below sets forth certain informationregarding changes in interest income and interest expense of the Bank for theperiods indicated.  For each category ofinterest-earning and interest-bearing liabilities, information is provided onchanges attributable to (i) changes in volume (change in average volumemultiplied by old rate); (ii) changes in rates (changes in rate multiplied byold average volume); (iii) changes in rate-volume (changes in rate multipliedby the change in average volume).

 
|                                |   | **Year Ended  June 30,**        |   |
|-------------------------------------|--------|---------------------------------|--------|
|                                |   | **2002 vs  2001**               |   |
|                                |   | **Increase  (decrease) due to** |   |
|                                |   | **Volume**                      |   | **Rate** |   | **Rate/Volume** |   | **Net** |   |
|                                |   | **(dollars  in thousands)**     |   |
| 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, 2002, our investment securities portfoliorepresented approximately 21.3% of our earning assets of $45 million.  We also held investments in stock of theFederal Home Loan Bank in the amount of $238,800.

 

At June 30, 2001, our investment securities portfoliorepresented approximately 25.8% of our earning assets of $37 million.

 
|                     |   | **June 30,  2002**    |      |
|--------------------------|--------|-----------------------|-----------|
|                     |   | **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 | % | $ | 249,378 |   | 4.63 | % | $ | 1,003,677 |   | 4.94 | % | $ | - |   | 0.00 | % | $ | 1,253,055 |   | 4.88 | % |
| Mortgage-back 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 | % |

 

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|                       |   | **June 30,  2001**    |    |
|----------------------------|--------|-----------------------|---------|
|                       |   | **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              |   | $                     | 101,031 |   | 6.01 | % | $ | 704,911 |   | 5.84 | % | $ | 2,194,004 |   | 6.20 | % | $ | - |   | 0.00 | % | $ | 2,999,946 |   | 6.11 | % |
| Mortgage-backed securities |   | -                     |    | 0.00 | % | 203,446 |   | 7.06 | % | - |   | 0.00 | % | 6,176,534 |   | 6.38 | % | 6,379,980 |   | 6.40 | % |
| Corporate Bonds            |   | -                     |    | 0.00 | % | - |   | 0.00 | % | 244,036 |   | 6.57 | % | - |   | 0.00 | % | 244,036 |   | 6.57 | % |
| Mutual Fund                |   | -                     |    | 0.00 | % | - |   | 0.00 | % | - |   | 0.00 | % | - |   | 0.00 | % | - |   | 0.00 | % |
|                       |   | $                     | 101,031 |   | 6.01 | % | $ | 908,357 |   | 6.11 | % | $ | 2,438,040 |   | 6.23 | % | $ | 6,176,534 |   | 6.38 | % | $ | 9,623,962 |   | 6.31 | % |

 

Contractual maturities and yields on our investment(all available for sale) are summarized in the above table.  Expected maturities may differ fromcontractual maturities because issuers may have the right to call or prepayobligations with or without call or prepayment penalties.Short-term investmentsin the amount of $1.0 million at June 30, 2002 were funds invested in FederalFunds sold on an overnight basis which are considered cash equivalent.

 

**Interest Rate Sensitivity Analysis**

 

We continually evaluate the asset mix of our balancesheet in terms of several variables: yields, credit quality, appropriatefunding sources and liquidity.  Toeffectively manage the liability mix of the balance sheet, we focus onexpanding various funding sources.  Theinterest rate sensitivity position at June 30, 2001 and 2002 is summarized inthe following tables.  The differencebetween rate sensitive assets and rate sensitive liabilities, or the interestrate sensitivity gap, for each period is shown at the bottom of eachtable.  Since all interest rates andyields do not adjust at the same velocity, the gap is only a general indicatorof rate sensitivity.  The tables may notbe indicative of our rate sensitivity position at other points in time.

 

28

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|                                                                  |   | **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 Liabilties                                    |   | $                           | 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 | % |

 

 
|                                                                  |   | **As of June  30, 2001**    |   |
|-----------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                  |   | **Within**                  |   | **After  Three** |   | **After  Twelve** |   |   |   |   |   |
|                                                                  |   | **Three**                   |   | **but within** |   | **but within** |   | **After** |   |   |   |
|                                                                  |   | **Months**                  |   | **Twelve Months** |   | **Five Years** |   | **Five Years** |   | **Total** |   |
|                                                                  |   | **(Dollars  in Thousands)** |   |
| Interest Earning  Assets                                              |   |                        |   |   |   |   |   |   |   |   |   |
| Federal funds  sold                                                   |   | $                           | 3,438  |   | $ | - |   | $ | - |   | $ | - |   | $ | 3,438 |   |
| Investment  securities                                                |   | 1,512                       |   | 304 |   | 5,370 |   | 2,438 |   | 9,624 |   |
| Loans receivable                                                      |   | 8,264                       |   | 1,129 |   | 9,754 |   | 5,199 |   | 24,346 |   |
| Total Earning  Assets                                                 |   | $                           | 13,214 |   | $ | 1,433 |   | $ | 15,124 |   | $ | 7,637 |   | $ | 37,408 |   |
|                                                                  |   |                        |   |   |   |   |   |   |   |   |   |
| Interest Bearing  Liabilities                                         |   |                        |   |   |   |   |   |   |   |   |   |
| NOW and money  market                                                 |   | $                           | 3,548  |   | $ | - |   | $ | - |   | $ | - |   | $ | 3,548 |   |
| Savings                                                               |   | 4,713                       |   | - |   | - |   | - |   | 4,713 |   |
| Time deposits                                                         |   | 3,297                       |   | 11,692 |   | 8,098 |   | - |   | 23,087 |   |
| Borrowed funds                                                        |   | 100                         |   | 1,225 |   | 1,050 |   | 500 |   | 2,875 |   |
| Total Interest  Bearing Liabilties                                    |   | $                           | 11,658 |   | $ | 12,917 |   | $ | 9,148 |   | $ | 500 |   | $ | 34,223 |   |
|                                                                  |   |                        |   |   |   |   |   |   |   |   |   |
| Interest  Sensitivity Gap                                             |   | 1,556                       |   | (11,484 | ) | 5,976 |   | 7,137 |   | 3,185 |   |
| Cumulative  Interest Sensitivity Gap                                  |   | 1,556                       |   | (9,928 | ) | (3,952 | ) | 3,185 |   | 3,185 |   |
| Ratio of  Interest Sensitivity Gap to total earning assets            |   | 4.16                        | %      | -30.70 | % | 15.98 | % | 19.08 | % | 8.51 | % |
| Ratio of  Cumulative Interest Sensitivity Gap to total earning assets |   | 4.16                        | %      | -26.54 | % | -10.56 | % | 8.51 | % | 8.51 | % |
|                                                                       |        |                             |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

29

----

 

**LoanPortfolio**

 

Since loans typically provide higher interest yieldsthan do other types of earning assets, our intent is to channel a substantialpercentage of our earning assets into the loan category.  The gross loans outstanding, including loansheld for sale, were approximately $35 million as of June 30, 2002 and $24million as of June 30, 2001. The following table summarizes the composition ofour loan portfolio.

 
|                            |   | **June 30,  2002** |       | **June 30,  2001** |   |
|---------------------------------|--------|--------------------|------------|--------------------|--------|
|                            |   | **Amount**         |       | **% of Total**     |   | **Amount** |   | **% of Total** |   |
| Commercial &  Agricultural  |   | $                  | 6,616,193  |               | 18.93  | % | $ | 4,903,794 |   | 20.14 | % |
| Real Estate -  construction     |   | 2,375,318          |       | 6.80               | %      | 2,307,478 |   | 9.48 | % |
| Real Estate -  mortgages        |   | 13,962,496         |       | 39.96              | %      | 6,117,538 |   | 25.13 | % |
| Consumer Loans                  |   | 11,809,464         |       | 33.80              | %      | 10,588,900 |   | 43.49 | % |
| Lease Financing                 |   | 179,995            |       | 0.51               | %      | 428,447 |   | 1.76 | % |
| Total Loans                     |   | $                  | 34,943,466 |               | 100.00 | % | $ | 24,346,157 |   | 100.00 | % |
| Net Deferred  Loans(fees)/costs |   | 180,131            |       |               |   | 161,166 |   |   |   |
| Less: Allowance  for Loan Loss  |   | (661,170           | )          |               |   | (234,989 | ) |   |   |
| Total Net Loans                 |   | $                  | 34,462,427 |               |   |   | $ | 24,272,334 |   |   |   |

 

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

 

The information in the following tables is based onthe contractual maturities of individual loans, including loans which may havebeen subject to renewal at their contractual maturity.  Renewal of these loans is subject to reviewand credit approval, as well as modifications in terms upon theirmaturity.  Actual repayments of loansmay differ from maturities reflected below because borrowers have the right toprepay obligations with or without prepayment penalties.  The following tables summarize loanmaturities, by type, and related interest rate characteristics:

 
|                                |   | **As of June  30, 2002** |   |
|-------------------------------------|--------|--------------------------|--------|
|                                |   | **One Year**             |   | **After One  but** |   | **After** |   |   |   |
|                                |   | **or Less**              |   | **within  Five Years** |   | **Five Years** |   | **Total** |   |
| Commercial &  Agricultural      |   | $2,728,795               |   | $2,252,871 |   | $1,634,527 |   | $6,616,193 |   |
| Real Estate -  construction         |   | 2,295,594                |   | 9,126,974 |   | 2,539,928 |   | 13,962,496 |   |
| Real Estate -  mortgages            |   | 2,108,064                |   | 267,254 |   | - |   | 2,375,318 |   |
| 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 |   | $5,446,399 |   | $34,943,466 |   |
| Loans maturing  after one year with |   |                     |   |   |   |   |   |   |   |
| Fixed Interest  Rate                |   | $20,555,588              |   |   |   |   |   |   |   |
| Floating  Interest Rates            |   | $4,034,436               |   |   |   |   |   |   |   |

 

30

----

 
|                                |   | **As of June  30, 2001** |       |
|-------------------------------------|--------|--------------------------|------------|
|                                |   | **One Year**             |       | **After One  but** |   | **After** |   |   |   |
|                                |   | **or Less**              |       | **within  Five Years** |   | **Five Years** |   | **Total** |   |
| Commercial  Agricultural            |   | $                        | 1,629,904  |   | $ | 1,195,930 |   | $ | 2,077,960 |   | $ | 4,903,794 |   |
| Real Estate -  construction         |   | 1,944,702                |       | 180,133 |   | 182,642 |   | 2,307,478 |   |
| Real Estate -  mortgages            |   | 606,878                  |       | 1,680,620 |   | 3,830,042 |   | 6,117,538 |   |
| Consumer loans                      |   | 4,047,104                |       | 2,305,044 |   | 4,236,751 |   | 10,588,900 |   |
| Lease Financing                     |   | 18,662                   |       | 361,425 |   | 48,360 |   | 428,447 |   |
| Total                               |   | $                        | 8,247,250  |   | $ | 5,723,152 |   | $ | 10,375,755 |   | $ | 24,346,157 |   |
| Loans maturing  after one year with |   |                     |       |   |   |   |   |   |   |
| Fixed Interest  Rate                |   | $                        | 14,775,932 |   |   |   |   |   |   |   |
| Floating  Interest Rates            |   | $                        | 1,322,975  |   |   |   |   |   |   |   |
|                                |   |                     |       |   |   |   |   |   |   |

 

**Provisionand Allowance for Loan Losses**

 

We have developed policies and procedures forevaluating the overall quality of our credit portfolio and the timelyidentification of potential credit problems. Additions to the allowance for loan losses will be made periodically tomaintain the allowance in an appropriate level based on our analysis of thepotential risk in the loan portfolio.

