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** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D.C.  20549**

 

**FORM 10-Q/A**

 

**AmendmentNo. 1**

 

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

 

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

 

**o****         TRANSITION REPORTPURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**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 |       | (I.R.S. Employer    |
| Incorporation or organization)  |       | Identification No.) |

 

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

(Address of principal executive 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 of August 10,2009 was 6,306,877.

 

 

 

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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 June 30,2009 to amend and restate the Corporation’s unaudited consolidated financialstatements as of and for the three and six months ended June 30, 2009, asfiled with the Securities and Exchange Commission (the “SEC”) on August 10,2009 (the “Original Filing”).

 

Asinitially reported in the Corporation’s Quarterly Report on Form 10-Q forthe quarter ended September 30, 2009, management identified a materialweakness in its 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 and the Provision for Loan andLease Losses during the second quarter ending 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. TheAllowance for Loan and Lease Losses and Provision for Loan and Lease Losseswere increased from amounts previously reported due to this weakness.

 

Managementconcluded that the Allowance for Loan and Lease Losses and the Provision forLoans and Lease Losses as of and for the three and six months ended June 30,2009 should be increased by $3.5 million.  The increases over theamounts reported in the Original Filing can be attributed primarily to $6.2million of commercial real estate loans to one customer for which the originalloan terms have been modified due to the borrower’s financialdifficulties.  As of June 30, 2009,management has evaluated these loans for impairment and has allocated aspecific reserve of $2.6 million to these loans at June 30, 2009 throughan increase in the provision for loan and lease losses. The remaining increasein the Provision for Loan and Lease Losses and the Allowance for Loan and LeaseLosses is attributable to two commercial real estate loans where currentappraisals existed prior to the Original Filing but were not utilized in thequantification of the specific reserve for the previously identified impairedloans.

 

Subsequentto the year ended December 31, 2009, management also identified a materialweakness in its internal controls related to the Corporation’s process toreview the valuation of mortgage loans held for sale.  Mortgage loans heldfor sale represent mortgage loans originated by the Corporation and held untilsold to secondary market investors. Upon the closing of a residential mortgageloan originated by the Corporation, the mortgage loan is typically warehousedfor a period of time and then sold into the secondary market. While in thiswarehouse phase, mortgage loans held for sale are recorded at fair value underthe fair value option with changes in fair value recognized through earnings. An error was identified in the Corporation’s process to properly identifya certain population of loans held for sale prior to sending the loan detailsto the Corporation’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 June 30, 2009;however the unrealized gains(losses) associated with these loans was notreflected in the Consolidated Balance Sheet and the Statement of Operations.This error resulted in an understatement in the carrying amount of loans heldfor sale at June 30, 2009, as well as an understatement of net income forthe three and six months ended June 30, 2009.  As a result of thematerial weakness noted above, the Corporation underreported in the OriginalFiling net gains from mortgage banking by $14 thousand and $1.2 million for thethree and six months ended June 30, 2009, respectively.   Loans held for sale reported on the June 30,2009 Consolidated Balance Sheet were understated $1.2 million in the OriginalFiling.

 

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 second quarter 2009 financial statements was approvedby the Board 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, 

 

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thisAmendment should be read in conjunction with the Corporation’s subsequentfilings with the SEC, as information in such filings may update or supersedecertain information contained in this Amendment.

 

Based on the foregoing, only the following items have been amended:

 

·                  Part I — Financial Information:

·                  Item 1 — FinancialStatements

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

·                  Item 3 — Quantitative andQualitative Disclosures About Market Risk

·                  Item 4 — Controls andProcedures

 

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  June 30, 2009 (unaudited and restated) and December 31, 2008                       |       | 1        |
| ** **    | ** **            | ** **                                                                                                                 | ** ** |     |
|          |                  | Consolidated  Statements of Operations  Three and Six Months Ended June 30, 2009 (restated) and 2008 (unaudited)      |       | 2        |
|          |                  |                                                                                                                       |       |     |
|          |                  | Consolidated  Statements of Cash Flows  Six-Months Ended June 30, 2009 (restated) and 2008 (unaudited)                |       | 3        |
|          |                  |                                                                                                                       |       |     |
|          |                  | Consolidated  Statements of Stockholders’ Equity  Six-Months Ended June 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                                |       | 22       |
|          |                  |                                                                                                                       |       |     |
|          | Item  3 -             | Quantitative  and Qualitative Disclosures About Market Risk                                                                | ** ** | 38       |
|          |                  |                                                                                                                       |       |     |
|          | Item 4 -              | Controls &  Procedures                                                                                            |       | 38       |
|          |                  |                                                                                                                       |       |     |
| Part II. | OTHER INFORMATION     |                                                                                                                       | 40         |
|          |                  |                                                                                                                       |       |     |
|          | Item 1 -              | Legal Proceedings                                                                                                          |       | 40       |
|          |                  |                                                                                                                       |       |     |
|          | Item 1A -             | Risk Factors                                                                                                               |       | 40       |
|          |                  |                                                                                                                       |       |     |
|          | Item 2 -              | Unregistered  Sales of Equity Securities and Use of Proceeds                                                               |       | 40       |
|          |                  |                                                                                                                       |       |     |
|          | Item 3 -              | Defaults Upon  Senior Securities                                                                                           |       | 40       |
|          |                  |                                                                                                                       |       |     |
|          | Item 4 -              | Submission of  Matters to a Vote of Security Holders                                                                       |       | 40       |
|          |                  |                                                                                                                       |       |     |
|          | Item 5 -              | Other Information                                                                                                          |       | 41       |
|          | *** ***          | *** ***                                                                                                               |       |     |
|          | Item 6 -              | Exhibits                                                                                                                   |       | 41       |
|          |                  |                                                                                                                       |       |     |
|          | Signatures            |                                                                                                                       |       | 43       |
|          |                  |                                                                                                                       |       |     |
|          | Index  to Exhibits    |                                                                                                                       | 44         |

 

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**FIRST CHESTER COUNTYCORPORATION AND SUBSIDIARIES**

 

**PART I. FINANCIALINFORMATION**

 

**ITEM 1.  Financial Statements**

 

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                               | ** ** | **June 30,**                         | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|-----------------------|------------|
| **(Dollars  in thousands)**                                                                                                                              | ** ** | **2009**                                  | ** ** | **2008**              | ** ** |
| ** **                                                                                                                                               | ** ** | **(Unaudited — Restated)** | ** ** | ** **            | ** ** |
| ASSETS                                                                                                                                                   |       |                                      |       |                  |       |
| Cash and due from banks                                                                                                                                  |       | $                                         | 15,123     |                  | $          | 24,939 |   |
| Federal funds sold and other overnight investments                                                                                                       |       | 2,301                                     |       | 4,884                 |       |
| Interest bearing deposits                                                                                                                                |       | 4,935                                     |       | 65,327                |       |
| Total cash and cash equivalents                                                                                                                          |       | 22,359                                    |       | 95,150                |       |
|                                                                                                                                                     |       |                                      |       |                  |       |
| Investment securities available-for-sale, at fair  value                                                                                                 |       | 81,893                                    |       | 114,584               |       |
|                                                                                                                                                     |       |                                      |       |                  |       |
| Mortgage loans held for sale                                                                                                                             |       | 342,785                                   |       | 90,940                |       |
|                                                                                                                                                     |       |                                      |       |                  |       |
| Loans and leases                                                                                                                                         |       | 947,914                                   |       | 940,083               |       |
| Less: allowance for loan and lease losses                                                                                                                |       | (15,528                                   | )          | (10,335               | )          |
| Net loans and leases                                                                                                                                     |       | 932,386                                   |       | 929,748               |       |
|                                                                                                                                                     |       |                                      |       |                  |       |
| Premises and equipment, net                                                                                                                              |       | 23,613                                    |       | 22,076                |       |
| Net deferred tax asset                                                                                                                                   |       | 9,409                                     |       | 8,585                 |       |
| Due from mortgage investors                                                                                                                              |       | —                                    |       | 9,036                 |       |
| Bank owned life insurance                                                                                                                                |       | 1,424                                     |       | 1,398                 |       |
| Goodwill                                                                                                                                                 |       | 8,126                                     |       | 5,906                 |       |
| Other assets                                                                                                                                             |       | 27,740                                    |       | 22,755                |       |
| Total assets                                                                                                                                             |       | $                                         | 1,449,735  |                  | $          | 1,300,178 |   |
| LIABILITIES                                                                                                                                              |       |                                      |       |                  |       |
| Deposits                                                                                                                                                 |       |                                      |       |                  |       |
| Non-interest-bearing                                                                                                                                     |       | $                                         | 155,297    |                  | $          | 146,248 |   |
| Interest-bearing (including certificates of  deposit over $100 of $163,117 and $100,018 at June 30, 2009 and December 31,  2008, respectively) |       | 860,137                                   |       | 868,944               |       |
| Total deposits                                                                                                                                           |       | 1,015,434                                 |       | 1,015,192             |       |
| Federal Home Loan Bank advances and other  borrowings                                                                                                    |       | 305,373                                   |       | 171,170               |       |
| Subordinated debentures                                                                                                                                  |       | 20,795                                    |       | 15,465                |       |
| Other liabilities                                                                                                                                        |       | 19,670                                    |       | 13,034                |       |
| Total liabilities                                                                                                                                        |       | 1,361,272                                 |       | 1,214,861             |       |
|                                                                                                                                                     |       |                                      |       |                  |       |
| STOCKHOLDERS’ EQUITY                                                                                                                                |       |                                      |       |                  |       |
| Common stock, par value $1.00; authorized  25,000,000 shares; Outstanding, 6,331,975 at June 30, 2009 and  December 31, 2008                   |       | 6,332                                     |       | 6,332                 |       |
| Additional paid-in capital                                                                                                                               |       | 23,492                                    |       | 24,708                |       |
| Retained earnings                                                                                                                                        |       | 59,649                                    |       | 57,899                |       |
| Accumulated other comprehensive loss                                                                                                                     |       | (2,404                                    | )          | (3,292                | )          |
| Treasury stock, at cost: 26,118 shares and 92,931  shares at June 30, 2009 and December 31, 2008, respectively                                 |       | (409                                      | )          | (1,815                | )          |
| Total First Chester County Corporation  stockholders’ equity                                                                                        |       | 86,660                                    |       | 83,832                |       |
| Non-controlling interest                                                                                                                                 |       | 1,803                                     |       | 1,485                 |       |
| Total stockholders’ equity                                                                                                                          |       | 88,463                                    |       | 85,317                |       |
|                                                                                                                                                     |       |                                      |       |                  |       |
| Total liabilities and stockholders’ equity                                                                                                          |       | $                                         | 1,449,735  |                  | $          | 1,300,178 |   |

 

The accompanying notes are anintegral part of these statements.

 

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**FIRST CHESTER COUNTYCORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF OPERATIONS**

(**UNAUDITED**)

 
| ** **                                                     | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                     | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| **(Dollars  in thousands - except per share)**                 | ** ** | **2009**               | ** ** | **2008**             | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                     | ** ** | **(Restated)**         | ** ** | ** **           | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
| INTEREST INCOME                                                |       |                   |       |                 |       |   |   |   |   |
| Loans and leases, including fees                               |       | $                      | 13,367     |                 | $          | 12,020 |   | $ | 26,572 |   | $ | 24,409 |   |
| Mortgage loans held for sale                                   |       | 3,095                  |       | 8                    |       | 4,939 |   | 15 |   |
| Investment securities                                          |       | 996                    |       | 1,351                |       | 2,227 |   | 2,581 |   |
| Federal funds sold and deposits in banks                       |       | 17                     |       | 417                  |       | 44 |   | 868 |   |
| Total interest income                                          |       | 17,475                 |       | 13,796               |       | 33,782 |   | 27,873 |   |
| INTEREST EXPENSE                                               |       |                   |       |                 |       |   |   |   |   |
| Deposits                                                       |       | 3,883                  |       | 3,954                |       | 8,354 |   | 8,452 |   |
| Subordinated debt                                              |       | 252                    |       | 215                  |       | 426 |   | 474 |   |
| Federal Home Loan Bank and other borrowings                    |       | 1,617                  |       | 1,478                |       | 3,153 |   | 2,920 |   |
| Total interest expense                                         |       | 5,752                  |       | 5,647                |       | 11,933 |   | 11,846 |   |
|                                                           |       |                   |       |                 |       |   |   |   |   |
| Net interest income                                            |       | 11,723                 |       | 8,149                |       | 21,849 |   | 16,027 |   |
| Provision for loan and lease losses                            |       | 5,084                  |       | 449                  |       | 6,471 |   | 660 |   |
| Net interest income after provision for loan and  lease losses |       | 6,639                  |       | 7,700                |       | 15,378 |   | 15,367 |   |
|                                                           |       |                   |       |                 |       |   |   |   |   |
| NON-INTEREST INCOME                                            |       |                   |       |                 |       |   |   |   |   |
| Wealth management and advisory services                        |       | 1,048                  |       | 1,080                |       | 1,966 |   | 2,075 |   |
| Service charges on deposit accounts                            |       | 659                    |       | 643                  |       | 1,291 |   | 1,196 |   |
| Gains (losses) on sales of investment securities,  net         |       | 89                     |       | (78                  | )          | 1 |   | 184 |   |
| Operating lease rental income                                  |       | 345                    |       | 330                  |       | 685 |   | 639 |   |
| Net gains on the sale of fixed assets and OREO                 |       | 72                     |       | 45                   |       | 117 |   | 91 |   |
| Loan fees and other                                            |       | 1,801                  |       | 89                   |       | 2,836 |   | 180 |   |
| Net gain from mortgage banking activities                      |       | 13,430                 |       | 94                   |       | 25,439 |   | 164 |   |
| Bank owned life insurance                                      |       | 13                     |       | 92                   |       | 26 |   | 157 |   |
| Other                                                          |       | 545                    |       | 476                  |       | 1,051 |   | 943 |   |
| Total non-interest income                                      |       | 18,002                 |       | 2,771                |       | 33,412 |   | 5,629 |   |
|                                                           |       |                   |       |                 |       |   |   |   |   |
| NON-INTEREST EXPENSE                                           |       |                   |       |                 |       |   |   |   |   |
| Salaries and employee benefits                                 |       | 15,605                 |       | 4,201                |       | 27,769 |   | 8,998 |   |
| Occupancy, equipment and data processing                       |       | 2,893                  |       | 1,470                |       | 5,669 |   | 2,908 |   |
| Depreciation expense on operating leases                       |       | 290                    |       | 271                  |       | 570 |   | 526 |   |
| FDIC deposit insurance                                         |       | 1,062                  |       | 118                  |       | 1,475 |   | 212 |   |
| Bank shares tax                                                |       | 232                    |       | 193                  |       | 467 |   | 386 |   |
| Professional services                                          |       | 1,677                  |       | 495                  |       | 2,923 |   | 919 |   |
| Marketing                                                      |       | 566                    |       | 335                  |       | 824 |   | 533 |   |
| Other                                                          |       | 2,002                  |       | 922                  |       | 3,763 |   | 1,971 |   |
| Total non-interest expense                                     |       | 24,327                 |       | 8,005                |       | 43,460 |   | 16,453 |   |
| Income before income taxes                                     |       | 314                    |       | 2,466                |       | 5,330 |   | 4,543 |   |
| INCOME TAXES                                                   |       | (257                   | )          | 624                  |       | 1,201 |   | 1,181 |   |
| Net income including noncontrolling interests                  |       | $                      | 571        |                 | $          | 1,842 |   | $ | 4,129 |   | $ | 3,362 |   |
| Less: Net income from non-controlling interests                |       | 633                    |       | —               |       | 870 |   | — |   |
| NET (LOSS) INCOME FOR FIRST CHESTER COUNTY  CORPORATION        |       | $                      | (62        | )                    | $          | 1,842 |   | $ | 3,259 |   | $ | 3,362 |   |
| PER SHARE DATA                                                 |       |                   |       |                 |       |   |   |   |   |
| Net (loss) income per share (Basic)                            |       | $                      | (0.01      | )                    | $          | 0.36 |   | $ | 0.52 |   | $ | 0.65 |   |
| Net (loss) income per share (Diluted)                          |       | $                      | (0.01      | )                    | $          | 0.35 |   | $ | 0.52 |   | $ | 0.65 |   |
| Dividends declared                                             |       | $                      | 0.14       |                 | $          | 0.14 |   | $ | 0.28 |   | $ | 0.28 |   |
|                                                           |       |                   |       |                 |       |   |   |   |   |
| Basic weighted average shares outstanding                      |       | 6,268,195              |       | 5,187,398            |       | 6,255,295 |   | 5,181,955 |   |
|                                                           |       |                   |       |                 |       |   |   |   |   |
| Diluted weighted average shares outstanding                    |       | 6,268,195              |       | 5,206,736            |       | 6,255,295 |   | 5,202,278 |   |

 

The accompanying notes arean integral part of these statements.

