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** **

 

** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C.  20549**

 

**FORM 10-Q/A**

 

**AmendmentNo. 1**

 

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

 

**For the quarterly period ended September 30, 2009**

 

**o**                   **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from                 to                 .**

 

**Commission File No. 0-12870.**

 

**FIRST CHESTER COUNTY CORPORATION**

(Exact name of Registrant asspecified in its charter)

 

| **Pennsylvania**                                               | ** ** | **23-2288763**                       |
|----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of Incorporation or organization) |       | (I.R.S. Employer Identification No.) |

 

**9 North High Street, West Chester, Pennsylvania 19380**

(Address of principalexecutive office)

(Zip code)

** **

**(484) 881-4000**

(Registrant’s telephonenumber, including area code)

 

Indicate by check mark whether the registrant: (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  Yes x  No o

 

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

 

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

 

| Large accelerated filer o                |   | Accelerated filer x              |
|-----------------------------------------------|--------|----------------------------------|
|                                          |   |                             |
| Non-accelerated filer o                  |   | Smaller reporting company o |
| (Do not check if a smaller reporting company) |   |                             |

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act). Yes o  No x

 

Thenumber of shares outstanding of Common Stock of the registrant as ofNovember 9, 2009 was 6,303,731.

 

 

 

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**EXPLANATORY NOTE**

 

FirstChester County Corporation (the “Corporation”) is filing this Amendment No. 1on Form 10-Q/A to its Quarterly Report for the quarter ended September 30,2009 (this “Amendment”) to amend and restate the Corporation’s unauditedconsolidated financial statements as of and for the three and nine months endedSeptember 30, 2009, as filed with the Securities and Exchange Commission(the “SEC”) on November 13, 2009 (the “Original Filing”).

 

Asreported in the Original Filing, management identified a material weakness inthe Corporation’s internal controls related to the design and implementation ofpolicies to promptly identify problem loans and to quantify the elements ofrisk in problem loans.  The Bank’s policies and procedures were notsystematically applied, which caused a failure in the identification of problemloans on a timely basis and a failure to accurately estimate the risk in theportfolio; this in turn caused a failure to accurately determine theappropriate Allowance for Loan and Lease Losses at June 30, 2009.  Management also discovered a monitoringweakness that contributed to the characterization of the status of certainloans to be classified as fully performing, when in fact these loans were not.  As a result of the June 30, 2009Allowance for Loan and Lease Losses shortfall of $3.5 million, amountsoriginally recorded as Provision for Loan and Lease Losses for the three monthsended September 30, 2009 were restated to the three month period ended June 30,2009.  This restatement created amaterial misstatement in the Consolidated Statements of Operations for thethree months ended September 30, 2009, as well as related footnotedisclosures as reported in the Original Filing.

 

Managementconcluded that the Provision for Loan and Lease Losses for the three monthsended September 30, 2009 should decrease $3.5 million and increase $56,000for the nine months ended September 30, 2009.

 

Subsequent to the year endedDecember 31, 2009, management identified a material weakness in internalcontrols related to the Corporation’s process to review the valuation ofMortgage Loans Held for Sale.  Mortgage Loans Held for Sale representmortgage loans originated by the Corporation and held until sold to secondarymarket investors. Upon the closing of a residential mortgage loan originated bythe Corporation, the mortgage loan is typically warehoused for a period of timeand then sold into the secondary market. While in this warehouse phase,mortgage loans held for sale are recorded at fair value under the fair valueoption with changes in fair value recognized through earnings.  An errorwas identified in the Corporation’s process to properly identify a certainpopulation of loans held for sale prior to sending the loan details to theCorporation’s third party valuation firm.  As such, the Corporationerroneously excluded from the population to be fair valued, loans which wereidentified for sale but for which the Corporation was awaiting theconsideration from the counterparty to complete the salestransaction.   These particular loans were correctly classified asloans held for sale on the Consolidated Balance Sheet at September 30,2009; however the unrealized gain associated with these loans was not reflectedin the Consolidated Balance Sheet and the Statement of Operations. This errorresulted in an understatement in the carrying amount of loans held for sale at September 30,2009, as well as an understatement  netincome for the three and nine months ended June 30, 2009.  As aresult of the material weakness noted above, the Corporation underreported inthe Original Filing net gains from mortgage banking by $1.5 million and $2.7million for the three and nine months ended September 30, 2009,respectively.   Mortgage Loans Held forSale reported on the September 30, 2009 Consolidated Balance Sheet wereunderstated $2.7 million in the Original Filing.

 

Asof the date of this Amendment, management is continuing their ongoing effortsto correct, revise and test the processes surrounding the material weaknessesdescribed above.  Additional changes willbe implemented as determined necessary.

 

Thedecision to restate the third quarter financial statements was approved by theBoard of Directors of First Chester County Corporation on March 18, 2010.

 

Theinformation in this Amendment has been updated to give effect to therestatement.  The Corporation has not modified nor updated theinformation in the Original Filing, except as necessary to reflect the effectsof the restatement described above.  This Amendment continues tospeak as of the dates described herein, and the Corporation has not updated thedisclosures contained in the Original Filing to reflect any events thatoccurred subsequent to such dates.  Information not affected by therestatement is unchanged and reflects the disclosures made at the time of theOriginal Filing.  Accordingly, this Amendment should be read inconjunction with the Corporation’s subsequent filings with the SEC, asinformation in such filings may update or supersede certain informationcontained in this Amendment.

 

Basedon the foregoing, only the following items have been amended:

 

·                  Part I – Financial Information

·                  Item 1 – Financial Statement

·                  Item 2 – Management’sDiscussion and Analysis of Financial Condition and Results of Operations

·                  Item 3 – Quantitative andQualitative Disclosures About Market Risk

·                  Item 4 – Controls and Procedures

 

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Forthe convenience of the reader, this Form 10-Q/A sets forth theinitial Form 10-Q in its entirety, although the Corporation is onlyamending those portions affected by the restatement described above.

 

Inaddition, as required by Rule 12b-15 under the Securities ExchangeAct of 1934, as amended, new, currently-dated certifications of our principalexecutive officer and principal financial officer are filed herewith.

 

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**INDEX**

 
| ** **    | ** **            | ** **                                                                                                                       | ** **   | **Page** |
|---------------|-----------------------|----------------------------------------------------------------------------------------------------------------------------------|--------------|----------|
| ** **    | ** **            | ** **                                                                                                                       | ** **   |     |
| Part I.  | FINANCIAL INFORMATION |                                                                                                                             | 1            |
|          |                  |                                                                                                                             |         |     |
|          | Item 1 -              | Financial Statements                                                                                                             |         | 1        |
|          |                  | Consolidated Balance Sheets  September 30, 2009 (unaudited and restated) and December 31, 2008                         |         | 1        |
|          |                  |                                                                                                                             |         |     |
|          |                  | Consolidated Statements of Operations  Three and Nine Months Ended September 30, 2009 (restated) and 2008  (unaudited)      |         | 2        |
|          |                  |                                                                                                                             |         |     |
|          |                  | Consolidated Statements of Cash Flows  Nine Months Ended September 30, 2009 (restated) and 2008 (unaudited)                 |         | 3        |
|          |                  |                                                                                                                             |         |     |
|          |                  | Consolidated  Statements of Stockholders’ Equity  Nine Months Ended September 30, 2009 (restated) and 2008 (unaudited) |         | 4        |
|          |                  |                                                                                                                             |         |     |
|          |                  | Notes to Consolidated Financial Statements (unaudited  and restated)                                                             |         | 5        |
|          |                  |                                                                                                                             |         |     |
|          | Item 2 -              | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                      |         | 26       |
|          |                  |                                                                                                                             |         |     |
|          | Item  3 -             | Quantitative  and Qualitative Disclosures About Market Risk                                                                      |         | 42       |
|          |                  |                                                                                                                             |         |     |
|          | Item 4 -              | Controls &  Procedures                                                                                                  |         | 42       |
|          |                  |                                                                                                                             |         |     |
| Part II. | OTHER INFORMATION     |                                                                                                                             | 44           |
|          |                  |                                                                                                                             |         |     |
|          | Item 1 -              | Legal  Proceedings                                                                                                               |         | 44       |
|          |                  |                                                                                                                             |         |     |
|          | Item 1A -             | Risk Factors                                                                                                                     |         | 44       |
|          |                  |                                                                                                                             |         |     |
|          | Item  2 -             | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                     |         | 45       |
|          |                  |                                                                                                                             |         |     |
|          | Item  3 -             | Defaults  Upon Senior Securities                                                                                                 |         | 45       |
|          |                  |                                                                                                                             |         |     |
|          | Item  4 -             | Submission  of Matters to a Vote of Security Holders                                                                             |         | 45       |
|          |                  |                                                                                                                             |         |     |
|          | Item 5 -              | Other  Information                                                                                                               |         | 46       |
| *** ***  | *** ***          | *** ***                                                                                                                     | *** *** |     |
|          | Item 6 -              | Exhibits                                                                                                                         |         | 46       |
| *** ***  | *** ***          | *** ***                                                                                                                     | *** *** |     |
|          | Signatures            |                                                                                                                             |         | 47       |
|          |                  |                                                                                                                             |         |     |
|          | Exhibits              |                                                                                                                             |         | 48       |

 

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**FORWARD-LOOKING STATEMENTS**

 

This Quarterly Report onForm 10-Q contains “forward-looking statements.”  These forward-looking statements are made ingood faith pursuant to the “safe harbor” provisions of the Private SecuritiesLitigation Reform Act of 1995.  The words“may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,”“intend,” “plan” and similar expressions are intended to identifyforward-looking statements. References to “we,” “our” and the “Corporation”refer to First Chester County Corporation, together in each case with ourconsolidated subsidiaries unless the context suggests otherwise.

 

Theforward-looking statements contained in this Quarterly Report on Form 10-Qare based on current expectations, estimates, forecasts and projections aboutthe industry in which we operate and management’s beliefs and assumptions.These statements are not guarantees of future performance and involve risks,uncertainties and assumptions that are difficult to predict. Therefore, actualoutcomes and results may differ materially from what is expressed or forecastedin such forward-looking statements, including as a result of risks discussed in“Part I, Item 1A. Risk Factors” in our Annual Report onForm 10-K for the fiscal year ended December 31, 2008 and in thisQuarterly Report on Form 10-Q.

 

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**FIRST CHESTER COUNTYCORPORATION AND SUBSIDIARIES**

 

**PART I. FINANCIALINFORMATION**

 

**ITEM 1.  Financial Statements**

 

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                    | ** ** | **September 30,**           | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|-----------------------|------------|
| **(Dollars  in thousands)**                                                                                                                                   | ** ** | **2009**                         | ** ** | **2008**              | ** ** |
| ** **                                                                                                                                                    | ** ** | **(Unaudited  – Restated)** | ** ** | ** **            | ** ** |
| ASSETS                                                                                                                                                        |       |                             |       |                  |       |
| Cash and due from banks                                                                                                                                       |       | $                                | 19,107     |                  | $          | 24,939 |   |
| Federal funds sold and other overnight investments                                                                                                            |       | 2,347                            |       | 4,884                 |       |
| Interest bearing deposits                                                                                                                                     |       | 1,497                            |       | 65,327                |       |
| Total cash and cash equivalents                                                                                                                               |       | 22,951                           |       | 95,150                |       |
|                                                                                                                                                          |       |                             |       |                  |       |
| Investment securities available-for-sale, at fair  value                                                                                                      |       | 89,866                           |       | 114,584               |       |
|                                                                                                                                                          |       |                             |       |                  |       |
| Mortgage loans held for sale                                                                                                                                  |       | 190,201                          |       | 90,940                |       |
|                                                                                                                                                          |       |                             |       |                  |       |
| Loans and leases                                                                                                                                              |       | 957,502                          |       | 940,083               |       |
| Less: allowance for loan and lease losses                                                                                                                     |       | (23,490                          | )          | (10,335               | )          |
| Net loans and leases                                                                                                                                          |       | 934,012                          |       | 929,748               |       |
|                                                                                                                                                          |       |                             |       |                  |       |
| Premises and equipment, net                                                                                                                                   |       | 23,142                           |       | 22,076                |       |
| Net deferred tax asset                                                                                                                                        |       | 10,854                           |       | 8,585                 |       |
| Due from mortgage investors                                                                                                                                   |       | —                           |       | 9,036                 |       |
| Bank owned life insurance                                                                                                                                     |       | 1,437                            |       | 1,398                 |       |
| Goodwill                                                                                                                                                      |       | 8,079                            |       | 5,906                 |       |
| Other real estate owned                                                                                                                                       |       | 3,062                            |       | 1,872                 |       |
| Other assets                                                                                                                                                  |       | 24,809                           |       | 20,883                |       |
| Total assets                                                                                                                                                  |       | $                                | 1,308,413  |                  | $          | 1,300,178 |   |
| LIABILITIES                                                                                                                                                   |       |                             |       |                  |       |
| Deposits                                                                                                                                                      |       |                             |       |                  |       |
| Non-interest-bearing                                                                                                                                          |       | $                                | 153,299    |                  | $          | 146,248 |   |
| Interest-bearing (including certificates of  deposit over $100 of $173,135 and $100,018 at September 30, 2009 and  December 31, 2008, respectively) |       | 832,815                          |       | 868,944               |       |
| Total deposits                                                                                                                                                |       | 986,114                          |       | 1,015,192             |       |
| Federal Home Loan Bank advances and other  borrowings                                                                                                         |       | 202,123                          |       | 171,170               |       |
| Subordinated debentures                                                                                                                                       |       | 20,795                           |       | 15,465                |       |
| Other liabilities                                                                                                                                             |       | 16,271                           |       | 13,034                |       |
| Total liabilities                                                                                                                                             |       | 1,225,303                        |       | 1,214,861             |       |
|                                                                                                                                                          |       |                             |       |                  |       |
| Commitments and contingencies — See Note 14                                                                                                              |       |                             |       |                  |       |
|                                                                                                                                                          |       |                             |       |                  |       |
| STOCKHOLDERS’ EQUITY                                                                                                                                     |       |                             |       |                  |       |
| Common stock, par value $1.00; authorized  25,000,000 shares; Outstanding, 6,331,975 at September 30, 2009 and  December 31, 2008                   |       | 6,332                            |       | 6,332                 |       |
| Additional paid-in capital                                                                                                                                    |       | 23,515                           |       | 24,708                |       |
| Retained earnings                                                                                                                                             |       | 52,321                           |       | 57,899                |       |
| Accumulated other comprehensive loss                                                                                                                          |       | (523                             | )          | (3,292                | )          |
| Treasury stock, at cost: 24,200 shares and 92,931  shares at September 30, 2009 and December 31, 2008, respectively                                 |       | (374                             | )          | (1,815                | )          |
| Total First Chester County Corporation  stockholders’ equity                                                                                             |       | 81,271                           |       | 83,832                |       |
| Non-controlling interests                                                                                                                                     |       | 1,839                            |       | 1,485                 |       |
| Total stockholders’ equity                                                                                                                               |       | 83,110                           |       | 85,317                |       |
|                                                                                                                                                          |       |                             |       |                  |       |
| Total liabilities and stockholders’ equity                                                                                                               |       | $                                | 1,308,413  |                  | $          | 1,300,178 |   |

 

The accompanying notes arean integral part of these statements.

 

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**FIRST CHESTER COUNTYCORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF OPERATIONS**

(**UNAUDITED**)

 
| ** **                                                         | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|--------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                         | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| **(Dollars  in thousands - except per share)**                     | ** ** | **2009**               | ** ** | **2008**               | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                         | ** ** | **(Restated)**         | ** ** | ** **             | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
| INTEREST INCOME                                                    |       |                   |       |                   |       |   |   |   |   |
| Loans and leases, including fees                                   |       | $                      | 13,565     |                   | $          | 12,418 |   | $ | 40,136 |   | $ | 36,836 |   |
| Mortgage loans held for sale                                       |       | 2,866                  |       | 3                      |       | 7,805 |   | 9 |   |
| Investment securities                                              |       | 764                    |       | 1,255                  |       | 2,991 |   | 3,836 |   |
| Federal funds sold and deposits in banks                           |       | 5                      |       | 200                    |       | 50 |   | 1,068 |   |
| Total interest income                                              |       | 17,200                 |       | 13,876                 |       | 50,982 |   | 41,749 |   |
|                                                               |       |                   |       |                   |       |   |   |   |   |
| INTEREST EXPENSE                                                   |       |                   |       |                   |       |   |   |   |   |
| Deposits                                                           |       | 3,512                  |       | 3,647                  |       | 11,866 |   | 12,099 |   |
| Subordinated debt                                                  |       | 295                    |       | 209                    |       | 721 |   | 683 |   |
| Federal Home Loan Bank and other borrowings                        |       | 1,559                  |       | 1,470                  |       | 4,712 |   | 4,390 |   |
| Total interest expense                                             |       | 5,366                  |       | 5,326                  |       | 17,299 |   | 17,172 |   |
|                                                               |       |                   |       |                   |       |   |   |   |   |
| Net interest income                                                |       | 11,834                 |       | 8,550                  |       | 33,683 |   | 24,577 |   |
|                                                               |       |                   |       |                   |       |   |   |   |   |
| Provision for loan and lease losses                                |       | 11,222                 |       | 290                    |       | 17,693 |   | 950 |   |
| Net interest income after provision for loan and lease losses |       | 612                    |       | 8,260                  |       | 15,990 |   | 23,627 |   |
|                                                               |       |                   |       |                   |       |   |   |   |   |
| NON-INTEREST INCOME                                                |       |                   |       |                   |       |   |   |   |   |
| Wealth management and advisory services                            |       | 965                    |       | 994                    |       | 2,931 |   | 3,069 |   |
| Service charges on deposit accounts                                |       | 669                    |       | 657                    |       | 1,960 |   | 1,853 |   |
| Gains on sales of investment securities, net                       |       | 1                      |       | 89                     |       | 1 |   | 273 |   |
| Operating lease rental income                                      |       | 314                    |       | 328                    |       | 999 |   | 967 |   |
| Net gains (losses) on fixed assets and OREO                        |       | 162                    |       | (123                   | )          | 279 |   | (33 | ) |
| Loan fees and other                                                |       | 738                    |       | 118                    |       | 3,574 |   | 298 |   |
| Net gain from mortgage banking activities                          |       | 11,735                 |       | 33                     |       | 37,172 |   | 197 |   |
| Bank owned life insurance                                          |       | 13                     |       | 46                     |       | 39 |   | 203 |   |
| Asset impairment                                                   |       | (1,576                 | )          | (1,267                 | )          | (1,576 | ) | (1,267 | ) |
| Other                                                              |       | 521                    |       | 452                    |       | 1,574 |   | 1,395 |   |
| Total non-interest income                                          |       | 13,542                 |       | 1,327                  |       | 46,953 |   | 6,955 |   |
|                                                               |       |                   |       |                   |       |   |   |   |   |
| NON-INTEREST EXPENSE                                               |       |                   |       |                   |       |   |   |   |   |
| Salaries and employee benefits                                     |       | 14,948                 |       | 4,847                  |       | 42,718 |   | 13,845 |   |
| Occupancy, equipment and data processing                           |       | 3,207                  |       | 1,434                  |       | 8,877 |   | 4,342 |   |
| Depreciation expense on operating leases                           |       | 259                    |       | 273                    |       | 828 |   | 799 |   |
| FDIC deposit insurance                                             |       | 422                    |       | 136                    |       | 1,897 |   | 347 |   |
| Bank shares tax                                                    |       | 207                    |       | 207                    |       | 674 |   | 592 |   |
| Professional services                                              |       | 2,039                  |       | 449                    |       | 4,962 |   | 1,368 |   |
| Marketing                                                          |       | 337                    |       | 171                    |       | 1,161 |   | 704 |   |
| Other real estate expense                                          |       | 35                     |       | 12                     |       | 142 |   | 16 |   |
| Other                                                              |       | 1,923                  |       | 1,103                  |       | 5,580 |   | 3,071 |   |
|                                                               |       |                   |       |                   |       |   |   |   |   |
| Total non-interest expense                                         |       | 23,377                 |       | 8,632                  |       | 66,839 |   | 25,084 |   |
|                                                               |       |                   |       |                   |       |   |   |   |   |
| (Loss) income before income taxes                                  |       | (9,223                 | )          | 955                    |       | (3,896 | ) | 5,498 |   |
|                                                               |       |                   |       |                   |       |   |   |   |   |
| INCOME TAXES                                                       |       | (3,273                 | )          | 148                    |       | (2,073 | ) | 1,329 |   |
|                                                               |       |                   |       |                   |       |   |   |   |   |
| Net (loss) income including noncontrolling  interests              |       | $                      | (5,950     | )                      | $          | 807 |   | $ | (1,823 | ) | $ | 4,169 |   |
|                                                               |       |                   |       |                   |       |   |   |   |   |
| Less: Net income from non-controlling interests                    |       | 494                    |       | —                 |       | 1,363 |   | — |   |
|                                                               |       |                   |       |                   |       |   |   |   |   |
| NET (LOSS) INCOME FOR FIRST CHESTER COUNTY  CORPORATION            |       | $                      | (6,444     | )                      | $          | 807 |   | $ | (3,186 | ) | $ | 4,169 |   |
|                                                               |       |                   |       |                   |       |   |   |   |   |
| PER SHARE DATA                                                     |       |                   |       |                   |       |   |   |   |   |
| Net (loss) income per share (Basic)                                |       | $                      | (1.02      | )                      | $          | 0.16 |   | $ | (0.51 | ) | $ | 0.80 |   |
| Net (loss) income per share (Diluted)                              |       | $                      | (1.02      | )                      | $          | 0.16 |   | $ | (0.51 | ) | $ | 0.80 |   |
| Dividends declared                                                 |       | $                      | 0.140      |                   | $          | 0.140 |   | $ | 0.420 |   | $ | 0.420 |   |
|                                                               |       |                   |       |                   |       |   |   |   |   |
| Basic weighted average shares outstanding                          |       | 6,306,889              |       | 5,188,562              |       | 6,272,682 |   | 5,184,173 |   |
| Diluted weighted average shares outstanding                        |       | 6,306,899              |       | 5,197,787              |       | 6,272,682 |   | 5,200,200 |   |

 

The accompanying notes arean integral part of these statements.

 

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**FIRST CHESTER COUNTYCORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF CASHFLOWS**

(**UNAUDITED**)

 
| ** **                                                                                          | ** ** | **Nine Months Ended**  | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                          | ** ** | **September 30,** | ** ** |
| **(Dollars  in thousands)**                                                                         | ** ** | **2009  (Restated)**   | ** ** | **2008** | ** ** |
| OPERATING ACTIVITIES                                                                                |       |                   |       |   |   |
| Net(loss) income                                                                                    |       | $                      | (3,186     | ) | $ | 4,169 |   |
| Adjustments to reconcile net (loss) income to net  cash (used in) provided by operating activities: |       |                   |       |   |   |
| Depreciation                                                                                        |       | 2,728                  |       | 1,848 |   |
| Provision for loan and lease losses                                                                 |       | 17,693                 |       | 950 |   |
| Amortization of investment security premiums and  accretion of discounts, net                       |       | 300                    |       | 250 |   |
| Amortization of deferred loan fees                                                                  |       | (728                   | )          | (570 | ) |
| Losses on sales of investment securities available  for sale, net                                   |       | (1                     | )          | (273 | ) |
| Net (gain) loss from on fixed assets and OREO                                                       |       | (279                   | )          | 33 |   |
| Net gain from mortgage banking activities                                                           |       | (37,172                | )          | (197 | ) |
| Proceeds from the sale of mortgage loans held for  sale                                             |       | 1,897,596              |       | 12,038 |   |
| Origination of mortgage loans held for sale                                                         |       | (1,950,649             | )          | (12,303 | ) |
| Net cash paid for the settlement of derivative  contracts                                           |       | (277                   | )          | — |   |
| Stock-based compensation expense                                                                    |       | 147                    |       | 132 |   |
| Loss on investment securities                                                                       |       | 1,576                  |       | 850 |   |
| Increase in other assets                                                                            |       | (15,540                | )          | (824 | ) |
| Increase (decrease) in other liabilities                                                            |       | 2,369                  |       | (1,645 | ) |
|                                                                                                |       |                   |       |   |   |
| Net cash (used in) provided by operating  activities                                                |       | (85,423                | )          | 4,458 |   |
|                                                                                                |       |                   |       |   |   |
| INVESTING ACTIVITIES                                                                                |       |                   |       |   |   |
| Net increase in loans                                                                               |       | (24,587                | )          | (64,589 | ) |
| Proceeds from the sale of portfolio loans                                                           |       | 3,479                  |       | — |   |
| Proceeds from sales of investment securities  available-for-sale                                    |       | 33,641                 |       | 21,414 |   |
| Proceeds from maturities prepayments and calls of  investment securities available-for-sale         |       | 10,048                 |       | 11,877 |   |
| Purchases of investment securities  available-for-sale                                              |       | (16,649                | )          | (42,557 | ) |
| Purchase of BOLI (Bank Owned Life Insurance)                                                        |       | —                 |       | (10,000 | ) |
| Proceeds from the sale of OREO                                                                      |       | 5,060                  |       | — |   |
| Purchase of premises and equipment                                                                  |       | (3,794                 | )          | (3,752 | ) |
| Proceeds from the sale of premises and equipment                                                    |       | 114                    |       | 119 |   |
|                                                                                                |       |                   |       |   |   |
| Net cash provided by (used in) investing  activities                                                |       | 7,312                  |       | (87,488 | ) |
|                                                                                                |       |                   |       |   |   |
| FINANCING ACTIVITIES                                                                                |       |                   |       |   |   |
| Change in subsidiary’s shares from non-controlling  interest                                   |       | 354                    |       | — |   |
| Increase in short term Federal Home Loan Bank and  other short term borrowings                      |       | 49,700                 |       | — |   |
| Increase in long term Federal Home Loan Bank and  other borrowings                                  |       | 58,300                 |       | 111,500 |   |
| Repayment of long term Federal Home Loan Bank and  other borrowings                                 |       | (77,047                | )          | (78,300 | ) |
| Proceeds from issuance of subordinated debentures                                                   |       | 5,330                  |       | — |   |
| Net(decrease) increase in deposits                                                                  |       | (29,077                | )          | 56,621 |   |
| Cash dividends paid                                                                                 |       | (1,759                 | )          | (2,179 | ) |
| Net treasury stock transactions                                                                     |       | 111                    |       | 26 |   |
|                                                                                                |       |                   |       |   |   |
| Net cash provided by financing activities                                                           |       | 5,912                  |       | 87,668 |   |
|                                                                                                |       |                   |       |   |   |
| NET (DECREASE) INCREASE IN CASH AND CASH  EQUIVALENTS                                               |       | (72,199                | )          | 4,638 |   |
|                                                                                                |       |                   |       |   |   |
| Cash and cash equivalents at beginning of period                                                    |       | 95,150                 |       | 53,360 |   |
|                                                                                                |       |                   |       |   |   |
| Cash and cash equivalents at end of period                                                          |       | $                      | 22,951     |   | $ | 57,998 |   |

 

The accompanying notes are an integral part of these statements.

