UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C.  20549










FORM
10-K





ANNUAL
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE


SECURITIES
EXCHANGE ACT OF 1934





For the
Year Ended December 31, 2009





Commission
File No. 0-22345





SHORE BANCSHARES,
INC.


(Exact
name of registrant as specified in its charter)





Maryland
              
              52-1974638(State
      or Other Jurisdiction of
              
              (I.R.S.
      EmployerIncorporation
      or Organization)
              
              Identification
      No.)18 East Dover Street, Easton,
      Maryland
              
              21601(Address
      of Principal Executive Offices)
              
              (Zip
      Code)





(410)
822-1400


Registrant’s
Telephone Number, Including Area Code





Securities
Registered pursuant to Section 12(b) of the Act:





Title of Each
      Class:
                  
                  Name of Each Exchange
      on Which Registered:Common
      stock, par value $.01 per share
                  
                  Nasdaq
      Global Select
Market





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.   ̈





Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 16(d) of the Act.  ̈





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days Yes R No £





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files).  Yes £ No £ (Not
Applicable)





Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of the registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K £





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer (check one):


Large
accelerated filer £ Accelerated filer R Non-accelerated filer £ Smaller Reporting Company
£





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act):  Yes £ No R





State the
aggregate market value of the voting and non-voting common equity held by
non-affiliates computed by reference to the price at which the common equity was
last sold, or the average bid and asked price of such common equity, as of the
last business day of the registrant’s most recently completed second fiscal
quarter:  $141,610,915.





The
number of shares outstanding of the registrant’s common stock as of the latest
practicable date: 8,443,436 as of March 2,
2010.





Documents
Incorporated by Reference





Certain
information required by Part III of this annual report is incorporated herein by
reference to the definitive proxy statement for the 2010 Annual Meeting of
Stockholders.








INDEX





Part IItem 1.
                  Business
                  2Item 1A.
                  Risk
      Factors
                  10Item 1B.
                  Unresolved
      Staff Comments
                  16Item 2.
                  Properties
                  16Item 3.
                  Legal
      Proceedings
                  17Part IIItem 4.
                  [Reserved]
                  17Item 5.
                  Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
                  18Item 6.
                  Selected
      Financial Data
                  21Item 7.
                  Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                  22Item 7A.
                  Quantitative
      and Qualitative Disclosures About Market Risk
                  37Item 8.
                  Financial
      Statements and Supplementary Data
                  37Item 9.
                  Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
                  72Item 9A.
                  Controls
      and Procedures
                  72Item 9B.
                  Other
      Information
                  72Part IIIItem 10.
                  Directors,
      Executive Officers and Corporate Governance
                  72Item 11.
                  Executive
      Compensation
                  72Item 12.
                  Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
                  73Item 13.
                  Certain
      Relationships and Related Transactions, and Director
      Independence
                  73Item 14.
                  Principal
      Accountant Fees and Services
                  73Part IVItem 15.
                  Exhibits
      and Financial Statement Schedules
                  73SIGNATURES
                  73EXHIBIT LIST
                  75





This
Annual Report of Shore Bancshares, Inc. (the “Company”) on Form 10-K contains
forward-looking statements within the meaning of The Private Securities
Litigation Reform Act of 1995.  Readers of this report should be aware
of the speculative nature of “forward-looking statements”.  Statements
that are not historical in nature, including the words “anticipate”, “estimate”,
“should”, “expect”, “believe”, “intend”, and similar expressions, are based on
current expectations, estimates and projections about (among other things) the
industry and the markets in which the Company and its subsidiaries operate; they
are not guarantees of future performance.  Whether actual results will
conform to expectations and predictions is subject to known and unknown risks
and uncertainties, including risks and uncertainties discussed in this Form
10-K, general economic, market or business conditions; changes in interest
rates, deposit flow, the cost of funds, and demand for loan products and
financial services; changes in our competitive position or competitive actions
by other companies; changes in the quality or composition of loan and investment
portfolios; the ability to mange growth; changes in laws or regulations or
policies of federal and state regulators and agencies; and other circumstances
beyond the Company’s control.  Consequently, all of the
forward-looking statements made in this document are qualified by these
cautionary statements, and there can be no assurance that the actual results
anticipated will be realized, or if substantially realized, will have the
expected consequences on the Company’s business or operations.  For a
more complete discussion of these and other risk factors, see Item 1A of Part I
of this report.  Except as required by applicable laws, we do not
intend to publish updates or revisions of forward-looking statements it makes to
reflect new information, future events or otherwise.





Except as
expressly provided otherwise, the term “Company” as used in this report refers
to Shore Bancshares, Inc. and the terms “we”, “us” and “our” refer collectively
to Shore Bancshares, Inc. and its consolidated subsidiaries.





PART
I





Item
      1.
            Business.





BUSINESS





General





The
Company was incorporated under the laws of Maryland on March 15, 1996 and is a
financial holding company registered under the Bank Holding Company Act of 1956,
as amended (the “BHC Act”).  The Company’s primary business is acting
as the parent company to several financial institution and insurance
entities.  The Company engages in the banking business through CNB, a
Maryland trust company with commercial banking powers, The Talbot Bank of
Easton, Maryland, a Maryland commercial bank (“Talbot Bank”), and The Felton
Bank, a Delaware commercial bank  (“Felton Bank” and, together with
CNB and Talbot Bank, the “Banks”).  Until December 31, 2009, CNB did
business as The Centreville National Bank of Maryland, a national banking
association.  It was converted to a Maryland charter on that
date.





The
Company engages in the insurance business through two general insurance producer
firms, The Avon-Dixon Agency, LLC, a Maryland limited liability company, and
Elliott Wilson Insurance, LLC, a Maryland limited liability company; one marine
insurance producer firm, Jack Martin & Associates, Inc., a Maryland
corporation; three wholesale insurance firms, Tri-State General Insurance
Agency, LTD, a Maryland corporation, Tri-State General Insurance Agency of New
Jersey, Inc., a New Jersey corporation, and Tri-State General Insurance Agency
of Virginia, Inc., a Virginia corporation; and two insurance premium finance
companies, Mubell Finance, LLC, a Maryland limited liability company, and ESFS,
Inc., a Maryland corporation (all of the foregoing are collectively referred to
as the “Insurance Subsidiaries”).





On March
1, 2008, the Company established a mortgage broker subsidiary, Wye Mortgage
Group, LLC (the “Mortgage Group”).  The Company also has two inactive
subsidiaries, Wye Financial Services, LLC and Shore Pension Services, LLC, both
of which were organized under Maryland law.





Talbot
Bank owns all of the issued and outstanding securities of Dover Street Realty,
Inc., a Maryland corporation that engages in the business of holding and
managing real property acquired by Talbot Bank as a result of loan
foreclosures.





We
operate in two business segments:  community banking and insurance
products and services.  Financial information related to our
operations in these segments for each of the two years ended December 31, 2009
is provided in Note 26 to the Company’s Consolidated Financial Statements
included in Item 8 of Part II of this report.




2





Banking
Products and Services





CNB
commenced operations in 1876.  Talbot Bank is a Maryland commercial
bank that commenced operations in 1885 and was acquired by the Company in its
December 2000 merger with Talbot Bancshares, Inc. (“Talbot
Bancshares”).  Felton Bank is a Delaware commercial bank that
commenced operations in 1908 and was acquired by the Company in April 2004 when
it merged with Midstate Bancorp, Inc.  The Banks operate 19 full
service branches and 22 ATMs and provide a full range of commercial and consumer
banking products and services to individuals, businesses, and other
organizations in the Kent County, Queen Anne’s County, Caroline County, Talbot
County and Dorchester County in Maryland and in Kent County,
Delaware.  The Banks’ deposits are insured by the Federal Deposit
Insurance Corporation (the “FDIC”).





The Banks
are independent community banks and serve businesses and individuals in their
respective market areas.  Services offered are essentially the same as
those offered by larger regional institutions that compete with the Banks.
Services provided to businesses include commercial checking, savings,
certificate of deposit and overnight investment sweep accounts. The Banks offer
all forms of commercial lending, including secured and unsecured loans, working
capital loans, lines of credit, term loans, accounts receivable financing, real
estate acquisition development, construction loans and letters of
credit.  Merchant credit card clearing services are available as well
as direct deposit of payroll, internet banking and telephone banking
services.





Services
to individuals include checking accounts, various savings programs, mortgage
loans, home improvement loans, installment and other personal loans, credit
cards, personal lines of credit, automobile and other consumer financing, safe
deposit boxes, debit cards, 24-hour telephone banking, internet banking, and
24-hour automatic teller machine services.  The Banks also offer
nondeposit products, such as mutual funds and annuities, and discount brokerage
services to their customers.  Additionally, the Banks have Saturday
hours and extended hours on certain evenings during the week for added customer
convenience.





Lending
Activities





The Banks
originate secured and unsecured loans for business
purposes.  Commercial loans are typically secured by real estate,
accounts receivable, inventory, equipment and/or other assets of the
business.  Commercial loans generally involve a greater degree of
credit risk than one to four family residential mortgage
loans.  Repayment is often dependent on the successful operation of
the business and may be affected by adverse conditions in the local economy or
real estate market. The financial condition and cash flow of commercial
borrowers is therefore carefully analyzed during the loan approval process, and
continues to be monitored by obtaining business financial statements, personal
financial statements and income tax returns.  The frequency of this
ongoing analysis depends upon the size and complexity of the credit and
collateral that secures the loan.  It is also the Company’s general
policy to obtain personal guarantees from the principals of the commercial loan
borrowers.





Commercial
real estate loans are primarily those secured by land for residential and
commercial development, agricultural purpose properties, service industry
buildings such as restaurants and motels, retail buildings and general purpose
business space.  The Banks attempt to mitigate the risks associated
with these loans through thorough financial analyses, conservative underwriting
procedures, including prudent loan to value ratio standards, obtaining
additional collateral when prudent, closely monitoring construction projects to
control disbursement of funds on loans, and management’s knowledge of the local
economy in which the Banks lend.





The Banks
provide residential real estate construction loans to builders and individuals
for single family dwellings. Residential construction loans are usually granted
based upon “as completed” appraisals and are secured by the property under
construction.  Additional collateral may be taken if loan to value
ratios exceed 80%.  Site inspections are performed to determine
pre-specified stages of completion before loan proceeds are
disbursed.  These loans typically have maturities of six to 12 months
and may have fixed or variable rate features.  Permanent financing
options for individuals include fixed and variable rate loans with three- and
five-year balloon features and one-, three- and five-year adjustable rate
mortgage loans.  The risk of loss associated with real estate
construction lending is controlled through conservative underwriting procedures
such as loan to value ratios of 80% or less, obtaining additional collateral
when prudent, and closely monitoring construction projects to control
disbursement of funds on loans.





The Banks
originate fixed and variable rate residential mortgage loans.  As with
any consumer loan, repayment is dependent on the borrower’s continuing financial
stability, which can be adversely impacted by job loss, divorce, illness, or
personal bankruptcy.  Underwriting standards recommend loan to value
ratios not to exceed 80% based on appraisals performed by approved appraisers.
The Banks rely on title insurance to protect their lien priorities and protect
the property securing the loans by requiring fire and casualty
insurance.





The
Mortgage Group brokers long-term fixed rate residential mortgage loans for sale
on the secondary market for which it receives commissions upon
settlement.





A variety
of consumer loans are offered to customers, including home equity loans, credit
cards and other secured and unsecured lines of credit and term
loans.  Careful analysis of an applicant’s creditworthiness is
performed before granting credit, and on going monitoring of loans outstanding
is performed in an effort to minimize risk of loss by identifying problem loans
early.




3





Deposit
Activities





The Banks
offer a full array of deposit products including checking, savings and money
market accounts, regular and IRA certificates of deposit, and Christmas Savings
accounts.  The Banks also offer the CDARS program, providing up to $50
million of FDIC insurance to our customers.  In addition, we offer our
commercial customers packages which include Cash Management services and various
checking opportunities.





Trust
Services





CNB has a
trust department through which it markets trust, asset management and financial
planning services to customers within our market areas using the trade name Wye
Financial & Trust.





Insurance
Activities





The
Avon-Dixon Agency, LLC, Elliott Wilson Insurance, LLC, and Mubell Finance, LLC
were formed as a result of the Company’s acquisition of the assets of The
Avon-Dixon Agency, Inc., Elliott Wilson Insurance, Inc., Avon-Dixon Financial
Services, Inc., Joseph M. George & Son, Inc. and 59th Street Finance Company
on May 1, 2002.  In November 2002, The Avon-Dixon Agency, LLC acquired
certain assets of W. M. Freestate & Son, Inc., a full-service insurance
producer firm located in Centreville, Maryland.  Jack Martin &
Associates, Inc., Tri-State General Insurance Agency, LTD, Tri-State General
Insurance Agency of New Jersey, Inc., Tri-State General Insurance Agency of
Virginia, Inc., and ESFS, Inc. were acquired on October 1, 2007.





The
Insurance Subsidiaries offer a full range of insurance products and services to
customers, including insurance premium financing.





Seasonality





Management
does not believe that our business activities are seasonal in
nature.  Demand for our products and services may vary depending on
local and national economic conditions, but management believes that any
variation will not have a material impact on our planning or policy-making
strategies.





Employees





At
February 28, 2010, we employed 361 persons, of which 320 were employed on a
full-time basis.





COMPETITION





The
banking business, in all of its phases, is highly competitive.  Within
our market areas, we compete with commercial banks (including local banks and
branches or affiliates of other larger banks), savings and loan associations and
credit unions for loans and deposits, with money market and mutual funds and
other investment alternatives for deposits, with consumer finance companies for
loans, with insurance companies, agents and brokers for insurance products, and
with other financial institutions for various types of products and
services.  There is also competition for commercial and retail banking
business from banks and financial institutions located outside our market
areas.





The
primary factors in competing for deposits are interest rates, personalized
services, the quality and range of financial services, convenience of office
locations and office hours.  The primary factors in competing for
loans are interest rates, loan origination fees, the quality and range of
lending services and personalized services.  The primary factors in
competing for insurance customers are competitive rates, the quality and range
of insurance products offered, and quality, personalized service.





To
compete with other financial services providers, we rely principally upon local
promotional activities, including advertisements in local newspapers, trade
journals and other publications and on the radio, personal relationships
established by officers, directors and employees with customers, and specialized
services tailored to meet its customers’ needs.  In those instances in
which we are unable to accommodate the needs of a customer, we will arrange for
those services to be provided by other financial services providers with which
we have a relationship.  We additionally rely on referrals from
satisfied customers.


4


The
following tables set forth deposit data for FDIC-insured institutions in Kent
County, Queen Anne’s County, Caroline County, Talbot County and Dorchester
County in Maryland and for Kent County, Delaware as of June 30, 2009, the most
recent date for which comparative information is available.
 
 %
      ofKent County, Maryland
                      
                      Deposits
                      
                      
                      Total(in thousands)Peoples
      Bank of Kent County, Maryland
                      
                      $
                      175,605
                      
                      
                      
                      34.20
                      %PNC
      Bank National Assn
                      
                      
                      154,195
                      
                      
                      
                      30.03Chesapeake
      Bank and Trust Co.
                      
                      
                      64,914
                      
                      
                      
                      12.64Branch
      Banking & Trust
                      
                      
                      49,559
                      
                      
                      
                      9.65CNB
                      
                      
                      38,488
                      
                      
                      
                      7.50SunTrust
      Bank
                      
                      
                      30,645
                      
                      
                      
                      5.97Total
                      
                      $
                      513,406
                      
                      
                      
                      100.00
                      %
 
 Source:  FDIC
DataBook
 % ofQueen Anne’s County,
    Maryland
                    
                    Deposits
                    
                    
                    Total(in thousands)The
      Queenstown Bank of Maryland
                    
                    $
                    344,185
                    
                    
                    
                    42.67
                    %CNB
                    
                    
                    197,981
                    
                    
                    
                    24.55Bank
      of America, National Association
                    
                    
                    65,494
                    
                    
                    
                    8.12PNC
      Bank National Assn
                    
                    
                    62,625
                    
                    
                    
                    7.76M&T
                    
                    
                    46,951
                    
                    
                    
                    5.82Bank
      Annapolis
                    
                    
                    44,790
                    
                    
                    
                    5.55Branch
      Banking & Trust
                    
                    
                    23,995
                    
                    
                    
                    2.97Chevy
      Chase Bank FSP
                    
                    
                    10,528
                    
                    
                    
                    1.31Sun
      Trust Bank
                    
                    
                    6,536
                    
                    
                    
                    0.81Peoples
      Bank
                    
                    
                    3,517
                    
                    
                    
                    0.44Total
                    
                    $
                    806,602
                    
                    
                    
                    100.00
                    %
 
 Source:  FDIC
DataBook
 % ofCaroline County, Maryland
                    
                    Deposits
                    
                    
                    Total(in thousands)Provident
      State Bank of Preston, Maryland
                    
                    $
                    147,857
                    
                    
                    
                    37.78
                    %PNC
      Bank National Assn
                    
                    
                    102,202
                    
                    
                    
                    26.12CNB
                    
                    
                    54,007
                    
                    
                    
                    13.80Branch
      Banking & Trust
                    
                    
                    32,035
                    
                    
                    
                    8.19M&T
                    
                    
                    25,043
                    
                    
                    
                    6.40Bank
      of America, National Association
                    
                    
                    17,500
                    
                    
                    
                    4.47Easton
      Bank & Trust
                    
                    
                    11,606
                    
                    
                    
                    2.97The
      Queenstown Bank of Maryland
                    
                    
                    1,061
                    
                    
                    
                    0.27Total
                    
                    $
                    391,311
                    
                    
                    
                    100.00
                    %
 
 Source:  FDIC
DataBook
  5
 
 % ofTalbot County, Maryland
                    
                    Deposits
                    
                    
                    Total(in thousands)The
      Talbot Bank of Easton, Maryland
                    
                    $
                    601,164
                    
                    
                    
                    50.80
                    %PNC
      Bank National Assn
                    
                    
                    136,888
                    
                    
                    
                    11.57Easton
      Bank & Trust
                    
                    
                    125,452
                    
                    
                    
                    10.60Bank
      of America, National Association
                    
                    
                    94,763
                    
                    
                    
                    8.01Branch
      Banking & Trust
                    
                    
                    50,464
                    
                    
                    
                    4.26SunTrust
      Bank
                    
                    
                    46,097
                    
                    
                    
                    3.90The
      Queenstown Bank of Maryland
                    
                    
                    36,981
                    
                    
                    
                    3.13M&T
                    
                    
                    32,447
                    
                    
                    
                    2.74Chevy
      Chase Bank
                    
                    
                    22,458
                    
                    
                    
                    1.90First
      Mariner Bank
                    
                    
                    20,945
                    
                    
                    
                    1.77Provident
      State Bank of Preston, Maryland
                    
                    
                    15,621
                    
                    
                    
                    1.32Total
                    
                    $
                    1,183,280
                    
                    
                    
                    100.00
                    %
 
 Source:  FDIC
DataBook
 % ofDorchester County, Maryland
                    
                    Deposits
                    
                    
                    Total(in thousands)Bank
      of the Eastern Shore
                    
                    $
                    189,998
                    
                    
                    
                    31.67
                    %The
      National Bank of Cambridge
                    
                    
                    187,467
                    
                    
                    
                    31.25Hebron
      Savings Bank
                    
                    
                    54,125
                    
                    
                    
                    9.02Branch
      Banking & Trust
                    
                    
                    44,731
                    
                    
                    
                    7.46Provident
      State Bank of Preston, Maryland
                    
                    
                    36,604
                    
                    
                    
                    6.10Bank
      of America, National Association
                    
                    
                    26,698
                    
                    
                    
                    4.45M&T
                    
                    
                    21,095
                    
                    
                    
                    3.52SunTrust
      Bank
                    
                    
                    20,283
                    
                    
                    
                    3.38The
      Talbot Bank of Easton, Maryland
                    
                    
                    18,865
                    
                    
                    
                    3.14Total
                    
                    $
                    599,866
                    
                    
                    
                    100.00
                    %
 
 Source:  FDIC
DataBook
 % ofKent County, Delaware
                    
                    Deposits
                    
                    
                    Total(in thousands)Wilmington
      Trust
                    
                    $
                    506,333
                    
                    
                    
                    29.94
                    %PNC
      Bank Delaware
                    
                    
                    245,764
                    
                    
                    
                    14.53First
      NB of Wyoming
                    
                    
                    231,063
                    
                    
                    
                    13.66RBS
      Citizens National Assn
                    
                    
                    197,624
                    
                    
                    
                    11.69Wachovia
      Bank of Delaware
                    
                    
                    168,053
                    
                    
                    
                    9.94Wilmington
      Savings Fund Society
                    
                    
                    103,590
                    
                    
                    
                    6.13The
      Felton Bank
                    
                    
                    73,497
                    
                    
                    
                    4.35Artisans
      Bank
                    
                    
                    65,705
                    
                    
                    
                    3.89TD
      Bank National Assn
                    
                    
                    49,806
                    
                    
                    
                    2.95County
      Bank
                    
                    
                    45,089
                    
                    
                    
                    2.67Fort
      Sill National Bank
                    
                    
                    4,448
                    
                    
                    
                    0.26Total
                    
                    $
                    1,690,972
                    
                    
                    
                    100.00
                    %
 
 Source:  FDIC
DataBook
 
 For
further information about competition in our market areas, see the Risk Factor
entitled “We operate in a highly competitive market and our inability to
effectively compete in our markets could have an adverse impact on our financial
condition and results of operations” in Item 1A of Part I of this annual
report.
 
 SUPERVISION
AND REGULATION
 
 The
following is a summary of the material regulations and policies applicable to us
and is not intended to be a comprehensive discussion.  Changes
in applicable laws and regulations may have a material effect on our business,
financial condition and results of operations.
  6
 
 General
 
 The
Company is a financial holding company registered with the Board of Governors of
the Federal Reserve System (the “FRB”) under the BHC Act and, as such, is
subject to the supervision, examination and reporting requirements of the BHC
Act and the regulations of the FRB.
 
 CNB and
Talbot Bank are Maryland commercial banks subject to the banking laws of
Maryland and to regulation by the Commissioner of Financial Regulation of
Maryland, who is required by statute to make at least one examination in each
calendar year (or at 18-month intervals if the Commissioner determines that an
examination is unnecessary in a particular calendar year).  Felton
Bank is a Delaware commercial bank subject to the banking laws of Delaware and
to regulation by the Delaware Office of the State Bank Commissioner, who is
entitled by statute to make examinations of Felton Bank as and when deemed
necessary or expedient.  The FDIC is the primary federal regulator of
CNB, Talbot Bank and Felton Bank, which is also entitled to conduct regular
examinations.  The deposits of the Banks are insured by the FDIC, so
certain laws and regulations administered by the FDIC also govern their deposit
taking operations.  In addition to the foregoing, the Banks are
subject to numerous state and federal statutes and regulations that affect the
business of banking generally.
 
 Nonbank
affiliates of the Company are subject to examination by the FRB, and, as
affiliates of the Banks, may be subject to examination by the Banks’ regulators
from time to time.  In addition, the Insurance Subsidiaries are each
subject to licensing and regulation by the insurance authorities of the states
in which they do business.  Retail sales of insurance products by the
Insurance Subsidiaries to customers of the Banks are also subject to the
requirements of the Interagency Statement on Retail Sales of Nondeposit
Investment Products promulgated in 1994, as amended, by the FDIC, the FRB and
the other federal banking agencies. The Mortgage Group is subject to supervision
by the banking agencies of the states in which it does business.
 
 Regulation
of Financial Holding Companies
 
 In
November 1999, the federal Gramm-Leach-Bliley Act (the “GLB Act”) was signed
into law.  Effective in pertinent part on March 11, 2000, the GLB Act
revised the BHC Act and repealed the affiliation provisions of the
Glass-Steagall Act of 1933, which, taken together, limited the securities,
insurance and other non-banking activities of any company that controls an FDIC
insured financial institution.  Under the GLB Act, a bank holding
company can elect, subject to certain qualifications, to become a “financial
holding company”.  The GLB Act provides that a financial holding
company may engage in a full range of financial activities, including insurance
and securities sales and underwriting activities, and real estate development,
with new expedited notice procedures.
 
 Under FRB
policy, the Company is expected to act as a source of strength to its subsidiary
banks, and the FRB may charge the Company with engaging in unsafe and unsound
practices for failure to commit resources to a subsidiary bank when
required.  In addition, under the Financial Institutions Reform,
Recovery and Enforcement Act of 1989 (“FIRREA”), depository institutions insured
by the FDIC can be held liable for any losses incurred by, or reasonably
anticipated to be incurred by, the FDIC in connection with (i) the default of a
commonly controlled FDIC-insured depository institution or (ii) any assistance
provided by the FDIC to a commonly controlled FDIC-insured depository
institution in danger of default.  Accordingly, in the event that any
insured subsidiary of the Company causes a loss to the FDIC, other insured
subsidiaries of the Company could be required to compensate the FDIC by
reimbursing it for the estimated amount of such loss.  Such cross
guaranty liabilities generally are superior in priority to obligations of a
financial institution to its stockholders and obligations to other
affiliates.
 
 Federal
Regulation of Banks
 
 Federal
and state banking regulators may prohibit the institutions over which they have
supervisory authority from engaging in activities or investments that the
agencies believes are unsafe or unsound banking practices.  These
banking regulators have extensive enforcement authority over the institutions
they regulate to prohibit or correct activities that violate law, regulation or
a regulatory agreement or which are deemed to be unsafe or unsound
practices.  Enforcement actions may include the appointment of a
conservator or receiver, the issuance of a cease and desist order, the
termination of deposit insurance, the imposition of civil money penalties on the
institution, its directors, officers, employees and institution-affiliated
parties, the issuance of directives to increase capital, the issuance of formal
and informal agreements, the removal of or restrictions on directors, officers,
employees and institution-affiliated parties, and the enforcement of any such
mechanisms through restraining orders or other court actions.
  7
 
 The Banks
are subject to the provisions of Section 23A and Section 23B of the Federal
Reserve Act.  Section 23A limits the amount of loans or extensions of
credit to, and investments in, the Company and its nonbank affiliates by the
Banks.  Section 23B requires that transactions between any of the
Banks and the Company and its nonbank affiliates be on terms and under
circumstances that are substantially the same as with
non-affiliates.
 
 The Banks
are also subject to certain restrictions on extensions of credit to executive
officers, directors, and principal stockholders or any related interest of such
persons, which generally require that such credit extensions be made on
substantially the same terms as are available to third parties dealing with the
Banks and not involve more than the normal risk of repayment.  Other
laws tie the maximum amount that may be loaned to any one customer and its
related interests to capital levels.
 
 As part
of the Federal Deposit Insurance Company Improvement Act of 1991 (“FDICIA”),
each federal banking regulator adopted non-capital safety and soundness
standards for institutions under its authority.  These standards
include internal controls, information systems and internal audit systems, loan
documentation, credit underwriting, interest rate exposure, asset growth, and
compensation, fees and benefits.  An institution that fails to meet
those standards may be required by the agency to develop a plan acceptable to
meet the standards.  Failure to submit or implement such a plan may
subject the institution to regulatory sanctions.  The Company, on
behalf of the Banks, believes that the Banks meet substantially all standards
that have been adopted.  FDICIA also imposes capital standards on
insured depository institutions.
 
 The
Community Reinvestment Act (“CRA”) requires that, in connection with the
examination of financial institutions within their jurisdictions, the federal
banking regulators evaluate the record of the financial institution in meeting
the credit needs of their communities including low and moderate income
neighborhoods, consistent with the safe and sound operation of those
banks.  These factors are also considered by all regulatory agencies
in evaluating mergers, acquisitions and applications to open a branch or
facility.  As of the date of its most recent examination report, each
of the Banks has a CRA rating of “Satisfactory.”
 
 On
October 14, 2008, the FDIC announced the creation of the Temporary Liquidity
Guarantee Program (the “TLGP”) to decrease the cost of bank funding and,
hopefully, normalize lending.  This program is comprised of two
components. The first component guarantees senior unsecured debt issued between
October 14, 2008 and June 30, 2009.  The guarantee will remain in
effect until June 30, 2012 for such debts that mature beyond June 30,
2009.  The second component, called the Transaction Accounts Guarantee
Program (“TAG”), provided full coverage for non-interest bearing transaction
deposit accounts, IOLTAs, and NOW accounts with interest rates of 0.50% or less,
regardless of account balance, initially until December 31, 2009.  The
TAG program has been extended until June 30, 2010.  We elected to
participate in both programs and paid additional FDIC premiums in 2009 as a
result.
 
 Capital
Requirements
 
 FDICIA
established a system of prompt corrective action to resolve the problems of
undercapitalized institutions.  Under this system, federal banking
regulators are required to rate supervised institutions on the basis of five
capital categories: “well -capitalized,” “adequately capitalized,”
“undercapitalized,” “significantly undercapitalized,” and “critically
undercapitalized;” and to take certain mandatory actions, and are authorized to
take other discretionary actions, with respect to institutions in the three
undercapitalized categories.  The severity of the actions will depend
upon the category in which the institution is placed.  A depository
institution is “well capitalized” if it has a total risk based capital ratio of
10% or greater, a Tier 1 risk based capital ratio of 6% or greater, and a
leverage ratio of 5% or greater and is not subject to any order, regulatory
agreement, or written directive to meet and maintain a specific capital level
for any capital measure.  An “adequately capitalized” institution is
defined as one that has a total risk based capital ratio of 8% or greater, a
Tier 1 risk based capital ratio of 4% or greater and a leverage ratio of 4% or
greater (or 3% or greater in the case of a bank with a composite CAMELS rating
of 1).
 
 FDICIA
generally prohibits a depository institution from making any capital
distribution, including the payment of cash dividends, or paying a management
fee to its holding company if the depository institution would thereafter be
undercapitalized.  Undercapitalized depository institutions are
subject to growth limitations and are required to submit capital restoration
plans.  For a capital restoration plan to be acceptable, the
depository institution’s parent holding company must guarantee (subject to
certain limitations) that the institution will comply with such capital
restoration plan.
 
 Significantly
undercapitalized depository institutions may be subject to a number of other
requirements and restrictions, including orders to sell sufficient voting stock
to become adequately capitalized and requirements to reduce total assets and
stop accepting deposits from correspondent banks.  Critically
undercapitalized depository institutions are subject to the appointment of a
receiver or conservator, generally within 90 days of the date such institution
is determined to be critically undercapitalized.
 
 As of
December 31, 2009, the Banks were each deemed to be “well
capitalized.”  For more information regarding the capital condition of
the Company, see Note 18 of Consolidated Financial Statements appearing in Item
8 of Part II of this report.
  8
 
 Deposit
Insurance
 
 The
deposits of the Banks are insured to a maximum of $100,000 per depositor through
the Deposit Insurance Fund, which is administered by the FDIC, and the Banks are
required to pay quarterly deposit insurance premium assessments to the
FDIC.  The Deposit Insurance Fund was created pursuant to the Federal
Deposit Insurance Reform Act of 2005 (the “Reform Act”), which was signed into
law on February 8, 2006.  Under new law, (i) the current $100,000
deposit insurance coverage will be indexed for inflation (with adjustments every
five years, commencing January 1, 2011), and (ii) deposit insurance coverage for
retirement accounts was increased to $250,000 per participant subject to
adjustment for inflation.  Effective October 3, 2008, however, the
Emergency Economic Stabilization Act of 2008 (the “EESA”) was enacted and, among
other things, temporarily raised the basic limit on federal deposit insurance
coverage from $100,000 to $250,000 per depositor.  EESA initially
contemplated that the coverage limit would return to $100,000 after December 31,
2009, but the expiration date was recently extended to December 31,
2013.  The coverage for retirement accounts did not change and remains
at $250,000.
 
 The
Reform Act also gave the FDIC greater latitude in setting the assessment rates
for insured depository institutions which could be used to impose minimum
assessments.  On May 22, 2009, the FDIC imposed an emergency insurance
assessment in an effort to restore the Deposit Insurance Fund to an acceptable
level.  On November 12, 2009, the FDIC adopted a final rule requiring
insured depository institutions to prepay their estimated quarterly risk-based
deposit assessments for the fourth quarter of 2009, and for all of 2010, 2011,
and 2012, on December 30, 2009, along with each institution’s risk based deposit
insurance assessment for the third quarter of 2009.  It was also
announced that the assessment rate will increase by 3 basis points effective
January 1, 2011.  The prepayment will be accounted for as a prepaid
expense to be amortized quarterly. The prepaid assessment will qualify for a
zero risk weight under the risk-based capital requirements.  The
Banks’ three-year prepaid assessment was $5.4 million.  The Banks paid
a total of $2.1 million in FDIC premiums during 2009, of which $513 thousand was
a one-time special deposit insurance assessment.
 
 USA
PATRIOT Act
 
 Congress
adopted the USA PATRIOT Act (the “Patriot Act”) on October 26, 2001 in response
to the terrorist attacks that occurred on September 11, 2001.  Under
the Patriot Act, certain financial institutions, including banks, are required
to maintain and prepare additional records and reports that are designed to
assist the government’s efforts to combat terrorism.  The Patriot Act
includes sweeping anti-money laundering and financial transparency laws and
required additional regulations, including, among other things, standards for
verifying client identification when opening an account and rules to promote
cooperation among financial institutions, regulators and law enforcement
entities in identifying parties that may be involved in terrorism or money
laundering.
 
 Federal
Securities Laws
 
 The
shares of the Company’s common stock are registered with the Securities and
Exchange Commission (the “SEC”) under Section 12(b) of the Securities Exchange
Act of 1934, as amended (the “Exchange Act”), and listed on the NASDAQ Global
Select Market.  The Company is subject to information reporting
requirements, proxy solicitation requirements, insider trading restrictions and
other requirements of the Exchange Act, including the requirements imposed under
the federal Sarbanes-Oxley Act of 2002.  Among other things, loans to
and other transactions with insiders are subject to restrictions and heightened
disclosure, directors and certain committees of the Board must satisfy certain
independence requirements, and the Corporation is generally required to comply
with certain corporate governance requirements.
 
 Governmental
Monetary and Credit Policies and Economic Controls
 
 The
earnings and growth of the banking industry and ultimately of the Bank are
affected by the monetary and credit policies of governmental authorities,
including the FRB.  An important function of the FRB is to regulate
the national supply of bank credit in order to control recessionary and
inflationary pressures. Among the instruments of monetary policy used by the FRB
to implement these objectives are open market operations in U.S. Government
securities, changes in the federal funds rate, changes in the discount rate of
member bank borrowings, and changes in reserve requirements against member bank
deposits.  These means are used in varying combinations to influence
overall growth of bank loans, investments and deposits and may also affect
interest rates charged on loans or paid for deposits.  The monetary
policies of the FRB authorities have had a significant effect on the operating
results of commercial banks in the past and are expected to continue to have
such an effect in the future.  In view of changing conditions in the
national economy and in the money markets, as well as the effect of actions by
monetary and fiscal authorities, including the FRB, no prediction can be made as
to possible future changes in interest rates, deposit levels, loan demand or
their effect on the business and earnings of the Company and its
subsidiaries.
  9
 
 AVAILABLE
INFORMATION
 
 The
Company maintains an Internet site at www.shbi.net on which
it makes available, free of charge, its Annual Report on Form 10-K, Quarterly
Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to the
foregoing as soon as reasonably practicable after these reports are
electronically filed with, or furnished to, the SEC.  In addition,
stockholders may access these reports and documents on the SEC’s web site at
www.sec.gov.
 
 Item 1A.  RISK FACTORS.
 
 The
following factors may impact our business, financial condition and results of
operations and should be considered carefully in evaluating an investment in
shares of common stock of the Company.
 
 Risks
Relating to Our Business
 
 The
Company’s future depends on the successful growth of its
subsidiaries
 
 The
Company’s primary business activity for the foreseeable future will be to act as
the holding company of CNB, Talbot Bank, Felton Bank, and its other
subsidiaries.  Therefore, the Company’s future profitability will
depend on the success and growth of these subsidiaries.  In the
future, part of the Company’s growth may come from buying other banks and buying
or establishing other companies.  Such entities may not be profitable
after they are purchased or established, and they may lose money, particularly
at first.  A new bank or company may bring with it unexpected
liabilities, bad loans, or bad employee relations, or the new bank or company
may lose customers.
 