 

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**FIRST CHESTER COUNTYCORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF CASHFLOWS**

(**UNAUDITED**)

 
| ** **                                                                                   | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                   | ** ** | **June 30,**    | ** ** |
| **(Dollars  in thousands)**                                                                  | ** ** | **2009**             | ** ** | **2008** | ** ** |
| ** **                                                                                   | ** ** | **(Restated)**       | ** ** | ** ** | ** ** |
| OPERATING ACTIVITIES                                                                         |       |                 |       |   |   |
| Net income                                                                                   |       | $                    | 3,259      |   | $ | 3,362 |   |
| Adjustments to reconcile net income to net cash  (used in) Provided by operating activities: |       |                 |       |   |   |
| Depreciation                                                                                 |       | 1,835                |       | 1,221 |   |
| Provision for loan and lease losses                                                          |       | 6,471                |       | 660 |   |
| Amortization of investment security premiums and  accretion of discounts, net                |       | 182                  |       | 159 |   |
| Amortization of deferred loan fees                                                           |       | (1,099               | )          | (411 | ) |
| Gains on sales of investment securities, net                                                 |       | (1                   | )          | (184 | ) |
| Gains from sales of assets                                                                   |       | —               |       | (91 | ) |
| Net gain from mortgage banking activities                                                    |       | (25,439              | )          | (164 | ) |
| Proceeds from the sale of mortgage loans held for  sale                                      |       | 1,218,374            |       | 9,636 |   |
| Origination of mortgage loans held for sale                                                  |       | (1,435,744           | )          | (9,966 | ) |
| Net cash paid for the settlement of derivative  contracts                                    |       | (1,005               | )          | — |   |
| Stock-based compensation expense                                                             |       | 100                  |       | 92 |   |
| Increase in other assets                                                                     |       | (4,826               | )          | (677 | ) |
| Increase (decrease) in other liabilities                                                     |       | 5,762                |       | (1,368 | ) |
|                                                                                         |       |                 |       |   |   |
| Net cash provided by (used in) operating  activities                                         |       | $                    | (232,131   | ) | $ | 2,269 |   |
|                                                                                         |       |                 |       |   |   |
| INVESTING ACTIVITIES                                                                         |       |                 |       |   |   |
| Net increase in loans                                                                        |       | (8,010               | )          | (42,247 | ) |
| Proceeds from sales of investment securities  available-for-sale                             |       | 30,333               |       | 13,228 |   |
| Proceeds from maturities of investment securities  available-for-sale                        |       | 6,867                |       | 9,537 |   |
| Purchases of investment securities  available-for-sale                                       |       | (5,786               | )          | (41,542 | ) |
| Purchase of BOLI (Bank Owned Life Insurance)                                                 |       | —               |       | (10,000 | ) |
| Purchase of premises and equipment                                                           |       | (3,372               | )          | (3,139 | ) |
| Proceeds from the sale of fixed assets                                                       |       | —               |       | 48 |   |
|                                                                                         |       |                 |       |   |   |
| Net cash provided by (used in) investing  activities                                         |       | $                    | 20,032     |   | $ | (74,115 | ) |
|                                                                                         |       |                 |       |   |   |
| FINANCING ACTIVITIES                                                                         |       |                 |       |   |   |
| Change in subsidiary’s shares from non-controlling  interest                            |       | 318                  |       | — |   |
| Increase in short term Federal Home Loan Bank and  other short term borrowings               |       | 145,000              |       | — |   |
| Increase in long term Federal Home Loan Bank and  other borrowings                           |       | 48,300               |       | 51,500 |   |
| Repayment of long term Federal Home Loan Bank and  other borrowings                          |       | (59,097              | )          | (13,782 | ) |
| Proceeds from issuance of subordinated debentures                                            |       | 5,330                |       | — |   |
| Net increase in deposits                                                                     |       | 241                  |       | 24,448 |   |
| Cash dividends paid                                                                          |       | (874                 | )          | (1,453 | ) |
| Net increase (decrease) in treasury stock  transactions                                      |       | 90                   |       | (69 | ) |
|                                                                                         |       |                 |       |   |   |
| Net cash provided by financing activities                                                    |       | 139,308              |       | 60,644 |   |
|                                                                                         |       |                 |       |   |   |
| NET DECREASE IN CASH AND CASH EQUIVALENTS                                                    |       | (72,791              | )          | (11,202 | ) |
|                                                                                         |       |                 |       |   |   |
| Cash and cash equivalents at beginning of period                                             |       | 95,150               |       | 53,360 |   |
|                                                                                         |       |                 |       |   |   |
| Cash and cash equivalents at end of period                                                   |       | $                    | 22,359     |   | $ | 42,158 |   |

 

The accompanying notes are an integral part of these statements.

 

3

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Table of Contents

 

**FIRST CHESTER COUNTYCORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATEDSTATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY**

(**UNAUDITED**)

 
| ** **                                                        | ** ** | ** ** | ** ** | ** **    | ** ** | ** **     | ** ** | ** **   | ** ** | **Accumulated**   | ** ** | ** **   | ** ** | ** **      | ** ** | ** **             | ** ** | ** **        | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|---------------|------------|----------------|------------|--------------|------------|-------------------|------------|--------------|------------|-----------------|------------|------------------------|------------|-------------------|------------|
| ** **                                                        | ** ** | ** ** | ** ** | ** **    | ** ** | **Additional** | ** ** | ** **   | ** ** | **Other**         | ** ** | ** **   | ** ** | **Non-**        | ** ** | **Total**              | ** ** | ** **        | ** ** |
| ** **                                                        | ** ** | **Common** | ** ** | **Stock**     | ** ** | **Paid-in**    | ** ** | **Retained** | ** ** | **Comprehensive** | ** ** | **Treasury** | ** ** | **controlling** | ** ** | **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                                                        |       |       |       |          |       |           |       | 3,362        |       |              |       |         |       |            |       | 3,362                  |       | $                 |       | 3,362 |   |
| Cash dividends declared                                           |       |       |       |          |       |           |       | (1,453       | )          |              |       |         |       |            |       | (1,453                 | )          |              |       |
| Other comprehensive income                                        |       |       |       |          |       |           |       |         |       |              |       |         |       |            |       |                   |       |              |       |
| Net unrealized losses on investment securities available-for-sale |       |       |       |          |       |           |       |         |       | (1,270            | )          |         |       |            |       | (1,270                 | )          | (1,270            | )          |
| Treasury stock transactions                                       |       |       |       |          |       | (723           | )          |         |       |              |       | 746          |       |            |       | 23                     |       |              |       |
| Total comprehensive income                                        |       |       |       |          |       |           |       |         |       |              |       |         |       |            |       |                   |       | $                 |       | 2,092 |   |
|                                                              |       |       |       |          |       |           |       |         |       |              |       |         |       |            |       |                   |       |              |       |
| Balance June 30, 2008                                        |       | 5,279,815  |       | $             |       | 5,280          |       | $            |       | 10,390            |       | $            |       | 57,256          |       | $                      |       | (2,477            | )          | $ |   | (1,808 | ) | — |   | $ |   | 68,641 |   |   |   |
|                                                              |       |       |       |          |       |           |       |         |       |              |       |         |       |            |       |                   |       |              |       |
| 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        |       |       |       |          |       |           |       |         |       |              |       |         |       | (552            | )          | (552                   | )          |              |       |
| Net income (restated)                                             |       |       |       |          |       |           |       | 3,259        |       |              |       |         |       | 870             |       | 4,129                  |       | 4,129             |       |
| Cash dividends declared                                           |       |       |       |          |       |           |       | (1,749       | )          |              |       |         |       |            |       | (1,749                 | )          |              |       |
| Other comprehensive income                                        |       |       |       |          |       |           |       |         |       |              |       |         |       |            |       |                   |       |              |       |
| Net unrealized gains on investment securities available-for-sale  |       |       |       |          |       |           |       |         |       | 888               |       |         |       |            |       | 888                    |       | 888               |       |
| Treasury stock transactions                                       |       |       |       |          |       | (1,316         | )          |         |       |              |       | 1,406        |       |            |       | 90                     |       |              |       |
| Stock based compensation                                          |       |       |       |          |       | 100            |       |         |       |              |       |         |       |            |       | 100                    |       |              |       |
| Total comprehensive income (restated)                             |       |       |       |          |       |           |       |         |       |              |       |         |       |            |       |                   |       | $                 |       | 5,017 |   |
|                                                              |       |       |       |          |       |           |       |         |       |              |       |         |       |            |       |                   |       |              |       |
| Balance June 30, 2009 (restated)                             |       | 6,331,975  |       | $             |       | 6,332          |       | $            |       | 23,492            |       | $            |       | 59,649          |       | $                      |       | (2,404            | )          | $ |   | (409 | ) | 1,803 |   | $ |   | 88,463 |   |   |   |

 

The accompanying notes are an integral part of these statements.

 

4

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Table of Contents

 

**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**(UNAUDITED)**

 

**1.****        ****BASIS OF PRESENTATION, ASRESTATED**

 

The foregoing unaudited financial statements have been prepared inaccordance with accounting principles generally accepted in the United States (“GAAP”)for interim financial information.  Inthe opinion of Management, all adjustments (consisting only of normal recurringadjustments) necessary for a fair presentation of the financial position andthe results of operations for the interim period presented have beenincluded.  These interim financialstatements should be read in conjunction with the consolidated financial statementsand footnotes thereto included in our Annual Report on Form 10-K for theyear ended December 31, 2008 (our “2008 Annual Report”).

 

The results of operations for the three and six month periods ended June 30,2009 are not necessarily indicative of the results to be expected for the fullyear.  Information regarding risks anduncertainties that could cause actual results to vary materially from our priorperformance may be found in Part I, Item 1A of our 2008 AnnualReport.

 

The consolidated financialstatements include the accounts of First Chester County Corporation (the“Corporation”) and First National Bank of Chester County (the “Bank”). Allmaterial intercompany balances and transactions have been eliminated inconsolidation.

 

The Corporation completed its acquisition of American Home Bank (“AHB”)on December 31, 2008, and, accordingly, the December 31, 2008 and theJune 30, 2009 consolidated balance sheets reflect the addition of assetsacquired and liabilities assumed in this acquisition. The results of operationspresented in the consolidated income statement for the three and six monthsended June 30, 2009 include the results of operations from AHB.

 

As a result of the acquisition of AHB’soperations, the Corporation reports the following new lines in the incomestatement:

 

·      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**

 

During the preparation of our consolidated financial statements for theyear ended December 31, 2009, the Corporation determined that certainmortgage loans held for sale were excluded from the mark-to-marketprocess.  This has resulted in a materialunderstatement of net income for the three and six month periods ended June 30,2009.  Mortgage loans held for salereported on the June 30, 2009 Consolidated Balance Sheet was alsounderstated in the Original Filing.

 

TheCorporation erroneously excluded from the population to be fair valued, certainloans which were identified for sale to a third party but for which theCorporation was awaiting the final approval and agreement from the counterpartyto complete the transaction.  TheCorporation’s policy is to continue to record the loans in thisportfolio-segment as loans held for sale until the criteria for a sale is metand to record loans held for sale at fair value under the fair value option.

 

Inaddition, during the preparation of our consolidated financial statements forthe nine months ended September 30, 2009, management identified a materialweakness in the Corporation’s internal controls related to the design andimplementation of policies to promptly identify problem loans and to quantifythe elements of risk in problem loans.  The weakness caused a failure toaccurately identify 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 and the Provisionfor Loan and Lease Losses during the second quarter ending June 30, 2009.The Allowance for Loan and Lease Losses and Provision for Loan and Lease Losseswere increased from amounts previously reported due to this weakness.

 

Asa result of these errors, the Corporation’s Board of Directors, in consultationwith management and its Audit Committee, determined that the consolidatedfinancial statements contained in the Corporation’s Quarterly Report on Form 10-Qfor the period ended June 30, 2009 could no longer be relied upon.  Accordingly, we have restated our unauditedconsolidated financial statements as of and for the three and six month periodsended June 30, 2009 to record adjustments for the corrections of theseerrors.  As a result of the restatement,the following financial statement line items were adjusted (dollars inthousands, except per share amounts):

 

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Table ofContents

 

**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 
| ** **                                                        | ** ** | **June 30, 2009** | ** ** |
|-------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                        | ** ** | **As Reported**        | ** ** | **Adjustment** | ** ** | **As Restated** | ** ** |
| **Statement of Financial  Condition**                             |       |                   |       |   |   |   |   |
| Assets                                                            |       |                   |       |   |   |   |   |
| Mortgage loans held for sale                                      |       | 341,609                |       | 1,176 |   | 342,785 |   |
| Allowance for possible loan losses                                |       | (12,016                | )          | (3,512 | ) | (15,528 | ) |
| Net loans and leases                                              |       | 935,898                |       | (3,512 | ) | 932,386 |   |
| Net deferred tax asset                                            |       | 8,615                  |       | 794 |   | 9,409 |   |
| Total Assets                                                      |       | 1,451,276              |       | (1,541 | ) | 1,449,735 |   |
|                                                              |       |                   |       |   |   |   |   |
| Liabilities and  Stockholders’ Equity                        |       |                   |       |   |   |   |   |
| Retained earnings                                                 |       | 61,190                 |       | (1,541 | ) | 59,649 |   |
| Total First Chester County Corporation  Stockholders’ equity |       | 88,201                 |       | (1,541 | ) | 86,660 |   |
| Total stockholders’ equity                                   |       | 90,004                 |       | (1,541 | ) | 88,463 |   |
| Total liabilities and stockholders’ equity                   |       | 1,451,276              |       | (1,541 | ) | 1,449,735 |   |

 
| ** **                                                                                 | ** ** | **Three Months Ended June 30, 2009** | ** ** | **Six Months Ended June 30, 2009** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                 | ** ** | **As  Reported**                          | ** ** | **Adjustment**                          | ** ** | **As  Restated** | ** ** | **As  Reported** | ** ** | **Adjustment** | ** ** | **As  Restated** | ** ** |
| **Statement of Income**                                                                    |       |                                      |       |                                    |       |   |   |   |   |   |   |   |   |
|                                                                                       |       |                                      |       |                                    |       |   |   |   |   |   |   |   |   |
| Provision for loan and lease losses                                                        |       | 1,572                                     |       | 3,512                                   |       | 5,084 |   | 2,959 |   | 3,512 |   | 6,471 |   |
| Net interest income after provision for loan and  lease losses                             |       | 10,151                                    |       | (3,512                                  | )          | 6,639 |   | 18,890 |   | (3,512 | ) | 15,378 |   |
| Net gains from mortgage banking activities                                                 |       | 13,416                                    |       | 14                                      |       | 13,430 |   | 24,263 |   | 1,176 |   | 25,439 |   |
| Total non-interest income                                                                  |       | 17,988                                    |       | 14                                      |       | 18,002 |   | 32,236 |   | 1,176 |   | 33,412 |   |
| Income before income taxes and cumulative effect  of change in accounting for income taxes |       | 3,812                                     |       | (3,498                                  | )          | 314 |   | 7,666 |   | (2,336 | ) | 5,330 |   |
| Income Taxes                                                                               |       | 932                                       |       | (1,189                                  | )          | (257 | ) | 1,996 |   | (795 | ) | 1,201 |   |
| Net Income                                                                                 |       | 2,880                                     |       | (2,309                                  | )          | 571 |   | 5,670 |   | (1,541 | ) | 4,129 |   |
| Net (loss) income attributable to First Chester  County Corporation                        |       | 2,247                                     |       | (2,309                                  | )          | (62 | ) | 4,800 |   | (1,541 | ) | 3,259 |   |
| Net (Loss)Income per share (Basic)                                                         |       | 0.36                                      |       | (0.37                                   | )          | (0.01 | ) | 0.77 |   | (0.25 | ) | 0.52 |   |
| Net (Loss) Income per share (Diluted)                                                      |       | 0.36                                      |       | (0.37                                   | )          | (0.01 | ) | 0.77 |   | (0.25 | ) | 0.52 |   |

 
| ** **                                | ** ** | **Six Months Ended June 30, 2009** | ** ** |
|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                | ** ** | **As Reported**                         | ** ** | **Adjustment** | ** ** | **As Restated** | ** ** |
| **Statement of Cash Flows**               |       |                                    |       |   |   |   |   |
|                                      |       |                                    |       |   |   |   |   |
| Net Income                                |       | 4,800                                   |       | (1,541 | ) | 3,259 |   |
| Provision for loan losses                 |       | 2,959                                   |       | 3,512 |   | 6,471 |   |
| Net gain from mortgage banking activities |       | (24,263                                 | )          | (1,176 | ) | (25,439 | ) |
| Increase in other assets (DTA)            |       | (4,031                                  | )          | (795 | ) | (4,826 | ) |

 

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Table of Contents

 

**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

**2.****        ****SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES**

 

Thefollowing supplements the significant accounting policies described in thefootnotes to the consolidated financial statements in the 2008 Annual Report:

 

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

 

Loanfees and other consist mainly of fees earned at the inception of a loan as wellas fees earned on the servicing of loan portfolios not owned by the Bank. Loanfees and other also includes gains and losses on the Bank’s mortgage servicingrights.

 

Netgain from mortgage banking activities consists of unrealized gains and losseson interest rate lock commitments, loans held for sale, and forward salecommitments combined with realized gains and losses on the actual sale of theloan and the settlement of forward sale commitments.

 

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

 

At June 30, 2009, the Corporation had one stock based compensationplan, pursuant to which, shares of the Corporation’s common stock could beissued, subject to certain restrictions. The plan, adopted in 2005, allows theCorporation to grant up to 150 thousand shares of restricted stock to employees.During the six months ended June 30, 2009, the Corporation granted 54,650shares valued at $11.35 per share at the grant date. These shares, or a portionthereof will vest on the third anniversary of the grant subject to certainemployment and company performance requirements. During the six months ended June 30,2008, the Corporation granted 34,500 shares valued at $17.80 per share at thegrant date. These shares, or a portion thereof will vest on the thirdanniversary of the grant subject to certain employment and company performancerequirements. These restricted stock grants are also subject to acceleratedvesting of all or a portion of the shares upon the occurrence of certainevents, as described more fully in our Proxy Statement for the 2009 AnnualMeeting of Shareholders. A summary of the Corporation’s unvested restrictedshares is as follows:

 

(Dollars in 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                        |       |       |       |                                 |       |                                                                  |       |
| Unvested at June 30, 2009   |       | 92,325     |       | $                                    | 14.21      |                                                                  | $          | 950.9 |   |
|                                  |            |            |            |                                      |            |                                                                       |            |  |  |

 

The Corporation recorded approximately $100 thousand and $92 thousandof restricted stock expense for the six months ended June 30, 2009 and2008, respectively.

 

The Corporation’s ability to issue stock options under the Corporation’s1995 Stock Option Plan has expired. Outstanding stock options, however, 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 June 30, 2009 is presented below.

 

7

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Table of Contents

 

**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

(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      |                                                       | —     |                            | $          | 0 |   |
| Granted                             |       | —     |       | —                                  |       | —                                                     |       | —                          |       |
| Exercised                           |       | —     |       | —                                  |       | —                                                     |       | —                          |       |
| Forfeited                           |       | —     |       | —                                  |       | —                                                     |       | —                          |       |
| Expired                             |       | (8,987     | )          | $                                       | 18.04      |                                                       | —     |                            | —     |   |
| Outstanding at June 30, 2009   |       | 289,047    |       | $                                       | 15.35      |                                                       | 3.12       |                            | $          | 0 |   |
| Exercisable at June 30, 2009   |       | 289,047    |       | $                                       | 15.35      |                                                       | 3.12       |                            | $          | 0 |   |

 

There were no options granted during the six months ended June 30,2009.  The total intrinsic value (marketvalue on date of exercise less grant price) of options exercised during theyear ended December 31, 2008 was $0.

 

**4.****        ****EARNINGS (LOSS) PER SHARE, ASRESTATED**

 

**Three Months ended June 30, 2009**

 
| ** **                                  | ** ** | **Loss**        | ** ** | ** **        | ** ** | ** **     | ** ** |
|---------------------------------------------|------------|-----------------|------------|-------------------|------------|----------------|------------|
| ** **                                  | ** ** | **(thousands)** | ** ** | ** **        | ** ** | **Per Share**  | ** ** |
| ** **                                  | ** ** | **(numerator)** | ** ** | **Shares**        | ** ** | **Amount**     | ** ** |
| ** **                                  | ** ** | **(Restated)**  | ** ** | **(denominator)** | ** ** | **(Restated)** | ** ** |
| Basic earnings per share                    |       |            |       |              |       |           |       |
| Net loss available to common stockholders   |       | $               | (62        | )                 | 6,268,195  |           | $          | (0.01 | ) |
| Effect of Dilutive Securities               |       |            |       |              |       |           |       |
| Options to purchase common stock            |       | —          |       | —            |       | —         |       |
| Diluted earnings per share                  |       |            |       |              |       |           |       |
| Net income available to common stockholders |       | $               | (62        | )                 | 6,268,195  |           | $          | (0.01 | ) |

 

289,047anti-dilutive weighted average shares have been excluded from this computationbecause the option exercise price was greater than the average market price of thecommon shares.