 

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Table of Contents

 

**FIRST CHESTER COUNTYCORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY**

(**UNAUDITED**)

 
| ** **                                                              | ** ** | **Common  Stock** | ** ** | **Additional  Paid-in** | ** ** | **Retained** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Treasury**      | ** ** | **Non-  Controlling** | ** ** | **Total  Stockholders’** | ** ** | **Comprehensive** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------|------------|-------------------------|------------|--------------|------------|---------------------------------------|------------|-------------------|------------|-----------------------|------------|-------------------------------|------------|-------------------|------------|
| **(Dollars in thousands)**                                              | ** ** | **Shares**        | ** ** | **Par  Value**          | ** ** | **Capital**  | ** ** | **Earnings**                          | ** ** | **Income/(loss)** | ** ** | **Stock**             | ** ** | **Interest**                  | ** ** | **Equity**        | ** ** | **Income** | ** ** |
| ** **                                                              | ** ** | ** **        | ** ** | ** **              | ** ** | ** **   | ** ** | ** **                            | ** ** | ** **        | ** ** | ** **            | ** ** | ** **                    | ** ** | ** **        | ** ** | ** ** | ** ** |
| Balance  January 1, 2008                                           |       | 5,279,815         |       | $                       | 5,280      |         | $          | 11,113                                |       | $                 | 55,347     |                  | $          | (1,207                        | )          | $                 | (2,554     | ) | — |   | $ | 67,979 |   |   |   |
|                                                                    |       |              |       |                    |       |         |       |                                  |       |              |       |                  |       |                          |       |              |       |   |   |
| Net  income                                                             |       | —            |       | —                  |       | —       |       | 4,169                                 |       | —            |       | —                |       | —                        |       | 4,169             |       | 4,169 |   |
| Cash  dividends declared                                                |       | —            |       | —                  |       | —       |       | (2,179                                | )          | —            |       | —                |       | —                        |       | (2,179            | )          | — |   |
| Other  comprehensive income                                             |       |              |       |                    |       |         |       |                                  |       |              |       |                  |       |                          |       |              |       |   |   |
| Net  unrealized losses on investment securities Available-for-sale |       | —            |       | —                  |       | —       |       | —                                |       | (2,775            | )          | —                |       | —                        |       | (2,775            | )          | (2,775 | ) |
| Treasury  stock transactions                                            |       | —            |       | —                  |       | (719         | )          | —                                |       | —            |       | 746                   |       | —                        |       | 27                |       | — |   |
| Stock  based compensation                                               |       |              |       |                    |       | 132          |       |                                  |       |              |       |                  |       |                          |       | 132               |       |   |   |
| Total  comprehensive income                                             |       |              |       |                    |       |         |       |                                  |       |              |       |                  |       |                          |       |              |       | $ | 1,394 |   |
|                                                                    |       |              |       |                    |       |         |       |                                  |       |              |       |                  |       |                          |       |              |       |   |   |
| Balance  September 30, 2008                                        |       | 5,279,815         |       | $                       | 5,280      |         | $          | 10,526                                |       | $                 | 57,337     |                  | $          | (3,982                        | )          | $                 | (1,808     | ) | — |   | $ | 67,353 |   |   |   |
|                                                                    |       |              |       |                    |       |         |       |                                  |       |              |       |                  |       |                          |       |              |       |   |   |
| Balance  January 1, 2009                                           |       | 6,331,975         |       | $                       | 6,332      |         | $          | 24,708                                |       | $                 | 57,899     |                  | $          | (3,292                        | )          | $                 | (1,815     | ) | $ | 1,485 |   | $ | 85,317 |   |   |   |
|                                                                    |       |              |       |                    |       |         |       |                                  |       |              |       |                  |       |                          |       |              |       |   |   |
| Cumulative  effect adjustment under FASB no. 156                   |       |              |       |                    |       |         |       | 240                                   |       |              |       |                  |       |                          |       | 240               |       |   |   |
| Balance  January 1, 2009, as adjusted                              |       | 6,331,975         |       | 6,332                   |       | 24,708       |       | 58,139                                |       | (3,292            | )          | (1,815                | )          | 1,485                         |       | 85,557            |       |   |   |
|                                                                    |       |              |       |                    |       |         |       |                                  |       |              |       |                  |       |                          |       |              |       |   |   |
| Change  in subsidiary shares from non-controlling interest              |       | —            |       | —                  |       | —       |       | —                                |       | —            |       | —                |       | (1,009                        | )          | (1,009            | )          |   |   |
| Net  income (loss) (restated)                                           |       | —            |       | —                  |       | —       |       | (3,186                                | )          | —            |       | —                |       | 1,363                         |       | (1,823            | )          | (1,823 | ) |
| Cash  dividends declared                                                |       | —            |       | —                  |       | —       |       | (2,632                                | )          | —            |       | —                |       | —                        |       | (2,632            | )          |   |   |
| Other  comprehensive income                                             |       | —            |       | —                  |       | —       |       | —                                |       | —            |       | —                |       | —                        |       | —            |       |   |   |
| Net  unrealized gains on investment securities available-for-sale  |       | —            |       | —                  |       | —       |       | —                                |       | 2,769             |       | —                |       | —                        |       | 2,769             |       | 2,769 |   |
| Treasury  stock transactions                                            |       | —            |       | —                  |       | (1,330       | )          | —                                |       | —            |       | 1,441                 |       | —                        |       | 111               |       | — |   |
| Stock  based Compensation                                               |       | —            |       | —                  |       | 147          |       | —                                |       | —            |       | —                |       | —                        |       | 147               |       | — |   |
| Stock  based Compensation Tax Benefit                                   |       | —            |       | —                  |       | (10          | )          | —                                |       | —            |       | —                |       | —                        |       | (10               | )          | — |   |
| Total  comprehensive loss (restated)                                    |       |              |       |                    |       |         |       |                                  |       |              |       |                  |       |                          |       |              |       | $ | 946 |   |
|                                                                    |       |              |       |                    |       |         |       |                                  |       |              |       |                  |       |                          |       |              |       |   |   |
| Balance  September 30, 2009 (restated)                             |       | 6,331,975         |       | $                       | 6,332      |         | $          | 23,515                                |       | $                 | 52,321     |                  | $          | (523                          | )          | $                 | (374       | ) | $ | 1,839 |   | $ | 83,110 |   |   |   |

 

The accompanying notes are an integral part of these statements.

 

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Tableof Contents

 

**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

**1.**            **SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES,AS RESTATED**

 

**Basis of presentation**

 

The foregoing unaudited financial statements havebeen prepared in accordance with accounting principles generally accepted inthe United States (“GAAP”) for interim financial information.  In the opinion of Management, all adjustments(consisting only of normal recurring adjustments) necessary for a fairpresentation of the financial position and the results of operations for theinterim period presented have been included. These interim financial statements should be read in conjunction withthe consolidated financial statements and footnotes thereto included in ourAnnual Report on Form 10-K for the year ended December 31, 2008 (our “2008Annual Report”).

 

The results of operations for the three and ninemonth periods ended September 30, 2009 are not necessarily indicative ofthe results to be expected for the full year. Information regarding risks and uncertainties that could cause actualresults to vary materially from our prior performance may be found inPart I, Item 1A of our 2008 Annual Report.

 

The consolidated financial statements include theaccounts of First Chester County Corporation (the “Corporation”) and FirstNational Bank of Chester County (the “Bank”). All material intercompany balances and transactions have been eliminatedin consolidation.

 

The Corporation completed its acquisition of American Home Bank (“AHB”)on December 31, 2008, and, accordingly, the December 31, 2008 and theSeptember 30, 2009 consolidated balance sheets reflect the addition ofassets acquired and liabilities assumed in this acquisition. The results ofoperations presented in the consolidated income statement for the three andnine months ended September 30, 2009 include the results of operationsfrom AHB.

 

Asa result of the acquisition of AHB’s operations, the Corporation reports thefollowing new lines in the income statement:

 

·                  Loan fees and other consist mainly of feesearned at the inception of a loan as well as fees earned on the servicing ofloan portfolios not owned by the Bank. Loan fees and other also includes gainsand losses on the Bank’s mortgage servicing rights.

 

·                  Net gain from mortgage banking activitiesconsists of unrealized gains and losses on interest rate lock commitments,loans held for sale, and forward sale commitments combined with realized gainsand losses on the actual sale of the loan and the settlement of forward salecommitments.

 

**Restatement of Previously Issued Financial Statements**

 

Duringthe preparation of our consolidated financial statements for the nine monthsended September 30, 2009, the Corporation determined that the allowancefor loan and lease losses (“ALLL”) was understated.  This has resulted in a material misstatementof net income(loss) as of and for the three and nine month periods ended September 30,2009.

 

Aspreviously disclosed, management identified a material weakness in theCorporation’s internal controls related to the design and implementation ofpolicies to promptly identify problem loans and to quantify the elements ofrisk in problem loans.  The weakness caused a failure to accuratelyidentify problem loans on a timely basis and a failure to accurately estimatethe risk in the portfolio.  This caused afailure to accurately determine the appropriate Allowance for Loan and LeaseLosses and the Provision for Loan and Lease Losses during the second quarterending June 30, 2009.  As a resultof a June 30, 2009 Allowance shortfall, amounts recorded as Provision forthe three months ended September 30, 2009 were reclassed to the three monthperiod ended June 30, 2009.  TheAllowance for Loan and Lease Losses and Provision for Loan and Lease Losseswere increased from amounts previously reported due to this weakness.

 

Inaddition, during the preparation of our consolidated financial for the yearended December 31, 2009, the Corporation identified an error in itsaccounting for the fair value adjustment to its loans held for sale portfolio,resulting in an adjustment to net income for the three and nine months ending September 30,2009 related to the Corporation’s process for establishing the fair value ofloans held for sale (primarily the residential loan portfolio).  The Corporation erroneously excluded from thepopulation to be valued, loans which were identified for sale to a third partybut for which the Corporation was awaiting the final approval and agreementfrom the counterparty to complete the transaction.  The 

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

Corporation’spolicy is to continue to record the loans in this portfolio-segment as loansheld for sale until the criteria for sale are met and to record loans held forsale at fair value.

 

Asa result of these errors, the Company’s Board of Directors, in consultationwith management and its Audit Committee, determined that the consolidatedfinancial statements contained in the Company’s Quarterly Report on Form 10-Qfor the quarter ended September 30, 2009 could no longer be relied upon.Accordingly, we have restated our unaudited consolidated financial statementsas of and for the three and nine month periods ended September 30, 2009 torecord the adjustments for the corrections of these errors.  As a result of the restatement, the followingfinancial statement line items were adjusted (dollars in thousands, except pershare amounts):

** **
| ** **                                                        | ** ** | **September 30, 2009** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                        | ** ** | **As Reported**             | ** ** | **Adjustment** | ** ** | **As Restated** | ** ** |
| **Statement of Financial  Condition**                             |       |                        |       |   |   |   |   |
| Assets                                                            |       |                        |       |   |   |   |   |
| Mortgage loans held for sale                                      |       | 187,521                     |       | 2,680 |   | 190,201 |   |
| Allowance for possible loan losses                                |       | (23,434                     | )          | (56 | ) | (23,490 | ) |
| Net loans and leases                                              |       | 934,068                     |       | (56 | ) | 934,012 |   |
| Net deferred tax asset                                            |       | 11,746                      |       | (892 | ) | 10,854 |   |
| Total Assets                                                      |       | 1,306,681                   |       | 1,732 |   | 1,308,413 |   |
|                                                              |       |                        |       |   |   |   |   |
| Liabilities and  Stockholders’ Equity                        |       |                        |       |   |   |   |   |
| Retained earnings                                                 |       | 50,589                      |       | 1,732 |   | 52,321 |   |
| Total First Chester County Corporation  Stockholders’ equity |       | 79,539                      |       | 1,732 |   | 81,271 |   |
| Total stockholders’ equity                                   |       | 81,378                      |       | 1,732 |   | 83,110 |   |
| Total liabilities and stockholders’ equity                   |       | 1,306,681                   |       | 1,732 |   | 1,308,413 |   |

 
| ** **                                                                               | ** ** | **Three Months Ended September  30, 2009** | ** ** | **Nine Months Ended September  30, 2009** | ** ** |
|------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                               | ** ** | **As  Reported**                           | ** ** | **Adjustment**                            | ** ** | **As  Restated** | ** ** | **As  Reported** | ** ** | **Adjustment** | ** ** | **As  Restated** | ** ** |
| **Statement of Operations**                                                              |       |                                       |       |                                      |       |   |   |   |   |   |   |   |   |
|                                                                                     |       |                                       |       |                                      |       |   |   |   |   |   |   |   |   |
| Provision for loan and lease losses                                                      |       | 14,678                                     |       | (3,456                                    | )          | 11,222 |   | 17,637 |   | 56 |   | 17,693 |   |
| Net interest income after provision for loan and  lease losses                           |       | (2,844                                     | )          | 3,456                                     |       | 612 |   | 16,046 |   | (56 | ) | 15,990 |   |
| Net gains from mortgage banking activities                                               |       | 10,231                                     |       | 1,504                                     |       | 11,735 |   | 34,492 |   | 2,680 |   | 37,172 |   |
| Total non-interest income                                                                |       | 12,038                                     |       | 1,504                                     |       | 13,542 |   | 44,273 |   | 2,680 |   | 46,953 |   |
| Loss before income taxes and cumulative effect of  change in accounting for income taxes |       | (14,183                                    | )          | 4,960                                     |       | (9,223 | ) | (6,520 | ) | 2,624 |   | (3,896 | ) |
| Income Taxes                                                                             |       | (4,960                                     | )          | 1,687                                     |       | (3,273 | ) | (2,965 | ) | 892 |   | (2,073 | ) |
| Net Loss                                                                                 |       | (9,223                                     | )          | 3,273                                     |       | (5,950 | ) | (3,555 | ) | 1,732 |   | (1,823 | ) |
| Net loss attributable to First Chester County  Corporation                               |       | (9,717                                     | )          | 3,273                                     |       | (6,444 | ) | (4,918 | ) | 1,732 |   | (3,186 | ) |
| Net (loss) income per share (Basic)                                                      |       | (1.54                                      | )          | 0.52                                      |       | (1.02 | ) | (0.78 | ) | 0.27 |   | (0.51 | ) |
| Net (loss) income per share (Diluted)                                                    |       | (1.54                                      | )          | 0.52                                      |       | (1.02 | ) | (0.78 | ) | 0.27 |   | (0.51 | ) |

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 
| ** **                                | ** ** | **Nine Months Ended September 30, 2009** | ** ** |
|-------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                | ** ** | **As Reported**                               | ** ** | **Adjustment** | ** ** | **As Restated** | ** ** |
| **Statement of Cash Flows**               |       |                                          |       |   |   |   |   |
|                                      |       |                                          |       |   |   |   |   |
| Net (loss) income                         |       | (4,918                                        | )          | 1,732 |   | (3,186 | ) |
| Provision for loan losses                 |       | 17,637                                        |       | 56 |   | 17,693 |   |
| Net gain from mortgage banking activities |       | (34,492                                       | )          | (2,680 | ) | (37,172 | ) |
| Increase in other assets (DTA)            |       | (16,432                                       | )          | 892 |   | (15,540 | ) |

 

**Recent accounting pronouncements**

 

In August 2009, theFASB issued Accounting Standards Update No. 2009-05, “MeasuringLiabilities at Fair Value” (“ASU 2009-5”). ASU 2009-5 provides amendments toSubtopic 820-10, “Fair Value Measurement and Disclosure — Overall” for the fairvalue measurement of liabilities. It provides clarification that incircumstances in which a quoted price in an active market for identicalliabilities is not available, a reporting entity is required to measure fairvalue using quoted prices of identical liabilities when traded as an asset,quoted prices for similar liabilities when traded as an asset, or othervaluation techniques that are consistent with the principles of Topic 820. ASU 2009-5is effective for interim reporting periods beginning after August 2009.Although we are still evaluating the impact that ASU 2009-5 will have, we donot expect that the guidance will have a material impact on our consolidatedfinancial statements.

 

In June 2009, the FASBissued Statement of Financial Accounting Standard No. 168, “The FASBAccounting Standards Codification and the hierarchy of Generally AcceptedAccounting Principles,” (“SFAS No. 168”). The standard, which replacesStatement No. 162, establishes the FASB**Accounting Standards Codification (ASC)which will become the source of authoritative U.S. generally acceptedaccounting principles recognized by the FASB. SFAS No. 168 is effectivefor interim and annual financial periods ending after September 15, 2009.We adopted the provisions of SFAS No. 168 for the three and nine monthsended September 2009. The adoption of this statement did not have amaterial effect on our consolidated financial statements.

 

In June 2009, the FASBissued Statement of Financial Accounting Standard No. 167, “Amendments toFASB Interpretation No. 46(R),” (“SFAS No. 167”). This Statementamends Interpretation 46(R) to replace the quantitative-based risks andrewards calculation for determining which enterprise, if any, has a controllingfinancial interest in a variable interest entity with an approach focused on,among other things, identifying which enterprise has the power to direct theactivities of a variable interest entity that most significantly impact the entity’seconomic performance. The statement also requires additional disclosures aboutan enterprise’s involvement in variable interest entities. SFAS No. 167has not been superseded by the FASB Accounting Standards Codification andtherefore is still authoritative. SFAS No. 167 is effective for interimand annual financial periods beginning after November 15, 2009. Althoughwe have not yet determined the impact that SFAS No. 167 will have, we donot expect that the statement will have a material impact on our consolidatedfinancial statements.

 

InJune 2009, the FASB issued Statement of Financial Accounting StandardNo. 166, “Accounting for Transfers of Financial Assets, an amendment ofFASB Statement No. 140,” (“SFAS No. 166”). This statement clarifiesexisting and establishes new requirements and objectives for transactions toqualify for “sale accounting” treatment. SFAS No. 166 has not beensuperseded by the FASB Accounting Standards Codification and therefore is stillauthoritative. SFAS No. 166 is effective for interim and annual financialperiods beginning after November 15, 2009. Although we have not yetdetermined the impact that SFAS No. 166 will have, we do not expect thatthe statement will have a material impact on our consolidated financial statements.

 

InMay 2009, the FASB issued guidance on accounting and disclosure forsubsequent events. This guidance has been incorporated into the FASBCodification under accounting standard codification (“ASC”) 855 — “SubsequentEvents.” ASC 855 establishes general standards of accounting for and disclosureof events that occur after the balance sheet date but before financialstatements are issued or are available to be issued. The guidance under ASC 855is effective for interim or annual financial periods ending after June 15,2009. We adopted the provisions of ASC 855 in June 2009. The adoption ofthis guidance did not have a material effect on our consolidated financialstatements. We added the subsequent events disclosure that is required by thisstatement to our consolidated financial statements.

 

InApril 2009, the FASB issued guidance on other-than temporary impairmentfor investment securities.  This guidancehas been incorporated into the FASB Codification under ASC 320-10 — “Investments— Debts and Equity Securities.”

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

ASC320-10 amends the other-than-temporary impairment guidance for investments andchanges some of the investment financial statement disclosure requirements. ASC320-10 is effective for interim reporting periods ending after June 15,2009. We adopted the other-than temporary impairment guidance of ASC 320-10 inJune 2009. The adoption of this guidance did not have a material effect onour consolidated financial statements. In accordance with the requirements ofASC 320-10 we analyzed the other than temporary impairment charge that theCorporation took in the third quarter of 2008 and concluded that the chargetaken was entirely due to an other than temporary credit loss as opposed toother factors. Accordingly, no adjustment was made to the other than temporarycharge taken in the third quarter of 2008.  We added the investmentdisclosures that are required by this guidance to Footnote 3 of theseconsolidated financial statements.

 

InApril 2009, the FASB issued guidance on interim disclosure about the fairvalue of financial instruments. This guidance was incorporated into the FASBCodification under ASC 825-10 — “Financial Instruments.” The guidance expandsdisclosures for fair value of financial instruments by requiring certain fairvalue disclosures for interim periods that were previously only requiredannually. The interim fair value disclosure requirements of ASC 825-10 areeffective for interim reporting periods ending after June 15, 2009. Weadopted the interim reporting requirements of ASC 825-10 in June 2009. Theadoption of this statement did not have a material effect on our consolidatedfinancial statements. We added the required fair market value disclosure thatis required by this statement to Footnote 10 of these consolidated financialstatements.

 

InApril 2009, the FASB issued guidance on determining fair value when thevolume and level of activity for an asset or liability have significantlydecreased as well as guidance on identifying transactions that are not orderly.This new guidance was incorporated into the FASB Codification under ASC 820-10— “Fair Value Measurements and Disclosures” and provides guidance for estimating fair value in accordancewith previously existing fair value guidance when the volume and level ofactivity for the asset or liability have significantly decreased.  ASC 820-10 also includes guidance onidentifying circumstances that indicate a transaction is not orderly. The newguidance is effective for interim and annual reporting periods ending afterJune 15, 2009. We adopted the new guidance of ASC 820-10 inJune 2009.  The adoption of this guidance did not have amaterial impact on our consolidated financial statements.

 

InJanuary 2009, the FASB issued amendments to previously issued impairmentguidance on purchased beneficial interests and beneficial interests thatcontinue to be held by a transferor in securitized financial assets. The newguidance was incorporated into the FASB Codification under ASC 325-40 — “BeneficialInterests in Securitized Financial Assets.” The purpose of this guidance was toachieve a more consistent evaluation of whether there is an OTTI for the debtsecurities under the scope of debt securities that fall within the scope of ASC325-40 and the debt securities not within the scope of ASC 325-40 that wouldfall under the scope of 320-10, “Investments in Debt and Equity Securities.”The guidance is effective for interim and annual reporting periods ending afterDecember 15, 2008. We adopted the new provisions of ASC 325-40 as of January 1,2009. The adoption of this guidance did not have an impact on our consolidatedfinancial statements.

 

InSeptember 2008, the FASB issued guidance that amended previously issuedguidance concerning derivatives and hedging activities as well as disclosurerequirements for guarantees. This new guidance was incorporated into the FASBCodification under ASC 850-10 — “Derivatives and Hedging” and requiresdisclosures by sellers of credit derivatives, including credit derivativesembedded in a hybrid instrument. The guidance also requires an additionaldisclosure about the current status of the payment/performance risk of aguarantee.  The new guidance is effective for annual or interimreporting periods ending after November 15, 2008. We adopted the new provisionsof ASC 850-10 as of January 1, 2009. The adoption of this guidance did nothave an impact on our consolidated financial statements.

 

In June 2008, the FASB issued guidance on determining whether instruments granted inshare-based payment transactions are participating securities. This newguidance was incorporated into the FASB Codification under ASC 260-10 — “EarningsPer Share” and addressed whether instruments granted in share-based paymenttransactions are participating securities prior to vesting and, therefore, needto be included in the calculation of earnings per share (EPS). The new guidance of ASC 260-10 iseffective for financial statements issued for fiscal years beginning afterDecember 15, 2008 with prior period EPS data adjusted retrospectively toconform to its provisions. The adoption of this guidance did not have amaterial impact on our consolidated financial statements.

 

InMarch 2008, the FASB issued new requirements for disclosures about derivative instruments and hedging activities.This new guidance was incorporated into the FASB Codification under ASC 815-10— “Derivatives and Hedging” and amends the disclosure requirements forderivative instruments and hedging activities. The new disclosure requirements

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

areeffective for financial statements issued for fiscal years and interim periodsbeginning after November 15, 2008. The adoption of these requirements did not have a material impact on ourconsolidated financial statements.

 

InFebruary 2008, the FASB amended previously issued accounting guidance fornew fair value requirements by delaying the effective date of new accountingguidance issued under FAS 157 for all nonfinancial assets and nonfinancialliabilities, except those that are recognized or disclosed at fair value on a recurringbasis (at least annually) to fiscal years beginning after November 15,2008, and interim periods within those fiscal years. FAS 157 wassuperseded by FASB Codification ASC 820-10. The adoption of this guidance didnot have a material impact on our consolidated financial statements.