 

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

 
|                                                                                       |   | **Year Ended**     |    |
|--------------------------------------------------------------------------------------------|--------|--------------------|---------|
|                                                                                       |   | **June 30,  2002** |    | **June 30,  2001** |   |
| Balance at  Beginning of Period                                                            |   | $                  | 234,989 |   | $ | 181,500 |   |
| Charge-offs                                                                                |   | (359,751           | )       | (8,615 | ) |
| Recoveries                                                                                 |   | 857                |    | 4,590 |   |
| Net Charge Offs                                                                            |   | (358,894           | )       | (4,025 | ) |
| Provision  charged to operations                                                           |   | 785,075            |    | 57,514 |   |
|                                                                                       |   |               |    |   |   |
| Balance at End  of Period                                                                  |   | $                  | 661,170 |   | $ | 234,989 |   |
|                                                                                       |   |               |    |   |   |
| Ratio of net  charge-offs during the period to average loans outstanding during the period |   | 1.22               | %       | 0.02 | % |

 

The allowance for loan losses was allocated as follows:

 
|                           |   | **June 30,  2002** |    | **June 30,  2001**    |   |
|--------------------------------|--------|--------------------|---------|-----------------------|--------|
|                           |   |               |    | **Percent of  Loans** |   |   |   | **Percent of  Loans** |   |
|                           |   |               |    | **in Each  Category** |   |   |   | **in Each  Category** |   |
|                           |   | **Amount**         |    | **of Total  Loans**   |   | **Amount** |   | **of Total  Loans** |   |
| Commercial &  Agricultural |   | $                  | 42,318  |                  | 18.93  | % | $ | 47,327 |   | 20.14 | % |
| Real Estate -  construction    |   | 17,815             |    | 6.80                  | %      | 22,277 |   | 9.48 | % |
| Real Estate -  mortgages       |   | 85,373             |    | 39.96                 | %      | 59,053 |   | 25.13 | % |
| Consumer loans                 |   | 514,123            |    | 33.80                 | %      | 102,197 |   | 43.49 | % |
| Lease Financing                |   | 1,541              |    | 0.51                  | %      | 4,135 |   | 1.76 | % |
| Total                          |   | $                  | 661,170 |                  | 100.00 | % | $ | 234,989 |   | 100.00 | % |

 

31

----

 

**Depositsand Other Interest-Bearing Liabilities**

 

As of June 30, 2002, deposits were 95.0% of interest-bearingliabilities compared to 95.9% for the same period ending June 30, fiscal year2001.  The following tables summarizedeposits by category.

 
|                               |   | **As of June  30, 2002** |       |
|------------------------------------|--------|--------------------------|------------|
|                               |   |                     |       |   |   |   |   | **Percentage** |   |   |   |
|                               |   |                     |       | **Percentage** |   |   |   | **of Total** |   |   |   |
|                               |   | **Ending**               |       | **of Total** |   | **Average** |   | **Average** |   | **Effective** |   |
|                               |   | **Balance**              |       | **Deposits** |   | **Balance** |   | **Deposits** |   | **Cost** |   |
| 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, 2001** |       |
|------------------------------------|--------|--------------------------|------------|
|                               |   |                     |       |   |   |   |   | **Percentage** |   |   |   |
|                               |   |                     |       | **Percentage** |   |   |   | **of Total** |   |   |   |
|                               |   | **Ending**               |       | **of Total** |   | **Average** |   | **Average** |   | **Effective** |   |
|                               |   | **Balance**              |       | **Deposits** |   | **Balance** |   | **Deposits** |   | **Cost** |   |
| Demand Deposit                     |   | $                        | 1,468,846  |   | 4.48 | % | $ | 1,339,955 |   | 5.16 | % | 0.00 | % |
| Now and money  market              |   | 3,548,246                |       | 10.81 | % | 2,493,152 |   | 9.60 | % | 3.20 | % |
| Savings                            |   | 4,713,914                |       | 14.36 | % | 4,126,187 |   | 15.90 | % | 4.32 | % |
| Time Accounts  less than $100,000  |   | 19,202,472               |       | 58.51 | % | 14,716,018 |   | 56.69 | % | 6.91 | % |
| Time Accounts of  $100,000 or more |   | 3,884,586                |       | 11.84 | % | 3,282,492 |   | 12.65 | % | 6.95 | % |
| Total Deposits                     |   | $                        | 32,818,064 |   | 100.00 | % | $ | 25,957,804 |   | 100.00 | % |   |   |

** **

**               **As of June 30, 2002 the Bank had deposits classifiedas brokered deposit totaling $2.6 million. The Bank does not rely on brokered deposits. Core deposits, excludingtime deposits of $100,000 or more, provide a relatively stable funding sourcefor our loan portfolio and other earning assets.  Our core deposits were $18.6 million at June 30, fiscal year 2002and $14.7 million at June 30, 2001.  Ourloan to deposit ratio was 88.9% at June 30, fiscal year 2002 and 71.7% at June30, 2001.  The maturity distribution ofour time deposits is as follows.

 

32

----

 
|                              |   | **June 30,  2002** |      |
|-----------------------------------|--------|--------------------|-----------|
|                              |   | **3 months**       |      | **Over 3  months** |   | **Over 6  months** |   | **Over** |   |   |   |
|                              |   | **or less**        |      | **thru 6  months** |   | **thru 12  months** |   | **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 |   |

 
|                              |   | **June 30,  2001** |      |
|-----------------------------------|--------|--------------------|-----------|
|                              |   | **3 months**       |      | **Over 3  months** |   | **Over 6  months** |   | **Over** |   |   |   |
|                              |   | **or less**        |      | **thru 6  months** |   | **thru 12  months** |   | **12 months** |   | **Total** |   |
| Time Accounts  less than $100,000 |   | $                  | 2,469,435 |   | $ | 3,922,274 |   | $ | 5,831,186 |   | $ | 6,979,577 |   | $ | 19,202,472 |   |
| Time Accounts of  $100,00 or more |   | 827,298            |      | 527,500 |   | 1,411,300 |   | 1,118,488 |   | 3,884,586 |   |
| Total                             |   | $                  | 3,296,733 |   | $ | 4,449,774 |   | $ | 7,242,486 |   | $ | 8,098,065 |   | $ | 23,087,058 |   |

 

33

----

 

**ITEM7.   FINANCIAL STATEMENTS**

 

 

 

 

 

** **

**NorthernStar Financial, Inc.and Subsidiary**

**ConsolidatedFinancial Report**

**June 30,2002**

 

 

34

----

 

**CONTENTS**
| INDEPENDENT AUDITOR’S  REPORTS                   |   |
|-------------------------------------------------------|--------|
|                                                  |   |
| FINANCIAL  STATEMENTS                                 |   |
|                                                  |   |
| Consolidated  balance sheets                          |   |
|                                                  |   |
| Consolidated  statements of operations                |   |
|                                                  |   |
| Consolidated  statements of stockholders’ equity |   |
|                                                  |   |
| Consolidated  statements of cash flows                |   |
|                                                  |   |
| Notes to  consolidated financial statements           |   |
|                                                  |   |

 

 

 

35

----

 

 

INDEPENDENT AUDITOR’S REPORT

 

 

 

To the Board of DirectorsNorthern Star Financial, Inc. and SubsidiaryMankato, Minnesota

 

We have audited theaccompanying consolidated balance sheet of Northern Star Financial, Inc. andSubsidiary as of June 30, 2002, and the related consolidated statements ofoperations, stockholders’ equity, and cash flows for the year then ended. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour 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 financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audit provides a reasonable basisfor 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, 2002, 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.

 

As explained in Note 17to the consolidated financial statements, the Company is a defendant insignificant litigation matters.

 

/s/ McGladrey &Pullen, LLP

 

Minneapolis, MinnesotaAugust 14, 2002

 

 

 

36

----

 

INDEPENDENT AUDITORS’ REPORT

 

 

 

To the Board ofDirectors and ShareholdersNorthern Star Financial, Inc. and SubsidiaryMankato,  Minnesota  56001

 

We have auditedthe accompanying consolidated balance sheet of Northern Star Financial, Inc.and Subsidiary (the Company) as of June 30, 2001, and the related consolidatedstatements of operations, changes in shareholders’ equity, and cash flows forthe year then ended.  These consolidatedfinancial statements are the responsibility of management.  Our responsibility is to express an opinionon these consolidated financial statements based on our audit.

 

We conducted ouraudit in accordance with auditing standards generally accepted in the UnitedState of America.  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that our auditprovides a reasonable basis for our opinion.

 

In our opinion,the consolidated financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of Northern StarFinancial, Inc. and Subsidiary as of June 30, 2001, and the consolidatedresults of their operations and their cash flows for the year then ended, inconformity with accounting principle generally accepted in the United States ofAmerica.