 

**Six Months ended June 30, 2009**

 
| ** **                                  | ** ** | **Income**      | ** ** | ** **        | ** ** | ** **     | ** ** |
|---------------------------------------------|------------|-----------------|------------|-------------------|------------|----------------|------------|
| ** **                                  | ** ** | **(thousands)** | ** ** | ** **        | ** ** | **Per Share**  | ** ** |
| ** **                                  | ** ** | **(numerator)** | ** ** | **Shares**        | ** ** | **Amount**     | ** ** |
| ** **                                  | ** ** | **(Restated)**  | ** ** | **(denominator)** | ** ** | **(Restated)** | ** ** |
| Basic earnings per share                    |       |            |       |              |       |           |       |
| Net income available to common stockholders |       | $               | 3,259      |              | 6,255,295  |           | $          | 0.52 |   |
| Effect of Dilutive Securities               |       |            |       |              |       |           |       |
| Options to purchase common stock            |       | —          |       | —            |       | —         |       |
| Diluted earnings per share                  |       |            |       |              |       |           |       |
| Net income available to common stockholders |       | $               | 3,259      |              | 6,255,295  |           | $          | 0.52 |   |

 

289,047anti-dilutive weighted shares have been excluded from this computation becausethe option exercise price was greater than the average market price of thecommon shares.

 

8

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Table of Contents

 

**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

**Three Months ended June 30, 2008**

 
| ** **                                  | ** ** | **Income**      | ** ** | ** **        | ** ** | ** **    | ** ** |
|---------------------------------------------|------------|-----------------|------------|-------------------|------------|---------------|------------|
| ** **                                  | ** ** | **(thousands)** | ** ** | **Shares**        | ** ** | **Per Share** | ** ** |
| ** **                                  | ** ** | **(numerator)** | ** ** | **(denominator)** | ** ** | **Amount**    | ** ** |
| Basic earnings per share                    |       |            |       |              |       |          |       |
| Net income available to common stockholders |       | $               | 1,842      |              | 5,187,398  |          | $          | 0.36 |   |
| Effect of Dilutive Securities               |       |            |       |              |       |          |       |
| Options to purchase common stock            |       | —          |       | 19,338            |       | (.01          | )          |
| Diluted earnings per share                  |       |            |       |              |       |          |       |
| Net income available to common stockholders |       | $               | 1,842      |              | 5,206,736  |          | $          | 0.35 |   |

 

23,929anti-dilutive weighted average shares have been excluded from this computationbecause the option exercise price was greater than the average market price ofthe common shares.

 

**Six Months ended June 30, 2008**

** **
| ** **                                  | ** ** | **Income**      | ** ** | ** **        | ** ** | ** **    | ** ** |
|---------------------------------------------|------------|-----------------|------------|-------------------|------------|---------------|------------|
| ** **                                  | ** ** | **(thousands)** | ** ** | **Shares**        | ** ** | **Per Share** | ** ** |
| ** **                                  | ** ** | **(numerator)** | ** ** | **(denominator)** | ** ** | **Amount**    | ** ** |
| Basic earnings per share                    |       |            |       |              |       |          |       |
| Net income available to common stockholders |       | $               | 3,362      |              | 5,181,955  |          | $          | 0.65 |   |
| Effect of Dilutive Securities               |       |            |       |              |       |          |       |
| Options to purchase common stock            |       | —          |       | 20,323            |       | —        |       |
| Diluted earnings per share                  |       |            |       |              |       |          |       |
| Net income available to common stockholders |       | $               | 3,362      |              | 5,202,278  |          | $          | 0.65 |   |

 

23,935anti-dilutive weighted shares have been excluded from this computation becausethe option exercise price was greater than the average market price of thecommon shares.

 

**5.****        ****COMPREHENSIVE INCOME, AS RESTATED**

 

Components of comprehensive income are presented in the followingchart:

 
| ** **                                                      | ** ** | **Three Months Ended** | ** ** | **S****ix Months Ended** | ** ** |
|-----------------------------------------------------------------|------------|------------------------|------------|--------------------------|------------|
| ** **                                                      | ** ** | **June 30,**      | ** ** | **June 30,**        | ** ** |
| ** **                                                      | ** ** | **2009**               | ** ** | ** **               | ** ** | **2009** | ** ** | ** ** | ** ** |
| ** **                                                      | ** ** | **(Restated)**         | ** ** | **2008**                 | ** ** | **(Restated)** | ** ** | **2008** | ** ** |
| Unrealized gains (losses) on securities:                        |       |                   |       |                     |       |   |   |   |   |
| Unrealized gains (losses) arising in period                     |       | $                      | 1,869      |                     | $          | (2,118 | ) | $ | 1,345 |   | $ | (2,108 | ) |
| Reclassification adjustment                                     |       | 89                     |       | (78                      | )          | 1 |   | 184 |   |
| Net unrealized gain (loss)                                      |       | 1,958                  |       | (2,196                   | )          | 1,346 |   | (1,924 | ) |
| Other comprehensive income (loss) before taxes                  |       | 1,958                  |       | (2,196                   | )          | 1,346 |   | (1,924 | ) |
| Income tax benefit (expense)                                    |       | (666                   | )          | 747                      |       | (458 | ) | 654 |   |
| Other comprehensive income (loss)                               |       | 1,292                  |       | (1,449                   | )          | 888 |   | (1,270 | ) |
| Net income including non-controlling interests                  |       | 571                    |       | 1,842                    |       | 4,129 |   | 3,362 |   |
| Comprehensive income                                            |       | 1,863                  |       | 393                      |       | 5,017 |   | 2,092 |   |
| Comprehensive income attributable to non-controlling  interests |       | 633                    |       | —                   |       | 870 |   | — |   |
| Comprehensive income for First Chester County  Corporation      |       | $                      | 1,230      |                     | $          | 393 |   | $ | 4,147 |   | $ | 2,092 |   |

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

**6.****        ****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 six monthperiods ended June 30, 2009 and 2008 was $12.3 million and $12.2 million,respectively.  Cash paid for income taxesfor the six month periods ended June 30, 2009 and 2008 was $1.3 millionand $1.8 million, respectively.

 

**7.****        ****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 FCCC commonstock were issuable to the holders of 90% of AHB’s outstanding common stock and$1.8 million was payable to the holders of 10% of AHB’s outstanding commonstock. In addition, pursuant to the terms of the Merger Agreement, each AHBoption to purchase shares of AHB common stock at the effective time of theMerger converted into an option to purchase such number of shares of FCCCcommon stock equal to the number of shares of the AHB option multiplied by0.7000, rounded down to the nearest whole share, at an exercise price equal tothe exercise price of the AHB option at the effective time of the Mergerdivided by 0.7000, rounded up to the nearest whole cent. Each outstanding AHBwarrant at the effective time of the Merger was cancelled and converted intothe right to receive cash in the amount equal to the difference between the AHBwarrant 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 six months ended June 30, 2009 the goodwill from the AHB acquisitionwas adjusted to reflect adjustments to the purchase price allocation. Thefollowing shows the prior and current balance of goodwill:

 
| **(Dollars in thousands)** | ** ** | **Goodwill  Balance** | ** ** |
|--------------------------------------|------------|-----------------------|------------|
|                                 |       |                  |       |
| December 31, 2008               |       | $                     | 5,906      |   |
|                                 |       |                  |       |
| Adjustment to consideration paid (A) |       | 1,600                 |       |
|                                 |       |                  |       |
| Other adjustments (B)                |       | 620                   |       |
|                                 |       |                  |       |
| June 30, 2009                   |       | $                     | 8,126      |   |

 

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(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 for the AHB shares of former executiveofficers of AHB in connection with the finalization of the AHB ManagementIncentive Plan (as described in the Corporation’s Current Report on Form 8-Kfiled on May 5, 2009 containing Item 5.02 disclosure). The full amount ofthis additional consideration was allocated to goodwill.

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

(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.

 

**8.****        ****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 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.  The AHB Division also holds some residentialmortgage and residential construction loans. The AHB Division was formed on December 31,2008 following the acquisition of American Home Bank, National Association.

 

Reportablesegment-specific information and reconciliation to consolidated financialinformation is as follows:

 
| ** **                  | ** ** | **As of and for the three months ended June 30, 2009** | ** ** |
|-----------------------------|------------|-------------------------------------------------------------|------------|
| ** **                  | ** ** | **Community Banking**                                       | ** ** | **Mortgage Banking** | ** ** | ** ** | ** ** |
| ** **                  | ** ** | **Segment**                                                 | ** ** | **Segment** | ** ** | **Consolidated** | ** ** |
| **(Dollars  in thousands)** | ** ** | **(Restated)**                                              | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| Total assets                |       | $                                                           | 970,988    |   | $ | 478,747 |   | $ | 1,449,735 |   |
|                        |       |                                                        |       |   |   |   |   |
| Net interest income         |       | $                                                           | 8,862      |   | $ | 2,861 |   | $ | 11,723 |   |
|                        |       |                                                        |       |   |   |   |   |
| Total non-interest income   |       | $                                                           | 2,707      |   | $ | 15,295 |   | $ | 18,002 |   |
| Total non-interest expense  |       | $                                                           | 10,442     |   | $ | 13,885 |   | $ | 24,327 |   |
|                        |       |                                                        |       |   |   |   |   |
| Net (Loss) Income           |       | $                                                           | (2,241     | ) | $ | 2,179 |   | $ | (62 | ) |

 
| ** **                           | ** ** | **As of and for the six months ended June 30, 2009** | ** ** |
|--------------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|
| ** **                           | ** ** | **Community Banking**                                                                             | ** ** | **Mortgage Banking** | ** ** | ** ** | ** ** |
| ** **                           | ** ** | **Segment**                                                                                            | ** ** | **Segment** | ** ** | **Consolidated** | ** ** |
| **(Dollars in thousands)** | ** ** | **(Restated)**                                                                                         | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| Total assets                         |       | $                                                                                                      | 970,988    |   | $ | 478,747 |   | $ | 1,449,735 |   |
|                                 |       |                                                                                                   |       |   |   |   |   |
| Net interest income                  |       | $                                                                                                      | 16,910     |   | $ | 4,939 |   | $ | 21,849 |   |
|                                 |       |                                                                                                   |       |   |   |   |   |
| Total non-interest income            |       | $                                                                                                      | 5,030      |   | $ | 28,382 |   | $ | 33,412 |   |
| Total non-interest expense           |       | $                                                                                                      | 19,398     |   | $ | 24,063 |   | $ | 43,461 |   |
|                                 |       |                                                                                                   |       |   |   |   |   |
| Net (Loss) Income                    |       | $                                                                                                      | (1,770     | ) | $ | 5,029 |   | $ | 3,259 |   |

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 
| ** **                  | ** ** | **As of and for the three months ended June 30, 2008** | ** ** |
|-----------------------------|------------|-------------------------------------------------------------|------------|
| ** **                  | ** ** | **Community Banking**                                  | ** ** | **Mortgage Banking** | ** ** | ** ** | ** ** |
| **(Dollars  in thousands)** | ** ** | **Segment**                                                 | ** ** | **Segment** | ** ** | **Consolidated** | ** ** |
|                        |       |                                                        |       |   |   |   |   |
| Total assets                |       | $                                                           | 976,150    |   | $ | — |   | $ | 976,150 |   |
|                        |       |                                                        |       |   |   |   |   |
| Net interest income         |       | $                                                           | 8,149      |   | $ | — |   | $ | 8,149 |   |
|                        |       |                                                        |       |   |   |   |   |
| Total non-interest income   |       | $                                                           | 2,771      |   | $ | — |   | $ | 2,771 |   |
| Total non-interest expense  |       | $                                                           | 8,005      |   | $ | — |   | $ | 8,005 |   |
|                        |       |                                                        |       |   |   |   |   |
| Net Income                  |       | $                                                           | 1,842      |   | $ | — |   | $ | 1,842 |   |

 
| ** **                  | ** ** | **As of and for the six months ended June 30, 2008** | ** ** |
|-----------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|
| ** **                  | ** ** | **Community Banking**                                                                             | ** ** | **Mortgage Banking** | ** ** | ** ** | ** ** |
| **(Dollars  in thousands)** | ** ** | **Segment**                                                                                            | ** ** | **Segment** | ** ** | **Consolidated** | ** ** |
|                        |       |                                                                                                   |       |   |   |   |   |
| Total assets                |       | $                                                                                                      | 976,150    |   | $ | — |   | $ | 976,150 |   |
|                        |       |                                                                                                   |       |   |   |   |   |
| Net interest income         |       | $                                                                                                      | 16,027     |   | $ | — |   | $ | 16,027 |   |
|                        |       |                                                                                                   |       |   |   |   |   |
| Total non-interest income   |       | $                                                                                                      | 5,629      |   | $ | — |   | $ | 5,629 |   |
| Total non-interest expense  |       | $                                                                                                      | 16,453     |   | $ | — |   | $ | 16,453 |   |
|                        |       |                                                                                                   |       |   |   |   |   |
| Net Income                  |       | $                                                                                                      | 3,362      |   | $ | — |   | $ | 3,362 |   |

 

**9.****             ****RECENTACCOUNTING PRONOUNCEMENTS**

 

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 whichwill become the source of authoritative U.S. generally accepted accountingprinciples recognized by the FASB. SFAS No. 168 is effective for interimand annual financial periods ending after September 15, 2009. Although theCorporation has not yet determined the impact that SFAS No. 168 will have,we do not expect that the statement will have a material impact on ourconsolidated 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 theentity’s economic performance. The statement also requires additionaldisclosures about an enterprise’s involvement in variable interest entities.SFAS No. 167 is effective for interim and annual financial periods beginningafter November 15, 2009. Although the Corporation has not yet determinedthe impact that SFAS No. 167 will have, we do not expect that thestatement will have a material impact on our consolidated financial statements.

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

In June 2009, the FASBissued Statement of Financial Accounting Standard No. 166, “Accounting forTransfers of Financial Assets, an amendment of FASB Statement No. 140,” (“SFASNo. 166”). This statement clarifies existing and establishes newrequirements and objectives for transactions to qualify for “sale accounting”treatment. SFAS No. 166 is effective for interim and annual financialperiods beginning after November 15, 2009. Although the Corporation hasnot yet determined the impact that SFAS No. 166 will have, we do notexpect that the statement will have a material impact on our consolidatedfinancial statements.

 

In May 2009, the FASBissued Statement of Financial Accounting Standard No. 165, “SubsequentEvents,” (“SFAS No. 165”). This statement establishes general standards ofaccounting for and disclosure of events that occur after the balance sheet datebut before financial statements are issued or are available to be issued. SFAS No. 165is effective for interim or annual financial periods ending after June 15,2009. We adopted the provisions of SFAS No. 165 in June 2009. Theadoption of this statement did not have a material effect on our consolidatedfinancial statements. We added the subsequent events disclosure that isrequired by this statement to our consolidated financial statements.

 

In April 2009, the FASBissued FSP FAS 115-2 and FAS 124-2, “Recognition and Presentation ofOther-Than-Temporary Impairments” (“FSP FAS 115-2”). This statement amends theother-than-temporary impairments guidance for investments and changes some ofthe investment financial statement disclosure requirements. FSP FAS 115-2 iseffective for interim reporting periods ending after June 15, 2009. Weadopted the provisions of FSP FAS 115-2 in June 2009. The adoption of thisstatement did not have a material effect on our consolidated financialstatements. In accordance with the requirements of FSP FAS 115-2 we analyzedthe other than temporary impairment charge that the Corporation took in thethird quarter of 2008 and concluded that the charge taken was entirely due toan other than temporary credit loss as opposed to temporary other factors.Accordingly, no adjustment was made to the other than temporary charge taken inthe third quarter of 2008.  We added the investment disclosures that are requiredby this statement to our consolidated financial statements.

 

In April 2009, the FASBissued FSP FAS 107-1 and APB 28-1, “Interim Disclosures about Fair Value ofFinancial Instruments,” (“FSP FAS 107-1”). FSP 107-1 expands disclosures forfair value of financial instruments that are within the scope of FASB statementnumber 107 (“SFAS 107”) and now requires the FAS107 fair value disclosures ininterim period reports. FSP FAS 107-1 is effective for interim reportingperiods ending after June 15, 2009. We adopted the provisions of FSP FAS107-1 in June 2009. The adoption of this statement did not have a materialeffect on our consolidated financial statements. We added the required fairmarket value disclosure that is required by this statement to our consolidatedfinancial statements.

 

In April 2009, the FASBissued FSP FAS 157-4, “Determining FairValue When the Volume and Level of Activity for the Asset or Liability HaveSignificantly Decreased and Identifying Transactions That Are Not Orderly,” (“FSP157-4”). FSP 157-4 provides guidance for estimating fair value inaccordance with FASB Statement No. 157, Fair Value Measurements, when the volume and level of activityfor the asset or liability have significantly decreased. FSP 157-4 alsoincludes guidance on identifying circumstances that indicate a transaction isnot orderly. FSP 157-4 is effective for interim and annual reporting periodsending after June 15, 2009. We adopted the provisions of FSP FAS 157-4 in June 2009.  FSPFAS 157-4 did not have a material impact on our consolidated financialstatements.

 

In June 2008, the FASBposted FASB Staff Position No. EITF 03-6-1,**“DeterminingWhether Instruments Granted in Share-Based Payment Transactions AreParticipating Securities,” (“FSP EITF 03-6-1”).  This statementaddressed whether instruments granted in share-based payment transactions areparticipating securities prior to vesting and, therefore, need to be includedin the calculation of earnings per share (EPS) as described in FASB Statement No. 128,*“*Earningsper Share*.*”* *  FSP EITF 03-6-1 iseffective for financial statements issued for fiscal years beginning after December 15,2008 with prior period EPS data adjusted retrospectively to conform to itsprovisions. FSP EITF 03-6-1 did not have a material impact on our consolidatedfinancial statements.

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

In March 2008, the FASBissued Statement of Financial Accounting Standards No. 161,**“Disclosuresabout Derivative Instruments and Hedging Activities,” (“SFAS No. 161”). This statement is an amendment to Statement no. 133 and changes the disclosurerequirements for derivative instruments and hedging activities. No. 161 iseffective for financial statements issued for fiscal years and interim periodsbeginning after November 15, 2008. SFAS No. 161 did not have a material impact on our consolidatedfinancial statements.

 

In February 2008, theFASB issued Staff Position 157-2 (“FSP 157-2”), “Effective Date of FASBStatement No. 157.”  FSP 157-2 delays the effective date of FAS157 for all nonfinancial assets and nonfinancial liabilities, except those thatare recognized or disclosed at fair value on a recurring basis (at leastannually) to fiscal years beginning after November 15, 2008, and interimperiods within those fiscal years. FSP 157-2 did not have a material impacton our consolidated financial statements.