 

InDecember 2007, the FASB issued new guidance on accounting for businesscombinations that replaced SFAS 141, “Business Combinations.”  The new guidance was incorporated into theFASB Codification under ASC 805 — “Business Combinations” and retains thefundamental requirements of SFAS 141 that the acquisition method of accounting(which SFAS 141 called the “purchase method”) be used for all businesscombinations and for an acquirer to be identified for each business combination.  This guidance also establishes principles andrequirements for how the acquirer: a) recognizes and measures in its financialstatements the identifiable assets acquired, the liabilities assumed, and any noncontrollinginterest in the acquiree; b) recognizes and measures the goodwill acquired inthe business combination or a gain from a bargain purchase and c) determineswhat information to disclose to enable users of the financial statements toevaluate the nature and financial effects of the business combination. The newguidance will apply prospectively to business combinations for which theacquisition date is on or after the first annual reporting period beginning onor after December 15, 2008.  Weadopted the provisions of ASC 805 as of January 1, 2009. The adoption ofFASB ASC 805 did not have a material impact on our consolidated financialstatements.

 

In December 2007, the FASB issued new guidanceon accounting and presenting non-controlling interests in consolidatedfinancial statements. The new guidance was incorporated in the FASBCodification under ASC 810-10 — “Consolidation” and amends previously existingguidance by establishing accounting and reporting standards for thenoncontrolling (minority) interest in a subsidiary and for the deconsolidationof a subsidiary.  It clarifies that anoncontrolling interest in a subsidiary is an ownership interest in theconsolidated entity that should be reported as equity in the consolidatedfinancial statements.  The new guidanceis effective for fiscal years beginning on or after December 15, 2008. Weadopted the new provisions of ASC 810-10 on January 1, 2009 andaccordingly, changed the way in which we report minority interest in ourbalance sheet and income statement. We now include minority interest in theequity section of the balance sheet and present net income attributable tonon-controlling interests above net income in the income statement.

 

**2.**            **ACQUISITION**

 

OnDecember 31, 2008, the Corporation completed its acquisition of AHB. Thisacquisition was intended to diversify the Bank’s products, services, andsources of income as well as to expand the Bank’s geographic footprint. As aresult of the merger, each outstanding share of AHB common stock was convertedinto the right to receive either $11.00 in cash or 0.70 shares of FCCC commonstock, plus cash in lieu of fractional shares. Pursuant to the allocationprocedures set forth in the Merger Agreement, 1,052,160 shares of First ChesterCounty Corporation (“FCCC”) common stock were issuable to the holders of 90% ofAHB’s outstanding common stock and $1.8 million was payable to the holders of10% of AHB’s outstanding common stock. In addition, pursuant to the terms ofthe Merger Agreement, each AHB option to purchase shares of AHB common stock atthe effective time of the Merger converted into an option to purchase suchnumber of shares of FCCC common stock equal to the number of shares of the AHBoption multiplied by 0.7000, rounded down to the nearest whole share, at anexercise price equal to the exercise price of the AHB option at the effectivetime of the Merger divided by 0.7000, rounded up to the nearest whole cent.Each outstanding AHB warrant at the effective time of the Merger was cancelledand converted into the right to receive cash in the amount equal to thedifference between the AHB warrant strike price and $11.00.

 

TheAHB merger was accounted for under the purchase method of accounting inaccordance with SFAS No. 141, “Business Combinations.”  The purchase price has been allocated to theassets acquired and the liabilities assumed based on their estimated fairvalues at the merger date. In accordance with SFAS No. 141, certaindeal costs and other cash paid are capitalized as part of the total purchaseprice. Goodwill resulted from the acquisition.

 

Duringthe nine months ended September 30, 2009 the goodwill from the AHBacquisition was adjusted to reflect adjustments to the purchase priceallocation. The following shows the prior and current balance of goodwill:

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

(Dollarsin thousands)

 
| ** **                           | ** ** | **Goodwill  Balance** | ** ** |
|--------------------------------------|------------|-----------------------|------------|
|                                 |       |                  |       |
| December 31, 2008               |       | $                     | 5,906      |   |
|                                 |       |                  |       |
| Adjustment to consideration paid (A) |       | 1,600                 |       |
|                                 |       |                  |       |
| Other adjustments (B)                |       | 573                   |       |
|                                 |       |                  |       |
| September 30, 2009              |       | $                     | 8,079      |   |

 

----

(A)           During the first quarter of2009, the Corporation recorded a $1.6 million purchase accounting adjustmentrelated to additional consideration identified for the acquisition. This amountrelates to the lump sum payments to former executive officers of AHB inconnection with the finalization of the AHB Management Incentive Plan (asdescribed in the Corporation’s Current Report on Form 8-K filed onMay 5, 2009). The full amount of this additional consideration wasallocated to goodwill.

 

(B)             Other adjustments relate toamounts recorded in the second quarter of 2009 to updated acquisition datevaluation estimates of certain assets and liabilities including other realestate owned, deferred rent, expense accruals and deferred tax assets.

 

**3.**            **INVESTMENTSECURITIES**

 

The Corporation’s investmentportfolio consists of the following categories of securities:

 

·                  US Treasury - Consists of debt securitiesissued by the US Government.

 

·                  US Government Agency Notes - Consists of debtinstruments issued by US Government agencies such as the Federal Home Loan Bankand Freddie Mac.

 

·                  US Government Agency Mortgage BackedSecurities - Consists of residential mortgage pass-through securities andcollateralized mortgage obligations “CMOs” issued by US government agenciessuch as GNMA, FNMA and Freddie Mac. The GNMA pass-through securities or theunderlying GNMA securities backing the CMOs are guaranteed by the USGovernment, while the FNMA and Freddie Mac pass-through securities or theunderlying FNMA and Freddie Mac securities backing the CMOs are guaranteed bythe respective US Government agency.

 

·                  Collateralized Mortgage Obligations -Residential — Consists of private label CMOs backed by non-government agencyresidential mortgage pools.

 

·                  Collateralized Mortgage Obligations -Commercial — Consists of private label CMOs backed by non-government agencycommercial mortgage pools.

 

·                  State and Municipal— Consists of securitiesissued by state, city or local governments.

 

·                  Corporate Debt Securities — Consists ofcorporate debt securities.

 

·                  Bank equity securities — Consists of equitysecurities of banks, bank holding companies or bank trust preferred securities.

 

·                  Other Equity Securities — Consists primarilyof equity securities of the Federal Reserve and the Federal Home Loan Bank.

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

The amortized cost, grossunrealized gains and losses, and fair market value of the Corporation’savailable-for-sale securities at September 30, 2009 and December 31,2008 are summarized as follows:

 

(Dollarsin thousands)

 
| ** **                                        | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|------------|------------|
| ** **                                        | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair**   | ** ** |
| **As of  September 30, 2009**                | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Value**  | ** ** |
|                                              |       |          |       |           |       |           |       |       |       |
| US Treasury                                       |       | $             | 5,004      |           | $          | 17             |       | $          | —     |   | $ | 5,021 |   |
| US Government agency notes                        |       | 6,372         |       | 11             |       | (7             | )          | 6,376      |       |
| US Government agency mortgage-backed securities   |       | 47,780        |       | 1,561          |       | —         |       | 49,341     |       |
| Collateralized mortgage obligations - Residential |       | 1,340         |       | 1              |       | (252           | )          | 1,089      |       |
| Collateralized mortgage obligations - Commercial  |       | 1,004         |       | —         |       | (411           | )          | 593        |       |
| State and municipal                               |       | 5,840         |       | 56             |       | —         |       | 5,896      |       |
| Corporate debt securities                         |       | 11,212        |       | —         |       | (1,791         | )          | 9,421      |       |
| Bank equity securities                            |       | 1,210         |       | 50             |       | (27            | )          | 1,233      |       |
| Other equity securities                           |       | 10,896        |       | —         |       | —         |       | 10,896     |       |
|                                              |       | $             | 90,658     |           | $          | 1,696          |       | $          | (2,488     | ) | $ | 89,866 |   |

 

(Dollarsin thousands)

 
| ** **                                        | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|------------|------------|
| ** **                                        | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair**   | ** ** |
| **As of  December 31, 2008**                 | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Value**  | ** ** |
|                                              |       |          |       |           |       |           |       |       |       |
| US Government agency notes                        |       | $             | 8,300      |           | $          | 134            |       | $          | —     |   | $ | 8,434 |   |
| US Government agency mortgage-backed securities   |       | 56,033        |       | 984            |       | (102           | )          | 56,915     |       |
| Collateralized mortgage obligations - Residential |       | 1,630         |       | —         |       | (426           | )          | 1,204      |       |
| Collateralized mortgage obligations - Commercial  |       | 1,004         |       | —         |       | (594           | )          | 410        |       |
| State and municipal                               |       | 10,327        |       | 74             |       | —         |       | 10,401     |       |
| Corporate debt securities                         |       | 28,455        |       | —         |       | (4,052         | )          | 24,403     |       |
| Bank equity securities                            |       | 2,811         |       | 50             |       | (892           | )          | 1,969      |       |
| Other equity securities                           |       | 10,848        |       | —         |       | —         |       | 10,848     |       |
|                                              |       | $             | 119,408    |           | $          | 1,242          |       | $          | (6,066     | ) | $ | 114,584 |   |

 

The amortized cost and estimated fair value of debt securitiesclassified as available-for-sale at September 30, 2009, by contractualmaturity, are shown in the following table. Expected maturities will differ from contractual maturities because borrowersmay have the right to call or prepay obligations with or without call orprepayment penalties.

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

(Dollarsin thousands)

 
| ** **                              | ** ** | **Amortized** | ** ** | **Fair**  | ** ** |
|-----------------------------------------|------------|---------------|------------|-----------|------------|
| ** **                              | ** ** | **Cost**      | ** ** | **Value** | ** ** |
| Due in one year or less                 |       | $             | 1,075      |      | $          | 1,081 |   |
| Due after one year through five years   |       | 18,491        |       | 17,276    |       |
| Due after five years through ten years  |       | 7,872         |       | 7,776     |       |
| Due after ten years                     |       | 990           |       | 581       |       |
|                                    |       | 28,428        |       | 26,714    |       |
| Mortgage-backed securities and CMOs     |       | 50,124        |       | 51,023    |       |
| Bank equity and other equity securities |       | 12,106        |       | 12,129    |       |
|                                    |       | $             | 90,658     |      | $          | 89,866 |   |

 

Proceedsfrom the sale of investment securities available for sale for the three andnine months ended September 30, 2009 were $33.6 million and $866,000,respectively. Proceeds from the sale of investment securities available forsale for the three and nine months ended September 30, 2008 were $8.2million and $21.4 million, respectively. Gross gains from the sale of investment securities for the three andnine month periods ended September 30, 2009 were $1,000 and $392,000,respectively.  Gross losses for the sameperiod in 2009 were $0 and $391,000, respectively.  Gross gains from the sales of investmentsecurities for the three and nine month periods ended September 30, 2008were $89,000 and $370,000, respectively. Gross losses for the same period were $0 and $97,000, respectively.  These securities were sold at fair valueswhich approximated the Corporation’s amortized cost.  The Corporation uses the specificidentification method to determine the cost of the securities sold. Theprincipal amount of investment securities pledged to secure public deposits andfor other purposes required or permitted by law was $77.7 million atSeptember 30, 2009 and $89.0 million at December 31, 2008. There wereno securities held from a single issuer that represented more than 10% ofstockholders’ equity.

 

The table below indicatesthe length of time individual securities have been in a continuous unrealizedloss position at September 30, 2009.

 

(Dollars in thousands)

 
| ** **                                             | ** ** | **Less than 12 months** | ** ** | **12 months or longer** | ** ** | **Total**      | ** ** |
|--------------------------------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|----------------|------------|
| **Description of**                                | ** ** | **Number of**                     | ** ** | **Fair**                               | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| **Securities**                                         | ** ** | **Securities**                         | ** ** | **Value**                              | ** ** | **Losses**     | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
| US Government agency notes                             |       | 1                                      |       | $                                      | 2,307      |           | $          | (7 | ) | $ | — |   | $ | — |   | $ | 2,307 |   | $ | (7 | ) |
|                                                   |       |                                   |       |                                   |       |           |       |   |   |   |   |   |   |   |   |
| Collateralized mortgage obligations — Residential |       | 3                                      |       | 7                                      |       | —         |       | 765 |   | (252 | ) | 772 |   | (252 | ) |
| Collateralized mortgage obligations — Commercial  |       | 1                                      |       | —                                 |       | —         |       | 593 |   | (411 | ) | 593 |   | (411 | ) |
|                                                   |       |                                   |       |                                   |       |           |       |   |   |   |   |   |   |   |   |
| Corporate debt securities                              |       | 8                                      |       | —                                 |       | —         |       | 9,421 |   | (1,791 | ) | 9,421 |   | (1,791 | ) |
|                                                   |       |                                   |       |                                   |       |           |       |   |   |   |   |   |   |   |   |
| Bank equity securities                                 |       | 2                                      |       | 3                                      |       | (1             | )          | 225 |   | (26 | ) | 228 |   | (27 | ) |
|                                                   |       |                                   |       |                                   |       |           |       |   |   |   |   |   |   |   |   |
| Total temporarily impaired investment securities       |       | 15                                     |       | $                                      | 2,317      |           | $          | (8 | ) | $ | 11,004 |   | $ | (2,480 | ) | $ | 13,321 |   | $ | (2,488 | ) |

 

The table below indicates the length of time individual securities havebeen in a continuous unrealized loss position at December 31, 2008.

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

(Dollars in thousands)

 
| ** **                                             | ** ** | **Less than 12 months** | ** ** | **12 months or longer** | ** ** | **Total**      | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|----------------|------------|
| **Description  of**                                    | ** ** | **Number of**           | ** ** | **Fair**                | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| **Securities**                                         | ** ** | **Securities**          | ** ** | **Value**               | ** ** | **Losses**     | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
| US Government agency mortgage-backed securities        |       | 6                       |       | $                       | 6,253      |           | $          | (100 | ) | $ | 536 |   | $ | (2 | ) | $ | 6,789 |   | $ | (102 | ) |
|                                                   |       |                    |       |                    |       |           |       |   |   |   |   |   |   |   |   |
| Collateralized mortgage obligations — Residential |       | 3                       |       | 429                     |       | (402           | )          | 767 |   | (24 | ) | 1,196 |   | (426 | ) |
| Collateralized mortgage obligations — Commercial  |       | 1                       |       | —                  |       | —         |       | 409 |   | (594 | ) | 409 |   | (594 | ) |
|                                                   |       |                    |       |                    |       |           |       |   |   |   |   |   |   |   |   |
| Corporate debt securities                              |       | 21                      |       | 17,176                  |       | (1,575         | )          | 7,227 |   | (2,477 | ) | 24,403 |   | (4,052 | ) |
|                                                   |       |                    |       |                    |       |           |       |   |   |   |   |   |   |   |   |
| Bank equity securities                                 |       | 5                       |       | —                  |       | —         |       | 1,620 |   | (892 | ) | 1,620 |   | (892 | ) |
|                                                   |       |                    |       |                    |       |           |       |   |   |   |   |   |   |   |   |
| Total temporarily impaired  investment securities |       | 36                      |       | $                       | 23,858     |           | $          | (2,077 | ) | $ | 10,559 |   | $ | (3,989 | ) | $ | 34,417 |   | $ | (6,066 | ) |

 

**Other than Temporary Impairment**

 

Managementrecorded a $1.6 million charge to earnings in the third quarter of 2009 for another than temporary impairment  (“OTTI”)on four bank equity securities held in the Corporation’s available for saleinvestment portfolio. The 2008 consolidated statement of income included an$850,000 non-cash pretax other than temporary impairment loss on a $1.0 millionLehman Brothers note held in the Bank’s available for sale investmentportfolio. This security has since matured and the remaining $150,000 carryingvalue is carried as a receivable in the Corporation’s Other Asset line of theBalance Sheet.  Management believes thatthere are no additional securities that were other than temporarily impaired asof September 30, 2009 and December 31, 2008.

 

Managementuses a multi-factor approach to determine whether a security is other thantemporarily impaired. This approach is applied to each individual security. Theapproach incorporates ideas and concepts outlined in relevant accountingguidance and include such factors as:

 

·                  The length of time and the extent to whichthe market value has been less than cost;

·                  The financial condition of the securityissuer as well as near and long-term prospect for the issuer;

·                  The rating of the security;

·                  Historic volatility and movement in the fairmarket value of the security; and

·                  Adverse conditions relative to the security,issue or industry.

 

Managementalso consults with an outside investment advisor in addressing whethersecurities in a loss position are other than temporarily impaired. Specificconclusions for each category of securities with an unrealized loss positionare summarized below:

 

*Collateralized MortgageObligations (“CMO”) — Residential and Commercial*

 

There are a total of fourprivate label CMO securities that had unrealized loss positions atSeptember 30, 2009. Three of the securities had a AAA rating from S&Pand one had an AA rating from S&P. All contractual cash flows have beenreceived on these securities. All of these issuances have subordinated tranchessupporting principal. In addition, we conducted due diligence of publiclyavailable information regarding these securities and no material informationcame to our attention that would indicate an inability to recover our basis inthese securities. The depreciation on two of the securities accounted for 99%of the total depreciation within this category. For these securities, wereviewed and considered information about the underlying collateral as well asloss and prepayment stress test information performed by professionalinvestment advisors. This information indicated likelihood that subordinatetranches of the CMO provide sufficient protection to the Bank’s senior tranchessuch that management can conclude that the probability of suffering a principalloss is unlikely. Because the Company does not intend to sell these securitiesand it is more likely than not that the Company will not be required to sellthe securities before recovery of its amortized cost basis, which may bematurity, it does not consider these investments to beother-than-temporarily impaired at September 30, 2009.

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

*Corporate Debt Securities*

 

There are a total of eightsecurities in this category that had unrealized loss positions atSeptember 30, 2009. All of these securities are obligations of well-known,established companies or subsidiaries thereof. All contractual cash flows havebeen received on these securities. Depreciation on six of the securitiesaccounted for 98% of the total depreciation in this category. For these sixsecurities Management reviewed rating agency information and noted that five ofthe six securities had investment grade ratings from Moody’s. We reviewedcurrent news and filings as well as the length and duration of the depreciationand concluded that there was no information that would indicate a going concernor other issue that would impair our ability to recover our cost basis.Management performed additional analysis on the security that was notinvestment grade, which included reviewing analysis from our third partyinvestment advisor as well as current news and filings. The conclusion drawnfrom this information was that there was no information that indicated a goingconcern or other issue that would impair our ability to recover our cost basis.Because the Corporation does not intend to sell these securities and it is notmore likely than not that the Corporation will be required to sell thesecurities before recovery of its amortized cost basis, it does not considerthese investments to be other-than-temporarily impaired atSeptember 30, 2009.

 

*Bank Equity Securities*

 

The Corporation recorded a$1.6 million other than temporary impairment charge on four securities in thiscategory in the third quarter of 2009. The securities are publically tradedstock of well-known, established bank holding companies. During the quarter,Management concluded that the impairment on the securities is other thantemporary mainly due to continued deterioration of the financial condition ofthese companies and Management’s conclusion that the Corporation may no longerhave the intent to hold these securities until anticipated recovery. The $1.6million loss is presented on the Asset impairment line of the income statement.

 

**4.**            **LOANSAND LEASES, AS RESTATED**

 

Thefollowing charts present information about major loan classifications as wellas impaired loans and lease balances as of September 30, 2009 andDecember 31, 2008:

 

September 30, 2009

 
| **(Dollars  in thousands)**                 | ** ** | **Loan  Balance** | ** ** | **Impaired  Loan  Balance** | ** ** | **Number of  Impaired  Loans** | ** ** | **Specific  Allowance  on  Impaired  Loans** | ** ** |
|---------------------------------------------|------------|-------------------|------------|-----------------------------|------------|--------------------------------|------------|----------------------------------------------|------------|
| ** **                                  | ** ** | ** **        | ** ** | **(Restated)**              | ** ** | **(Restated)**                 | ** ** | **(Restated)**                               | ** ** |
| Commercial loans                            |       | $                 | 346,174    |                        | $          | 18,356                         |       | 28                                           |       | $ | 2,957 |   |
| Real estate — commercial               |       | 298,495           |       | 9,673                       |       | 9                              |       | 4,298                                        |       |
| Real estate — commercial construction  |       | 66,255            |       | 2,300                       |       | 2                              |       | 85                                           |       |
| Real estate — residential              |       | 79,793            |       | 1,004                       |       | 3                              |       | 250                                          |       |
| Real estate — residential construction |       | 40,604            |       | 4,086                       |       | 12                             |       | 1,725                                        |       |
| Consumer loans                              |       | 123,447           |       | 1,542                       |       | 28                             |       | 283                                          |       |
| Lease financing receivables                 |       | 2,734             |       | 350                         |       | 6                              |       | 119                                          |       |
|                                        |       |              |       |                        |       |                           |       |                                         |       |
| Totals                                      |       | $                 | 957,502    |                        | $          | 37,311                         |       | 88                                           |       | $ | 9,717 |   |

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

December 31, 2008

 
| ** **                                  | ** ** | ** **  | ** ** | ** **   | ** ** | ** **    | ** ** | **Specific**  | ** ** |
|---------------------------------------------|------------|-------------|------------|--------------|------------|---------------|------------|---------------|------------|
| ** **                                  | ** ** | ** **  | ** ** | ** **   | ** ** | ** **    | ** ** | **Allowance** | ** ** |
| ** **                                  | ** ** | ** **  | ** ** | **Impaired** | ** ** | **Number of** | ** ** | **on**        | ** ** |
| ** **                                  | ** ** | **Loan**    | ** ** | **Loan**     | ** ** | **Impaired**  | ** ** | **Impaired**  | ** ** |
| **(Dollars  in thousands)**                 | ** ** | **Balance** | ** ** | **Balance**  | ** ** | **Loans**     | ** ** | **Loans**     | ** ** |
|                                        |       |        |       |         |       |          |       |          |       |
| Commercial loans                            |       | $           | 327,472    |         | $          | 3,632         |       | 20            |       | $ | 285 |   |
| Real estate — commercial               |       | 280,549     |       | 1,650        |       | 2             |       | 126           |       |
| Real estate — commercial construction  |       | 69,057      |       | —       |       | —        |       | —        |       |
| Real estate — residential              |       | 87,413      |       | 3,876        |       | 13            |       | 350           |       |
| Real estate — residential construction |       | 45,466      |       | —       |       | —        |       | —        |       |
| Consumer loans                              |       | 125,318     |       | 1,166        |       | 30            |       | 95            |       |
| Lease financing receivables                 |       | 4,808       |       | 190          |       | 4             |       | —        |       |
|                                        |       |        |       |         |       |          |       |          |       |
| Totals                                      |       | $           | 940,083    |         | $          | 10,514        |       | 69            |       | $ | 856 |   |

 

The following chart presentschanges in the allowance for loan and lease losses for the nine months endedSeptember 30, 2009 and 2008:

 
| ** **                              | ** ** | **Nine Months Ended**  | ** ** |
|-----------------------------------------|------------|------------------------|------------|
| ** **                              | ** ** | **September 30,** | ** ** |
| **(Dollars  in thousands)**             | ** ** | **2009  (Restated)**   | ** ** | **2008** | ** ** |
| Balance at beginning of year            |       | $                      | 10,335     |   | $ | 7,817 |   |
| Provision charged to operating expenses |       | 17,693                 |       | 950 |   |
| Recoveries                              |       | 339                    |       | 233 |   |
| Loans charged-off                       |       | (4,549                 | )          | (423 | ) |
| Allowance adjustment — Other       |       | (328                   | )          | 60 |   |
| Balance at end of year                  |       | $                      | 23,490     |   | $ | 8,637 |   |

 

**5.**            **OTHERREAL ESTATE OWNED**

 

Other real estate owned (“OREO”) represents property owned by the Bankfollowing default by the borrowers. OREO property acquired through foreclosureis initially transferred at fair value based on an appraised value lessestimated cost to dispose. Adjustments are subsequently made to mark theproperty below this amount if circumstances warrant.  Losses arising from foreclosure transactionsare charged against the allowance for loan losses. Costs to maintain realestate owned and any subsequent gains or losses are included in the Corporation’sresults of operations. The following table summarizes properties held asOREO as of September 30, 2009 and December 31, 2008:

 

(Dollarsin thousands)

 
| ** **                | ** ** | **September 30,  2009** | ** ** | **Number  of  properties** | ** ** | **December 31,  2008** | ** ** | **Number  of  properties** | ** ** |
|---------------------------|------------|------------------------------|------------|----------------------------|------------|-----------------------------|------------|----------------------------|------------|
| Land                      |       | $                            | 50         |                       | 1          |                        | $          | —                     |       | — |   |
| Residential  Construction |       | 280                          |       | 1                          |       | —                      |       | —                     |       |
| Residential  1-4 family   |       | 2,732                        |       | 10                         |       | 1,872                       |       | 9                          |       |
| Total                     |       | $                            | 3,062      |                       | 12         |                        | $          | 1,872                      |       | 9 |   |

 

**6.**            **BORROWINGS**

 

InApril 2009, the Corporation completed the placement of $5,175,000aggregate liquidation amount of fixed rate trust preferred securities (the “TrustPreferred Securities”), through a newly formed subsidiary, First Chester CountyCapital Trust IV, a wholly owned Delaware statutory trust (the “Trust”). Inconnection with the sale of the Trust Preferred

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

Securities,the Corporation issued $5,330,000 of junior subordinated deferrable interestdebentures (the “Debentures”) to the Trust. The Trust Preferred Securities andthe Debentures have a 30 year maturity, and carry a fixed rate of interest of 12%.The Corporation has retained the right to redeem the Trust Preferred Securitiesat par (plus accrued but unpaid interest) on any interest payment date on orafter April 28, 2014.