 A
majority of our business is concentrated in Maryland and Delaware, a significant
amount of which is concentrated in real estate lending, so a decline in the
local economy and real estate markets could adversely impact our financial
condition and results of operations
 
 Because
most of our loans are made to customers who reside on the Eastern Shore of
Maryland and in Delaware, a decline in local economic conditions may have a
greater effect on our earnings and capital than on the earnings and capital of
larger financial institutions whose loan portfolios are geographically
diverse.  Further, we make many real estate secured loans, including
construction and land development loans, all of which are in greater demand when
interest rates are low and economic conditions are good.  The national
and local economies have significantly weakened during the past two years in
large part due to the widely-reported problems in the sub-prime mortgage loan
market and the more recent meltdown of the financial industry as a
whole.  As a result, real estate values across the country, including
in our market areas, have decreased and the general availability of credit,
especially credit to be secured by real estate, has also
decreased.  These conditions have made it more difficult for real
estate owners and owners of loans secured by real estate to sell their assets at
the times and at the prices they desire.  In addition, these
conditions have increased the risk that the market values of the real estate
securing our loans may deteriorate, which could cause us to lose money in the
event a borrower fails to repay a loan and we are forced to foreclose on the
property.  There can be no guarantee as to when or whether economic
conditions will improve.
 
 Additionally,
the FRB and the FDIC, along with the other federal banking regulators, issued
final guidance on December 6, 2006 entitled “Concentrations in Commercial Real
Estate Lending, Sound Risk Management Practices” directed at institutions that
have particularly high concentrations of commercial real estate loans within
their lending portfolios.  This guidance suggests that institutions
whose commercial real estate loans exceed certain percentages of capital should
implement heightened risk management practices appropriate to their
concentration risk and may be required to maintain higher capital ratios than
institutions with lower concentrations in commercial real estate
lending.  Based on our commercial real estate concentration as of
December 31, 2009, we may be subject to further supervisory analysis during
future examinations.  We cannot guarantee that any risk management
practices we implement will be effective to prevent losses relating to our
commercial real estate portfolio.  Management cannot predict the
extent to which this guidance will impact our operations or capital
requirements.
 
 Interest
rates and other economic conditions will impact our results of
operations
 
 The
national economy and the local economy have significantly weakened during the
past two years, primarily as a result of the widely reported financial
institution meltdown.  This weakening has caused real estate values to
drop, decreased the demand for credit, and caused public anxiety regarding the
health and future of the financial services industry as a whole.
  10
 
 Our
results of operations may be materially and adversely affected by changes in
prevailing economic conditions, including declines in real estate values, rapid
changes in interest rates and the monetary and fiscal policies of the federal
government.  Our profitability is in part a function of the spread
between the interest rates earned on assets and the interest rates paid on
deposits and other interest-bearing liabilities (i.e., net interest income),
including advances from the Federal Home Loan Bank (the “FHLB”) of Atlanta and
the FHLB of Pittsburgh.  Interest rate risk arises from mismatches
(i.e., the interest
sensitivity gap) between the dollar amount of repricing or maturing assets and
liabilities and is measured in terms of the ratio of the interest rate
sensitivity gap to total assets.  More assets repricing or maturing
than liabilities over a given time period is considered asset-sensitive and is
reflected as a positive gap, and more liabilities repricing or maturing than
assets over a given time period is considered liability-sensitive and is
reflected as negative gap.  An asset-sensitive position (i.e., a positive gap) could
enhance earnings in a rising interest rate environment and could negatively
impact earnings in a falling interest rate environment, while a
liability-sensitive position (i.e., a negative gap) could
enhance earnings in a falling interest rate environment and negatively impact
earnings in a rising interest rate environment.  Fluctuations in
interest rates are not predictable or controllable.  We have attempted
to structure our asset and liability management strategies to mitigate the
impact on net interest income of changes in market interest rates, but there can
be no assurance that these attempts will be successful in the event of future
changes.
 
 The
Banks may experience credit losses in excess of their allowances, which would
adversely impact our financial condition and results of operations
 
 The risk
of credit losses on loans varies with, among other things, general economic
conditions, the type of loan being made, the creditworthiness of the borrower
over the term of the loan and, in the case of a collateralized loan, the value
and marketability of the collateral for the loan.  Management of each
of the Banks bases the allowance for credit losses upon, among other things,
historical experience, an evaluation of economic conditions and regular reviews
of delinquencies and loan portfolio quality.  Based upon such factors,
management makes various assumptions and judgments about the ultimate
collectability of the loan portfolio and provides an allowance for credit losses
based upon a percentage of the outstanding balances and for specific loans when
their ultimate collectability is considered questionable.  If
management’s assumptions and judgments prove to be incorrect and the allowance
for credit losses is inadequate to absorb future losses, or if the bank
regulatory authorities, as a part of their examination process, require our bank
subsidiaries to increase their respective allowance for credit losses, our
earnings and capital could be significantly and adversely
affected.  Although management uses the best information available to
make determinations with respect to the allowance for credit losses, future
adjustments may be necessary if economic conditions differ substantially from
the assumptions used or adverse developments arise with respect to the Banks’
nonperforming or performing loans.  Material additions to the
allowance for credit losses of one of the Banks would result in a decrease in
that Bank’s net income and capital and could have a material adverse effect on
our financial condition.
 
 The
market value of our investments might decline
 
 As of
December 31, 2009, we had classified 92% of our investment securities as
available-for-sale pursuant to the Financial Accounting Standards Board’s
Accounting Standards Codification Topic 320 (“ASC 320”)  relating to
accounting for investments. ASC 320 requires that unrealized gains and losses in
the estimated value of the available-for-sale portfolio be “marked to market”
and reflected as a separate item in stockholders’ equity (net of tax) as
accumulated other comprehensive income.   The remaining
investment securities are classified as held-to-maturity in accordance with ASC
320 and are stated at amortized cost.
 
 In the
past, gains on sales of investment securities have not been a significant source
of income for us.   There can be no assurance that future market
performance of our investment portfolio will enable us to realize income from
sales of securities.  Stockholders’ equity will continue to reflect
the unrealized gains and losses (net of tax) of these
investments.  There can be no assurance that the market value of our
investment portfolio will not decline, causing a corresponding decline in
stockholders’ equity.
 
 CNB and
Talbot Bank are members of the FHLB of Atlanta and Felton Bank is a member of
the FHLB of Pittsburgh.  A member of the FHLB system is required to
purchase stock issued by the relevant FHLB bank based on how
much it borrows from the FHLB and the quality of the collateral
pledged to secure that borrowing.  Accordingly, our investments
include stock issued by the FHLB of Atlanta and the FHLB of
Pittsburgh.  During 2008, the banking industry became concerned about
the financial strength of the banks in the FHLB system, and some FHLB banks
stopped paying dividends on and redeeming FHLB stock.  During 2009,
the FHLB of Atlanta continued paying dividends but the FHLB of Pittsburgh did
not. The FHLB of
Pittsburgh last paid a dividend in the third quarter of 2008. Accordingly, there
can be no guaranty that the FHLB of Pittsburgh will declare future
dividends.
 
 Moreover,
accounting guidance indicates that an investor in FHLB stock should recognize
impairment if it concludes that it is not probable that it will ultimately
recover the par value of its shares. The decision of whether impairment exists
is a matter of judgment that should reflect the investor's view of an FHLB
bank's long-term performance, which includes factors such as its operating
performance, the severity and duration of declines in the market value of its
net assets related to its capital stock amount, its commitment to make payments
required by law or regulation and the level of such payments in relation to its
operating performance, the impact of legislation and regulatory changes on the
FHLB bank, and accordingly, on the members of that FHLB bank and its liquidity
and funding position.
  11
 
 After
evaluating all of these considerations, we believe the par value of our FHLB
stock will be recovered, but future evaluations of the above mentioned factors
could result in the Company recognizing an impairment charge.
 
 Management
believes that several factors will affect the market values of our investment
portfolio.  These include, but are not limited to, changes in interest
rates or expectations of changes, the degree of volatility in the securities
markets, inflation rates or expectations of inflation and the slope of the
interest rate yield curve (the yield curve refers to the differences between
shorter-term and longer-term interest rates; a positively sloped yield curve
means shorter-term rates are lower than longer-term rates).  Also, the
passage of time will affect the market values of our investment securities, in
that the closer they are to maturing, the closer the market price should be to
par value.  These and other factors may impact specific categories of
the portfolio differently, and management cannot predict the effect these
factors may have on any specific category.
 
 The
banking industry is heavily regulated; significant regulatory changes could
adversely affect our operations
 
 Our
operations are and will be affected by current and future legislation and by the
policies established from time to time by various federal and state regulatory
authorities.  The Company is subject to supervision by the FRB; CNB
and Talbot Bank are subject to supervision and periodic examination by the
Maryland Commissioner and the FDIC; and Felton Bank is subject to supervision
and periodic examination by the Delaware Commissioner and the
FDIC.  Banking regulations, designed primarily for the safety of
depositors, may limit a financial institution’s growth and the return to its
investors by restricting such activities as the payment of dividends, mergers
with or acquisitions by other institutions, investments, loans and interest
rates, interest rates paid on deposits, expansion of branch offices, and the
offering of securities or trust services.  The Company and the Banks
are also subject to capitalization guidelines established by federal law and
could be subject to enforcement actions to the extent that those institutions
are found by regulatory examiners to be undercapitalized.  It is not
possible to predict what changes, if any, will be made to existing federal and
state legislation and regulations or the effect that such changes may have on
our future business and earnings prospects.  Management also cannot
predict the nature or the extent of the effect on our business and earnings of
future fiscal or monetary policies, economic controls, or new federal or state
legislation.  Further, the cost of compliance with regulatory
requirements may adversely affect our ability to operate
profitably.
 
 We
operate in a highly competitive market, and our inability to effectively compete
in our markets could have an adverse impact on our financial condition and
results of operations
 
 We
operate in a competitive environment, competing for loans, deposits, insurance
products and customers with commercial banks, savings associations and other
financial entities.  Competition for deposits comes primarily from
other commercial banks, savings associations, credit unions, money market and
mutual funds and other investment alternatives.  Competition for loans
comes primarily from other commercial banks, savings associations, mortgage
banking firms, credit unions and other financial
intermediaries.  Competition for other products, such as insurance and
securities products, comes from other banks, securities and brokerage companies,
insurance companies, insurance agents and brokers, and other nonbank financial
service providers in our market areas.  Many of these competitors are
much larger in terms of total assets and capitalization, have greater access to
capital markets, and/or offer a broader range of financial services than those
offered by us.  In addition, banks with a larger capitalization and
financial intermediaries not subject to bank regulatory restrictions have larger
lending limits and are thereby able to serve the needs of larger
customers.  Our growth and profitability will depend upon our ability
to attract and retain skilled managerial, marketing and technical
personnel.  Competition for qualified personnel in the financial
services industry is intense, and there can be no assurance that we will be
successful in attracting and retaining such personnel.
 
 In
addition, current banking laws facilitate interstate branching, merger activity
among banks, and expanded activities.  Since September 1995, certain
bank holding companies have been authorized to acquire banks throughout the
United States.  Since June 1, 1997, certain banks have been permitted
to merge with banks organized under the laws of different states.  As
a result, interstate banking is now an accepted element of competition in the
banking industry and the Corporation may be brought into competition with
institutions with which it does not presently compete.  Moreover, as
discussed above, the GLB Act revised the BHC Act in 2000 and repealed the
affiliation provisions of the Glass-Steagall Act of 1933, which, taken together,
limited the securities, insurance and other non-banking activities of any
company that controls an FDIC insured financial institution.  These
laws may increase the competition we face in our market areas in the future,
although management cannot predict the degree to which such competition will
impact our financial condition or results of operations.
  12
  Our
regulatory expenses will likely increase due to federal laws, rules and programs
that have been enacted or adopted in response to the recent banking crisis and
the current national recession
 
 In
response to the banking crisis that began in 2008 and the resulting national
recession, the federal government took drastic steps to help stabilize the
credit market and the financial industry.  These steps included the
enactment of EESA, which, among other things, raised the basic limit on federal
deposit insurance coverage to $250,000, and the FDIC’s adoption of the TLGP,
which, under the TAG portion, provides full deposit insurance coverage through
June 30, 2010 for non-interest bearing transaction deposit accounts, IOLTAs, and
NOW accounts with interest rates of 0.50% or less, regardless of account
balance.  The TLGP requires participating institutions, like us, to
pay 10 basis points per annum for the additional insured
deposits.  These actions will cause our regulatory expenses to
increase.  Additionally, due in part to the failure of several
depository institutions around the country since the banking crisis began, the
FDIC imposed an emergency insurance assessment to help restore the Deposit
Insurance Fund and further required insured depository institutions to prepay
their estimated quarterly risk-based deposit assessments through 2012 on
December 30, 2009.  Given the current state of the national economy,
there can be no assurance that the FDIC will not impose future emergency
assessments or further revise its rate structure.
 
 Customer
concern about deposit insurance may cause a decrease in deposits held at the
Banks
 
 With
recent increased concerns about bank failures, customers increasingly are
concerned about the extent to which their deposits are insured by the
FDIC.  Customers may withdraw deposits from the Banks in an effort to
ensure that the amount they have on deposit with us is fully
insured.  Decreases in deposits may adversely affect our funding costs
and net income.
 
 Our
funding sources may prove insufficient to replace deposits and support our
future growth
 
 We rely
on customer deposits, advances from the FHLB, and lines of credit at other
financial institutions to fund our operations.  Although we have
historically been able to replace maturing deposits and advances if desired, no
assurance can be given that we would be able to replace such funds in the future
if our financial condition or the financial condition of the FHLB or market
conditions were to change.  Our financial flexibility will be severely
constrained and/or our cost of funds will increase if we are unable to maintain
our access to funding or if financing necessary to accommodate future growth is
not available at favorable interest rates.  Finally, if we are
required to rely more heavily on more expensive funding sources to support
future growth, our revenues may not increase proportionately to cover our costs.
In this case, our profitability would be adversely affected.
 
 The
loss of key personnel could disrupt our operations and result in reduced
earnings
 
 Our
growth and profitability will depend upon our ability to attract and retain
skilled managerial, marketing and technical personnel.  Competition
for qualified personnel in the financial services industry is intense, and there
can be no assurance that we will be successful in attracting and retaining such
personnel.  Our current executive officers provide valuable services
based on their many years of experience and in-depth knowledge of the banking
industry.  Due to the intense competition for financial professionals,
these key personnel would be difficult to replace and an unexpected loss of
their services could result in a disruption to the continuity of operations and
a possible reduction in earnings.
 
 We
may lose key personnel because of our participation in the Troubled Asset Relief
Program Capital Purchase Program
 
 On
January 9, 2009, we participated in the Troubled Asset Relief Program (“TARP”)
Capital Purchase Program (the “CPP”) adopted by the U.S. Department of Treasury
(“Treasury”) by selling $25 million in shares of our Fixed Rate Cumulative
Perpetual Preferred Stock, Series A (the “Series A Preferred Stock”) to Treasury
and issuing a 10-year common stock purchase warrant (the “Warrant”) to
Treasury.  As part of these transactions, we adopted Treasury’s
standards for executive compensation and corporate governance for the period
during which Treasury holds any shares of the Series A Preferred Stock and/or
any shares of common stock that may be acquired upon exercise of the
Warrant.  On February 17, 2009, the American Recovery and Reinvestment
Act of 2009 (the “Recovery Act”) was signed into law, which, among other things,
imposes additional executive compensation restrictions on institutions that
participate in TARP for so long as any TARP assistance remains
outstanding.  Among these restrictions is a prohibition against making
most severance payments to our “senior executive officers”, which term includes
our Chairman and Chief Executive Officer, our Chief Financial Officer and,
generally, the three next most highly compensated executive officers, and to the
next five most highly compensated employees.  The restrictions also
limit the type, timing and amount of bonuses, retention awards and incentive
compensation that may be paid to our five most highly compensated
employees.
 
 On April
15, 2009, the Company redeemed all of the outstanding Series A Preferred Stock
from the Treasury, so the foregoing restrictions ceased to
apply.  However, the Treasury still holds the Warrant which, if
exercised, would again subject us to these restrictions.  If the
Treasury were to exercise the Warrant for shares of our common stock, these
restrictions, coupled with the competition we face from other institutions,
including institutions that did not participate in TARP, may make it more
difficult for us to attract and/or retain exceptional key
employees.
  13
 
 Our
lending activities subject us to the risk of environmental
liabilities
 
 A
significant portion of our loan portfolio is secured by real
property.  During the ordinary course of business, we may foreclose on
and take title to properties securing certain loans.  In doing so,
there is a risk that hazardous or toxic substances could be found on these
properties.  If hazardous or toxic substances are found, we may be
liable for remediation costs, as well as for personal injury and property
damage.  Environmental laws may require us to incur substantial
expenses and may materially reduce the affected property’s value or limit our
ability to use or sell the affected property.  In addition, future
laws or more stringent interpretations of enforcement policies with respect to
existing laws may increase our exposure to environmental
liability.  Although we have policies and procedures to perform an
environmental review before initiating any foreclosure action on real property,
these reviews may not be sufficient to detect all potential environmental
hazards.  The remediation costs and any other financial liabilities
associated with an environmental hazard could have a material adverse effect on
our financial condition and results of operations.
 
 We
may be subject to other claims
 
 We may
from time to time be subject to claims from customers for losses due to alleged
breaches of fiduciary duties, errors and omissions of employees, officers and
agents, incomplete documentation, the failure to comply with applicable laws and
regulations, or many other reasons.  Also, our employees may knowingly
or unknowingly violate laws and regulations.  Management may not be
aware of any violations until after their occurrence.  This lack of
knowledge may not insulate the Company or our subsidiaries from
liability.  Claims and legal actions may result in legal expenses and
liabilities that may reduce our profitability and hurt our financial
condition.
 
 We
may be adversely affected by other recent legislation
 
 As
discussed above, the GLB Act repealed restrictions on banks affiliating with
securities firms and it also permitted bank holding companies that become
financial holding companies to engage in additional financial activities,
including insurance and securities underwriting and agency activities, merchant
banking, and insurance company portfolio investment activities that are
currently not permitted for bank holding companies.  Although the
Company is a financial holding company, this law may increase the competition we
face from larger banks and other companies.  It is not possible to
predict the full effect that this law will have on us.
 
 The
Sarbanes-Oxley Act of 2002 requires management of publicly traded companies to
perform an annual assessment of their internal controls over financial reporting
and to report on whether the system is effective as of the end of the Company’s
fiscal year.  Disclosure of significant deficiencies or material
weaknesses in internal controls could cause an unfavorable impact to shareholder
value by affecting the market value of our stock.
 
 The
Patriot Act requires certain financial institutions, such as the Banks, to
maintain and prepare additional records and reports that are designed to assist
the government’s efforts to combat terrorism. This law includes sweeping
anti-money laundering and financial transparency laws and required additional
regulations, including, among other things, standards for verifying client
identification when opening an account and rules to promote cooperation among
financial institutions, regulators and law enforcement entities in identifying
parties that may be involved in terrorism or money laundering.  If we
fail to comply with this law, we could be exposed to adverse publicity as well
as fines and penalties assessed by regulatory agencies.
 
 We
may not be able to keep pace with developments in technology in which case we
may become less competitive and lose customers
 
 We use
various technologies in our business, including telecommunication, data
processing, computers, automation, internet-based banking, and debit
cards.  Technology changes rapidly.  Our ability to compete
successfully with other banks and non-bank entities may depend on whether we can
exploit technological changes.  We may not be able to exploit
technological changes, and any investment we do make may not make us more
profitable.  We converted to a new core data processing system during
the second quarter of 2009.  Although management expects that this new
system will improve operating efficiencies, there can be no guaranty that it
will do so or that software, hardware or other technical problems will not delay
its effectiveness.
  14
  Risks
Relating to the Company’s Securities
 
 The
Company’s shares of common stock and the Warrant are not insured
 
 The
shares of the Company’s common stock and the Warrant are not deposits and are
not insured against loss by the FDIC or any other governmental or private
agency.
 
 The
Company’s ability to pay dividends is limited by applicable banking and
corporate law
 
 The
Company’s stockholders are entitled to dividends on their shares of common stock
if, when, and as declared by the Company’s Board of Directors out of funds
legally available for that purpose.  The Company’s current ability to
pay dividends to stockholders is largely dependent upon the receipt of dividends
from the Banks.  Both federal and state laws impose restrictions on
the ability of the Banks to pay dividends.  Federal law prohibits the
payment of a dividend by an insured depository institution if the depository
institution is considered “undercapitalized” or if the payment of the dividend
would make the institution “undercapitalized”.  For a Maryland
state-chartered bank, dividends may be paid out of undivided profits or, with
the prior approval of the Maryland Commissioner, from surplus in excess of 100%
of required capital stock.  If, however, the surplus of a Maryland
bank is less than 100% of its required capital stock, then cash dividends may
not be paid in excess of 90% of net earnings.  For a Delaware
state-chartered bank, dividends may be paid out of net profits, but only if its
surplus fund is equal to or greater than 50% of its required capital
stock.  If a Delaware bank’s surplus is less than 100% of capital
stock when it declares a dividend, then it must carry 25% of its net profits of
the preceding period for which the dividend is paid to its surplus fund until
the surplus amounts to 100% of its capital stock.  In addition to
these specific restrictions, bank regulatory agencies also have the ability to
prohibit proposed dividends by a financial institution that would otherwise be
permitted under applicable regulations if the regulatory body determines that
such distribution would constitute an unsafe or unsound
practice.  Because of these limitations, there can be no guarantee
that the Company’s Board will declare dividends in any fiscal
quarter.
 
 There
is no market for the Warrant, and the common stock is not heavily
traded
 
 There is
no established trading market for the Warrant.  The Company’s common
stock is listed on the NASDAQ Global Select Market, but shares of the common
stock are not heavily traded.  Securities that are not heavily traded
can be more volatile than stock trading in an active public
market.  Factors such as our financial results, the introduction of
new products and services by us or our competitors, and various factors
affecting the banking industry generally may have a significant impact on the
market price of the shares of the common stock.  Management cannot
predict the extent to which an active public market for any of the Company’s
securities will develop or be sustained in the future.  Accordingly,
holders of the Company’s securities may not be able to sell such securities at
the volumes, prices, or times that they desire.
 
 The
Company’s Articles of Incorporation and By-Laws and Maryland law may discourage
a corporate takeover
 
 The
Company’s Amended and Restated Articles of Incorporation, as supplemented (the
“Charter”), and Amended and Restated By-Laws, as amended (the “By-Laws”),
contain certain provisions designed to enhance the ability of the Board of
Directors to deal with attempts to acquire control of the
Company.  The Charter and By-Laws provide for the classification of
the Board into three classes; directors of each class generally serve for
staggered three-year periods.  No director may be removed except for
cause and then only by a vote of at least two-thirds of the total eligible
stockholder votes.  The Charter gives the Board certain powers in
respect of the Company’s securities.  First, the Board has the
authority to classify and reclassify unissued shares of stock of any class or
series of stock by setting, fixing, eliminating, or altering in any one or more
respects the preferences, rights, voting powers, restrictions and qualifications
of, dividends on, and redemption, conversion, exchange, and other rights of,
such securities.  Second, a majority of the Board, without action by
the stockholders, may amend the Charter to increase or decrease the aggregate
number of shares of stock or the number of shares of stock of any class that the
Company has authority to issue.  The Board could use these powers,
along with its authority to authorize the issuance of securities of any class or
series, to issue securities having terms favorable to management to persons
affiliated with or otherwise friendly to management.
 
 Maryland
law also contains anti-takeover provisions that apply to the
Company.  The Maryland Business Combination Act generally prohibits,
subject to certain limited exceptions, corporations from being involved in any
“business combination” (defined as a variety of transactions, including a
merger, consolidation, share exchange, asset transfer or issuance or
reclassification of equity securities) with any “interested shareholder” for a
period of five years following the most recent date on which the interested
shareholder became an interested shareholder.  An interested
shareholder is defined generally as a person who is the beneficial owner of 10%
or more of the voting power of the outstanding voting stock of the corporation
after the date on which the corporation had 100 or more beneficial owners of its
stock or who is an affiliate or associate of the corporation and was the
beneficial owner, directly or indirectly, of 10% percent or more of the voting
power of the then outstanding stock of the corporation at any time within the
two-year period immediately prior to the date in question and after the date on
which the corporation had 100 or more beneficial owners of its
stock.  The Maryland Control Share Acquisition Act applies to
acquisitions of “control shares”, which, subject to certain exceptions, are
shares the acquisition of which entitle the holder, directly or indirectly, to
exercise or direct the exercise of the voting power of shares of stock of the
corporation in the election of directors within any of the following ranges of
voting power:  one-tenth or more, but less than one-third of all
voting power; one-third or more, but less than a majority of all voting power or
a majority or more of all voting power.  Control shares have limited
voting rights.  The By-Laws exempt the Company’s capital securities
from the Maryland Control Share Acquisition Act, but the Board has the authority
to eliminate the exemption without stockholder approval.
  15
 
 Although
these provisions do not preclude a takeover, they may have the effect of
discouraging, delaying or deferring a tender offer or takeover attempt that a
shareholder might consider in his or her best interest, including those attempts
that might result in a premium over the market price for the common
stock.  Such provisions will also render the removal of the Board of
Directors and of management more difficult and, therefore, may serve to
perpetuate current management.  These provisions could potentially
adversely affect the market price of the Company’s common stock.
 
 Item
      1B.
              Unresolved
      Staff Comments.
 
 None.
 
 Item
      2.
              Properties.
 
 Our
offices are listed in the tables below.  The Company’s main office is
the same as Talbot Bank’s main office.  The Company owns real property
at 28969 Information Lane in Easton, Maryland, which houses the Operations,
Information Technology and Finance departments of the Company and its
subsidiaries, and certain operations of The Avon-Dixon Agency, LLC.
 
 The
      Talbot Bank of Easton, MarylandBranchesMain
      Office
                    18
      East Dover Street
                    Easton,
      Maryland 21601
                  Tred
      Avon Square Branch
                    212
      Marlboro Road
                    Easton,
      Maryland 21601
                  St.
      Michaels Branch
                    1013
      South Talbot Street
                    St.
      Michaels, Maryland 21663Elliott
      Road Branch
                    8275
      Elliott Road
                    Easton,
      Maryland 21601
                  Sunburst
      Branch
                    424
      Dorchester Avenue
                    Cambridge,
      Maryland 21613
                  Tilghman
      Branch
                    5804
      Tilghman Island Road
                    Tilghman,
      Maryland 21671Trappe
      Branch
                    29349
      Maple Avenue, Suite 1
                    Trappe,
      Maryland  21673ATMsMemorial
      Hospital at Easton
                    219
      South Washington Street
                    Easton,
      Maryland 21601
                  Talbottown
                    218
      North Washington Street
                    Easton,
      Maryland 21601
 
 CNBBranchesMain
      Office
                                109
      North Commerce Street
                                Centreville,
      Maryland 21617
                              Route
      213 South Branch
                                2609
      Centreville Road
                                Centreville,
      Maryland 21617
                              Chester
      Branch
                                300
      Castle Marina Road
                                Chester,
      Maryland 21619Chestertown
      Branch
                                305
      High Street
                                Chestertown,
      Maryland 21620
                              Denton
      Branch
                                850
      South 5th
      Avenue
                                Denton,
      Maryland 21629
                              Grasonville
      Branch
                                202
      Pullman Crossing
                                Grasonville,
      Maryland
21638
  16
  Hillsboro
      Branch
                              21913
      Shore Highway
                              Hillsboro,
      Maryland 21641
                            Stevensville
      Branch
                              408
      Thompson Creek Road
                              Stevensville,
      Maryland  21666
                            Washington
      Square Branch
                              899
      Washington Avenue
                              Chestertown,
      Maryland 21620Division
      Office - Wye Financial & Trust
                              16
      North Washington Street, Suite 1
                              Easton,
      Maryland 21601ATM
                              Queenstown
      Harbor Golf Links
                              Queenstown,
      Maryland
21658
  The
      Felton BankMain
      Office
                    120
      West Main Street
                    Felton,
      Delaware 19943
                  Milford
      Branch
                    698-A  North
      Dupont Boulevard
                    Milford,
      Delaware 19963
                  Camden
      Wal-Mart Supercenter
                    263
      Wal-Mart Drive
                    Camden,
      Delaware 19934The Avon-Dixon Agency,
      LLCHeadquarters
                    28969
      Information Lane
                    Easton,
      Maryland 21601
                  Easton
      Office
                    106
      North Harrison Street
                    Easton,
      Maryland 21601
                  Chestertown
      Office
                    899
      Washington Avenue
                    Chestertown,
      Maryland 21620Grasonville
      Office
                    202
      Pullman Crossing
                    Grasonville,
      Maryland 21638
                  Centreville
      Office
                    105
      Lawyers Row
                    Centreville,
      Maryland 21617Elliott-Wilson
      Insurance, LLC
                  Mubell
      Finance, LLC
                  Wye
      Mortgage Group, LLC106
      North Harrison Street
                    Easton,
      Maryland 21601
                  106
      North Harrison Street
                    Easton,
      Maryland 21601
                  17
      East Dover Street, Suite 101
                    Easton,
      Maryland 21601Jack
      Martin & Associates, Inc.
                    135
      Old Solomon’s Island Road
                    Annapolis,
      Maryland 21401
                  Tri-State
      General Insurance
                    Agencies
      and ESFS, Inc.
                    One
      Plaza East, 4th
      Floor
                    Salisbury,
      Maryland 21802
 
 Talbot
Bank owns the real property on which all of its offices are located, except that
it operates under leases at its St. Michaels, Tilghman and Trappe
branches.  CNB owns the real property on which all of its offices are
located, except that it operates under leases at its Hillsboro branch and the
office of Wye Financial and Trust in Easton.  Felton Bank leases the
real property on which all of its offices are located.  The Insurance
Subsidiaries do not own any real property, but operate under leases. Wye
Mortgage occupies space in Talbot Bank’s main office.  For information
about rent expense for all leased premises, see Note 6 to the Consolidated
Financial Statements appearing in Item 8 of Part II of this report.
 
 Item
      3.
              Legal
      Proceedings.
 
 We are at
times, in the ordinary course of business, subject to legal
actions.  Management, upon the advice of counsel, believes that
losses, if any, resulting from current legal actions will not have a material
adverse effect on our financial condition or results of operation.
 
 PART
II
 
 Item
      4.
              [Reserved]
  17
  Item
      5.
              Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities.
 
 MARKET
PRICE, HOLDERS AND CASH DIVIDENDS
 
 The
shares of the common stock of the Company are listed on the NASDAQ Global Select
Market under the symbol “SHBI”.  As of March 2, 2010, the Company had
approximately 1,686 holders of record.  The high and low sales prices
for the shares of common stock of the Company, as reported on the NASDAQ Global
Select Market, and the cash dividends declared on those shares for each
quarterly period of 2009 and 2008 are set forth in the table below.
 
 2009
                    
                    
                    2008Price Range
                    
                    
                    Dividends
                    
                    
                    Price Range
                    
                    
                    DividendsHigh
                    
                    
                    Low
                    
                    
                    Paid
                    
                    
                    High
                    
                    
                    Low
                    
                    
                    PaidFirst
      Quarter
                    
                    $
                    24.43
                    
                    
                    $
                    11.00
                    
                    
                    $
                    0.16
                    
                    
                    $
                    23.40
                    
                    
                    $
                    20.00
                    
                    
                    $
                    0.16Second
      Quarter
                    
                    
                    21.46
                    
                    
                    
                    15.18
                    
                    
                    
                    0.16
                    
                    
                    
                    26.47
                    
                    
                    
                    18.52
                    
                    
                    
                    0.16Third
      Quarter
                    
                    
                    20.72
                    
                    
                    
                    16.64
                    
                    
                    
                    0.16
                    
                    
                    
                    27.25
                    
                    
                    
                    18.00
                    
                    
                    
                    0.16Fourth
      Quarter
                    
                    
                    17.71
                    
                    
                    
                    13.52
                    
                    
                    
                    0.16
                    
                    
                    
                    25.97
                    
                    
                    
                    17.50
                    
                    
                    
                    0.16$
                    0.64
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    
                    $
                    0.64
 
 On March
2, 2010, the closing sales price for the shares of common stock as reported on
the NASDAQ Global Select Market was $12.05 per share.
 
 Stockholders
received cash dividends totaling $5.4 million in 2009 and in
2008.  The ratio of dividends per share to earnings per share was
100.00% in 2009, compared to 46.72% in 2008.  Cash dividends are
typically declared on a quarterly basis and are at the discretion of the Board
of Directors, based upon such factors as operating results, financial condition,
capital adequacy, regulatory requirements, and stockholder
return.  The Company’s ability to pay dividends is limited by federal
banking and state corporate law and is generally dependent on the ability of the
Company’s subsidiaries, particularly the Banks, to declare dividends to the
Company.  For more information regarding these limitations, see Item
1A of Part I of this report under the headings, “The Company’s ability to pay
dividends is limited by applicable banking and corporate law”, which is
incorporated herein by reference.
 
 Management
plans to retain more from earnings in stockholders’ equity by reducing dividends
in 2010. The Company reduced the quarterly common stock dividend
to $0.06 from $0.16 per share, effective for the dividend
payable February 26, 2010.  The reduction in dividends and
resultant increase in capital projected for 2010 is intended to support the
Company’s growth and enhance capital ratios.
 
 The
transfer agent for the Company’s common stock is:
 
 Registrar
& Transfer Company
 10
Commerce Drive
 Cranford,
New Jersey 07016
 Investor
Relations:  1-800-368-5948
 E-mail
for investor inquiries: info@rtco.com.
  18
  The
performance graph below compares the cumulative total shareholder return on the
common stock of the Company with the cumulative total return on the equity
securities included in the NASDAQ Composite Index (reflecting overall stock
market performance), the NASDAQ Bank Index (reflecting changes in banking
industry stocks), and the SNL Small Cap Bank Index (reflecting changes in stocks
of banking institutions of a size similar to the Company) assuming in each case
an initial $100 investment on December 31, 2004 and reinvestment of dividends as
of the end of the Company’s fiscal years.  Returns are shown on a
total return basis.   The performance graph represents past
performance and should not be considered to be an indication of future
performance.
 
 
 
 Period EndingIndex
                              
                              
                              12/31/04
                              
                              
                              12/31/05
                              
                              
                              12/31/06
                              
                              
                              12/31/07
                              
                              
                              12/31/08
                              
                              
                              12/31/09Shore
      Bancshares, Inc.
                              
                              
                              
                              100.00
                              
                              
                              
                              89.60
                              
                              
                              
                              130.67
                              
                              
                              
                              97.53
                              
                              
                              
                              109.58
                              
                              
                              
                              68.76NASDAQ
      Composite
                              
                              
                              
                              100.00
                              
                              
                              
                              101.37
                              
                              
                              
                              111.03
                              
                              
                              
                              121.92
                              
                              
                              
                              72.49
                              
                              
                              
                              104.31NASDAQ
      Bank
                              
                              
                              
                              100.00
                              
                              
                              
                              95.67
                              
                              
                              
                              106.20
                              
                              
                              
                              82.76
                              
                              
                              
                              62.96
                              
                              
                              
                              51.31SNL
      Small Cap Bank
                              
                              
                              
                              100.00
                              
                              
                              
                              98.49
                              
                              
                              
                              112.41
                              
                              
                              
                              81.28
                              
                              
                              
                              68.32
                              
                              
                              
                              48.02
 
 ISSUER
REPURCHASES
 
 On
February 2, 2006, the Company’s Board of Directors authorized the Company to
repurchase up to 165,000 shares of its common stock over a period not to exceed
60 months.  Shares may be repurchased in the open market or in
privately negotiated transactions at such times and in such amounts per
transaction as the President of the Company determines to be appropriate,
subject to Board oversight.  The Company intends to use the
repurchased shares to fund the Company’s employee benefit plans and for other
general corporate purposes.  No shares were repurchased by or on
behalf of the Company and its affiliates (as defined by Exchange Act Rule
10b-18) during 2009.
  19




EQUITY
COMPENSATION PLAN INFORMATION





T he
Company maintains two equity compensation plans under which it may issue shares
of common stock or grant other equity-based awards to employees, officers,
and/or directors of the Company and its subsidiaries: (i) the Shore Bancshares,
Inc. 2006 Stock and Incentive Compensation Plan (the “2006 Plan”), which
authorizes the grant of stock options, stock appreciation rights, stock awards,
stock units, and performance units; and (ii) the Shore Bancshares, Inc. 1998
Stock Option Plan, which authorizes the grant of stock options (the “1998 Option
Plan”). The Company’s ability to grant options under the 1998 Option Plan
expired on March 3, 2008 pursuant to the terms of that plan, but stock options
granted under that plan were outstanding as of December 31, 2009. Each of these
plans was approved by the Company’s Board of Directors and its
stockholders .