 

In December 2007, theFASB issued Statement No. 141(R) (“SFAS 141(R)”), “BusinessCombinations.”  This Statement replacesSFAS 141, “Business Combinations.”  ThisStatement retains the fundamental requirements in Statement 141 that theacquisition method of accounting (which Statement 141 called the “purchasemethod”) be used for all business combinations and for an acquirer to beidentified for each business combination. This Statement also establishes principles and requirements for how theacquirer: a) recognizes and measures in its financial statements theidentifiable 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. SFAS 141(R) willapply prospectively to business combinations for which the acquisition date ison or after the first annual reporting period beginning on or after December 15,2008.  The Corporation adopted theprovisions of SFAS 141(R) as of January 1, 2009. The adoption of SFAS141 (R) did not have a material impact on out consolidated financialstatements

 

In December 2007, theFASB issued Statement No. 160 (“SFAS 160”), “Noncontrolling Interests inConsolidated Financial Statements.”  ThisStatement amends Accounting Research Bulletin 51 to establish accounting andreporting standards for the noncontrolling (minority) interest in a subsidiaryand for the deconsolidation of a subsidiary. It clarifies that a noncontrolling interest in a subsidiary is anownership interest in the consolidated entity that should be reported as equityin the consolidated financial statements. SFAS 160 is effective for fiscal years beginning on or after December 15,2008. The Corporation adopted the provisions of SFAS 160 on January 1,2009 and accordingly, changed the way in which it reports minority interest inthe Corporation’s balance sheet. The Corporation now includes minority interestin the equity section of the balance sheet.

 

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

 

Statement157 defines fair value as the exchange price that would be received for anasset or paid to transfer a liability (an exit price) in an orderly transactionbetween market participants on the measurement date. Statement 157 also establishesa fair value hierarchy which requires an entity to maximize the use ofobservable inputs and minimize the use of unobservable inputs when measuringfair value. FSP FAS 157-3 and FSP FAS 157-4 clarify the application of SFAS 157in 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. We considered the requirementsof FSP 157-3 and FSP FAS 157-4 when estimating fair value.

 

FASBStatement No. 159 permits entities to choose to measure many financialinstruments and certain other items at fair value at specified election dates.The Corporation elected to account for loans held for sale under this electionoption.

 

Statement157 describes three levels of inputs that may be used to measure fair value:

 

Level1: Quoted prices (unadjusted) for identical assets or liabilities in activemarkets that the entity has the ability to access as of the measurement date.

 

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**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

Level2: Significant other observable inputs other than Level 1 prices, such asquoted prices for similar assets or liabilities, quoted prices in markets thatare not active, and other inputs that are observable or can be corroborated byobservable market data.

 

Level3: Significant unobservable inputs that reflect a company’s own assumptionsabout the assumptions that market participants would use in pricing an asset orliability.

 

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

 

Securities:Trading securities and investment securities available-for-sale are recorded atfair value on a recurring basis. Fair value measurement is based upon quotedprices, if available. If quoted prices are not available, fair values aremeasured using matrix pricing, which is a mathematical technique used widely inthe industry to value debt securities without relying exclusively on quotedprices for the specific securities but rather by relying on the securities’relationship to other benchmark quoted securities. Level 1 securities includethose traded on nationally recognized securities exchanges, U.S. Treasury andAgency securities, and money market funds. Level 2 securities includemortgage-backed securities issued by government sponsored entities, municipalbonds and corporate debt securities. Securities classified as Level 3 includeasset-backed securities in less liquid markets.

 

Loansheld for sale: The fair value of loans held for sale is based primarily onsecondary-market price quotes. If no such quoted price exists, the fair valueof a loan is determined using quoted prices for comparable instruments. Assuch, the Corporation classifies loans subjected to nonrecurring fair valueadjustments as Level 2.

 

Loansand leases: The Corporation does not record loans at fair value on a recurringbasis. However, from time to time, a loan is considered impaired and anallowance for loan losses is established. Loans for which it is probable thatpayment of interest and principal will not be made in accordance with thecontractual terms of the loan agreement are considered impaired. Once a loan isidentified as individually impaired, management measures impairment inaccordance with SFAS 114, “Accounting by Creditors for Impairment of a Loan,” (“SFAS114”). The fair value of impaired loans is estimated using one of severalmethods, including collateral value, market value of similar debt, enterprisevalue, liquidation value and discounted cash flows. Those impaired loans notrequiring an allowance represent loans for which the fair value of the expectedrepayments or collateral exceed the recorded investments in such loans. At June 30,2009, substantially all of the total impaired loans were evaluated based on thefair value of the collateral. In accordance with SFAS 157, impaired loans wherean 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.

 

OtherReal Estate Owned (“OREO”): OREO is adjusted to fair value upon transfer of theloans to foreclosed assets. Subsequently, OREO is carried at the lower ofcarrying value or fair value. Fair value is based upon independent marketprices, appraised values of the collateral or management’s estimation of thevalue of the collateral. The Corporation records the foreclosed asset asnonrecurring Level 3.

 

MortgageServicing Rights (“MSRs”): To determine the fair value of MSRs, the Bank usesan independent third party to estimate the present value of estimated futurenet servicing income. This valuation method incorporates an assumption thatmarket participants would use in estimating future net servicing income, whichinclude estimates of the cost to service, the discount rate, custodial earningsrate, an inflation rate, ancillary income, prepayment speeds, and default ratesand losses. The fair value of servicing rights was determined using discountrates ranging from 8.0% to 10.4%, prepayment speeds ranging from 6.6% to 37.1%depending on the stratification of the specific right, and a weighted averagedefault rate of 6.7%. The Corporation records the MSR as a recurring Level 3.

 

Derivativeinstruments: The fair value of interest rate lock commitments and forward salescommitments are estimated using a process similar to mortgage loans held forsale. Interest rate lock commitments are recorded as a recurring Level 3. Loancommitments and best efforts commitments are assigned a probability that therelated loan will be funded and 

 

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**NOTES TO CONSOLIDATED FINANCIAL 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.

 

The table below presents the balance of assets andliabilities at June 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 |       | $           | 937        |           | $          | 80,956      |       | $              | —     |   | $ | 81,893 |   |
| Loans held for sale                      |       | —      |       | 342,785        |       | —      |       | 342,785        |       |
| Mortgage servicing rights                |       | —      |       | —         |       | 532         |       | 532            |       |
| Interest rate lock commitments           |       | —      |       | —         |       | 1,717       |       | 1,717          |       |
| Liabilities                              |       |        |       |           |       |        |       |           |       |
| Forward sales commitments                |       | $           | —     |           | $          | 449         |       | $              | —     |   | $ | 449 |   |

 

Theaggregate unpaid principal balance of mortgage loans held for sale is $336.5million.

 

Thetable below presents the balance of assets and liabilities at June 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 |       | $           | —     |        | $          | —         |       | $              | 20,602     |   | $ | 20,602 |   |
|                             |       |        |       |        |       |           |       |           |       |
| OREO                             |       | —      |       | —      |       | 1,592          |       | 1,592          |       |
|                                  |            |             |            |             |            |                |            |                |            |  |  |  |  |

 

Thetable below presents the rollforward of assets that are valued using significantunobservable inputs (Level 3) for the six months ended June 30, 2009:

 
| **Dollars in thousands**    | ** ** | **Mortgage  Servicing  Rights** | ** ** | **Interest Rate  Lock  Commitments** | ** ** | **Loans  (Restated)** | ** ** | **OREO** | ** ** |
|---------------------------------------|------------|---------------------------------|------------|-------------------------------------------|------------|-----------------------|------------|----------|------------|
| Beginning balance                     |       | $                               | 239        |                                      | $          | 412                   |       | $        | 9,658      |   | $ | 1,872 |   |
| Net transferred into (out of) level 3 |       | 239                             |       | 1,305                                     |       | 12,154                |       | (280     | )          |
| Net unrealized gains  (losses)        |       | 54                              |       | —                                    |       | (1,210                | )          |     |       |
| Ending Balance                        |       | $                               | 532        |                                      | $          | 1,717                 |       | $        | 20,602     |   | $ | 1,592 |   |

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

 

The estimated fair valuesand carrying amounts of the balance sheet are summarized as follows:

 
| ** **                                                      | ** ** | **June 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ** **                                                      | ** ** | **Estimated**               | ** ** | **Carrying**                    | ** ** | **Estimated** | ** ** | **Carrying** | ** ** |
| **(Dollars in thousands)**                            | ** ** | **Fair Value**         | ** ** | **Amount**                      | ** ** | **Fair Value** | ** ** | **Amount** | ** ** |
| ** **                                                      | ** ** | ** **                  | ** ** | **(Restated)**                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Financial Assets                                                |       |                        |       |                            |       |   |   |   |   |
| Cash and cash equivalents                                       |       | $                           | 22,359     |                            | $          | 22,359 |   | $ | 95,150 |   | $ | 95,150 |   |
| Investment securities available-for-sale                        |       | 81,893                      |       | 81,893                          |       | 114,584 |   | 114,584 |   |
| Loans held for sale                                             |       | 341,609                     |       | 342,785                         |       | 90,940 |   | 90,940 |   |
| Gross loans and leases                                          |       | 1,038,261                   |       | 947,914                         |       | 1,042,799 |   | 940,083 |   |
| Due from mortgage investors                                     |       | —                      |       | —                          |       | 9,036 |   | 9,036 |   |
| Mortgage servicing rights                                       |       | 532                         |       | 532                             |       | 239 |   | 239 |   |
| Derivative instruments                                          |       | 1,717                       |       | 1,717                           |       | 412 |   | 412 |   |
|                                                            |       |                        |       |                            |       |   |   |   |   |
| Financial Liabilities                                           |       |                        |       |                            |       |   |   |   |   |
| Deposits with no stated maturities                              |       | 551,537                     |       | 599,633                         |       | 524,737 |   | 563,501 |   |
| Deposits with stated maturities                                 |       | 414,971                     |       | 415,801                         |       | 451,691 |   | 451,691 |   |
| FHLB and other borrowings                                       |       | 304,581                     |       | 305,373                         |       | 167,766 |   | 171,170 |   |
| Subordinated debentures                                         |       | 20,795                      |       | 20,795                          |       | 15,465 |   | 15,465 |   |
| Derivative instruments                                          |       | 449                         |       | 449                             |       | 618 |   | 618 |   |
| Off-Balance-Sheet                                               |       |                        |       |                            |       |   |   |   |   |
| Commitments to extend credit and outstanding  letters of credit |       | $                           | 232,818    |                            | —     |   | $ | 244,033 |   | — |   |
|                                                                 |            |                             |            |                                 |            |  |  |  |  |  |  |  |  |

 

**11.****                              ****INVESTMENTSECURITIES**

 

Theamortized cost, gross unrealized gains and losses, and fair market value of theCorporation’s available-for-sale securities at June 30, 2009 and December 31,2008 are summarized as follows:

 
| ** **                                  | ** ** | ** **    | ** **   | **Gross**      | ** ** | **Gross**      | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|---------------|--------------|----------------|------------|----------------|------------|------------|------------|
| **(Dollars in thousands)**        | ** ** | **Amortized** | ** **   | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair**   | ** ** |
| **As of June 30, 2009** | ** ** | **Cost**      | ** **   | **Gains**      | ** ** | **Losses**     | ** ** | **Value**  | ** ** |
|                                        |       |          |         |           |       |           |       |       |       |
| U.S. Treasury                               |       | $             | 5,004        |           | $          | —         |       | $          | (1         | ) | $ | 5,003 |   |
| U.S. Government agency                      |       | 8,757         |         | 140            |       | (5             | )          | 8,892      |       |
| Mortgage-backed securities                  |       | 37,660        |         | 765            |       | (29            | )          | 38,396     |       |
| State and municipal                         |       | 6,698         |         | 44             |       | (7             | )          | 6,735      |       |
| Corporate securities                        |       | 13,684        |         | —         |       | (2,820         | )          | 10,864     |       |
| Other equity securities                     |       | 13,732        |         | 50             |       | (1,779         | )          | 12,003     |       |
|                                        |       | $             |  85,535 |           | $          | 999            |       | $          | (4,641     | ) | $ | 81,893 |   |

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 
| ** **                                      | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | ** ** | ** ** |
|-------------------------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|------------|------------|
| **(Dollars in thousands)**            | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair**   | ** ** |
| **As of December 31, 2008** | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Value**  | ** ** |
|                                            |       |          |       |           |       |           |       |       |       |
| U.S. Government agency                          |       | $             | 12,182     |           | $          | 144            |       | $          | (7         | ) | $ | 12,319 |   |
| Mortgage-backed securities                      |       | 52,151        |       | 974            |       | (95            | )          | 53,030     |       |
| State and municipal                             |       | 10,327        |       | 74             |       | —         |       | 10,401     |       |
| Corporate securities                            |       | 31,089        |       | —         |       | (5,072         | )          | 26,017     |       |
| Other equity securities                         |       | 13,659        |       | 50             |       | (892           | )          | 12,817     |       |
|                                            |       | $             | 119,408    |           | $          | 1,242          |       | $          | (6,066     | ) | $ | 114,584 |   |

 

Theamortized cost and estimated fair value of debt securities classified asavailable-for-sale at June 30, 2009, by contractual maturity, are shown inthe following table.  Expected maturitieswill differ from contractual maturities because borrowers may have the right tocall or prepay obligations with or without call or prepayment penalties.

 
| ** **                             | ** ** | **Amortized** | ** ** | **Fair**  | ** ** |
|----------------------------------------|------------|---------------|------------|-----------|------------|
| **(Dollars  in thousands)**            | ** ** | **Cost**      | ** ** | **Value** | ** ** |
| Due in one year or less                |       | $             | 6,268      |      | $          | 6,268 |   |
| Due after one year through five years  |       | 14,170        |       | 12,802    |       |
| Due after five years through ten years |       | 3,018         |       | 2,879     |       |
| Due after ten years                    |       | 10,687        |       | 9,545     |       |
|                                   |       | 34,143        |       | 31,494    |       |
| Mortgage-backed securities             |       | 37,660        |       | 38,396    |       |
| Other equity securities                |       | 13,732        |       | 12,003    |       |
|                                   |       | $             | 85,535     |      | $          | 81,893 |   |

 

Proceeds from the sale ofinvestment securities available for sale for the three and six months ended June 30,2009 were $18.5 million and $30.3 million respectively. Proceeds from the saleof investment securities available for sale for the three and six months ended June 30,2008 were $1.5 million and $13.2 million respectively.  For the three and six months ended June 30,2009 the corporation recorded gains of $89 thousand and $1 thousand,respectively. For the three and six months ended June 30, 2008 thecorporation recorded a loss of $78 thousand and a gain of $184 thousand,respectively.  The Corporation uses thespecific identification method to determine the cost of the securities sold.The principal amount of investment securities pledged to secure public depositsand for other purposes required or permitted by law was $69.8 million at June 30,2009 and $89.0 million at December 31, 2008. There were no securities heldfrom a single issuer that represented more than 10% of stockholders’ equity.

 

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

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL 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** | ** ** |
|                                             |       |               |       |                                   |       |                                   |       |      |       |   |   |   |   |   |   |
| U.S. Treasury                                    |       | 1                  |       | $                                      | 5,003      |                                   | $          | (1        | )          | $ | — |   | $ | — |   | $ | 5,003 |   | $ | (1 | ) |
| U.S. Government agency                           |       | 2                  |       | 1,467                                  |       | (6                                     | )          | —    |       | — |   | 1,467 |   | (6 | ) |
| Mortgage-backed securities                       |       | 3                  |       | 4,325                                  |       | (15                                    | )          | 1,350     |       | (13 | ) | 5,675 |   | (28 | ) |
| State and municipal                              |       | 5                  |       | 734                                    |       | (7                                     | )          | —    |       | — |   | 734 |   | (7 | ) |
| Corporate Securities                             |       | 13                 |       | 7                                      |       | (0                                     | )          | 10,857    |       | (2,820 | ) | 10,864 |   | (2,820 | ) |
| Marketable Equity Securities                     |       | 6                  |       | —                                 |       | —                                 |       | 2,515     |       | (1,779 | ) | 2,515 |   | (1,779 | ) |
|                                             |       |               |       |                                   |       |                                   |       |      |       |   |   |   |   |   |   |
| Total temporarily impaired investment securities |       | 30                 |       | $                                      | 11,536     |                                   | $          | (29       | )          | $ | 14,722 |   | $ | (4,612 | ) | $ | 26,258 |   | $ | (4,641 | ) |

 

Thetable below indicates the length of time individual securities have been in acontinuous unrealized loss position at December 31, 2008.

 
| **(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** | ** ** |
|                                             |       |               |       |                                   |       |                                   |       |      |       |   |   |   |   |   |   |
| U.S. Government agency                           |       | 2                  |       | $                                      | 1,475      |                                   | $          | (5        | )          | $ | 173 |   | $ | (2 | ) | $ | 1,648 |   | $ | (7 | ) |
| Mortgage-backed securities                       |       | 4                  |       | 3,332                                  |       | (45                                    | )          | 1,809     |       | (50 | ) | 5,141 |   | (95 | ) |
| State and municipal                              |       | —             |       | —                                 |       | —                                 |       | —    |       | — |   | — |   | — |   |
| Corporate Securities                             |       | 25                 |       | 17,605                                 |       | (1,977                                 | )          | 8,412     |       | (3,095 | ) | 26,017 |   | (5,072 | ) |
| Marketable Equity Securities                     |       | 5                  |       | —                                 |       | —                                 |       | 13,658    |       | (892 | ) | 13,658 |   | (892 | ) |
|                                             |       |               |       |                                   |       |                                   |       |      |       |   |   |   |   |   |   |
| Total temporarily impaired investment securities |       | 36                 |       | $                                      | 22,412     |                                   | $          | (2,027    | )          | $ | 24,052 |   | $ | (4,039 | ) | $ | 46,464 |   | $ | (6,066 | ) |

 

Management has consideredfactors regarding other than temporarily impaired securities and has determinedthat there was one other than temporarily impaired security at June 30,2009 and December 31, 2008. The 2008 consolidated statement of incomeincludes an $850 thousand non-cash pretax other than temporary impairment losson a $1.0 million Lehman Brothers Note held in the Bank’s investment portfolio.Management believes that there are no additional securities that were impairedas of December 31, 2008 and June 30, 2009. 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 the intent to hold the security until recovery.

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

**12.****                              ****DERIVATIVEINSTRUMENTS**

 

TheBank, as part of its real estate lending and mortgage banking activities,originates fixed-rate 1-4 unit residential loans for sale in the secondarymarket.  At the time of origination,management identifies loans that are expected to be sold in the nearfuture.  These warehoused loans have beenclassified as 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 a specifiedinterest 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 construction loan.  Unfunded loans for which commitments havebeen entered into are called “pipeline loans.” Some of these rate lock commitments will ultimately expire without beingcompleted.  To the extent that a loan isultimately granted and the borrower ultimately accepts the terms of the loan,these rate lock commitments expose the Bank to variability in their fair valuedue to changes in interest rates.  Ifinterest rates increase, the value of these rate lock commitmentsdecreases.  Conversely, if interest ratesdecrease, the value of these rate lock commitments increases.