 

During2009, the Bank began borrowing from the Federal Reserve. The balance of theseovernight borrowings was $51.7 million at September 30, 2009, compared to$0 at December 31, 2008. The rate paid on these borrowings is 0.50%.

 

**7.**            **DERIVATIVEINSTRUMENTS**

 

TheBank, as part of its mortgage banking activities, originates fixed-rate 1-4unit residential loans for sale in the secondary market.  At the time of origination, Managementidentifies loans that are expected to be sold in the near future.  These warehoused loans have been classifiedas mortgage loans held for sale in the consolidated balance sheet.  These loans expose the Bank to variability intheir fair value due to changes in interest rates.  If interest rates increase, the value of theloans decreases.  Conversely, if interestrates decrease, the value of the loans increases.

 

TheBank enters into rate lock commitments to extend credit to borrowers at aspecified interest rate upon the ultimate funding of the loan.  These rate lock commitments are generally 30days for a permanent loan and can range up to 360 days for a constructionloan.  Unfunded loans for whichcommitments have been entered into are called “pipeline loans.”  Some of these rate lock commitments willultimately expire without being completed. To the extent that a loan is ultimately granted and the borrowerultimately accepts the terms of the loan, these rate lock commitments exposethe Bank to variability in their fair value due to changes in interestrates.  If interest rates increase, thevalue of these rate lock commitments decreases. Conversely, if interest rates decrease, the value of these rate lockcommitments increases.

 

Loancommitments relate to the origination of mortgage loans that will be held forsale and are accounted for as derivative instruments.  Such commitments are recorded at fair valueas derivative assets or liabilities, with changes in fair value recorded in theNet gain from mortgage activities line of the income statement.

 

Tomitigate the effect of this interest rate risk on both the held for sale loansand interest rate lock commitments, the Bank enters into offsetting derivativecontracts, primarily forward loan sale commitments. These forward salescommitments lock in the price for the sale of specific loans or loans to befunded under specific interest rate lock commitments or for a generic group ofloans with similar characteristics. Mandatory forward sales commitments are agreements to sell a certainnotional amount of loans at a specified future time period at a specifiedprice.  The Bank incurs a penalty forfailure to follow through with the commitment. Best efforts forward sales commitments also result in direct or indirectfinancial penalties for failure to follow through if the related loans close.  The fair value of forward loan salescommitments that hedge warehouse loans and interest rate lock commitments, aswell as interest rate lock commitments themselves, are summarized as follows atSeptember 30, 2009.  The fair valuesof all of these items are recorded on the balance sheet within other assets andother liabilities as these items are financial derivatives.

 

Althoughthe purpose of these derivative instruments is to economically hedge certainrisks, there are no hedge designations under FASB ASC 815-10 (“StatementNo. 133”).

 

Thefair value of derivative instruments not designated as hedging instrumentsunder FASB ASC 815-10 at September 30, 2009 are presented in the followingtable:

 
| ** **                          | ** ** | **Asset Derivatives** | ** ** | **Liability Derivatives** | ** ** |
|-------------------------------------|------------|-----------------------|------------|---------------------------|------------|
| ** **                          | ** ** | **Balance**           | ** ** | ** **                | ** ** | ** ** | ** ** | **Balance** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                          | ** ** | **Sheet**             | ** ** | **Fair**                  | ** ** | **Notional** | ** ** | **Sheet** | ** ** | **Fair** | ** ** | **Notional** | ** ** |
| **(Dollars  in thousands)**         | ** ** | **Location**          | ** ** | **Value**                 | ** ** | **Value** | ** ** | **Location** | ** ** | **Value** | ** ** | **Value** | ** ** |
|                                |       |                  |       |                      |       |   |   |   |   |   |   |   |   |
| Mandatory forward sales commitments |       | Other assets          |       | $                         | —     |   | $ | — |   | Other Liabilities |   | $ | 903 |   | $ | 52,250 |   |
| Interest rate lock commitments      |       | Other assets          |       | 2,411                     |       | 126,598 |   | Other Liabilities |   | — |   | — |   |
|                                     |            |                       |            |                           |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

Thefair value of derivative instruments not designated as hedging instrumentsunder FASB ASC 815-10 at December 31, 2008 are presented in the followingtable:

 
| ** **                             | ** ** | **Asset Derivatives** | ** ** | **Liability Derivatives** | ** ** |
|----------------------------------------|------------|-----------------------|------------|---------------------------|------------|
| ** **                             | ** ** | **Balance**           | ** ** | ** **                | ** ** | ** ** | ** ** | **Balance** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Sheet**             | ** ** | **Fair**                  | ** ** | **Notional** | ** ** | **Sheet** | ** ** | **Fair** | ** ** | **Notional** | ** ** |
| **(Dollars  in thousands)**            | ** ** | **Location**          | ** ** | **Value**                 | ** ** | **Value** | ** ** | **Location** | ** ** | **Value** | ** ** | **Value** | ** ** |
|                                   |       |                  |       |                      |       |   |   |   |   |   |   |   |   |
| Mandatory forward sales commitments    |       | Other assets          |       | $                         | —     |   | $ | — |   | Other Liabilities |   | $ | 583 |   | $ | 30,250 |   |
| Best efforts forward sales commitments |       | Other assets          |       | —                    |       | — |   | Other Liabilities |   | 35 |   | 84,282 |   |
| Interest rate lock commitments         |       | Other assets          |       | 412                       |       | 23,064 |   | Other Liabilities |   | — |   | — |   |
|                                        |            |                       |            |                           |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

**8.**            **EARNINGS (LOSS) PER SHARE, AS RESTATED**

 

**Three Months endedSeptember 30, 2009**

 
| ** **                                | ** ** | **Loss**        | ** ** | ** **        | ** ** | ** **     | ** ** |
|-------------------------------------------|------------|-----------------|------------|-------------------|------------|----------------|------------|
| ** **                                | ** ** | **(thousands)** | ** ** | **Shares (1)**    | ** ** | **Per Share**  | ** ** |
| ** **                                | ** ** | **(numerator)** | ** ** | **(denominator)** | ** ** | **Amount**     | ** ** |
| ** **                                | ** ** | **(Restated)**  | ** ** | ** **        | ** ** | **(Restated)** | ** ** |
| Basic loss per share                      |       |            |       |              |       |           |       |
| Net loss available to common stockholders |       | $               | (6,444     | )                 | 6,306,889  |           | $          | (1.02 | ) |
| Effect of Dilutive Securities             |       |            |       |              |       |           |       |
| Options to purchase common stock          |       | —          |       | —            |       |           |       |
| Diluted loss per share                    |       |            |       |              |       |           |       |
| Net loss available to common stockholders |       | $               | (6,444     | )                 | 6,306,889  |           | $          | (1.02 | ) |

 

----

(1)          234,109 anti-dilutiveweighted average shares have been excluded from this computation because theoption exercise price was greater than the average market price of the commonshares.

 

**Nine Months endedSeptember 30, 2009**

 
| ** **                                | ** ** | **Income**      | ** ** | ** **        | ** ** | ** **     | ** ** |
|-------------------------------------------|------------|-----------------|------------|-------------------|------------|----------------|------------|
| ** **                                | ** ** | **(thousands)** | ** ** | **Shares (1)**    | ** ** | **Per Share**  | ** ** |
| ** **                                | ** ** | **(numerator)** | ** ** | **(denominator)** | ** ** | **Amount**     | ** ** |
| ** **                                | ** ** | **(Restated)**  | ** ** | ** **        | ** ** | **(Restated)** | ** ** |
| Basic loss per share                      |       |            |       |              |       |           |       |
| Net loss available to common stockholders |       | $               | (3,186     | )                 | 6,272,682  |           | $          | (0.51 | ) |
| Effect of Dilutive Securities             |       |            |       |              |       |           |       |
| Options to purchase common stock          |       | —          |       | —            |       |           |       |
| Diluted loss per share                    |       |            |       |              |       |           |       |
| Net loss available to common stockholders |       | $               | (3,186     | )                 | 6,272,682  |           | $          | (0.51 | ) |

 

----

(1)          234,109 anti-dilutiveweighted shares have been excluded from this computation because the optionexercise price was greater than the average market price of the common shares.

 

**Three Months ended September 30, 2008**

 
| ** **                                  | ** ** | **Income**      | ** ** | ** **        | ** ** | ** **    | ** ** |
|---------------------------------------------|------------|-----------------|------------|-------------------|------------|---------------|------------|
| ** **                                  | ** ** | **(thousands)** | ** ** | **Shares (1)**    | ** ** | **Per Share** | ** ** |
| ** **                                  | ** ** | **(numerator)** | ** ** | **(denominator)** | ** ** | **Amount**    | ** ** |
| Basic earnings per share                    |       |            |       |              |       |          |       |
| Net income available to common stockholders |       | $               | 807        |              | 5,188,562  |          | $          | 0.16 |   |
| Effect of Dilutive Securities               |       |            |       |              |       |          |       |
| Options to purchase common stock            |       | —          |       | 9,225             |       | —        |       |
| Diluted earnings per share                  |       |            |       |              |       |          |       |
| Net income available to common stockholders |       | $               | 807        |              | 5,197,787  |          | $          | 0.16 |   |

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

----

(1)          58,768 anti-dilutiveweighted average shares have been excluded from this computation because theoption exercise price was greater than the average market price of the commonshares.

 

**Nine Months ended September 30,2008**

 
| ** **                                  | ** ** | **Income**      | ** ** | ** **        | ** ** | ** **    | ** ** |
|---------------------------------------------|------------|-----------------|------------|-------------------|------------|---------------|------------|
| ** **                                  | ** ** | **(thousands)** | ** ** | **Shares (1)**    | ** ** | **Per Share** | ** ** |
| ** **                                  | ** ** | **(numerator)** | ** ** | **(denominator)** | ** ** | **Amount**    | ** ** |
| Basic earnings per share                    |       |            |       |              |       |          |       |
| Net income available to common stockholders |       | $               | 4,169      |              | 5,184,173  |          | $          | 0.80 |   |
| Effect of Dilutive Securities               |       |            |       |              |       |          |       |
| Options to purchase common stock            |       | —          |       | 16,027            |       | —        |       |
| Diluted earnings per share                  |       |            |       |              |       |          |       |
| Net income available to common stockholders |       | $               | 4,169      |              | 5,200,200  |          | $          | 0.80 |   |

 

----

(1)          62,665 anti-dilutiveweighted shares have been excluded from this computation because the optionexercise price was greater than the average market price of the common shares.

 

**9.****        ****COMPREHENSIVE INCOME (LOSS) , ASRESTATED**

 

Components of comprehensive income (loss) are presented in thefollowing chart:

 
| ** **                                                        | ** ** | **Three Months Ended** | ** ** | **Nine****Months Ended** | ** ** |
|-------------------------------------------------------------------|------------|------------------------|------------|--------------------------|------------|
| ** **                                                        | ** ** | **September 30,** | ** ** | **September 30,**   | ** ** |
| ** **                                                        | ** ** | **2009**               | ** ** | **2008**                 | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                        | ** ** | **(Restated)**         | ** ** | ** **               | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
| Unrealized gains (losses) on securities:                          |       |                   |       |                     |       |   |   |   |   |
| Unrealized gains (losses) arising in period                       |       | $                      | 4,425      |                     | $          | (1,519 | ) | $ | 5,771 |   | $ | (3,627 | ) |
| Reclassification adjustment                                       |       | (1,575                 | )          | (761                     | )          | (1,575 | ) | (577 | ) |
| Net unrealized gain (loss)                                        |       | 2,850                  |       | (2,280                   | )          | 4,196 |   | (4,204 | ) |
| Other comprehensive income (loss) before taxes                    |       | 2,850                  |       | (2,280                   | )          | 4,196 |   | (4,204 | ) |
| Income tax (expense) benefit                                      |       | (969                   | )          | 775                      |       | (1,427 | ) | 1,429 |   |
| Other comprehensive income (loss)                                 |       | 1,881                  |       | (1,505                   | )          | 2,769 |   | (2,775 | ) |
| Net (loss) income including non-controlling  interests            |       | (5,950                 | )          | 807                      |       | (1,823 | ) | 4,169 |   |
| Comprehensive (loss) income                                       |       | (4,069                 | )          | (698                     | )          | 946 |   | 1,394 |   |
| Comprehensive income attributable to  non-controlling interests   |       | (494                   | )          | —                   |       | (1,363 | ) | — |   |
| Comprehensive (loss) income for First Chester  County Corporation |       | $                      | (4,563     | )                        | $          | (698 | ) | $ | (417 | ) | $ | 1,394 |   |

 

**10.****      ****FAIR VALUE MEASUREMENT AND FAIRVALUE OF FINANCIAL INSTRUMENTS, AS RESTATED**

 

FASBASC 820-10 defines fair value as the exchange price that would be received foran asset or paid to transfer a liability (an exit price) in an orderlytransaction between market participants on the measurement date. FASB ASC820-10 also establishes a fair value hierarchy which requires an entity to maximizethe use of observable inputs and minimize the use of unobservable inputs whenmeasuring fair value. FASB ASC 820-10 clarifies proper fair value determinationin a market that is not active and provides an example to illustrate keyconsiderations in determining the fair value of a financial asset when themarket for that financial asset is not active. The Corporation considered therequirements of FASB ASC 820-10 when estimating fair value.

 

FASB ASC 825-10 — *Financial Instruments*permits entities to choose to measure many financial instruments and certainother items at fair value at specified election dates. The Corporation electedto account for loans held for sale under this election option.

 

FASBASC 820-10 describes three levels of inputs that may be used to measure fairvalue:

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**(UNAUDITED)**

 

·                  Level 1: Quoted prices (unadjusted) foridentical assets or liabilities in active markets that the entity has theability to access as of the measurement date.

 

·                  Level 2: Significant other observable inputsother than Level 1 prices, such as quoted prices for similar assets orliabilities, quoted prices in markets that are not active, and other inputsthat are observable or can be corroborated by observable market data.

 

·                  Level 3: Significant unobservable inputs thatreflect a company’s own assumptions about the assumptions that marketparticipants would use in pricing an asset or liability.

 

TheCorporation used the following methods and significant assumptions to estimatefair value:

 

Securities: Investment securities available-for-sale arerecorded at fair value on a recurring basis. Fair value measurement is basedupon quoted prices, if available. If quoted prices are not available, fairvalues are measured using matrix pricing, which is a mathematical techniqueused widely in the industry to value debt securities without relyingexclusively on quoted prices for the specific securities but rather by relyingon the securities’ relationship to other benchmark quoted securities. Level 1securities include those traded on nationally recognized securities exchanges,U.S. Treasury and Agency securities, and money market funds. Level 2 securitiesinclude mortgage-backed securities issued by government sponsored entities,municipal bonds and corporate debt securities. Securities classified as Level 3include asset-backed securities in less liquid markets.

 

Loans held for sale: The fair value of loansheld for sale is estimated by utilizing either: (i) the value ofsecurities backed by similar mortgage loans, adjusted for certain factors toapproximate the value of a whole mortgage loan, including the valueattributable to mortgage servicing and credit risk, (ii) currentcommitments to purchase loans or (iii) recent observable market trades forsimilar loans, adjusted for credit risk and other individual loancharacteristics.  As such, theCorporation classifies loans subjected to nonrecurring fair value adjustmentsas Level 2.

 

Loans and leases: The Corporation does not record loans atfair value on a recurring basis. However, from time to time, a loan isconsidered impaired and an allowance for loan losses is established. Loans forwhich it is probable that payment of interest and principal will not be made inaccordance with the contractual terms of the loan agreement are consideredimpaired. Once a loan is identified as individually impaired, managementmeasures impairment in accordance with FASB ASC 310. The fair value of impairedloans is estimated using one of several methods, including collateral value,market value of similar debt, enterprise value, liquidation value anddiscounted cash flows. Those impaired loans not requiring an allowancerepresent loans for which the fair value of the expected repayments orcollateral exceed the recorded investments in such loans. At September 30,2009, substantially all of the impaired loans were evaluated based on the fairvalue of the collateral. In accordance with FASB ASC 820-10 impaired loanswhere an allowance is established based on the fair value of collateral requireclassification in the fair value hierarchy. When the fair value of thecollateral is based on an observable market price or a current appraised value,the Corporation records the impaired loan as nonrecurring Level 3.

 

Other Real Estate Owned (“OREO”): OREO is adjusted to fairvalue upon transfer of the loans to foreclosed assets. Subsequently, OREO iscarried at the lower of carrying value or fair value. Fair value is based uponindependent market prices, appraised values of the collateral or management’sestimation of the value of the collateral. The Corporation records theforeclosed asset as nonrecurring Level 3.

 

Mortgage Servicing Rights (“MSRs”): To determine the fairvalue of MSRs, the Bank uses an independent third party to estimate the presentvalue of estimated future net servicing income. This valuation methodincorporates an assumption that market participants would use in estimatingfuture net servicing income, which include estimates of the cost to service,the discount rate, custodial earnings rate, an inflation rate, ancillaryincome, prepayment speeds, and default rates and losses. The fair value ofservicing rights was determined using discount rates ranging from 8.0% to10.4%, prepayment speeds ranging from 6.6% to 49.1% depending on thestratification of the specific right, and a weighted average default rate of16.5%. The Corporation records the MSR as a recurring Level 3.

 

Derivative instruments: The fair value of interestrate lock commitments and forward sales commitments are estimated using aprocess similar to mortgage loans held for sale. Interest rate lock commitmentsare recorded as a recurring Level 3. Loan commitments and best effortscommitments are assigned a probability that the related loan will be funded and

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

thecommitment will be exercised. The Bank relies on historical “pull-through”percentages in establishing probability. Forward sale commitments are recordedas a recurring Level 2.

 

Thetable below presents the balance of assets and liabilities atSeptember 30, 2009, measured at fair value on a recurring basis:

 

*Dollars in thousands*

 
| ** **                               | ** ** | **Level 1** | ** ** | **Level 2**    | ** ** | **Level 3** | ** ** | **Total**      | ** ** |
|------------------------------------------|------------|-------------|------------|----------------|------------|-------------|------------|----------------|------------|
| ** **                               | ** ** | ** **  | ** ** | **(Restated)** | ** ** | ** **  | ** ** | **(Restated)** | ** ** |
| Assets                                   |       |        |       |           |       |        |       |           |       |
| Investment securities available for sale |       | $           | 1,113      |           | $          | 88,753      |       | $              | —     |   | $ | 89,866 |   |
| Loans held for sale                      |       | —      |       | 190,201        |       | —      |       | 190,201        |       |
| Mortgage servicing rights                |       | —      |       | —         |       | 614         |       | 614            |       |
| Interest rate lock commitments           |       | —      |       | —         |       | 2,411       |       | 2,411          |       |
| Liabilities                              |       |        |       |           |       |        |       |           |       |
| Mandatory Forward Sales Commitments      |       | —      |       | 903            |       | —      |       | 903            |       |
|                                          |            |             |            |                |            |             |            |                |            |  |  |  |  |

 

Theaggregate unpaid principal balance of mortgage loans held for sale is $190.2million.

 

Thetable below presents the balance of assets and liabilities atSeptember 30, 2009, measured at fair value on a nonrecurring basis:

 

*Dollars in thousands*

 
| ** **                       | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3**    | ** ** | **Total**      | ** ** |
|----------------------------------|------------|-------------|------------|-------------|------------|----------------|------------|----------------|------------|
| ** **                       | ** ** | ** **  | ** ** | ** **  | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| Impaired loans & leases |       | $           | —     |        | $          | —         |       | $              | 27,594     |   | $ | 27,594 |   |
|                             |       |        |       |        |       |           |       |           |       |
| OREO                             |       | —      |       | —      |       | 3,062          |       | 3,062          |       |
|                                  |            |             |            |             |            |                |            |                |            |  |  |  |  |

 

Thetable below presents the rollforward of assets that are valued usingsignificant unobservable inputs (Level 3) for the nine months endedSeptember 30, 2009:

 

*Dollars in thousands*

 
| ** **                            | ** ** | **Mortgage  Servicing  Rights** | ** ** | **Interest Rate  lock  Commitments** | ** ** | **Loans**      | ** ** | **OREO**   | ** ** |
|---------------------------------------|------------|---------------------------------|------------|--------------------------------------|------------|----------------|------------|------------|------------|
| ** **                            | ** ** | ** **                      | ** ** | ** **                           | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
| Beginning balance                     |       | $                               | 239        |                                 | $          | 412            |       | $          | 9,658      |   | $ | 1,872 |   |
| Net transferred into (out of) level 3 |       | 321                             |       | 1,999                                |       | 26,502         |       | 1,190      |       |
| Net unrealized gains (losses)         |       | 54                              |       | —                               |       | (8,566         | )          | —     |       |
| Ending Balance                        |       | $                               | 614        |                                 | $          | 2,411          |       | $          | 27,594     |   | $ | 3,062 |   |

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

The estimated fair values and carrying amounts of the balance sheet aresummarized as follows:

 

(Dollars in thousands)

 
| ** **                                                      | ** ** | **September 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                                                      | ** ** | **Estimated**               | ** ** | **Carrying**               | ** ** | **Estimated** | ** ** | **Carrying** | ** ** |
| ** **                                                      | ** ** | **Fair Value**              | ** ** | **Amount**                 | ** ** | **Fair Value** | ** ** | **Amount** | ** ** |
| ** **                                                      | ** ** | ** **                  | ** ** | **(Restated)**             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Financial Assets                                                |       |                        |       |                       |       |   |   |   |   |
| Cash and cash equivalents                                       |       | $                           | 22,951     |                       | $          | 22,951 |   | $ | 95,150 |   | $ | 95,150 |   |
| Investment securities available-for-sale                        |       | 89,866                      |       | 89,866                     |       | 114,584 |   | 114,584 |   |
| Loans held for sale                                             |       | 187,521                     |       | 190,201                    |       | 90,940 |   | 90,940 |   |
| Gross loans and leases                                          |       | 1,028,522                   |       | 957,502                    |       | 1,042,799 |   | 940,083 |   |
| Due from mortgage investors                                     |       | —                      |       | —                     |       | 9,036 |   | 9,036 |   |
| Mortgage servicing rights                                       |       | 614                         |       | 614                        |       | 239 |   | 239 |   |
| Derivative instruments                                          |       | 2,411                       |       | 2,411                      |       | 412 |   | 412 |   |
|                                                            |       |                        |       |                       |       |   |   |   |   |
| Financial Liabilities                                           |       |                        |       |                       |       |   |   |   |   |
| Deposits with no stated maturities                              |       | 539,461                     |       | 591,484                    |       | 524,737 |   | 563,501 |   |
| Deposits with stated maturities                                 |       | 392,819                     |       | 394,630                    |       | 451,691 |   | 451,691 |   |
| FHLB and other borrowings                                       |       | 199,378                     |       | 202,123                    |       | 167,766 |   | 171,170 |   |
| Subordinated debentures                                         |       | 20,795                      |       | 20,795                     |       | 15,465 |   | 15,465 |   |
| Derivative instruments                                          |       | 903                         |       | 903                        |       | 618 |   | 618 |   |
|                                                            |       |                        |       |                       |       |   |   |   |   |
| Off-Balance-Sheet                                               |       |                        |       |                       |       |   |   |   |   |
| Commitments to extend credit and outstanding  letters of credit |       | 238,812                     |       | —                     |       | 244,033 |   | — |   |
|                                                                 |            |                             |            |                            |            |  |  |  |  |  |  |  |  |

 

**11.****      ****SEGMENT REPORTING, AS RESTATED**

 

The Corporation has determined that it has two operating and reportingsegments: Community Banking and Mortgage Banking.

 

The Corporation’s Community Banking segment consists of commerciallending, commercial construction lending, commercial deposits, retail banking,as well as wealth management. The Community Banking segment is managed as asingle strategic unit, which generates revenue from a variety of products andservices provided by the Corporation. For example, construction and commerciallending is dependent upon the ability of the Corporation to fund itself withretail deposits and other borrowings and to manage interest rate and creditrisk. This situation is also similar for consumer lending.

 

The Corporation’s Mortgage Banking segment operates under the tradename, “American Home Bank, a division of First National Bank of Chester County,”referred to herein as the “AHB Division”. Its principal activities includeproviding mortgages and associated products to customers and selling most of thosemortgages into the secondary market on a servicing released basis. The AHBDivision retains the servicing on a portion of the loans that it sells.  The AHB Division also holds some residentialmortgage and residential construction loans for investment. The AHB Divisionwas formed on December 31, 2008 following the acquisition of American HomeBank, National Association.