The
following table contains information about these equity compensation plans as of
December 31, 2009:





Number of securities to be
                  issued upon exercise of
                  outstanding options,
                  warrants and rights
                
                
                Weighted-average exercise
                  price of outstanding
                  options, warrants, and
                  rights
                
                
                Number of securities
                  remaining available for
                  future issuance under
                  equity compensation plans
                  [excluding securities
                  reflected in column (a)]Plan Category
                
                (a)
                
                
                (b)
                
                
                (c)Equity
      compensation plans approved by security holders (1)
                
                
                10,850
                
                
                $
                13.36
                
                
                
                567,718Equity
      compensation plans not approved by security holders
                
                
                0
                
                
                
                0.00
                
                
                
                0Total
                
                
                10,850
                
                
                $
                13.36
                
                
                
                567,718







(1)
            In
      addition to stock options and stock appreciation rights, the 2006 Plan
      permits the grant of stock awards, stock units, and performance units, and
      the shares available for issuance shown in column (c) may be granted
      pursuant to such awards.  Subject to the anti-dilution
      provisions of the Omnibus Plan, the maximum number of shares of restricted
      stock that may be granted to any participant in any calendar year is
      45,000; the maximum number of restricted stock units that may be granted
      to any one participant in any calendar year is 45,000; and the maximum
      dollar value of performance units that may be granted to any one
      participant in any calendar year is $1,500,000.  As of December
      31, 2009, the Company has granted 32,282 shares of restricted stock that
      are not reflected in column (a) of this
table.




20


Item 6.
              Selected
      Financial Data.





The
following table sets forth certain selected financial data for the five years
ended December 31, 2009, and is qualified in its entirety by the detailed
statistical and other information contained in this report, including
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations” appearing in Item 7 of Part II of this report and the financial
statements and notes thereto appearing in Item 8 of Part II of this
report.





Years Ended December 31,(Dollars in thousands, except per share
      data)
                
                2009
                
                
                2008
                
                
                2007
                
                
                2006
                
                
                2005RESULTS
      OF OPERATIONS:Interest
      income
                
                $
                58,789
                
                
                $
                61,474
                
                
                $
                65,141
                
                
                $
                57,971
                
                
                $
                47,384Interest
      expense
                
                
                17,411
                
                
                
                21,555
                
                
                
                24,105
                
                
                
                19,074
                
                
                
                11,899Net
      interest income
                
                
                41,378
                
                
                
                39,919
                
                
                
                41,036
                
                
                
                38,897
                
                
                
                35,485Provision
      for credit losses
                
                
                8,986
                
                
                
                3,337
                
                
                
                1,724
                
                
                
                1,493
                
                
                
                810Net
      interest income after provision for credit losses
                
                
                32,392
                
                
                
                36,582
                
                
                
                39,312
                
                
                
                37,404
                
                
                
                34,675Noninterest
      income
                
                
                19,541
                
                
                
                20,350
                
                
                
                14,679
                
                
                
                12,839
                
                
                
                11,498Noninterest
      expense
                
                
                40,248
                
                
                
                38,370
                
                
                
                32,539
                
                
                
                28,535
                
                
                
                25,431Income
      before income taxes
                
                
                11,685
                
                
                
                18,562
                
                
                
                21,452
                
                
                
                21,708
                
                
                
                20,742Income
      tax expense
                
                
                4,412
                
                
                
                7,092
                
                
                
                8,002
                
                
                
                8,154
                
                
                
                7,854Net
      income
                
                
                7,273
                
                
                
                11,470
                
                
                
                13,450
                
                
                
                13,554
                
                
                
                12,888Preferred
      stock dividends and discount accretion
                
                
                1,876
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Net
      income available to common stockholders
                
                $
                5,397
                
                
                $
                11,470
                
                
                $
                13,450
                
                
                $
                13,554
                
                
                $
                12,888PER
      COMMON SHARE DATA:Net
      income – basic
                
                $
                0.64
                
                
                $
                1.37
                
                
                $
                1.61
                
                
                $
                1.62
                
                
                $
                1.55Net
      income – diluted
                
                
                0.64
                
                
                
                1.37
                
                
                
                1.60
                
                
                
                1.61
                
                
                
                1.54Dividends
      paid
                
                
                0.64
                
                
                
                0.64
                
                
                
                0.64
                
                
                
                0.59
                
                
                
                0.54Book
      value (at year end)
                
                
                15.18
                
                
                
                15.16
                
                
                
                14.35
                
                
                
                13.28
                
                
                
                12.17Tangible
      book value (at year end)1
                
                
                12.64
                
                
                
                12.55
                
                
                
                11.68
                
                
                
                11.67
                
                
                
                10.51FINANCIAL
      CONDITION (at year end):Loans
                
                $
                916,557
                
                
                $
                888,528
                
                
                $
                776,350
                
                
                $
                699,719
                
                
                $
                627,463Assets
                
                
                1,156,516
                
                
                
                1,044,641
                
                
                
                956,911
                
                
                
                945,649
                
                
                
                851,638Deposits
                
                
                990,937
                
                
                
                845,371
                
                
                
                765,895
                
                
                
                774,182
                
                
                
                704,958Long-term
      debt
                
                
                1,429
                
                
                
                7,947
                
                
                
                12,485
                
                
                
                25,000
                
                
                
                4,000Stockholders’
      equity
                
                
                127,810
                
                
                
                127,385
                
                
                
                120,235
                
                
                
                111,327
                
                
                
                101,448PERFORMANCE
      RATIOS (for the year):Return
      on average total assets
                
                
                0.48
                %
                
                
                1.13
                %
                
                
                1.42
                %
                
                
                1.52
                %
                
                
                1.51
                %Return
      on average stockholders’ equity
                
                
                4.00
                
                
                
                9.22
                
                
                
                11.79
                
                
                
                12.66
                
                
                
                13.20Net
      interest margin
                
                
                3.90
                
                
                
                4.23
                
                
                
                4.64
                
                
                
                4.70
                
                
                
                4.69Efficiency
      ratio2
                
                
                66.07
                
                
                
                63.66
                
                
                
                58.40
                
                
                
                55.15
                
                
                
                54.13Dividend
      payout ratio
                
                
                100.00
                
                
                
                46.72
                
                
                
                39.75
                
                
                
                36.42
                
                
                
                34.84Average
      stockholders’ equity to average total assets
                
                
                11.96
                
                
                
                12.30
                
                
                
                12.04
                
                
                
                11.98
                
                
                
                11.86





1
              Total
      stockholders’ equity, net of goodwill and other intangible assets, divided
      by the number of shares of common stock outstanding at year
      end.


2
              Noninterest
      expense as a percentage of total revenue (net interest income plus total
      noninterest income).  Lower ratios indicate improved
      productivity.




21





Item 7.
              Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations.





The
following discussion compares the Company’s financial condition at December 31,
2009 to its financial condition at December 31, 2008 and the results of
operations for the years ended December 31, 2009, 2008, and
2007.  This discussion should be read in conjunction with the
Consolidated Financial Statements and the Notes thereto appearing in Item 8 of
Part II of this report.





PERFORMANCE
OVERVIEW


The
Company recorded a decline in net income for 2009 when compared to 2008 and
2007.  Net income available to common stockholders for the year ended
December 31, 2009 was $5.4 million, compared to $11.5 million and $13.5 million
for the years ended December 31, 2008 and 2007, respectively.  Basic
and diluted earnings per common share for 2009 was $0.64, a decrease of 53.3%
from basic and diluted earnings per common share of $1.37 for
2008.  In 2007, basic and diluted earnings per common share was $1.61
and $1.60, respectively.





During
2009, net income available to common stockholders was negatively impacted by
dividends and discount accretion associated with the sale and subsequent
redemption of the Company’s Series A Preferred Stock issued to the Treasury
under the TARP Capital Purchase Plan (the “CPP”).  The impact on 2009
earnings from the preferred stock activity was $1.9 million.





Return on
average assets was 0.48% for 2009, compared to 1.13% for 2008 and 1.42% for
2007.  Return on average stockholders’ equity for 2009 was 4.00%,
compared to 9.22% for 2008 and 11.79% for 2007.  Comparing the year
ended December 31, 2009 to the year ended December 31, 2008, average assets
increased 11.7% to $1.129 billion, average loans increased 9.1% to $913.6
million, average deposits increased 16.4% to $949.7 million, and average
stockholders’ equity increased 8.5% to $135.0 million.





CRITICAL
ACCOUNTING POLICIES


The
Company’s consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America and
follow general practices within the industries in which it operates. Application
of these principles requires management to make estimates, assumptions, and
judgments that affect the amounts reported in the financial statements and
accompanying notes.  These estimates, assumptions, and judgments are
based on information available as of the date of the financial statements;
accordingly, as this information changes, the financial statements could reflect
different estimates, assumptions, and judgments.  Certain policies
inherently have a greater reliance on the use of estimates, assumptions, and
judgments and as such have a greater possibility of producing results that could
be materially different than originally reported. Estimates, assumptions, and
judgments are necessary when assets and liabilities are required to be recorded
at fair value, when a decline in the value of an asset not carried on the
financial statements at fair value warrants an impairment write-down or
valuation reserve to be established, or when an asset or liability needs to be
recorded contingent upon a future event.  Carrying assets and
liabilities at fair value inherently results in more financial statement
volatility.  The fair values and the information used to record
valuation adjustments for certain assets and liabilities are based either on
quoted market prices or are provided by other third-party sources, when
available.





The most
significant accounting policies that the Company follows are presented in Note 1
to the Consolidated Financial Statements.  These policies, along with
the disclosures presented in the other financial statement notes and in this
discussion, provide information on how significant assets and liabilities are
valued in the financial statements and how those values are
determined.  Based on the valuation techniques used and the
sensitivity of financial statement amounts to the methods, assumptions, and
estimates underlying those amounts, management has determined that the
accounting policy with respect to the allowance for credit losses to be the
accounting area that requires the most subjective or complex judgments, and, as
such, could be most subject to revision as new information becomes
available.  Accordingly, the allowance for credit losses is considered
to be a critical accounting policy, as discussed below.





The
allowance for credit losses represents management’s estimate of credit losses
inherent in the loan portfolio as of the balance sheet
date.  Determining the amount of the allowance for credit losses is
considered a critical accounting estimate because it requires significant
judgment and the use of estimates related to the amount and timing of expected
future cash flows on impaired loans, estimated losses on pools of homogeneous
loans based on historical loss experience, and consideration of current economic
trends and conditions, all of which may be susceptible to significant
change.  The loan portfolio also represents the largest asset type on
the consolidated balance sheets.  Note 1 to the Consolidated Financial
Statements describes the methodology used to determine the allowance for credit
losses and a discussion of the factors driving changes in the amount of the
allowance for credit losses is included in the Provision for Credit Losses and
Risk Management section of this discussion.


22


RECENT
ACCOUNTING PRONOUNCEMENTS AND DEVELOPMENTS


The
Financial Accounting Standards Board’s (FASB) Accounting Standards Codification
became effective on July 1, 2009. At that date, the codification became FASB’s
officially recognized source of authoritative U.S. generally accepted accounting
principles (GAAP) applicable to all public and non-public non-governmental
entities, superseding existing FASB, American Institute of Certified Public
Accountants (AICPA), Emerging Issues Task Force (EITF) and related literature.
Rules and interpretive releases of the SEC under the authority of federal
securities laws are also sources of authoritative GAAP for SEC registrants. All
other accounting literature is considered non-authoritative. The switch to the
codification affects the way companies refer to U.S. GAAP in financial
statements and accounting policies. Citing particular content in the
codification involves specifying the unique numeric path to the content through
the Topic, Subtopic, Section and Paragraph structure.





Note 1 to
the Consolidated Financial Statements discusses new accounting policies that the
Company adopted during 2009 and the expected impact of accounting policies
recently issued or proposed but not yet required to be adopted.  To
the extent the adoption of new accounting standards materially affects our
financial condition, results of operations or liquidity, the impacts are
discussed in the applicable section(s) of this discussion and Notes to the
Consolidated Financial Statements.





RESULTS
OF OPERATIONS





Net
Interest Income and Net Interest Margin


In 2009,
the interest rate environment was less volatile than it was in the previous two
years.  During 2009, the FRB made no changes to the fed funds rate,
unlike during 2008 and 2007 when the FRB reduced the fed funds rate by 400 and
100 basis points, respectively.  The New York Prime rate, the primary
index used for variable rate loans, also remained unchanged during 2009 but
declined by 400 basis points during 2008 and 100 basis points during
2007.  These rate changes had a significant impact on our overall
yields earned and rates paid.





Net
interest income remains the most significant component of our
earnings.  It is the excess of interest and fees earned on loans,
investment securities, and federal funds sold over interest owed on deposits and
borrowings.  Tax equivalent net interest income for 2009 was $41.7
million, representing a 3.4% increase over 2008.    For
2009, higher average balances on earning assets and lower rates paid on interest
bearing liabilities were sufficient to offset the decline in yields on earning
assets.  Tax equivalent net interest income for 2008 was $40.3
million, a 2.7% decrease from 2007. During 2008, the increase in the volume of
earning assets and lower rates paid on interest bearing liabilities were not
enough to offset the decrease in yields on earning assets.  The tax
equivalent yield on earning assets was 5.53% for 2009, compared to 6.49% and
7.34% for 2008 and 2007, respectively. Average earning assets increased to
$1.069 billion during 2009, compared to $954.0 million and $893.0 million for
2008 and 2007, respectively.





The rate
paid for interest bearing liabilities was 2.01% for the year ended December 31,
2009, representing a decrease of 80 basis points from the 2.81% paid for the
year ended December 31, 2008.  In 2008, the overall rate paid for
interest bearing liabilities decreased 55 basis points when compared to the rate
paid for the year ended December 31, 2007.


23





The
following table sets forth the major components of net interest income, on a tax
equivalent basis, for the years ended December 31, 2009, 2008, and
2007.





2009
                            
                            
                            2008
                            
                            
                            2007Average
                            
                            
                            Interest
                            
                            
                            Yield/
                            
                            
                            Average
                            
                            
                            Interest
                            
                            
                            Yield/
                            
                            
                            Average
                            
                            
                            Interest
                            
                            
                            Yield(Dollars
      in thousands)
                            
                            Balance
                            
                            
                            (1)
                            
                            
                            Rate
                            
                            
                            Balance
                            
                            
                            (1)
                            
                            
                            Rate
                            
                            
                            Balance
                            
                            
                            (1)
                            
                            
                            /RateEarning
      assetsLoans
      (2) (3)
                            
                            $
                            913,631
                            
                            
                            $
                            55,369
                            
                            
                            
                            6.06
                            %
                            
                            $
                            837,739
                            
                            
                            $
                            57,041
                            
                            
                            
                            6.81
                            %
                            
                            $
                            728,766
                            
                            
                            $
                            57,637
                            
                            
                            
                            7.91
                            %Investment
      securities:Taxable
                            
                            
                            84,283
                            
                            
                            
                            3,184
                            
                            
                            
                            3.78
                            
                            
                            
                            85,105
                            
                            
                            
                            3,788
                            
                            
                            
                            4.45
                            
                            
                            
                            112,384
                            
                            
                            
                            5,105
                            
                            
                            
                            4.54Tax-exempt
                            
                            
                            8,071
                            
                            
                            
                            458
                            
                            
                            
                            5.67
                            
                            
                            
                            11,031
                            
                            
                            
                            646
                            
                            
                            
                            5.86
                            
                            
                            
                            13,424
                            
                            
                            
                            786
                            
                            
                            
                            5.85Federal
      funds sold
                            
                            
                            59,416
                            
                            
                            
                            84
                            
                            
                            
                            0.14
                            
                            
                            
                            16,427
                            
                            
                            
                            308
                            
                            
                            
                            1.87
                            
                            
                            
                            21,312
                            
                            
                            
                            1,108
                            
                            
                            
                            5.20Interest
      bearing deposits
                            
                            
                            3,200
                            
                            
                            
                            11
                            
                            
                            
                            0.35
                            
                            
                            
                            3,666
                            
                            
                            
                            92
                            
                            
                            
                            2.51
                            
                            
                            
                            17,086
                            
                            
                            
                            893
                            
                            
                            
                            5.23Total
      earning assets
                            
                            
                            1,068,601
                            
                            
                            
                            59,106
                            
                            
                            
                            5.53
                            %
                            
                            
                            953,968
                            
                            
                            
                            61,875
                            
                            
                            
                            6.49
                            %
                            
                            
                            892,972
                            
                            
                            
                            65,529
                            
                            
                            
                            7.34
                            %Cash
      and due from banks
                            
                            
                            17,049
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            14,829
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            16,938Other
      assets
                            
                            
                            54,016
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            50,275
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            44,136Allowance
      for credit losses
                            
                            
                            (10,754
                            )
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (8,270
                            )
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (6,898
                            )Total
      assets
                            
                            $
                            1,128,912
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            $
                            1,010,802
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            $
                            947,148Interest
      bearing liabilitiesDemand
      deposits
                            
                            $
                            124,758
                            
                            
                            
                            315
                            
                            
                            
                            0.25
                            %
                            
                            $
                            113,002
                            
                            
                            
                            437
                            
                            
                            
                            0.39
                            %
                            
                            $
                            112,553
                            
                            
                            
                            1,069
                            
                            
                            
                            0.95
                            %Money
      market and savings deposits
                            
                            
                            218,125
                            
                            
                            
                            1,354
                            
                            
                            
                            0.62
                            
                            
                            
                            175,376
                            
                            
                            
                            2,406
                            
                            
                            
                            1.37
                            
                            
                            
                            177,256
                            
                            
                            
                            3,175
                            
                            
                            
                            1.79Certificates
      of deposit $100,000 or more
                            
                            
                            258,879
                            
                            
                            
                            7,670
                            
                            
                            
                            2.96
                            
                            
                            
                            193,678
                            
                            
                            
                            7,955
                            
                            
                            
                            4.11
                            
                            
                            
                            159,532
                            
                            
                            
                            7,748
                            
                            
                            
                            4.86Other
      time deposits
                            
                            
                            234,468
                            
                            
                            
                            7,679
                            
                            
                            
                            3.28
                            
                            
                            
                            226,201
                            
                            
                            
                            9,079
                            
                            
                            
                            4.01
                            
                            
                            
                            213,823
                            
                            
                            
                            9,701
                            
                            
                            
                            4.54Interest
      bearing deposits
                            
                            
                            836,230
                            
                            
                            
                            17,018
                            
                            
                            
                            2.04
                            
                            
                            
                            708,257
                            
                            
                            
                            19,877
                            
                            
                            
                            2.81
                            
                            
                            
                            663,164
                            
                            
                            
                            21,693
                            
                            
                            
                            3.27Short-term
      borrowings
                            
                            
                            25,519
                            
                            
                            
                            127
                            
                            
                            
                            0.50
                            
                            
                            
                            47,765
                            
                            
                            
                            1,147
                            
                            
                            
                            2.40
                            
                            
                            
                            33,138
                            
                            
                            
                            1,264
                            
                            
                            
                            3.81Long-term
      debt
                            
                            
                            4,792
                            
                            
                            
                            266
                            
                            
                            
                            5.55
                            
                            
                            
                            11,598
                            
                            
                            
                            531
                            
                            
                            
                            4.58
                            
                            
                            
                            21,271
                            
                            
                            
                            1,148
                            
                            
                            
                            5.40Total
      interest bearing liabilities
                            
                            
                            866,541
                            
                            
                            
                            17,411
                            
                            
                            
                            2.01
                            %
                            
                            
                            767,620
                            
                            
                            
                            21,555
                            
                            
                            
                            2.81
                            %
                            
                            
                            717,573
                            
                            
                            
                            24,105
                            
                            
                            
                            3.36
                            %Noninterest
      bearing deposits
                            
                            
                            113,430
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            107,430
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            106,462Other
      liabilities
                            
                            
                            13,963
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            11,388
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            9,074Stockholders’
      equity
                            
                            
                            134,978
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            124,364
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            114,039Total
      liabilities and stockholders’ equity
                            
                            $
                            1,128,912
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            $
                            1,010,802
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            $
                            947,148Net
      interest spread
                            
                            
                            
                            
                            
                            $
                            41,695
                            
                            
                            
                            3.52
                            %
                            
                            
                            
                            
                            
                            $
                            40,320
                            
                            
                            
                            3.68
                            %
                            
                            
                            
                            
                            
                            $
                            41,424
                            
                            
                            
                            3.98
                            %Net
      interest margin
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            3.90
                            %
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            4.23
                            %
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            4.64
                            %





(1)
All amounts are reported on a tax equivalent basis computed using the statutory
federal income tax rate of 34.2% for 2009 and 35% for 2008 and 2007, exclusive
of the alternative minimum tax rate and nondeductible interest
expense.  The taxable equivalent adjustment amounts utilized in the
above table to compute yields aggregated $317 thousand in 2009, $401 thousand in
2008, and $388 thousand in 2007.


(2)
Average loan balances include nonaccrual loans.


(3)
Interest income on loans includes amortized loan fees, net of costs, and yields
are stated to include all.





On a tax
equivalent basis, total interest income was $59.1 million for 2009, compared to
$61.9 million for 2008 and $65.5 million for 2007. The Company’s largest source
of interest income is loans.  The tax equivalent yield on loans
decreased to 6.06% for 2009, compared to 6.81% for 2008 and 7.91% for
2007.   The $75.9 million increase in average loans was not
enough to offset the decrease of 75 basis points in the yield on loans which was
the primary reason for the decline in interest income in 2009.  The
decline in interest income in 2008 was due to similar reasons as in 2009 - a
$109.0 million increase in average loans was not enough to offset the decrease
of 110 basis points in the yield on loans.  For 2009, average federal
funds sold increased while average investment securities and interest bearing
deposits with other banks decreased.  All of the yields on these other
earning assets decreased in 2009 compared to yields in 2008.  For
2008, the volume and yields on all other earning assets decreased when compared
to 2007.  During 2009, the overall decrease in yields on earning
assets produced $2.8 million less in interest income, $7.7 million of which was
due to lower rates net of $4.9 million due to increased volume.  In
2008, the overall decrease in yields on earning assets produced $3.7 million
less in interest income, $5.8 million of which was due to lower rates net of
$2.1 million due to increased volume.


24





Interest
expense was $17.4 million for 2009, compared to $21.6 million for 2008 and $24.1
million for 2007. Although overall volume increased, lower rates paid for
interest bearing liabilities, primarily deposits and short-term borrowings, was
the main reason for the decrease in interest expense in 2009. A similar
situation prevailed during 2008, with overall volumes increasing but rates
decreasing enough to reduce interest expense.  The Company incurs the
largest amount of interest expense from time deposits. The average rate paid for
certificates of deposit of $100,000 or more decreased 115 basis points to 2.96%
for 2009 from 4.11% for 2008 and decreased 75 basis points in 2008 from 4.86%
for 2007.   The  rate paid for all other time deposits
decreased 73 basis points to 3.28% for 2009, compared to 4.01% for 2008, and
decreased 53 basis points in 2008 from 4.54% for 2007.   During
2009, the overall decrease in rates on interest bearing liabilities produced
$4.1 million less in interest expense, $6.5 million of which was due to lower
rates net of $2.4 million due to increased volume.  In 2008, the
overall decrease in rates on interest bearing liabilities produced $2.5 million
less in interest expense, $3.9 million of which was due to lower rates net of
$1.4 million due to increased volume.





Average
earning assets grew $114.6 million, or 12.0%, for the year ended December 31,
2009, driven primarily by growth in loans.  In 2008, average earning
assets increased $61.0 million, or 6.8%, when compared to 2007, also mainly due
to loan growth. Average loans increased 9.1%, totaling $913.6 million for the
year ended December 31, 2009, compared to an increase of  15.0% for
2008. For the year ended December 31, 2009, average investment securities and
interest bearing deposits in other banks  decreased a combined $4.2
million, or 4.3%, while federal funds sold was $59.4 million, nearly four times
the amount for 2008. The increase in federal funds sold represented the excess
available for funding earning assets from increased deposits. Average investment
securities decreased 24.0%, interest bearing deposits in other banks decreased
78.5% and federal funds sold decreased 22.9% for 2008 when compared to
2007.   As a percentage of total average earning assets, loans,
investment securities and federal funds sold were 85.5%, 8.6%  and
5.6%, respectively, for 2009, compared to 87.8%, 10.1%  and 1.7%,
respectively, for 2008 and 81.6%, 14.1% and 2.4%, respectively, for
2007.





The
following Rate/Volume Variance Analysis identifies the portion of the changes in
tax equivalent net interest income attributable to changes in volume of average
balances or to changes in the yield on earning assets and rates paid on interest
bearing liabilities.




2009 over (under) 2008
                      
                      
                      2008 over (under) 2007Total
                      
                      
                      Caused By
                      
                      
                      Total
                      
                      
                      Caused By(Dollars in thousands)
                      
                      Variance
                      
                      
                      Rate
                      
                      
                      Volume
                      
                      
                      Variance
                      
                      
                      Rate
                      
                      
                      VolumeInterest
      income from earning assets:Loans
                      
                      $
                      (1,672
                      )
                      
                      $
                      (6,583
                      )
                      
                      $
                      4,911
                      
                      
                      $
                      (596
                      )
                      
                      $
                      (4,880
                      )
                      
                      $
                      4,284Taxable
      investment securities
                      
                      
                      (604
                      )
                      
                      
                      (568
                      )
                      
                      
                      (36
                      )
                      
                      
                      (1,317
                      )
                      
                      
                      (111
                      )
                      
                      
                      (1,206
                      )Tax-exempt
      investment securities
                      
                      
                      (188
                      )
                      
                      
                      (20
                      )
                      
                      
                      (168
                      )
                      
                      
                      (140
                      )
                      
                      
                      1
                      
                      
                      
                      (141
                      )Federal
      funds sold
                      
                      
                      (224
                      )
                      
                      
                      (479
                      )
                      
                      
                      255
                      
                      
                      
                      (800
                      )
                      
                      
                      (455
                      )
                      
                      
                      (345
                      )Interest
      bearing deposits
                      
                      
                      (81
                      )
                      
                      
                      (71
                      )
                      
                      
                      (10
                      )
                      
                      
                      (801
                      )
                      
                      
                      (320
                      )
                      
                      
                      (481
                      )Total
      interest income
                      
                      
                      (2,769
                      )
                      
                      
                      (7,721
                      )
                      
                      
                      4,952
                      
                      
                      
                      (3,654
                      )
                      
                      
                      (5,765
                      )
                      
                      
                      2,111Interest
      expense on depositsand
      borrowed funds:Interest
      bearing demand deposits
                      
                      
                      (122
                      )
                      
                      
                      (164
                      )
                      
                      
                      42
                      
                      
                      
                      (632
                      )
                      
                      
                      (636
                      )
                      
                      
                      4Money
      market and savings deposits
                      
                      
                      (1,052
                      )
                      
                      
                      (1,627
                      )
                      
                      
                      575
                      
                      
                      
                      (769
                      )
                      
                      
                      (801
                      )
                      
                      
                      32Time
      deposits
                      
                      
                      (1,685
                      )
                      
                      
                      (4,278
                      )
                      
                      
                      2,593
                      
                      
                      
                      (415
                      )
                      
                      
                      (1,727
                      )
                      
                      
                      1,312Short-term
      borrowings
                      
                      
                      (1,020
                      )
                      
                      
                      (604
                      )
                      
                      
                      (416
                      )
                      
                      
                      (117
                      )
                      
                      
                      (627
                      )
                      
                      
                      510Long-term
      debt
                      
                      
                      (265
                      )
                      
                      
                      95
                      
                      
                      
                      (360
                      )
                      
                      
                      (617
                      )
                      
                      
                      (155
                      )
                      
                      
                      (462
                      )Total
      interest expense
                      
                      
                      (4,144
                      )
                      
                      
                      (6,578
                      )
                      
                      
                      2,434
                      
                      
                      
                      (2,550
                      )
                      
                      
                      (3,946
                      )
                      
                      
                      1,396Net
      interest income
                      
                      $
                      1,375
                      
                      
                      $
                      (1,143
                      )
                      
                      $
                      2,518
                      
                      
                      $
                      (1,104
                      )
                      
                      $
                      (1,819
                      )
                      
                      $
                      715


The
rate and volume variance for each category has been allocated on a consistent
basis between rate and volume variances, based on a percentage of rate, or
volume, variance to the sum of the absolute two variances.





Our net
interest margin (i.e.,
tax equivalent net interest income divided by average earning assets) represents
the net yield on earning assets.   The net interest margin is
managed through loan and deposit pricing and asset/liability
strategies.  The net interest margin was 3.90% for 2009, compared to
4.23% for 2008 and 4.64% for 2007.  The increase in net interest
income was not enough to improve the net interest margin in 2009 when compared
to 2008. The lower net interest margin in 2008 when compared to 2007 was
primarily due to decreased yields on earning assets. The net interest spread,
which is the difference between the average yield on earning assets and the rate
paid for interest bearing liabilities, was 3.52% for 2009, 3.68% for 2008 and
3.98% for 2007.


25


Noninterest
Income


Noninterest
income decreased $809 thousand, or 4.0%, in 2009, compared to an increase of
$5.7 million, or 38.6%, in 2008.  A decline in insurance agency
commissions of $959 thousand and net gains on asset sales of $524 thousand in
2008 accounted for most of the decrease in 2009, partially offset by an increase
of $687 thousand in other noninterest income.   The net gains in
2008 included a $1.3 million gain on the sale of a bank branch, offset by a
combined $386 thousand other than temporary impairment and subsequent loss on
the sale of Freddie Mac Preferred Stock and a $337 thousand loss on the sale of
the Company’s investment in Delmarva Bank Data Processing Center, Inc., an
unconsolidated subsidiary.  The increase in other noninterest income
in 2009 when compared to 2008 included a $420 thousand mark to market gain on
interest rate swaps and a $273 thousand increase in revenue from the mortgage
subsidiary.





The
increase in noninterest income in 2008 when compared to 2007 was primarily
related to the acquisition of two insurance entities during the fourth quarter
of 2007.  Other service charges and fees increased $834 thousand,
approximately half of which was from the new insurance entities, 30% was from
the trust division, and the remainder was from banking
activities.   Insurance agency commissions income was $12.1
million in 2008, compared to $7.7 million in 2007, with the increase of $4.4
million primarily due to the two insurance entities acquired in
2007.  The previously mentioned $524 thousand one-time net gains on
asset sales during 2008 also added to the increase over
2007.  Partially offsetting these increases was a decrease of $438
thousand in other noninterest income primarily due to less revenue from the
mortgage subsidiary.





The
following table summarizes our noninterest income for the years ended December
31.





Years Ended
                              
                              
                              Change from Prior Year2009/08
                              
                              
                              2008/07(Dollars in thousands)
                              
                              2009
                              
                              
                              2008
                              
                              
                              2007
                              
                              
                              Amount
                              
                              
                              Percent
                              
                              
                              Amount
                              
                              
                              PercentService
      charges on deposit accounts
                              
                              $
                              3,424
                              
                              
                              $
                              3,600
                              
                              
                              $
                              3,372
                              
                              
                              $
                              (176
                              )
                              
                              
                              (4.9
                              )%
                              
                              $
                              228
                              
                              
                              
                              6.8
                              %Other
      service charges and fees
                              
                              
                              3,143
                              
                              
                              
                              3,029
                              
                              
                              
                              2,195
                              
                              
                              
                              114
                              
                              
                              
                              3.8
                              
                              
                              
                              834
                              
                              
                              
                              38.0Gains
      (losses) on sales of investment securities
                              
                              
                              49
                              
                              
                              
                              (15
                              )
                              
                              
                              5
                              
                              
                              
                              64
                              
                              
                              
                              426.7
                              
                              
                              
                              (20
                              )
                              
                              
                              (400.0
                              )Other
      than temporary impairment of securities
                              
                              
                              -
                              
                              
                              
                              (371
                              )
                              
                              
                              -
                              
                              
                              
                              371
                              
                              
                              
                              100.0
                              
                              
                              
                              (371
                              )
                              
                              
                              -Insurance
      agency commissions income
                              
                              
                              11,131
                              
                              
                              
                              12,090
                              
                              
                              
                              7,698
                              
                              
                              
                              (959
                              )
                              
                              
                              (7.9
                              )
                              
                              
                              4,392
                              
                              
                              
                              57.1Gains
      (losses) on disposals of premises and equipment
                              
                              
                              -
                              
                              
                              
                              1,247
                              
                              
                              
                              (136
                              )
                              
                              
                              (1,247
                              )
                              
                              
                              (100.0
                              )
                              
                              
                              1,383
                              
                              
                              
                              1,016.9Loss
      on sale of investment in unconsolidated subsidiary
                              
                              
                              -
                              
                              
                              
                              (337
                              )
                              
                              
                              -
                              
                              
                              
                              337
                              
                              
                              
                              100.0
                              
                              
                              
                              (337
                              )
                              
                              
                              -Other
      noninterest income:Interest
      rate swaps
                              
                              
                              420
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              420
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -Mortgage
      broker fees
                              
                              
                              848
                              
                              
                              
                              575
                              
                              
                              
                              955
                              
                              
                              
                              273
                              
                              
                              
                              47.5
                              
                              
                              
                              (380
                              )
                              
                              
                              (39.8
                              )Other
                              
                              
                              526
                              
                              
                              
                              532
                              
                              
                              
                              590
                              
                              
                              
                              (6
                              )
                              
                              
                              (1.1
                              )
                              
                              
                              (58
                              )
                              
                              
                              (9.8
                              )Total
                              
                              
                              1,794
                              
                              
                              
                              1,107
                              
                              
                              
                              1,545
                              
                              
                              
                              687
                              
                              
                              
                              62.1
                              
                              
                              
                              (438
                              )
                              
                              
                              (28.3
                              )Total
                              
                              $
                              19,541
                              
                              
                              $
                              20,350
                              
                              
                              $
                              14,679
                              
                              
                              $
                              (809
                              )
                              
                              
                              (4.0
                              )
                              
                              $
                              5,671
                              
                              
                              
                              38.6





Noninterest
Expense


Total
noninterest expense increased $1.9 million, or 4.9%,  in 2009, which
was lower than the increase of $5.8 million, or 17.9%, in 2008.  A
significant portion of the increase in 2009 was due to increased FDIC insurance
premium expense of $1.7 million when compared to 2008.  The increase
in FDIC insurance premiums was attributable to higher overall rates, a one-time
special assessment of $513 thousand and growth in our deposits.  Other
noninterest expenses for 2009 increased $490 thousand when compared to 2008,
over half of which included expenses related to collection and other real estate
owned activities.  Occupancy expense increased $145 thousand mainly
due to one additional bank branch and usual annual rent
increases.  Partially offsetting these increases in expense were lower
insurance agency commissions expense of $335 thousand and lower employee
benefits expense of $264 thousand.  Employee benefits declined from
2008 amounts primarily due to less expense accrued for the Company’s profit
sharing plan contribution for 2009.