 

Loancommitments relate to the origination of mortgage loans that will be held forsale and are accounted for as derivative instruments.  Such commitments, along with any related feesreceived from potential borrowers, are recorded at fair value as derivativeassets or liabilities, with changes in fair value recorded in net revenue fromsales and brokering of loans.

 

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 loansclose.  The fair value of forward loansales commitments that hedge warehouse loans and interest rate lockcommitments, as well as interest rate lock commitments themselves, aresummarized as follows at June 30, 2009. The fair values of all of these items are recorded on the balance sheetwithin other assets and other liabilities as these items are financialderivatives.

 

Althoughthe purpose of these derivative instruments is to economically hedge certainrisks, there are no hedge designations under FASB Statement No. 133.

 

Thefair value of derivative instruments not designated as hedging instrumentsunder FASB Statement No. 133 are presented in the following table:

 
| ** **                             | ** ** | **Asset Derivatives**   | ** ** | **Liability Derivatives**  | ** ** |
|----------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                             | ** ** | **June 30, 2009**  | ** ** | **December 31, 2008** | ** ** | **June 30, 2009** | ** ** | **December 31, 2008** | ** ** |
| **(Dollars in  thousands)**       | ** ** | **Balance  Sheet  Location** | ** ** | **Fair  Value**                 | ** ** | **Balance  Sheet  Location** | ** ** | **Fair  Value** | ** ** | **Balance  Sheet  Location** | ** ** | **Fair  Value** | ** ** | **Balance  Sheet  Location** | ** ** | **Fair  Value** | ** ** |
|                                   |       |                         |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Mandatory forward sales commitments    |       | Other assets                 |       | $                               | —     |   | Other assets |   | $ | — |   | Other Liabilities |   | $ | 449 |   | Other Liabilities |   | $ | 583 |   |
| Best efforts forward sales commitments |       | Other assets                 |       | —                          |       | Other assets |   | — |   | Other Liabilities |   | — |   | Other Liabilities |   | 35 |   |
| Interest rate lock commitments         |       | Other assets                 |       | 1,717                           |       | Other assets |   | 412 |   | Other Liabilities |   | — |   | Other Liabilities |   | — |   |
|                                        |            |                              |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

**13.****      ****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 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%. The Corporation hasretained the right to redeem the Trust Preferred Securities at par (plusaccrued but unpaid interest) on any interest payment date on or after April 28,2014.

 

**14.****      ****SUBSEQUENT EVENTS**

 

TheCorporation evaluated its June 30, 2009 financial statements forsubsequent events through August 10, 2009. The Corporation is not aware ofany subsequent events which would require recognition or disclosure in thefinancial statements.

 

**15.****      ****RECLASSIFICATIONS**

 

Certain2008 numbers have been reclassified to conform with current periodpresentation. These reclassifications have no impact on net income or earningsper share.

 

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**ITEM 2.                 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION 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 wholly-owned subsidiaries. It should beread in conjunction with the consolidated financial statements included in thisreport.

 

Inaddition to historical information, this discussion and analysis containsstatements relating to future results of the Corporation that are considered “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995.  These statements can often beidentified by the use of forward-looking terminology such as “believes,” “expects,”“intends,” “may,” “will,” “should” “or anticipates” or similarterminology.  These statements involverisks and uncertainties and are based on various assumptions.  Although the Corporation believes that itsexpectations are based on reasonable assumptions, investors and prospectiveinvestors are cautioned that such statements are only projections, and thatthese risks and uncertainties are all difficult to predict and most are beyondthe control of the Corporation’s Management. Information about the primary risks and uncertainties that could causethe Corporation’s actual future results to differ materially from our historicresults or the results described in forward-looking statements made in thisreport or presented elsewhere by Management from time to time are included in Part I, Item1A of our Annual Report on Form 10-K for the year ended December 31,2008 (our “2008 Annual Report”). Material changes to such “risk factors” may be reported in subsequentQuarterly Reports on Form 10-Q in Part II, Item 1A.  There have been no such changes from the riskfactors set forth in our 2008 Annual Report.

 

TheCorporation undertakes no obligation to publicly release any revisions to anyforward-looking statements to reflect events or circumstances after the date ofthis Report.

 

**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.

 

**Goodwill**

 

Goodwillwas recorded as a result of the American Home Bank (“AHB”) acquisition.Goodwill and other intangible assets must be reviewed at least annually forpotential impairment, or more often if events or circumstances indicate thatthere may be impairment, in accordance with SFAS No. 142, “Goodwill andOther Intangible Assets and SFAS No. 144, “Accounting for the Impairmentor Disposal of Long-Lived Assets.” Goodwill is tested for impairment at thereporting unit level and requires that the fair value of each of our reportingunits be compared to the carrying amount of its net assets, including goodwill.An impairment loss is recorded to the extent that the carrying amount ofgoodwill exceeds its implied fair value. The Corporation will utilize generalindustry practices in evaluating the fair value of its goodwill and otherintangible assets.

 

**InvestmentSecurities**

 

Inaccordance with FASB Statement No. 115, the Corporation evaluates theindividual securities making up the investment portfolio for other thantemporary impairment on a quarterly basis. If a security is deemed to be otherthan temporarily impaired, the impairment is recorded in non-interest income inthe period in which it is recognized. Evaluating whether a security is otherthan temporarily impaired involves a high degree of judgment. Factorsconsidered by management in determining whether a security is other than temporarilyimpaired include current and forecasted market conditions for that security aswell as our ability and intent to hold the security until recovery.

 

**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 

 

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determinedbased on Management’s review and evaluation of the loan and lease portfolio inrelation to past loss experience, the size and composition of the portfolio,current economic events and conditions, and other pertinent factors, includingManagement’s assumptions as to future delinquencies, recoveries and losses. Allof these factors may be susceptible to significant change.  To the extent actual outcomes differ fromManagement’s estimates, additional provisions for loan and lease losses may berequired that would adversely impact earnings 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.

 

**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 and associated products to customers and selling most of thosemortgages into the secondary market on a servicing released basis. The Bankretains the servicing on a portion of the loans that it sells. The sourcing ofmortgage loans is conducted through a direct, retail delivery channel comprisedof retail loan offices, affiliated business arrangements with builders andrealtors, and a wholesale lending operation. The wholesale operation sourcesloans through relationships with unrelated mortgage brokers.

 

**EARNINGS AND DIVIDEND SUMMARY**

 

TheCorporation completed its acquisition of AHB on December 31, 2008, and,accordingly, the December 31, 2008 and the June 30, 2009 consolidatedbalance sheets reflect the addition of assets acquired and liabilities assumedin this acquisition. The results of operations presented in the consolidatedincome statement for the three and six months ended June 30, 2009 includethe results of operations from AHB; however, the consolidated income statementfor the three and six months ended June 30, 2008 does not include theresults of AHB.

 

Netloss for the three months ended June 30, 2009 was $62 thousand, a decreaseof approximately $1.9 million from $1.8 million for the same period in2008.  Diluted (loss) earnings per sharefor the three months ended June 30, 2009 were ($0.01) compared to $0.35for the same period in 2008.  Cashdividends declared for the three months ended June 30, 2009 were $0.14 pershare compared to $0.14 per share for the three months ended June 30,2008.

 

Netincome for the six months ended June 30, 2009 was $3.3 million, comparedto $3.4 million for the same period in 2008. Diluted earnings per share for the six months ended June 30, 2009were $0.52 compared to $0.65 for the same period in 2008.  Cash dividends declared for the six monthsended June 30, 2009 were $0.28 per share compared to $0.28 per share forthe six months ended June 30, 2008.

 

Thedecrease in net income for the three months ended June 30, 2009 wasprimarily due to an increase non-interest expense combined with an increase inthe provision for loan and lease losses. The increase in non-interest expensewas due mainly to the addition of AHB’s operations as well as an increase inFDIC insurance expense while the increase in the provision for loan losses canbe attributed to a continued uncertainty in the economic environment, increasedtrends in delinquency and non-accruals, and a higher level of net charge-offsdue to diminished operating cash flows of our borrowers and depreciatedcollateral values.  Offsetting theseincreases in expenses was an increase in non-interest income, mainlyattributable to the net gains from the mortgage banking activities of the AHBDivision. In addition, an increase was noted in net interest income due mainlyto the higher average interest-earning assets resulting from the acquisition ofAHB.

 

Thedecrease in net income for the six months ended June 30, 2009 primarilydue to an increase in non-interest expense combined with an increase in theprovision for loan and lease losses. The increase in non-interest expense wasdue mainly to the addition of AHB’s operations as well as an increase in FDICinsurance expense while the increase in the provision was driven by the ongoingimpact from recessionary economic conditions. Offsetting these increases was an increase in non-interest income,mainly attributable to the net gains from the mortgage banking activities ofthe AHB 

 

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Division. In addition the increase in netincome was due to an increase in net interest income due mainly to the higheraverage interest-earning assets from the acquisition of AHB.

 

**SELECTEDRATIOS**

 
| ** **               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **               | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **               | ** ** | **2009**                         | ** ** | **2008**                       | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **               | ** ** | **(Restated)**                   | ** ** | ** **                     | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
| Return on Average Assets |       | (0.02                            | )%         | 0.74                           | %          | 0.49 | % | 0.69 | % |
| Return on Average Equity |       | (0.28                            | )%         | 10.64                          | %          | 7.47 | % | 9.72 | % |
| Dividend Payout Ratio    |       | (1,411.29                        | )%         | 39.40                          | %          | 53.67 | % | 43.19 | % |
| Book Value Per Share     |       | $                                | 14.03      |                           | $          | 13.23 |   | $ | 14.03 |   | $ | 13.23 |   |
|                          |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |

 

**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 six months ended June 30,2009 and 2008 is presented in Note 8 to the Corporation’s Financial Statements.

 

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 theMortgage Banking segment. Factors driving net interest income and the provisionfor loan and lease losses are similar for the loans held in each of thesesegments. Specific discussion is made below where factors driving the specificcomponents of Non-interest income and expense for the operating segments differfrom the consolidated Corporation.

 

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**CONSOLIDATED AVERAGE BALANCE SHEET**

**AND TAXABLE EQUIVALENT INCOME/EXPENSE AND RATES FOR THE**

**THREE MONTHS ENDED JUNE 30,**

 
| ** **                                                                                             | ** ** | **2009**    | ** ** | **2008**     | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|-------------|------------|--------------|------------|
| ** **                                                                                             | ** ** | **Average** | ** ** | ** **   | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **(Dollars  in thousands)**                                                                            | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Rate%** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Rate%** | ** ** |
| ASSETS                                                                                                 |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Federal funds sold, interest-bearing  deposits in banks and other overnight investments |       | $           | 16,019     |         | $          | 17 |   | 0.41 | % | $ | 55,248 |   | $ | 417 |   | 3.04 | % |
| Investment securities:                                                                            |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Taxable                                                                                                |       | 87,642      |       | 934          |       | 4.28 | % | 103,764 |   | 1,242 |   | 4.81 | % |
| Tax-exempt (1)                                                                                    |       | 7,544       |       | 91           |       | 4.82 | % | 13,386 |   | 157 |   | 4.73 | % |
| Total investment securities                                                                  |       | 95,186      |       | 1,025        |       | 4.32 | % | 117,150 |   | 1,399 |   | 4.80 | % |
|                                                                                                   |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Loans held for sale                                                                                    |       | 267,299     |       | 3,095        |       | 4.64 | % | 721 |   | 8 |   | 4.46 | % |
|                                                                                                   |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Loans and leases: (2)                                                                   |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Taxable                                                                                                |       | 924,294     |       | 13,112       |       | 5.69 | % | 753,386 |   | 11,788 |   | 6.29 | % |
| Tax-exempt (1)                                                                                    |       | 20,532      |       | 377          |       | 7.36 | % | 18,906 |   | 340 |   | 7.24 | % |
| Total loans and leases                                                                  |       | 944,826     |       | 13,489       |       | 5.73 | % | 772,292 |   | 12,128 |   | 6.31 | % |
|                                                                                                   |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Total interest-earning assets                                                                |       | 1,323,330   |       | 17,626       |       | 5.34 | % | 945,411 |   | 13,952 |   | 5.94 | % |
| Non-interest-earning assets                                                                       |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Allowance for loan and lease losses                                                     |       | (11,236     | )          |         |       |   |   | (7,972 | ) |   |   |   |   |
| Cash and due from banks                                                            |       | 10,848      |       |         |       |   |   | 17,957 |   |   |   |   |   |
| Other assets                                                                                      |       | 47,004      |       |         |       |   |   | 39,775 |   |   |   |   |   |
|                                                                                                   |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Total assets                                                                                      |       | $           | 1,369,946  |         |       |   |   |   | $ | 995,171 |   |   |   |   |   |
|                                                                                                   |       |        |       |         |       |   |   |   |   |   |   |   |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                              |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Savings, NOW, and money market  deposits                                           |       | $           | 437,316    |         | $          | 1,040 |   | 0.95 | % | $ | 393,554 |   | $ | 1,605 |   | 1.64 | % |
| Certificates of deposit and other time                                        |       | 429,948     |       | 2,843        |       | 2.65 | % | 235,775 |   | 2,349 |   | 4.01 | % |
| Total interest-bearing deposits                                                              |       | 867,264     |       | 3,883        |       | 1.80 | % | 629,329 |   | 3,954 |   | 2.53 | % |
| Subordinated debt                                                                                 |       | 19,436      |       | 252          |       | 5.20 | % | 15,465 |   | 215 |   | 5.59 | % |
| Federal Home Loan Bank advances and  other borrowings                                   |       | 228,188     |       | 1,617        |       | 2.84 | % | 152,288 |   | 1,478 |   | 3.90 | % |
| Total interest-bearing liabilities                                                           |       | 1,114,888   |       | 5,752        |       | 2.07 | % | 797,082 |   | 5,647 |   | 2.85 | % |
| Non-interest-bearing liabilities:                                                                 |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Non-interest-bearing demand deposits                                                                   |       | 149,078     |       |         |       |   |   | 119,951 |   |   |   |   |   |
| Other liabilities                                                                                 |       | 16,925      |       |         |       |   |   | 8,877 |   |   |   |   |   |
| Total liabilities                                                                                 |       | 1,280,891   |       |         |       |   |   | 925,910 |   |   |   |   |   |
| Stockholders’ equity                                                                         |       | 89,055      |       |         |       |   |   | 69,261 |   |   |   |   |   |
| Total liabilities and stockholders’ equity                                    |       | $           | 1,369,946  |         |       |   |   |   | $ | 995,171 |   |   |   |   |   |
|                                                                                                   |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Net interest income                                                                          |       |        |       | $            | 11,874     |   |   |   |   |   | $ | 8,305 |   |   |   |
| Net yield on interest-earning assets                                               |       |        |       |         |       | 3.60 | % |   |   |   |   | 3.53 | % |

 

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(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 disallowancefor 2009 and 2008.

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

 

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**CONSOLIDATED AVERAGE BALANCE SHEET**

**AND TAXABLE EQUIVALENT INCOME/EXPENSE AND RATES FOR THE**

**SIX MONTHS ENDED JUNE 30,**

 
| ** **                                                                                             | ** ** | **2009**    | ** ** | **2008**     | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|-------------|------------|--------------|------------|
| ** **                                                                                             | ** ** | **Average** | ** ** | ** **   | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **(Dollars  in thousands)**                                                                            | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Rate%** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Rate%** | ** ** |
| ASSETS                                                                                                 |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Federal funds sold, interest-bearing  deposits in banks and other overnight investments |       | $           | 21,238     |         | $          | 44 |   | 0.42 | % | $ | 52,365 |   | $ | 868 |   | 3.34 | % |
| Investment securities:                                                                            |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Taxable                                                                                                |       | 94,732      |       | 2,087        |       | 4.44 | % | 98,231 |   | 2,358 |   | 4.83 | % |
| Tax-exempt (1)                                                                                    |       | 8,569       |       | 204          |       | 4.81 | % | 13,532 |   | 321 |   | 4.77 | % |
| Total investment securities                                                                  |       | 103,301     |       | 2,291        |       | 4.47 | % | 111,763 |   | 2,679 |   | 4.82 | % |
|                                                                                                   |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Loans held for sale                                                                                    |       | 209,291     |       | 4,939        |       | 4.76 | % | 664 |   | 15 |   | 4.54 | % |
|                                                                                                   |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Loans and leases: (2)                                                                   |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Taxable                                                                                                |       | 921,975     |       | 26,062       |       | 5.70 | % | 740,925 |   | 23,938 |   | 6.50 | % |
| Tax-exempt (1)                                                                                    |       | 20,633      |       | 754          |       | 7.36 | % | 19,239 |   | 689 |   | 7.20 | % |
| Total loans and leases                                                                  |       | 942,608     |       | 26,816       |       | 5.74 | % | 760,164 |   | 24,627 |   | 6.51 | % |
|                                                                                                   |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Total interest-earning assets                                                                |       | 1,276,438   |       | 34,090       |       | 5.39 | % | 924,956 |   | 28,189 |   | 6.13 | % |
| Non-interest-earning assets                                                                       |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Allowance for loan and lease losses                                                     |       | (10,904     | )          |         |       |   |   | (7,928 | ) |   |   |   |   |
| Cash and due from banks                                                            |       | 19,353      |       |         |       |   |   | 19,552 |   |   |   |   |   |
| Other assets                                                                                      |       | 54,057      |       |         |       |   |   | 37,395 |   |   |   |   |   |
|                                                                                                   |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Total assets                                                                                      |       | $           | 1,338,944  |         |       |   |   |   | $ | 973,975 |   |   |   |   |   |
|                                                                                                   |       |        |       |         |       |   |   |   |   |   |   |   |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                              |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Savings, NOW, and money market  deposits                                           |       | $           | 431,189    |         | $          | 2,246 |   | 1.05 | % | $ | 383,526 |   | $ | 3,640 |   | 1.91 | % |
| Certificates of deposit and other time                                        |       | 438,686     |       | 6,108        |       | 2.81 | % | 228,451 |   | 4,812 |   | 4.24 | % |
| Total interest-bearing deposits                                                              |       | 869,875     |       | 8,354        |       | 1.94 | % | 611,977 |   | 8,452 |   | 2.78 | % |
| Subordinated debt                                                                                 |       | 17,461      |       | 426          |       | 4.92 | % | 15,465 |   | 474 |   | 6.16 | % |
| Federal Home Loan Bank advances  and other borrowings                    |       | 201,343     |       | 3,153        |       | 3.16 | % | 149,425 |   | 2,920 |   | 3.93 | % |
| Total interest-bearing liabilities                                                           |       | 1,088,679   |       | 11,933       |       | 2.21 | % | 776,867 |   | 11,846 |   | 3.07 | % |
| Non-interest-bearing liabilities:                                                                 |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Non-interest-bearing demand deposits                                                         |       | 146,583     |       |         |       |   |   | 118,216 |   |   |   |   |   |
| Other liabilities                                                                                 |       | 15,667      |       |         |       |   |   | 9,705 |   |   |   |   |   |
| Total liabilities                                                                                 |       | 1,250,929   |       |         |       |   |   | 904,788 |   |   |   |   |   |
| Stockholders’ equity                                                                         |       | 88,015      |       |         |       |   |   | 69,187 |   |   |   |   |   |
| Total liabilities and stockholders’ equity                                    |       | $           | 1,338,944  |         |       |   |   |   | $ | 973,975 |   |   |   |   |   |
|                                                                                                   |       |        |       |         |       |   |   |   |   |   |   |   |   |
| Net interest income                                                                          |       |        |       | $            | 22,157     |   |   |   |   |   | $ | 16,343 |   |   |   |
| Net yield on interest-earning assets                                               |       |        |       |         |       | 3.50 | % |   |   |   |   | 3.55 | % |

 

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(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 disallowancefor 2009 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 June 30, 2009 was $11.9 million, an increase of 43.0% from$8.3 million for the same period in 2008. Net interest income on a tax equivalent basis for the six month periodended June 30, 2009 was $22.2 million, an increase of 35.6% from $16.3million for the same period in 2008.  Thenet yield on interest-earning assets, on a tax-equivalent basis, was 3.60% forthe three-month period ended June 30, 2009, compared to 3.53% for the sameperiod in 2008, an increase of 7 basis points (one basis point is equal to1/100 of a percent).  For the six monthperiod ended June 30, 2009, the net yield on interest earning assetsdecreased 5 basis points to 3.50% from 3.55% during the same period in 2008.