 

 

/s/ Bertram Cooper& Co., LLPBertram Cooper& Co., LLPWaseca, MinnesotaAugust 31, 2001

 

 

37

----

 

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

 

**CONSOLIDATEDBALANCE SHEETSJune 30, 2002 and 2001**

 
|                                                                                                      |   | **2002**       |           | **2001**   |   |
|-----------------------------------------------------------------------------------------------------------|--------|----------------|----------------|------------|--------|
| **ASSETS**                                                                                                |   |           | ** **     |       |   |
| Cash                                                                                                      |   | **$**          | **2,348,081**  | ** ** | $      | 870,133 |   |
| Federal funds  sold                                                                                       |   | **1,037,000**  | ** **     | 3,438,000  |   |
| Available-for-sale  securities (Note 2)                                                                   |   | **9,598,520**  | ** **     | 9,623,962  |   |
| Investment in  Federal Home Loan Bank stock, restricted                                                   |   | **238,800**    | ** **     | 138,800    |   |
| Loans held for  sale                                                                                      |   | **625,735**    | ** **     | 825,649    |   |
| Loans, net of  allowances for loan losses of $661,170 in 2002 and  $234,989 in 2001 (Notes 3, 10, and 13) |   | **33,836,692** | ** **     | 23,446,685 |   |
| Premises and  equipment, net (Note 4)                                                                     |   | **535,938**    | ** **     | 381,527    |   |
| Accrued interest  receivable and other assets (Note 9)                                                    |   | **351,771**    | ** **     | 409,978    |   |
|                                                                                                      |   | **$**          | **48,572,537** | ** ** | $      | 39,134,734 |   |
|                                                                                                      |   |           | ** **     |       |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                            |   |           | ** **     |       |   |
|                                                                                                      |   |           | ** **     |       |   |
| Liabilities                                                                                               |   |           | ** **     |       |   |
| Deposits (Note  5):                                                                                       |   |           | ** **     |       |   |
| Noninterest-bearing                                                                                       |   | **$**          | **4,574,282**  | ** ** | $      | 1,468,846 |   |
| Interest-bearing                                                                                          |   | **35,015,447** | ** **     | 31,348,218 |   |
| **Total  deposits**                                                                                       |   | **39,589,729** | ** **     | 32,817,064 |   |
|                                                                                                      |   |           | ** **     |       |   |
| Notes payable  and other borrowing (Note 6)                                                               |   | **5,275,000**  | ** **     | 2,875,000  |   |
| Convertible  subordinated notes payable (Note 7)                                                          |   | **1,400,000**  | ** **     | -          |   |
| Accrued interest  payable and other liabilities                                                           |   | **384,144**    | ** **     | 461,086    |   |
| **Total  liabilities**                                                                                    |   | **46,648,873** | ** **     | 36,153,150 |   |
|                                                                                                      |   |           | ** **     |       |   |
| Commitments,  Contingencies, and Credit Risk (Notes 10 and 17)                                            |   |           | ** **     |       |   |
|                                                                                                      |   |           | ** **     |       |   |
| Stockholders’  Equity (Notes 8, 11, and 14)                                                          |   |           | ** **     |       |   |
| Common stock,  $0.01 par value; 15,000,000 shares authorized;  479,506 shares issued                      |   | **4,795**      |           | 4,795      |   |
| Undesignated  stock, $0.01 par value; 5,000,000 shares authorized; no  shares issued                      |   | **-**          | ** **     | -          |   |
| Additional  paid-in capital                                                                               |   | **4,158,504**  | ** **     | 4,158,504  |   |
| Accumulated  deficit                                                                                      |   | **(2,280,359** | **)**          | (1,192,043 | )      |
| Unearned stock  compensation (Note 11)                                                                    |   | **(12,004**    | **)**          | (16,000    | )      |
| Accumulated  other comprehensive income (Note 2)                                                          |   | **52,728**     | ** **     | 26,328     |   |
| **Total  stockholders’ equity**                                                                      |   | **1,923,664**  | ** **     | 2,981,584  |   |
|                                                                                                      |   | **$**          | **48,572,537** | ** ** | $      | 39,134,734 |   |

 

See Notes to ConsolidatedFinancial Statements.

 

38

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

 

**CONSOLIDATED STATEMENTS OF OPERATIONS****Years Ended June 30, 2002 and 2001**

 

 
|                                                     |   | **2002**       |           | **2001**   |   |
|----------------------------------------------------------|--------|----------------|----------------|------------|--------|
| Interest income:                                         |   |           | ** **     |       |   |
| Loans                                                    |   | **$**          | **2,130,429**  | ** ** | $      | 1,993,140 |   |
| Securities                                               |   | **554,514**    | ** **     | 379,551    |   |
| Federal funds  sold                                      |   | **57,857**     | ** **     | 142,369    |   |
|                                                     |   | **2,742,800**  | ** **     | 2,515,060  |   |
|                                                     |   |           | ** **     |       |   |
| Interest  expense:                                       |   |           | ** **     |       |   |
| Deposits                                                 |   | **1,504,181**  | ** **     | 1,503,011  |   |
| Notes payable  and other borrowing                       |   | **302,819**    | ** **     | 186,172    |   |
|                                                     |   | **1,807,000**  | ** **     | 1,689,183  |   |
|                                                     |   |           | ** **     |       |   |
| **Net  interest income**                                 |   | **935,800**    | ** **     | 825,877    |   |
|                                                     |   |           | ** **     |       |   |
| Provision for  loan losses (Note 3)                      |   | **785,075**    | ** **     | 57,514     |   |
| **Net  interest income after provision for loan losses** |   | **150,725**    | ** **     | 768,363    |   |
|                                                     |   |           | ** **     |       |   |
| Other income:                                            |   |           | ** **     |       |   |
| Service charges  and other fees                          |   | **135,159**    | ** **     | 91,840     |   |
| Mortgage  origination and service release fees           |   | **249,479**    | ** **     | 117,567    |   |
| Gain on sale of  securities (Note 2)                     |   | **62,827**     | ** **     | 51,761     |   |
|                                                     |   | **447,465**    | ** **     | 261,168    |   |
|                                                     |   |           | ** **     |       |   |
| Other expenses:                                          |   |           | ** **     |       |   |
| Salaries and  employee benefits (Note 12)                |   | **754,261**    | ** **     | 459,229    |   |
| Directors’ fees                                     |   | **91,250**     | ** **     | 88,000     |   |
| Occupancy  expenses (Note 13)                            |   | **229,944**    | ** **     | 85,446     |   |
| Data processing                                          |   | **108,762**    | ** **     | 89,778     |   |
| Professional  fees                                       |   | **79,388**     | ** **     | 76,002     |   |
| Other expenses                                           |   | **422,901**    | ** **     | 306,871    |   |
|                                                     |   | **1,686,506**  | ** **     | 1,105,326  |   |
|                                                     |   |           | ** **     |       |   |
| **Loss  from continuing operations before income taxes** |   | **(1,088,316** | **)**          | (75,795    | )      |
|                                                     |   |           | ** **     |       |   |
| Provision for  income taxes (Note 9)                     |   | **-**          | ** **     | -          |   |
| **Loss  from continuing operations**                     |   | **(1,088,316** | **)**          | (75,795    | )      |
|                                                     |   |           | ** **     |       |   |
| Loss from  discontinued operation                        |   | **-**          | ** **     | (15,220    | )      |
| **Net  loss**                                            |   | **$**          | **(1,088,316** | **)**      | $      | (91,015 | ) |
|                                                     |   |           | ** **     |       |   |
| Basic and  dilutive earnings per share:                  |   |           | ** **     |       |   |
| Loss from  continuing operations                         |   | **$**          | **(2.27**      | **)**      | $      | (0.17 | ) |
| Loss from  discontinued operations                       |   | **-**          | ** **     | (0.04      | )      |
| **Net  loss per share**                                  |   | **$**          | **(2.27**      | **)**      | $      | (0.21 | ) |

 

See Notes to ConsolidatedFinancial Statements.

 

39

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

 

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY****Years Ended June 30, 2002 and 2001**

 
|                                    |   | **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, 2000                  |   |                              |        | $                            | 4,276     |                             | $      | 3,939,557                |       | $                                 | (1,101,028     | )                                                    | $      | (20,000     | )          | $ | (34,401 | ) | $ | 2,788,404 |   |
| Comprehensive income:                   |   |                              |        |                         |      |                             |   |                     |       |                              |           |                                                 |   |        |       |
| Net loss                                |   | $                                 | (91,015     | )                            | -         |                             | -      |                     | (91,015    | )                                 | -              |                                                 | -      |        | (91,015    | ) |
| Unrealized gain on securities  (Note 2) |   | 60,729                            |        | -                            |      | -                                |   | -                        |       | -                                 |           | 60,729                                               |   | 60,729      |       |
|                                    |   | $                                 | (30,286     | )                            |      |                             |   |                     |       |                              |           |                                                 |   |        |       |   |
| Issuance of common stock                |   |                              |        | 519                          |      | 544,494                          |   | -                        |       | -                                 |           | -                                                    |   | 545,013     |       |
| Stock offering costs                    |   |                              |        | -                            |      | (325,547                         | )      | -                        |       | -                                 |           | -                                                    |   | (325,547    | )          |
| Restricted stock earned                 |   |                              |        | -                            |      | -                                |   | -                        |       | 4,000                             |           | -                                                    |   | 4,000       |       |
| Balance, June 30, 2001                  |   |                              |        | 4,795                        |      | 4,158,504                        |   | (1,192,043               | )          | (16,000                           | )              | 26,328                                               |   | 2,981,584   |       |
| Comprehensive income:                   |   |                              |        |                         |      |                             |   |                     |       |                              |           |                                                 |   |        |       |
| Net loss                                |   | $                                 | (1,088,316  | )                            | -         |                             | -      |                     | (1,088,316 | )                                 | -              |                                                 | -      |        | (1,088,316 | ) |
| Unrealized gain on securities  (Note 2) |   | 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** | ** ** |
|                                         |        |                                   |             |                              |           |                                  |        |                          |            |                                   |                |                                                      |        |             |            |  |  |  |  |  |  |  |  |  |

 

See Notes to ConsolidatedFinancial Statements.