The
increase in noninterest expense in 2008 when compared to 2007 was primarily
attributable to the operating costs of the two insurance entities acquired
during the fourth quarter of 2007. These operating costs included salaries,
benefits, occupancy, amortization of intangibles, insurance agency commissions
and other noninterest expenses.  Furniture and equipment, data
processing and directors’ fees expenses either decreased or remained relatively
flat compared to 2007.




26




Amortization
of other intangible assets relate to Felton Bank and the operation of the
Insurance Subsidiaries.  See Note 8 to the Consolidated Financial
Statements for further information regarding the impact of goodwill and other
intangible assets on the financial statements.




We had
335 full-time equivalent employees at December 31, 2009, compared to 333 and 338
at December 31, 2008 and 2007, respectively.





The
following table summarizes our noninterest expense for the years ended December
31.





Years Ended
                          
                          
                          Change from Prior Year2009/08
                          
                          
                          2008/07(Dollars in thousands)
                          
                          2009
                          
                          
                          2008
                          
                          
                          2007
                          
                          
                          Amount
                          
                          
                          Percent
                          
                          
                          Amount
                          
                          
                          PercentSalaries
      and wages
                          
                          $
                          18,488
                          
                          
                          $
                          18,426
                          
                          
                          $
                          15,947
                          
                          
                          $
                          62
                          
                          
                          
                          0.3
                          %
                          
                          $
                          2,479
                          
                          
                          
                          15.5
                          %Employee
      benefits
                          
                          
                          4,631
                          
                          
                          
                          4,895
                          
                          
                          
                          4,044
                          
                          
                          
                          (264
                          )
                          
                          
                          (5.4
                          )
                          
                          
                          851
                          
                          
                          
                          21.0Occupancy
      expense
                          
                          
                          2,324
                          
                          
                          
                          2,179
                          
                          
                          
                          1,962
                          
                          
                          
                          145
                          
                          
                          
                          6.7
                          
                          
                          
                          217
                          
                          
                          
                          11.1Furniture
      and equipment expense
                          
                          
                          1,183
                          
                          
                          
                          1,185
                          
                          
                          
                          1,312
                          
                          
                          
                          (2
                          )
                          
                          
                          (0.2
                          )
                          
                          
                          (127
                          )
                          
                          
                          (9.7
                          )Data
      processing
                          
                          
                          2,463
                          
                          
                          
                          2,323
                          
                          
                          
                          2,175
                          
                          
                          
                          140
                          
                          
                          
                          6.0
                          
                          
                          
                          148
                          
                          
                          
                          6.8Directors’
      fees
                          
                          
                          478
                          
                          
                          
                          558
                          
                          
                          
                          605
                          
                          
                          
                          (80
                          )
                          
                          
                          (14.3
                          )
                          
                          
                          (47
                          )
                          
                          
                          (7.8
                          )Amortization
      of intangible assets
                          
                          
                          515
                          
                          
                          
                          515
                          
                          
                          
                          333
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          182
                          
                          
                          
                          54.7Insurance
      agency commissions expense
                          
                          
                          1,913
                          
                          
                          
                          2,248
                          
                          
                          
                          557
                          
                          
                          
                          (335
                          )
                          
                          
                          (14.9
                          )
                          
                          
                          1,691
                          
                          
                          
                          303.6FDIC
      insurance premium expense
                          
                          
                          2,078
                          
                          
                          
                          356
                          
                          
                          
                          99
                          
                          
                          
                          1,722
                          
                          
                          
                          483.7
                          
                          
                          
                          257
                          
                          
                          
                          259.6Other
      noninterest expense
                          
                          
                          6,175
                          
                          
                          
                          5,685
                          
                          
                          
                          5,505
                          
                          
                          
                          490
                          
                          
                          
                          8.6
                          
                          
                          
                          180
                          
                          
                          
                          3.3Total
                          
                          $
                          40,248
                          
                          
                          $
                          38,370
                          
                          
                          $
                          32,539
                          
                          
                          $
                          1,878
                          
                          
                          
                          4.9
                          
                          
                          $
                          5,831
                          
                          
                          
                          17.9





Income
Taxes


Income
tax expense was $4.4 million for 2009, compared to $7.1 million for 2008 and
$8.0 million for 2007. The effective tax rates on earnings were 37.8%, 38.2% and
37.3% for 2009, 2008, and 2007, respectively.  The effective tax rate
decreased in 2009 mainly because the Company’s federal income tax rate was
34.2%, compared to 35.0% for 2008. The higher effective tax rate in 2008 was
primarily due to a 1.25% increase in the Maryland corporate income tax rate at
the beginning of 2008.





REVIEW
OF FINANCIAL CONDITION





Asset and
liability composition, asset quality, capital resources, liquidity, market risk
and interest sensitivity are all factors that affect our financial
condition.





Assets


Total
assets increased 10.7% during 2009 to $1.157 billion at December 31, 2009,
compared to an increase of 9.2% for 2008. Average total assets for the year
ended December 31, 2009 were $1.129 billion, an increase of 11.7% over
2008.  Average total assets increased 6.7% in 2008, totaling $1.011
billion for the year.  The loan portfolio is the primary source of our
income, and it represented 85.5%, 87.8% and 81.6% of average earning assets for
2009, 2008 and 2007, respectively.





Funding
for loans is provided primarily by core deposits.  Additional funding
is obtained through short-term and long-term borrowings.  Average
total deposits increased 16.4% to $949.7 million at December 31, 2009, compared
to a 6.0% increase for 2008.Deposits provided funding
for approximately 88.9%, 85.5% and 86.2% of average earning assets for 2009,
2008 and 2007, respectively.





The
following table sets forth the average balance of the components of average
earning assets as a percentage of total average earning assets for the year
ended December 31.





2009
                
                
                2008
                
                
                2007
                
                
                2006
                
                
                2005Loans
                
                
                85.5
                %
                
                
                87.8
                %
                
                
                81.6
                %
                
                
                79.6
                %
                
                
                79.6
                %Investment
      securities
                
                
                8.6
                
                
                
                10.1
                
                
                
                14.1
                
                
                
                14.8
                
                
                
                15.9Federal
      funds sold
                
                
                5.6
                
                
                
                1.7
                
                
                
                2.4
                
                
                
                3.4
                
                
                
                4.1Interest
      bearing deposits with other banks
                
                
                0.3
                
                
                
                0.4
                
                
                
                1.9
                
                
                
                2.2
                
                
                
                0.4100.0
                %
                
                
                100.0
                %
                
                
                100.0
                %
                
                
                100.0
                %
                
                
                100.0
                %




27


Interest
Bearing Deposits With Other Banks and Federal Funds Sold


We invest
excess cash balances in interest bearing accounts and federal funds sold offered
by our correspondent banks.  These liquid investments are maintained
at a level necessary to meet immediate liquidity needs.  Average
interest bearing deposits with other banks and federal funds sold increased
$42.5 million to $62.6 million for the year ended December 31, 2009, compared to
a decrease of $18.3 million in 2008. The increase in 2009 represented the excess
available for funding earning assets from increased deposits and created
additional liquidity.





Investment
Securities


The
investment portfolio is structured to provide us with liquidity and also plays
an important role in the overall management of interest rate
risk.    Investment securities available for sale are stated
at estimated fair value based on quoted market prices.  They represent
securities which may be sold as part of the asset/liability management strategy
or which may be sold in response to changing interest rates.  Net
unrealized holding gains and losses on these securities are reported net of
related income taxes as accumulated other comprehensive income, a separate
component of stockholders’ equity.  Investment securities in the held
to maturity category are stated at cost adjusted for amortization of premiums
and accretion of discounts.  We have the intent and current ability to
hold such securities until maturity. At December 31, 2009, 92% of the portfolio
was classified as available for sale and 8% as held to maturity, compared to 89%
and 11%, respectively, at December 31, 2008 and 88% and 12%, respectively, at
December 31, 2007.  The percentage of securities designated as
available for sale reflects the amount needed to support our anticipated growth
and liquidity needs.  With the exception of municipal securities, our
general practice is to classify all newly purchased securities as available for
sale.





Investment
securities available for sale increased $21.5 million, or 27.2%, in 2009,
totaling $100.7 million at December 31, 2009, compared to $79.2 million at
December 31, 2008.  In 2008, investment securities available for sale
decreased $17.9 million, or 18.5%.





Investment
securities held to maturity, consisting primarily of tax-exempt municipal bonds,
totaled $8.9 million at December 31, 2009, compared to $10.3 million at December
31, 2008 and $12.9 million at December 31, 2007.  We do not typically
invest in structured notes or other derivative securities.





The
following table sets forth the maturities and weighted average yields of the
bond investment portfolio as of December 31, 2009.





1 Year or Less
                        
                        
                        1-5 Years
                        
                        
                        5-10 Years
                        
                        
                        Over 10 YearsCarrying
                        
                        
                        Average
                        
                        
                        Carrying
                        
                        
                        Average
                        
                        
                        Carrying
                        
                        
                        Average
                        
                        
                        Carrying
                        
                        
                        Average(Dollars in thousands)
                        
                        Amount
                        
                        
                        Yield
                        
                        
                        Amount
                        
                        
                        Yield
                        
                        
                        Amount
                        
                        
                        Yield
                        
                        
                        Amount
                        
                        
                        YieldAvailable
      for sale:U.S.
      Treasury and government agencies
                        
                        $
                        7,557
                        
                        
                        
                        3.09
                        %
                        
                        $
                        37,217
                        
                        
                        
                        2.88
                        %
                        
                        $
                        10,019
                        
                        
                        
                        4.21
                        %
                        
                        $
                        5,945
                        
                        
                        
                        3.65
                        %Mortgage-backed
      securities
                        
                        
                        1,427
                        
                        
                        
                        6.52
                        
                        
                        
                        9,864
                        
                        
                        
                        4.82
                        
                        
                        
                        7,527
                        
                        
                        
                        4.22
                        
                        
                        
                        17,489
                        
                        
                        
                        4.20Total
      available for sale
                        
                        $
                        8,984
                        
                        
                        
                        3.62
                        
                        
                        $
                        47,081
                        
                        
                        
                        3.28
                        
                        
                        $
                        17,546
                        
                        
                        
                        4.22
                        
                        
                        $
                        23,434
                        
                        
                        
                        3.67Held
      to maturity:Obligations
      of states and political subdivisions1
                        
                        $
                        2,470
                        
                        
                        
                        5.39
                        %
                        
                        $
                        4,514
                        
                        
                        
                        5.18
                        %
                        
                        $
                        943
                        
                        
                        
                        4.27
                        %
                        
                        $
                        1,013
                        
                        
                        
                        5.21
                        %1Yields
      adjusted to reflect a tax equivalent basis assuming a federal tax rate of
      34.2%.





Loans


During
2009, loan growth slowed compared to the prior year as the weakened economy
created fewer loan opportunities and  more loan charge
offs.   Loans, net of unearned income, totaled $916.6 million at
December 31, 2009, an increase of $28.0 million, or 3.2%, over
2008.  Loans increased $112.2 million, or 14.4%,  in 2008
when compared to 2007.  Because most of our loans are secured by real
estate, the largest impact on the slower growth was in the combination
of  construction, residential and commercial real estate loans, which
increased $31.5 million, or 4.1%, in 2009, compared to an increase of $113.1
million, or 17.1%, in 2008. Commercial loans, which include financial and
agricultural loans, remained relatively flat in 2009 and in
2008.  Consumer loans, a small percentage of the overall loan
portfolio, decreased $3.6 million and $300 thousand in 2009 and 2008,
respectively.  At December 31, 2009, 52.2% of the loan portfolio had
fixed interest rates and 47.8% had adjustable interest rates.  We have
brokered long-term fixed rate residential mortgage loans for sale on the
secondary market since 2002.  At December 31, 2009, 2008 and 2007,
there were no loans held for sale. We do not engage in foreign or subprime
lending activities.


28





The table
below sets forth trends in the composition of the loan portfolio over the past
five years (including net deferred loan fees/costs).





December 31,(Dollars in thousands)
                
                2009
                
                
                2008
                
                
                2007
                
                
                2006
                
                
                2005Real
      estate – construction
                
                $
                161,437
                
                
                $
                179,847
                
                
                $
                155,513
                
                
                $
                158,943
                
                
                $
                134,380Real
      estate – residential
                
                
                327,873
                
                
                
                289,510
                
                
                
                256,195
                
                
                
                222,687
                
                
                
                212,769Real
      estate – commercial
                
                
                315,930
                
                
                
                304,396
                
                
                
                248,953
                
                
                
                217,781
                
                
                
                187,860Commercial
                
                
                91,783
                
                
                
                91,644
                
                
                
                92,258
                
                
                
                80,186
                
                
                
                75,527Consumer
                
                
                19,534
                
                
                
                23,131
                
                
                
                23,431
                
                
                
                20,122
                
                
                
                16,927Total
                
                $
                916,557
                
                
                $
                888,528
                
                
                $
                776,350
                
                
                $
                699,719
                
                
                $
                627,463





The table
below sets forth the maturities and interest rate sensitivity of the loan
portfolio at December 31, 2009.





(Dollars in thousands)
                
                Maturing
                  within one year
                
                
                Maturing after
                  one but within
                  five years
                
                
                Maturing after
                  five years
                
                
                TotalReal
      estate – construction
                
                $
                118,120
                
                
                $
                35,641
                
                
                $
                7,676
                
                
                $
                161,437Real
      estate – residential
                
                
                112,847
                
                
                
                109,755
                
                
                
                105,271
                
                
                
                327,873Real
      estate – commercial
                
                
                98,546
                
                
                
                192,114
                
                
                
                25,270
                
                
                
                315,930Commercial
                
                
                49,889
                
                
                
                29,695
                
                
                
                12,199
                
                
                
                91,783Consumer
                
                
                11,991
                
                
                
                6,267
                
                
                
                1,276
                
                
                
                19,534Total
                
                $
                391,393
                
                
                $
                373,472
                
                
                $
                151,692
                
                
                $
                916,557Rate
      terms:Fixed-interest
      rate loans
                
                $
                144,050
                
                
                $
                285,917
                
                
                $
                48,835
                
                
                $
                478,802Adjustable-interest
      rate loans
                
                
                247,343
                
                
                
                87,555
                
                
                
                102,857
                
                
                
                437,755Total
                
                $
                391,393
                
                
                $
                373,472
                
                
                $
                151,692
                
                
                $
                916,557





Deposits


We use
core deposits primarily to fund loans and to purchase investment
securities.   Average deposits increased $134.0 million, or
16.4%, in 2009, compared to a 6.0% increase in 2008.  The majority of
the deposit growth was in certificates of deposit during 2009 and
2008.  Average certificates of deposit $100,000 or more increased
$65.2 million, or 33.7%, in 2009, compared to an increase of $34.1 million, or
21.4%, in 2008.  Large municipal deposits, expanded levels of FDIC
insurance coverage and customers seeking investments with less risk contributed
to the increase.  Average other time deposits increased $8.3 million
and $12.4 million in 2009 and 2008, respectively.  During the second
quarter of 2009, the Company began to participate in the Promontory Insured
Network Deposits Program (“IND”), affecting the growth in average money market
and savings deposits which increased $42.7 million, or 24.4%, from the
comparable amounts for 2008. The impact from the IND program was an increase of
$58.6 million in average money market deposits partially offset by a decrease
from funds shifting to certificates of deposit.  The IND program has a
five-year term and has a guaranteed minimum funding level of $70
million.  Money market and savings deposits decreased $1.9 million, or
1.1%, for 2008.  As in 2009, the competitive environment and higher
rates offered for certificates of deposit caused a shifting of balances from
money market to certificates of deposit in 2008. Average interest bearing demand
deposits increased $11.8 million, or 10.4%, in 2009 but increased less than one
percent in 2008. Participation in IND in 2009 contributed to $1.1 million of the
increase. The Banks continued to focus growth initiatives on core deposits
during 2009. Average noninterest bearing demand deposits increased $6.0 million,
or 5.6%, for 2009, compared to a slight increase in 2008.


29


The
following table sets forth the average balances of deposits and the percentage
of each category to total average deposits for the years ended December
31.





Average Balances(Dollars
      in thousands)
                
                2009
                
                
                2008
                
                
                2007Noninterest
      bearing demand
                
                $
                113,430
                
                
                
                11.9
                %
                
                $
                107,430
                
                
                
                13.2
                %
                
                $
                106,462
                
                
                
                13.9
                %Interest
      bearing depositsDemand
                
                
                124,758
                
                
                
                13.1
                
                
                
                113,002
                
                
                
                13.9
                
                
                
                112,553
                
                
                
                14.6Money
      market and savings
                
                
                218,125
                
                
                
                23.0
                
                
                
                175,376
                
                
                
                21.5
                
                
                
                177,256
                
                
                
                23.0Certificates
      of deposit $100,000 or more
                
                
                258,879
                
                
                
                27.3
                
                
                
                193,678
                
                
                
                23.7
                
                
                
                159,532
                
                
                
                20.7Other
      time deposits
                
                
                234,468
                
                
                
                24.7
                
                
                
                226,201
                
                
                
                27.7
                
                
                
                213,823
                
                
                
                27.8Total
                
                $
                949,660
                
                
                
                100.0
                %
                
                $
                815,687
                
                
                
                100.0
                %
                
                $
                769,626
                
                
                
                100.0
                %





The
following table sets forth the maturity ranges of certificates of deposit with
balances of $100,000 or more as of December 31, 2009.





(Dollars in thousands)Three
      months or less
                    
                    $
                    101,350Over
      three through twelve months
                    
                    
                    118,016Over
      twelve months
                    
                    
                    43,297Total
                    
                    $
                    262,663





Short-Term
Borrowings


Short-term
borrowings primarily consist of securities sold under agreements to repurchase
and short-term borrowings from the FHLB.  Securities sold under
agreements to repurchase are issued in conjunction with cash management services
for commercial depositors.  We also borrow from the FHLB on a
short-term basis and occasionally borrow from correspondent banks under federal
fund lines of credit arrangements to meet short-term liquidity needs. At
December 31, 2009, short-term borrowings included $3.4 million drawn on a $10.0
million line of credit with a commercial bank.  The Company obtained
this line of credit during the fourth quarter of 2009.





The
average balance of short-term borrowings decreased $22.2 million, or 46.6%, in
2009, whereas the balance increased $14.6 million, or 44.1%, in
2008.  The decrease in average short-term borrowings in 2009 reflected
less dependence on  short-term borrowings for funding growth than was
required in 2008. Also, the need for short-term borrowings was reduced due to
larger increases in average deposits during 2009 than in 2008.





The
following table sets forth our position with respect to short-term
borrowings.





2009
                
                
                2008
                
                
                2007Interest
                
                
                
                
                
                Interest
                
                
                
                
                
                Interest(Dollars in thousands)
                
                Balance
                
                
                Rate
                
                
                Balance
                
                
                Rate
                
                
                Balance
                
                
                RateAverage
      outstanding for the year
                
                $
                25,519
                
                
                
                0.50
                %
                
                $
                47,765
                
                
                
                2.40
                %
                
                $
                33,138
                
                
                
                3.81
                %Outstanding
      at year end
                
                
                20,404
                
                
                
                0.82
                
                
                
                52,969
                
                
                
                0.49
                
                
                
                47,694
                
                
                
                3.86Maximum
      outstanding at any month end
                
                
                46,270
                
                
                
                -
                
                
                
                73,094
                
                
                
                -
                
                
                
                57,036
                
                
                
                -





Long-Term
Debt


We use
long-term borrowings from the FHLB to meet longer term liquidity needs,
specifically to fund loan growth where deposit growth is not
sufficient.  At the end of 2009, there were no long-term borrowings
outstanding from the FHLB. The $6.0 million FHLB long-term borrowings
outstanding at the end of 2008 were repaid in July of 2009, in connection with
which we incurred a $78 thousand early repayment penalty that was reflected in
interest expense.  At December 31, 2009, our long-term debt was $1.4
million, a decrease of $6.5 million from year-end 2008.  Long-term
debt at December 31, 2008 decreased $4.5 million when compared to year-end
2007.  All long-term debt at year-end 2009 was related to the
acquisition of TSGIA in 2007.  Acquisition-related debt was $1.9
million and $2.5 million of total long-term debt at year-end 2008 and 2007,
respectively.


30


Capital
Management


Total
stockholders’ equity for the Company was $127.8 million at December 31, 2009,
slightly higher than the previous year.  Stockholders’ equity at
December 31, 2008 increased 5.9% over December 31, 2007.  The
increases in stockholders’ equity in 2009 and 2008 were due primarily to
earnings for those years, reduced by dividends paid on shares of the common
stock of the Company. In addition, during 2009 stockholders’ equity increased
$1.5 million due to the Warrant issued to the Treasury under the CPP but
decreased $1.8 million as a result of dividends paid on the Company’s Series A
Preferred Stock issued under the CPP.  Management plans to retain more
from earnings in stockholders’ equity by reducing dividends in
2010.  The Company reduced the quarterly common stock dividend
to $0.06 from $0.16 per share, effective for the dividend
payable February 26, 2010.  The reduction in dividends and
resultant increase in capital projected for 2010 is intended to support the
Company’s growth and enhance capital ratios.  Even though
stockholders’ equity remained relatively flat at the end of 2009 when compared
to 2008, the Company and the Banks continued to maintain capital at levels in
excess of the risk-based capital guidelines adopted by the federal banking
agencies. At year-end 2009, the Company remained well in excess of regulatory
requirements for well capitalized institutions.





We record
unrealized holding gains (losses), net of tax, on investment securities
available for sale and on cash flow hedging activities as accumulated other
comprehensive income (loss), a separate component of stockholders’
equity.  At December 31, 2009, the portion of the investment portfolio
designated as “available for sale” had net unrealized holding gains, net of tax,
of $728 thousand, compared to net unrealized holding gains, net of tax, of $1.4
million at December 31, 2008 and net unrealized holding gains, net of tax, of
$247 thousand at December 31, 2007.  There were $568 thousand in net
unrealized holding losses on cash flow hedging activities at the end of 2009 and
none at the end of 2008 and 2007.  See Note 21 to the Consolidated
Financial Statements for further information on hedging activities.





The
following table compares the Company’s capital ratios as of December 31 to the
minimum regulatory requirements.





(Dollars in thousands)
                
                2009
                
                
                2008
                
                
                2007
                
                
                Minimum
                  Regulatory
                  RequirementsTier
      1 capital
                
                $
                106,391
                
                
                $
                104,117
                
                
                $
                97,744Tier
      2 capital
                
                
                10,537
                
                
                
                9,755
                
                
                
                7,950Total
      risk-based capital
                
                
                116,928
                
                
                
                113,872
                
                
                
                105,694Net
      risk weighted assets
                
                
                928,933
                
                
                
                894,024
                
                
                
                804,240Adjusted
      average total assets
                
                
                1,148,077
                
                
                
                1,013,815
                
                
                
                930,619Risk-based
      capital ratios:Tier
      1
                
                
                11.45
                %
                
                
                11.65
                %
                
                
                12.15
                %
                
                
                4.0
                %Total
      capital
                
                
                12.59
                
                
                
                12.74
                
                
                
                13.14
                
                
                
                8.0Tier
      1 leverage ratio
                
                
                9.27
                
                
                
                10.27
                
                
                
                10.50
                
                
                
                4.0





Management
knows of no trends or demands, commitments, events or uncertainties that are
likely to have a material adverse impact on capital.  See Note 18 to
the Consolidated Financial Statements for further information about the
regulatory capital positions of the Company and the Banks.





Provision
for Credit Losses and Risk Management


Originating
loans involves a degree of risk that credit losses will occur in varying amounts
according to, among other factors, the types of loans being made, the
credit-worthiness of the borrowers over the term of the loans, the quality of
the collateral for the loan, if any, as well as general economic
conditions.  The Company’s Board of Directors demands accountability
of management, keeping the interests of stockholders in
focus.  Through its Asset/Liability Management and Audit Committee,
the Board actively reviews critical risk positions, including credit, market,
liquidity and operational risk.  The Company’s goal in managing risk
is to reduce earnings volatility, control exposure to unnecessary risk, and
ensure appropriate returns for risk assumed.  Senior members of
management actively manage risk at the product level, supplemented with
corporate level oversight through the Asset/Liability Management Committee and
internal audit function.  The risk management structure is designed to
identify risk issues through a systematic process, enabling timely and
appropriate action to avoid and mitigate risk.





Credit
risk is mitigated through portfolio diversification, limiting exposure to any
single industry or customer, collateral protection and standard lending policies
and underwriting criteria.  The following discussion provides
information and statistics on the overall quality of the Company’s loan
portfolio.  Note 1 to the Consolidated Financial Statements describes
the accounting policies related to nonperforming loans and charge-offs and
describes the methodologies used to develop the allowance for credit losses,
including the specific, formula and nonspecific
components.  Management believes the policies governing nonperforming
loans and charge-offs are consistent with regulatory standards.  The
amount of the allowance for credit losses and the resulting provision are
reviewed monthly by senior members of management and approved quarterly by the
Board of Directors.


31





The
allowance is increased by provisions for credit losses charged to expense and
recoveries of loans previously charged-off.  It is decreased by loans
charged-off in the current period.  Provisions for credit losses are
made to bring the allowance for credit losses within the range of balances that
are considered appropriate based upon the allowance methodology and to reflect
losses within the loan portfolio as of the balance sheet date.





The
adequacy of the allowance for credit losses is determined based upon
management’s estimate of the inherent risks associated with lending activities,
estimated fair value of collateral, past experience and present indicators such
as loan delinquency trends, nonaccrual loans and current market
conditions.  Management believes the allowance is adequate; however,
future changes in the composition of the loan portfolio and financial condition
of borrowers may result in additions to the allowance.  Examination of
the portfolio and allowance by various regulatory agencies and consultants
engaged by the Company may result in the need for additional provisions based
upon information available at the time of the examination.  Each of
the Banks maintains a separate allowance for credit losses, which is only
available to absorb losses from their respective loan portfolios.  The
allowance set by each of the Banks is subject to regulatory examination and
determination as to its adequacy.





The
allowance for credit losses is comprised of three parts: the specific allowance,
the formula allowance and the nonspecific allowance.  The specific
allowance is the portion of the allowance that results from management’s
evaluation of specific loss allocations for identified problem loans and pooled
reserves based on historical loss experience for each loan
category.  The formula allowance is determined based on management’s
assessment of industry trends and economic factors in the markets in which we
operate.  The determination of the formula allowance involves a higher
risk of uncertainty and considers current risk factors that may not have yet
manifested themselves in our historical loss factors.  The nonspecific
allowance captures losses that have impacted the portfolio but have yet to be
recognized in either the specific or formula allowance.





The
specific allowance is used to individually allocate an allowance to loans
identified as impaired. An impaired loan may show deficiencies in the borrower’s
overall financial condition, payment history, support available from financial
guarantors and/or the fair market value of collateral. When a loan is identified
as impaired, a specific allowance is established based on our assessment of the
loss that may be associated with the individual loan.





The
formula allowance is used to estimate the loss on internally risk rated loans,
exclusive of those identified as impaired. Loans identified as special mention,
substandard, doubtful and loss, as well as impaired, are segregated from
performing loans. Remaining loans are then grouped by type (commercial real
estate and construction, residential real estate, commercial or consumer). Each
loan type is assigned an allowance factor based on management’s estimate of the
risk, complexity and size of individual loans within a particular
category.  Classified loans are assigned higher allowance factors than
non-rated loans due to management’s concerns regarding collectibility or
management’s knowledge of particular elements regarding the borrower. Allowance
factors grow with the worsening of the internal risk rating.





The
nonspecific allowance is used to estimate the loss of non-classified loans
stemming from more global factors such as delinquencies, loss history, trends in
volume and terms of loans, effects of changes in lending policy, the experience
and depth of management, national and local economic trends, concentrations of
credit, the quality of the loan review system and the effect of external factors
such as competition and regulatory requirements.





As stated
elsewhere in this report, the economy has significantly weakened over the past
three years.  Although the economy of our market area does not appear
to be as weak as in other parts of the country, we have experienced weakness in
the local real estate market and related construction industry as a result of
the widely-publicized banking crisis and its impact on the global
economy.  These weaknesses in the local economy have resulted in
higher provisions for credit losses, loan charge-offs and nonperforming assets
for us.





At
December 31, 2009, the allowance for credit losses was $10.9 million, or 1.19%
of average outstanding loans, and 67% of total nonaccrual loans. This compares
to an allowance of $9.3 million, or 1.11% of average outstanding loans and 115%
of nonaccrual loans, at December 31, 2008, and an allowance for credit losses of
$7.6 million, or 1.04% of outstanding loans and 213% of nonaccrual loans, at
December 31, 2007.  The ratio of net charge-offs to average loans was
0.81% in 2009, 0.19% in 2008 and 0.06% in 2007.





The
provision for credit losses was $9.0 million for 2009, compared to $3.3 million
and $1.7 million for 2008 and 2007, respectively. The increased provision in
2009 reflected the continued overall growth of the loan portfolio, an increase
in loan charge-offs and nonperforming assets, and a deterioration in overall
economic conditions.  Net loan charge-offs totaled $7.4 million for
2009, a $5.8 million increase when compared to $1.6 million in net charge-offs
for 2008. Net charge-offs were $473 thousand in 2007.


32





The
following table sets forth a summary of our loan loss experience for the years
ended December 31.





(Dollars in thousands)
                
                2009
                
                
                2008
                
                
                2007
                
                
                2006
                
                
                2005Balance,
      beginning of year
                
                $
                9,320
                
                
                $
                7,551
                
                
                $
                6,300
                
                
                $
                5,236
                
                
                $
                4,692Loans
      charged offReal
      estate – construction
                
                
                (674
                )
                
                
                (536
                )
                
                
                -
                
                
                
                -
                
                
                
                -Real
      estate – residential
                
                
                (2,621
                )
                
                
                (316
                )
                
                
                (137
                )
                
                
                -
                
                
                
                -Real
      estate – commercial
                
                
                (1,695
                )
                
                
                (238
                )
                
                
                -
                
                
                
                (2
                )
                
                
                -Commercial
                
                
                (2,304
                )
                
                
                (447
                )
                
                
                (276
                )
                
                
                (539
                )
                
                
                (266
                )Consumer
                
                
                (417
                )
                
                
                (276
                )
                
                
                (301
                )
                
                
                (137
                )
                
                
                (183
                )Total
                
                
                (7,711
                )
                
                
                (1,813
                )
                
                
                (714
                )
                
                
                (678
                )
                
                
                (449
                )RecoveriesReal
      estate – construction
                
                
                2
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Real
      estate – residential
                
                
                70
                
                
                
                19
                
                
                
                -
                
                
                
                -
                
                
                
                -Real
      estate – commercial
                
                
                6
                
                
                
                -
                
                
                
                -
                
                
                
                46
                
                
                
                2Commercial
                
                
                66
                
                
                
                136
                
                
                
                165
                
                
                
                123
                
                
                
                110Consumer
                
                
                137
                
                
                
                90
                
                
                
                76
                
                
                
                80
                
                
                
                71Total
                
                
                281
                
                
                
                245
                
                
                
                241
                
                
                
                249
                
                
                
                183Net
      loans charged off
                
                
                (7,430
                )
                
                
                (1,568
                )
                
                
                (473
                )
                
                
                (429
                )
                
                
                (266
                )Provision
      for credit losses
                
                
                8,986
                
                
                
                3,337
                
                
                
                1,724
                
                
                
                1,493
                
                
                
                810Balance,
      end of year
                
                $
                10,876
                
                
                $
                9,320
                
                
                $
                7,551
                
                
                $
                6,300
                
                
                $
                5,236Average
      loans outstanding
                
                $
                913,631
                
                
                $
                837,739
                
                
                $
                728,766
                
                
                $
                664,244
                
                
                $
                607,017Percentage
      of net charge-offs to average loans outstanding during the
      year
                
                
                0.81
                %
                
                
                0.19
                %
                
                
                0.06
                %
                
                
                0.06
                %
                
                
                0.04
                %Percentage
      of allowance for credit losses at year-end to average
loans
                
                
                1.19
                %
                
                
                1.11
                %
                
                
                1.04
                %
                
                
                0.95
                %
                
                
                0.86
                %





Total
nonaccrual loans increased to 1.78% of total loans at December 31, 2009,
compared to 0.91% at December 31, 2008 and 0.46% at December 31,
2007.  Specific valuation allowances totaling $468 thousand, $341
thousand and $819 thousand were established to address nonaccrual loans at
December 31, 2009, 2008 and 2007, respectively.  Loans 90 days past
due and still accruing were $7.4 million, $1.4 million and $1.6 million at
year-end 2009, 2008 and 2007, respectively. Nonaccrual loans and loans 90
days past due and still accruing at December 31, 2009 were represented primarily
by real estate loans.  Management believes these loans have been
adequately provided for in the allowance for credit losses.


33





The
following table summarizes our nonperforming and past due assets as of December
31.





(Dollars in thousands)
                      
                      2009
                      
                      
                      2008
                      
                      
                      2007
                      
                      
                      2006
                      
                      
                      2005Nonperforming
      assetsNonaccrual
      loansReal
      estate – construction
                      
                      $
                      7,163
                      
                      
                      $
                      5,277
                      
                      
                      $
                      1,668
                      
                      
                      $
                      -
                      
                      
                      $
                      -Real
      estate – residential
                      
                      
                      4,246
                      
                      
                      
                      1,015
                      
                      
                      
                      876
                      
                      
                      
                      158
                      
                      
                      
                      174Real
      estate – commercial
                      
                      
                      2,828
                      
                      
                      
                      1,682
                      
                      
                      
                      877
                      
                      
                      
                      5,819
                      
                      
                      
                      242Commercial
                      
                      
                      2,028
                      
                      
                      
                      137
                      
                      
                      
                      114
                      
                      
                      
                      1,673
                      
                      
                      
                      430Consumer
                      
                      
                      37
                      
                      
                      
                      4
                      
                      
                      
                      5
                      
                      
                      
                      8
                      
                      
                      
                      -Total
      nonaccrual loans
                      
                      
                      16,302
                      
                      
                      
                      8,115
                      
                      
                      
                      3,540
                      
                      
                      
                      7,658
                      
                      
                      
                      846Other
      real estate and other assets owned
                      
                      
                      2,572
                      
                      
                      
                      148
                      
                      
                      
                      176
                      
                      
                      
                      398
                      
                      
                      
                      302Total
      nonperforming assets
                      
                      
                      18,874
                      
                      
                      
                      8,263
                      
                      
                      
                      3,716
                      
                      
                      
                      8,056
                      
                      
                      
                      1,148Loans
      90 days past due and still accruingReal
      estate – construction
                      
                      
                      5,096
                      
                      
                      
                      64
                      
                      
                      
                      637
                      
                      
                      
                      -
                      
                      
                      
                      -Real
      estate – residential
                      
                      
                      2,274
                      
                      
                      
                      583
                      
                      
                      
                      473
                      
                      
                      
                      352
                      
                      
                      
                      709Real
      estate – commercial
                      
                      
                      -
                      
                      
                      
                      726
                      
                      
                      
                      137
                      
                      
                      
                      256
                      
                      
                      
                      -Commercial
                      
                      
                      -
                      
                      
                      
                      3
                      
                      
                      
                      337
                      
                      
                      
                      18
                      
                      
                      
                      -Consumer
                      
                      
                      55
                      
                      
                      
                      5
                      
                      
                      
                      22
                      
                      
                      
                      15
                      
                      
                      
                      109Total
      loans 90 days past due
                      
                      
                      7,425
                      
                      
                      
                      1,381
                      
                      
                      
                      1,606
                      
                      
                      
                      641
                      
                      
                      
                      818Total
      nonperforming assets and past due loans
                      
                      $
                      26,299
                      
                      
                      $
                      9,644
                      
                      
                      $
                      5,322
                      
                      
                      $
                      8,697
                      
                      
                      $
                      1,966Nonaccrual
      loans to total loans at period end
                      
                      
                      1.78
                      %
                      
                      
                      0.91
                      %
                      
                      
                      0.46
                      %
                      
                      
                      1.09
                      %
                      
                      
                      0.13
                      %Nonperforming
      assets and past due loans, to total loans and other real estate and other
      assets owned
                      
                      
                      2.86
                      %
                      
                      
                      1.09
                      %
                      
                      
                      0.69
                      %
                      
                      
                      1.24
                      %
                      
                      
                      0.31
                      %





During
2009, there was no change in the methods or assumptions affecting the allowance
methodology.  The amount of the provision is determined based upon
management’s analysis of the portfolio, growth and changes in the condition of
credits and their resultant specific loss allocations.  Historically,
we have experienced the majority of our losses in the commercial loan portfolio,
which are typically not secured by real estate.  However, during 2009
and 2008 the Company experienced significantly higher losses on real estate
secured loans due to declining real estate values and the slowing
economy.