 

The yield earned on interest-earning assets was 5.34% for the threemonth period ended June 30, 2009, compared to 5.94% for the same period in2008, a decrease of 60 basis points. For the six month period ended June 30,2009, the yield earned on interest earning assets decreased 74 basis points to5.39% from 6.13% during the same period in 2008.

 

Average interest-earning assets increased approximately $377.9 millionor 40.0% to $1.3 billion for the three-months ended June 30, 2009 from$945.4 million in the same period last year. The increase in average interest-earning assets for the three-monthperiod ended June 30, 2009 was the result of $266.6 million increase inLoans held for sale combined with a 22.3% or $172.5 million increase in averagetotal Loans and leases. These increases were partially offset by an 18.7% or$22.0 million decrease in average investment securities and a 71.0% or $39.2million decrease in the average Federal funds sold and interest bearingdeposits in banks balance..

 

For the six month period ended June 30, 2009 averageinterest-earning assets increased approximately $351.5 million or 38.0% to $1.3billion from $925.0 million in the same period last year.  The increase in average interest-earningassets for the six-month period ended June 30, 2009 was the result of a$208.6 million increase in Loans held for sale combined with a 24.0% or $182.4million increase in average total Loans and leases. These increases werepartially offset by a 7.6% or $8.5 million decrease in average investmentsecurities and a 59.4% or $31.1 million decrease in the average Federal fundssold and interest bearing deposits in banks balance.

 

Average interest-bearing liabilities increased approximately $317.8million or 39.9% to $1.1 billion for the three-months ended June 30, 2009,from $797.1 million in the same period in 2008. The increase in average interest-bearing liabilities for the three-monthperiod was the result of a $237.9 million or 37.8% increase in interest-bearingdeposits, combined with a $75.9 million or 49.8% increase in Federal Home LoanBank (FHLB) advances and other borrowings and a $4.0 million or 25.7% increasein Subordinated debt.

 

For the six month period ended June 30, 2009 averageinterest-bearing liabilities increased approximately $311.8 million or 40.1% to$1.1 billion from $776.9 million in the same period in 2008.  The increase in average interest-bearing liabilitiesfor the six-month period was the result of a $257.9 million or 42.1% increasein interest-bearing deposits, combined with a $51.9 million or 34.7% increasein Federal Home Loan Bank (FHLB) advances and other borrowings and a $2.0million or 12.9% increase in Subordinated debentures.

 

**INTERESTINCOME**

 

Interest income on federal funds sold and interest-bearing deposits inbanks for the three and six month periods ended June 30, 2009 decreased95.9% and 94.9% to approximately $17 thousand and $44 thousand respectively,when compared to the same periods in 2008. The decrease in interest income on federal funds sold andinterest-bearing deposits in banks for the three and six month periods isprimarily the result of a $39.3 million and $31.1 million decrease in theaverage federal funds sold and interest bearing deposits at banks balancescombined with a 263 and 292 basis point decrease on the rates earned on theseassets. The decrease in these balances was mainly because Federal funds soldand interest bearing deposits at banks balances were used to fund the increasein loans held for sale while the decrease in rate is a primarily a result ofFederal Reserve actions to reduce market interest rates. The decrease in therate earned on these balances was also due to management’s decision to investavailable cash in more secure, but lower yielding, overnight investmentalternatives.

 

On a tax equivalent basis, interest income on investment securitiesdecreased by 26.7% or approximately $374 thousand to $1.0 million for thethree-month period ended June 30, 2009 from $1.4 million for the sameperiod in 2008.  For the six month periodended June 30, 2009, interest income on investment securities decreased14.5% or $388 thousand to $2.3 million from $2.7 million when compared to thesame period in 2008.  The decreases forthe three and six months

 

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periods were the result of a 48 and 35 basis point decrease in theyield earned on investment securities, respectively. This was combined with a$22.0 million and $8.5 million decrease in average total investment securitybalances for the three and six month periods, respectively. The decrease ininvestment security balances reflects Management’s decision to reduce the Bank’sexposure to corporate bonds.

 

Interest income on loans held for sale increased to $3.1 million duringthe three month period ended June 30, 2009.  For the six month period ended June 30,2009 interest income on loans held for sale increased to $4.9 million.  These increases were due to a significantincrease in the average loans held for sale balance.  Average loans held for sale for the three andsix months periods ended June 30, 2009 were $267.3 million and $209.3million as compared to approximately $721 thousand and $664 thousand for thesame periods in 2008. This increase was due to the AHB acquisition. $89.5million of loans held for sale were acquired at December 31, 2008 throughthe acquisition. The increase in average balance from December 31, 2008 toJune 30, 2009 was due to increased volume in residential mortgage loanoriginations.

 

Interest income on loans, on a tax equivalent basis, generated by theCorporation’s loan portfolio increased 11.2% or $1.4 million to $13.5 millionfor the three-month period ended June 30, 2009 compared to $12.1 millionfor the three months ended June 30, 2008. For the six month period ended June 30, 2009, interest income onloans, on a tax equivalent basis increased 8.9% or $2.2 million when comparedto the same period in 2008.  Theseincreases in interest income for the three and six month periods ended June 30,2009 were primarily due to a $172.5 million or 22.3% and increase in averageloans outstanding for the three month period and a $182.4 million or 24.0%increase in average loans outstanding for the six month period as compared tothe same periods in 2008. These increases in average loan balances wereprimarily due to the AHB acquisition. $110.9 million of loans were acquired at December 31,2008 through the acquisition. The impact from the increase in average loanbalances was partially offset by a decrease in the tax equivalent yield earnedon average loans outstanding, which decreased by 58 and 74 basis points to5.73% and 5.74% for the three and six month periods ended June 30, 2009 from6.31% and 6.51% for the same periods in 2008. This rate decrease is the resultof Federal Reserve actions to reduce market interest rates.

 

**INTERESTEXPENSE**

 

Interest expense on deposit accounts decreased by approximately $71thousand or 1.8% to $3.9 million for the three-month period ended June 30,2009 from $4.0 million for the same period in 2008.  Interest expense on deposit accountsdecreased $98 thousand or 1.2% to $8.4 million for the six months ended June 30,2009 compared to the same period in 2008. The decreases for the three and six month periods were primarily due toa decrease in the average interest rates paid on interest-bearing deposits. Theaverage rate paid for the three month period in 2009 was 1.80%, a 73 basispoint decrease from 2.53% in 2008. The average rate paid for the six monthperiod in 2009 was 1.94%, an 84 basis point decrease from 2.78% in 2008. Theserate decreases were primarily the result of Federal Reserve actions to reducemarket interest rates. The impact from rate decreases was partially offset byincreases in average interest-bearing deposit balances. These balancesincreased $237.9 million for the three month period to $867.3 million in 2009from $629.3 million in 2008. These balances increased $257.9 million for thesix month period to $869.9 million in 2009 from $612.0 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.

 

Interest expense on subordinated debentures increased approximately $37thousand to $252 thousand for the three-month period ended June 30, 2009from approximately $215 thousand 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 June 30,2009 decreased 39 basis points from 5.59% in 2008 to 5.20% in 2009 primarilydue to a decrease in the 3 month LIBOR between the two periods, partiallyoffset by the higher rate on the new issuance. Interest expense on subordinateddebentures decreased approximately $48 thousand to $426 thousand for the sixmonth period ended June 30, 2009 from $474 thousand for the same period in2008. The decrease for the six month period is primarily due to a 124 basispoint decrease in the average interest rate paid on these debentures. The ratedecrease was mainly due to a decrease in the 3 month LIBOR between the twoperiods combined with the impact of a higher rate issuance that was called in July 2008.The impact from these rate decreases was partially offset by the higher rate onthe May 2009 new issuance.

 

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Interest expense on FHLB and other borrowings increased byapproximately $139 thousand or 9.4% to $1.6 million for the three-month periodended June 30, 2009 from $1.5 million for the same period in 2008.Interest expense on FHLB and other borrowings for the six months ended June 30,2009 increased approximately $233 thousand or 8.0% to $3.2 million from $2.9 millionin 2008. These increases in interest expense were primarily due to increases inthe average balances of these funding sources in 2009 as compared to 2008. Theaverage balance of FHLB and other borrowings for the three months ended June 30,2009 increased by 49.8% or $75.9 million between the two periods. Averagebalances of these funding sources for the six month period increased 34.7% or$51.9 million between the two periods. The increase in average FHLB and other borrowings was partially due to theAHB acquisition. $36.6 million of FHLB and other borrowings balances wereacquired at December 31, 2008 through the acquisition. The increase inbalance from December 31, 2008 through June 30, 2009 was due to anincrease in borrowings from the FHLB and Federal Reserve to fund the increasein loans held for sale.

 

FHLB and other borrowings are a favorable alternative to deposits tosupport asset growth. The impact from the average balance increase waspartially offset by a decrease in the average rate paid on these borrowings.The average rate paid was 2.84% for the three months ended June 30, 2009,a decrease of 106 basis points from 3.90% during the same period in 2008. Theaverage rate paid on these borrowings was 3.16% for the six months ended June 30,2009, a decrease of 77 basis points from 3.93% during the same period in 2008.The lower average rate paid was primarily a result of Federal Reserve actionsto reduce market interest rates

 

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

 

The allowance for loan and lease losses is an amount that Managementbelieves will be adequate to absorb probable loan losses on existing loans thatmay become uncollectible and is established based on Management’s evaluation ofthe collectability 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 six months ended June 30, 2009, theCorporation recorded $5.1 million and $6.5 million in provision for loan andlease losses, respectively, as compared to $449 thousand and $660 thousand forthe same period in 2008. The increase in the provision for loan losses in thethree and six months ended June 30, 2009 can be attributed to uncertaintyin the economic environment, increased trends in delinquency, non-accruals andother impaired loans, as well as depreciated values of collateral supportingsuch loans.  Charge-offs also continuedto increase due to diminished operating cash flows of our borrowers.  The allowance for loan and lease losses as apercentage of loans and leases at June 30, 2009 was 1.64% compared to1.10% at December 31, 2008 and 1.07% at June 30, 2008. Netcharge-offs for the three and six months ended June 30, 2009 were $0.8million and $1.1 million compared to $20 thousand and $79 thousand for the sameperiods in 2008.

 

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The following chart presents an analysis of the Allowance for Loan andLease Losses:

 
| ** **                                                                           | ** ** | **Three Months**  | ** ** | **Six Months**    | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                                           | ** ** | **Ended**         | ** ** | **Ended**         | ** ** |
| ** **                                                                           | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| ** **                                                                           | ** ** | **2009**          | ** ** | **2008**          | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                                           | ** ** | **(Restated)**    | ** ** | ** **        | ** ** | **(Restated)** | ** ** | ** ** | ** ** |
| Balance at beginning of period                                                       |       | $                 | 11,263     |              | $          | 7,930 |   | $ | 10,335 |   | $ | 7,817 |   |
|                                                                                 |       |              |       |              |       |   |   |   |   |
| Provision charged to operating expense                                               |       | 5,084             |       | 449               |       | 6,471 |   | 660 |   |
|                                                                                 |       |              |       |              |       |   |   |   |   |
| Recoveries of loans previously charged-off                                           |       | 104               |       | 97                |       | 249 |   | 197 |   |
| Loans charged-off                                                                    |       | (924              | )          | (117              | )          | (1,366 | ) | (276 | ) |
| Net loan charge-offs                                                                 |       | (820              | )          | (20               | )          | (1,117 | ) | (79 | ) |
|                                                                                 |       |              |       |              |       |   |   |   |   |
| Allowance other adjustment (1)                                                       |       | 1                 |       | 74                |       | (161 | ) | 35 |   |
|                                                                                 |       |              |       |              |       |   |   |   |   |
| Balance at end of period                                                             |       | $                 | 15,528     |              | $          | 8,433 |   | $ | 15,528 |   | $ | 8,433 |   |
|                                                                                 |       |              |       |              |       |   |   |   |   |
| Period-end loans outstanding                                                         |       | $                 | 947,914    |              | $          | 786,548 |   | $ | 947,914 |   | $ | 786,548 |   |
| Average loans outstanding                                                            |       | $                 | 944,826    |              | $          | 772,292 |   | $ | 942,608 |   | $ | 760,164 |   |
|                                                                                 |       |              |       |              |       |   |   |   |   |
| Allowance for loan and lease losses as a percentage  of period-end loans outstanding |       | 1.64              | %          | 1.07              | %          | 1.64 | % | 1.07 | % |
| Net charge-offs to average loans outstanding                                         |       | 0.09              | %          | 0.00              | %          | 0.12 | % | 0.01 | % |

 

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(1) The “Allowance other adjustment” represents thereclassification of an allowance for probable losses on unfunded loans andunused lines of credit.  These loans andlines of credit, although unfunded, have been committed to 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.  The Corporation’s policy is to writedown all non-performing loans to net realizable value based on updatedappraisals.  Non-accrual loans reduce theCorporation’s earnings because interest income is not earned on such assets.The total non-performing loans and lease balance at June 30, 2009 was$27.3 million as compared to $10.5 million at December 31, 2008 and $2.0million at June 30, 2008. The percentage of non-performing loans to grossloans was 2.88% at June 30, 2009 compared to 1.21% at December 31,2008 and 0.27% at June 30, 2008.

 

OREO represents real estate owned by the Bank following default by theborrowers. OREO is recorded at the lower of the loan carryingvalue or fair market value. Fair market value is based primarily uponindependent market prices, appraised values of the collateral or management’sestimation of the value of the collateral. OREO reduces the Corporation’searnings because interest income is not earned on such assets.

 

The following chart presents detailed information regardingnon-performing loans and leases and OREO:

 
| ** **                                                                              | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| **(Dollars  in thousands)**                                                             | ** ** | **2009**          | ** ** | **2008**              | ** ** | **2008** | ** ** |
| ** **                                                                              | ** ** | **(Restated)**    | ** ** | ** **            | ** ** | ** ** | ** ** |
| Past due over 90 days and still accruing                                                |       | $                 | 686        |                  | $          | 115 |   | $ | 870 |   |
| Non-accrual loans and leases (1)                                                        |       | 19,111            |       | 2,042                 |       | 10,514 |   |
| Restructured and other impaired loans                                                   |       | 7,015             |       | —                |       | — |   |
| Total non-performing loans and leases                                                   |       | 26,812            |       | 2,157                 |       | 11,384 |   |
|                                                                                    |       |              |       |                  |       |   |   |
| Other real estate owned                                                                 |       | 1,592             |       | 459                   |       | 1,872 |   |
| Total non-performing assets                                                             |       | $                 | 28,404     |                  | $          | 2,616 |   | $ | 13,256 |   |
|                                                                                    |       |              |       |                  |       |   |   |
| Non-performing loans and leases as a percentage of  total loans and leases              |       | 2.83              | %          | 0.27                  | %          | 1.21 | % |
|                                                                                    |       |              |       |                  |       |   |   |
| Allowance for loan and lease losses as a  percentage of non-performing loans and leases |       | 57.91             | %          | 400.63                | %          | 90.78 | % |
|                                                                                    |       |              |       |                  |       |   |   |
| Non-performing assets as a percentage of total  loans and other real estate owned       |       | 2.99              | %          | 0.33                  | %          | 1.41 | % |
|                                                                                    |       |              |       |                  |       |   |   |
| Allowance for loan and lease losses as a  percentage of non-performing assets           |       | 54.67             | %          | 330.40                | %          | 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.

 

Management is not aware of any loans or leases other than thoseincluded in these tables that would be considered potential problem loans andcause Management to have doubts as to the borrower’s ability to comply withloan repayment terms.

 

The Corporation identifies a loan as impaired when it is probable thatinterest and principal will not be collected according to the contractual termsof the loan agreement. With the exception of troubled debt restructurings, theaccrual of interest is discontinued on impaired loans and no income isrecognized until all recorded amounts of interest and principal are recoveredin full.

 

The Corporation examines loans individually when it is probable that wewill be unable to collect all contractual interest and principal paymentsaccording to the contractual terms of the loan agreement and assesses forimpairment.  The average recorded balanceof impaired loans was $13.5 million and $1.6 million at June 30, 2009 and2008, respectively.  Interest incomerecognized during the time within the period that the loans were impaired was$22 thousand for the six months ended June 30, 2009. There was no interestincome recorded on impaired loans for the same period ending June 30, 2008as all impaired loans were also non-accrual.

 

Included in the June 30, 2009 restructured and other impairedloans of $7.0 million were $5.7 million of loans to one commercial real estaterelationship for which the original loan terms have been modified due to theborrower’s financial difficulties.  As ofJune 30, 2009 these loans were performing under the re-negotiated termsand are not classified as non-accrual. These loans are classified as commercial real estate and the Corporationhas allocated a specific reserve of $2.6 million at June 30, 2009.  The remaining increase in restructured andother impaired loans at June 30, 2009 is attributable to one $1.3 millioncommercial real estate construction loan which was performing under its contractualterms at June 30, 2009 but was evaluated by Management and deemedimpaired.  The specific impairment onthis loan at June 30, 2009 was $101 thousand.  Management continues to closely monitor thisrelationship.