 

40

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

** **

**CONSOLIDATED STATEMENTS OF CASH FLOWS****Years Ended June 30, 2002 and 2001**

 
|                                                                         |   | **2002**        |           | **2001**    |   |
|------------------------------------------------------------------------------|--------|-----------------|----------------|-------------|--------|
| Cash Flows From  Operating Activities                                        |   |            | ** **     |        |   |
| Net loss                                                                     |   | **$**           | **(1,088,316** | **)**       | $      | (91,015 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |   |            | ** **     |        |   |
| Net amortization  and accretion of bond premiums and discounts               |   | **62,725**      | ** **     | (6,681      | )      |
| Originations of  loans held for sale                                         |   | **(17,116,084** | **)**          | (7,578,602  | )      |
| Proceeds from  sales of loans held for sale                                  |   | **17,315,998**  | ** **     | 7,255,570   |   |
| Securities gains                                                             |   | **(62,827**     | **)**          | (51,761     | )      |
| Provision for  loan losses                                                   |   | **785,075**     | ** **     | 57,514      |   |
| Depreciation                                                                 |   | **87,654**      | ** **     | 67,722      |   |
| Earned stock  compensation                                                   |   | **3,996**       | ** **     | 4,000       |   |
| Other                                                                        |   | **(36,337**     | **)**          | (37,765     | )      |
| **Net  cash used in operating activities**                                   |   | **(48,116**     | **)**          | (381,018    | )      |
|                                                                         |   |            | ** **     |        |   |
| Cash Flows From  Investing Activities                                        |   |            | ** **     |        |   |
| Purchases of  available-for-sale securities                                  |   | **(15,781,310** | **)**          | (13,442,750 | )      |
| Proceeds from  maturities of available-for-sale securities                   |   | **1,588,621**   | ** **     | 3,818,747   |   |
| Proceeds from  sales of available-for-sale securities                        |   | **14,262,235**  | ** **     | 4,372,085   |   |
| Net (increase)  decrease in federal funds sold                               |   | **2,401,000**   | ** **     | (3,133,894  | )      |
| Net increase in  loans                                                       |   | **(11,175,082** | **)**          | (6,792,705  | )      |
| Purchases of  restricted stock                                               |   | **(100,000**    | **)**          | (41,300     | )      |
| Purchases of  premises and equipment                                         |   | **(242,065**    | **)**          | (17,317     | )      |
| Other                                                                        |   | **-**           | ** **     | 67,352      |   |
| **Net  cash used in investing activities**                                   |   | **(9,046,601**  | **)**          | (15,169,782 | )      |
|                                                                         |   |            | ** **     |        |   |
| Cash Flows From  Financing Activities                                        |   |            | ** **     |        |   |
| Net increase in  deposits                                                    |   | **6,772,665**   | ** **     | 14,729,744  |   |
| Proceeds from  notes payable                                                 |   | **2,500,000**   | ** **     | 2,875,000   |   |
| Payment on notes  payable                                                    |   | **(100,000**    | **)**          | (1,950,000  | )      |
| Proceeds from  issuance of convertible subordinated notes payable            |   | **1,400,000**   | ** **     | -           |   |
| Proceeds from  issuance of common stock, net                                 |   | **-**           | ** **     | 381,091     |   |
| **Net  cash provided by financing activities**                               |   | **10,572,665**  | ** **     | 16,035,835  |   |
|                                                                         |   |            | ** **     |        |   |
| **Increase  in cash**                                                        |   | **1,477,948**   | ** **     | 485,035     |   |
|                                                                         |   |            | ** **     |        |   |
| Cash                                                                         |   |            | ** **     |        |   |
| Beginning                                                                    |   | **870,133**     | ** **     | 385,098     |   |
| Ending                                                                       |   | **$**           | **2,348,081**  | ** **  | $      | 870,133 |   |
|                                                                         |   |            | ** **     |        |   |
| Supplemental  Disclosures of Cash Flow Information                           |   |            | ** **     |        |   |
| Cash payments  for interest                                                  |   | **$**           | **1,899,553**  | ** **  | $      | 1,402,138 |   |

 

See Notes to ConsolidatedFinancial Statements.

 

41

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

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 1**.                                  Summary of Significant AccountingPolicies

**Nature of business:**Northern Star Financial, Inc., is a one-bank holdingcompany. Its wholly owned subsidiary, Northern Star Bank (Bank), is acommercial bank with operations in Mankato and St. Cloud, Minnesota. The Bankprovides retail and commercial loan and deposit services principally tocustomers within 30 miles of the Bank’s locations.

 

**Use of estimates:** The preparation of financial statements requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities as of the date of the balance sheet and revenues andexpenses for the period. Actual results could differ from those estimates. Amaterial estimate that is particularly susceptible to significant changerelates to the determination of the allowance for loan losses.

 

**Principles of consolidation:** The accompanying consolidated financial statementsinclude the accounts of Northern Star Financial, Inc., and its wholly ownedsubsidiary. These entities are collectively referred to herein as the Company.All significant intercompany balances and transactions have been eliminated inconsolidation.

 

**Cash and cash flows:** For purposes of reporting cash flows, cash includescash on hand and amounts due from banks. Cash flows from loans, federal fundssold, and deposits are reported net.

 

**Available-for-sale securities:** Securities classified as available-for-sale are thosedebt securities that the Company intends to hold for an indefinite period oftime, but not necessarily to maturity. Any decision to sell a securityclassified as available-for-sale would be based on various factors, includingsignificant movements in interest rates, changes in the maturity mix of theCompany’s assets and liabilities, liquidity needs, regulatory capitalconsiderations, and other similar factors. Securities available for sale arecarried at fair value. Unrealized gains or losses, net of the related deferredtax effect, are reported as a separate component of other comprehensive income.Realized gains or losses, determined on the basis of the cost of specificsecurities sold, are included in earnings.

 

**Loans held for sale:**Loans that the Company has the intent to sell in theforeseeable future are carried at the lower of aggregate cost or market value.The market value calculation includes consideration of all open positions.Gains and losses on sales of loans are recognized at trade dates and aredetermined by the difference between the sales proceeds and the carrying valueof the loans. All sales are made without recourse and with servicing released.

 

**Loans and allowance for loan losses:** Loans are stated at the amount of unpaidprincipal, reduced by an allowance for loan losses.

 

42

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The allowance for loanlosses is established through a provision for loan losses charged to expense.Loans are charged against the allowance for loan losses when managementbelieves that collectibility of the principal is unlikely. The allowance is anamount that management believes will be adequate to absorb estimated losses onexisting loans that may become uncollectible, based on evaluation of thecollectibility of loans and prior loan loss experience. This evaluation alsotakes into consideration such factors as changes in the nature and volume ofthe loan portfolio, overall portfolio quality, review of specific problem loans,and current economic conditions that may affect the borrower’s ability to pay.While management uses the best information available to make its evaluation,future adjustments to the allowance may be necessary if there are significantchanges in economic conditions.

 

A loan is impaired whenit is probable the Company will be unable to collect all principal and interestpayments due in accordance with the terms of the loan agreement. Impaired loansare measured based on the present value of expected future cash flows or,alternatively, the observable market price or the fair value of the collateralif the loan is collateral dependent. The amount of impairment, if any, and anysubsequent changes are included in the allowance for loan losses.

 

Interest on loans isaccrued daily on the outstanding balances. For impaired loans, accrual ofinterest is discontinued on a loan when management believes, after consideringcollection efforts and other factors, that the borrower’s financial conditionis such that collection of interest is doubtful. Interest on these loans isrecognized only when actually paid by the borrower if collection of theprincipal is likely to occur.

 

**Premises and equipment:** Premises and equipment are stated at cost lessaccumulated depreciation. Depreciation is provided principally by thestraight-line method over the estimated useful lives of the assets.

 

**Income taxes:** Deferred taxes are provided on an asset and liabilitymethod whereby deferred tax assets are recognized for deductible temporarydifferences and operating loss or tax credit carryforwards, and deferred taxliabilities are recognized for taxable temporary differences. Temporarydifferences are the differences between the amounts of assets and liabilitiesrecorded for income tax and financial reporting purposes. Deferred tax assetsare reduced by a valuation allowance when management determines that it is morelikely than not that some portion or all of the deferred tax assets will not berealized. Deferred tax assets and liabilities are adjusted for the effects ofchanges in tax laws and rates on the date of enactment.

 

**Salary reduction—SIMPLE IRA plan:** The Company provides a salary reductionplan which covers substantially all of the Company’s employees who are eligibleas to age and length of service. A participant may elect to make contributionsof up to the maximum amount eligible by law. The Company makes contributions of2 percent of each participant’s compensation and complies with therequirements of the plan agreement.

 

43

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**Fair value of financial instruments:**The following methods and assumptionswere used by the Bank in estimating the fair value of its financialinstruments:

 

***Cash and due from banks, federal funds sold, and restrictedstock:*** Thecarrying amounts reported in the consolidated balance sheet for cash and duefrom banks, federal funds sold, and restricted stock approximate their fairvalues.

 

***Securities available for sale*****:**Fair values for securities are based on quoted market prices, where available.If quoted market prices are not available, fair values are based on quotedmarket prices of comparable instruments.

 

***Loans held for sale*****:****Fair values are based on quoted marketprices of similar loans sold on the secondary market.

 

***Loans*****:** For variable-rate loans that repricefrequently and with no significant change in credit risk, fair values are basedon carrying values. Fair values for impaired loans are estimated usingdiscounted cash flow analyses or underlying collateral values, whereapplicable. The fair values for all other loans are estimated using discountedcash flow analyses, using interest rates currently being offered for loans withsimilar terms to borrowers with similar credit quality.

 

***Deposit liabilities*****:**The fair values disclosed for deposits with no defined maturities are equal totheir carrying amounts, which represent the amount payable on demand. Thecarrying amounts for variable-rate, fixed-term money market accounts andcertificates of deposit approximate their fair values at the reporting date.Fair values for fixed-rate certificates of deposit are estimated using adiscounted cash flow calculation that applies interest rates currently beingoffered on certificates to a schedule of aggregated expected monthly maturitieson time deposits.

 

***Notes payable, other borrowings, and convertiblesubordinated notes payable***: The fair values of the Company’s long-termborrowings (other than deposits) are estimated using discounted cash flowanalyses, based on the Company’s current incremental borrowing rates forsimilar types of borrowing arrangements.

 

***Accrued interest*****:** The carrying amounts of accrued interestreceivable and payable approximate their fair values.

 

***Off-balance-sheet instruments*****:**Fair values for the Company’s off-balance-sheet lending commitments are basedon fees currently charged to enter into similar agreements, taking into accountthe remaining terms of the agreements and the counterparties’ credit standing.Since the majority of the Company’s off-balance-sheet instruments consist ofnonfee-producing, variable-rate loan commitments, the Company has determinedthey do not have a distinguishable fair value.

 

 

44

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**Earnings per share:** Basic income per share amounts are computed bydividing net income by weighted-average number of common shares outstanding.Common shares issuable upon conversion of subordinated debt (see Note 7) andexercise of stock options (see Note 8) have not been included in thecomputation of diluted earnings per share because their inclusion would havehad an antidilutive effect. Therefore, basic and diluted earnings per share arethe same.

 

**Reclassification:** Certain of the 2001 amounts have been reclassified toconform with the 2002 presentation. These reclassifications had no effect onnet income or stockholders’ equity.