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

Reportable segment-specificinformation and reconciliation to consolidated financial information is asfollows:

 

(Dollars in thousands)

 
| ** **                 | ** ** | **As of and for the three months ended September 30, 2009** | ** ** |
|----------------------------|------------|------------------------------------------------------------------|------------|
| ** **                 | ** ** | **Community  Banking**                                           | ** ** | **Mortgage Banking** | ** ** | ** ** | ** ** |
| ** **                 | ** ** | **Segment**                                                      | ** ** | **Segment** | ** ** | **Consolidated** | ** ** |
| ** **                 | ** ** | **(Restated)**                                                   | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| Total assets               |       | $                                                                | 979,079    |   | $ | 329,334 |   | $ | 1,308,413 |   |
|                       |       |                                                             |       |   |   |   |   |
| Net interest income        |       | $                                                                | 8,870      |   | $ | 2,964 |   | $ | 11,834 |   |
|                       |       |                                                             |       |   |   |   |   |
| Total non-interest income  |       | $                                                                | 973        |   | $ | 12,569 |   | $ | 13,542 |   |
| Total non-interest expense |       | $                                                                | 9,964      |   | $ | 13,413 |   | $ | 23,377 |   |
|                       |       |                                                             |       |   |   |   |   |
| Net loss                   |       | $                                                                | (6,484     | ) | $ | 40 |   | $ | (6,444 | ) |

 

(Dollars in thousands)

 
| ** **                 | ** ** | **As of and for the nine months ended September 30, 2009** | ** ** |
|----------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                 | ** ** | **Community  Banking**                                          | ** ** | **Mortgage Banking** | ** ** | ** ** | ** ** |
| ** **                 | ** ** | **Segment**                                                     | ** ** | **Segment** | ** ** | **Consolidated** | ** ** |
| ** **                 | ** ** | **(Restated)**                                                  | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| Total assets               |       | $                                                               | 979,079    |   | $ | 329,334 |   | $ | 1,308,413 |   |
|                       |       |                                                            |       |   |   |   |   |
| Net interest income        |       | $                                                               | 25,780     |   | $ | 7,903 |   | $ | 33,683 |   |
|                       |       |                                                            |       |   |   |   |   |
| Total non-interest income  |       | $                                                               | 6,092      |   | $ | 40,861 |   | $ | 46,953 |   |
| Total non-interest expense |       | $                                                               | 29,452     |   | $ | 37,387 |   | $ | 66,839 |   |
|                       |       |                                                            |       |   |   |   |   |
| Net (loss) income          |       | $                                                               | (8,255     | ) | $ | 5,069 |   | $ | (3,186 | ) |

 

Prior to the acquisition of American Home Bank at December 31,2008, the Corporation’s operations consisted of the Community Banking segment.Accordingly, comparative information for 2008 is not applicable.

 

**12.****      ****ACCOUNTING FOR STOCK-BASEDCOMPENSATION PLANS**

 

At September 30, 2009, the Corporation had one stock basedcompensation plan, pursuant to which, shares of the Corporation’s common stockcould be issued, subject to certain restrictions. The plan, adopted in 2005,allows the Corporation to grant up to 150,000 shares of restricted stock toemployees. During the nine months ended September 30, 2009, theCorporation granted 54,650 shares valued at $11.35 per share at the grant date.These shares, or a portion thereof will vest on the third anniversary of thegrant subject to certain employment and company performance requirements.During the nine months ended September 30, 2008, the Corporation granted34,500 shares valued at $17.80 per share at the grant date. These shares, or aportion thereof will vest on the third anniversary of the grant subject tocertain employment and company performance requirements. These restricted stockgrants are also subject to accelerated vesting of all or a portion of theshares upon the occurrence of certain events, as described more fully in ourProxy Statement for the 2009 Annual Meeting of Shareholders. A summary of theCorporation’s unvested restricted shares is as follows:

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

(Dollarsin thousands, except shares, and per share data)

 
| ** **                          | ** ** | **Shares** | ** ** | **Grant Date  Fair  Value** | ** ** | **Aggregate Intrinsic  Value  of Unvested Shares** | ** ** |
|-------------------------------------|------------|------------|------------|-----------------------------|------------|----------------------------------------------------|------------|
| Unvested at January 1, 2009    |       | 44,075     |       | $                           | 18.74      |                                               |       |   |
| Granted                             |       | 54,650     |       | $                           | 11.35      |                                               |       |   |
| Vested                              |       | 6,400      |       | $                           | 21.05      |                                               |       |   |
| Forfeited                           |       | 6,000      |       | $                           | 14.58      |                                               |       |   |
| Unvested at September 30, 2009 |       | 86,325     |       | $                           | 14.18      |                                               | $          | 861.5 |   |
|                                     |            |            |            |                             |            |                                                    |            |  |  |

 

The Corporation recorded approximately $147,000 and $132,000 ofrestricted stock expense for the nine months ended September 30, 2009 and2008, respectively.

 

The Corporation’s ability to issue stock options under the Corporation’s1995 Stock Option Plan has expired. However, outstanding stock options remainin effect according to their terms. Aggregated information regarding theCorporation’s Stock Option Plan as well as options assumed in connection withthe AHB acquisition as of September 30, 2009 is presented below.

 

(Dollars in thousands,except shares, per share and years data)

 
| **Options**                            | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Term (years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|----------------------------------------|------------|------------|------------|-----------------------------------------|------------|--------------------------------------------------------------|------------|---------------------------------|------------|
| Outstanding at January 1, 2009    |       | 298,034    |       | $                                       | 15.43      |                                                         |       |                            | $          | — |   |
| Granted                                |       | —     |       |                                    |       |                                                         |       |                            |       |
| Exercised                              |       | —     |       |                                    |       |                                                         |       |                            |       |
| Forfeited                              |       | —     |       |                                    |       |                                                         |       |                            |       |
| Expired                                |       | (63,925    | )          | $                                       | 14.09      |                                                         |       |                            |       |   |
| Outstanding at September 30, 2009 |       | 234,109    |       | $                                       | 15.80      |                                                         | 3.56       |                            | $          | — |   |
| Exercisable at September 30, 2009 |       | 234,109    |       | $                                       | 15.80      |                                                         | 3.56       |                            | $          | — |   |

 

There were no options granted during the nine months endedSeptember 30, 2009.  The totalintrinsic value (market value on date of exercise less grant price) of optionsexercised during the nine months ended September 30, 2008 was $0.

 

**13.****      ****CASH FLOW INFORMATION**

 

For purposes of reporting cash flows, cash and cash equivalents includecash on hand, amounts due from banks, and federal funds sold and overnightinvestments.  Generally, federal fundsand overnight investments are purchased and sold for one-day periods.  Cash paid for interest for the nine monthperiods ended September 30, 2009 and 2008 was $17.5 million and $17.7million, respectively.  Cash paid forincome taxes for the nine month periods ended September 30, 2009 and 2008was $2.8 million and $2.3 million, respectively. Loans transferred to OREO were$6.2 million and approximately $427,000 for the nine months endedSeptember 30, 2009 and 2008, respectively.

 

**14.****      ****COMMITMENTSAND CONTINGENCIES**

 

**Reserve for Unfunded Commitments**

 

TheCorporation maintains a reserve for unfunded loan commitments and letters ofcredit which is reported in other liabilities in the Unaudited ConsolidatedStatements of Financial Condition consistent with ASC 825-10. As of the balancesheet date, the Corporation records estimated losses inherent with unfundedloan commitments in accordance with ASC 450-20, and estimated futureobligations under letters of credit in accordance with ASC 460-10. Themethodology used to determine the adequacy of this reserve is integrated in theCorporation’s process for establishing the allowance for loan losses andconsiders the probability of future losses and obligations that may be incurredunder these off-balance sheet agreements.  The reserve for unfundedloan commitments and letters of credit as of 

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

September 30,2009 and December 31, 2008 was approximately $652,000 and $445,000,respectively. Management believes this reserve level is sufficient to absorbestimated probable losses related to these commitments.

 

**Loan Recourse**

 

TheCorporation sells its residential mortgage loans on a non-recourse basis. TheCorporation also provides representations and warranties to purchasers andinsurers of the loans sold. In the event of a breach of these representationsand warranties, the Corporation may be required to repurchase a mortgage loanor indemnify the purchaser, and any subsequent loss on the mortgage loan may beborne by the Corporation. If there is no breach of a representation andwarranty provision, the Corporation has no obligation to repurchase the loan orindemnify the investor against loss. The unpaid principal balance of the loanssold by the Corporation represents the maximum potential exposure related torepresentations and warranty provisions; however, the Corporation cannotestimate its maximum exposure because it does not service all of the loans forwhich it has provided a representation or warranty. As of September 30,2009, the Corporation had a liability of $780,000 included in Other liabilitiesin the Consolidated Balance Sheet, for probable losses related to theCorporation’s recourse exposure.

 

**15.****      ****REGULATORYMATTERS**

 

OnOctober 20, 2009, the Board of Directors of the Bank entered into aninformal Memorandum of Understanding (“MOU”) on October 16, 2009, with theOffice of the Comptroller of the Currency (the “OCC”).  An MOU withregulatory authorities is an informal action that is not published or publiclyavailable and that is used when circumstances warrant a milder form of actionthan a formal supervisory action, such as a formal written agreement or order.Among other things, under the MOU, the Bank has agreed to address the followingmatters:

 

·                  Develop a comprehensive three-year capitalplan;

 

·                  Take action to protect criticized assets andadopt and implement a program to eliminate the basis of criticism of suchassets;

 

·                  Establish an effective program that providesfor early problem loan identification and a formal plan to proactively managethose assets;

 

·                  Review the adequacy of the Bank’s informationtechnology activities and Bank Secrecy Act compliance and approve writtenprograms of policies and procedures to provide for compliance; and

 

·                  Establish a Compliance Committee of the Boardto monitor and coordinate the Bank’s adherence to the provisions of the MOU.

 

TheBoard of Directors and management have already initiated corrective actions tocomply with the provisions of the MOU.

 

Subsequentto September 30, 2009, the OCC has also required the Bank toincrease its Tier 1 leverage capital ratio to not less than 8%, its Tier 1risk-based capital ratio to not less than 10% and its total risk-based capitalratio to not less than 12% by December 31, 2009.

 

TheCompany has also received notice from the Federal Reserve, the primaryregulator of the Corporation, that the Federal Reserve must approve any dividendsto be paid by the Corporation in advance of the declaration or payment.

 

**16.****      ****SUBSEQUENTEVENTS**

 

TheCorporation evaluated its September 30, 2009 financial statements forsubsequent events through November 13, 2009.  The Corporation is not aware of anysubsequent events which would require recognition or disclosure in thefinancial statements other than those discussed below.

 

TheBank is currently undergoing a restructuring, which includes the previouslyannounced appointment of John A. Featherman, III as President, James M.Deitch as Chief Operating Officer and Sheryl S. Vittitoe as Chief Financial 

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

Officer.  The restructuring will also include thetermination of certain Bank employees, including employees from its AHBDivision by year-end.  The Bank expectsto incur a charge of approximately $1.0 million in the fourth quarter forseverance liability connected with this restructuring.  The Bank also intends to reorganize its twocurrent divisions into four divisions: Commercial, Consumer, Wealth Managementand Administration. The Bank is closing three branches as part of therestructuring; the Bank expects to incur a charge of approximately $1.1 millionin the fourth quarter related to branch closure expenses, including estimatedlease liabilities and write-off of certain leasehold improvements and fixedassets related to the branch closures. The Bank is also closing 13 mortgage loan production offices related toVision Mortgage Division of AHB related to the restructuring, and will close anadditional six mortgage loan production offices operated as AHB productionbranches.  The Bank will incurapproximately $60,000 in charges related to severance, lease obligations andthe write off of leasehold improvements, and fixed assets related to suchclosures.

 

TheCorporation borrowed an aggregate principal amount of $4.0 million during thesecond and third quarters of 2009 on an unsecured, short-term basis from twoshareholders, with interest payable in each case at 12% per annum. On October 20,2009, the Corporation received a demand for payment of $3.0 million principalamount of such borrowings in accordance with terms of the loans, with thedemand payable on November 20, 2009. The other $1.0 million principalamount of unsecured loan originally matured on November 24, 2009, but hasbeen extended by the lender to May 24, 2010. The Corporation is currentlyattempting to negotiate to extend the maturity of the $3 million due on November 20,2009. If the Corporation is unable to extend the loans, the Bank may need todividend to the Corporation some or all of such funds. Under its informal MOUwith the OCC, the Bank is required to obtain supervisory approval to dividendany funds to the Corporation. Any such dividend to the Corporation willdirectly affect the Bank’s capital and in turn, its fourth quarter regulatorycapital ratios.

 

**17.****      ****RECLASSIFICATIONS**

 

Certain 2008 numbers have been reclassified to conform with currentperiod presentation. These reclassifications have no impact on net income orearnings per share.

 

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**ITEM 2.****         ****MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

Thisdiscussion is intended to further your understanding of the consolidatedfinancial condition and results of operations of First Chester CountyCorporation and its direct and indirect subsidiaries. It should be read inconjunction with the consolidated financial statements included in this report.

 

**OVERVIEW**

 

Westrive to remain a leader in meeting the financial service needs of the localcommunity and to provide quality service to the individuals and businesses inour market areas.  Historically, we havebeen a community-oriented provider of traditional banking products and servicesto business organizations and individuals, including products such asresidential and commercial real estate loans, consumer loans and a variety ofdeposit products.  We meet the needs ofour local community through a community-based and service-oriented approach tobanking.

 

The Corporation completed its acquisition of AHB on December 31,2008, and, accordingly, the December 31, 2008 and the September 30,2009 consolidated balance sheets reflect the addition of assets acquired andliabilities assumed in this acquisition. The results of operations presented inthe consolidated income statement for the three and nine months endedSeptember 30, 2009 include the results of operations from AHB; however,the consolidated income statement for the three and nine months endedSeptember 30, 2008 does not include the results of AHB.

 

TheCorporation reported a net loss of $6.4 million for the three months endedSeptember 30, 2009 as compared to $807,000 of net income for the threemonths ended September 30, 2008. Diluted loss per share for the threemonths ended September 30, 2009 was $1.02 compared to diluted earnings pershare of $0.16 for the same period in 2008. Cash dividends declared for the threemonths ended September 30, 2009 were $0.14 per share compared to $0.14 pershare for the three months ended September 30, 2008.

 

TheCorporation reported a net loss of $3.2 million for the nine months endedSeptember 30, 2009 as compared to $4.2 million of net income for the ninemonths ended September 30, 2008. Diluted loss per share for the ninemonths ended September 30, 2009 were $0.51 compared to diluted earningsper share of $0.80 for the same period in 2008. Cash dividends declared for the nine months ended September 30,2009 were $0.42 per share compared to $0.42 per share for the nine months endedSeptember 30, 2008.

 

The decrease in net incomefor the three and nine months ended September 30, 2009 was due primarilyto an increase in the provision for loan and lease losses combined with a $1.6million other than temporary impairment charge on the four equity securities inthe Bank’s available for sale investment portfolio. The decrease in net incomewas also caused by an increase in non-interest expense. The increase in theprovision was driven by the ongoing impact from recessionary economicconditions while the increase in non-interest expense was due mainly to theaddition of AHB’s operations as well as an increase in FDIC insurance expense.Offsetting these impacts were increases in non-interest income, mainlyattributable to the net gains from the mortgage banking activities of the AHBDivision, combined with an increase in net interest income due mainly to thehigher average interest-earning assets from the acquisition of AHB.

 

**CRITICAL ACCOUNTING POLICIES, JUDGMENTS AND ESTIMATES**

 

Theaccounting and reporting policies of the Corporation conform with theaccounting principles generally accepted in the United States of America andgeneral practices within the financial services industry.  The preparation of the financial statementsin conformity with accounting principles generally accepted in the UnitedStates of America requires management to make estimates and assumptions thataffect the amounts reported in the financial statements and the accompanyingnotes. Actual results could differ from those estimates. For a discussion ofsignificant accounting policies please refer to the footnotes to theCorporation’s consolidated financial statements included in this Report and inour 2008 Annual Report.

 

**InvestmentSecurities**

 

Inaccordance with FASB ASC 320-10, the Corporation evaluates the individualsecurities making up the investment portfolio for other than temporaryimpairment on a quarterly basis. If a security is deemed to be other thantemporarily impaired, the impairment is recorded in non-interest income in theperiod in which it is recognized. Evaluating whether a security is other thantemporarily impaired involves a high degree of judgment. Factors considered bymanagement in determining whether a security is other than temporarily impairedinclude current and forecasted market conditions for that security as well asour ability and intent to hold the security until recovery.

 

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**Allowance for Loan and Lease Losses**

 

TheCorporation considers that the determination of the allowance for loan andlease losses involves a higher degree of judgment and complexity than its othersignificant accounting policies.  Thebalance in the allowance for loan losses is determined based on Management’sreview and evaluation of the loan and lease portfolio in relation to past lossexperience, the size and composition of the portfolio, current economic eventsand conditions, and other pertinent factors, including Management’s assumptionsas to future delinquencies, recoveries and losses. All of these factors may besusceptible to significant change.  Tothe extent actual outcomes differ from Management’s estimates, additionalprovisions for loan and lease losses may be required that would adverselyimpact earnings in future periods.

 

**Goodwill**

 

Goodwillwas recorded as a result of the AHB acquisition. Goodwill is the excess of thepurchase price over the fair value of liabilities assumed over the fair valueof tangible and identifiable intangible assets acquired in a businesscombination. The goodwill acquired in the American Home Bank acquisition wasall attributable to the Mortgage Banking segment. Goodwill is not amortized butis tested for impairment annually or more frequently if events or changes incircumstances indicate that the asset might be impaired.  FASB ASC350-10 outlines a two-step goodwill impairment test.  Significantjudgment is applied when goodwill is assessed for impairment.  Stepone, which is used to identify potential impairment, compares the fair value ofthe reporting unit with its carrying amount, including goodwill.  Ifthe fair value of a reporting unit exceeds its carrying value, goodwill of thereporting unit is considered not impaired and step two is thereforeunnecessary.  If the carrying amount of the reporting unit exceedsits implied fair value, the second step is performed to measure the amount ofthe impairment loss, if any.  An implied loss is recorded to theextent that the carrying amount of goodwill exceeds its implied fair value.

 

TheCorporation’s annual impairment testing for goodwill was completed as ofSeptember 30, 2009. As part of its step one procedures to identifygoodwill impairment, management compared the fair value of the Mortgage Bankingsegment to the carrying amount of its net assets, including goodwill. Inperforming step one, the Corporation estimated the fair value of the MortgageBanking segment through a discounted economic value analysis based on internalforecasts, recent financials and the projected outlook for theindustry. No indication or determination of goodwill impairment at thatdate was evident. Management will continue to monitor events that could impactthis conclusion in future periods.

 

**Income Taxes**

 

Underthe liability method, deferred tax assets and liabilities are determined basedon the difference between the financial statement and tax basis of assets andliabilities.  Deferred tax assets aresubject to Management’s judgment based upon available evidence that futurerealization is more likely than not.  IfManagement determines that the Corporation may be unable to realize all or partof the net deferred tax assets in the future, a direct charge to income taxexpense may be required to reduce the recorded value of the net deferred taxasset to the expected realizable amount.

 

**Fair Value Measurement**

 

FASB ASC 820-10 defines fair value as the exchangeprice that would be received for an asset or paid to transfer a liability (anexit price) in an orderly transaction between market participants on themeasurement date. FASB ASC 820-10 also establishes a fair value hierarchy whichrequires an entity to maximize the use of observable inputs and minimize theuse of unobservable inputs when measuring fair value. FASB ASC 820-10 clarifiesproper fair value determination in a market that is not active and provides anexample to illustrate key considerations in determining the fair value of afinancial asset when the market for that financial asset is not active. TheCorporation considered the requirements of FASB ASC 820-10 when estimating fairvalue.  *See*Footnote 10 of the Notes to Consolidated Financial Statements for furtherdiscussion on Fair Value Measurement.

 

**ACQUISITION**

 

EffectiveDecember 31, 2008, the Corporation completed its acquisition of AHB. Themortgage banking business of AHB is now operating as a division of the Bankunder the trade name, “American Home Bank, a Division of First National Bank ofChester County.” The Bank’s mortgage-banking activities include providingmortgages to customers and selling most of those mortgages into the secondarymarket on a servicing released basis. The Bank retains the servicing on aportion of the loans that it sells. The sourcing of mortgage loans is conductedthrough a direct, retail delivery channel comprised of retail loan offices,affiliated business arrangements with builders and realtors, and a wholesalelending operation. The wholesale operation sources loans through relationshipswith unrelated mortgage brokers.

 

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**SEGMENT INFORMATION**

 

TheCorporation has determined that it has two operating and reporting segments:Community Banking and Mortgage Banking.

 

TheCorporation’s Community Banking segment consists of commercial, commercialconstruction, retail banking and wealth management. The Community Bankingsegment is managed as a single strategic unit, which generates revenue from avariety of products and services provided by the Corporation. For example,construction and commercial lending is dependent upon the ability of theCorporation to fund itself with retail deposits and other borrowings and tomanage interest rate and credit risk. This situation is also similar forconsumer lending.

 

TheCorporation’s Mortgage Banking segment operates under the trade name, “AmericanHome Bank, a division of First National Bank of Chester County,” referred toherein as (the “AHB Division”). Its principal activities include providingresidential mortgages and associated products to customers and selling most ofthose mortgages into the secondary market on a servicing released basis. TheAHB Division retains the servicing on a portion of the loans that it sells. TheAHB Division also holds some residential mortgage and construction loans. TheAHB Division was formed on December 31, 2008 following the acquisition ofAmerican Home Bank, National Association.

 

Asummary of segment performance for the three and nine months endedSeptember 30, 2009 is presented in Note 11 to the Corporation’s FinancialStatements.

 

Theresults presented in the Net Interest Income, Interest Income, InterestExpense and Provision for Loan and Lease Losses sections present informationfor both the loans held in the Community Banking segment as well as the MortgageBanking segment. Factors driving net interest income and the provision for loanand lease losses are similar for the loans held in each of these segments, withthe exception of loans held for sale, which are not reserved for in theallowance for loan and lease losses, as they are carried at fair market value.Specific discussion is made below where factors driving the specific componentsof non-interest income and expense for the operating segments differ from theconsolidated Corporation.

 

**SELECTEDRATIOS**

 
| ** **               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|--------------------------|------------|------------------------|------------|------------------------|------------|
| ** **               | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **               | ** ** | **2009**               | ** ** | **2008**               | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **               | ** ** | **(Restated)**         | ** ** | ** **             | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
| Return on Average Assets |       | (1.90                  | )%         | 0.32                   | %          | (0.32 | )% | 0.57 | % |
| Return on Average Equity |       | (28.43                 | )%         | 4.65                   | %          | (4.80 | )% | 8.03 | % |
| Dividend Payout Ratio    |       | (13.70                 | )%         | 89.96                  | %          | (82.61 | )% | 52.27 | % |
| Book Value Per Share     |       | $                      | 13.18      |                   | $          | 12.98 |   | $ | 13.18 |   | $ | 12.98 |   |
|                          |            |                        |            |                        |            |  |  |  |  |  |  |  |  |

 

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The following table provides detail regarding the Corporation’s averagebalances with corresponding interest income (on a tax-equivalent basis) andinterest expense as well as yield and cost information for the periodspresented.

 

(Dollarsin thousands)

 
| ** **                                                                              | ** ** | **Three Months ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                              | ** ** | **2009**                                  | ** ** | **2008** | ** ** |
| ** **                                                                              | ** ** | **Average**                               | ** ** | ** ** | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                              | ** ** | **Balance**                               | ** ** | **Interest** | ** ** | **Rate%** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Rate%** | ** ** |
| ASSETS                                                                                  |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold, interest-bearing deposits in banks  and other overnight investments |       | $                                         | 4,552      |   | $ | 5 |   | 0.50 | % | $ | 32,732 |   | $ | 200 |   | 2.43 | % |
| Investment securities:                                                                  |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Taxable                                                                                 |       | 81,339                                    |       | 711 |   | 3.47 | % | 95,261 |   | 1,157 |   | 4.83 | % |
| Tax-exempt (1)                                                                          |       | 6,522                                     |       | 78 |   | 4.72 | % | 12,180 |   | 142 |   | 4.63 | % |
| Total investment securities                                                             |       | 87,861                                    |       | 789 |   | 3.56 | % | 107,441 |   | 1,299 |   | 4.81 | % |
|                                                                                    |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Loans held for sale                                                                     |       | 236,970                                   |       | 2,866 |   | 4.80 | % | 377 |   | 3 |   | 3.17 | % |
|                                                                                    |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Loans and leases: (2)                                                                   |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Taxable                                                                                 |       | 929,161                                   |       | 13,313 |   | 5.68 | % | 779,718 |   | 12,187 |   | 6.22 | % |
| Tax-exempt (1)                                                                          |       | 20,102                                    |       | 373 |   | 7.35 | % | 18,477 |   | 340 |   | 7.33 | % |
| Total loans and leases                                                                  |       | 949,263                                   |       | 13,686 |   | 5.72 | % | 798,195 |   | 12,527 |   | 6.24 | % |
|                                                                                    |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Total interest-earning assets                                                           |       | 1,278,646                                 |       | 17,346 |   | 5.38 | % | 938,745 |   | 14,029 |   | 5.95 | % |
| Non-interest-earning assets                                                             |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for loan and lease losses                                                     |       | (12,383                                   | )          |   |   |   |   | (8,507 | ) |   |   |   |   |
| Cash and due from banks                                                                 |       | 17,010                                    |       |   |   |   |   | 22,003 |   |   |   |   |   |
| Other assets                                                                            |       | 59,184                                    |       |   |   |   |   | 41,572 |   |   |   |   |   |
|                                                                                    |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Total assets                                                                            |       | $                                         | 1,342,457  |   |   |   |   |   | $ | 993,813 |   |   |   |   |   |
|                                                                                    |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                               |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Savings, NOW, and money market Deposits                                                 |       | $                                         | 448,763    |   | $ | 941 |   | 0.83 | % | $ | 405,983 |   | $ | 1,646 |   | 1.61 | % |
| Certificates of deposit and other time                                                  |       | 409,779                                   |       | 2,571 |   | 2.49 | % | 222,231 |   | 2,001 |   | 3.58 | % |
| Total interest-bearing deposits                                                         |       | 858,542                                   |       | 3,512 |   | 1.62 | % | 628,214 |   | 3,647 |   | 2.31 | % |
| Subordinated debt                                                                       |       | 20,795                                    |       | 295 |   | 5.63 | % | 15,465 |   | 209 |   | 5.38 | % |
| Federal Home Loan Bank advances and other borrowings                                    |       | 202,854                                   |       | 1,559 |   | 3.05 | % | 151,521 |   | 1,470 |   | 3.86 | % |
| Total interest-bearing liabilities                                                      |       | 1,082,191                                 |       | 5,366 |   | 1.97 | % | 795,200 |   | 5,326 |   | 2.66 | % |
| Non-interest-bearing liabilities:                                                       |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Non-interest-bearing demand deposits                                                    |       | 152,047                                   |       |   |   |   |   | 119,885 |   |   |   |   |   |
| Other liabilities                                                                       |       | 18,301                                    |       |   |   |   |   | 9,325 |   |   |   |   |   |
| Total liabilities                                                                       |       | 1,252,539                                 |       |   |   |   |   | 924,410 |   |   |   |   |   |
| Stockholders’ equity                                                               |       | 89,918                                    |       |   |   |   |   | 69,403 |   |   |   |   |   |
| Total liabilities and stockholders’ equity                                         |       | $                                         | 1,342,457  |   |   |   |   |   | $ | 993,813 |   |   |   |   |   |
|                                                                                    |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                                                     |       |                                      |       | $ | 11,980 |   |   |   |   |   | $ | 8,703 |   |   |   |
| Net yield on interest-earning assets                                                    |       |                                      |       |   |   | 3.72 | % |   |   |   |   | 3.69 | % |

 

----

(1)       The indicated income and annual rate are presentedon a taxable equivalent basis using the federal marginal rate of 34% adjustedfor the TEFRA 20% interest expense disallowance for 2009 and 2008.