As seen
in the table below, the unallocated portion of the allowance for credit losses
was $124 thousand at December 31, 2009 and $216 thousand at December 31,
2008.  There  was no unallocated portion of the allowance at
December 31, 2007.  At December 31, 2009, 70.3% and 17.6% of our total
loans were real estate mortgage loans and real estate construction and land
development loans, respectively, compared to 66.9% and 20.2% at December 31,
2008, and 65.1% and 20.0% at December 31, 2007.





The
following table sets forth the allocation of the allowance for credit losses and
the percentage of loans in each category to total loans for the years ended
December 31.





2009
                  
                  
                  2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005%
      of
                  
                  
                  
                  
                  
                  %
      of
                  
                  
                  
                  
                  
                  %
      of
                  
                  
                  
                  
                  
                  %
      of
                  
                  
                  
                  
                  
                  %
      of(Dollars in thousands)
                  
                  Amount
                  
                  
                  Loans
                  
                  
                  Amount
                  
                  
                  Loans
                  
                  
                  Amount
                  
                  
                  Loans
                  
                  
                  Amount
                  
                  
                  Loans
                  
                  
                  Amount
                  
                  
                  LoansReal
      estate - construction
                  
                  $
                  2,630
                  
                  
                  
                  17.6
                  %
                  
                  $
                  2,749
                  
                  
                  
                  20.2
                  %
                  
                  $
                  1,398
                  
                  
                  
                  20.0
                  %
                  
                  $
                  1,229
                  
                  
                  
                  22.7
                  %
                  
                  $
                  945
                  
                  
                  
                  21.4
                  %Real
      estate - mortgage
                  
                  
                  5,475
                  
                  
                  
                  70.3
                  
                  
                  
                  4,001
                  
                  
                  
                  66.9
                  
                  
                  
                  4,075
                  
                  
                  
                  65.1
                  
                  
                  
                  3,275
                  
                  
                  
                  62.9
                  
                  
                  
                  2,299
                  
                  
                  
                  63.9Commercial
                  
                  
                  2,132
                  
                  
                  
                  10.0
                  
                  
                  
                  2,073
                  
                  
                  
                  10.3
                  
                  
                  
                  1,826
                  
                  
                  
                  11.9
                  
                  
                  
                  1,525
                  
                  
                  
                  11.5
                  
                  
                  
                  1,780
                  
                  
                  
                  12.0Consumer
                  
                  
                  515
                  
                  
                  
                  2.1
                  
                  
                  
                  281
                  
                  
                  
                  2.6
                  
                  
                  
                  252
                  
                  
                  
                  3.0
                  
                  
                  
                  271
                  
                  
                  
                  2.9
                  
                  
                  
                  212
                  
                  
                  
                  2.7Unallocated
                  
                  
                  124
                  
                  
                  
                  -
                  
                  
                  
                  216
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Total
                  
                  $
                  10,876
                  
                  
                  
                  100.0
                  %
                  
                  $
                  9,320
                  
                  
                  
                  100.0
                  %
                  
                  $
                  7,551
                  
                  
                  
                  100.0
                  %
                  
                  $
                  6,300
                  
                  
                  
                  100.0
                  %
                  
                  $
                  5,236
                  
                  
                  
                  100.0
                  %


34





Market
Risk Management


Market
risk is the risk of loss arising from adverse changes in the fair value of
financial instruments due to changes in interest rates, exchange rates or equity
pricing.  Our principal market risk is interest rate risk that arises
from our lending, investing and deposit taking activities.  Our
profitability is largely dependent on the Banks’ net interest
income.  Interest rate risk can significantly affect net interest
income to the degree that interest bearing liabilities mature or reprice at
different intervals than interest earning assets.  The Banks’
Asset/Liability Management Committees oversee the management of interest rate
risk.  The primary purpose of these committees is to manage the
exposure of net interest margins to unexpected changes due to interest rate
fluctuations.  These efforts affect our loan pricing and deposit rate
policies as well as asset mix, volume guidelines, and liquidity and capital
planning.





During
2009, the Company began using  derivative instruments to hedge its
exposure to changes in interest rates.  The Company does not use
derivatives for any trading or other speculative purposes.See Note 21 to the
Consolidated Financial Statements for further information on hedging
activities.





Because
we are not exposed to market risk from trading activities and do not utilize
off-balance sheet management strategies, the Asset/Liability Management
Committees of the Banks rely on “gap” analysis as its primary tool in managing
interest rate risk.  Gap analysis summarizes the amount of interest
sensitive assets and liabilities, which will reprice over various time
intervals.  The excess between the volume of assets and liabilities
repricing in each interval is the interest sensitivity
“gap”.  “Positive gap” occurs when more assets reprice in a given time
interval, while “negative gap” occurs when more liabilities
reprice.  As of December 31, 2009, we had an overall negative gap
position within the one-year repricing interval because the interest sensitive
liabilities exceeded the interest sensitive assets within the one-year repricing
interval by $150.8 million, or 13.0% of total assets.  The negative
gap position within the one-year interval at December 31, 2008 totaled $101.3
million, or 9.7% of total assets.  The $49.5 million increase in the
one-year negative gap for 2009 when compared to 2008 was primarily from the
increase in federal funds sold, more than offset by the increase in money market
and savings deposits.  Also, more time deposits were in the one-year
interval gap at the end of 2009 than at the end of 2008.  The negative
gap position within the one-year interval at December 31, 2007, totaled $99.1
million, or 10.4% of total assets.





The
following table summarizes our interest sensitivity at December 31,
2009.  Loans, federal funds sold, time deposits and short-term
borrowings are classified based upon contractual maturities if fixed rate or
earliest repricing date if variable rate.  Investment securities are
classified by contractual maturities or, if they have call provisions, by the
most likely repricing date.





3 Months
                  
                  
                  1 Year
                  
                  
                  3 Years
                  
                  
                  
                  
                  
                  Non-Within
                  
                  
                  through
                  
                  
                  through
                  
                  
                  through
                  
                  
                  After
                  
                  
                  SensitiveDecember 31, 2009
                  
                  3 Months
                  
                  
                  12 Months
                  
                  
                  3 Years
                  
                  
                  5 Years
                  
                  
                  5 Years
                  
                  
                  Funds
                  
                  
                  Total(Dollars in thousands)ASSETSLoans,
      net
                  
                  $
                  438,277
                  
                  
                  $
                  104,787
                  
                  
                  $
                  208,013
                  
                  
                  $
                  114,072
                  
                  
                  $
                  51,407
                  
                  
                  $
                  (10,875
                  )
                  
                  $
                  905,681Investment
      securities
                  
                  
                  19,296
                  
                  
                  
                  14,436
                  
                  
                  
                  31,459
                  
                  
                  
                  15,536
                  
                  
                  
                  25,258
                  
                  
                  
                  3,699
                  
                  
                  
                  109,684Federal
      funds sold
                  
                  
                  60,637
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  60,637Interest
      bearing deposits with other banks
                  
                  
                  598
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  598Other
      assets
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  79,916
                  
                  
                  
                  79,916Total
      assets
                  
                  
                  518,808
                  
                  
                  
                  119,223
                  
                  
                  
                  239,472
                  
                  
                  
                  129,608
                  
                  
                  
                  76,665
                  
                  
                  
                  72,740
                  
                  
                  
                  1,156,516LIABILITIESNoninterest
      bearing demand deposits
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  122,492
                  
                  
                  
                  122,492Interest
      bearing demand deposits
                  
                  
                  133,946
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  133,946Money
      market and savings deposits
                  
                  
                  249,793
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  249,793Certificates
      of deposit, $100,000 or more
                  
                  
                  101,350
                  
                  
                  
                  118,016
                  
                  
                  
                  33,569
                  
                  
                  
                  9,728
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  262,663Other
      time deposits
                  
                  
                  59,207
                  
                  
                  
                  105,596
                  
                  
                  
                  43,804
                  
                  
                  
                  13,436
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  222,043Short-term
      borrowings
                  
                  
                  20,404
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  20,404Long-term
      debt
                  
                  
                  -
                  
                  
                  
                  497
                  
                  
                  
                  932
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1,429Other
      liabilities
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  15,936
                  
                  
                  
                  15,936STOCKHOLDERS’
      EQUITY
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  127,810
                  
                  
                  
                  127,810Total
      Liabilities and Stockholders’ Equity
                  
                  
                  564,700
                  
                  
                  
                  224,109
                  
                  
                  
                  78,305
                  
                  
                  
                  23,164
                  
                  
                  
                  -
                  
                  
                  
                  266,238
                  
                  
                  
                  1,156,516(Deficit)
      excess
                  
                  $
                  (45,892
                  )
                  
                  $
                  (104,886
                  )
                  
                  $
                  161,167
                  
                  
                  $
                  106,444
                  
                  
                  $
                  76,665
                  
                  
                  $
                  (193,498
                  )
                  
                  $
                  -Cumulative
      (deficit) excess
                  
                  $
                  (45,892
                  )
                  
                  $
                  (150,778
                  )
                  
                  $
                  10,389
                  
                  
                  $
                  116,833
                  
                  
                  $
                  193,498
                  
                  
                  $
                  -
                  
                  
                  $
                  -Cumulative
      (deficit) excess as percent of total assets
                  
                  
                  (4.0
                  )%
                  
                  
                  (13.0
                  )%
                  
                  
                  0.9
                  %
                  
                  
                  10.1
                  %
                  
                  
                  16.7
                  %
                  
                  
                  -
                  %
                  
                  
                  -
                  %


35





In
addition to gap analysis, the Banks utilize simulation models to quantify the
effect a hypothetical immediate plus or minus 300 basis point change in rates
would have on their net interest income and the fair value of
capital.  The model takes into consideration the effect of call
features of investment securities as well as prepayments of loans in periods of
declining rates.  When actual changes in interest rates occur, the
changes in interest earning assets and interest bearing liabilities may differ
from the assumptions used in the model.  The chart below provides the
sensitivity profiles for net interest income and the fair value of capital as of
year-end 2009 and 2008.  As of December 31, 2009 and 2008, due to the
low interest-rate environment, we believe the results of the minus 300 basis
point change in rates is not meaningful.





Immediate Change in Rates-300
                              
                              
                              -200
                              
                              
                              -100
                              
                              
                              +100
                              
                              
                              +200
                              
                              
                              +300Basis Points
                              
                              
                              Basis Points
                              
                              
                              Basis Points
                              
                              
                              Basis Points
                              
                              
                              Basis Points
                              
                              
                              Basis Points2009%
      Change in Net Interest Income
                              
                              
                              N/A
                              
                              
                              
                              (12.81
                              )%
                              
                              
                              (1.35
                              )%
                              
                              
                              2.69
                              %
                              
                              
                              4.98
                              %
                              
                              
                              7.31
                              %%
      Change in Value of Capital
                              
                              
                              N/A
                              
                              
                              
                              3.34
                              %
                              
                              
                              0.19
                              %
                              
                              
                              3.25
                              %
                              
                              
                              6.26
                              %
                              
                              
                              8.33
                              %2008%
      Change in Net Interest Income
                              
                              
                              N/A
                              
                              
                              
                              (16.65
                              )%
                              
                              
                              (7.10
                              )%
                              
                              
                              6.49
                              %
                              
                              
                              12.55
                              %
                              
                              
                              17.54
                              %%
      Change in Value of Capital
                              
                              
                              N/A
                              
                              
                              
                              5.31
                              %
                              
                              
                              1.20
                              %
                              
                              
                              2.51
                              %
                              
                              
                              5.43
                              %
                              
                              
                              7.25
                              %





Off-Balance
Sheet Arrangements


In the
normal course of business, to meet the financing needs of its customers, the
Banks are parties to financial instruments with off-balance sheet
risk.  These financial instruments include commitments to extend
credit and standby letters of credit.  The Banks’ exposure to credit
loss in the event of nonperformance by the other party to these financial
instruments is represented by the contractual amount of the
instruments.  The Banks use the same credit policies in making
commitments and conditional obligations as they use for on-balance sheet
instruments.  The Banks generally require collateral or other security
to support the financial instruments with credit risk.  The amount of
collateral or other security is determined based on management’s credit
evaluation of the counterparty.  The Banks evaluate each customer’s
creditworthiness on a case-by-case basis.





Commitments
to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract.  Letters of
credit are conditional commitments issued by the Banks to guarantee the
performance of a customer to a third party.  Letters of credit and
other commitments generally have fixed expiration dates or other termination
clauses and may require payment of a fee.  Because many of the letters
of credit and commitments are expected to expire without being drawn upon, the
total commitment amount does not necessarily represent future cash
requirements.  Further information about these arrangements is
provided in Note 22 to the Consolidated Financial Statements.





Management
does not believe that any of the foregoing arrangements have or are reasonably
likely to have a current or future effect on our financial condition, revenues
or expenses, results of operations, liquidity, capital expenditures or capital
resources that is material to investors.





Liquidity
Management


Liquidity
describes our ability to meet financial obligations that arise during the normal
course of business.  Liquidity is primarily needed to meet the
borrowing and deposit withdrawal requirements of customers and to fund current
and planned expenditures.  Liquidity is derived through increased
customer deposits, maturities in the investment portfolio, loan repayments and
income from earning assets.  To the extent that deposits are not
adequate to fund customer loan demand, liquidity needs can be met in the
short-term funds markets.  We have arrangements with correspondent
banks whereby we have $56.5 million available in federal funds lines of credit
and a reverse repurchase agreement available to meet any short-term needs which
may not otherwise be funded by the Banks’ portfolio of readily marketable
investments that can be converted to cash.  The Banks are also members
of the Federal Home Loan Bank, which provides another source of
liquidity.  At December 31, 2009, the Banks had credit availability of
approximately $10.1 million from the Federal Home Loan Bank.  In
addition, during 2009 the Company obtained a $10.0 million line of credit with a
commercial bank.





At
December 31, 2009, our loan to deposit ratio was approximately 92.5%, a more
liquid position than the 105% and 101% at year-end 2008 and 2007,
respectively.  During the second quarter of 2009, we began
participating in the IND program which increased liquidity. Investment
securities available for sale totaling $100.7 million at the end of 2009 were
available for the management of liquidity and interest rate risk.  The
comparable amounts were $79.2 million and $97.1 million at December 31, 2008 and
2007, respectively.  Cash and cash equivalents were $75.6 million at
December 31, 2009, compared to $27.3 million at year-end 2008 and $26.9 million
at year-end 2007.  The increase in cash and cash equivalents at the
end of 2009 compared to the end of 2008 was due to a larger amount in federal
funds sold.  Management is not aware of any demands, commitments,
events or uncertainties that will materially affect our ability to maintain
liquidity at satisfactory levels.


36





We have
various financial obligations, including contractual obligations and commitments
that may require future cash payments. The purchase obligations in the table
below include costs associated with our new core data processing
system.  The conversion to the new system occurred in the second
quarter of 2009.  With the new system, we are experiencing automation
efficiencies and expecting to achieve future cost savings.





The
following table presents, as of December 31, 2009, significant fixed and
determinable contractual obligations to third parties by payment
date.





(Dollars in thousands)
                
                Within
                  one year
                
                
                One to
                  three years
                
                
                Three to
                  five years
                
                
                Over
                  five years
                
                
                TotalLong-term
      debt
                
                $
                497
                
                
                $
                932
                
                
                $
                -
                
                
                $
                -
                
                
                $
                1,429Operating
      leases
                
                
                763
                
                
                
                1,320
                
                
                
                725
                
                
                
                1,807
                
                
                
                4,615Purchase
      obligations
                
                
                2,124
                
                
                
                3,197
                
                
                
                3,128
                
                
                
                9,647
                
                
                
                18,096Total
                
                $
                3,384
                
                
                $
                5,449
                
                
                $
                3,853
                
                
                $
                11,454
                
                
                $
                24,140





Item
      7A.
            Quantitative
      and Qualitative Disclosures About Market
Risk.





The
information required by this item may be found in Item 7 of Part II of this
report under the caption “Market Risk Management”, which is incorporated herein
by reference.





Item
      8.
            Financial
      Statements and Supplementary Data.





INDEX
TO CONSOLIDATED FINANCIAL STATEMENTS





Management’s
      Report on Internal Control over Financial Reporting
                
                38Report
      of Independent Registered Public Accounting Firm
                
                39Consolidated
      Balance Sheets
                
                40Consolidated
      Statements of Income
                
                41Consolidated
      Statements of Changes in Stockholders’ Equity
                
                42Consolidated
      Statements of Comprehensive Income
                
                43Consolidated
      Statements of Cash Flows
                
                44Notes
      to Consolidated Financial Statements
                
                46


37





MANAGEMENT’S
REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING





Management
of Shore Bancshares, Inc. (the “Company”) is responsible for the preparation,
integrity and fair presentation of the consolidated financial statements
included in this annual report.  The Company’s consolidated financial
statements have been prepared in accordance with accounting principles generally
accepted in the United States of America and, as such, include some amounts that
are based on the best estimates and judgments of management.





The
Company’s management is responsible for establishing and maintaining adequate
internal control over financial reporting.  This internal control
system is designed to provide reasonable assurance to management and the Board
of Directors regarding the reliability of the Company’s financial reporting and
the preparation and presentation of financial statements for external reporting
purposes in conformity with accounting principles generally accepted in the
United States of America, as well as to safeguard assets from unauthorized use
or disposition.  The system of internal control over financial
reporting is evaluated for effectiveness by management and tested for
reliability through a program of internal audit with actions taken to correct
potential deficiencies as they are identified.  Because of inherent
limitations in any internal control system, no matter how well designed,
misstatement due to error or fraud may occur and not be detected, including the
possibility of the circumvention or overriding of
controls.  Accordingly, even an effective internal control system can
provide only reasonable assurance with respect to financial statement
preparation.  Further, because of changes in conditions, internal
control effectiveness may vary over time.





Management
assessed the effectiveness of the Company’s internal control over financial
reporting as of December 31, 2009 based upon criteria set forth inInternal Control –
Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO).





Based on this assessment
and on the foregoing criteria, management has concluded that, as of December 31,
2009, the Company’s internal control over financial reporting is
effective.Stegman & Company, the Company’s independent
registered public accounting firm that audited the financial statements included
in this annual report, has issued a report on the Company’s internal control
over financial reporting, which appears on the
following page.





March 12,
2010





/s/ W. Moorhead Vermilye
                
                /s/ Susan E. LeavertonW.
      Moorhead Vermilye
                
                Susan
      E. Leaverton, CPAPresident
      and Chief Executive Officer
                
                Principal
      Accounting Officer


38


REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





To the
Board of Directors and


Stockholders
of Shore Bancshares, Inc.





We have
audited the accompanying consolidated balance sheets of Shore Bancshares, Inc.
(the “Company”) as of December 31, 2009 and 2008, and the consolidated
statements of income, changes in stockholders’ equity, comprehensive income and
cash flows for each of the years in the three-year period ended December 31,
2009. We also have audited the Company’s internal control over financial
reporting as of December 31, 2009, based on criteria established in Internal Control—Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO).  The Company’s management is responsible
for these financial statements, for maintaining effective internal control over
financial reporting, and for its assessment of the effectiveness of internal
control over financial reporting, included in the accompanying Management’s Report on Internal
Control over Financial Reporting.  Our responsibility is to
express an opinion on these consolidated financial statements and an opinion on
the Company’s internal control over financial reporting based on our
audits.




We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audits to obtain reasonable assurance about whether
the financial statements are free of material misstatement and whether effective
internal control over financial reporting was maintained in all material
respects.  Our audits of the consolidated financial statements
included examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation.  Our audit of internal control over
financial reporting included obtaining an understanding of internal control over
financial reporting, assessing the risk that a material weakness exists, and
testing and evaluating the design and operating effectiveness of internal
control based on the assessed risk.  Our audits also included
performing such other procedures as we considered necessary in the
circumstances. We believe that our audits provide a reasonable basis for our
opinions.




A
company’s internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles.  A company’s internal
control over financial reporting includes those policies and procedures that (1)
pertain to the maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the company;
(2) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company’s
assets that could have a material effect on the financial
statements.




Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements.  Also, projections of any evaluation
of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.




In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Shore Bancshares, Inc. as of
December 31, 2009 and 2008, and the results of its operations and its cash flows
for each of the years in the three-year period ended December 31, 2009 in
conformity with accounting principles generally accepted in the United States of
America.  Also in our opinion, Shore Bancshares, Inc. maintained, in
all material respects, effective internal control over financial reporting as of
December 31, 2009, based on criteria established in Internal Control—Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO).











Baltimore,
Maryland


March 12,
2010


39


SHORE
BANCSHARES, INC.


CONSOLIDATED
BALANCE SHEETS


December
31,





(In thousands, except share data)
                
                2009
                
                
                2008ASSETSCash
      and due from banks
                
                $
                14,411
                
                
                $
                16,803Interest-bearing
      deposits with other banks
                
                
                598
                
                
                
                481Federal
      funds sold
                
                
                60,637
                
                
                
                10,010Investment
      securities:Available
      for sale, at fair value
                
                
                100,744
                
                
                
                79,204Held
      to maturity, at amortized cost –fair value of $9,012 (2009) and $10,390
      (2008)
                
                
                8,940
                
                
                
                10,252Loans
                
                
                916,557
                
                
                
                888,528Less:  allowance
      for credit losses
                
                
                (10,876
                )
                
                
                (9,320
                )Loans,
      net
                
                
                905,681
                
                
                
                879,208Premises
      and equipment, net
                
                
                14,307
                
                
                
                13,855Goodwill
                
                
                15,954
                
                
                
                15,954Other
      intangible assets, net
                
                
                5,406
                
                
                
                5,921Other
      real estate and other assets owned, net
                
                
                2,572
                
                
                
                148Other
      assets
                
                
                27,266
                
                
                
                12,805Total
      assets
                
                $
                1,156,516
                
                
                $
                1,044,641LIABILITIESDeposits:Noninterest-bearing
      demand
                
                $
                122,492
                
                
                $
                102,584Interest-bearing
      demand
                
                
                133,946
                
                
                
                125,370Money
      market and savings
                
                
                249,793
                
                
                
                150,958Certificates
      of deposit, $100,000 or more
                
                
                262,663
                
                
                
                235,235Other
      time
                
                
                222,043
                
                
                
                231,224Total
      deposits
                
                
                990,937
                
                
                
                845,371Short-term
      borrowings
                
                
                20,404
                
                
                
                52,969Other
      liabilities
                
                
                15,936
                
                
                
                10,969Long-term
      debt
                
                
                1,429
                
                
                
                7,947Total
      liabilities
                
                
                1,028,706
                
                
                
                917,256STOCKHOLDERS’
      EQUITYCommon
      stock, par value $.01, authorized 35,000,000 shares; shares issued and
      outstanding–8,418,963 (2009) and 8,404,684 (2008)
                
                
                84
                
                
                
                84Warrant
                
                
                1,543
                
                
                
                -Additional
      paid in capital
                
                
                29,872
                
                
                
                29,768Retained
      earnings
                
                
                96,151
                
                
                
                96,140Accumulated
      other comprehensive income
                
                
                160
                
                
                
                1,393Total
      stockholders’ equity
                
                
                127,810
                
                
                
                127,385Total
      liabilities and stockholders’ equity
                
                $
                1,156,516
                
                
                $
                1,044,641





The notes
to the consolidated financial statements are an integral part of these
statements.


40


SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF INCOME


For the
Years Ended December 31,





(Dollars in thousands, except per share data)
                
                2009
                
                
                2008
                
                
                2007INTEREST
      INCOMEInterest
      and fees on loans
                
                $
                55,209
                
                
                $
                56,866
                
                
                $
                57,524Interest
      and dividends on investment securities:Taxable
                
                
                3,184
                
                
                
                3,788
                
                
                
                5,105Tax-exempt
                
                
                301
                
                
                
                420
                
                
                
                511Interest
      on federal funds sold
                
                
                84
                
                
                
                308
                
                
                
                1,108Interest
      on deposits with other banks
                
                
                11
                
                
                
                92
                
                
                
                893Total
      interest income
                
                
                58,789
                
                
                
                61,474
                
                
                
                65,141INTEREST
      EXPENSEInterest
      on deposits
                
                
                17,018
                
                
                
                19,877
                
                
                
                21,693Interest
      on short-term borrowings
                
                
                127
                
                
                
                1,147
                
                
                
                1,264Interest
      on long-term debt
                
                
                266
                
                
                
                531
                
                
                
                1,148Total
      interest expense
                
                
                17,411
                
                
                
                21,555
                
                
                
                24,105NET
      INTEREST INCOME
                
                
                41,378
                
                
                
                39,919
                
                
                
                41,036Provision
      for credit losses
                
                
                8,986
                
                
                
                3,337
                
                
                
                1,724NET
      INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES
                
                
                32,392
                
                
                
                36,582
                
                
                
                39,312NONINTEREST
      INCOMEService
      charges on deposit accounts
                
                
                3,424
                
                
                
                3,600
                
                
                
                3,372Other
      service charges and fees
                
                
                3,143
                
                
                
                3,029
                
                
                
                2,195Gains
      (losses) on sales of investment securities
                
                
                49
                
                
                
                (15
                )
                
                
                5Other
      than temporary impairment of securities
                
                
                -
                
                
                
                (371
                )
                
                
                -Insurance
      agency commissions income
                
                
                11,131
                
                
                
                12,090
                
                
                
                7,698Gains
      (losses) on disposals of premises and equipment
                
                
                -
                
                
                
                1,247
                
                
                
                (136
                )Loss
      on sale of investment in unconsolidated subsidiary
                
                
                -
                
                
                
                (337
                )
                
                
                -Other
      noninterest income
                
                
                1,794
                
                
                
                1,107
                
                
                
                1,545Total
      noninterest income
                
                
                19,541
                
                
                
                20,350
                
                
                
                14,679NONINTEREST
      EXPENSESalaries
      and wages
                
                
                18,488
                
                
                
                18,426
                
                
                
                15,947Employee
      benefits
                
                
                4,631
                
                
                
                4,895
                
                
                
                4,044Occupancy
      expense
                
                
                2,324
                
                
                
                2,179
                
                
                
                1,962Furniture
      and equipment expense
                
                
                1,183
                
                
                
                1,185
                
                
                
                1,312Data
      processing
                
                
                2,463
                
                
                
                2,323
                
                
                
                2,175Directors’
      fees
                
                
                478
                
                
                
                558
                
                
                
                605Amortization
      of intangible assets
                
                
                515
                
                
                
                515
                
                
                
                333Insurance
      agency commissions expense
                
                
                1,913
                
                
                
                2,248
                
                
                
                557FDIC
      insurance premium expense
                
                
                2,078
                
                
                
                356
                
                
                
                99Other
      noninterest expenses
                
                
                6,175
                
                
                
                5,685
                
                
                
                5,505Total
      noninterest expense
                
                
                40,248
                
                
                
                38,370
                
                
                
                32,539INCOME
      BEFORE INCOME TAXES
                
                
                11,685
                
                
                
                18,562
                
                
                
                21,452Income
      tax expense
                
                
                4,412
                
                
                
                7,092
                
                
                
                8,002NET
      INCOME
                
                
                7,273
                
                
                
                11,470
                
                
                
                13,450Preferred
      stock dividends and discount accretion
                
                
                1,876
                
                
                
                -
                
                
                
                -Net
      income available to common stockholders
                
                $
                5,397
                
                
                $
                11,470
                
                
                $
                13,450Basic
      earnings per common share
                
                $
                0.64
                
                
                $
                1.37
                
                
                $
                1.61Diluted
      earnings per common share
                
                $
                0.64
                
                
                $
                1.37
                
                
                $
                1.60Cash
      dividends paid per common share
                
                $
                0.64
                
                
                $
                0.64
                
                
                $
                0.64





The notes
to the consolidated financial statements are an integral part of these
statements.


41


SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY


For the
Years Ended December 31, 2009, 2008, and 2007





(Dollars in thousands, except per share data)
                  
                  Preferred
                    Stock
                  
                  
                  Common
                    Stock
                  
                  
                  Warrant
                  
                  
                  Additional
                    Paid In
                    Capital
                  
                  
                  Retained
                    Earnings
                  
                  
                  Accumulated
                    Other
                    Comprehensive
                    Income (Loss)
                  
                  
                  Total
                    Stockholders’
                    EquityBalances, December 31,
      2006
                  
                  $
                  -
                  
                  
                  $
                  84
                  
                  
                  $
                  -
                  
                  
                  $
                  29,688
                  
                  
                  $
                  82,279
                  
                  
                  $
                  (724
                  )
                  
                  $
                  111,327Comprehensive
      income:Net
      income
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  13,450
                  
                  
                  
                  -
                  
                  
                  
                  13,450Unrealized
      gains on available-for-sale securities, net of reclassification
      adjustment, net of taxes
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  971
                  
                  
                  
                  971Total
      comprehensive income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  14,421Shares
      issued for employee stock-based awards
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  54
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  54Stock-based
      compensation expense
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  63
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  63Stock
      repurchased and retired
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (266
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (266
                  )Cash
      dividends paid ($0.64 per share)
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (5,364
                  )
                  
                  
                  -
                  
                  
                  
                  (5,364
                  )Balances,
      December 31, 2007
                  
                  
                  -
                  
                  
                  
                  84
                  
                  
                  
                  -
                  
                  
                  
                  29,539
                  
                  
                  
                  90,365
                  
                  
                  
                  247
                  
                  
                  
                  120,235Adjustment
      to initially apply EITF Issue 06-4
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (318
                  )
                  
                  
                  -
                  
                  
                  
                  (318
                  )Comprehensive
      income:Net
      income
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  11,470
                  
                  
                  
                  -
                  
                  
                  
                  11,470Unrealized
      gains on available-for-sale securities, net of reclassification
      adjustment, net of taxes
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1,146
                  
                  
                  
                  1,146Total
      comprehensive income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  12,616Shares
      issued for employee stock-based awards
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  138
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  138Stock-based
      compensation expense
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  91
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  91Cash
      dividends paid ($0.64 per share)
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (5,377
                  )
                  
                  
                  -
                  
                  
                  
                  (5,377
                  )Balances,
      December 31, 2008
                  
                  
                  -
                  
                  
                  
                  84
                  
                  
                  
                  -
                  
                  
                  
                  29,768
                  
                  
                  
                  96,140
                  
                  
                  
                  1,393
                  
                  
                  
                  127,385Comprehensive
      income:Net
      income
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  7,273
                  
                  
                  
                  -
                  
                  
                  
                  7,273Unrealized
      losses on available-for-sale securities, net of reclassification
      adjustment, net of taxes
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (665
                  )
                  
                  
                  (665
                  )Unrealized
      losses on cash flow hedging activities, net of taxes
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (568
                  )
                  
                  
                  (568
                  )Total
      comprehensive income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  6,040Warrant
      issued
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1,543
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1,543Preferred
      shares issued pursuant to TARP
                  
                  
                  25,000
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  25,000Discount
      from issuance of preferred stock
                  
                  
                  (1,543
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (1,543
                  )Discount
      accretion
                  
                  
                  68
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (68
                  )
                  
                  
                  -
                  
                  
                  
                  -Redemption
      of preferred stock
                  
                  
                  (23,525
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (23,525
                  )Shares
      issued for employee stock-based awards
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2Stock-based
      compensation expense
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  102
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  102Preferred
      stock dividends
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (1,808
                  )
                  
                  
                  -
                  
                  
                  
                  (1,808
                  )Cash
      dividends paid ($0.64 per share)
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (5,386
                  )
                  
                  
                  -
                  
                  
                  
                  (5,386
                  )Balances,
      December 31, 2009
                  
                  $
                  -
                  
                  
                  $
                  84
                  
                  
                  $
                  1,543
                  
                  
                  $
                  29,872
                  
                  
                  $
                  96,151
                  
                  
                  $
                  160
                  
                  
                  $
                  127,810





The notes
to the consolidated financial statements are an integral part of these
statements.


42


SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF COMPREHENSIVE INCOME


For the
Years Ending December 31,





(Dollars in thousands)
                
                2009
                
                
                2008
                
                
                2007Net
      income
                
                $
                7,273
                
                
                $
                11,470
                
                
                $
                13,450Other
      comprehensive (loss) income:Securities
      available for sale:Unrealized
      holding (losses) gains on available-for-sale securities
                
                
                (1,061
                )
                
                
                1,525
                
                
                
                1,598Tax
      effect
                
                
                425
                
                
                
                (609
                )
                
                
                (624
                )Reclassification
      of (gains) losses recognized in net income
                
                
                (49
                )
                
                
                386
                
                
                
                (5
                )Tax
      effect
                
                
                20
                
                
                
                (156
                )
                
                
                2Net
      of tax amount
                
                
                (665
                )
                
                
                1,146
                
                
                
                971Cash
      flow hedging activities:Unrealized
      holding losses on cash flow hedging activities
                
                
                (952
                )
                
                
                -
                
                
                
                -Tax
      effect
                
                
                384
                
                
                
                -
                
                
                
                -Net
      of tax amount
                
                
                (568
                )
                
                
                -
                
                
                
                -Total
      other comprehensive (loss) income
                
                
                (1,233
                )
                
                
                1,146
                
                
                
                971Comprehensive
      income
                
                $
                6,040
                
                
                $
                12,616
                
                
                $
                14,421





The notes
to the consolidated financial statements are an integral part of these
statements.