 

**Note 2.**                                  Available-for-Sale Securities

**Summary of securities:**

 

 

 
|                                       |   | **June 30,  2002** |      |
|--------------------------------------------|--------|--------------------|-----------|
|                                       |   |               |      | **Gross** |   | **Gross** |   |   |   |
|                                       |   | **Amortized**      |      | **Unrealized** |   | **Unrealized** |   | **Fair** |   |
|                                       |   | **Cost**           |      | **Gains** |   | **Losses** |   | **Value** |   |
| U.S. government  corporations and agencies |   | $                  | 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 |   |
|                                       |   | $                  | 9,510,639 |   | $ | 88,423 |   | $ | (542 | ) | $ | 9,598,520 |   |

 

 
|                                       |   | **June 30,  2001** |      |
|--------------------------------------------|--------|--------------------|-----------|
|                                       |   |               |      | **Gross** |   | **Gross** |   |   |   |
|                                       |   | **Amortized**      |      | **Unrealized** |   | **Unrealized** |   | **Fair** |   |
|                                       |   | **Cost**           |      | **Gains** |   | **Losses** |   | **Value** |   |
| U.S. government  corporations and agencies |   | $                  | 2,989,196 |   | $ | 10,907 |   | $ | (157 | ) | $ | 2,999,946 |   |
| Mortgage-backed  securities                |   | 6,343,686          |      | 46,405 |   | (10,111 | ) | 6,379,980 |   |
| Corporate bonds                            |   | 247,200            |      | - |   | (3,164 | ) | 244,036 |   |
|                                       |   | $                  | 9,580,082 |   | $ | 57,312 |   | $ | (13,432 | ) | $ | 9,623,962 |   |

 

 

45

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**Contractual maturities:**

 
|                                   |   | **June  30,2002**   |   |
|----------------------------------------|--------|---------------------|--------|
|                                   |   | **Amortized  Cost** |   | **Fair   Value** |   |
| Due in one year  or less               |   | $                   | -      |   | $ | - |   |
| Due after one  year through five years |   | 747,522             |   | 761,298 |   |
| Due after five  years through 10 years |   | 1,000,000           |   | 1,003,677 |   |
|                                   |   | 1,747,522           |   | 1,764,975 |   |
|                                   |   |                |   |   |   |
| Mortgage-backed  securities            |   | 5,263,117           |   | 5,331,031 |   |
| Mutual fund                            |   | 2,500,000           |   | 2,502,514 |   |
|                                   |   |                | $      | 9,510,639 |   | $ | 9,598,520 |   |
|                                        |        |                     |        |  |  |  |  |  |

 

 

Anticipated maturities onmortgage-backed securities are not readily determinable since they may beprepaid without penalty, and mutual funds do not have stated maturity dates.

 

**Realized gains and losses:**

 
|            |   | **Years  Ended June 30** |   |
|-----------------|--------|--------------------------|--------|
|            |   | **2002**                 |   | **2001** |   |
| Realized gains  |   | $                        | 74,911 |   | $ | 51,761 |   |
| Realized losses |   | (12,084                  | )      | - |   |
|            |   | $                        | 62,827 |   | $ | 51,761 |   |

 

 

**Pledged securities:** Available-for-sale securities with an approximatecarrying value of $3,200,000 and $3,100,000 at June 30, 2002 and 2001,respectively, were pledged to secure borrowings and for other purposes asrequired or permitted by law.

 

**Changes in the unrealized gain (loss) on available-for-salesecurities:**

 
|                                                                |   | **Years  Ended June 30** |   |
|---------------------------------------------------------------------|--------|--------------------------|--------|
|                                                                |   | **2002**                 |   | **2001** |   |
| Balance,  beginning                                                 |   | $                        | 26,328 |   | $ | (34,401 | ) |
| Unrealized gain  during the year                                    |   | 106,829                  |   | 152,976 |   |
| Less  reclassification adjustments for gains realized in net income |   | (62,827                  | )      | (51,761 | ) |
| Deferred tax  effect related to unrealized gain                     |   | (17,602                  | )      | (40,486 | ) |
| Balance, ending                                                     |   | $                        | 52,728 |   | $ | 26,328 |   |

 

 

46

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**Note 3.**                                  Loans

**Composition of loans:**

 
|                            |   | **June 30** |       |
|---------------------------------|--------|-------------|------------|
|                            |   | **2002**    |       | **2001** |   |
| Commercial                      |   | $           | 6,616,193  |   | $ | 4,903,794 |   |
| Real estate,  construction      |   | 2,375,318   |       | 2,307,478 |   |
| Real estate,  other             |   | 13,336,761  |       | 5,291,889 |   |
| Consumer                        |   | 11,809,464  |       | 10,588,900 |   |
| Leases                          |   | 179,995     |       | 428,447 |   |
|                            |   | 34,317,731  |       | 23,520,508 |   |
|                            |   |        |       |   |   |
| Deferred loan  costs, net       |   | 180,131     |       | 161,166 |   |
| Less allowance  for loan losses |   | (661,170    | )          | (234,989 | ) |
| Loans, net                      |   | $           | 33,836,692 |   | $ | 23,446,685 |   |

 

 

**Allowance for loan losses:**

 
|                             |   | **Years  Ended June 30** |    |
|----------------------------------|--------|--------------------------|---------|
|                             |   | **2002**                 |    | **2001** |   |
| Balance,  beginning              |   | $                        | 234,989 |   | $ | 181,500 |   |
| Provision  charged to operations |   | 785,075                  |    | 57,514 |   |
| Loans charged  off               |   | (359,751                 | )       | (8,615 | ) |
| Recoveries                       |   | 857                      |    | 4,590 |   |
| Balance, ending                  |   | $                        | 661,170 |   | $ | 234,989 |   |

 

 

**Impaired loans:**Information about impaired loans as of and for theyear ended June 30, 2002, is as follows:

 
| Loans receivable at  year-end, all of which have a related allowance for credit losses | $       | 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  |

 

 

Impaired loans andinterest income recognized on impaired loans were insignificant in fiscal 2001.

 

 

47

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**Note 4.**                                  Premises and Equipment

 
|                           |   | **June 30** |    |
|--------------------------------|--------|-------------|---------|
|                           |   | **2002**    |    | **2001** |   |
| Leasehold  improvements        |   | $           | 250,009 |   | $ | 205,653 |   |
| Furniture and  equipment       |   | 530,970     |    | 333,262 |   |
|                           |   | 780,979     |    | 538,915 |   |
|                           |   |        |    |   |   |
| Less accumulated  depreciation |   | 245,041     |    | 157,388 |   |
|                           |   | $           | 535,938 |   | $ | 381,527 |   |

 

 

**Note 5.**                                  Deposits

 
|                                 |   | **June 30** |       |
|--------------------------------------|--------|-------------|------------|
|                                 |   | **2002**    |       | **2001** |   |
| Demand deposits                      |   | $           | 4,574,282  |   | $ | 1,468,846 |   |
| NOW and money  market accounts       |   | 7,718,574   |       | 3,567,924 |   |
| Savings deposits                     |   | 4,533,290   |       | 5,570,506 |   |
| Time  certificates, $100,000 or more |   | 4,141,303   |       | 3,675,843 |   |
| Other time  deposits                 |   | 16,037,280  |       | 18,533,945 |   |
| Brokered  deposits                   |   | 2,585,000   |       | - |   |
|                                 |   | $           | 39,589,729 |   | $ | 32,817,064 |   |

 

 

The scheduled maturitiesof time deposits are as follows:

 
| Years ending June 30: |      |
|-----------------------|-----------|
| 2003                  | $         | 15,673,708 |
| 2004                  | 5,020,182 |
| 2005                  | 585,123   |
| 2006                  | 745,124   |
| 2007                  | 739,446   |
|                  | $         | 22,763,583 |

 

 

48

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**Note 6.**                                  Notes Payable and Other Borrowing

 
|                                                                                                                                                                                                                                                                                 |   | **June 30** |      |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------|-----------|
|                                                                                                                                                                                                                                                                                 |   | **2002**    |      | **2001** |   |
| Fixed-rate  advances from the Federal Home Loan Bank of Des Moines, interest payable  monthly (2.20% to 6.95%), due at varying dates through 2011, secured by  securities with a carrying value of $3,200,000 and residential real estate  loans with a carrying value of $3,957,000 |   | $           | 4,675,000 |   | $ | 2,775,000 |   |
| Note payable to  a bank, variable interest (5.25% at June 30, 2002) payable quarterly, secured  by common stock of Northern Star Bank, matures August 13, 2002                                                                                                                       |   | 600,000     |      | 100,000 |   |
|                                                                                                                                                                                                                                                                                 |   | $           | 5,275,000 |   | $ | 2,875,000 |   |

 

 

In connection with thenote payable to bank, the Company has agreed, among other things, to maintaincertain financial ratios. The agreement also has restrictions on the payment ofdividends and limits future borrowing by the Company.

 

A $500,000 advance fromthe Federal Home Loan Bank with a maturity date of October 2010 is callable atvarious dates beginning in 2003. At June 30, 2002, scheduled maturities, basedon contractual maturity dates, of the Company’s borrowings, includingconvertible subordinated notes payable (see Note 7), were as follows:

 
| Years ending June 30: |      |
|-----------------------|-----------|
| 2003                  | $         | 3,150,000 |
| 2004                  | 2,225,000 |
| 2005                  | 500,000   |
| 2006                  | -         |
| 2007                  | 100,000   |
| 2008                  | -         |
| Thereafter            | 700,000   |
|                  | $         | 6,675,000 |

 

 

49

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**Note 7.**                                  Convertible Subordinated Notes Payable

The Company has completedtwo issuances of three-year, unsecured convertible 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. The conversion rate is adjustable if the numberof outstanding shares changes. A summary of the convertible subordinated notespayable follows:

 
|                         |   | **First  Issue** |      | **Second  Issue** |   |
|------------------------------|--------|------------------|-----------|-------------------|--------|
| Total authorized             |   | $                | 1,000,000 |              | $      | 500,000 |   |
| Principal  outstanding       |   | 1,000,000        |      | 400,000           |   |
| Interest rate                |   | 8.0              | %         | 7.0               | %      |
| Maturity date                |   | August 2004      |      | June 2005         |   |
| Conversion rate  (per share) |   | $                | 10.50     |              | $      | 9.00 |   |

 

 

**Note 8.**                                  Stock Options

The Company hasestablished an equity incentive plan for the purpose of attracting andretaining employees, motivating employees to achieve performance goals, andenabling the participants to share in the long-term success of the Company. Theplan provides a means for the Company to provide incentive stock options andnonqualified stock options to employees and directors.

 

Incentive stock optionsmay be granted during the 10-year period from the effective date of the plan(August 1998). The option price of incentive stock options shall not be lessthan 100 percent of the fair value of the common stock as of the grant date,and the term of options is determinable by the administrator of the plan, notto exceed 10 years. In the event the participant owns greater than 10 percentof all outstanding voting stock, the option price shall not be less than 110percent of the fair value of the common stock as of the grant date, and theterm of options is limited to five years. The administrator determines the datethe options become exercisable.

 

Nonqualified stockoptions may be granted until the plan is discontinued or terminated by theBoard of Directors. The option price of nonqualified stock options shall be 100percent of the fair value of the common stock as of the grant date. Theadministrator determines the term of the options granted and the date theoptions become exercisable.

 

The plan provides for anautomatic nonqualified option grant for each nonemployee director who was adirector on the date the plan was adopted or the date the director is electedto the Board. Each director who is reelected will automatically be grantednonqualified options to purchase 3,000 shares.