 

(2)       Non-accruing loans are included in the averagebalance.

 

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Thefollowing table provides detail regarding the Corporation’s average balanceswith corresponding interest income (on a tax-equivalent basis) and interestexpense as well as yield and cost information for the periods presented.

 

(Dollarsin thousands)

 
| ** **                                                                              | ** ** | **Nine Months ended**  | ** ** |
|-----------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                              | ** ** | **September 30,** | ** ** |
| ** **                                                                              | ** ** | **2009**               | ** ** | **2008** | ** ** |
| ** **                                                                              | ** ** | **Average**            | ** ** | ** ** | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                              | ** ** | **Balance**            | ** ** | **Interest** | ** ** | **Rate%** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Rate%** | ** ** |
| ASSETS                                                                                  |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold, interest-bearing deposits in banks  and other overnight investments |       | $                      | 15,615     |   | $ | 50 |   | 0.43 | % | $ | 45,773 |   | $ | 1,068 |   | 3.12 | % |
| Investment securities:                                                                  |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Taxable                                                                                 |       | 90,219                 |       | 2,798 |   | 4.15 | % | 97,234 |   | 3,515 |   | 4.83 | % |
| Tax-exempt (1)                                                                          |       | 7,879                  |       | 282 |   | 4.78 | % | 13,078 |   | 463 |   | 4.73 | % |
| Total investment securities                                                             |       | 98,098                 |       | 3,080 |   | 4.20 | % | 110,312 |   | 3,978 |   | 4.82 | % |
|                                                                                    |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Loans held for sale                                                                     |       | 218,619                |       | 7,805 |   | 4.77 | % | 568 |   | 9 |   | 2.12 | % |
|                                                                                    |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Loans and leases: (2)                                                                   |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Taxable                                                                                 |       | 924,397                |       | 39,375 |   | 5.70 | % | 753,950 |   | 36,134 |   | 6.40 | % |
| Tax-exempt (1)                                                                          |       | 20,454                 |       | 1,126 |   | 7.36 | % | 18,983 |   | 1,029 |   | 7.24 | % |
| Total loans and leases                                                                  |       | 944,851                |       | 40,501 |   | 5.73 | % | 772,933 |   | 37,163 |   | 6.42 | % |
|                                                                                    |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Total interest-earning assets                                                           |       | 1,277,183              |       | 51,436 |   | 5.38 | % | 929,586 |   | 42,218 |   | 6.07 | % |
| Non-interest-earning assets                                                             |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for loan and lease losses                                                     |       | (11,403                | )          |   |   |   |   | (8,122 | ) |   |   |   |   |
| Cash and due from banks                                                                 |       | 18,563                 |       |   |   |   |   | 20,375 |   |   |   |   |   |
| Other assets                                                                            |       | 55,785                 |       |   |   |   |   | 38,797 |   |   |   |   |   |
|                                                                                    |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Total assets                                                                            |       | $                      | 1,340,128  |   |   |   |   |   | $ | 980,636 |   |   |   |   |   |
|                                                                                    |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                               |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Savings, NOW, and money market Deposits                                                 |       | $                      | 437,111    |   | $ | 3,187 |   | 0.97 | % | $ | 391,067 |   | $ | 5,287 |   | 1.81 | % |
| Certificates of deposit and other time                                                  |       | 428,945                |       | 8,679 |   | 2.71 | % | 226,362 |   | 6,812 |   | 4.02 | % |
| Total interest-bearing deposits                                                         |       | 866,056                |       | 11,866 |   | 1.83 | % | 617,429 |   | 12,099 |   | 2.62 | % |
| Subordinated debt                                                                       |       | 18,585                 |       | 721 |   | 5.18 | % | 15,465 |   | 683 |   | 5.90 | % |
| Federal Home Loan Bank advances and other borrowings                                    |       | 201,852                |       | 4,712 |   | 3.12 | % | 150,129 |   | 4,390 |   | 3.91 | % |
| Total interest-bearing liabilities                                                      |       | 1,086,493              |       | 17,299 |   | 2.13 | % | 783,023 |   | 17,172 |   | 2.93 | % |
| Non-interest-bearing liabilities:                                                       |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Non-interest-bearing demand deposits                                                    |       | 148,424                |       |   |   |   |   | 118,776 |   |   |   |   |   |
| Other liabilities                                                                       |       | 16,555                 |       |   |   |   |   | 9,577 |   |   |   |   |   |
| Total liabilities                                                                       |       | 1,251,472              |       |   |   |   |   | 911,376 |   |   |   |   |   |
| Stockholders’ equity                                                               |       | 88,656                 |       |   |   |   |   | 69,260 |   |   |   |   |   |
| Total liabilities and stockholders’ equity                                         |       | $                      | 1,340,128  |   |   |   |   |   | $ | 980,636 |   |   |   |   |   |
|                                                                                    |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                                                     |       |                   |       | $ | 34,137 |   |   |   |   |   | $ | 25,046 |   |   |   |
| Net yield on interest-earning assets                                                    |       |                   |       |   |   | 3.57 | % |   |   |   |   | 3.60 | % |

 

----

(1)    The indicated income andannual rate are presented on a taxable equivalent basis using the federalmarginal rate of 34% adjusted for the TEFRA 20% interest expense disallowance for2009 and 2008.

 

(2)    Non-accruing loans areincluded in the average balance.

 

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**NETINTEREST INCOME**

 

Net interest income is the difference between interest income earned oninterest-earning assets and interest expense paid on interest-bearingliabilities. Net interest income on a tax equivalent basis for the three-monthperiod ended September 30, 2009 was $12.0 million, an increase of 37.7%from $8.7 million for the same period in 2008. Net interest income on a tax equivalent basis for the nine month periodended September 30, 2009 was $34.1 million, an increase of 36.3% from$25.0 million for the same period in 2008. The net yield on interest-earning assets, on a tax-equivalent basis, was3.72% for the three-month period ended September 30, 2009, compared to3.69% for the same period in 2008, an increase of 3 basis points (one basispoint is equal to 1/100 of a percent). For the nine month period ended September 30, 2009, the net yieldon interest earning assets decreased 3 basis points to 3.57% from 3.60% duringthe same period in 2008.

 

The yield earned on average interest-earning assets was 5.38% for thethree month period ended September 30, 2009, compared to 5.95% for thesame period in 2008, a decrease of 57 basis points. For the nine month periodended September 30, 2009, the yield earned on interest earning assetsdecreased 69 basis points to 5.38% from 6.07% during the same period in 2008.

 

Average interest-earning assets increased approximately $339.9 millionor 36.2% to $1.3 billion for the three-months ended September 30, 2009from $938.7 million in the same period last year.  The increase in average interest-earningassets for the three-month period ended September 30, 2009 was the resultof a $236.6 million increase in Loans held for sale combined with a 18.9% or$151.1 million increase in average total Loans and leases. These increases werepartially offset by an 18.2% or $19.6 million decrease in average investmentsecurities and an 86.1% or $28.2 million decrease in the average Federal fundssold and interest bearing deposits in banks balance.

 

For the nine month period ended September 30, 2009, averageinterest-earning assets increased approximately $347.6 million or 37.4% to $1.3billion from $929.6 million in the same period last year.  The increase in average interest-earningassets for the nine month period ended September 30, 2009 was the result ofa $218.1 million increase in Loans held for sale combined with a 22.2% or$171.9 million increase in average total Loans and leases. These increases werepartially offset by an 11.1% or $12.2 million decrease in average investmentsecurities and a 65.9% or $30.2 million decrease in the average Federal fundssold and interest bearing deposits in banks balance.

 

Averageinterest-bearing liabilities increased approximately $287.0 million or 36.1% to$1.1 billion for the three months ended September 30, 2009, from $795.2million in the same period in 2008.  Theincrease in average interest-bearing liabilities for the three-month period wasthe result of a $230.3 million or 36.7% increase in interest-bearing deposits,combined with a $51.3 million or 33.9% increase in Federal Home Loan Bank (“FHLB”)advances and other borrowings and a $5.3 million or 34.5% increase insubordinated debentures.

 

For the nine month period ended September 30, 2009, averageinterest-bearing liabilities increased approximately $303.5 million or 38.8% to$1.1 billion from $783.0 million in the same period in 2008.  The increase in average interest-bearingliabilities for the nine month period was the result of a $248.6 million or40.3% increase in interest-bearing deposits, combined with a $51.7 million or34.5% increase in FHLB advances and other borrowings and a $3.1 million or20.2% increase in subordinated debentures.

 

**INTERESTINCOME**

 

Interestincome on federal funds sold and interest-bearing deposits in banks for thethree and nine month periods ended September 30, 2009 decreased 97.5% and95.3% to approximately $5,000 and $50,000, respectively, when compared to thesame periods in 2008.  The decrease ininterest income on federal funds sold and interest-bearing deposits in banks forthe three and nine month periods is primarily the result of a $28.2 million and$30.2 million decrease in the average federal funds sold and interest bearingdeposits at banks balances from the same periods in 2008 combined with a 193and 269 basis point decrease on the rates earned on these assets. The decreasein these balances occurred as available liquidity was utilized to fund theincrease in loans held for sale. The decrease in rate was primarily a result ofFederal Reserve actions to reduce market interest rates coupled with Management’sdecision to invest available cash in more secure, but lower yielding, overnightinvestment alternatives.

 

Ona tax equivalent basis, interest income on investment securities decreased by39.3% or approximately $510,000 to $789,000 for the three month period endedSeptember 30, 2009 from $1.3 million for the same period in 2008.  For the nine month period endedSeptember 30, 2009, interest income on investment securities decreased22.6% or approximately $898,000 to $3.1 million from $4.0 million when comparedto the same period in 2008.  Thedecreases for the three and nine month periods were the result of a 125 and 62basis point decrease in the yield earned on investment securities,respectively.

 

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Thiswas combined with $19.6 million and $12.2 million decreases in average totalinvestment security balances for the three and nine month periods,respectively. The decrease in investment security balances reflects Management’sdecision to reduce the Bank’s exposure to corporate bonds.

 

Interestincome on loans held for sale increased to $2.9 million during the three monthperiod ended September 30, 2009. For the nine month period ended September 30, 2009, interest incomeon loans held for sale increased to $7.8 million.  These increases were due to a significantincrease in the average loans held for sale balance.  Average loans held for sale for the three andnine months periods ended September 30, 2009 were $236.6 million and$218.1 million as compared to approximately $377,000 and $568,000 for the sameperiods in 2008. This increase was due to increased volume in residential mortgageloan originations resulting from the AHB acquisition. $89.5 million of loansheld for sale were acquired at December 31, 2008 through the acquisition.The increase in the average balance during 2009 as compared to theDecember 31, 2008 level was attributable to an increase in residentialmortgage origination volume throughout 2009. The increase in origination volumewas caused by the refinancing boom driven by low interest rates.

 

Interestincome on loans, on a tax equivalent basis, generated by the Corporation’s loanportfolio increased 9.3% or $1.2 million to $13.7 million for the three monthperiod ended September 30, 2009 compared to $12.5 million for the threemonths ended September 30, 2008. For the nine month period ended September 30, 2009, interest incomeon loans, on a tax equivalent basis increased 9.0% or $3.3 million whencompared to the same period in 2008. These increases in interest income for the three and nine month periodsended September 30, 2009 were primarily due to a $151.1 million or 18.9%increase in average loans outstanding for the three month period and a $171.9million or 22.2% increase in average loans outstanding for the nine monthperiod as compared to the same periods in 2008. These increases in average loanbalances were primarily due to the AHB acquisition. $110.9 million of loanswere acquired at December 31, 2008 through the acquisition. The impactfrom the increase in average loan balances was partially offset by a decreasein the tax equivalent yield earned on average loans outstanding, whichdecreased by 52 and 69 basis points to 5.72% and 5.73% for the three and ninemonth periods ended September 30, 2009 from 6.24% and 6.42% for the sameperiods in 2008. This rate decrease is the result of Federal Reserve actions toreduce market interest rates.

 

**INTERESTEXPENSE**

 

Interestexpense on deposit accounts decreased by approximately $135,000 or 3.7% to $3.5million for the three-month period ended September 30, 2009 from $3.6million for the same period in 2008. Interest expense on deposit accounts decreased approximately $233,000 or1.9% to $11.9 million for the nine months ended September 30, 2009compared to the same period in 2008.  Thedecreases for the three and nine month periods were primarily due to a decreasein the average interest rates paid on interest-bearing deposits. The averagerate paid for the three month period in 2009 was 1.62%, a 69 basis pointdecrease from 2.31% in 2008. The average rate paid for the nine month period in2009 was 1.83%, an 79 basis point decrease from 2.62% in 2008. These ratedecreases were primarily the result of Federal Reserve actions to reduce marketinterest rates. The impact from rate decreases was partially offset byincreases in average interest-bearing deposit balances. These balancesincreased $230.3 million for the three month period to $858.5 million in 2009from $628.2 million in 2008. These balances increased $248.6 million for thenine month period to $866.1 million in 2009 from $617.4 million in 2008.  The increase in average interest bearingdeposit balances was primarily due to the AHB acquisition. $186.7 million ofinterest bearing deposit balances were acquired at December 31, 2008through the acquisition. The increase was also due to stronger consumer demandfor traditional interest-bearing deposit products.

 

Interestexpense on subordinated debentures increased approximately $86,000 toapproximately $295,000 for the three-month period ended September 30, 2009from approximately $209,000 for the same period in 2008.  This increase was mainly due to an increasein the average balance of subordinated debentures caused by the issuance of a$5.3 million junior subordinated debenture in April 2009. This newissuance carries a 12% fixed interest rate which is currently higher than theaverage rate paid on our other subordinated debentures. The rates paid on othersubordinated debenture issuances are primarily based on three month LIBOR. Thetotal average rate paid on subordinated debentures for the three months ended September 30,2009 increased 25 basis points from 5.38% in 2008 to 5.63% in 2009 primarilydue to the higher rate on the new issuance partially offset by a decrease inthe 3 month LIBOR between the two periods. Interest expense on subordinateddebentures increased approximately $38,000 to approximately $721,000 for thenine month period ended September 30, 2009 from approximately $683,000 forthe same period in 2008. The decrease for the nine month period is primarilydue to a 72 basis point decrease in the average interest rate paid on thesedebentures. The rate decrease was mainly due to a decrease in the 3 month LIBORbetween the two periods, partially offset by the higher rate on theApril 2009 new issuance.

 

Interestexpense on FHLB and other borrowings increased by approximately $89,000 or 6.1%to $1.6 million for the three-month period ended September 30, 2009 from$1.5 million for the same period in 2008. Interest expense on FHLB and otherborrowings for the nine months ended September 30, 2009 increasedapproximately $322,000 or 7.3% to $4.7 million from $4.4 million in 2008. Theseincreases in interest expense were primarily due to increases in the averagebalances of these funding sources in 2009 as compared to 2008. The averagebalance of FHLB and other borrowings for the three months 

 

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endedSeptember 30, 2009 increased by 33.9% or $51.3 million between the twoperiods. Average balances of these funding sources for the nine month periodincreased 34.5% or $51.7 million between the two periods.  The increase in average FHLB and otherborrowings was partially due to the AHB acquisition. $36.6 million of FHLB andother borrowings balances were acquired at December 31, 2008 through theacquisition. The increase in these borrowings from December 31, 2008through September 30, 2009 was also due to an increase in borrowings fromthe FHLB and Federal Reserve to fund the increase in loans held for sale.

 

FHLBand other borrowings are a favorable alternative to deposits to support assetgrowth. The impact from the average balance increase was partially offset by adecrease in the average rate paid on these borrowings. The average rate paidwas 3.05% for the three months ended September 30, 2009, a decrease of 81basis points from 3.86% during the same period in 2008. The average rate paidon these borrowings was 3.12% for the nine months ended September 30, 2009,a decrease of 79 basis points from 3.91% during the same period in 2008. Thelower average rate paid was primarily a result of Federal Reserve actions toreduce market interest rates.

 

**PROVISIONFOR LOAN AND LEASE LOSSES, AS RESTATED**

 

Theallowance for loan and lease losses is an amount that Management believes willbe adequate to absorb probable loan losses on existing loans that may becomeuncollectible and is established based on Management’s evaluation of thecollectability of loans.  Theseevaluations take into consideration such factors as changes in the nature andvolume of the loan portfolio, overall portfolio quality, adequacy ofcollateral, review of specific problem loans, and current economic conditionsthat may affect our borrowers’ ability to pay.

 

During the three and ninemonths ended September 30, 2009, the Corporation recorded $11.2 millionand $17.7 million in provision for loan and lease losses, respectively, ascompared to $290,000 and $950,000 for the same period in 2008. The increase in theprovision for loan losses in the three and nine months ended September 30,2009 can be attributed to uncertainty in the economic environment, increasedtrends in delinquency, non-accruals, and other impaired loans, as well asdepreciated values of collateral supporting such loans.  Charge-offs also continued to increase due todiminished operating cash flows of our borrowers.  The percentage of non-performing loans togross loans was 3.66% at September 30, 2009 compared to 1.21% atDecember 31, 2008 and 0.40% at September 30, 2008. The allowance forloan and lease losses as a percentage of gross loans and leases atSeptember 30, 2009 was 2.45% compared to 1.10% at December 31, 2008and 1.07% at September 30, 2008. Net charge-offs for the three and ninemonths ended September 30, 2009 were $3.1 million and $4.2 millioncompared to $111,000 and $190,000 for the same periods in 2008.

 

Additionalinformation about the material weakness in internal control surrounding theAllowance for Loan and Leases losses identified by Management and ourremediation plan is provided in Item 4, “Controls and Procedures.”

 

Thefollowing chart presents an analysis of the Allowance for Loan and LeaseLosses:

 
| ** **                                                                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                           | ** ** | **2009**                                   | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                                           | ** ** | **(Restated)**                             | ** ** | ** **                                | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
| Balance at beginning of period                                                       |       | $                                          | 15,528     |                                      | $          | 8,433 |   | $ | 10,335 |   | $ | 7,817 |   |
|                                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Provision charged to operating expense                                               |       | 11,222                                     |       | 290                                       |       | 17,693 |   | 950 |   |
|                                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Recoveries of loans previously charged-off                                           |       | 90                                         |       | 36                                        |       | 339 |   | 233 |   |
| Loans charged-off                                                                    |       | (3,183                                     | )          | (147                                      | )          | (4,549 | ) | (423 | ) |
| Net loan charge-offs                                                                 |       | (3,093                                     | )          | (111                                      | )          | (4,210 | ) | (190 | ) |
|                                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Allowance other adjustment (1)                                                       |       | (167                                       | )          | 25                                        |       | (328 | ) | 60 |   |
|                                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Balance at end of period                                                             |       | $                                          | 23,490     |                                      | $          | 8,637 |   | $ | 23,490 |   | $ | 8,637 |   |
|                                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Period-end loans outstanding                                                         |       | $                                          | 957,502    |                                      | $          | 808,621 |   | $ | 957,502 |   | $ | 808,621 |   |
| Average loans outstanding                                                            |       | $                                          | 949,263    |                                      | $          | 798,195 |   | $ | 944,851 |   | $ | 772,933 |   |
|                                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Allowance for loan and lease losses as a  percentage of period-end loans outstanding |       | 2.45                                       | %          | 1.07                                      | %          | 2.45 | % | 1.07 | % |
| Net charge-offs to average loans outstanding                                         |       | 0.33                                       | %          | 0.01                                      | %          | 0.45 | % | 0.02 | % |

 

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(1)   The “Allowance otheradjustment” represents the reclassification of an allowance for probable losseson unfunded loans and unused lines of credit. These loans and lines of credit, although unfunded, have been committedto by the Corporation.

 

Non-performing loans and leases include those on non-accrual status,loans past due 90 days or more and still accruing, troubled debt restructuringsand other loans deemed impaired.  TheCorporation’s policy is to write down all non-performing loans to net realizablevalue.  Non-performing loans aregenerally collateralized and are in the process of collection.  Non-accrual loans reduce the Corporation’searnings because interest income is not earned on such assets. The non-accrualloan and lease balance at September 30, 2009 was $15.8 million as comparedto $10.5 million at December 31, 2008 and $3.1 million atSeptember 30, 2008. Non-accrual loans and leases have increased during2009 over 2008 because of the effects of a recessionary economy.

 

Other real estate owned (“OREO”) represents property owned by the Bankfollowing default by the borrowers. OREO property acquired through foreclosureis initially transferred at fair value based on an appraised value lessestimated cost to dispose. Adjustments are subsequently made to mark theproperty below this amount if circumstances warrant.  Losses arising from foreclosure transactionsare charged against the allowance for loan losses. Costs to maintain realestate owned and any subsequent gains or losses are included in the Corporation’sresults of operations. The total OREO balance at September 30, 2009was $3.1 million as compared to $1.9 million at December 31, 2008 andapproximately $346,000 at September 30, 2008. OREO balances have increasedduring 2009 over 2008 because of increased foreclosure activity, stemming fromthe recessionary economic conditions.

 

Thefollowing chart presents detailed information regarding non-performing loansand leases and OREO:

 

(Dollarsin thousands)

 
| ** **                                                                                   | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                   | ** ** | **2009**               | ** ** | **2008**              | ** ** | **2008** | ** ** |
| ** **                                                                                   | ** ** | **(Restated)**         | ** ** | ** **            | ** ** | ** ** | ** ** |
| Past due over 90 days and still accruing                                                     |       | $                      | —     |                  | $          | 209 |   | $ | 870 |   |
| Non-accrual loans and leases (1)                                                             |       | 15,787                 |       | 3,057                 |       | 10,514 |   |
| Restructured and other impaired loans                                                        |       | 21,524                 |       | —                |       | — |   |
| Total non-performing loans and leases                                                        |       | 37,311                 |       | 3,266                 |       | 11,384 |   |
|                                                                                         |       |                   |       |                  |       |   |   |
| Other real estate owned                                                                      |       | 3,062                  |       | 346                   |       | 1,872 |   |
| Total non-performing assets                                                                  |       | $                      | 40,373     |                  | $          | 3,612 |   | $ | 13,256 |   |
|                                                                                         |       |                   |       |                  |       |   |   |
| Non-performing loans and leases as a percentage of  total loans and leases                   |       | 3.90                   | %          | 0.40                  | %          | 1.21 | % |
|                                                                                         |       |                   |       |                  |       |   |   |
| Allowance for loan and lease losses as a  percentage of non-performing loans and leases |       | 62.96                  | %          | 264.43                | %          | 90.78 | % |
|                                                                                         |       |                   |       |                  |       |   |   |
| Non-performing assets as a percentage of total  loans and other real estate owned       |       | 4.20                   | %          | 0.45                  | %          | 1.41 | % |
|                                                                                         |       |                   |       |                  |       |   |   |
| Allowance for loan and lease losses as a  percentage of non-performing assets           |       | 58.18                  | %          | 239.12                | %          | 77.96 | % |

 

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(1)   Generally, the Bank places aloan or lease in non-accrual status when principal or interest has been indefault for a period of 90 days or more unless the loan is both well securedand in the process of collection.

 

TheCorporation identifies a loan as impaired when it is probable that interest andprincipal will not be collected according to the contractual terms of the loanagreement. With the exception of troubled debt restructurings, the accrual ofinterest is discontinued on impaired loans and no income is recognized untilall recorded amounts of interest and principal are recovered in full.