43


SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS


For the
Years Ended December 31,




(Dollars in thousands)
                
                2009
                
                
                2008
                
                
                2007CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      income
                
                $
                7,273
                
                
                $
                11,470
                
                
                $
                13,450Adjustments
      to reconcile net income to net cash provided by operating
      activities:Provision
      for credit losses
                
                
                8,986
                
                
                
                3,337
                
                
                
                1,724Depreciation
      and amortization
                
                
                1,880
                
                
                
                1,784
                
                
                
                1,523Discount
      accretion on debt securities
                
                
                (226
                )
                
                
                (199
                )
                
                
                (190
                )Stock-based
      compensation expense
                
                
                102
                
                
                
                91
                
                
                
                63Excess
      tax benefits from stock-based arrangements
                
                
                (5
                )
                
                
                (4
                )
                
                
                (3
                )Deferred
      income taxes
                
                
                (928
                )
                
                
                (498
                )
                
                
                (377
                )(Gain)
      loss on sales of securities
                
                
                (49
                )
                
                
                15
                
                
                
                (5
                )Other
      than temporary impairment of securities
                
                
                -
                
                
                
                371
                
                
                
                -(Gain)
      loss on disposals of premises and equipment
                
                
                -
                
                
                
                (1,247
                )
                
                
                136Loss
      on sale of investment in unconsolidated subsidiary
                
                
                -
                
                
                
                337
                
                
                
                -Loss
      (gain) on sales of other real estate owned
                
                
                26
                
                
                
                50
                
                
                
                (51
                )Write-downs
      of other real estate owned
                
                
                159
                
                
                
                -
                
                
                
                -Gain
      on interest rate swaps
                
                
                (420
                )
                
                
                -
                
                
                
                -Net
      changes in:Insurance
      premiums receivable
                
                
                365
                
                
                
                (265
                )
                
                
                (510
                )Accrued
      interest receivable
                
                
                (198
                )
                
                
                402
                
                
                
                (116
                )Prepaid
      FDIC premium expense
                
                
                (5,425
                )
                
                
                (10
                )
                
                
                -Other
      assets
                
                
                (1,481
                )
                
                
                (1,673
                )
                
                
                1,503Accrued
      interest payable
                
                
                (569
                )
                
                
                (443
                )
                
                
                550Other
      liabilities
                
                
                689
                
                
                
                491
                
                
                
                30Net
      cash provided by operating activities
                
                
                10,179
                
                
                
                14,009
                
                
                
                17,727CASH
      FLOWS FROM INVESTING ACTIVITIES:Proceeds
      from maturities and principal payments of securities available for
      sale
                
                
                53,668
                
                
                
                82,063
                
                
                
                92,293Proceeds
      from sales of securities available for sale
                
                
                2,048
                
                
                
                2
                
                
                
                3,500Purchases
      of securities available for sale
                
                
                (78,376
                )
                
                
                (62,551
                )
                
                
                (74,897
                )Proceeds
      from maturities and principal payments of securities held to
      maturity
                
                
                3,934
                
                
                
                3,666
                
                
                
                1,174Purchases
      of securities held to maturity
                
                
                (2,623
                )
                
                
                (1,026
                )
                
                
                (117
                )Net
      increase in loans
                
                
                (38,190
                )
                
                
                (114,033
                )
                
                
                (77,977
                )Purchases
      of premises and equipment
                
                
                (1,553
                )
                
                
                (331
                )
                
                
                (695
                )Proceeds
      from sales of premises and equipment
                
                
                -
                
                
                
                2,773
                
                
                
                -Proceeds
      from sale of investment in unconsolidated subsidiary
                
                
                -
                
                
                
                600
                
                
                
                -Proceeds
      from sales of other real estate owned
                
                
                122
                
                
                
                264
                
                
                
                1,148Purchases
      of interest rate caps
                
                
                (6,475
                )
                
                
                -
                
                
                
                -Acquisition,
      net of cash acquired
                
                
                -
                
                
                
                -
                
                
                
                (5,259
                )Net
      cash used in investing activities
                
                
                (67,445
                )
                
                
                (88,573
                )
                
                
                (60,830
                )CASH
      FLOWS FROM FINANCING ACTIVITIESNet
      increase (decrease) in demand, money market and savings
      deposits
                
                
                127,319
                
                
                
                (10,688
                )
                
                
                (18,843
                )Net
      increase in certificates of deposit
                
                
                18,247
                
                
                
                90,163
                
                
                
                10,556Excess
      tax benefits from stock-based arrangements
                
                
                5
                
                
                
                4
                
                
                
                3Net
      (decrease) increase in short-term borrowings
                
                
                (32,565
                )
                
                
                5,276
                
                
                
                19,170Proceeds
      from issuance of long-term debt
                
                
                -
                
                
                
                3,000
                
                
                
                3,000Repayment
      of long-term debt
                
                
                (6,518
                )
                
                
                (7,538
                )
                
                
                (18,000
                )Net
      receipt of counterparty collateral – interest rate caps
                
                
                4,847
                
                
                
                -
                
                
                
                -Proceeds
      from issuance of preferred stock and warrant
                
                
                25,000
                
                
                
                -
                
                
                
                -Redemption
      of preferred stock
                
                
                (23,525
                )
                
                
                -
                
                
                
                -Proceeds
      from issuance of common stock
                
                
                2
                
                
                
                138
                
                
                
                54Common
      stock repurchased and retired
                
                
                -
                
                
                
                -
                
                
                
                (266
                )Preferred
      stock dividends paid
                
                
                (1,808
                )
                
                
                -
                
                
                
                -Common
      stock dividends paid
                
                
                (5,386
                )
                
                
                (5,377
                )
                
                
                (5,364
                )Net
      cash provided (used) by financing activities
                
                
                105,618
                
                
                
                74,978
                
                
                
                (9,690
                )


44





SHORE
BANCSHARES, INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS (CONTINUED)


For the
Years Ended December 31,





(Dollars in thousands)
                
                2009
                
                
                2008
                
                
                2007NET
      INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
                
                
                48,352
                
                
                
                414
                
                
                
                (52,793
                )CASH
      AND CASH EQUIVALENTS AT BEGINNING OF YEAR
                
                
                27,294
                
                
                
                26,880
                
                
                
                79,673CASH
      AND CASH EQUIVALENTS AT END OF YEAR
                
                $
                75,646
                
                
                $
                27,294
                
                
                $
                26,880Supplemental
      cash flow information:Interest
      paid
                
                $
                17,980
                
                
                $
                21,998
                
                
                $
                23,555Income
      taxes paid
                
                $
                4,975
                
                
                $
                9,704
                
                
                $
                8,462Transfers
      from loans to other real estate owned
                
                $
                2,731
                
                
                $
                286
                
                
                $
                874Details
      of acquisitions:Fair
      value of assets acquired
                
                $
                -
                
                
                $
                -
                
                
                $
                3,705Fair
      value of liabilities assumed
                
                
                -
                
                
                
                -
                
                
                
                (3,404
                )Fair
      value of debt issued
                
                
                -
                
                
                
                -
                
                
                
                (2,485
                )Purchase
      price in excess of net assets acquired
                
                
                -
                
                
                
                -
                
                
                
                9,215Net
      cash paid for acquisitions
                
                $
                -
                
                
                $
                -
                
                
                $
                7,031





The notes
to consolidated financial statements are an integral part of these
statements.


45


SHORE
BANCSHARES, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


For the
Years Ended December 31, 2009, 2008, and 2007





NOTE
1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





The
consolidated financial statements include the accounts of Shore Bancshares, Inc.
and its subsidiaries (collectively referred to in these Notes as the “Company”),
with all significant intercompany transactions eliminated.  The
investments in subsidiaries are recorded on the Company’s books (Parent only) on
the basis of its equity in the net assets of the subsidiaries.  The
accounting and reporting policies of the Company conform to accounting
principles generally accepted in the United States of America (“GAAP”). For
purposes of comparability, certain reclassifications have been made to amounts
previously reported to conform with the current period
presentation.





In 2009,
the Financial Accounting Standards Board (the “FASB”) established the Accounting
Standards Codification (“ASC”) as the source of authoritative accounting
principles recognized by the FASB to be applied by non-governmental entities in
the preparation of financial statements in conformity with generally accepted
accounting principles. Rules and interpretive releases of the U.S. Securities
and Exchange Commission (the “SEC”) under authority of federal securities laws
are also sources of authoritative guidance for SEC registrants. All guidance
contained in the ASC carries an equal level of authority. All non-grandfathered,
non-SEC accounting literature not included in the ASC is superseded and deemed
non-authoritative. The switch to the ASC affects the way companies refer to U.S.
GAAP in financial statements and accounting policies.  Citing
particular content in the ASC involves specifying the unique numeric path to the
content through the Topic, Subtopic, Section and Paragraph
structure.





The
Company has evaluated events and transactions occurring subsequent to the
balance sheet date as of December 31, 2009 through the date the financial
statements were filed, for items that should potentially be recognized or
disclosed in these financial statements as prescribed by recently issued FASB
ASC Topic 855, “Subsequent Events”.  The evaluation was conducted and
it was concluded that no items required disclosure.





Nature
of Operations


The
Company engages in the banking business through CNB, a Maryland trust company
with commercial banking powers, The Talbot Bank of Easton, Maryland, a Maryland
commercial bank (“Talbot Bank”), and The Felton Bank, a Delaware commercial
bank  (“Felton Bank” and, together with CNB and Talbot Bank, the
“Banks”).  Its primary source of revenue is interest earned on
commercial, real estate and consumer loans made to customers located on the
Delmarva Peninsula.  The Company engages in the insurance business
through two general insurance producer firms, The Avon-Dixon Agency, LLC, a
Maryland limited liability company, and Elliott Wilson Insurance, LLC, a
Maryland limited liability company; one marine insurance producer firm, Jack
Martin & Associates, Inc., a Maryland corporation; three wholesale insurance
firms, Tri-State General Insurance Agency, LTD, a Maryland corporation,
Tri-State General Insurance Agency of New Jersey, Inc., a New Jersey
corporation, and Tri-State General Insurance Agency of Virginia, Inc., a
Virginia corporation; and two insurance premium finance companies, Mubell
Finance, LLC, a Maryland limited liability company, and ESFS, Inc., a Maryland
corporation (all of the foregoing are collectively referred to as the “Insurance
Subsidiaries”).  The Company also has a mortgage broker subsidiary,
Wye Mortgage Group, LLC (the “Mortgage Group”).





Use
of Estimates


The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period.  Actual results could differ from those
estimates.





The
allowance for credit losses is a material estimate that is particularly
susceptible to significant changes in the near term.  Management
believes that the allowance for credit losses is sufficient to address the
probable losses in the current portfolio.  While management uses
available information to recognize losses on loans, future additions to the
allowance may be necessary based on changes in economic
conditions.  In addition, various regulatory agencies, as an integral
part of their examination processes, periodically review the Company’s allowance
for credit losses.  Such agencies may require the Company to recognize
additions to the allowance based on their judgments about information available
to them at the time of their examination.


46





Investment Securities Available for
Sale


Investment
securities available for sale are stated at estimated fair value based on quoted
market prices.  They represent those securities which management may
sell as part of its asset/liability strategy or which may be sold in response to
changing interest rates, changes in prepayment risk or other similar
factors.  The cost of securities sold is determined by the specific
identification method.  Purchase premiums and discounts are recognized
in interest income using the interest method over the terms of the
securities.  Net unrealized holding gains and losses on these
securities are reported as accumulated other comprehensive income, a separate
component of stockholders’ equity, net of related income
taxes.  Declines in the fair value of individual available-for-sale
securities below their cost that are other than temporary result in write-downs
of the individual securities to their fair value and are reflected in earnings
as realized losses.  Factors affecting the determination of whether an
other-than-temporary impairment has occurred include a downgrading of the
security by a rating agency, a significant deterioration in the financial
condition of the issuer, or that management would have the intent to sell a
security or be required to sell a security before recovery of its amortized
cost.  Equity securities include Federal Home Loan Bank stock, Federal
Reserve Bank stock and Atlantic Central Banker’s Bank stock which are considered
restricted as to marketability and are recorded at cost.





Investment
Securities Held to Maturity


Investment
securities held to maturity are stated at cost adjusted for amortization of
premiums and accretion of discounts.  Purchase premiums and discounts
are recognized in interest income using the interest method over the terms of
the securities.  The Company intends and has the ability to hold such
securities until maturity.  Declines in the fair value of individual
held-to-maturity securities below their cost that are other than temporary
result in write-downs of the individual securities to their fair
value.  Factors affecting the determination of whether an
other-than-temporary impairment has occurred include a downgrading of the
security by a rating agency, a significant deterioration in the financial
condition of the issuer, or that management would have the intent to sell a
security or be required to sell a security before recovery of its amortized
cost.





Loans


Loans are
stated at their principal amount outstanding net of any deferred fees and
costs.  Interest income on loans is accrued at the contractual rate
based on the principal amount outstanding.  Fees charged and costs
capitalized for originating loans are being amortized substantially on the
interest method over the term of the loan. A loan is placed on nonaccrual when
it is specifically determined to be impaired or when principal or interest is
delinquent for 90 days or more, unless the loan is well secured and in the
process of collection.  Any unpaid interest previously accrued on
those loans is reversed from income.  Interest income generally is not
recognized on specific impaired loans unless the likelihood of further loss is
remote.  Interest payments received on nonaccrual loans are applied as
a reduction of the loan principal balance unless collectability of the principal
amount is reasonably assured, in which case interest is recognized on a cash
basis.  Loans are returned to accrual status when all principal and
interest amounts contractually due are brought current and future payments are
reasonably assured.





Loans are
considered impaired when it is probable that the Company will not collect all
principal and interest payments according to the loan’s contractual
terms.  The impairment of a loan is measured at the present value of
expected future cash flows using the loan’s effective interest rate, or at the
loan’s observable market price or the fair value of the collateral if the loan
is collateral dependent.  Generally, the Company measures impairment
on such loans by reference to the fair value of the collateral. Income on
impaired loans is recognized on a cash basis, and payments are first applied
against the principal balance outstanding.  Impaired loans do not
include groups of smaller balance homogeneous loans such as residential mortgage
and consumer installment loans that are evaluated collectively for
impairment.  Reserves for probable credit losses related to these
loans are based upon historical loss ratios and are included in the allowance
for credit losses.





Allowance
for Credit Losses


The
allowance for credit losses is maintained at a level believed adequate by
management to absorb losses inherent in the loan portfolio as of the balance
sheet date and is based on the size and current risk characteristics of the loan
portfolio, an assessment of individual problem loans and actual loss experience,
current economic events in specific industries and geographical areas, including
unemployment levels, and other pertinent factors, including regulatory guidance
and general economic conditions and other observable
data.  Determination of the allowance is inherently subjective as it
requires significant estimates, including the amounts and timing of expected
future cash flows or collateral value of impaired loans, estimated losses on
pools of homogeneous loans that are based on historical loss experience, and
consideration of current economic trends, all of which may be susceptible to
significant change.  Loan losses are charged off against the
allowance, while recoveries of amounts previously charged off are credited to
the allowance.  A provision for credit losses is charged to operations
based on management’s periodic evaluation of the factors previously mentioned,
as well as other pertinent factors.  Evaluations are conducted at
least quarterly and more often if deemed necessary.


47





The
allowance for credit losses is an estimate of the losses that may be sustained
in the loan portfolio.  The allowance is based on two basic principles
of accounting: (i) ASC Topic 450, “Contingencies”, which requires that losses be
accrued when they are probable of occurring and estimable, and (ii) ASC Topic
310, “Receivables,” which requires that losses be accrued based on the
differences between the loan balance and the value of collateral, present value
of future cash flows or values that are observable in the secondary
market.  Management uses many factors, including economic conditions
and trends, the value and adequacy of collateral, the volume and mix of the loan
portfolio, and our internal loan processes in determining the inherent loss that
may be present in our loan portfolio.  Actual losses could differ
significantly from management’s estimates.  In addition, GAAP itself
may change from one previously acceptable method to another.  Although
the economics of transactions would be the same, the timing of events that would
impact the transactions could change.





The
allowance for credit losses is comprised of three parts: the specific allowance,
the formula allowance and the nonspecific allowance.  The specific
allowance is the portion of the allowance that results from management’s
evaluation of specific loss allocations for identified problem loans and pooled
reserves based on historical loss experience for each loan
category.  The formula allowance is determined based on management’s
assessment of industry trends and economic factors in the markets in which we
operate.  The determination of the formula allowance involves a higher
risk of uncertainty and considers current risk factors that may not have yet
manifested themselves in our historical loss factors.  The nonspecific
allowance captures losses that have impacted the portfolio but have yet to be
recognized in either the specific or formula allowance.





Premises
and Equipment


Premises
and equipment are stated at cost less accumulated depreciation and
amortization.  Depreciation and amortization are calculated using the
straight-line method over the estimated useful lives of the
assets.  Useful lives range from three to ten years for furniture,
fixtures and equipment; three to five years for computer hardware and data
handling equipment; and ten to forty years for buildings and building
improvements.  Land improvements are amortized over a period of
fifteen years and leasehold improvements are amortized over the term of the
respective lease.  Sale-leaseback transactions are considered normal
leasebacks and any realized gains are deferred and amortized to other income on
a straight-line basis over the initial leave term.  Maintenance and
repairs are charged to expense as incurred, while improvements which extend the
useful life of an asset are capitalized and depreciated over the estimated
remaining life of the asset.





Long-lived
assets are evaluated periodically for impairment when events or changes in
circumstances indicate the carrying amount may not be
recoverable.  Impairment exists when the expected undiscounted future
cash flows of a long-lived asset are less than its carrying value.  In
that event, the Company recognizes a loss for the difference between the
carrying amount and the estimated fair value of the asset.





Goodwill
and Other Intangible Assets


Goodwill
represents the excess of the cost of an acquisition over the fair value of the
net assets acquired.  Other intangible assets represent purchased
assets that also lack physical substance but can be distinguished from goodwill
because of contractual or other legal rights or because the asset is capable of
being sold or exchanged either on its own or in combination with a related
contract, asset or liability.  Goodwill and other intangible assets
with indefinite lives are tested at least annually for
impairment.  Intangible assets that have finite lives are amortized
over their estimated useful lives and also are subject to impairment
testing.  The Company’s other intangible assets that  have
finite lives are amortized on a straight-line basis over varying periods not
exceeding 21 years.  Note 8 includes a summary of the Company’s
goodwill and other intangible assets.





Other
Real Estate Owned


Other
real estate owned represents assets acquired in satisfaction of loans either by
foreclosure or deeds taken in lieu of foreclosure.  Properties
acquired are recorded at the lower of cost or fair value less estimated selling
costs at the time of acquisition with any deficiency charged to the allowance
for credit losses.  Thereafter, costs incurred to operate or carry the
properties as well as reductions in value as determined by periodic appraisals
are charged to operating expense.  Gains and losses resulting
from the final disposition of the properties are included in noninterest
income.





Short-Term
Borrowings


Short-term
borrowings are comprised primarily of Federal Home Loan Bank advances and
repurchase agreements.  The repurchase agreements are securities sold
to the Company’s customers, at the customers’ request, under a continuing
“roll-over” contract that matures in one business day.  The underlying
securities sold are U.S.  Government agency securities, which are
segregated from the Company’s other investment securities by its safekeeping
agents.





Long-Term
Debt


Long-term
debt generally consists of advances from the Federal Home Loan
Bank.  These borrowings are used to fund earning asset growth of the
Company.





Income
Taxes


The
Company and its subsidiaries file a consolidated federal income tax
return.  The Company accounts for income taxes using the liability
method in accordance with required accounting guidance.  Under this
method, deferred tax assets and liabilities are determined by applying the
applicable federal and state income tax rates to cumulative temporary
differences.  These temporary differences represent differences
between financial statement carrying amounts and the corresponding tax bases of
certain assets and liabilities.  Deferred taxes are provided as a
result of such temporary differences.


48





Deferred
tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax
bases.  Deferred tax assets and liabilities are measured using enacted
tax rates expected to apply to taxable income in the years in which those
temporary differences are expected to be recovered or settled.  The
effect on deferred tax assets and liabilities of a change in tax rates is
recognized in the period that includes the enactment date.  The
Company recognizes accrued interest and penalties related to unrecognized tax
benefits as a component of tax expense.





Basic
and Diluted Earnings Per Common Share


Basic
earnings per share is derived by dividing net income available to common
stockholders by the weighted-average number of common shares outstanding and
does not include the effect of any potentially dilutive common stock
equivalents.  Diluted earnings per share is derived by dividing net
income by the weighted-average number of shares outstanding, adjusted for the
dilutive effect of stock-based awards.





Transfers
of Financial Assets


Transfers
of financial assets are accounted for as sales, when control over the assets has
been surrendered.  Control over transferred assets is deemed to be
surrendered when (1) the assets have been isolated from the Company, (2) the
transferee obtains the right (free of conditions that constrain it from taking
advantage of that right) to pledge or exchange the transferred assets, and (3)
the Company does not maintain effective control over the transferred assets
through an agreement to repurchase them before their maturity.





Statement
of Cash Flows


Cash and
due from banks, interest bearing deposits with other banks and federal funds
sold are considered “cash and cash equivalents” for financial reporting
purposes.





Stock-Based
Compensation


Accounting
guidance for stock-based compensation requires that expense relating to such
transactions be recognized as compensation cost in the income
statement.  Stock-based compensation expense is recognized ratably
over the requisite service period for all awards and is based on the grant date
fair value.  Note 14 includes a summary of and activity in the
Company’s stock-based compensation plans.





Derivative
Instruments and Hedging Activities


Under
accounting guidance for derivative instruments and hedging activities, all
derivatives are recorded as other assets or other liabilities on the balance
sheet at their respective fair values.  When the purpose of a
derivative is to hedge the variability of a floating rate asset or liability,
the derivative is considered a “cash flow” hedge.  To account for the
effective portion of a cash flow hedge, unrealized gains and losses due to
changes in the fair value of the derivative designated as a cash flow hedge are
recorded in other comprehensive income.  Ineffectiveness resulting
from differences between the cash flows of the hedged item and changes in fair
value of the derivative is recognized as other noninterest
income.  The net interest settlement on a derivative designated
as  a cash flow hedge is treated as an adjustment of the interest
income or interest expense of the hedged asset or liability.





Advertising
Costs


Advertising
costs are generally expensed as incurred.  The Company incurred
advertising costs of approximately $383 thousand, $513 thousand and $473
thousand for the years ended December 31, 2009, 2008 and 2007,
respectively.





New
Accounting Pronouncements





Pronouncements
adopted


FASB ASC Topic 260, “Earnings Per
Share”.New accounting guidance under ASC Topic 260 clarifies
that instruments granted in share-based payment transactions can be
participating securities prior to the requisite service having been rendered. A
basic principle of this guidance is that unvested share-based payment awards
that contain nonforfeitable rights to dividends or dividend equivalents (whether
paid or unpaid) are participating securities and are to be included in the
computation of EPS pursuant to the two-class method. The provisions of this
guidance are effective for financial statements issued for fiscal years
beginning after December 15, 2008, and interim periods within those years. All
prior-period EPS data presented are required to be adjusted retrospectively to
conform with the provisions of this guidance. The Company adopted this new
accounting guidance effective March 31, 2009, and adoption did not have a
material effect on the Company’s consolidated results of operations or earnings
per share.


49


FASB ASC Topic 805, “Business
Combinations”.  New accounting guidance under ASC Topic 805
recognizes and measures the goodwill acquired in a business combination and
defines a bargain purchase, and requires the acquirer to recognize that excess
as a gain attributable to the acquirer. In contrast, previous accounting
guidance required the “negative goodwill” amount to be allocated as a pro rata
reduction of the amounts assigned to assets acquired. ASC Topic 805 requires
that assets acquired and liabilities assumed in a business combination that
arise from contingencies be recognized at fair value if fair value can be
reasonably estimated. If fair value of such an asset or liability cannot be
reasonably estimated, the asset or liability would generally be recognized in
accordance with ASC Topic 450, “Contingencies.” Under ASC Topic 805, the
requirements of ASC Topic 420, “Exit or Disposal Cost Obligations,” would have
to be met in order to accrue for a restructuring plan in purchase accounting.
This new accounting guidance applies prospectively to business combinations for
which the acquisition date is on or after December 15, 2008. The Company adopted
this guidance effective January 1, 2009.  This new accounting guidance
will change the Company’s accounting treatment for business combinations on a
prospective basis.





FASB ASC Topic 810,
“Consolidation”. During December 2007, the
FASB issued new accounting guidance under ASC Topic 810 to establish accounting
and reporting standards for the noncontrolling interest in a subsidiary and for
the deconsolidation of a subsidiary. It clarifies that a noncontrolling interest
in a subsidiary is an ownership interest in the consolidated entity that should
be reported as equity in the consolidated financial statement, but separate from
the parent’s equity.  This guidance is effective for fiscal years, and
interim periods within those fiscal years, beginning on or after December 15,
2008. Management adopted this new accounting guidance effective January 1, 2009,
and adoption did not have a material impact on the Company’s consolidated
financial condition or results of operations.





FASB ASC Topic 815, “Derivatives and
Hedging”.  New accounting guidance under ASC Topic 815 is
intended to enhance the disclosures required under previous accounting guidance
to include how and why an entity uses derivative instruments, how derivative
instruments and related hedge items are accounted for and their impact on an
entity’s financial positions, results of operations and cash
flows.  This guidance is effective for financial statements issued for
fiscal years and interim periods beginning after November 15,
2008.  Adoption of this new accounting guidance did not have a
material impact on the consolidated financial statements.





FASB ASC Topic 820, “Fair Value
Measurements and Disclosures”. New accounting guidance under ASC Topic
820 addresses concerns regarding (1) determining whether a market is not active
and a transaction is not orderly, (2) recognition and presentation of
other-than-temporary impairments and (3) interim disclosures of fair values of
financial instruments. The guidance is effective for interim and annual periods
ending after June 15, 2009, with early adoption permitted for periods ending
after March 15, 2009. The Company adopted the new accounting guidance effective
June 30, 2009 and adoption did not have a material effect on the Company’s
consolidated results of operations.





FASB ASC Topic 855, “Subsequent
Events”.New accounting guidance under ASC Topic 855
incorporates accounting guidance that originated as U.S. auditing standards into
the body of authoritative literature issued by the FASB.  This
guidance is based on the same principles as those that currently exist in the
auditing standards.  However, the new guidance does make a few changes
such as eliminating Type I and Type II subsequent events and requiring an entity
to determine whether events and transactions occurring subsequent to the balance
sheet date through the date the financial statements are filed require
disclosure.  This guidance is effective for interim or annual periods
ending after June 15, 2009.  The Company adopted this new accounting
guidance effective June 30, 2009 and adoption did not have a material effect on
the Company’s consolidated financial statements.





Pronouncements
issued but not yet effective


FASB ASC Topic 810,
“Consolidation”.New accounting guidance under ASC Topic 810
amends prior guidance to change how a company determines when an entity that is
insufficiently capitalized or is not controlled through voting (or similar
rights) should be consolidated. The determination of whether a company is
required to consolidate an entity is based on, among other things, an entity’s
purpose and design and a company’s ability to direct the activities of the
entity that most significantly impact the entity’s economic performance. This
guidance requires additional disclosures about the reporting entity’s
involvement with variable-interest entities and any significant changes in risk
exposure due to that involvement as well as its affect on the entity’s financial
statements. This new accounting guidance will be effective January 1, 2010
and is not expected to have a significant impact on the Company’s financial
statements.





FASB ASC Topic 860, “Transfers and
Servicing”. New accounting guidance under ASC Topic 860 amends prior
accounting guidance to enhance reporting about transfers of financial assets,
including securitizations, and where companies have continuing exposure to the
risks related to transferred financial assets. This guidance eliminates the
concept of a “qualifying special-purpose entity” and changes the requirements
for derecognizing financial assets. This guidance also requires additional
disclosures about all continuing involvements with transferred financial assets
including information about gains and losses resulting from transfers during the
period. This new accounting guidance will be effective January 1, 2010 and
is not expected to have a significant impact on the Company’s financial
statements.


50





NOTE
2.  ACQUISITIONS





Effective
October 1, 2007, the Company acquired Jack Martin & Associates, Inc. (“JM”),
a marine insurance agency located in Annapolis, Maryland.  Pursuant to
the acquisition agreement, the Company paid $3.7 million in cash for all of the
issued and outstanding capital stock of JM.  The total fair value of
assets acquired was $484 thousand and the total of liabilities assumed was $433
thousand. Total intangible assets recorded relating to the acquisition of JM
included $1.9 million of goodwill, $1.2 million of intangible assets subject to
amortization, and $0.8 million of intangible assets not subject to
amortization.  In addition to the purchase price, the acquisition
agreement calls for a deferred payment to be made on or before February 14, 2011
if the acquired business meets certain performance criteria through December 31,
2010.





Effective
October 1, 2007, the Company acquired TSGIA, Inc. and its operating
subsidiaries, Tri-State General Insurance Agency, LTD, Tri-State General
Insurance Agency of New Jersey, Inc., Tri-State General Insurance Agency of
Virginia, Inc., and ESFS, Inc. (collectively, “TSGIA”).  In accordance
with the purchase agreement, the Company paid $5.85 million for
TSGIA.  The total fair value of assets acquired was $3.2 million and
the total of liabilities assumed was $3.0 million.  Additionally, the
Company assumed $2.5 million in long-term debt.  Total intangible
assets recorded relating to the acquisition of TSGIA included $2.1 million of
goodwill, $1.5 million of intangible assets subject to amortization, and $1.7
million of intangible assets not subject to amortization.   In
addition to the purchase price, the acquisition agreement calls for a deferred
payment to be made on or before February 14, 2013 if the acquired business meets
certain performance criteria through December 31, 2012.





The
results of operations of JM and TSGIA subsequent to the acquisition date are
included in the Company’s Consolidated Statements of Income.





NOTE
3. CASH
AND DUE FROM BANKS





The Board
of Governors of the Federal Reserve System (the “FRB”) requires banks to
maintain certain minimum cash balances consisting of vault cash and deposits in
the appropriate Federal Reserve Bank or in other commercial
banks.  Such balances for the Company’s bank subsidiaries averaged
approximately $1.5 million and $1.4 million during 2009 and 2008,
respectively.


51





NOTE
4.  INVESTMENT SECURITIES





The
amortized cost and estimated fair values of investment securities are as
follows:





Gross
                
                
                Gross
                
                
                EstimatedAmortized
                
                
                Unrealized
                
                
                Unrealized
                
                
                Fair(Dollars in thousands)
                
                Cost
                
                
                Gains
                
                
                Losses
                
                
                ValueAvailable-for-sale
      securities:December
      31, 2009:Obligations
      of U.S. Treasury
                
                $
                2,998
                
                
                $
                -
                
                
                $
                -
                
                
                $
                2,998Obligations
      of U.S. Government agencies and corporations
                
                
                57,258
                
                
                
                879
                
                
                
                397
                
                
                
                57,740Mortgage-backed
      securities
                
                
                35,579
                
                
                
                818
                
                
                
                90
                
                
                
                36,307Federal
      Home Loan Bank stock
                
                
                2,822
                
                
                
                -
                
                
                
                -
                
                
                
                2,822Federal
      Reserve Bank stock
                
                
                302
                
                
                
                -
                
                
                
                -
                
                
                
                302Other
      equity securities
                
                
                571
                
                
                
                4
                
                
                
                -
                
                
                
                575Total
                
                $
                99,530
                
                
                $
                1,701
                
                
                $
                487
                
                
                $
                100,744December
      31, 2008:Obligations
      of U.S. Treasury
                
                $
                1,000
                
                
                $
                -
                
                
                $
                -
                
                
                $
                1,000Obligations
      of U.S. Government agencies and corporations
                
                
                49,996
                
                
                
                1,451
                
                
                
                -
                
                
                
                51,447Mortgage-backed
      securities
                
                
                22,028
                
                
                
                879
                
                
                
                8
                
                
                
                22,899Federal
      Home Loan Bank stock
                
                
                3,003
                
                
                
                -
                
                
                
                -
                
                
                
                3,003Federal
      Reserve Bank stock
                
                
                302
                
                
                
                -
                
                
                
                -
                
                
                
                302Other
      equity securities
                
                
                551
                
                
                
                2
                
                
                
                -
                
                
                
                553Total
                
                $
                76,880
                
                
                $
                2,332
                
                
                $
                8
                
                
                $
                79,204Held-to-maturity
      securities:December
      31, 2009:Obligations
      of states and political subdivisions
                
                $
                8,940
                
                
                $
                163
                
                
                $
                91
                
                
                $
                9,012December
      31, 2008:Obligations
      of states and political subdivisions
                
                $
                10,252
                
                
                $
                159
                
                
                $
                21
                
                
                $
                10,390





Gross
unrealized losses and fair value by length of time that the individual
available-for-sale securities have been in a continuous unrealized loss position
at December 31, 2009, are as follows:





Less than
                  12 Months
                
                
                More than
                  12 Months
                
                
                Total(Dollars in thousands)
                
                Fair
                  Value
                
                
                Unrealized
                  Losses
                
                
                Fair
                  Value
                
                
                Unrealized
                  Losses
                
                
                Fair
                  Value
                
                
                Unrealized
                  LossesAvailable-for-sale
      securities:U.S.
      Gov’t agencies and corporations
                
                $
                22,835
                
                
                $
                397
                
                
                $
                -
                
                
                $
                -
                
                
                $
                22,835
                
                
                $
                397Mortgage-backed
      securities
                
                
                8,998
                
                
                
                90
                
                
                
                -
                
                
                
                -
                
                
                
                8,998
                
                
                
                90Total
                
                $
                31,833
                
                
                $
                487
                
                
                $
                -
                
                
                $
                -
                
                
                $
                31,833
                
                
                $
                487


52


The
available-for-sale securities have a fair value of approximately $100.7 million,
of which approximately $31.8 million have unrealized losses when compared to
their amortized cost.  The securities with the unrealized losses in
the available-for-sale portfolio all have modest duration risk, low credit risk,
and minimal losses (approximately 0.49%) when compared to amortized
cost.  The unrealized losses that exist are the result of market
changes in interest rates since the original purchase.  Because the
Company does not intend to sell these securities and it is not more likely than
not that the Company will be required to sell these securities before recovery
of their amortized cost bases, which may be at maturity, the Company considers
the unrealized losses in the available-for-sale portfolio to be
temporary.





Gross
unrealized losses and fair value by length of time that the individual
held-to-maturity securities have been in a continuous unrealized loss position
at December 31, 2009 are as follows:





Less than
                  12 Months
                
                
                More than
                  12 Months
                
                
                Total(Dollars in thousands)
                
                Fair
                  Value
                
                
                Unrealized
                  Losses
                
                
                Fair
                  Value
                
                
                Unrealized
                  Losses
                
                
                Fair
                  Value
                
                
                Unrealized
                  LossesHeld-to-maturity
      securities:Obligations
      of states and political subdivisions
                
                $
                2,065
                
                
                $
                87
                
                
                $
                186
                
                
                $
                4
                
                
                $
                2,251
                
                
                $
                91





The
held-to-maturity securities have a fair value of approximately $9.0 million, of
which approximately $2.3 million have unrealized losses when compared to their
amortized cost.  All of the securities with the unrealized losses in
the held-to-maturity portfolio are municipal securities with modest duration
risk, low credit risk, and minimal losses (approximately 1.02%) when compared to
amortized cost.  The unrealized losses that exist are the result of
market changes in interest rates since the original purchase.  Because
the Company does not intend to sell these securities and it is not more likely
than not that the Company will be required to sell these securities before
recovery of their amortized cost bases, which may be at maturity, the Company
considers that the unrealized losses in the held-to-maturity portfolio to be
temporary.





The
amortized cost and estimated fair values of investment securities by maturity
date at December 31, 2009 are as follows:





Available-for-sale
                
                
                Held-to-maturityAmortized
                
                
                Estimated
                
                
                Amortized
                
                
                Estimated(Dollars in thousands)
                
                Cost
                
                
                Fair Value
                
                
                Cost
                
                
                Fair ValueDue
      in one year or less
                
                $
                8,872
                
                
                $
                8,984
                
                
                $
                2,470
                
                
                $
                2,484Due
      after one year through five years
                
                
                46,087
                
                
                
                47,081
                
                
                
                4,514
                
                
                
                4,642Due
      after five years through ten years
                
                
                17,589
                
                
                
                17,546
                
                
                
                943
                
                
                
                937Due
      after ten years
                
                
                23,287
                
                
                
                23,434
                
                
                
                1,013
                
                
                
                94995,835
                
                
                
                97,045
                
                
                
                8,940
                
                
                
                9,012Equity
      securities
                
                
                3,695
                
                
                
                3,699
                
                
                
                -
                
                
                
                -Total
                
                $
                99,530
                
                
                $
                100,744
                
                
                $
                8,940
                
                
                $
                9,012





The
maturity dates for mortgage-backed securities are determined by expected
maturity dates.  The maturity dates for the remaining debt securities
are determined using contractual maturity dates.





The
following table sets forth the amortized cost and estimated fair values of
securities which have been pledged as collateral for obligations to federal,
state and local government agencies, and other purposes as required or permitted
by law, or sold under agreements to repurchase.  All pledged
securities are in the available-for-sale investment portfolio.





December 31, 2009
                    
                    
                    December 31, 2008Amortized
                    
                    
                    Estimated
                    
                    
                    Amortized
                    
                    
                    Estimated(Dollars in thousands)
                    
                    Cost
                    
                    
                    Fair Value
                    
                    
                    Cost
                    
                    
                    Fair ValuePledged
      available-for-sale securities
                    
                    $
                    64,856
                    
                    
                    $
                    66,024
                    
                    
                    $
                    69,124
                    
                    
                    $
                    71,322





There
were no obligations of states or political subdivisions with carrying values, as
to any issuer, exceeding 10% of stockholders’ equity at December 31, 2009 or
2008.