 

Asa recurring part of its portfolio management program, the Corporation hasidentified approximately $59.7 million in potential problem loans at June 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 June 30, 2009, potential problem loansprimarily consisted of commercial loans and commercial real estate. There canbe no assurance that additional loans will not become nonperforming, requirerestructuring, or require increased provision for loan losses.

 

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The following charts present additional information about impairedloans and lease balances as of June 30, 2009 and December 31, 2008:

 

June30, 2009

 
| ** **                                  | ** ** | ** **  | ** ** | ** **       | ** ** | **Number of**  | ** ** | ** **      | ** ** |
|---------------------------------------------|------------|-------------|------------|------------------|------------|----------------|------------|-----------------|------------|
| ** **                                  | ** ** | **Loan**    | ** ** | **Impaired**     | ** ** | **Impaired**   | ** ** | **Allowance**   | ** ** |
| **(Dollars  in thousands)**                 | ** ** | **Balance** | ** ** | **Loan Balance** | ** ** | **Loans**      | ** ** | **on Impaired** | ** ** |
| ** **                                  | ** ** | ** **  | ** ** | **(Restated)**   | ** ** | **(Restated)** | ** ** | **(Restated)**  | ** ** |
| Commercial loans                            |       | $           | 342,582    |             | $          | 4,796          |       | 18              |       | $ | 189 |   |
| Real estate – commercial               |       | 291,587     |       | 9,804            |       | 9              |       | 4,064           |       |
| Real estate – commercial construction  |       | 69,511      |       | 3,657            |       | 3              |       | 599             |       |
| Real estate – residential              |       | 85,875      |       | 1,307            |       | 5              |       | 44              |       |
| Real estate – residential construction |       | 32,385      |       | 4,869            |       | 14             |       | 474             |       |
| Consumer loans                              |       | 123,243     |       | 1,533            |       | 23             |       | 154             |       |
| Lease financing receivables                 |       | 2,731       |       | 160              |       | 3              |       | —          |       |
|                                        |       |        |       |             |       |           |       |            |       |
| Totals                                      |       | $           | 947,914    |             | $          | 26,126         |       | 75              |       | $ | 5,524 |   |

 

December31, 2008

 
| ** **                                  | ** ** | ** **  | ** ** | ** **       | ** ** | **Number of** | ** ** | ** **      | ** ** |
|---------------------------------------------|------------|-------------|------------|------------------|------------|---------------|------------|-----------------|------------|
| ** **                                  | ** ** | **Loan**    | ** ** | **Impaired**     | ** ** | **Impaired**  | ** ** | **Allowance**   | ** ** |
| **(Dollars  in thousands)**                 | ** ** | **Balance** | ** ** | **Loan 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 |   |

 

**NON-INTERESTINCOME, AS RESTATED**

 

Total non-interest income increased $15.2 million to $18.0 million forthe three months ended June 30, 2009, compared to $2.8 million for thesame period in 2008.  Total non-interestincome increased $26.6 million to $33.4 million for the six months ended June 30,2009, compared to $5.6 million for the same period in 2008.  The various components of non-interest incomeare discussed below.

 

Wealth management and advisory services revenue decreased $32 thousandor 3.0% to $1.0 million for the three months ended June 30, 2009 from $1.1million during the same period in 2008. Wealth management and advisory services revenue decreased $109 thousandor 5.2% to $2.0 million for the six months ended June 30, 2009 from $2.1million during the same period in 2008. Wealth management and advisory services revenue includes fee income fromboth the Wealth Management division of the Bank and the First NationalFinancial Advisory Services subsidiary of the Bank. In aggregate, wealthmanagement and advisory services revenue consists primarily of fee income fromservices such as trust and portfolio management, estate management, insurance,full-service brokerage, financial planning and mutual fund services. Wealthmanagement and advisory services revenue is based partially on the market valueof assets under management.  The marketvalue of assets under management decreased $51.1 million or 9.2% to $506.0million at June 30, 2009 as compared to $557.0 million at June 30,2008. These balances decreased primarily due to decreases in the market valuesof the underlying securities within the assets under management.

 

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Service charges on deposit accounts increased $16 thousand or 2.5% to$659 thousand for the three-month period ended June 30, 2009 compared to$643 thousand for the same period in 2008. For the six month period ended June 30, 2009, service charges ondeposit accounts increased $95 thousand or 7.9% to $1.3 million compared to$1.2 million for the same period in 2008.The increase in service charges isprimarily due to increases in deposit account balances.

 

The Corporation recognized a net gain of $89 thousand on sales ofinvestment securities during the three-month period ended June 30, 2009compared with a net loss of $78 thousand during the same period in 2008.  The corporation recognized a net gain of $1thousand on sales of investment securities during the six month period ended June 30,2009 compared with a net gain of $184 thousand during the same period in 2008.  These net gains and losses were taken as aresult of normal portfolio management.

 

The Corporation has operating lease agreements with one customer. Theincome on these leases is classified as “Rental Income”.  Rental Income on operating lease agreementsfor the three-month period ended June 30, 2009 was $345 thousand, anincrease of $15 thousand or 4.5% from $330 thousand during the same period in2008.  Rental Income on operating leaseagreements increased $46 thousand or 7.2% to $685 thousand for the for the sixmonths ended June 30, 2009 as compared to $639 thousand for the sameperiod in 2008. The increases were the result of an increase in operatingleases outstanding during the respective periods.

 

Gains on the sale of fixed assets and OREO was $72 thousand and $117thousand for the three and six month periods ended June 30, 2009 ascompared to gains of $45 thousand and $91 thousand for the same periods in2008. $46 thousand and $91 thousand of the gains recorded in the three and sixmonths of 2009, respectively, were the amortization of a deferred gainattributable to a sale-leaseback transaction that occurred during 2007, theremaining $26 thousand of gains for the three and six month periods wereattributable to the sale of two OREO properties in the second quarter of2009.  The gains recorded in 2008 werethe amortization of a deferred gain attributable to the sale-leasebacktransaction that occurred during 2007.

 

Loan fees and other was $1.8 million and $2.8 million for the three andsix months ended June 30, 2009, compared to gains of $89 thousand and $180thousand during the same period in 2008. Loan servicing fees and otherprimarily relates to the Mortgage Banking segment and consist mainly of feesearned at the inception of a loan as well as fees earned on the servicing ofresidential loan portfolios not owned by the Bank. Loan servicing fees andother also includes gains and losses on the Bank’s mortgage servicing rights.The increase in loan servicing fees was due to the addition of the AHB division’smortgage operations.

 

Net gain from mortgage banking activities relates to the MortgageBanking segment and consists of unrealized gains and losses on interest ratelock commitments, loans held for sale, and forward sale commitments combinedwith realized gains and losses on the actual sale of the loan and thesettlement of forward sale commitments. The increase in the net gain frommortgage banking activities during the three and six months of 2009 wasprimarily from the addition of the AHB’s residential mortgage operations.

 

The distinguishing activity within the mortgage banking segment is theorigination and sale of residential mortgage and construction loans. Thisactivity drives the net gain on mortgage banking activity line of the income statement.For the three and six months ended June 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 refinanceactivity reduced the negative impact from weak new and existing home salesectors.  The residential mortgagedivision originated $1.4 billion of loans during the period, with refinanceactivity accounting for 75%, or $1.1 billion of the total.  Loans for the purchase of new or existinghomes totaled $340.3 million, or 23% of total originations, while loans toindividual borrowers for construction of single-family residences were $26.3million, or 2% of total originations.

 

Bank-owned life insurance (“BOLI”) income relates to a policy acquiredthrough the AHB acquisition. BOLI involves the purchase of a life insurancepolicy on a group of employees. The Bank is the owner and beneficiary of thepolicy. The BOLI investment is carried on the balance sheet at the cashsurrender value of the underlying policies. Income or loss resulting fromincreases or decreases in the cash surrender value of the properties isrecorded on the income statement.  BOLIgains for the three and six month periods ended June 30, 2009 were $13thousand and $26 thousand, respectively. The BOLI gains and losses in 2008related to a different BOLI policy that cancelled in December 2008.

 

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Other non-interest income increased 14.5% or $69 thousand to $545thousand for the three-month period ended June 30, 2009.  Other non-interest income increased $108thousand or 11.5% to $1.1 million for the six months ended June 30, 2009compared to same period in 2008.  Theincrease for the three and six month period is primarily due to increases invarious fee income earned from the AHB operations. Other non-interest incomealso includes ATM surcharge revenue, STAR/Visa Check Card revenue, safe depositbox income, merchant services income, rental income, lease referral fees andother miscellaneous income.

 

Wealth management and advisory services revenue, Service charges ondeposit accounts, Gains and losses on investment securities, Operating leaserental income, Gains on the sale of fixed assets and OREO and nearly all ofOther non-interest income are included within the results of the communitybanking segment. Nearly all of Loan servicing fees and other and all of Netgain from mortgage banking activities are included within the mortgage bankingsegment.

 

**NON-INTERESTEXPENSE**

 

Total non-interest expense increased $16.3 million or 203.9% to $24.3million for the three-month period ended June 30, 2009, compared to $8.0million during the same period in 2008. Total non-interest expense increased $27.0 million or 164.2% to $43.5million for the six months ended June 30, 2009, from $16.5 million duringthe same period in 2008.  The variouscomponents of non-interest expense are discussed below.

 

Salaries and employee benefits increased $11.4 million to $15.6 millionfor the three month period ended June 30, 2009 compared to the same periodin 2008. Salaries and employee benefits increased $18.8 million to $27.8million for the six month period ended June 30, 2009 compared to the sameperiod in 2008. The higher salary and benefits expense was primarily due to theaddition of the AHB operations in the first quarter of 2009.

 

Salaries and benefits directly attributable to the Mortgage Bankingsegment totaled $9.2 million for the quarter and $15.9 million for the sixmonths ended June 30, 2009. Of these amounts, variable compensation, thatis compensation paid to loan originators, accounted for $6.6 million, or 71% ofthe total for the three months ended and $10.9 million or 69% for the sixmonths ended June 30, 2009. This variable compensation amounts to 0.76% oftotal originations, a rate typical in the mortgage banking industry.  This variable compensation is directlyrelated to the amount of, and type of, mortgage loans originated.

 

Net occupancy, equipment and data processing expense increased $1.4million or 96.8% to $2.9 million for the three-month period ended June 30,2009 when compared to the same periods in 2008. Net occupancy, equipment and data processing expense increased $2.8million or 95.0% to $5.7 million during the six months ended June 30, 2009when compared to the same period in 2008. Approximately $1.1 million and $2.2 million of this increase were due tothe addition of the AHB’s operations during the three and six months ended June 30,2009. Occupancy, equipment and data processing expense from AHB’s operationsinclude the operations of administrative facilities as well as two branchescombined with IT systems operations. The increase was also due to the openingof the new Jennersville grocery store branch as well as the opening of the newOne North High Street administrative complex in the first quarter of 2009.

 

Depreciation expense on operating leases increased $19 thousand or 6.9%to $290 thousand for the three-month period ended June 30, 2009 whencompared to the same period in 2008. Depreciation on operating leases increased $44 thousand or 8.3% to $570thousand for the six months ended June 30, 2009 when compared to the sameperiod in 2008. This depreciation expense is the result of operating leaseagreements the Bank has with one of our customers. The increases were theresult of an increase in operating leases outstanding during the respectiveperiods. The income associated with these operating leases is classified asRental Income, as discussed above.

 

FDIC insurance premiums increased $944 thousand or 800.2% to $1.1million for the three month period ended June 30, 2009 from $118 thousandduring the same period in 2008.  FDICinsurance premiums increased $1.3 million or 596.0% to $1.5 million for the sixmonth period ended June 30, 2009 from $212 thousand during the same periodin 2008.  In 2008 and 2009 the FDICadopted rules that increased FDIC premiums significantly for all banks forassessment periods beginning in the first quarter of 2009. In addition, theFDIC instituted a special assessment for all banks for the second quarter of2009. FDIC Deposit Insurance expense for the three and six months ended June 30,2009 included a $672 thousand accrual for this special assessment. Theincreased premium as well as the special assessment will cause the Bank’s 2009FDIC premiums and assessment expense to increase significantly over 2008.

 

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Professional services expense increased $1.2 million or 238.8% to $1.7million for the three-month period ended June 30, 2009 from $495 thousandfor the same period in 2008. Professional services expense increased $2.0 million or 218.0% to $2.9million for the six month period ended June 30, 2009 from $919 thousandfor the same period in 2008. Approximately $650 thousand and $1.3 million of the increase inprofessional fees are due to increased legal, consulting and audit fees fromthe addition of AHB’s operations. The balance of the increase was mainly due toincreased legal, audit and consulting fees related to the integration of AHB.

 

Marketing expense increased $231 thousand or 69.0% to $566 thousand forthe three month period ended June 30, 2009 from $335 thousand for the sameperiod in 2008.  Marketing expenseincreased $291 thousand or 54.6% to $824 thousand for the six month periodended June 30, 2009 from $533 thousand for the same period in 2009.

 

Total other non-interest expense increased $1.1 million or 117.2% to$2.0 million for the three-month period ended June 30, 2009 from $922thousand for the same period in 2008. Total other non-interest expense increased $1.8 million or 91.0% to $3.8million for the six month period ended June 30, 2009 from $2.0 million forthe same periods in 2008.  Othernon-interest expense includes loan costs, annual meeting and reports, trustprocessing, postage, directors’ costs, telephone, travel and entertainment andoperating supplies.  Most of the increaseis due to the addition of AHB’s operations.

 

**INCOMETAXES, AS RESTATED**

 

Income tax benefit for the three months ended June 30, 2009 was$257 thousand compared to an expense of $624 thousand for the same periods in2008.  This represents an effective taxrate of (80.6%) for the period ended June 30, 2009 compared with 25.3% forthe same period in 2008. The decrease in the effective income tax rate for thethree month period is mainly due to the increase in the effect of theCorporation’s permanent differences as a percentage of pretax income.

 

Income tax expense for the six months ended June 30, 2009 was $1.2million compared to $1.2 million for the same period in 2008.  This represents an effective tax rate of26.9% for the six month period ended June 30, 2009 compared with 26.0% forthe same period in 2008.

 

**LIQUIDITYMANAGEMENT AND INTEREST RATE SENSITIVITY**

 

The objective of liquidity management is to ensure the availability ofsufficient cash flows to meet all financial commitments and to capitalize onopportunities for business expansion. Liquidity management addresses the Corporation’s ability to meet depositwithdrawals either on demand or at contractual maturity, to repay borrowings asthey mature and 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 fromgrowth of our existing deposit base, new deposits, FHLB, and cash flow from theinvestment and loan portfolios.  TheCorporation considers funds from such sources to comprise its “core” fundingsources because of the historical stability of such sources of funds.  Additional liquidity comes from theCorporation’s non-interest bearing demand deposit accounts and creditfacilities.  Other deposit sourcesinclude a tiered savings product and certificates of deposit in excess of$100,000.

 

Details of core deposits, non-interest bearing demand deposit accounts,and other deposit sources are highlighted in the following table:

 
| ** **                            | ** ** | **For the Six Months Ended** | ** ** | **For the Year Ended**     | ** ** |
|---------------------------------------|------------|------------------------------|------------|----------------------------|------------|
| ** **                            | ** ** | **June 30, 2009**       | ** ** | **December 31, 2008** | ** ** |
| **(Dollars in thousands)**            | ** ** | **Average**                  | ** ** | **Effective**              | ** ** | **Average** | ** ** | **Effective** | ** ** |
| **DEPOSIT  TYPE**                     | ** ** | **Balance**                  | ** ** | **Yield**                  | ** ** | **Balance** | ** ** | **Yield** | ** ** |
| NOW Accounts                          |       | $                            | 185,193    |                       | 0.92       | % | $ | 179,512 |   | 1.64 | % |
| Money Market                          |       | 158,012                      |       | 1.30                       | %          | 117,393 |   | 2.46 | % |
| Statement Savings                     |       | 41,362                       |       | 0.60                       | %          | 40,300 |   | 0.70 | % |
| Other Savings                         |       | 1,658                        |       | 1.02                       | %          | 2,802 |   | 1.50 | % |
| Tiered Savings                        |       | 44,964                       |       | 1.14                       | %          | 48,915 |   | 1.30 | % |
| Total NOW Savings, and Money Market   |       | 431,189                      |       | 1.05                       | %          | 388,922 |   | 1.75 | % |
|                                  |       |                         |       |                       |       |   |   |   |   |
| CDs Less than $100,000                |       | 313,014                      |       | 2.78                       | %          | 162,650 |   | 3.73 | % |
| CDs Greater than $100,000             |       | 125,672                      |       | 2.88                       | %          | 74,822 |   | 3.90 | % |
| Total CDs                             |       | 438,686                      |       | 2.81                       | %          | 237,472 |   | 3.78 | % |
|                                  |       |                         |       |                       |       |   |   |   |   |
| Total Interest Bearing  Deposits      |       | 869,875                      |       |                       |       | 626,394 |   |   |   |
|                                  |       |                         |       |                       |       |   |   |   |   |
| Non-Interest Bearing Demand  Deposits |       | 146,583                      |       |                       |       | 120,941 |   |   |   |
|                                  |       |                         |       |                       |       |   |   |   |   |
| Total Deposits                        |       | $                            | 1,016,458  |                       |       |   | $ | 747,335 |   |   |   |

 

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The Bank maintains several credit facilities with the FHLB as well asthe Federal Reserve and other Banking institutions.  During the three and six month periods ended June 30,2009, average FHLB advances and other borrowings were $228.2 million and $201.3million, respectively, and consisted of term advances with a variety ofmaturities  The average interest ratepaid on these advances was 2.84% during the second quarter of 2009.  The Bank currently has a maximum borrowingcapacity with FHLB of approximately $395.2 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 $235 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.