 

TheCorporation examines loans individually when it is probable that we will beunable to collect all contractual interest and principal payments according tothe contractual terms of the loan agreement and assess for impairment. Theaverage recorded balance of impaired loans was $17.1 million and $2.2 millionat September 30, 2009 and 2008, respectively.  Interest income recognized during the timewithin the period that the loans were impaired was $258,000 for the nine monthsended September 30, 2009. There was no interest income recorded onimpaired loans for the same period ending September 30, 2008 as allimpaired loans were also non-accrual.

 

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Includedin the September 30, 2009 non-performing loans and leases were $21.5million of restructured and other impaired loans.  Included in this balance was $5.8 million ofloans to one commercial relationship for which the original loan terms havebeen modified due to the borrower’s financial difficulties.  As of September 30, 2009 these loanswere performing under the re-negotiated terms and are not classified asnon-accrual.  These loans are classifiedas commercial real estate and the Corporation has allocated a specific reserveof $2.7 million at September 30, 2009. Also included in restructured and other impaired are two loans to onecommercial relationship that total $8.1 million and five loans to anothercommercial relationship that total $4.0 with a specific reserves of $2.0million and $0.0 respectively. The loans are currently performing but have beenevaluated by management and deemed impaired. Management continues to closely monitor these relationships.

 

Asa recurring part of its portfolio management program, the Corporation hasidentified approximately $60.0 million in potential problem loans at September 30,2009.  Potential problem loans are loans that are currently performing,but where the borrower’s operating performance or other relevant factors couldresult in potential credit problems, and are typically classified by our loanrating system as “substandard.” At September 30, 2009, potential problemloans primarily consisted of commercial loans and commercial real estate. Therecan be no assurance that additional loans will not become nonperforming,require restructuring, or require increased provision for loan losses.

 

Thefollowing charts present additional information about impaired loans and leasebalances as of September 30, 2009 and December 31, 2008:

 

September 30, 2009

 
| **(Dollars  in thousands)**                 | ** ** | **Loan   Balance** | ** ** | **Impaired   Loan   Balance** | ** ** | **Number of   Impaired   Loans** | ** ** | **Specific   Allowance   on   Impaired   Loans** | ** ** |
|---------------------------------------------|------------|--------------------|------------|-------------------------------|------------|----------------------------------|------------|--------------------------------------------------|------------|
| ** **                                  | ** ** | ** **         | ** ** | **(Restated)**                | ** ** | **(Restated)**                   | ** ** | **(Restated)**                                   | ** ** |
| Commercial loans                            |       | $                  | 346,174    |                          | $          | 18,356                           |       | 28                                               |       | $ | 2,957 |   |
| Real estate — commercial               |       | 298,495            |       | 9,673                         |       | 9                                |       | 4,298                                            |       |
| Real estate — commercial construction  |       | 66,255             |       | 2,300                         |       | 2                                |       | 85                                               |       |
| Real estate — residential              |       | 79,793             |       | 1,004                         |       | 3                                |       | 250                                              |       |
| Real estate — residential construction |       | 40,604             |       | 4,086                         |       | 12                               |       | 1,725                                            |       |
| Consumer loans                              |       | 123,447            |       | 1,542                         |       | 28                               |       | 283                                              |       |
| Lease financing receivables                 |       | 2,734              |       | 350                           |       | 6                                |       | 119                                              |       |
|                                        |       |               |       |                          |       |                             |       |                                             |       |
| Totals                                      |       | $                  | 957,502    |                          | $          | 37,311                           |       | 88                                               |       | $ | 9,717 |   |

 

December 31, 2008

 
| ** **                                  | ** ** | ** **  | ** ** | **Impaired** | ** ** | **Number of** | ** ** | **Specific**    | ** ** |
|---------------------------------------------|------------|-------------|------------|--------------|------------|---------------|------------|-----------------|------------|
| ** **                                  | ** ** | **Loan**    | ** ** | **Loan**     | ** ** | **Impaired**  | ** ** | **Allowance**   | ** ** |
| **(Dollars  in thousands)**                 | ** ** | **Balance** | ** ** | **Balance**  | ** ** | **Loans**     | ** ** | **on Impaired** | ** ** |
|                                        |       |        |       |         |       |          |       |            |       |
| Commercial loans                            |       | $           | 327,472    |         | $          | 3,632         |       | 20              |       | $ | 285 |   |
| Real estate — commercial               |       | 280,549     |       | 1,650        |       | 2             |       | 126             |       |
| Real estate — commercial construction  |       | 69,057      |       | —       |       | —        |       | —          |       |
| Real estate — residential              |       | 87,413      |       | 3,876        |       | 13            |       | 350             |       |
| Real estate — residential construction |       | 45,466      |       | —       |       | —        |       | —          |       |
| Consumer loans                              |       | 125,318     |       | 1,166        |       | 30            |       | 95              |       |
| Lease financing receivables                 |       | 4,808       |       | 190          |       | 4             |       | —          |       |
|                                        |       |        |       |         |       |          |       |            |       |
| Totals                                      |       | $           | 940,083    |         | $          | 10,514        |       | 69              |       | $ | 856 |   |

 

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**NON-INTERESTINCOME. AS RESTATED**

 

Totalnon-interest income increased $12.2 million to $13.5 million for the threemonths ended September 30, 2009, compared to $1.3 million for the sameperiod in 2008.  Total non-interestincome increased $40.0 million to $47.0 million for the nine months endedSeptember 30, 2009, compared to $7.0 million for the same period in 2008.

 

Ofthese increases in non interest income, net gain from mortgage banking activityaccounted for $11.7 million and $37.2 million for the three and nine monthsended September 30, 2009, respectively. Net gain from mortgage bankingactivities relates to the Mortgage Banking segment and consists of unrealizedgains and losses on interest rate lock commitments, loans held for sale, andforward sale commitments combined with realized gains and losses on the actualsale of the loan and the settlement of forward sale commitments. The increasein the net gain from mortgage banking activities from the same periods in 2008was primarily from the addition of the AHB’s residential mortgage operations.

 

Thedistinguishing activity within the Mortgage Banking segment is the originationand sale of residential mortgage and construction loans. This activity drivesthe net gain on mortgage banking activity line of the income statement. For thethree and nine months ended September 30, 2009, this line was positivelyimpacted by the actions of the Federal Reserve to reduce market rates.  These actions resulted in mortgage interestrates declining, beginning in December 2008.  The decline in rates was advantageous toconsumers, leading many borrowers to refinance their existing mortgageloan.  The increase in refinance activityreduced the negative impact from weak new and existing home sale sectors.  The Mortgage Banking segment originated $1.95billion of loans during the nine months ended September 30, 2009 withrefinance activity accounting for 64%, or $1.25 billion of the total.  Loans for the purchase of new or existinghomes totaled $645 million, or 33% of total originations, while loans toindividual borrowers for construction of single-family residences were $52million, or 3% of total originations.

 

Loanfees and other was approximately $738,000 and $3.6 million for the three andnine months ended September 30, 2009, compared to approximately $118,000and $298,000 during the same period in 2008. Loan fees and other primarilyrelate to the Mortgage Banking segment and consist mainly of fees earned at theinception of a loan as well as fees earned on the servicing of residential loanportfolios not owned by the Bank. Loan fees and other also includes gains andlosses on the Bank’s mortgage servicing rights. The increase in loan servicingfees was due to the addition of the AHB division’s mortgage operations.

 

Duringthe third quarter of 2009, the Corporation recorded a $1.6 million other thantemporary impairment charge on four banking securities in the third quarter of2009. The securities are publically traded stock of well-known, establishedbank holding companies. During the quarter, Management concluded that theimpairment on the securities is other than temporary mainly due to continueddeterioration of the financial condition of these companies and Management’sconclusion that the Corporation may no longer have the intent to hold thesesecurities until anticipated recovery.

 

Assetimpairment of $1.3 million in 2008 related to the write-down of certainsecurities in 2008. In the third quarter of 2008, the Corporation recorded anapproximately $850,000 pre-tax other than temporary impairment loss on a $1.0million Lehman Brothers note held in the Bank’s investment portfolio. In thethird quarter of 2008, the Corporation also recorded a pretax loss ofapproximately $417,000 on a $13.9 million overnight investment in the ReservePrimary Fund. The Reserve Primary Fund was a short term overnight money marketfund designed to maintain a constant $1.00 per share value. The Bank typicallyused this type of fund to invest excess overnight cash. During the thirdquarter of 2008, the Fund’s value fell below $1.00 per share due to underlyingLehman Brothers commercial paper in the fund. The Fund is currently in processof liquidation. The Bank wrote its $13.9 million investment down to $13.5million in the third quarter of 2008 and subsequently received $12.5 millionover the remainder of 2008 and 2009. The Bank fully expects to realize theremaining $1.0 million.

 

Wealthmanagement and advisory services revenue remained relatively flat for the threemonths ended September 30, 2009, as compared to 2008 but decreasedapproximately $138,000 or 4.5% to $2.9 million for the nine months endedSeptember 30, 2009 from $3.1 million during the same period in 2008.Wealth management and advisory services revenue is based largely on the marketvalue of assets under management.  Thedecrease in wealth management and advisory services revenue for the nine monthsended September 30, 2009 was primarily due to a decrease in the averagemarket value of these assets between the two periods. The decline in marketvalue was driven by a decline in the market values of the underlying securitieswithin the assets under management.

 

TheCorporation recognized a net gain of approximately $1,000 on sales ofinvestment securities during the three month period ended September 30,2009, compared with a net gain of approximately $89,000 during the same periodin 2008.  The Corporation recognized anet gain of approximately $1,000 on sales of investment securities during thenine month period ended September 30, 2009, compared with a net gain ofapproximately $273,000 during the same period in 2008.  These net gains and losses were taken as aresult of normal portfolio management.

 

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Gainson fixed assets and OREO increased approximately $285,000 and $312,000 for thethree and nine months ended September 30, 2009 as compared to 2008. Theseincreases were due primarily to an approximately $114,000 gain from the sale ofoperating lease equipment in the third quarter of 2009 combined with anapproximately $169,000 loss recorded in the third quarter of 2008 from thewrite-down to fair market value of two OREO properties.

 

Othernon-interest income increased 15.3% or approximately $69,000 to $521,000 forthe three-month period ended September 30, 2009.  Other non-interest income increasedapproximately $179,000 or 12.8% to $1.6 million for the nine months endedSeptember 30, 2009, compared to same period in 2008.  The increase for the three and nine monthperiods are primarily due to increases in various fee income earned from theAHB operations.

 

Wealthmanagement and advisory services revenue, service charges on deposit accounts,gains and losses on investment securities, operating lease rental income, gainson the sale of fixed assets and OREO and nearly all of other non-interestincome are included within the results of the community banking segment. Nearlyall of loan servicing fees and other and all of net gain from mortgage bankingactivities are included within the mortgage banking segment.

 

**NON-INTERESTEXPENSE**

 

Totalnon-interest expense increased $14.7 million to $23.4 million for thethree-month period ended September 30, 2009, compared to $8.6 millionduring the same period in 2008.  Totalnon-interest expense increased $41.8 million to $66.8 million for the ninemonths ended September 30, 2009, from $25.1 million during the same periodin 2008.

 

Salariesand employee benefits increased $10.1 million to $14.9 million for the threemonth period ended September 30, 2009 compared to the same period in 2008.Salaries and employee benefits increased $28.9 million to $42.7 million for thenine month period ended September 30, 2009 compared to the same period in2008. The higher salary and benefits expense was primarily due to the additionof the AHB operations at December 31, 2008.

 

Salariesand related expenses allocable to the Mortgage Banking segment consist ofcommissions paid to employees involved in the loan origination process, as wellas compensation, payroll taxes and benefits paid to employees in the mortgageproduction operations and allocations for overhead.

 

Salariesdirectly attributable to the Mortgage Banking segment totaled $8.5 million forthe quarter and $24.7 million for the nine months ended September 30,2009. Of these amounts, variable compensation, that is compensation paid toloan originators, accounted for $5.4 million, or 64% of the total for the threemonths ended and $16.6 million or 67% for the nine months ended September 30,2009. This variable compensation amounts to 0.85% of total originations, a ratetypical in the mortgage banking industry.

 

Netoccupancy, equipment and data processing expense increased $1.8 million or123.6% to $3.2 million for the three months ended September 30, 2009, whencompared to the same period in 2008.  Netoccupancy, equipment and data processing expense increased $4.5 million or104.4% to $8.9 million during the nine months ended September 30, 2009,when compared to the same period in 2008. Approximately $1.4 million and $3.6 million of these increases were dueto the addition of AHB’s operations for the three and nine months endedSeptember 30, 2009. Occupancy, equipment and data processing expense fromAHB’s operations include the operations of administrative facilities as well astwo branches combined with IT systems operations. The increase was alsoattributable to the opening of the new Jennersville grocery store branch aswell as the opening of the new One North High Street administrative complex inthe first quarter of 2009. The year to date 2009 expense also includesapproximately $187,000 of merger-related IT system conversion expense recordedin the second quarter of 2009.

 

FDIC insurance premiumsincreased approximately $286,000 or 210.3% to approximately $422,000 for thethree months ended September 30, 2009, from approximately $136,000 duringthe same period in 2008.  FDIC insurancepremiums increased $1.6 million or 446.7% to $1.9 million for the nine monthperiod ended September 30, 2009, from approximately $347,000 during thesame period in 2008.  In 2008 and 2009,the FDIC adopted rules that increased FDIC premiums significantly for allbanks for assessment periods beginning in the first quarter of 2009. Inaddition, the FDIC instituted a special assessment for all banks for the secondquarter of 2009. FDIC Deposit Insurance expense for the nine months endedSeptember 30, 2009 includes approximately $673,000 for this specialassessment, recorded in the second quarter of 2009. The increased premium aswell as the special assessment will cause the Bank’s 2009 FDIC premiums andassessment expense to increase significantly over 2008.

 

Professionalservices expense increased $1.6 million to $2.0 million for the three monthperiod ended September 30, 2009 from $449,000 for the same period in2008.  Professional services expenseincreased $3.6 million or 262.7% to $5.0 million for the nine month periodended September 30, 2009 from $1.4 million for the same period in2008.  Approximately 

 

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$1.0million and $2.8 million of the increase in professional fees are due toincreased legal, consulting and audit fees from the addition of AHB’soperations. The balance of the increase was due to increased legal, audit andconsulting fees related to the integration of AHB, as well as other companyinitiatives.

 

Marketingexpense increased approximately $166,000 or 97.1% to approximately $337,000 forthe three month period ended September 30, 2009, from approximately$171,000 for the same period in 2008. Marketing expense increased approximately $457,000 or 64.9% to $1.2million for the nine month period ended September 30, 2009, fromapproximately $704,000 for the same period in 2008. The increases for the threeand nine month periods were primarily due to the addition of AHB’s operations.

 

Totalother non-interest expense increased approximately $820,000 or 74.3% to $1.9million for the three-month period ended September 30, 2009, from $1.1million for the same period in 2008. Total other non-interest expense increased $2.5 million or 81.7% to $5.6million for the nine month period ended September 30, 2009 from $3.1million for the same period in 2008. Most of the increases are due to theaddition of AHB’s operations.

 

**INCOMETAXES, AS RESTATED**

 

Income tax expense for thethree months ended September 30, 2009 was a $3.3 million benefit comparedto approximately $148,000 of expense for same period in 2008. Income taxexpense was a $2.1 million benefit for the nine months ended September 30,2009, compared to a $1.3 million expense for the same periods in 2008. Incometax expense is negative for the three and nine month periods in 2009 because ofa net operating loss combined with the effect of permanent tax benefit items.

 

**LIQUIDITYMANAGEMENT AND INTEREST RATE SENSITIVITY**

 

**LiquidityManagement**

 

Theobjective of liquidity management is to ensure the availability of sufficientcash flows to meet all financial commitments and to capitalize on opportunitiesfor business expansion.  Liquiditymanagement addresses the Corporation’s ability to meet deposit withdrawalseither on demand or at contractual maturity, to repay borrowings as they matureand to make new loans and investments as opportunities arise.  Liquidity is managed on a daily basisenabling Management to monitor changes in liquidity and to react accordingly tofluctuations in market conditions.  Theprimary sources of liquidity for the Corporation are funding available from thegrowth of the existing deposit base, new deposits, FHLB, Federal Reserve andcash flow from the investment and loan portfolios.  The Corporation considers funds from suchsources to comprise its “core” funding sources because of the historicalstability of such sources of funds. Additional liquidity comes from the Corporation’s non-interest bearingdemand deposit accounts and credit facilities. Other deposit sources include a tiered savings product and certificatesof deposit in excess of $100,000. Details of core deposits, non-interestbearing demand deposit accounts, and other deposit sources are highlighted inthe following table:

 

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(Dollars in thousands)

 
| ** **                           | ** ** | **For the Nine Months Ended  September 30, 2009** | ** ** | **For the Year Ended  December 31, 2008** | ** ** |
|--------------------------------------|------------|--------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                           | ** ** | **Average**                                            | ** ** | **Effective**                                  | ** ** | **Average** | ** ** | **Effective** | ** ** |
| ** **                           | ** ** | **Balance**                                            | ** ** | **Yield**                                      | ** ** | **Balance** | ** ** | **Yield** | ** ** |
| **DEPOSIT TYPE**                     |       |                                                   |       |                                           |       |   |   |   |   |
| NOW Accounts                         |       | $                                                      | 188,693    |                                           | 0.83       | % | $ | 179,512 |   | 1.64 | % |
| Money Market                         |       | 159,486                                                |       | 1.21                                           | %          | 117,393 |   | 2.46 | % |
| Statement Savings                    |       | 41,026                                                 |       | 0.58                                           | %          | 40,300 |   | 0.70 | % |
| Other Savings                        |       | 1,844                                                  |       | 0.97                                           | %          | 2,802 |   | 1.50 | % |
| Tiered Savings                       |       | 46,062                                                 |       | 1.09                                           | %          | 48,915 |   | 1.30 | % |
| Total NOW Savings, and Money Market  |       | 437,111                                                |       | 0.97                                           | %          | 388,922 |   | 1.75 | % |
|                                 |       |                                                   |       |                                           |       |   |   |   |   |
| CDs Less than $100,000               |       | 290,260                                                |       | 2.64                                           | %          | 162,650 |   | 3.73 | % |
| CDs Greater than $100,000            |       | 138,685                                                |       | 2.84                                           | %          | 74,822 |   | 3.90 | % |
| Total CDs                            |       | 428,945                                                |       | 2.71                                           | %          | 237,472 |   | 3.78 | % |
|                                 |       |                                                   |       |                                           |       |   |   |   |   |
| Total Interest Bearing Deposits      |       | 866,056                                                |       |                                           |       | 626,394 |   |   |   |
|                                 |       |                                                   |       |                                           |       |   |   |   |   |
| Non-Interest Bearing Demand Deposits |       | 148,424                                                |       |                                           |       | 120,941 |   |   |   |
|                                 |       |                                                   |       |                                           |       |   |   |   |   |
| Total Deposits                       |       | $                                                      | 1,014,480  |                                           |       |   | $ | 747,335 |   |   |   |

 

TheBank maintains several credit facilities with the FHLB as well as the FederalReserve and other Banking institutions. During the three and nine month periods ended September 30, 2009,average FHLB advances and other borrowings were $202.9 million and $201.9million, respectively, and consisted of term advances with a variety ofmaturities.  The average interest ratepaid on these advances was 3.05% during the third quarter of 2009.  The Bank currently has a maximum borrowingcapacity with FHLB of approximately $340.0 million.  FHLB advances are collateralized by a pledgeon the Bank’s portfolio of unencumbered investment securities, certain mortgageloans, and a lien on the Bank’s FHLB stock. The Bank also has $245.9 million ofborrowing capacity with the Federal Reserve. Federal Reserve borrowings arecollateralized by a pledge on certain mortgage loans and a lien on the Bank’sFederal Reserve stock.

 

**InterestRate Sensitivity**

 

Thegoal of interest rate sensitivity management is to avoid fluctuating netinterest margins, and to enhance consistent growth of net interest incomethrough periods of changing interest rates. Such sensitivity is measured as the difference in the volume of assetsand liabilities in the existing portfolio that are subject to repricing in afuture time period.  The Corporation’snet interest rate sensitivity gap within one year is a negative $289.3 millionor 22.1% of total assets at September 30, 2009, compared with a negative$292.9 million or 22.5% of total assets at December 31, 2008.  The Corporation’s gap position is one toolused to evaluate interest rate risk and the stability of net interestmargins.  Another tool that managementuses to evaluate interest rate risk is a computer simulation model thatassesses the impact of changes in interest rates on net interest income undervarious interest rate forecasts and scenarios. Management has set acceptable limits of risk within its Asset

 

LiabilityCommittee (“ALCO”) policy and monitors the results of the simulations againstthese limits quarterly.  As of the mostrecent quarter-end, all results are within policy limits and indicate anacceptable level of interest rate risk. Management monitors interest rate riskas a regular part of corporate operations****with theintention of maintaining a stable net interest margin. The following tablepresents our interest rate sensitivity analysis as of September 30, 2009:

 

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(Dollarsin thousands)

 
| ** **                                                        | ** ** | ** **     | ** ** | **Two**        | ** ** | **Over**       | ** ** | ** **     | ** ** | ** **     | ** ** |
|-------------------------------------------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| ** **                                                        | ** ** | **Within**     | ** ** | **through**    | ** ** | **five**       | ** ** | **Non-rate**   | ** ** | ** **     | ** ** |
| ** **                                                        | ** ** | **one year**   | ** ** | **five years** | ** ** | **years**      | ** ** | **sensitive**  | ** ** | **Total**      | ** ** |
| ** **                                                        | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| ASSETS                                                            |       |           |       |           |       |           |       |           |       |           |       |
| Federal funds sold and overnight investments                      |       | $              | 2,347      |           | $          | —         |       | $              | —     |           | $          | — |   | $ | 2,347 |   |
| Investment securities                                             |       | 58,706         |       | 14,858         |       | 4,173          |       | 12,129         |       | 89,866         |       |
| Interest bearing deposits in banks                                |       | 1,497          |       | —         |       | —         |       | —         |       | 1,497          |       |
| Loans held for sale                                               |       | 190,201        |       | —         |       | —         |       | —         |       | 190,201        |       |
| Net loans and leases                                              |       | 396,012        |       | 402,514        |       | 158,976        |       | (23,490        | )          | 934,012        |       |
| Cash and due from banks                                           |       | —         |       | —         |       | —         |       | 19,107         |       | 19,107         |       |
| Premises and equipment                                            |       | —         |       | —         |       | —         |       | 23,142         |       | 23,142         |       |
| Other assets                                                      |       | —         |       | —         |       | —         |       | 48,241         |       | 48,241         |       |
| Total assets                                                      |       | $              | 648,763    |           | $          | 417,372        |       | $              | 163,149    |           | $          | 79,129 |   | $ | 1,308,413 |   |
|                                                              |       |           |       |           |       |           |       |           |       |           |       |
| LIABILITIES AND CAPITAL                                           |       |           |       |           |       |           |       |           |       |           |       |
| Non-interest bearing deposits                                     |       | $              | —     |           | $          | —         |       | $              | —     |           | $          | 153,299 |   | $ | 153,299 |   |
| Interest bearing deposits                                         |       | 791,799        |       | 33,809         |       | 7,208          |       | —         |       | 832,816        |       |
| FHLB advances and other Borrowings                                |       | 128,107        |       | 74,016         |       | —         |       | —         |       | 202,123        |       |
| Subordinated debentures                                           |       | 15,465         |       | —         |       | 5,330          |       | —         |       | 20,795         |       |
| Other liabilities                                                 |       | —         |       | —         |       | —         |       | 16,270         |       | 16,270         |       |
| Capital                                                           |       | —         |       | —         |       | —         |       | 83,110         |       | 83,110         |       |
| Total liabilities & capital                              |       | $              | 935,371    |           | $          | 107,825        |       | $              | 12,538     |           | $          | 252,679 |   | $ | 1,308,413 |   |
| Net interest rate sensitivity gap                                 |       | $              | (286,608   | )              | $          | 309,547        |       | $              | 150,611    |           | $          | (173,550 | ) |   |   |
| Cumulative interest rate sensitivity gap                          |       | $              | (286,608   | )              | $          | 20,259         |       | $              | 150,611    |           | $          | — |   |   |   |
| Cumulative interest rate sensitivity gap divided  by total assets |       | (21.9          | )%         | 1.6            | %          | 11.5           | %          |           |       |           |       |

 

**BRANCHING,TECHNOLOGY AND CAPITAL PROJECTS**

 

Duringthe first quarter of 2009, the Bank completed renovations on a new officebuilding located at One North High Street in West Chester, PA. The building,along with and adjacent to our main branch and existing facility at Nine NorthHigh Street will serve as the Corporation’s headquarters.  During the first quarter of 2009, the Bankalso opened a new grocery store branch in Jennersville, PA. Technologicalimprovements, including enhanced security over customer information, a moreproactive disaster recovery system and an improved infrastructure to supportmore internet banking products are also expected in the future. We arecontinuously looking for appropriate opportunities to expand our branch systemand invest in technology to better serve our customers.

 

**CAPITAL****ADEQUACY**

 

TheCorporation is subject to Risk-Based Capital Guidelines adopted by the FederalReserve Board for bank holding companies. The Bank is also subject to similar capital requirements adopted by theOCC. Under these requirements, the regulatory agencies have set minimumthresholds for Tier I Capital, Total Capital, and Leverage ratios.  At September 30, 2009, both theCorporation’s and the Bank’s capital exceeded all minimum regulatoryrequirements, and the Bank was considered “well capitalized” as defined in theregulations issued pursuant to the FDIC Improvement Act of 1992. Subsequent toSeptember 30, 2009, the OCC is requiring the Bank to increase itsTier 1 leverage capital ratio to not less than 8%, its Tier 1 risk-basedcapital ratio to not less than 10% and its total risk-based capital ratio tonot less than 12% by December 31, 2009.