53


Proceeds
from sales of investment securities were  $2.0 million, $2 thousand,
and $3.5 million for the years ended December 31, 2009, 2008, and 2007,
respectively.  Gross gains from sales of investment securities were
$49 thousand, $0, and $5 thousand for the years ended December 31, 2009, 2008,
and 2007, respectively.  There were no gross losses for the years
ended December 31, 2009 or 2007.  Gross losses were $15 thousand for
the year ended December 31, 2008.  The investment securities losses in
2008 resulted from the sale of 10,000 shares of Freddie Mac preferred
stock.  The Company also incurred a $371 thousand other than temporary
impairment loss on these securities during 2008.





NOTE
5.  LOANS AND ALLOWANCE FOR CREDIT LOSSES





The
Company makes residential mortgage, consumer and commercial loans to customers
primarily in the Maryland counties of Talbot, Queen Anne’s, Kent, Caroline and
Dorchester and in Kent County, Delaware.  The principal categories of
the loan portfolio at December 31 are summarized as follows:





(Dollars in thousands)
                
                2009
                
                
                2008Real
      estate loans:Construction
      and land development
                
                $
                161,437
                
                
                $
                179,847Secured
      by farmland
                
                
                33,966
                
                
                
                24,797Secured
      by residential properties
                
                
                327,873
                
                
                
                289,510Secured
      by nonfarm, nonresidential properties
                
                
                281,964
                
                
                
                279,599Loans
      to farmers (loans to finance agricultural production and other
      loans)
                
                
                2,653
                
                
                
                2,724Commercial
      and industrial loans
                
                
                82,513
                
                
                
                80,107Loans
      to individuals for household, family, and other personal
      expenditures
                
                
                19,534
                
                
                
                22,606Obligations
      of states and political subdivisions in the United States,
      tax-exempt
                
                
                6,400
                
                
                
                7,419All
      other loans
                
                
                217
                
                
                
                1,919916,557
                
                
                
                888,528Allowance
      for credit losses
                
                
                (10,876
                )
                
                
                (9,320
                )Total
                
                $
                905,681
                
                
                $
                879,208





Loans are
net of unearned income of $221 thousand at year-end 2009 and $504 thousand at
year-end 2008.





In the
normal course of banking business, loans are made to officers and directors and
their affiliated interests.  These loans are made on substantially the
same terms and conditions as those prevailing at the time for comparable
transactions with outsiders and are not considered to involve more than the
normal risk of collectibility.  As of December 31, 2009, and 2008,
such loans outstanding, both direct and indirect (including guarantees), to
directors, their associates and policy-making officers, totaled approximately
$19.2  million and $9.5 million, respectively.  During 2009
and 2008, loan additions were approximately $11.7 million and $913 thousand,
respectively, and loan repayments were approximately $2.0 million and $2.4
million, respectively.





Activity
in the allowance for credit losses is summarized as follows:





(Dollars in thousands)
                
                2009
                
                
                2008
                
                
                2007Balance,
      beginning of year
                
                $
                9,320
                
                
                $
                7,551
                
                
                $
                6,300Loans
      charged offReal
      estate – construction
                
                
                (674
                )
                
                
                (536
                )
                
                
                -Real
      estate – residential
                
                
                (2,621
                )
                
                
                (316
                )
                
                
                (137
                )Real
      estate – commercial
                
                
                (1,695
                )
                
                
                (238
                )
                
                
                -Commercial
                
                
                (2,304
                )
                
                
                (447
                )
                
                
                (276
                )Consumer
                
                
                (417
                )
                
                
                (276
                )
                
                
                (301
                )Total
                
                
                (7,711
                )
                
                
                (1,813
                )
                
                
                (714
                )RecoveriesReal
      estate – construction
                
                
                2
                
                
                
                -
                
                
                
                -Real
      estate – residential
                
                
                70
                
                
                
                19
                
                
                
                -Real
      estate – commercial
                
                
                6
                
                
                
                -
                
                
                
                -Commercial
                
                
                66
                
                
                
                136
                
                
                
                165Consumer
                
                
                137
                
                
                
                90
                
                
                
                76Total
                
                
                281
                
                
                
                245
                
                
                
                241Net
      loans charged off
                
                
                (7,430
                )
                
                
                (1,568
                )
                
                
                (473
                )Provision
      for credit losses
                
                
                8,986
                
                
                
                3,337
                
                
                
                1,724Balance,
      end of year
                
                $
                10,876
                
                
                $
                9,320
                
                
                $
                7,551


54





Information
with respect to impaired loans and the related valuation allowance as of
December 31 is as follows:





(Dollars in thousands)
                
                2009
                
                
                2008
                
                
                2007Impaired
      loans with a valuation allowance
                
                $
                2,028
                
                
                $
                2,550
                
                
                $
                3,413Impaired
      loans with no valuation allowance
                
                
                14,274
                
                
                
                5,565
                
                
                
                127Total
      impaired loans
                
                $
                16,302
                
                
                $
                8,115
                
                
                $
                3,540Allowance
      for credit losses applicable to impaired loans
                
                $
                468
                
                
                $
                341
                
                
                $
                819Allowance
      for credit losses applicable to other than impaired loans
                
                
                10,408
                
                
                
                8,979
                
                
                
                6,732Total
      allowance for credit losses
                
                $
                10,876
                
                
                $
                9,320
                
                
                $
                7,551Average
      recorded investment in impaired loans
                
                $
                12,646
                
                
                $
                5,477
                
                
                $
                3,958





Gross
interest income of $859 thousand, $476 thousand and $404 thousand would have
been recorded in 2009, 2008 and 2007, respectively, if nonaccrual loans had been
current and performing in accordance with their original
terms.  Interest actually recorded on such loans was $4 thousand, $193
thousand and $142 thousand for 2009, 2008 and 2007, respectively.





NOTE
6. PREMISES AND EQUIPMENT





A summary
of premises and equipment at December 31 is as follows:





(Dollars in thousands)
                  
                  2009
                  
                  
                  2008Land
                  
                  $
                  4,337
                  
                  
                  $
                  4,337Buildings
      and land improvements
                  
                  
                  12,081
                  
                  
                  
                  11,202Furniture
      and equipment
                  
                  
                  7,823
                  
                  
                  
                  7,19524,241
                  
                  
                  
                  22,734Accumulated
      depreciation
                  
                  
                  9,934
                  
                  
                  
                  (8,879
                  )Total
                  
                  $
                  14,307
                  
                  
                  $
                  13,855





Depreciation
expense totaled $1.1 million for each of the three years in the period ended
December 31, 2009.  The increase in premises and equipment was
primarily from the purchases associated with the new core data processing
system.





On April
17, 2008, the Company entered into a sale-leaseback agreement with Milford Plaza
Enterprises, LLC (“Purchaser”).  Under the agreement, the Company
terminated its ground lease with the Purchaser and conveyed to the Purchaser
title to the Company’s improvements to the property, generally consisting of the
Company’s branch banking facility in Milford, Delaware.  The Company
received $1.3 million for this sale and an immaterial loss was recorded on the
transaction.  The Company has leased back the facility for an initial
period of 12 years.  Monthly rental expense under the agreement is
approximately $11 thousand.





The
Company leases facilities under operating leases.  Rental expense for
the years ended December 31, 2009, 2008, and 2007 was $774 thousand, $607
thousand and $380 thousand, respectively.  The increase in 2009 was
mainly due to one additional lease on a new bank branch and annual rent
increases.  Future minimum annual rental payments are approximately as
follows (dollars in thousands):





2010
                  
                  $
                  7632011
                  
                  
                  7142012
                  
                  
                  6062013
                  
                  
                  4052014
                  
                  
                  320Thereafter
                  
                  
                  1,807Total
      minimum lease payments
                  
                  $
                  4,615


55





NOTE
7.  INVESTMENT IN UNCONSOLIDATED SUBSIDIARY





During
2008, the Company sold its investment in 20.0% of the outstanding common stock
of the Delmarva Data Bank Processing Center, Inc. (“Delmarva
Data”).  The Company recorded a $337 thousand loss on the
sale.





December 31,(Dollars in thousands)
                  
                  2009
                  
                  
                  2008
                  
                  
                  2007Balance,
      beginning of year
                  
                  $
                  -
                  
                  
                  $
                  937
                  
                  
                  $
                  937Equity
      in net income
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Sale
      of investment
                  
                  
                  -
                  
                  
                  
                  (937
                  )
                  
                  
                  -Balance,
      end of year
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  937





Data
processing and other expenses paid to Delmarva Data totaled approximately $763
thousand, $1.7 million and $2.0 million for the years ended December 31, 2009,
2008 and 2007, respectively.  The decrease in expense during 2009 was
due to the Company contracting with a new vendor for data
processing.





NOTE
8.  GOODWILL AND OTHER INTANGIBLE ASSETS





Goodwill
totaled $16.0 million at both December 31, 2009 and December 31,
2008.  The Community banking segment had $4.1 million in goodwill and
the Insurance segment had $11.9 million in goodwill at December 31, 2009,
unchanged from December 31, 2008.  The Insurance segment increased its
goodwill by $4.0 million during 2007 due to the acquisition of two insurance
companies, JM and TSGIA.





The
significant components of goodwill and acquired intangible assets are as
follows:





December 31, 2009
                    
                    
                    December 31, 2008(Dollars in thousands)
                    
                    Gross
                      Carrying
                      Amount
                    
                    
                    Accumulated
                      Amortization
                    
                    
                    Net
                      Carrying
                      Amount
                    
                    
                    Weighted
                      Average
                      Remaining
                      Life
                    
                    
                    Gross
                      Carrying
                      Amount
                    
                    
                    Accumulated
                      Amortization
                    
                    
                    Net
                      Carrying
                      Amount
                    
                    
                    Weighted
                      Average
                      Remaining
                      LifeGoodwill
                    
                    $
                    16,621
                    
                    
                    $
                    (667
                    )
                    
                    $
                    15,954
                    
                    
                    
                    -
                    
                    
                    $
                    16,621
                    
                    
                    $
                    (667
                    )
                    
                    $
                    15,954
                    
                    
                    
                    -Other
      intangible assetsAmortized
      other intangible assetsEmployment
      agreements
                    
                    $
                    1,730
                    
                    
                    $
                    (561
                    )
                    
                    $
                    1,169
                    
                    
                    
                    4.7
                    
                    
                    $
                    1,730
                    
                    
                    $
                    (312
                    )
                    
                    $
                    1,418
                    
                    
                    
                    5.7Insurance
      expirations
                    
                    
                    1,270
                    
                    
                    
                    (640
                    )
                    
                    
                    630
                    
                    
                    
                    7.5
                    
                    
                    
                    1,270
                    
                    
                    
                    (555
                    )
                    
                    
                    715
                    
                    
                    
                    8.5Core
      deposit intangible
                    
                    
                    968
                    
                    
                    
                    (696
                    )
                    
                    
                    272
                    
                    
                    
                    2.3
                    
                    
                    
                    968
                    
                    
                    
                    (575
                    )
                    
                    
                    393
                    
                    
                    
                    3.3Customer
      relationships
                    
                    
                    960
                    
                    
                    
                    (135
                    )
                    
                    
                    825
                    
                    
                    
                    13.7
                    
                    
                    
                    960
                    
                    
                    
                    (75
                    )
                    
                    
                    885
                    
                    
                    
                    14.74,928
                    
                    
                    
                    (2,032
                    )
                    
                    
                    2,896
                    
                    
                    
                    
                    
                    
                    
                    4,928
                    
                    
                    
                    (1,517
                    )
                    
                    
                    3,411Unamortized
      other intangible assetsCarrier
      relationships
                    
                    
                    1,300
                    
                    
                    
                    -
                    
                    
                    
                    1,300
                    
                    
                    
                    -
                    
                    
                    
                    1,300
                    
                    
                    
                    -
                    
                    
                    
                    1,300
                    
                    
                    
                    -Trade
      name
                    
                    
                    1,210
                    
                    
                    
                    -
                    
                    
                    
                    1,210
                    
                    
                    
                    -
                    
                    
                    
                    1,210
                    
                    
                    
                    -
                    
                    
                    
                    1,210
                    
                    
                    
                    -2,510
                    
                    
                    
                    -
                    
                    
                    
                    2,510
                    
                    
                    
                    
                    
                    
                    
                    2,510
                    
                    
                    
                    -
                    
                    
                    
                    2,510Total
      other intangible assets
                    
                    $
                    7,438
                    
                    
                    $
                    (2,032
                    )
                    
                    $
                    5,406
                    
                    
                    
                    
                    
                    
                    $
                    7,438
                    
                    
                    $
                    (1,517
                    )
                    
                    $
                    5,921





The
current period and estimated future amortization expense for amortized other
intangible assets is as follows:





Amortization(Dollars in thousands)
                      
                      ExpenseYear
      ended December 31, 2009
                      
                      
                      $
                      515Estimate
      for years ended December 31,
                      2010
                      
                      
                      5152011
                      
                      
                      5152012
                      
                      
                      4022013
                      
                      
                      3062014
                      
                      
                      306


56


Under the
provisions of FASB ASC Topic 350, “Intangibles – Goodwill and Other”, goodwill
was subjected to an annual assessment for impairment during 2009.  As
a result of the annual assessment, the Company determined that there was no
impairment of goodwill.  The Company will continue to review goodwill
on an annual basis for impairment and as events occur or circumstances
change.





NOTE
9.  OTHER ASSETS AND LIABILITIES





The
Company had the following other assets at December 31.





(Dollars in thousands)
                
                2009
                
                
                2008Insurance
      premiums receivable
                
                $
                983
                
                
                $
                1,348Accrued
      interest receivable
                
                
                4,804
                
                
                
                4,606Deferred
      income taxes (1)
                
                
                3,337
                
                
                
                1,579Interest
      rate caps (2)
                
                
                6,168
                
                
                
                -Prepaid
      FDIC premium expense
                
                
                5,449
                
                
                
                24Other
      assets
                
                
                6,525
                
                
                
                5,248Total
                
                $
                27,266
                
                
                $
                12,805





The
Company had the following other liabilities at December 31.





(Dollars in thousands)
                
                2009
                
                
                2008Accrued
      interest payable
                
                $
                1,781
                
                
                $
                2,350Counterparty
      collateral relating to interest caps (2)
                
                
                4,847
                
                
                
                -Other
      liabilities
                
                
                9,308
                
                
                
                8,619Total
                
                $
                15,936
                
                
                $
                10,969





(1)  See
Note 16 for further discussion.


(2)  See
Note 21 for further discussion.





NOTE
10.  DEPOSITS





The
approximate amount of certificates of deposit of $100,000 or more at December
31, 2009 and 2008 was $262.7 million and $235.2 million,
respectively.





The
approximate maturities of time deposits at December 31 are as
follows:





(Dollars in thousands)
                
                2009
                
                
                2008Due
      in one year or less
                
                $
                384,169
                
                
                $
                328,367Due
      in one to three years
                
                
                77,373
                
                
                
                96,518Due
      in three to five years
                
                
                23,164
                
                
                
                41,574Total
                
                $
                484,706
                
                
                $
                466,459




57





NOTE
11.  SHORT-TERM BORROWINGS





The
following table summarizes certain information for short-term borrowings for the
years ended December 31:





2009
                
                
                2008(Dollars in thousands)
                
                Amount
                
                
                Rate
                
                
                Amount
                
                
                RateAverage
      for the YearRetail
      repurchase agreements
                
                $
                18,200
                
                
                
                0.41
                %
                
                $
                24,229
                
                
                
                1.48
                %Federal
      Home Loan Bank advances
                
                
                6,000
                
                
                
                0.60
                
                
                
                22,219
                
                
                
                3.39Other
      short-term borrowings
                
                
                1,319
                
                
                
                1.23
                
                
                
                1,317
                
                
                
                2.69Total
                
                $
                25,519
                
                
                
                0.50
                
                
                $
                47,765
                
                
                
                2.40At
      Year EndRetail
      repurchase agreements
                
                $
                17,026
                
                
                
                0.47
                %
                
                $
                24,469
                
                
                
                0.45
                %Federal
      Home Loan Bank advances
                
                
                -
                
                
                
                -
                
                
                
                24,050
                
                
                
                0.51Other
      short-term borrowings
                
                
                3,378
                
                
                
                2.51
                
                
                
                4,450
                
                
                
                0.45Total
                
                $
                20,404
                
                
                
                0.82
                
                
                $
                52,969
                
                
                
                0.49Maximum
      Month-End BalanceRetail
      repurchase agreements
                
                $
                29,220
                
                
                
                
                
                
                $
                33,094Federal
      Home Loan Bank advances
                
                
                17,050
                
                
                
                
                
                
                
                31,500Other
      short-term borrowings
                
                
                3,378
                
                
                
                
                
                
                
                8,500





Securities
sold under agreements to repurchase are securities sold to customers, at the
customers’ request, under a “roll-over” contract that matures in one business
day.  The underlying securities sold are U.S. Government agency
securities, which are segregated in the Company’s custodial accounts from other
investment securities.





The
Company may periodically borrow from a correspondent federal funds line of
credit arrangement, under a secured reverse repurchase agreement, or from the
Federal Home Loan Bank to meet short-term liquidity needs.





At
December 31, 2009, other short-term borrowings included $3.4 million drawn on a
$10.0 million line of credit with a commercial bank.  The Company
obtained this line of credit during the fourth quarter of 2009.





NOTE
12.  LONG-TERM DEBT





As of
December 31, the Company had the following long-term debt:





(Dollars in thousands)
                  
                  2009
                  
                  
                  2008FHLB
      4.17%Advance due in 2009
                  
                  $
                  -
                  
                  
                  $
                  3,000FHLB
      3.09% Advance due in 2010
                  
                  
                  -
                  
                  
                  
                  3,000Acquisition-related
      debt, 4.08% interest, annual payments over five years
                  
                  
                  1,429
                  
                  
                  
                  1,947Total
                  
                  $
                  1,429
                  
                  
                  $
                  7,947





The FHLB
borrowings were repaid in July of 2009.  The Company incurred a $78
thousand early repayment penalty which was reflected in interest
expense.  The Company pledged its real estate mortgage loan portfolio
under a blanket floating lien as collateral for the FHLB advances.





The
acquisition-related debt was incurred as part of the purchase price of TSGIA and
is payable to the seller thereof, who remains the President of that
subsidiary.


58


NOTE
13.  BENEFIT PLANS





401(k)
and Profit Sharing Plan





The
Company has a 401(k) and profit sharing plan covering substantially all
full-time employees.  The plan calls for matching contributions by the
Company, and the Company makes discretionary contributions based on profits.
Company contributions to this plan included in expense totaled $1.1 million,
$1.4 million, and $1.1 million for 2009, 2008, and 2007,
respectively.  The expense decreased in 2009 when compared to 2008 due
to a decline in the amount accrued for the profit sharing portion of the plan
based on lower profits.





TSGIA had
a separate 401(k) plan covering substantially all of its full-time employees in
2007.  The Company’s total expense under this plan was $11 thousand
for 2007.





NOTE
14.  STOCK-BASED COMPENSATION





A t
December 31, 2009, the Company maintained two equity compensation plans under it
may issue shares of common stock or grant other equity-based awards: (i) the
Shore Bancshares, Inc. 2006 Stock and Incentive Compensation Plan (“2006 Equity
Plan”); and (ii) the Shore Bancshares, Inc. 1998 Stock Option Plan (the “1998
Option Plan”). The Company's ability to grant options under the 1998 Option Plan
expired on March 3, 2008 pursuant to the terms of that plan, but stock options
granted thereunder were outstanding as of December 31, 2009. Until March 3,
2008, the Company also had the ability to grant stock options to employees under
the Shore Bancshares, Inc. Employee Stock Purchase Plan (“ESPP”). The ESPP gave
employees the right, for a 27-month term, to purchase shares of the Company’s
common stock at 85% of the fair market value on the date of grant. There were no
outstanding options under the ESPP as of December 31, 2009.




Under the
2006 Equity Plan, stock-based awards may be granted periodically to directors,
executive officers, and key employees at the discretion of the Compensation
Committee of the Company’s Board. Stock-based awards granted to date under the
2006 Equity Plan are generally time-based, vesting on each anniversary of the
grant date over a three to five year period of time and, in the case of stock
options, expiring 10 years from the grant date. The 2006 Equity Plan originally
reserved 600,000 shares of common stock for grant, and 567,718 shares remained
available for grant at December 31, 2009 .





The
following table summarizes restricted stock award activity for the Company under
the 2006 Equity Plan for the two years ended December 31, 2009:





Year Ended December 31, 2009
                  
                  
                  Year Ended December 31, 2008Number
                  
                  
                  Weighted Average Grant
                  
                  
                  Number
                  
                  
                  Weighted Average Grantof Shares
                  
                  
                  Date Fair Value
                  
                  
                  of Shares
                  
                  
                  Date Fair ValueNonvested
      at beginning of year
                  
                  
                  16,859
                  
                  
                  $
                  22.55
                  
                  
                  
                  3,845
                  
                  
                  $
                  25.31Granted
                  
                  
                  14,254
                  
                  
                  
                  18.12
                  
                  
                  
                  13,783
                  
                  
                  
                  21.93Vested
                  
                  
                  (3,708
                  )
                  
                  
                  22.63
                  
                  
                  
                  (769
                  )
                  
                  
                  25.31Cancelled
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Nonvested
      at end of year
                  
                  
                  27,405
                  
                  
                  
                  20.23
                  
                  
                  
                  16,859
                  
                  
                  
                  22.55





The total
fair value of restricted stock awards vested was $67 thousand in 2009 and $16
thousand in 2008.





The
following is a summary of stock option activity for the 1998 Option Plan and the
ESPP for 2009 and 2008:





Year Ended December 31, 2009
                  
                  
                  Year Ended December 31, 2008Number
                  
                  
                  Weighted Average
                  
                  
                  Number
                  
                  
                  Weighted Averageof Shares
                  
                  
                  Exercise Price
                  
                  
                  of Shares
                  
                  
                  Exercise PriceOutstanding
      at beginning of year
                  
                  
                  18,550
                  
                  
                  $
                  15.52
                  
                  
                  
                  33,797
                  
                  
                  $
                  15.67Granted
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Exercised
                  
                  
                  (25
                  )
                  
                  
                  21.33
                  
                  
                  
                  (13,181
                  )
                  
                  
                  15.46Expired/Cancelled
                  
                  
                  (7,675
                  )
                  
                  
                  18.55
                  
                  
                  
                  (2,066
                  )
                  
                  
                  18.47Outstanding
      at end of year
                  
                  
                  10,850
                  
                  
                  
                  13.36
                  
                  
                  
                  18,550
                  
                  
                  
                  15.52





The
following summarizes information about stock options outstanding at December 31,
2009:





Options OutstandingNumber
                  
                  Exercise Price
                  
                  
                  Weighted Average Remaining
                    Contract Life (in years)2,430
                  
                  $
                  14.00
                  
                  
                  
                  0.058,420
                  
                  
                  13.17
                  
                  
                  
                  2.2810,850




59





All
options outstanding are exercisable.





The
Company estimates the fair value of stock options using the Black-Scholes
valuation model with weighted average assumptions for dividend yield, expected
volatility, risk-free interest rate and expected lives (in
years).  The expected dividend yield is calculated by dividing the
total expected annual dividend payout by the average stock price.  The
expected volatility is based on historical volatility of the underlying
securities.  The risk-free interest rate is based on the Federal
Reserve Bank’s constant maturities daily interest rate in effect at grant
date.  The expected life of the options represents the period of time
that the Company expects the awards to be outstanding based on historical
experience with similar awards.  No options were granted during 2009
or 2008.





The total
intrinsic value of outstanding exercisable stock options was $12 thousand at
December 31, 2009.  The total intrinsic value of stock options
exercised during the years ended December 31, 2009, 2008, and 2007 was less than
$1 thousand, $80 thousand and $32 thousand, respectively.  No stock
options vested in 2009 or 2008.  The total fair value of stock options
vested for 2007 was $30 thousand.





Stock-based
compensation expense totaled $102 thousand, $91 thousand and $63 thousand in
2009, 2008, and 2007, respectively. Stock-based compensation expense is
recognized ratably over the requisite service period for all awards, is based on
the grant date fair value and reflects forfeitures as they occur.  The
total income tax benefit recognized in the accompanying consolidated statements
of income related to stock-based compensation was $5 thousand, $4 thousand, and
$3 thousand in 2009, 2008, and 2007, respectively.  Unrecognized
stock-based compensation expense related to stock-based awards totaled $455
thousand at December 31, 2009.  At such date, the weighted-average
period over which this unrecognized expense was expected to be recognized was
2.75 years.





NOTE
15.  DEFERRED COMPENSATION





The Shore
Bancshares, Inc. Executive Deferred Compensation Plan (the “Plan”) is for
members of management and highly compensated employees of the Company and its
subsidiaries.  The Plan permits a participant to elect, each year, to
defer receipt of up to 100% of his or her salary and bonus to be earned in the
following year. The Plan also permits the participant to defer the receipt of
performance-based compensation not later than six months before the end of the
period for which it is to be earned. The deferred amounts are credited to an
account maintained on behalf of the participant and are invested at the
discretion of each participant in certain deemed investment options selected
from time to time by the Compensation Committee of the Company’s
Board.   The Company may also make matching, mandatory and
discretionary contributions for certain participants.  A participant
is fully vested at all times in the amounts that he or she elects to
defer.  Any contributions by the Company will vest over a five-year
period.  The Company made contributions to the Plan totaling $85
thousand, $84 thousand, and $167 thousand for 2009, 2008, and 2007,
respectively.  Elective deferrals were made by one plan participant
during 2007.





The
Company has a supplemental deferred compensation plan to provide retirement
benefits to its President and Chief Executive Officer.  The
participant is 100% vested in amounts credited to his account.  No
contributions were made to this plan in 2009, 2008 or 2007.





CNB has
agreements with certain of its directors under which they have deferred part of
their fees and compensation.  The amounts deferred are invested in
insurance policies, owned by the Company, on the lives of the respective
individuals.  Amounts available under the policies are to be paid to
the individuals as retirement benefits over future years.   The
cash surrender value and the accrued benefit obligation included in other assets
and other liabilities at December 31 are as follows:





(Dollars in thousands)
                  
                  2009
                  
                  
                  2008Cash
      surrender value
                  
                  $
                  2,347
                  
                  
                  $
                  2,276Accrued
      benefit obligation
                  
                  
                  1,269
                  
                  
                  
                  1,252





NOTE
16.  INCOME TAXES





Income
taxes included in the balance sheets as of December 31 are as
follows:





(Dollars in thousands)
                
                2009
                
                
                2008Federal
      income taxes currently receivable
                
                $
                918
                
                
                $
                1,180State
      income taxes currently (payable) receivable
                
                
                (25
                )
                
                
                143Deferred
      income tax benefit
                
                
                3,337
                
                
                
                1,579


60





Components
of income tax expense for each of the three years ended December 31 are as
follows:





(Dollars in thousands)
                
                2009
                
                
                2008
                
                
                2007Current tax expense:Federal
                
                $
                4,078
                
                
                $
                6,120
                
                
                $
                7,162State
                
                
                1,262
                
                
                
                1,470
                
                
                
                1,2175,340
                
                
                
                7,590
                
                
                
                8,379Deferred
      income tax benefit:Federal
                
                
                (708
                )
                
                
                (334
                )
                
                
                (255
                )State
                
                
                (220
                )
                
                
                (164
                )
                
                
                (122
                )(928
                )
                
                
                (498
                )
                
                
                (377
                )Total
      income tax expense
                
                $
                4,412
                
                
                $
                7,092
                
                
                $
                8,002





A
reconciliation of tax computed at the statutory federal tax rate of 34.2% for
2009 and 35% for 2008 and 2007 to the actual tax expense for the three years
ended December 31 follows:





(Dollars in thousands)
                
                2009
                
                
                2008
                
                
                2007Tax
      at federal statutory rate
                
                
                34.2
                %
                
                
                35.0
                %
                
                
                35.0
                %Tax
      effect of:Tax-exempt
      income
                
                
                (1.6
                )
                
                
                (1.2
                )
                
                
                (1.0
                )Non-deductible
      expenses
                
                
                0.2
                
                
                
                0.1
                
                
                
                0.2State
      income taxes, net of federal benefit
                
                
                5.9
                
                
                
                4.6
                
                
                
                3.4Other
                
                
                (0.9
                )
                
                
                (0.3
                )
                
                
                (0.3
                )Actual
      income tax expense rate
                
                
                37.8
                %
                
                
                38.2
                %
                
                
                37.3
                %





Significant
components of the Company’s deferred tax assets and liabilities as of December
31 are as follows:





(Dollars in thousands)
                
                2009
                
                
                2008Deferred
      tax assets:Allowance
      for credit losses
                
                $
                4,311
                
                
                $
                3,688Reserve
      for off-balance sheet commitments
                
                
                171
                
                
                
                171Write-downs
      of other real estate owned
                
                
                56
                
                
                
                -Net
      operating loss carry forward
                
                
                156
                
                
                
                115Deferred
      gain on sale leaseback
                
                
                49
                
                
                
                52Deferred
      income
                
                
                665
                
                
                
                271Accrued
      employee benefits
                
                
                849
                
                
                
                710Accrued
      data processing expenses
                
                
                195
                
                
                
                -Unrealized
      losses on interest rate caps
                
                
                384
                
                
                
                -Other
                
                
                7
                
                
                
                8Total
      deferred tax assets
                
                
                6,843
                
                
                
                5,015Deferred
      tax liabilities:Depreciation
                
                
                529
                
                
                
                389Purchase
      accounting adjustments
                
                
                1,374
                
                
                
                1,161Federal
      Home Loan Bank stock dividend
                
                
                29
                
                
                
                29Deferred
      capital gain on branch sale
                
                
                493
                
                
                
                493Deferred
      gains on interest rate swaps
                
                
                169
                
                
                
                -Deferred
      loan costs
                
                
                373
                
                
                
                377Unrealized
      gains on available-for-sale securities
                
                
                486
                
                
                
                932Other
                
                
                53
                
                
                
                55Total
      deferred tax liabilities
                
                
                3,506
                
                
                
                3,436Net
      deferred tax assets
                
                $
                3,337
                
                
                $
                1,579


61





NOTE
      17.
            EARNINGS
      PER COMMON SHARE





Basic
earnings per common share are calculated by dividing net income available to
common stockholders by the weighted average number of common shares outstanding
during the period.  Diluted earnings per common share are calculated
by dividing net income available to common stockholders by the weighted average
number of common shares outstanding during the period, adjusted for the dilutive
effect of stock-based awards.  The following table provides
information relating to the calculation of earnings per common
share:





(In thousands, except per share data)
                
                2009
                
                
                2008
                
                
                2007Net
      income
                
                $
                5,397
                
                
                $
                11,470
                
                
                $
                13,450Weighted
      average shares outstanding – basic
                
                
                8,414
                
                
                
                8,400
                
                
                
                8,380Dilutive
      effect of stock-based awards
                
                
                3
                
                
                
                7
                
                
                
                14Weighted
      average shares outstanding – diluted
                
                
                8,417
                
                
                
                8,407
                
                
                
                8,394Earnings
      per common share – basic
                
                $
                0.64
                
                
                $
                1.37
                
                
                $
                1.61Earnings
      per common share – diluted
                
                $
                0.64
                
                
                $
                1.36
                
                
                $
                1.60





There
were 169 thousand antidilutive weighted average shares relating to a common
stock purchase warrant excluded from the diluted earnings per share calculation
for 2009 and none for 2008 and 2007.  There were 438 and 3,284
antidilutive weighted average stock-based awards excluded from the diluted
earnings per share calculation for 2009 and 2008, respectively.  For
the year ended December 31, 2007, there were no antidilutive weighted average
stock-based awards excluded from the diluted earnings per share
calculation.





NOTE
      18.
            REGULATORY
      CAPITAL REQUIREMENTS





The
Company and each of the Banks are subject to various regulatory capital
requirements administered by the federal banking agencies.  Failure to
meet minimum capital requirements can initiate certain mandatory - and possibly
additional discretionary - actions by regulators that, if undertaken, could have
a direct material effect on the Company’s financial statements.  Under
capital adequacy guidelines and the regulatory framework for prompt corrective
action, the Banks must meet specific capital guidelines that involve
quantitative measures of the Banks’ assets, liabilities, and certain off-balance
sheet items as calculated under regulatory accounting practices.  The
Banks’ capital amounts and classification are also subject to qualitative
judgments by the regulators about components, risk weightings, and other
factors.





Quantitative
measures established by regulation to ensure capital adequacy require the Banks
to maintain amounts and ratios (set forth in the table below) of Tier 1 and
total capital (as defined in the regulations) to risk-weighted assets (as
defined), and of Tier 1 capital (as defined) to average assets (leverage
ratio).  Management believes, as of December 31, 2009, that the
Company and the Banks met all capital adequacy requirements to which they are
subject.





As of
December 31, 2009 and 2008, the most recent notification from the Federal
Deposit Insurance Corporation and the Office of the Comptroller of the Currency
(which was CNB’s federal regulator until it converted to a Maryland-chartered
trust company in December 2009) categorized the Banks as well capitalized under
the regulatory framework for prompt corrective action.  To be
categorized as well capitalized, the Banks must maintain minimum Tier 1
risk-based and total risk-based capital ratios, and Tier 1 leverage
ratios.  Management knows of no trends or demands, commitments, events
or uncertainties that are likely to have a material adverse impact on the
ability of the Company or any of the Banks to remain in the well capitalized
category.





The
minimum ratios for capital adequacy purposes are 4.00%, 8.00% and 4.00% for the
Tier 1 risk-based capital, total risk-based capital and leverage ratios,
respectively.  To be categorized as well capitalized, a bank must
maintain minimum ratios of 6.00%, 10.00% and 5.00% for its Tier 1 risk-based
capital, total risk-based capital and leverage ratios,
respectively.  Shore Bancshares, Inc., as a financial holding company,
is subject to the well-capitalized requirement.





Capital
amounts and ratios for Shore Bancshares, Inc., Talbot Bank, CNB and Felton Bank
as of December 31, 2009 and 2008 are presented below:


62





December 31, 2009
                (Dollars in thousands)
              
              Tier 1
                Capital
              
              
              Total
                Risk-
                Based
                Capital
              
              
              Net
                Risk-
                Weighted
                Assets
              
              
              Adjusted
                Average
                Total Assets
              
              
              Tier 1
                Risk-Based
                Capital
                Ratio
              
              
              Total
                Risk-Based
                Capital
                Ratio
              
              
              Tier 1
                Leverage
                RatioCompany
              
              $
              106,391
              
              
              $
              116,928
              
              
              $
              928,933
              
              
              $
              1,148,077
              
              
              
              11.45
              %
              
              
              12.59
              %
              
              
              9.27
              %Talbot
      Bank
              
              
              67,539
              
              
              
              73,953
              
              
              
              602,944
              
              
              
              728,612
              
              
              
              11.20
              
              
              
              12.27
              
              
              
              9.27CNB
              
              
              31,461
              
              
              
              34,539
              
              
              
              245,852
              
              
              
              324,464
              
              
              
              12.80
              
              
              
              14.05
              
              
              
              9.70Felton
      Bank
              
              
              8,684
              
              
              
              9,642
              
              
              
              76,060
              
              
              
              90,268
              
              
              
              11.42
              
              
              
              12.68
              
              
              
              9.62





December 31, 2008
                  (Dollars in thousands)
                
                Tier 1
                  Capital
                
                
                Total
                  Risk-
                  Based
                  Capital
                
                
                Net
                  Risk-
                  Weighted
                  Assets
                
                
                Adjusted
                  Average
                  Total Assets
                
                
                Tier 1
                  Risk-Based
                  Capital
                  Ratio
                
                
                Total
                  Risk-Based
                  Capital
                  Ratio
                
                
                Tier 1
                  Leverage
                  RatioCompany
                
                $
                104,117
                
                
                $
                113,872
                
                
                $
                894,024
                
                
                $
                1,013,815
                
                
                
                11.65
                %
                
                
                12.74
                %
                
                
                10.27
                %Talbot
      Bank
                
                
                64,302
                
                
                
                70,101
                
                
                
                556,417
                
                
                
                605,533
                
                
                
                11.56
                
                
                
                12.60
                
                
                
                10.62CNB
                
                
                30,817
                
                
                
                33,327
                
                
                
                257,864
                
                
                
                314,232
                
                
                
                11.95
                
                
                
                12.92
                
                
                
                9.81Felton
      Bank
                
                
                7,182
                
                
                
                8,161
                
                
                
                79,085
                
                
                
                89,802
                
                
                
                9.08
                
                
                
                10.32
                
                
                
                8.00





Federal
and state laws and regulations applicable to banks and their holding companies
impose certain restrictions on dividend payments by the Banks, as well as
restricting extensions of credit and transfers of assets between the Banks and
the Company.  The Banks paid dividends of $5.1 million to the Company
during 2009.  At December 31, 2009, the Banks could have paid
dividends to the Company of approximately $7.2 million without the prior consent
and approval of the regulatory agencies.  The Company had no
outstanding receivables from subsidiaries at December 31, 2009 or
2008.