 

A total of 116,700 sharesof common stock have been reserved under the plan, leaving 20,900 sharesavailable for grant. In addition, outside the plan, the Company granted to itsorganizing directors options to purchase 30,800 shares.

 

 

50

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The Company has electedto account for the options under the provisions of APB Opinion No. 25 andrelated interpretations. Options granted in fiscal 2002 and 2001 had anexercise price approximating fair value at the date of grant; therefore, nocompensation cost has been recognized for these grants. Had compensation costbeen determined based on the fair value method prescribed in FASB StatementNo. 123, reported net loss (and loss per share) would have been increasedto:

 
| **Years  Ended**

**   June 30** |   | **Net  Loss** |       | **Loss  Per Share** |   |
|--------------------------------------------|--------|---------------|------------|---------------------|--------|
| 2002                                       |   | $             | (1,135,338 | )                   | $      | (2.37 | ) |
| 2001                                       |   | (171,333      | )          | (0.39               | )      |
|                                            |        |               |            |                     |        |  |  |

 

 

In determining the proforma amounts above, the value of each grant is estimated at the grant dateusing the fair value method prescribed in Statement No. 123, with the followingweighted-average assumptions for grants in 2002 and 2001, respectively:dividend rate of zero percent for all years; risk-free interest rates of 5.34and 5.31 percent, respectively; expected lives of five years in both 2002 and2001; and expected price volatility of 81 and 39 percent, respectively.

 

A summary of the stockoption activity is as follows:

 
|                    |   | **Options** |   | **Exercise  Price****Per Share** |          |
|-------------------------|--------|-------------|--------|----------------------------------|---------------|
| Balance, June  30, 2000 |   | 79,600      |   | $                                | 10.00 - 10.50 |   |
| Granted                 |   | 25,000      |   | 8.47                             |          |
| Balance, June  30, 2001 |   | 104,600     |   | 8.47 - 10.50                     |          |
| Granted                 |   | 22,000      |   | 6.50                             |          |
| Balance, June  30, 2002 |   | 126,600     |   | $                                | 6.50 - 10.50  |   |

 

 

The outstanding optionshave a weighted-average exercise price of $9.19 and a weighted-averagecontractual remaining life of 7.40 years. At June 30, 2002, 114,167 optionswith a weighted-average exercise price of $9.32 were exercisable.

 

 

51

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**Note 9.**                                  Income Taxes

The cumulative taxeffects of the primary temporary differences are shown in the following table:

 
|                                              |   | **June 30** |    |
|---------------------------------------------------|--------|-------------|---------|
|                                              |   | **2002**    |    | **2001** |   |
| Deferred tax  assets:                             |   |        |    |   |   |
| Loan loss  allowances                             |   | $           | 268,000 |   | $ | 94,000 |   |
| Net operating  loss carryover                     |   | 708,000     |    | 405,000 |   |
| Other                                             |   | 37,000      |    | 50,000 |   |
|                                              |   | 1,013,000   |    | 549,000 |   |
|                                              |   |        |    |   |   |
| Less valuation  allowance                         |   | (872,000    | )       | (471,000 | ) |
|                                              |   | 141,000     |    | 78,000 |   |
|                                              |   |        |    |   |   |
| Deferred tax  liabilities:                        |   |        |    |   |   |
| Propery and  equipment                            |   | 25,000      |    | 13,000 |   |
| Unrealized gain  on available-for-sale securities |   | 35,000      |    | 18,000 |   |
| Deferred loan  fees and costs                     |   | 81,000      |    | 65,000 |   |
|                                              |   | 141,000     |    | 96,000 |   |
| Net deferred tax  asset (liability)               |   | $           | -       |   | $ | (18,000 | ) |

 

 

The income tax provision(benefit) differs from the amount of income tax determined by applying the U.S.federal income tax rate of 35 percent to pretax income (loss) as follows:

 
|                                                 |   | **Years  Ended June 30** |     |
|------------------------------------------------------|--------|--------------------------|----------|
|                                                 |   | **2002**                 |     | **2001** |   |
| Computed  "expected" tax expense (benefit) |   | $                        | (380,000 | ) | $ | (30,945 | ) |
| Increase  (decrease) in income taxes resulting from: |   |                     |     |   |   |
| State income  taxes, net of federal tax benefit      |   | (69,000                  | )        | (6,371 | ) |
| Other                                                |   | 13,000                   |     | 6,275 |   |
| Change in  valuation allowance                       |   | 436,000                  |     | 31,041 |   |
|                                                 |   | $                        | -        |   | $ | - |   |

 

 

At June 30, 2002 theCompany has a cumulative net operating loss carryover for tax purposes ofapproximately $1,700,000 and it will begin to expire in 2019.

 

**Note 10.       ****Commitments and CreditRisk**

 

**Financial instruments with off-balance-sheet risk:** The Company is party to financialinstruments with off-balance-sheet risk in the normal course of business tomeet the financing needs of its customers. These financial instruments includecommitments to extend credit and standby letters of credit. They involve, tovarying degrees, elements of credit risk in excess of amounts recognized on theconsolidated balance sheets.

 

 

52

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The Company’s exposure tocredit loss in the event of nonperformance by the other parties to thefinancial instruments for these commitments is represented by the contractualamounts of the instruments. The Company uses the same credit policies in makingcommitments as it does for on-balance-sheet instruments. These commitments wereas follows:

 
|                         |   | **June 30** |      |
|------------------------------|--------|-------------|-----------|
|                         |   | **2002**    |      | **2001** |   |
| Undisbursed  lines of credit |   | $           | 4,285,000 |   | $ | 3,139,000 |   |
|                              |        |             |           |  |  |  |  |

 

 

***Undisbursed lines of credit:*** Lines of credit are agreements to lendto a customer as long as there is no violation of any condition established inthe contract. Since many of the lines of credit will not be fully drawn uponand some may expire without being drawn upon, the total commitment amounts donot necessarily represent future cash requirements. The Bank evaluates eachcustomer’s creditworthiness on a case-by-case basis. If deemed necessary uponextension of credit, the amount of collateral obtained is based on management’scredit evaluation of the party. Collateral held varies, but may includeaccounts receivable, inventory, property and equipment, and income-producingcommercial properties.

 

**Lease commitments:** The Company leases its banking facilities in Mankatoand St. Cloud from related parties under operating agreements that expire in2009 and 2012, respectively (see also Note 13). The following is a schedule ofapproximate future minimum base rental payments under these leases:

 
| Years ending June 30: |    |
|-----------------------|---------|
| 2003                  | $       | 120,000 |
| 2004                  | 123,000 |
| 2005                  | 127,000 |
| 2006                  | 132,000 |
| 2007                  | 143,000 |
| Thereafter            | 385,000 |
|                  | $       | 1,030,000 |

 

 

**Financial instruments with concentrations of credit risk:**

 

***Concentration over insured limits:***The nature of the Bank’s businessrequires that it maintain amounts due from banks which, at times, may exceedfederally insured limits. The Bank has not experienced any losses in such accounts.

 

***Concentration by geographic location:*** The Bank makes commercial, real estate,and consumer loans to its customers primarily in the Bank’s primary trade areasof 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.

 

 

53

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**Note 11.**                           Stockholders’ Equity Matters

**Warrants:** On October 9, 1998, the Company entered into anagency agreement for services to sell the Company’s common stock. The agent wascompensated, in part, with warrants to acquire 10,000 shares of the Company’sstock at $12.00 per share at any time prior to October 9, 2003.

 

On April 11, 2001, theCompany entered into an agency agreement for services to sell the Company’scommon stock. The agent was compensated, in part, with warrants to acquire 5,190shares of the Company’s stock at $12.60 per share anytime during the timeperiod of April 11, 2002 to April 11, 2006.

 

**Unearned stock compensation:**On December 22, 1999, the Company granted its chiefexecutive officer a restricted stock award of 2,000 shares of the Company’scommon stock. The shares are subject to a vesting period ranging from three tofive years. The earned compensation, measured by the quoted price of the stockon the award date ($10 per share), is shown as a separate reduction of stockholders’equity. The unearned compensation will be accounted for as expense over thevesting period.

 

**Note 12.**                           Benefit Plan

**Salary reduction—SIMPLE IRA:** Company contributions to the plan were $12,000 and$7,400 in 2002 and 2001, respectively.

 

**Note 13.**                           Loans and Other Transactions With RelatedParties

Shareholders of theCompany, executive officers, and directors, including their families andcompanies of which they are principal owners, are considered to be relatedparties. These related parties were loan customers of and had othertransactions with the Bank in the ordinary course of business. In management’sopinion, these loans and transactions were on the same terms as those forcomparable loans and transactions with nonrelated parties.

 

**Loans:** Total loans to related parties were approximately $3,957,000 and$1,233,000 at June 30, 2002 and 2001, respectively.

 

**Deposits:** Total deposits by related parties were approximately$6,144,000 and $4,227,000 at June 30, 2002 and 2001, respectively.

 

**Convertible subordinated notes payable:** Convertible subordinated notes payabletotaling $1,050,000 are issued to related parties at June 30, 2002.

 

**Leases:**The Company leases its offices from entities in whichcertain directors of the Company have a significant ownership interest (seealso Note 10). These leases are accounted for as operating leases. Expense fromthese leases approximated $117,000 and $78,000 in 2002 and 2001, respectively.

 

 

54

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**Note 14.**                           Regulatory Capital Requirements

The Bank is subject tovarious regulatory capital requirements administered by the Bank’s primaryfederal regulatory agency. Failure to meet minimum capital requirements caninitiate certain mandatory and possibly additional discretionary actions byregulators that, if undertaken, could have a direct material effect on theCompany’s consolidated financial statements. Under capital adequacy guidelinesand the regulatory framework for prompt corrective action, the Bank must meetspecific capital guidelines that involve quantitative measures of assets andcertain off-balance-sheet items as calculated under regulatory accountingpractices. The Bank’s capital amounts and classification are also subject toqualitative judgments by the regulators about components, risk weightings, andother factors.

 

Quantitative measuresestablished by regulation to ensure capital adequacy require the Bank tomaintain minimum ratios (set forth in the table below) of total and Tier Icapital to risk-weighted assets, and of Tier I capital to average assets(all as defined in the regulations). Management believes, as of June 30, 2002,that the Bank meets all capital adequacy requirements to which it is subject.

 

As of June 30, 2002, themost recent notification from the Bank’s primary regulator (FDIC) categorizedthe Bank as well capitalized under the regulatory framework for promptcorrective action. To be categorized as well capitalized, the Bank mustmaintain minimum total risk-based, Tier I risk-based, and Tier I leverageratios as set forth in the table below.