 

The goal of interest rate sensitivity management is to avoidfluctuating net interest margins, and to enhance consistent growth of netinterest income through periods of changing interest rates.  Such sensitivity is measured as thedifference in the volume of assets and liabilities in the existing portfoliothat are subject to repricing in a future time period.  The Corporation’s net interest ratesensitivity gap within one year is a negative $308.3 million or 21.2% of totalassets at June 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 tool used to evaluate interestrate risk and the stability of net interest margins.  Another tool that management uses to evaluateinterest rate risk is a computer simulation model that assesses the impact ofchanges in interest rates on net interest income, net income under variousinterest 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 sensitivity analysis as of June 30, 2009:

 
| ** **                                                                  | ** ** | ** **     | ** ** | **Two**        | ** ** | **Over**       | ** ** | ** **     | ** ** | ** **     | ** ** |
|-----------------------------------------------------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| ** **                                                                  | ** ** | **Within**     | ** ** | **through**    | ** ** | **five**       | ** ** | **Non-rate**   | ** ** | ** **     | ** ** |
| ** **                                                                  | ** ** | **one year**   | ** ** | **five years** | ** ** | **years**      | ** ** | **sensitive**  | ** ** | **Total**      | ** ** |
| **(Dollars  in thousands)**                                                 | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| ASSETS                                                                      |       |           |       |           |       |           |       |           |       |           |       |
| Federal funds sold and overnight investments                                |       | $              | 2,301      |           | $          | 0              |       | $              | 0          |           | $          | 0 |   | $ | 2,301 |   |
| Investment securities                                                       |       | 18,545         |       | 42,851         |       | 20,497         |       | 0              |       | 81,893         |       |
| Interest bearing deposits in banks                                          |       | 4,935          |       | 0              |       | 0              |       | 0              |       | 4,935          |       |
| Loans held for sale                                                         |       | 342,785        |       | 0              |       | 0              |       | 0              |       | 342,785        |       |
| Net loans and leases                                                        |       | 402,416        |       | 402,569        |       | 142,929        |       | (15,528        | )          | 932,386        |       |
| Cash and due from banks                                                     |       | 0              |       | 0              |       | 0              |       | 15,123         |       | 15,123         |       |
| Premises and equipment                                                      |       | 0              |       | 0              |       | 0              |       | 23,613         |       | 23,613         |       |
| Other assets                                                                |       | 0              |       | 0              |       | 0              |       | 46,699         |       | 46,699         |       |
| Total assets                                                                |       | $              | 770,982    |           | $          | 445,420        |       | $              | 163,426    |           | $          | 69,907 |   | $ | 1,449,735 |   |
|                                                                        |       |           |       |           |       |           |       |           |       |           |       |
| LIABILITIES AND CAPITAL                                                     |       |           |       |           |       |           |       |           |       |           |       |
| Non-interest bearing deposits                                               |       | $              | 0          |           | $          | 0              |       | $              | 0          |           | $          | 155,297 |   | $ | 155,297 |   |
| Interest bearing deposits                                                   |       | 832,013        |       | 21,371         |       | 6,753          |       | 0              |       | 860,137        |       |
| FHLB advances and other Borrowings                                          |       | 225,341        |       | 76,500         |       | 3,532          |       | 0              |       | 305,373        |       |
| Subordinated debentures                                                     |       | 20,795         |       | 0              |       | 0              |       | 0              |       | 20,795         |       |
| Other liabilities                                                           |       | 0              |       | 0              |       | 19,670         |       | 0              |       | 19,670         |       |
| Capital                                                                     |       | 0              |       | 0              |       | 0              |       | 88,463         |       | 88,463         |       |
| Total liabilities & capital                                        |       | $              | 1,078,149  |           | $          | 97,871         |       | $              | 29,955     |           | $          | 243,760 |   | $ | 1,449,735 |   |
| Net interest rate sensitivity gap                                      |       | $              | (307,167   | )              | $          | 347,549        |       | $              | 133,471    |           | $          | (173,853 | ) |   |   |
| Cumulative interest rate sensitivity gap                               |       | $              | (307,167   | )              | $          | 40,382         |       | $              | 173, 853   |           | $          | 0 |   |   |   |
| Cumulative interest rate sensitivity gap  divided by total assets |       | (21.2          | )%         | 2.4            | %          | 12.0           | %          |           |       |           |       |

 

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**BRANCHING,TECHNOLOGY AND CAPITAL PROJECTS**

 

During the first quarter of 2009, the Bank completed renovations on anew office building located at One North High Street in West Chester, PA. Thebuilding, along with and adjacent to our main branch and existing facility atNine North High street will serve as the company’s corporate 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**

 

The Corporation is subject to Risk-Based Capital Guidelines adopted bythe Federal Reserve Board for bank holding companies.  The Bank is also subject to similar capitalrequirements adopted by the Office of the Comptroller of the Currency. Underthese requirements, the regulatory agencies have set minimum thresholds forTier I Capital, Total Capital, and Leverage ratios.  At June 30, 2009, both the Corporation’sand the Bank’s capital exceeded all minimum regulatory requirements, and theBank was considered “well capitalized” as defined in the regulations issuedpursuant to the FDIC Improvement Act of 1992.

 

In April 2009, the Corporation completed the placement of$5,175,000 aggregate liquidation amount of fixed rate trust preferredsecurities (the “Trust Preferred Securities”), through a newly formedsubsidiary, First Chester County Capital Trust IV, a wholly owned Delawarestatutory trust (the “Trust”). In connection with the sale of the TrustPreferred Securities, the Corporation issued $5,330,000 of junior subordinateddeferrable interest debentures (the “Debentures”) to the Trust. The TrustPreferred Securities and the Debentures have a 30 year maturity, and carry afixed rate of interest of 12.0%. The Corporation has retained the right toredeem the Trust Preferred Securities at par (plus accrued but unpaid interest)on any interest payment date on or after April 28, 2014. The net proceedsof the offering have been contributed as additional paid in capital to fundgrowth in the banking operations of the Bank.

 
| ** **                     | ** ** | **As of June 30,** | ** ** | **As of December 31,** | ** ** | ** ** | ** ** |
|--------------------------------|------------|-------------------------|------------|-----------------------------|------------|------------|------------|
| ** **                     | ** ** | **2009**                | ** ** | ** **                  | ** ** | ** ** | ** ** | **“Well Capitalized”** | ** ** |
| ** **                     | ** ** | **(Restated)**          | ** ** | **2008**                    | ** ** | **2008**   | ** ** | **Requirements** | ** ** |
| Corporation                    |       |                    |       |                        |       |       |       |   |   |
| Leverage Ratio                 |       | 7.33                    | %          | 8.58                        | %          | 9.87       | %          | N/A |   |
| Tier I Capital Ratio           |       | 9.12                    | %          | 10.15                       | %          | 9.14       | %          | N/A |   |
| Total Risk-Based Capital Ratio |       | 10.37                   | %          | 11.22                       | %          | 10.15      | %          | N/A |   |
| Bank                           |       |                    |       |                        |       |       |       |   |   |
| Leverage Ratio                 |       | 7.39                    | %          | 8.02                        | %          | 9.95       | %          | 5.00 | % |
| Tier I Capital Ratio           |       | 9.20                    | %          | 9.48                        | %          | 9.40       | %          | 6.00 | % |
| Total Risk-Based Capital Ratio |       | 10.45                   | %          | 10.55                       | %          | 10.42      | %          | 10.00 | % |

 

The Bank is not under any agreement with the regulatory authorities noris it aware of any current recommendations by the regulatory authorities that,if they were to be implemented, would have a material affect on liquidity,capital resources, or operations of the Corporation.

 

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

 

There have been no material changes in the Corporation’s assessment ofits sensitivity to market risk since its presentation in the 2008 AnnualReport. Please refer to Item 7A on pages 39-42 of the Corporation’s 2008Annual Report for more information.

 

**ITEM 4.  CONTROLS AND PROCEDURES**

 

**Disclosure Controls and Procedures.**

 

Asof June 30, 2009, the end of the period covered by this Quarterly Reporton Form 10-Q, an evaluation of the effectiveness of our disclosurecontrols and procedures (as defined in Rules 13(a)-15(e) and 15(d)-15(e) promulgatedunder the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) wasperformed under the supervision and with the participation of management,including our President and CEO, Chief Operating Officer and our ChiefFinancial Officer. Based on that evaluation and the identification of thematerial weaknesses in our internal control over financial reporting asdescribed below, management has concluded that our disclosure controls andprocedures were not effective to ensure that information required to bedisclosed by us in the reports that we file or submit under the Exchange Act is(i) recorded, processed, summarized and reported within the time periodsspecified in the Securities and Exchange Commission’s rules and forms, and(ii) accumulated and communicated to management as appropriate to allow timelydecisions regarding required disclosures.

 

**Changes inInternal Control over Financial Reporting**

 

During the preparation of our consolidated financial statements 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 problem loans,which existed during the quarter ended June 30, 2009.  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 and the Provision for Loan andLease Losses during the second quarter ended June 30, 2009.  We also discovered a monitoring weakness thatcontributed to the characterization of the status of certain loans to beclassified as fully performing, when in fact these loans were not.  Management concluded that the Allowance forLoan and Lease Losses and the Provision for Loans and Lease Losses as of andfor the three and six months ended June 30, 2009 should be increased by$3.5 million.

 

Inaddition to the material weakness described above, management has previouslydisclosed in the Corporation’s Quarterly Report on Form 10-Q/A for theperiod ended March 31, 2009, a material weakness in internal controlsrelated to the Corporation’s process to review the valuation of mortgage loansheld for sale.  Mortgage loans held for sale represent mortgage loansoriginated by the Corporation and held until sold to secondary marketinvestors. Upon the closing of a residential mortgage loan originated by theCorporation, the mortgage loan is typically warehoused for a period of time andthen sold into the secondary market. While in this warehouse phase, mortgageloans held for sale are recorded at fair value under the fair value option withchanges in fair value recognized through earnings.  An error wasidentified 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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**Remediationof Material Weaknesses**

 

*Allowancefor Loan and Lease Losses*

 

Duringthe fourth quarter 2009 and subsequent to year-end, management began takingsteps to remediate the material weakness described above. The following stepshave 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-MarketAccounting of 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**

 

There are no material pending legal proceedings, other than ordinaryroutine litigation incidental to the business, to which the Corporation, or anyof its subsidiaries, is a party or of which any of their respective property isthe subject.

 

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

 

Information regarding risk factors appears in Part 1, Item 1Aof our Annual Report on Form 10-K for the year ended December 31,2008.  There are no material changes inthe risk factors relevant to our operations, except as discussed below.

 

**Our disclosure controls and procedures and internal controlover financial reporting were determined not to be effective as ofJune 30, 2009, as evidenced by a material weakness that existed in ourinternal controls. Our disclosure controls and procedures and internal controlover financial reporting may not be effective in future periods, as a result ofnewly identified material weakness in internal controls.**

 

Effective internal control over financial reporting is necessary forcompliance with the Sarbanes-Oxley Act of 2002 and appropriate financialreporting. Management is responsible for establishing and maintaining adequateinternal control over financial reporting. Internal control over financialreporting is a process, under the supervision of the Corporation’s ChiefExecutive Officer and Chief Financial Officer, designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof  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 a material weakness 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 remediationstatus of the material weakness identified. However, there can be no assurancethat additional material weaknesses will not be identified in the future. Weare committed to continuing to improve our internal control processes and wewill continue to diligently and vigorously review our financial reportingcontrols and procedures. As we continue to evaluate and improve our internalcontrol over financial reporting, we may determine to take additional measuresto address internal control deficiencies or determine to modify certain of theremediation measures described herein. We will continue to be at an increasedrisk that our financial statements could contain errors that will beundetected, and we will continue to incur significant expense and managementburdens associated with the additional procedures required to prepare ourconsolidated financial statements.

 

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

 

There were no sales by the Corporation of unregistered securitiesduring the three months ended June 30, 2009.

 

The following table providesthe total repurchases made by the Company during the three months ended June 30,2009:

 
| **Period**                           | ** ** | **Total  Number of  Shares (or  Units)  Purchased  (a) (1)** | ** ** | **Average  Price Paid  per Share  (or Unit)  (b) (1)** | ** ** | **Total  Number of  Shares (or Units)  Purchased as Part  of Publicly Announced  Plans  or Programs  (c) (2)** | ** ** | **Maximum  Number (or  Approximate Dollar Value) of  Shares (or Units) that May Yet  Be Purchased Under the Plans  or Programs  (d) (2)** | ** ** |
|--------------------------------------|------------|-------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| April 1  to April 30, 2009 |       | —                                                            |       | —                                                      |       | —                                                                                                              |       | $                                                                                                                                                   | 10,000,000 |   |
| May 1  to May 31, 2009     |       | —                                                            |       | —                                                      |       | —                                                                                                              |       | $                                                                                                                                                   | 10,000,000 |   |
| June 1  to June 30, 2009   |       | 519                                                               |       | $                                                           | 11.40      |                                                                                                                | —     |                                                                                                                                                | $          | 10,000,000 |   |
| Total                                |       | 519                                                               |       | $                                                           | 11.40      |                                                                                                                | —     |                                                                                                                                                | —     |   |

 

----

(1)   Pursuant to the trust agreement between the Corporation and thetrustee, these shares were repurchased from our 401(k) Plan. The purchaseprice was the average between the bid and the ask on the repurchase date.

 

(2)   We announced on November 16, 2007, a program to repurchase upto $10.0 million of our Common Stock. This program expires in November 2009.  This program replaced a previous program thatexpired in October 2007.

 

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

 

None

 

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

 

The Annual Meeting of Shareholders of the Corporation was held on May 5,2009 (the “Meeting”).  Notice of theMeeting was mailed to shareholders of record on or about April 10, 2009,together with proxy solicitation materials prepared in accordance with Section 14(a) ofthe Securities Exchange Act of 1934, as amended, and the regulations promulgatedthere under.

 

The only matter submitted to a vote of shareholders at the meeting wasthe election of four Class I directors.

 

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There was no solicitation inopposition to the nominees of the Board of Directors for election to the Boardof Directors.  All four of the nomineeswere elected.  The number of votes castfor or withheld as well as the number of abstentions and broker non-votes foreach of the nominees for election to the Board of Directors were as follows:

 
| **Nominee**               | ** ** | **For**   | ** ** | **Withheld** | ** ** |
|---------------------------|------------|-----------|------------|--------------|------------|
|                      |       |      |       |         |       |
| Clifford E. DeBaptiste    |       | 3,833,968 |       | 417,240      |       |
|                      |       |      |       |         |       |
| James M. Deitch           |       | 4,072,645 |       | 178,563      |       |
|                      |       |      |       |         |       |
| Lynn Marie Johnson-Porter |       | 3,985,632 |       | 265,576      |       |
|                      |       |      |       |         |       |
| John B. Waldron           |       | 3,843,448 |       | 407,760      |       |

 

The names of the otherdirectors whose terms of office as directors continued after the meeting are asfollow: Brian K. Campbell, M. Robert Clarke, Matthew S. Naylor, David L.Peirce, Kevin C. Quinn, John A. Featherman, John S. Halsted, J. Carol Hansonand Edward A. Leo.

 

There was no other businessthat came before the meeting or matters incident to the conduct of the Meeting.

 

**Item 5.****                           ****OtherInformation**

 

None

 

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

 

Exhibits marked as “(cp)” are management contracts or compensatoryplans, contracts or arrangements in which a director or executive officerparticipates or may participate. Exhibits marked with an asterisk are filed with this report.

 

3.1.                              Amended Articlesof Incorporation of First Chester County corporation (Incorporated herein byreference to Exhibit 3(i) to the Corporation’s Quarterly Report on Form 10-Qfor the quarter ended March 31, 2004.)

 

3.2.                              Bylaws of FirstChester County Corporation, as amended. (Incorporated herein by reference to Exhibit 3(ii) tothe Corporation’s Annual Report on Form 10-K for the year ended December 31,2007.)

 

10.1                           JuniorSubordinated Indenture, dated as of April 28, 2009, by and between theCorporation and Wilmington Trust Company. (Incorporated herein by reference to Exhibit 4.1to the Corporation’s Form 8-K, dated May 4, 2009.)

 

10.2                           Amended andRestated Trust Agreement, dated as of April 24, 2009, by and among theCorporation, Wilmington Trust Company, as property trustee, Wilmington TrustCompany, as Delaware trustee, and the Administrative Trustees named therein.(Incorporated herein by reference to Exhibit 4.3 to the Corporation’s Form 8-K,dated May 4, 2009.)

 

10.3                           GuaranteeAgreement, dated as of April 28, 2009, by and between the Corporation andWilmington Trust Company, as guarantee trustee. (Incorporated herein byreference to Exhibit 4.5 to the Corporation’s Form 8-K, dated May 4,2009.)

 

10.4                           Excerpts fromspeeches from the Annual Meeting of Shareholders on May 5, 2009 by KevinC. Quinn, James M. Deitch and John A. Featherman, III. (Incorporatedherein by reference to Exhibit 99.1 to the Corporation’s Form 8-K,dated May 5, 2009.)

 

10.5                           Agreement byand among the Corporation, the Bank, James M. Deitch and Anna Ruth Smith dated May 5,2009 to finalize the AHB Management Incentive Plan (Incorporated herein byreference to Exhibit 10.3 of the Corporation’s Form 10-Q dated May 11,2009.)

 

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31.1                           Rule 13a-14(a) Certificationof the President and Chief Executive Officer*

31.2                           Rule 13a-14(a) Certificationof the Interim Chief Financial Officer*

 

32.1                           Section 906Certification of the President and Chief Executive Officer*

32.2                           Section 906Certification of the Interim Chief Financial Officer*

 

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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.

 

 
| **FIRST CHESTER COUNTY  CORPORATION** |
|---------------------------------------|
|                                  |   |
|                                  | /s/  John A. Featherman |
|                                  | John  A. Featherman, III |
|                                  | President  and Chief Executive Officer |
|                                  | (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**

 

3.1.                              AmendedArticles of Incorporation of First Chester County corporation (Incorporatedherein by reference to Exhibit 3(i) to the Corporation’s QuarterlyReport on Form 10-Q for the quarter ended March 31, 2004.)

 

3.2.                              Bylaws of FirstChester County Corporation, as amended. (Incorporated herein by reference to Exhibit 3(ii) tothe Corporation’s Annual Report on Form 10-K for the year ended December 31,2007.)

 

10.1                           JuniorSubordinated Indenture, dated as of April 28, 2009, by and between theCorporation and Wilmington Trust Company. (Incorporated herein by reference to Exhibit 4.1to the Corporation’s Form 8-K, dated May 4, 2009.)

 

10.2                           Amended andRestated Trust Agreement, dated as of April 24, 2009, by and among theCorporation, Wilmington Trust Company, as property trustee, Wilmington TrustCompany, as Delaware trustee, and the Administrative Trustees named therein.(Incorporated herein by reference to Exhibit 4.3 to the Corporation’s Form 8-K,dated May 4, 2009.)

 

10.3                           GuaranteeAgreement, dated as of April 28, 2009, by and between the Corporation andWilmington Trust Company, as guarantee trustee. (Incorporated herein byreference to Exhibit 4.5 to the Corporation’s Form 8-K, dated May 4,2009.)

 

10.4                           Excerpts fromspeeches from the Annual Meeting of Shareholders on May 5, 2009 by KevinC. Quinn, James M. Deitch and John A. Featherman, III. (Incorporatedherein by reference to Exhibit 99.1 to the Corporation’s Form 8-K,dated May 5, 2009.)

 

10.5                           Agreement byand among the Corporation, the Bank, James M. Deitch and Anna Ruth Smith dated May 5,2009 to finalize the AHB Management Incentive Plan (Incorporated herein byreference to Exhibit 10.3 of the Corporation’s Form 10-Q dated May 11,2009.)

 

31.1                           Rule 13a-14(a) Certificationof the President and Chief Executive Officer*

31.2                           Rule 13a-14(a) Certificationof the Interim Chief Financial Officer*

 

32.1                           Section 906Certification of the President and Chief Executive Officer*

32.2                           Section 906Certification of the Interim Chief Financial Officer*

 

----

*Filedherewith

 

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