 

InApril 2009, the Corporation completed the placement of $5,175,000aggregate liquidation amount of fixed rate trust preferred securities (the “TrustPreferred Securities”), through a newly formed subsidiary, First Chester CountyCapital Trust IV, a wholly owned Delaware statutory trust (the “Trust”). Inconnection with the sale of the Trust Preferred Securities, the Corporationissued $5,330,000 of junior subordinated deferrable interest debentures (the “Debentures”)to the Trust. The Trust Preferred Securities and the Debentures have a 30 yearmaturity, and carry a fixed rate of interest of 12.0%. The Corporation hasretained the right to redeem the Trust Preferred Securities at par (plusaccrued but unpaid interest) on any interest payment date on or afterApril 28, 2014.

 

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TheCorporation’s trust preferred subsidiaries are deconsolidated in accordancewith GAAP and the related securities qualify as Tier 1 capital under federalregulatory guidelines.  These instruments are subject to a 25%capital limitation under risk-based capital guidelines developed by the FederalReserve Board. In March 2005, the Federal Reserve Board amended itsrisk-based capital standards to expressly allow the continued limited inclusionof outstanding and prospective issuances of trust preferred securities in abank holding company’s Tier 1 capital, subject to tightened quantitativelimits. The Federal Reserve’s amended rule was to become effectiveMarch 31, 2009, and would have limited trust preferred securities andother restricted core capital elements to 25% of all core capital elements, netof goodwill less any associated deferred tax liability.  OnMarch 16, 2009, the Federal Reserve Board extended for two years theability of bank holding companies to include restricted core capital elementsas Tier 1 capital up to 25% of all core capital elements, including goodwill.The portion that exceeds the 25% capital limitation qualifies as Tier 2, orsupplementary capital of the Corporation. At September 30, 2009, theentire $20.8 million in trust preferred securities qualify as Tier 1.

 
| ** **                     | ** ** | ** **                   | ** ** | ** **            | ** ** | ** **            | ** ** | **“Well** | ** ** |
|--------------------------------|------------|------------------------------|------------|-----------------------|------------|-----------------------|------------|----------------|------------|
| ** **                     | ** ** | ** **                   | ** ** | **As of**             | ** ** | **Capitalized”** | ** ** |
| ** **                     | ** ** | **As of September 30,** | ** ** | **December 31,** | ** ** | **Requirements**      | ** ** |
| ** **                     | ** ** | **2009**                     | ** ** | **2008**              | ** ** | **2008**              | ** ** | **(1)**        | ** ** |
| ** **                     | ** ** | **(Restated)**               | ** ** | ** **            | ** ** | ** **            | ** ** | ** **     | ** ** |
| Corporation                    |       |                         |       |                  |       |                  |       |           |       |
| Leverage Ratio                 |       | 7.15                         | %          | 8.66                  | %          | 9.87                  | %          | N/A            |       |
| Tier I Capital Ratio           |       | 9.12                         | %          | 10.04                 | %          | 9.14                  | %          | N/A            |       |
| Total Risk-Based Capital Ratio |       | 10.39                        | %          | 11.10                 | %          | 10.15                 | %          | N/A            |       |
| Bank                           |       |                         |       |                  |       |                  |       |           |       |
| Leverage Ratio                 |       | 7.34                         | %          | 8.03                  | %          | 9.95                  | %          | 5.00           | %          |
| Tier I Capital Ratio           |       | 9.37                         | %          | 9.31                  | %          | 9.40                  | %          | 6.00           | %          |
| Total Risk-Based Capital Ratio |       | 10.63                        | %          | 10.38                 | %          | 10.42                 | %          | 10.00          | %          |

 

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(1)          Subsequent toSeptember 30, 2009, the OCC required the Bank to increase itsTier 1 leverage capital ratio to not less than 8%, its Tier 1 risk-basedcapital ratio to not less than 10% and its total risk-based capital ratio tonot less than 12% by December 31, 2009.

 

**REGULATORYMATTERS**

 

On October 16, 2009, the Board ofDirectors of the Bank entered into an MOU with the OCC.  An MOU withregulatory authorities is an informal action that is not published or publiclyavailable and that is used when circumstances warrant a milder form of actionthan a formal supervisory action, such as a formal written agreement or order.Among other things, under the MOU, the Bank has agreed to address the followingmatters:

 

·                  Develop a comprehensive three-year capitalplan;

 

·                  Take action to protect criticized assets andadopt and implement a program to eliminate the basis of criticism of suchassets;

 

·                  Establish an effective program that providesfor early problem loan identification and a formal plan to proactively managethose assets;

 

·                  Review the adequacy of the Bank’s informationtechnology activities and Bank Secrecy Act compliance and approve writtenprograms of policies and procedures to provide for compliance; and

 

·                  Establish a Compliance Committee of the Boardto monitor and coordinate the Bank’s adherence to the provisions of the MOU.

 

The Board of Directors andmanagement have already initiated corrective actions to comply with theprovisions of the MOU.

 

Subsequent to September 30, 2009,the OCC has also required the Bank to increase its Tier 1 leveragecapital ratio to not less than 8%, its Tier 1 risk-based capital ratio to notless than 10% and its total risk-based capital ratio to not less than 12% byDecember 31, 2009.

 

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The Company has also received notice from theFederal Reserve, the primary regulator of the Corporation, that the FederalReserve must approve any dividends to be paid by the Corporation in advance ofthe declaration or payment of the dividend.

 

**ITEM 3.  QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Therehave been no material changes in the Corporation’s assessment of itssensitivity to market risk since its presentation in the 2008 Annual Report.Please refer to Item 7A of the Corporation’s 2008 Annual Report for moreinformation.

 

**ITEM 4.  CONTROLS AND PROCEDURES**

 

**DisclosureControls and Procedures**

 

Asof September 30, 2009, the end of the period covered by this QuarterlyReport on Form 10-Q, an evaluation of the effectiveness of our disclosurecontrols and procedures (as defined in Rules 13(a)-15(e) and15(d)-15(e) promulgated under the Securities Exchange Act of 1934, asamended (the “Exchange Act”)) was performed under the supervision and with theparticipation of Management, including our President and CEO, Chief OperatingOfficer and our Chief Financial Officer. Based on that evaluation and theidentification of material weaknesses in our internal controls over financialreporting as described below, management has concluded that our disclosurecontrols and procedures were not effective to ensure that information requiredto be disclosed by us in the reports that we file or submit under the ExchangeAct is (i) recorded, processed, summarized and reported within the timeperiods specified in the Securities and Exchange Commission’s rules andforms, and (ii) accumulated and communicated to management as appropriateto allow timely decisions regarding required disclosures.

 

**Changes in Internal Control over Financial Reporting**

 

Except for the material weaknesses in our internal controls previouslydisclosed in our Form 10-Q/A for the periods ended March 31, 2009 andJune 30, 2009, respectively, and the related remediation efforts describedbelow, there have not been any changes in our internal control over financialreporting (as defined in Rule 13a-15(f) of the Exchange Act)identified in connection with the evaluation required by Rule 13a-15(d) underthe Exchange Act during the quarter ended September 30, 2009, that hasmaterially affected, or is reasonably likely to materially affect, thosecontrols.

 

*Allowance for Loan andLease Losses*

 

During the preparation of the Corporation’s for the nine months ended September 30,2009, management identified a material weakness in the Corporation’s internalcontrols related to the design and implementation of policies to promptlyidentify problem loans and to quantify the elements of risk in problemloans.  The Bank’s policies andprocedures were not systematically applied, which caused a failure in theidentification of problem loans on a timely basis and a failure to accuratelyestimate the risk in the portfolio; this in turn caused a failure to accuratelydetermine the appropriate Allowance for Loan and Lease Losses at June 30,2009.  Management also discovered amonitoring weakness that contributed to the characterization of the status ofcertain loans to be classified as fully performing, when in fact these loanswere not.   Management concluded that theAllowance for Loan and Lease Losses and the Provision for Loans and LeaseLosses as of and for the three and six months ended June 30, 2009 shouldbe increased by $3.5 million.

 

*Mark-to-Market Accountingof Mortgage Loans Held for Sale*

 

Subsequent to the year endedDecember 31, 2009, management identified a material weakness in internalcontrols related to the Corporation’s process to review the valuation ofmortgage loans held for sale.  Mortgage loans held for sale representmortgage loans originated by the Corporation and held until sold to secondarymarket investors. Upon the closing of a residential mortgage loan originated bythe Corporation, the mortgage loan is typically warehoused for a period of timeand then sold into the secondary market. While in this warehouse phase,mortgage loans held for sale are recorded at fair value under the fair valueoption with changes in fair value recognized through earnings.  An errorwas identified in the Corporation’s process to properly identify a certainpopulation of loans held for sale prior to sending the loan details to theCorporation’s third party valuation firm.  As such, at March 31, June 30,and September 30, 2009, the Corporation erroneously excluded from thepopulation to be fair valued, loans which were identified for sale but forwhich the Corporation was awaiting the consideration from the counterparty tocomplete the sales transaction.   These particular loans werecorrectly classified as loans held for sale on the Consolidated Balance Sheetsof the Original Filings; however the unrealized gains(losses) associated withthese loans was not reflected in the Consolidated Balance Sheets and theStatement of Operations. This error resulted in an understatement in thecarrying amount of loans held for sale for the quarters ended March 31, June 30and September 30, 2009, as well as an understatement of net income for eachquarter. As a result of this material weakness, the Bank increased net gainsfrom mortgage banking by $1.2 million, $14 thousand and $2.7 million for thequarters ended March 31, June 30, and September 30, 2009,respectively.

 

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**Remediation of Material Weaknesses**

 

*Allowance for Loan andLease Losses*

 

During the fourthquarter 2009 and subsequent to year-end, management began taking steps toremediate the material weakness surrounding the Allowance for Loan and LeaseLosses. The following steps have been completed as of the time of this filing:

 

·                  hired a seasoned Credit Administration andCredit Policy Officer to oversee, manage and train lending personnel;

·                  engaged an independent third party to performthe quarterly loan review process, which includes 100% coverage of criticizedand classified assets;

·                  approved and implemented separation oflending and credit administration functions to increase internal controls andimprove segregation of duties;

·                  conductedrisk recognition training to improve criticized asset management and to ensureproper evaluation of ongoing credit ratings;

·                  improvedprocesses for identifying impaired loans and the determination of the amount ofimpairment in accordance with OCC guidelines;

·                  approved and implemented change of lendingauthorities to ensure better oversight of lenders and to increase oversight oncriticized assets;

·                  approved and implemented Board of Directorapproval for all new credit advances for criticized assets of $1,000,000 orgreater;

·                  transferred responsibilities for managementand oversight of the Loan Quality Committee, Loan Committee, DelinquencyCommittee and Classified Asset Committee to a separate Credit Administrationand Credit Policy Officer; and

·                  the Loan Review Committee shall continue toreview the Loan Quality Status Reports on a quarterly basis.

 

Further,management continues to review existing policies, procedures and practices forcompliance with risk rating, accountability and timeliness regarding creditadministration, risk recognition, credit management and credit assessment.

 

*Mark-to-Market Accountingof Mortgage Loans Held for Sale*

 

Subsequentto December 31, 2009, and immediately following management’sidentification of the material weakness surrounding the mark-to-marketaccounting of Mortgage Loans Held for Sale, management began to enhanceexisting processes that when fully implemented will ensure the portfolio ofMortgage Loans Held for Sale is complete prior to delivery to the third partyvaluation firm.  At each month-end a reconciliation will be performed toensure the loans held for sale included in file sent to the third partyvaluation firm reconciles to the Corporation’s internal subledger.  Thisinternal subledger of loans held for sale will be reconciled to the Corporation’sgeneral ledger.  These reconciliations will be reviewed by managementmonthly to ensure timely completion and that reconciling items, if any areappropriately addressed.

 

Asof the date of this Amendment, management continues their ongoing efforts tocorrect and revise the existing processes surrounding the material weaknessesdescribed above.  Additional changes will be implemented as determinednecessary.

 

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**PART II - OTHER INFORMATION**

 

**Item 1.****                   ****LegalProceedings**

 

Thereare no material pending legal proceedings, other than ordinary routinelitigation incidental to the business, to which the Corporation, or any of itssubsidiaries, is a party or of which any of their respective property is thesubject.

 

**Item 1A.****                ****RiskFactors**

 

Fora summary of risk factors relevant to our operations, see Part 1, Item1A, “Risk Factors” in our 2008 Annual Report on Form 10-K for the yearended December 31, 2008.  There areno material changes in the risk factors relevant to our operations, except asdiscussed below.

 

**We presently are subject to, and in the future may becomesubject to, regulatory enforcement actions that could have a material adverseeffect on our business, operations, financial condition, results of operationsor the value of our common stock.**

 

Underfederal and state laws and regulations pertaining to the safety and soundnessof insured depository institutions, various state regulators (for statechartered banks), the Federal Reserve (for bank holding companies), the Officeof the Comptroller of the Currency (for national banks) and separately theFederal Deposit Insurance Corporation (“FDIC”) as the insurer of bank deposits,have the authority to compel or restrict certain actions on our part if theydetermine that we have insufficient capital or are otherwise operating in amanner that may be deemed to be inconsistent with safe and sound bankingpractices. Under this authority, our bank regulators can require us to enterinto informal or formal enforcement orders, including board resolutions,memoranda of understanding, written agreements and consent or cease and desistorders, pursuant to which we would be required to take identified correctiveactions to address cited concerns and to refrain from taking certain actions.

 

InOctober 2009, the members of the Board of Directors of the Bank enteredinto an MOU with the OCC to address certain issues that arose in the Bank’smost recent regulatory examination. The issues required to be addressed bymanagement include, among other matters, to improve our loan portfolio andcredit risk management and related policies and procedures, address liquiditymanagement and current and future capital requirements, and strengthenenterprise risk management and Bank Secrecy Act practices. InNovember 2009, the OCC also required the Bank to increase its Tier 1leverage capital ratio to not less than 8%, its Tier 1 risk-based capital ratioto not less than 10% and its total risk-based capital ratio to not less than12% by December 31, 2009.

 

Ifwe are unable to comply with the terms of the MOU, or if we are unable tocomply with the terms of any future regulatory orders to which we may becomesubject, then we could become subject to additional, heightened supervisoryactions and orders, possibly including cease and desist orders, promptcorrective actions and/or other regulatory enforcement actions. If ourregulators were to take such additional supervisory actions, then we could, amongother things, become subject to significant restrictions on our ability todevelop any new business, as well as restrictions on our existing business. Theterms of any such supervisory action could have a material adverse effect onour business, operating flexibility, financial condition and the value of ourcommon stock.

 

**We are required to maintaincapital to meet regulatory requirements, and if we fail to maintain sufficientcapital, whether due to losses, an inability to raise additional capital or otherwise,our financial condition, liquidity and results of operations, as well as ourregulatory requirements, would be adversely affected.**

 

Bothwe and the Bank must meet regulatory capital requirements and maintainsufficient liquidity. The OCC recently required that the Bank achieve a Tier 1leverage capital ratio of not less than 8%, its Tier 1 risk-based capital ratioof not less than 10% and its total risk-based capital ratio of not less than12% by December 31, 2009, which are higher than the stated minimum capitalratios. Our ability to raise additional capital, when and if needed, willdepend on conditions in the capital markets, economic conditions and a numberof other factors, including investor perceptions regarding the banking industryand market conditions, and governmental activities, many of which are outsideour control, and on our financial condition and performance. Accordingly, wecannot assure you that we will be able to raise additional capital if needed oron terms acceptable to us. If we fail to meet these capital and otherregulatory requirements we may be subject to further enforcement actionspursuant to which we would be required to take identified corrective actions toaddress cited concerns and to refrain from taking certain actions.  These actions may materially and adverselyaffect our financial condition, liquidity and results of operations.

 

Ourfailure to remain “well capitalized” for bank regulatory purposes could affectcustomer confidence, our ability to grow, our costs of funds and FDIC insurancecosts, our ability to pay dividends on our common stock, our ability to make 

 

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distributionson our trust preferred securities, our ability to make acquisitions, ourinterest rates and our business, results of operation and financial conditions,generally.

 

**We depend primarily on dividends from the Bank for cash revenues, butthose dividends are subject to restrictions under the MOU and bank regulations.**

 

Ourability to satisfy our obligations and pay cash dividends to our shareholdersis primarily dependent on the earnings of and dividends from the Bank. However,payment of dividends by the Bank is limited by our MOU with the OCC and bydividend restrictions and capital requirements imposed by bank regulations.Under the MOU, the Bank is required to request supervisory approval to dividendany funds to us. We currently have $3.0 million of unsecured short-termborrowings which are due to be paid on November 20, 2009. In the event theBank is not permitted by the OCC to dividend funds to us in connection withthis debt repayment, we may be in default under the terms of the loans. Moregenerally, in the event the Bank is unable to pay dividends to us, we may notbe able to service our debt, pay our obligations or pay dividends on our commonstock.

 

**Our disclosure controls and procedures and internal controlover financial reporting were determined not to be effective as ofSeptember 30, 2009, as evidenced by material weaknesses that existed inour internal controls. Our disclosure controls and procedures and internalcontrol over financial reporting may not be effective in future periods, as a resultof newly identified material weaknesses in internal controls.**

 

Effectiveinternal control over financial reporting is necessary for compliance with theSarbanes-Oxley Act of 2002 and appropriate financial reporting. Management isresponsible for establishing and maintaining adequate internal control overfinancial reporting. Internal control over financial reporting is a process,under the supervision of the Corporation’s Chief Executive Officer and ChiefFinancial Officer, designed to provide reasonable assurance regarding thereliability of financial reporting and the preparation of  our financial statements for externalreporting purposes in accordance with GAAP. As disclosed in this QuarterlyReport on Form 10-Q, management’s assessment of our internal control overfinancial reporting identified material weaknesses as discussed in *Item 4. Controls and Procedures*. Amaterial weakness is a deficiency in internal control over financial reporting,such that there is a reasonable possibility that a material misstatement of theCorporation’s annual or interim financial statements will not be prevented ordetected on a timely basis. See *Item 4.Controls and Procedures*of this Form 10-Q for the remediationstatus of the material weaknesses identified. However, there can be noassurance that additional material weaknesses will not be identified in thefuture. We are committed to continuing to improve our internal controlprocesses and we will continue to diligently and vigorously review ourfinancial reporting controls and procedures. As we continue to evaluate andimprove our internal control over financial reporting, we may determine to takeadditional measures to address internal control deficiencies or determine tomodify certain of the remediation measures described herein. We will continueto be at an increased risk that our financial statements could contain errorsthat will be undetected, and we will continue to incur significant expense andmanagement burdens associated with the additional procedures required toprepare our consolidated financial statements.

 

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

 

TheCorporation announced on November 16, 2007, a program to repurchase up to$10.0 million of the Corporation’s Common Stock. This program expires inNovember 2009. This program replaced a previous program that expired inOctober 2007. No purchases have been made under the program during thethree months ended September 30, 2009.

 

Therewere no sales by the Corporation of unregistered securities during the threemonths ended September 30, 2009.

 

**Item 3.****   ****Defaultsupon Senior Securities**

 

None.

 

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

 

TheSpecial Meeting of Shareholders of the Corporation was held onSeptember 1, 2009 (the “Meeting”). Notice of the Meeting was mailed to shareholders of record on or aboutAugust 6, 2009, together with proxy solicitation materials prepared inaccordance with Section 14(a) of the Securities Exchange Act of 1934,as amended, and the regulations promulgated there under.

 

Therewere two matters submitted to a vote of shareholders at the meeting.

 

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1.     To amend the Corporation’sBy-Laws to permit the issuance of uncertificated shares (“Proposal One”)

 

2.     To amend the Corporation’sArticles of Incorporation and By-Laws to permit the Board of Directors theflexibility, if needed, to amend the By-Laws (“Proposal Two”).

 

Therewas no solicitation in opposition to either of the matters submitted tovote.  Both of the matters werepassed.  The number of votes cast for oragainst as well as the number of abstentions for each of the matters were asfollows:

 
| **Nominee**  | ** ** | **For**   | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|--------------|------------|-----------|------------|-------------|------------|-------------|------------|
|         |       |      |       |        |       |        |       |
| Proposal One |       | 4,655,462 |       | 170,115     |       | 33,136      |       |
|         |       |      |       |        |       |        |       |
| Proposal Two |       | 3,958,263 |       | 867,973     |       | 32,475      |       |

 

Therewas no other business that came before the meeting or matters incident to theconduct of the Meeting.

 

**Item 5.****        ****Other Information**

 

The Bank is currently undergoing a restructuring, which includes thepreviously announced appointment of John A. Featherman, III as President,James M. Deitch as Chief Operating Officer and Sheryl S. Vittitoe as ChiefFinancial Officer. The restructuring will also include the termination ofcertain Bank employees, including employees from its AHB Division by yearend.The Bank expects to incur a charge of approximately $1.0 million in the fourthquarter for severance liability connected with this restructuring. The Bankalso intends to reorganize its two current divisions into four divisions:Commercial, Consumer, Wealth Management and Administration. The Bank is closingthree branches as part of the restructuring; the Bank expects to incur a chargeof approximately $1.1 million in the fourth quarter related to branch closureexpenses, including estimated lease liabilities and write-off of certainleasehold improvements and fixed assets related to the branch closures. TheBank is also closing 13 mortgage loan production offices related to VisionMortgage Division of AHB related to the restructuring, and will close anadditional six mortgage loan production offices operated as AHB productionbranches. The Bank will incur approximately $60,000 in charges related toseverance, lease obligations and the write off of leasehold improvements, andfixed assets related to such closures.

 

TheCorporation borrowed an aggregate principal amount of $4.0 million during thesecond and third quarters of 2009 on an unsecured, short-term basis from twoshareholders, with interest payable in each case at 12% per annum. On October 20,2009, the Corporation received a demand for payment of $3.0 million principalamount of such borrowings in accordance with terms of the loans, with thedemand payable on November 20, 2009. The other $1.0 million principalamount of unsecured loan originally matured on November 24, 2009, but hasbeen extended by the lender to May 24, 2010. The Corporation is currentlyattempting to negotiate to extend the maturity of the $3 million due on November 20,2009. If the Corporation is unable to extend the loans, the Bank may need todividend to the Corporation some or all of such funds. Under its informal MOUwith the OCC, the Bank is required to obtain supervisory approval to dividendany funds to the Corporation. Any such dividend to the Corporation willdirectly affect the Bank’s capital and in turn, its fourth quarter regulatorycapital ratios.

 

**Item 6.****        ****Exhibits**

 

Thefollowing exhibits, which are furnished with this Quarterly Report orincorporated herein by reference, are filed as part of this Quarterly Report.

 
| 3.1  |   | Amended  Articles of Incorporation (incorporated herein by reference to  Exhibit 3.1 to the Corporation’s Quarterly Report on Form 10-Q for  the quarter ended March 31, 2004, filed May 14, 2004.) |
|------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2  |   | Amendment  to the Articles of Incorporation (incorporation herein by reference to  Exhibit 3.2 to the Corporation’s Form 8-A, filed October 22,  2009.)                                                  |
| 3.3  |   | Amended  and Restated Bylaws (incorporated herein by reference to Exhibit 3.3 to  the Corporation’s Form 8-A, filed October 22, 2009.)                                                                   |
| 31.1 |   | Certification  of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002*                                                                                                                   |
| 31.2 |   | Certification of Chief  Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002*                                                                                                                   |
| 32.1 |   | Certification  of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002*                                                                                                                   |
| 32.2 |   | Certification  of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002*                                                                                                                   |

 

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*Filed herewith.

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized on July 26, 2010.

 

**FIRSTCHESTER COUNTY CORPORATION**

 
|   | /s/  John A. Featherman, III                       |
|--------|---------------------------------------------------------|
|   | John  A. Featherman, III                           |
|   | Chairman,  Chief Executive Officer & President |
|   | (Principal  Executive Officer)                          |
|   |                                                    |
|   | /s/  Eric A. Segal                                      |
|   | Eric  A. Segal                                          |
|   | Interim  Chief Financial Officer                        |
|   | (Principal  Financial and Accounting Officer)           |

 

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**INDEXTO EXHIBITS**

 
| **Exhibit Number** | ** ** | **Exhibit**                                                                                                                                                                                                                  |
|-------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                     |       | Amended  Articles of Incorporation (incorporated herein by reference to  Exhibit 3.1 to the Corporation’s Quarterly Report on Form 10-Q for  the quarter ended March 31, 2004, filed May 14, 2004.) |
| 3.2                     |       | Amendment  to the Articles of Incorporation (incorporation herein by reference to  Exhibit 3.2 to the Corporation’s Form 8-A, filed October 22,  2009.)                                                  |
| 3.3                     |       | Amended  and Restated Bylaws (incorporated herein by reference to Exhibit 3.3 to  the Corporation’s Form 8-A, filed October 22, 2009.)                                                                   |
| 31.1                    |       | Certification  of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002*                                                                                                                   |
| 31.2                    |       | Certification  of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002*                                                                                                                   |
| 32.1                    |       | Certification  of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002*                                                                                                                   |
| 32.2                    |       | Certification  of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002*                                                                                                                   |

 

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*Filedherewith.

 

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