 

As a result of thelitigation matters (see Note 17), the Federal Deposit Insurance Corporation(FDIC) placed a memorandum of understanding (MOU) on the Bank effective January23, 2002. The MOU generally requires the Bank to develop certain plans to moreeffectively analyze concerned areas in the Bank. It also places restrictions onthe Bank to maintain a Tier 1 leverage capital ratio of not less than 8percent. The Bank must also prepare progress reports as requested by theregional director of the FDIC. At June 30, 2002, the Company believes itis in substantial compliance with the MOU.

 
|                                       |   | **Actual** |      | **For  Capital  Adequacy Purposes** |   | **To Be Well  Capitalized Under Prompt Corrective Action Provisions** |   |
|--------------------------------------------|--------|------------|-----------|-------------------------------------|--------|-----------------------------------------------------------------------|--------|
|                                       |   | **Amount** |      | **Ratio**                           |   | **Amount**                                                            |   | **Ratio** |   | **Amount** |   | **Ratio** |   |
| As of June 30,  2002:                      |   |       |      |                                |   |                                                                  |   |   |   |   |   |   |   |
| Total capital  (to risk-weighted assets):  |   |       |      |                                |   |                                                                  |   |   |   |   |   |   |   |
| Northern Star  Bank                        |   | $          | 4,298,000 |                                | 11.5   | %                                                                     | $      | 2,990,000 |   | >= 8.0 | % | $ | 3,737,000 |   | >= 10.0 | % |
| Tier I capital  (to risk-weighted assets): |   |       |      |                                |   |                                                                  |   |   |   |   |   |   |   |
| Northern Star  Bank                        |   | $          | 3,827,000 |                                | 10.2   | %                                                                     | $      | 1,496,000 |   | >= 4.0 | % | $ | 2,245,000 |   | >= 6.0 | % |
| Tier I capital  (to average assets):       |   |       |      |                                |   |                                                                  |   |   |   |   |   |   |   |
| Northern Star  Bank                        |   | $          | 3,827,000 |                                | 8.7    | %                                                                     | $      | 1,760,000 |   | >= 4.0 | % | $ | 2,199,000 |   | >= 5.0 | % |
|                                            |        |            |           |                                     |        |                                                                       |        |  |  |  |  |  |  |  |  |  |  |

 

----

*This capital requirementwas modified by the MOU described above.

 

Banking regulationsrestrict the amount of dividends that may be paid by the Bank without priorapproval of bank supervisory authorities.

 

 

55

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**Note 15.**                           Fair Values of Financial Instruments andInterest Rate Risk

The estimated fair valuesof the Bank’s financial instruments were as follows:

 
|                                    |   | **June 30,  2002**   |      | **June 30,  2001** |   |
|-----------------------------------------|--------|----------------------|-----------|--------------------|--------|
|                                    |   | **Carrying  Amount** |      | **Fair Value**     |   | **Carrying  Amount** |   | **Fair Value** |   |
| Financial  assets:                      |   |                 |      |               |   |   |   |   |   |
| Cash and cash  equivalents              |   | $                    | 2,348,081 |               | $      | 2,348,081 |   | $ | 870,133 |   | $ | 870,133 |   |
| Federal funds  sold                     |   | 1,037,000            |      | 1,037,000          |   | 3,438,000 |   | 3,438,000 |   |
| Securities                              |   | 9,598,520            |      | 9,598,520          |   | 9,623,962 |   | 9,623,962 |   |
| Investment in  FHLB stock               |   | 238,800              |      | 238,800            |   | 138,800 |   | 138,800 |   |
| Loans held for  sale                    |   | 625,735              |      | 625,735            |   | 825,649 |   | 825,649 |   |
| Loans                                   |   | 33,836,692           |      | 34,673,000         |   | 23,446,685 |   | 23,798,000 |   |
| Accrued interest  receivable            |   | 272,636              |      | 272,636            |   | 357,301 |   | 357,301 |   |
| Financial liabilities:                  |   |                 |      |               |   |   |   |   |   |
| Deposits                                |   | 39,589,729           |      | 40,121,000         |   | 32,817,064 |   | 33,012,000 |   |
| Notes payable  and other borrowing      |   | 5,275,000            |      | 5,300,000          |   | 2,875,000 |   | 2,813,431 |   |
| Convertible  subordinated notes payable |   | 1,400,000            |      | 1,421,000          |   | - |   | - |   |
| Accrued interest  payable               |   | 321,546              |      | 321,546            |   | 414,099 |   | 414,099 |   |
|                                         |        |                      |           |                    |        |  |  |  |  |  |  |  |  |

 

 

**Interest rate risk:** The Company assumes interest rate risk (the risk thatgeneral interest rate levels will change) as a result of its normal operations.As a result, the fair values of the Company’s financial instruments will changewhen interest rate levels change, and that change may be either favorable orunfavorable to the Company. Management attempts to match maturities of assetsand liabilities to the extent believed necessary to minimize interest raterisk. However, borrowers with fixed-rate obligations are less likely to prepayin a rising-rate environment and more likely to prepay in a falling-rateenvironment. Conversely, depositors who are receiving fixed rates are morelikely to withdraw funds before maturity in a rising-rate environment and lesslikely to do so in a falling-rate environment. Management monitors rates andmaturities of assets and liabilities and attempts to minimize interest raterisk by adjusting terms of new loans and deposits and by investing insecurities with terms that mitigate the Company’s overall interest rate risk.

 

 

56

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**Note 16.**                           Parent Only Condensed FinancialInformation

CONDENSED STATEMENTS OFFINANCIAL CONDITION

 
|                                    |   | **June 30** |      |
|-----------------------------------------|--------|-------------|-----------|
| **Assets**                              |   | **2002**    |      | **2001** |   |
| Cash on deposit  with subsidiary bank   |   | $           | 71,993    |   | $ | 20,178 |   |
| Investment in  subsidiary               |   | 3,879,824   |      | 3,065,215 |   |
|                                    |   | $           | 3,951,817 |   | $ | 3,085,393 |   |
|                                    |   |        |      |   |   |
| Liabilities and  Stockholders' Equty    |   |        |      |   |   |
|                                    |   |        |      |   |   |
| Note payable to  bank                   |   | $           | 600,000   |   | $ | 100,000 |   |
| Convertible  subordinated notes payable |   | 1,400,000   |      | - |   |
| Other  liabilities                      |   | 28,153      |      | 3,809 |   |
|                                    |   | 2,028,153   |      | 103,809 |   |
|                                    |   |        |      |   |   |
| Stockholders'  equity                   |   | 1,923,664   |      | 2,981,584 |   |
|                                    |   | $           | 3,951,817 |   | $ | 3,085,393 |   |

 

 

CONDENSED STATEMENTS OFINCOME

 
|                                                 |   | **Years  Ended June 30** |       |
|------------------------------------------------------|--------|--------------------------|------------|
|                                                 |   | **2002**                 |       | **2001** |   |
| Interest income                                      |   | $                        | 8,505      |   | $ | 1,586 |   |
| Equity in  undistributed income (loss) of subsidiary |   | (811,791                 | )          | 104,215 |   |
|                                                 |   | (803,286                 | )     | 105,801 |   |
|                                                 |   |                     |       |   |   |
| Interest expense                                     |   | 110,631                  |       | - |   |
| Noninterest  expense                                 |   | 174,399                  |       | 196,816 |   |
|                                                 |   | 285,030                  |       | 196,816 |   |
|                                                 |   |                     |       |   |   |
| Loss before  income taxes                            |   | (1,088,316               | )          | (91,015 | ) |
|                                                 |   |                     |       |   |   |
| Income tax  expense (benefit)                        |   | -                        |       | - |   |
| Net loss                                             |   | $                        | (1,088,316 | ) | $ | (91,015 | ) |

 

 

57

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** **

CONDENSED STATEMENTS OF CASH FLOWS

 
|                                                              |   | **Years  Ended June 30** |       |
|-------------------------------------------------------------------|--------|--------------------------|------------|
|                                                              |   | **2002**                 |       | **2001** |   |
| Cash flows from  operating activities:                            |   | $                        | (1,088,316 | ) | $ | (91,015 | ) |
| Net loss                                                          |   |                     |       |   |   |
| Adjustments:                                                      |   |                     |       |   |   |
| Equity in  undistributed (income) loss of subsidiary              |   | 811,791                  |       | (104,215 | ) |
| Earned stock  compensation                                        |   | 3,996                    |       | 4,000 |   |
| Other                                                             |   | 24,344                   |       | 57,549 |   |
|                                                              |   | (248,185                 | )          | (133,681 | )  |
| Cash flows from  investing activities:                            |   |                     |       |   |   |
| Capital  contributed to subsidiary bank                           |   | (1,600,00                | )          | (400,000 | ) |
|                                                              |   |                     |       |   |   |
| Cash flows from  financing activities:                            |   |                     |       |   |   |
| Proceeds from  issuance of common stock, net                      |   | -                        |       | 381,091 |   |
| Proceeds from  issuance of convertible subordinated notes payable |   | 1,400,000                |       | - |   |
| Proceeds from  notes payable and other borrowing                  |   | 500,000                  |       | 100,000 |   |
|                                                              |   | 1,900,000                |       | 481,091 |   |
|                                                              |   |                     |       |   |   |
| Net increase  (decrease) in cash                                  |   | 51,815                   |       | (52,590 | ) |
|                                                              |   |                     |       |   |   |
| Cash, beginning                                                   |   | 20,178                   |       | 72,768 |   |
| Cash, ending                                                      |   | $                        | 71,993     |   | $ | 20,178 |   |

 

 

**Note 17.**                           Litigation Matters

There are three assertedclaims currently outstanding against the Company. They all relate to issuesarising out of the tenure of one of the initial investors, who also served as aBoard member and was the former CFO of the Company (the Former CFO).

 

A summary of the threeclaims follows:

 

**Catalytic Combustion 401(k) Plan vs. Northern Star Financial,Inc.:** During theFormer CFO’s tenure as CFO and Board member of Northern Star Financial, Inc.,the Former CFO, who also owned an interest in Catalytic Combustion, used hisinfluence, it is asserted, to compel the Catalytic Combustion 401(k) Plan topurchase an investment in Northern Star Financial, Inc., common stock in theamount of approximately $300,000. The investment subsequently deteriorated invalue, and the trustees of the 401(k) plan now seek to rescind the initialinvestment, alleging the securities were not properly registered, and compelthe Company to reimburse the 401(k) plan for its losses plus interest andexpenses. The Company believes the claim is without merit and intends tovigorously defend themselves in this action.

** **

**Bridge Lenders, LLC vs.Northern Star Bank:**This matter relates to loansoriginally totaling approximately $2,400,000 made by Northern Star Bank tomembers of Bridge Lenders, LLC, during the Former CFO’s term with the Company.The loan proceeds were reportedly invested in Bridge Lenders, LLC, who subsequentlyinvested the funds in Phenix Biocomposites, a company for which the Former CFOwas also a Board member. Phenix Biocomposites has since experienced significantfinancial difficulties, and therefore the investments in Phenix Biocompositesmay be of little or no value. The plaintiffs claim the Bank had a fiduciaryduty to the plaintiffs because of the Former CFO’s dual role, and that the Bankviolated this duty when the Former CFO allegedly provided false information tomembers of Bridge Lenders, LLC, regarding business matters of PhenixBiocomposites. At this time, the amount of the claim is unspecified but appearsto be tied to the amount of the original investment of $2,400,000 by BridgeLenders, LLC, in Phenix Biocomposites. As of June 30, 2002, the principalamount outstanding to claimants in this matter approximates $1,360,000. Theseloans are considered by management to be impaired, and a specific reserverelating to these loans approximating $200,000 has been included in theallowance for loan losses.

 

**Trustee in bankruptcy for Former CFO vs. Northern StarFinancial, Inc.:**TheCompany made certain loans to the Former CFO during his tenure at the Company.These loans are collateralized by securities owned by the Former CFO. TheFormer CFO subsequently filed for bankruptcy. The Bankruptcy court claims thatsince certain of the collateral was conveyed to the Bank within one year of theFormer CFO’s filing for bankruptcy and the Former CFO was an insider, they arepreferential transfers and must be reversed. The effect of a successful outcomeby the Bankruptcy court would increase the risk of loss to the Company on theloans to the Former CFO. As of June 30, 2002, the principal balance of loansoutstanding approximates $475,000. These loans are considered by management tobe impaired, and a specific reserve relating to these loans approximating$237,000 has been included in the allowance for loan losses.

 

**General:** Each of the three litigation matters is in the earlystages of discovery, and therefore neither management nor the Company’s legalcounsel can determine the likelihood of loss or an estimated amount.Accordingly, no accrual, other than certain specific reserves for loan lossesnoted above, has been made for potential losses related to any of these claims.

 

Each of the suits issignificant to the Company and could have a detrimental impact on the future ofthe Company. A significant loss could result in the Company falling below theminimum regulatory capital requirements. Failure to meet minimum regulatoryrequirements can initiate certain mandatory and possible discretionary actionsby the regulators that, if taken, could have a direct material adverse effecton the Company’s consolidated financial statements.

 

The Company’s plan withregards to these potential losses is to raise additional equity capital to fundoperations, should the need arise. There is, however, no assurance that theCompany would be successful in raising additional capital should the needarise.

 

 

58

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

 

Previously reported in Form 10-KSB for fiscal yearended June 30, 2001.

 

 

**PARTIII**

 

 

**ITEM 9.****                  DIRECTORS,EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION16(a) OF THE EXCHANGE ACT**

 

The names and ages of the executive officers of theRegistrant and their positions and offices held are as follows:

 
| **Name**             |   | **Age** |   | **Position  with Company**                                                                                                                                                                                                                                                                                   |
|----------------------|--------|---------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Thomas P. Stienessen |   | 56      |   | 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. |
| Dean M. Doyscher     |   | 57      |   | Chief Financial Officer, Treasurer and Secretary of  the Registrant since August 29, 2001, and a Director of the Registrant since  formation.  Owner/Partner of Security  Management and Realty, an owner and manager of commercial property, since  1978.                                              |

 

The information required by Item 9 relating todirectors, family relationships and compliance with Section 16(a) of theExchange Act is incorporated herein by reference to the sections labeled“Election of Directors” and “Section 16(a) Beneficial Ownership ReportingCompliance,” respectively, which appear in the Company’s definitive ProxyStatement for its 2002 Annual Meeting of Shareholders.

 

 

**ITEM10.               EXECUTIVE COMPENSATION**

 

The information required by Item 10 is incorporatedherein by reference to the section labeled “Executive Compensation” whichappears in the Registrant’s definitive Proxy Statement for its 2000 AnnualMeeting of Shareholders.

 

 

**ITEM 11.               SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENTAND RELATED STOCKHOLDER MATTERS**

 

The information required by Item 11 relating tosecurity ownership of certain beneficial owners and management is incorporatedherein by reference to the section labeled “Shareholdings of PrincipalShareholders and Management,” which appears in the Registrant’s definitiveProxy Statement for its 2002 Annual Meeting of Shareholders.

 

 

59

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**ITEM 12.               CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**

 

The information required by Item 12 is incorporated byreference to the section labeled “Certain Transactions” which appears in theRegistrant’s definitive Proxy Statement for its 2002 Annual Meeting ofShareholders.

 

 

**ITEM 13.               EXHIBITSAND REPORTS ON FORM 8-K**

 

(a)           Exhibits.

 

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

 

(b)           Reports on Form 8-K

 

No reports on Form 8-K were filed during the lastfiscal quarter of the Registrant’s 2002 fiscal year.

 

** **

 

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** **

**SIGNATURES**

 

 

In accordance with Section 13 or 15(d) of the ExchangeAct, the registrant caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
|                             | NORTHERN STAR FINANCIAL, INC. |
|----------------------------------|-------------------------------|
|                             |                          |   |
| Dated:   September 20, 2002 | By:                           | /s/ Thomas P. Stienessen |
|                             |                          |   |   | Thomas P. Stienessen, Chief Executive Officer |
|                                  |                               |  |  |  |

 

In accordance with the Exchange Act, this Report hasbeen signed by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.

 

(Power of Attorney)

 

Each person whose signature appears below constitutesand appoints THOMAS P. STIENESSEN and DEAN M. DOYSCHER as true and lawfulattorneys-in-fact and agents, each acting alone, with full power ofsubstitution and resubstitution, for him and in his name, place and stead, inany and all capacities, to sign any or all amendments to this Annual Report onForm 10-KSB and to file the same, with all exhibits thereto, and other documentsin connection thereto, and other documents in connection therewith, with theSecurities and Exchange Commission, granting unto said attorneys-in-fact andagents, each acting alone, full power and authority to do and perform each andevery act and thing requisite and necessary to be done in and about thepremises, as fully to all intents and purposes as he might or could do inperson, hereby ratifying and confirming all said attorneys-in-fact and agents,each acting alone, or his substitute or substitutes, may lawfully do or causeto be done by virtue thereof.

 
| **Signature and Title**                                 |   | **Date**           |
|---------------------------------------------------------|--------|--------------------|
|                                                    |   |               |
| /s/ Thomas P. Stienessen                                |   | September 20, 2002 |
| Thomas P. Stienessen, President, Chief Executive        |   |               |
| Officer and Director                                    |   |               |
| (Principal Executive Officer)                           |   |               |
|                                                    |   |               |
| /s/ Dean M. Doyscher                                    |   | September 20, 2002 |
| Dean M. Doyscher, Chief Financial Officer and  Director |   |               |
| (Principal Financial and Accounting Officer)            |   |               |
|                                                    |   |               |
| /s/ Robert H. Dittrich                                  |   | September 20, 2002 |
| Robert H. Dittrich, Director                            |   |               |
|                                                    |   |               |
| /s/ Gerald W. Eick                                      |   | September 20, 2002 |
| Gerald W. Eick, Director                                |   |               |
|                                                    |   |               |
| /s/ James H. Illies                                     |   | September 20, 2002 |
| James H. Illies, Director                               |   |               |
|                                                    |   |               |
| /s/ Steven A. Loehr                                     |   | September 20, 2002 |
| Steven A. Loehr, Director                               |   |               |
|                                                    |   |               |
| /s/ Michael P. Reynolds                                 |   | September 20, 2002 |
| Michael P. Reynolds, Director                           |   |               |
|                                                    |   |               |
| /s/ Thomas J. Reynolds                                  |   | September 20, 2002 |
| Thomas J. Reynolds, Director                            |   |               |

 

 

61

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CERTIFICATION

 

 

 

 

 

                I, Thomas P.Stienessen, Chief Executive Officer of Northern Star Financial, Inc., certifythat:

 

                1.             I have reviewed this annual reporton Form 10-KSB of Northern Star Financial, Inc.;

 

                2.             Based on my knowledge, this annualreport does not contain any untrue statement of a material fact or omit tostate a material fact necessary to make the statements made, in light of thecircumstances under which such statements were made, not misleading withrespect to the period covered by this annual report; and

 

                3.             Based on my knowledge, thefinancial statements, and other financial information included in this annualreport, fairly present in all material respects the financial condition,results of operations and cash flows of the registrant as of, and for, theperiods presented in this annual report.

 

                Date:       September 20, 2002.

 

 

 

 
|   | /s/ Thomas P. Stienessen |
|--------|--------------------------|
|   | Thomas P. Stienessen     |
|   | Chief Executive Officer  |

 

 

62

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CERTIFICATION

 

 

 

 

 

                I, Dean M.Doyscher, Chief Financial Officer of Northern Star Financial, Inc., certifythat:

 

                1.             I have reviewed this annual reporton Form 10-KSB of Northern Star Financial, Inc.;

 

                2.             Based on my knowledge, this annualreport does not contain any untrue statement of a material fact or omit tostate a material fact necessary to make the statements made, in light of thecircumstances under which such statements were made, not misleading withrespect to the period covered by this annual report; and

 

                3.             Based on my knowledge, thefinancial statements, and other financial information included in this annualreport, fairly present in all material respects the financial condition,results of operations and cash flows of the registrant as of, and for, theperiods presented in this annual report.

 

                Date:       September 20, 2002.

 

 

 

 
|   | /s/ Dean M. Doyscher    |
|--------|-------------------------|
|   | Dean M. Doyscher        |
|   | Chief Financial Officer |

 

 

63

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NORTHERN STAR FINANCIAL,INC.

 

EXHIBIT INDEX TO FORM10-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.                                                                                                           |
|                |   |                                                                                                                                                                                                                                                                                                         |
| 10.6                |   | Form and amounts of Convertible Subordinated  Unsecured Notes issued by the Registrant to certain of its directors in July  and August, 2001.                                                                                                                                                                |
|                |   |                                                                                                                                                                                                                                                                                                         |
| 10.7                |   | Form and amounts of Convertible Subordinated  Unsecured Notes issued by the Registrant to certain of its directors in June,  2002.                                                                                                                                                                           |
|                |   |                                                                                                                                                                                                                                                                                                         |
| 11                  |   | Statement re: Computation of Earnings 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)                                                                                                                                                                                                                                               |
|                     |        |                                                                                                                                                                                                                                                                                                              |  |  |  |  |  |

 

 

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______________________________

*    Incorporated by reference - CommissionFile No. 000-25231 unless otherwise indicated.

** Indicates amanagement contract or compensatory plan or arrangement required to be filed asan exhibit to this Form 10-KSB.