NOTE
19.  LINES OF CREDIT





The Banks
had $56.5 million in unsecured federal funds lines of credit and a reverse
repurchase agreement available on a short-term basis from correspondent banks at
December 31, 2009.  The comparable amount was $57.5 million at
December 31, 2008.  In addition, the Banks had credit availability of
approximately $14.1 million and $62.1 million from the Federal Home Loan Bank at
December 31, 2009 and 2008, respectively. The Banks have pledged as collateral,
under a blanket lien, all qualifying residential loans under borrowing
agreements with the Federal Home Loan Bank.  At December 31, 2009 and
2008, the Federal Home Loan Bank had issued letters of credit in the amounts of
$71.0 million and $65.0 million, respectively, on behalf of the Banks to local
government entities as collateral for their deposits.  The Banks had
no short-term borrowings from the Federal Home Loan Bank at December 31, 2009
and $24.1 million at December 31, 2008.





During
2009, the Company obtained a $10.0 million line of credit with a commercial bank
to be used primarily for working capital or other general business
purposes.  At the end of 2009, short-term borrowings included $3.4
million drawn on this line.





NOTE
20. FAIR
VALUE MEASUREMENTS




Effective
January 1, 2008, the Company adopted ASC 820, “Fair Value Measurements and
Disclosures” which provides a framework for measuring and disclosing fair
value under GAAP. This accounting guidance requires disclosures about the fair
value of assets and liabilities recognized in the balance sheet in periods
subsequent to initial recognition, whether the measurements are made on a
recurring basis or on a nonrecurring basis.




ASC 820
defines fair value as the exchange price that would be received for an asset or
paid to transfer a liability (an exit price) in the principal or most
advantageous market for the asset or liability in an orderly transaction between
market participants on the measurement date. ASC 820 also establishes a fair
value hierarchy, which requires an entity to maximize the use of observable
inputs and minimize the use of unobservable inputs when measuring fair
value.




The
Company utilizes fair value measurements to record fair value adjustments to
certain assets and to determine fair value disclosures. Securities available for
sale and derivative assets and liabilities are recorded at fair value on a
recurring basis. Additionally, from time to time, the Company may be required to
record at fair value other assets on a nonrecurring basis, such as loans held
for investment (impaired loans) and foreclosed assets (other real estate owned).
These nonrecurring fair value adjustments typically involve application of lower
of cost or market accounting or write-downs of individual assets.




Under ASC
820, assets and liabilities are grouped at fair value in three levels, based on
the markets in which the assets and liabilities are traded and the reliability
of the assumptions used to determine their fair values. These hierarchy levels
are:


63





Level 1
inputs – Unadjusted quoted prices in active markets for identical assets or
liabilities that the entity has the ability to access at the measurement
date.





Level 2
inputs – Inputs other than quoted prices included in Level 1 that are observable
for the asset or liability, either directly or indirectly.  These
might include quoted prices for similar assets or liabilities in active markets,
and inputs other than quoted prices that are observable for the asset or
liability, such as interest rates and yield curves that are observable at
commonly quoted intervals.





Level 3
inputs – Unobservable inputs for determining the fair values of assets or
liabilities that reflect an entity’s own assumptions about the assumptions that
market participants would use in pricing the assets or
liabilities.




The
following is a description of valuation methodologies used for the Company’s
assets and liabilities recorded at fair value.





Investment Securities
Available for Sale


Investment
securities available for sale are recorded at fair value on a recurring basis.
Fair value measurement is based upon quoted prices, if available. If quoted
prices are not available, fair values are measured using independent pricing
models or other model-based valuation techniques such as the present value of
future cash flows, adjusted for the security’s credit rating, prepayment
assumptions and other factors such as credit loss assumptions. Level 1
securities include those traded on an active exchange such as the New York Stock
Exchange, Treasury securities that are traded by dealers or brokers in active
over-the-counter markets and money market funds. Level 2 securities include
mortgage-backed securities issued by government sponsored entities, municipal
bonds and corporate debt securities. Securities classified as Level 3 include
asset-backed securities in less liquid markets.





Loans


The
Company does not record loans at fair value on a recurring basis, however, from
time to time, a loan is considered impaired and an allowance for loan loss is
established. Loans for which it is probable that payment of interest and
principle will not be made in accordance with the contractual terms of the loan
are considered impaired.   The fair value of impaired loans is
estimated using one of several methods, including the collateral value, market
value of similar debt, enterprise value, liquidation value and discounted cash
flows. At December 31, 2009, substantially all impaired loans were evaluated
based upon the fair value of the collateral.  Those impaired loans not
requiring a specific allowance represent loans for which the fair value of
expected repayments or collateral exceed the recorded investment in such
loans.  Impaired loans that have an allowance established based on the
fair value of collateral require classification in the fair value hierarchy.
When the fair value of the collateral is based on an observable market price or
a current appraised value, the Company records the loan as nonrecurring Level 2.
When an appraised value is not available or management determines the fair value
of the collateral is further impaired below the appraised value and there is no
observable market price, the Company records the loan as nonrecurring Level
3.





Foreclosed
Assets


Foreclosed
assets are adjusted for fair value upon transfer of loans to foreclosed
assets.  Subsequently, foreclosed assets are carried at the lower of
carrying value and fair value.  Fair value is based upon independent
market prices, appraised value of the collateral or management’s estimation of
the value of the collateral.  When the fair value of the collateral is
based on an observable market price or a current appraised value, the Company
records the foreclosed asset as nonrecurring Level 2.  When an
appraised value is not available or management determines the fair value of the
collateral is further impaired below the appraised value and there is no
observable market price, the Company records the foreclosed asset as
nonrecurring Level 3.





Derivative Assets and
Liabilities


Derivative
instruments held or issued by the Company for risk management purposes are
traded in over-the-counter markets where quoted market prices are not readily
available.  For those derivatives, the Company measures fair value
using models that use primarily market observable inputs, such as yield curves
and option volatilities, and include the value associated with counterparty
credit risk.  The Company classifies derivative instruments held or
issued for risk management purposes as recurring Level 2.  As of
December 31, 2009, the Company’s derivative instruments consisted solely of
interest rate caps.  Derivative assets and liabilities are included in
other assets and liabilities, respectively, in the accompanying consolidated
balance sheet.


64




Assets Recorded at Fair
Value on a Recurring Basis


The table
below presents the recorded amount of assets measured at fair value on a
recurring basis at December 31, 2009.





(Dollars in thousands)
                
                Fair Value
                
                
                Quoted Prices
                  (Level 1)
                
                
                Significant Other
                  Observable Inputs
                  (Level 2)
                
                
                Significant
                  Unobservable Inputs
                  (Level 3)Securities
      available for sale:U.S.
      Treasury
                
                $
                2,998
                
                
                $
                2,998
                
                
                $
                -
                
                
                $
                -U.S.
      Government agencies
                
                
                57,740
                
                
                
                -
                
                
                
                57,740
                
                
                
                -Mortgage-backed
      securities
                
                
                36,307
                
                
                
                -
                
                
                
                36,307
                
                
                
                -Federal
      Home Loan Bank stock
                
                
                2,822
                
                
                
                -
                
                
                
                2,822
                
                
                
                -Federal
      Reserve Bank stock
                
                
                302
                
                
                
                -
                
                
                
                302
                
                
                
                -Other
      equity securities
                
                
                575
                
                
                
                -
                
                
                
                575
                
                
                
                -Total
                
                $
                100,744
                
                
                $
                2,998
                
                
                $
                97,746
                
                
                $
                -Interest
      rate caps
                
                $
                6,168
                
                
                $
                -
                
                
                $
                6,168
                
                
                $
                -





Assets Recorded at Fair
Value on a Nonrecurring Basis


The table
below presents the recorded amount of assets measured at fair value on a
nonrecurring basis at December 31, 2009.





(Dollars in thousands)
                
                Fair Value
                
                
                Quoted Prices
                  (Level 1)
                
                
                Significant Other
                  Observable Inputs
                  (Level 2)
                
                
                Significant
                  Unobservable Inputs
                  (Level 3)Impaired
      loans
                
                $
                15,834
                
                
                $
                -
                
                
                $
                -
                
                
                $
                15,834Other
      real estate owned
                
                
                2,572
                
                
                
                -
                
                
                
                -
                
                
                
                2,572





Impaired
loans had a carrying amount of $16.3 million with a valuation allowance of $468
thousand at December 31, 2009.





The
following disclosure is about the fair value of the company’s financial
instruments.  The methods and assumptions used to estimate the fair
value of each class of financial instruments for which it is practicable to
estimate that value is discussed below:





Cash and Cash
Equivalents


For
short-term instruments, the carrying amount is a reasonable estimate of fair
value.





Investment
Securities


For all
investments in debt securities, fair values are based on quoted market
prices.  If a quoted market price is not available, fair value is
estimated using quoted market prices for similar securities.





Loans


The fair
value of categories of fixed rate loans, such as commercial loans, residential
mortgage, and other consumer loans is estimated by discounting the future cash
flows using the current rates at which similar loans would be made to borrowers
with similar credit ratings and for the same remaining
maturities.  Other loans, including variable rate loans, are adjusted
for differences in loan characteristics.





Financial
Liabilities


The fair
value of demand deposits, savings accounts, and certain money market deposits is
the amount payable on demand at the reporting date.  The fair value of
fixed-maturity certificates of deposit is estimated using the rates currently
offered for deposits of similar remaining maturities.  These estimates
do not take into consideration the value of core deposit
intangibles.  The fair value of securities sold under agreements to
repurchase and long-term debt is estimated using the rates offered for similar
borrowings.





Commitments to Extend Credit
and Standby Letters of Credit


The
majority of the Company’s commitments to grant loans and standby letters of
credit are written to carry current market interest rates if converted to
loans.  Because commitments to extend credit and letters of credit are
generally unassignable by the Company or the borrower, they only have value to
the Company and the borrower and therefore it is impractical to assign any value
to these commitments.


65


The
estimated fair values of the Company’s financial instruments as of December 31
are as follows:





2009
                
                
                2008Estimated
                
                
                
                
                
                EstimatedCarrying
                
                
                Fair
                
                
                Carrying
                
                
                Fair(Dollars in thousands)
                
                Amount
                
                
                Value
                
                
                Amount
                
                
                ValueFinancial
      assetsCash
      and cash equivalents
                
                $
                75,646
                
                
                $
                75,646
                
                
                $
                27,294
                
                
                $
                27,294Investment
      securities
                
                
                109,684
                
                
                
                109,756
                
                
                
                89,456
                
                
                
                89,594Loans
                
                
                916,557
                
                
                
                934,362
                
                
                
                888,528
                
                
                
                914,695Less:  allowance
      for loan losses
                
                
                (10,876
                )
                
                -_
                
                
                
                (9,320
                )
                
                _ -Total
                
                $
                1,091,011
                
                
                $
                1,119,764
                
                
                $
                995,958
                
                
                $
                1,031,583Financial
      liabilitiesDeposits
                
                $
                990,937
                
                
                $
                999,016
                
                
                $
                845,371
                
                
                $
                861,951Short-term
      borrowings
                
                
                20,404
                
                
                
                20,404
                
                
                
                52,969
                
                
                
                52,969Long-term
      debt
                
                
                1,429
                
                
                
                1,530
                
                
                
                7,947
                
                
                
                8,060Total
                
                $
                1,012,770
                
                
                $
                1,020,950
                
                
                $
                906,287
                
                
                $
                922,980





NOTE
      21.
            DERIVATIVE
      INSTRUMENTS AND HEDGING ACTIVITIES





ASC 815,
“Derivatives and
Hedging”, defines derivatives, requires that derivatives be carried at
fair value on the balance sheet and provides for hedge accounting when certain
conditions are met.  Changes in the fair values of derivative
instruments designated as “cash flow” hedges, to the extent the hedges are
highly effective, are recorded in other comprehensive income, net of
taxes.  Ineffective portions of cash flow hedges, if any, are
recognized in current period earnings.  The Company uses derivative
instruments to hedge its exposure to changes in interest rates.  The
Company does not use derivatives for any trading or other speculative
purposes.





During
the second quarter of 2009, the Company entered into five-year interest rate
swap agreements with notional amounts of $70 million to effectively fix the
interest rate on $70 million of the Company’s money market deposit accounts at
2.97%. Because the interest rate swaps did not qualify for hedge accounting, the
Company restructured the original transactions and purchased interest rate caps
for $6.5 million during the third quarter of 2009. The interest rate caps
qualified for hedge accounting.  At December 31, 2009, the aggregate
fair value of these derivatives was an asset of $6.2 million.  For
2009, other noninterest income included a gain relating to the
swap  transactions of $420 thousand which was recorded in the second
quarter of 2009.





By
entering into derivative instrument contracts, the Company exposes itself, from
time to time, to counterparty credit risk.  Counterparty credit risk
is the failure of the counterparty to perform under the terms of the derivative
contract.  When the fair value of a derivative contract is in an asset
position, the counterparty has a liability to the Company, which creates credit
risk for the Company.  The Company attempts to minimize this risk by
selecting counterparties with investment grade credit ratings, limiting its
exposure to any single counterparty and regularly monitoring its market position
with each counterparty.  Also to minimize risk, the Company obtained
counterparty collateral which was recorded in other liabilities.  At
December 31, 2009, the counterparty collateral was $4.8 million.





NOTE
      22.
            FINANCIAL
      INSTRUMENTS WITH OFF-BALANCE SHEET
RISK





In the
normal course of business, to meet the financing needs of its customers, the
Banks are parties to financial instruments with off-balance sheet
risk.  These financial instruments include commitments to extend
credit and standby letters of credit.  The Banks’ exposure to credit
loss in the event of nonperformance by the other party to these financial
instruments is represented by the contractual amount of the
instruments.  The Banks use the same credit policies in making
commitments and conditional obligations as they do for on-balance sheet
instruments.  The Banks generally require collateral or other security
to support the financial instruments with credit risk.  The amount of
collateral or other security is determined based on management’s credit
evaluation of the counterparty. The Banks evaluate each customer’s
creditworthiness on a case-by-case basis.





Commitments
to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract.  Letters of
credit are conditional commitments issued by the Company to guarantee the
performance of a customer to a third party.  Letters of credit and
other commitments generally have fixed expiration dates or other termination
clauses and may require payment of a fee.  Because many of the letters
of credit and commitments are expected to expire without being drawn upon, the
total commitment amount does not necessarily represent future cash
requirements.


66


Commitments
outstanding as of December 31 are as follows:





(Dollars in thousands)
                  
                  2009
                  
                  
                  2008Commitments
      to extend credit
                  
                  $
                  147,339
                  
                  
                  $
                  211,423Letters
      of credit
                  
                  
                  18,957
                  
                  
                  
                  12,508Total
                  
                  $
                  166,296
                  
                  
                  $
                  223,931





NOTE
      23.
            CONTINGENCIES





In the
normal course of business, the Company and its subsidiaries may become involved
in litigation arising from banking, financial, and other
activities.  Management, after consultation with legal counsel, does
not anticipate that the future liability, if any, arising out of current
proceedings will have a material effect on the Company’s financial condition,
operating results, or liquidity.





NOTE
      24.
            PARENT
      COMPANY FINANCIAL INFORMATION





Condensed
financial information for Shore Bancshares, Inc. (Parent Company Only) is as
follows:




Condensed
Balance Sheets
 December
31,


(Dollars in thousands)
                    
                    2009
                    
                    
                    2008AssetsCash
                    
                    $
                    324
                    
                    
                    $
                    1,936Investment
      in subsidiaries
                    
                    
                    129,727
                    
                    
                    
                    125,642Income
      taxes receivable
                    
                    
                    21
                    
                    
                    
                    314Premises
      and equipment, net
                    
                    
                    3,003
                    
                    
                    
                    2,885Other
      assets
                    
                    
                    1,705
                    
                    
                    
                    604Total
      assets
                    
                    $
                    134,780
                    
                    
                    $
                    131,381LiabilitiesAccounts
      payable
                    
                    $
                    888
                    
                    
                    $
                    1,083Deferred
      tax liability
                    
                    
                    1,275
                    
                    
                    
                    966Short-term
      borrowings
                    
                    
                    3,378
                    
                    
                    
                    -Long-term
      debt
                    
                    
                    1,429
                    
                    
                    
                    1,947Total
      liabilities
                    
                    
                    6,970
                    
                    
                    
                    3,996Stockholders’
      equityCommon
      stock
                    
                    
                    84
                    
                    
                    
                    84Warrant
                    
                    
                    1,543
                    
                    
                    
                    -Additional
      paid in capital
                    
                    
                    29,872
                    
                    
                    
                    29,768Retained
      earnings
                    
                    
                    96,151
                    
                    
                    
                    96,140Accumulated
      other comprehensive income
                    
                    
                    160
                    
                    
                    
                    1,393Total
      stockholders’ equity
                    
                    
                    127,810
                    
                    
                    
                    127,385Total
      liabilities and stockholders’ equity
                    
                    $
                    134,780
                    
                    
                    $
                    131,381


67





Condensed
Statements of Income


For the
Years Ended December 31,





(Dollars in thousands)
                
                2009
                
                
                2008
                
                
                2007IncomeDividends
      from subsidiaries
                
                $
                5,725
                
                
                $
                6,131
                
                
                $
                11,234Management
      and other fees from subsidiaries
                
                
                5,952
                
                
                
                5,285
                
                
                
                5,078Rental
      income
                
                
                76
                
                
                
                76
                
                
                
                76Interest
      income
                
                
                68
                
                
                
                20
                
                
                
                14Total
      income
                
                
                11,821
                
                
                
                11,512
                
                
                
                16,402ExpensesInterest
      Expense
                
                
                87
                
                
                
                121
                
                
                
                -Salaries
      and employee benefits
                
                
                4,351
                
                
                
                4,111
                
                
                
                3,675Occupancy
      and equipment expense
                
                
                427
                
                
                
                367
                
                
                
                333Other
      operating expenses
                
                
                1,476
                
                
                
                1,268
                
                
                
                1,346Total
      expenses
                
                
                6,341
                
                
                
                5,867
                
                
                
                5,354Income
      before income tax expense and equity in undistributed net income of
      subsidiaries
                
                
                5,480
                
                
                
                5,645
                
                
                
                11,048Income
      tax expense (benefit)
                
                
                125
                
                
                
                (86
                )
                
                
                109Income
      before equity in undistributed net income of subsidiaries
                
                
                5,355
                
                
                
                5,731
                
                
                
                10,939Equity
      in undistributed net income of subsidiaries
                
                
                1,918
                
                
                
                5,739
                
                
                
                2,511Net
      income
                
                
                7,273
                
                
                
                11,470
                
                
                
                13,450Preferred
      stock dividends and discount accretion
                
                
                1,876
                
                
                
                -
                
                
                
                -Net
      income available to common stockholders
                
                $
                5,397
                
                
                $
                11,470
                
                
                $
                13,450


68





Condensed
Statements of Cash Flows


For the
Years Ended December 31,





(Dollars in thousands)
                
                2009
                
                
                2008
                
                
                2007Cash
      flows from operating activities:Net
      income
                
                $
                7,273
                
                
                $
                11,470
                
                
                $
                13,450Adjustments
      to reconcile net income to cash provided by operating
      activities:Equity
      in undistributed net income of subsidiaries
                
                
                (1,918
                )
                
                
                (5,739
                )
                
                
                (2,511
                )Depreciation
                
                
                215
                
                
                
                233
                
                
                
                166Loss
      on disposals of premises and equipment
                
                
                -
                
                
                
                1
                
                
                
                2Stock-based
      compensation expense
                
                
                102
                
                
                
                91
                
                
                
                63Excess
      tax benefits from stock-based arrangements
                
                
                (5
                )
                
                
                (4
                )
                
                
                (3
                )Net
      increase in other assets
                
                
                (808
                )
                
                
                (169
                )
                
                
                (267
                )Net
      increase in other liabilities
                
                
                114
                
                
                
                592
                
                
                
                553Net
      cash provided by operating activities
                
                
                4,973
                
                
                
                6,475
                
                
                
                11,453Cash
      flows from investing activities:Acquisition
                
                
                -
                
                
                
                -
                
                
                
                (8,001
                )Purchases
      of premises and equipment
                
                
                (333
                )
                
                
                (122
                )
                
                
                (135
                )Investment
      in subsidiaries
                
                
                (3,400
                )
                
                
                (85
                )
                
                
                -Net
      cash used by investing activities
                
                
                (3,733
                )
                
                
                (207
                )
                
                
                (8,136
                )Cash
      flows from financing activities:Net
      increase in short-term borrowings
                
                
                3,378
                
                
                
                -
                
                
                
                -Proceeds
      from long-term debt
                
                
                -
                
                
                
                -
                
                
                
                2,485Repayment
      of long-term debt
                
                
                (518
                )
                
                
                (538
                )
                
                
                -Excess
      tax benefits from stock-based arrangements
                
                
                5
                
                
                
                4
                
                
                
                3Proceeds
      from issuance of preferred stock and warrant
                
                
                25,000
                
                
                
                -
                
                
                
                -Redemption
      of preferred stock
                
                
                (23,525
                )
                
                
                -
                
                
                
                -Proceeds
      from issuance of common stock
                
                
                2
                
                
                
                138
                
                
                
                54Common
      stock repurchased and retired
                
                
                -
                
                
                
                -
                
                
                
                (266
                )Preferred
      stock dividends paid
                
                
                (1,808
                )
                
                
                -
                
                
                
                -Common
      stock dividends paid
                
                
                (5,386
                )
                
                
                (5,377
                )
                
                
                (5,364
                )Net
      cash used by financing activities
                
                
                (2,852
                )
                
                
                (5,773
                )
                
                
                (3,088
                )Net
      (decrease) increase in cash and cash equivalents
                
                
                (1,612
                )
                
                
                495
                
                
                
                229Cash
      and cash equivalents at beginning of year
                
                
                1,936
                
                
                
                1,441
                
                
                
                1,212Cash
      and cash equivalents at end of year
                
                $
                324
                
                
                $
                1,936
                
                
                $
                1,441


69


NOTE
      25.
            QUARTERLY
      FINANCIAL RESULTS (unaudited)





A summary
of selected consolidated quarterly financial data for the two years ended
December 31, 2009, is reported as follows:





(In thousands, except per share
      data)
                    
                    First
                      Quarter
                    
                    
                    Second
                      Quarter
                    
                    
                    Third
                      Quarter
                    
                    
                    Fourth
                      Quarter2009Interest
      income
                    
                    $
                    14,466
                    
                    
                    $
                    14,630
                    
                    
                    $
                    14,913
                    
                    
                    $
                    14,780Net
      interest income
                    
                    
                    10,058
                    
                    
                    
                    10,086
                    
                    
                    
                    10,428
                    
                    
                    
                    10,806Provision
      for credit losses
                    
                    
                    1,935
                    
                    
                    
                    1,681
                    
                    
                    
                    1,702
                    
                    
                    
                    3,668Income
      before income taxes
                    
                    
                    3,590
                    
                    
                    
                    3,059
                    
                    
                    
                    3,148
                    
                    
                    
                    1,888Net
      income
                    
                    
                    2,213
                    
                    
                    
                    1,893
                    
                    
                    
                    1,951
                    
                    
                    
                    1,216Preferred
      stock dividends and discount accretion
                    
                    
                    337
                    
                    
                    
                    1,539
                    
                    
                    
                    -
                    
                    
                    
                    -Net
      income available to common stockholders
                    
                    
                    1,876
                    
                    
                    
                    354
                    
                    
                    
                    1,951
                    
                    
                    
                    1,216Basic
      earnings per common share
                    
                    $
                    0.22
                    
                    
                    $
                    0.04
                    
                    
                    $
                    0.23
                    
                    
                    $
                    0.14Diluted
      earnings per common share
                    
                    $
                    0.22
                    
                    
                    $
                    0.04
                    
                    
                    $
                    0.23
                    
                    
                    $
                    0.142008Interest
      income
                    
                    $
                    15,923
                    
                    
                    $
                    15,127
                    
                    
                    $
                    15,298
                    
                    
                    $
                    15,126Net
      interest income
                    
                    
                    10,030
                    
                    
                    
                    9,632
                    
                    
                    
                    9,909
                    
                    
                    
                    10,348Provision
      for credit losses
                    
                    
                    462
                    
                    
                    
                    615
                    
                    
                    
                    875
                    
                    
                    
                    1,385Income
      before income taxes
                    
                    
                    5,479
                    
                    
                    
                    4,482
                    
                    
                    
                    4,851
                    
                    
                    
                    3,750Net
      income
                    
                    
                    3,372
                    
                    
                    
                    2,766
                    
                    
                    
                    3,071
                    
                    
                    
                    2,261Preferred
      stock dividends and discount accretion
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Net
      income available to common stockholders
                    
                    
                    3,372
                    
                    
                    
                    2,766
                    
                    
                    
                    3,071
                    
                    
                    
                    2,261Basic
      earnings per common share
                    
                    $
                    0.40
                    
                    
                    $
                    0.33
                    
                    
                    $
                    0.37
                    
                    
                    $
                    0.27Diluted
      earnings per common share
                    
                    $
                    0.40
                    
                    
                    $
                    0.33
                    
                    
                    $
                    0.37
                    
                    
                    $
                    0.27





Earnings
per share are based on quarterly results and may not be additive to the annual
earnings per share amounts.





NOTE
      26.
            SEGMENT
      REPORTING





The
Company operates two primary business segments:  Community Banking and
Insurance Products and Services.  The Community Banking business
provides services to consumers and small businesses on the Eastern Shore of
Maryland and in Delaware through its 19-branch network. Community banking
activities include small business services, retail brokerage, trust services and
consumer banking products and services.  Loan products available to
consumers include mortgage, home equity, automobile, marine, and installment
loans, credit cards and other secured and unsecured personal lines of
credit.    Small business lending includes commercial
mortgages, real estate development loans, equipment and operating loans, as well
as secured and unsecured lines of credit, credit cards, accounts receivable
financing arrangements, and merchant card services.





Through
the Insurance Products and Services business, the Company provides a full range
of insurance products and services to businesses and consumers in the Company’s
market areas.   Products include property and casualty, life,
marine, individual health and long-term care insurance.  Pension and
profit sharing plans and retirement plans for executives and employees are
available to suit the needs of individual businesses.


70


Selected
financial information by business segments is included in the following
table:





Community
                  
                  
                  Insurance Products
                  
                  
                  Parent(Dollars in thousands)
                  
                  Banking
                  
                  
                  and Services
                  
                  
                  Company
                  
                  
                  Total2009Interest
      income
                  
                  $
                  58,722
                  
                  
                  $
                  67
                  
                  
                  $
                  -
                  
                  
                  $
                  58,789Interest
      expense
                  
                  
                  (17,324
                  )
                  
                  
                  -
                  
                  
                  
                  (87
                  )
                  
                  
                  (17,411
                  )Provision
      for credit losses
                  
                  
                  (8,986
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (8,986
                  )Noninterest
      income
                  
                  
                  7,774
                  
                  
                  
                  11,767
                  
                  
                  
                  -
                  
                  
                  
                  19,541Noninterest
      expense
                  
                  
                  (23,256
                  )
                  
                  
                  (10,882
                  )
                  
                  
                  (6,110
                  )
                  
                  
                  (40,248
                  )Net
      intersegment (expense) income
                  
                  
                  (5,481
                  )
                  
                  
                  (470
                  )
                  
                  
                  5,951
                  
                  
                  
                  -Income
      (loss) before taxes
                  
                  
                  11,449
                  
                  
                  
                  482
                  
                  
                  
                  (246
                  )
                  
                  
                  11,685Income
      tax (expense) benefit
                  
                  
                  (4,323
                  )
                  
                  
                  (182
                  )
                  
                  
                  93
                  
                  
                  
                  (4,412
                  )Net
      income (loss)
                  
                  $
                  7,126
                  
                  
                  $
                  300
                  
                  
                  $
                  (153
                  )
                  
                  $
                  7,273Total
      assets
                  
                  $
                  1,133,673
                  
                  
                  $
                  19,390
                  
                  
                  $
                  3,453
                  
                  
                  $
                  1,156,5162008Interest
      income
                  
                  $
                  61,400
                  
                  
                  $
                  74
                  
                  
                  $
                  -
                  
                  
                  $
                  61,474Interest
      expense
                  
                  
                  (21,434
                  )
                  
                  
                  -
                  
                  
                  
                  (121
                  )
                  
                  
                  (21,555
                  )Provision
      for credit losses
                  
                  
                  (3,337
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (3,337
                  )Noninterest
      income
                  
                  
                  7,644
                  
                  
                  
                  12,707
                  
                  
                  
                  (1
                  )
                  
                  
                  20,350Noninterest
      expense
                  
                  
                  (20,864
                  )
                  
                  
                  (11,967
                  )
                  
                  
                  (5,539
                  )
                  
                  
                  (38,370
                  )Net
      intersegment (expense) income
                  
                  
                  (4,763
                  )
                  
                  
                  (412
                  )
                  
                  
                  5,175
                  
                  
                  
                  -Income
      (loss) before taxes
                  
                  
                  18,646
                  
                  
                  
                  402
                  
                  
                  
                  (486
                  )
                  
                  
                  18,562Income
      tax (expense) benefit
                  
                  
                  (7,124
                  )
                  
                  
                  (154
                  )
                  
                  
                  186
                  
                  
                  
                  (7,092
                  )Net
      income (loss)
                  
                  $
                  11,522
                  
                  
                  $
                  248
                  
                  
                  $
                  (300
                  )
                  
                  $
                  11,470Total
      assets
                  
                  $
                  1,021,715
                  
                  
                  $
                  20,146
                  
                  
                  $
                  2,780
                  
                  
                  $
                  1,044,6412007Interest
      income
                  
                  $
                  65,133
                  
                  
                  $
                  8
                  
                  
                  $
                  -
                  
                  
                  $
                  65,141Interest
      expense
                  
                  
                  (24,105
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (24,105
                  )Provision
      for credit losses
                  
                  
                  (1,724
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (1,724
                  )Noninterest
      income
                  
                  
                  6,775
                  
                  
                  
                  7,906
                  
                  
                  
                  (2
                  )
                  
                  
                  14,679Noninterest
      expense
                  
                  
                  (20,205
                  )
                  
                  
                  (7,124
                  )
                  
                  
                  (5,210
                  )
                  
                  
                  (32,539
                  )Net
      intersegment (expense) income
                  
                  
                  (4,646
                  )
                  
                  
                  (381
                  )
                  
                  
                  5,027
                  
                  
                  
                  -Income
      (loss) before taxes
                  
                  
                  21,228
                  
                  
                  
                  409
                  
                  
                  
                  (185
                  )
                  
                  
                  21,452Income
      tax (expense) benefit
                  
                  
                  (7,918
                  )
                  
                  
                  (153
                  )
                  
                  
                  69
                  
                  
                  
                  (8,002
                  )Net
      income (loss)
                  
                  $
                  13,310
                  
                  
                  $
                  256
                  
                  
                  $
                  (116
                  )
                  
                  $
                  13,450Total
      assets
                  
                  $
                  933,583
                  
                  
                  $
                  20,405
                  
                  
                  $
                  2,923
                  
                  
                  $
                  956,911





NOTE
      27.
            PREFERRED
      STOCK





On
January 9, 2009, Shore Bancshares, Inc. participated in the Troubled Asset
Relief Program Capital Purchase Program of the United States Department of the
Treasury (the “Treasury”) by issuing 25,000 shares of Fixed Rate Cumulative
Perpetual Preferred Stock, Series A (the “Preferred Stock”) and a common stock
purchase warrant covering 172,970 shares of common stock (the “Warrant”) to the
Treasury for a total sales price of $25 million.  On April 15, 2009,
Shore Bancshares, Inc. redeemed all 25,000 shares of the Preferred Stock from
Treasury for $25 million, plus accrued dividends of $208 thousand.  At
the time of the redemption, the Preferred Stock had a carrying value of $23.5
million.  The difference between the redemption price and carrying
value represented an additional accelerated deemed dividend of $1.5
million.  Total dividends paid on the Preferred Stock was $1.8 million
for 2009. Shore Bancshares, Inc. has the right to repurchase the Warrant at its
fair market value, but has not yet decided to do so.  The Treasury
must liquidate any portion of the Warrant not repurchased by Shore Bancshares,
Inc.  The Warrant may be exercised at any time until January 9, 2019,
at an exercise price of $21.68 per share, or an aggregate exercise price of
approximately $3.75 million.  The Warrant counts as tangible common
equity.




71




Item
      9.
            Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure.





None.





Item
      9A.
            Controls
      and Procedures.





The
Company maintains disclosure controls and procedures that are designed to ensure
that information required to be disclosed in the Company’s reports filed under
the Exchange Act with the SEC, such as this annual report, is recorded,
processed, summarized and reported within the time periods specified in those
rules and forms, and that such information is accumulated and communicated to
the Company’s management, including the President and Chief Executive Officer
(“CEO”) and the Principal Accounting Officer (“PAO”), as appropriate, to allow
for timely decisions regarding required disclosure.  A control system,
no matter how well conceived and operated, can provide only reasonable, not
absolute, assurance that the objectives of the control system are
met.  Further, the design of a control system must reflect the fact
that there are resource constraints, and the benefits of controls must be
considered relative to their costs.  These inherent limitations
include the realities that judgments in decision-making can be faulty, and that
breakdowns can occur because of simple error or
mistake.  Additionally, controls can be circumvented by the individual
acts of some persons, by collusion of two or more people, or by management
override of the control.  The design of any system of controls also is
based in part upon certain assumptions about the likelihood of future events,
and there can be no assurance that any design will succeed in achieving its
stated goals under all potential future conditions; over time, control may
become inadequate because of changes in conditions, or the degree of compliance
with the policies or procedures may deteriorate.





An
evaluation of the effectiveness of these disclosure controls as of December 31,
2009 was carried out under the supervision and with the participation of the
Company’s management, including the CEO and the PAO.  Based on that
evaluation, the Company’s management, including the CEO and the PAO, has
concluded that the Company’s disclosure controls and procedures are, in fact,
effective at the reasonable assurance level.





During
the fourth quarter of 2009, there was no change in the Company’s internal
control over financial reporting that has materially affected, or is reasonably
likely to materially affect, the Company’s internal control over financial
reporting.





As
required by Section 404 of the Sarbanes-Oxley Act of 2002, management has
performed an evaluation and testing of the Company’s internal control over
financial reporting as of December 31, 2009.  Management’s report on
the Company’s internal control over financial reporting and the related
attestation report of the Company’s independent registered public accounting
firm are included in Item 8 of Part II of this annual report, and each such
report is incorporated into this Item 9A by reference thereto.





Item
      9B.
            Other
      Information.





None.





PART
III





Item
      10.
            Directors,
      Executive Officers and Corporate
Governance.





The
Company has adopted a Code of Ethics that applies to all of its directors,
officers, and employees, including its principal executive officer, principal
financial officer, principal accounting officer, or controller, or persons
performing similar functions.  A written copy of the Company’s Code of
Ethics will be provided to stockholders, free of charge, upon request
to:  W. David Morse, Secretary, Shore Bancshares, Inc., 18 E. Dover
Street, Easton, Maryland 21601 or (410) 822-1400.





All other
information required by this item is incorporated herein by reference to the
Company’s definitive proxy statement to be filed in connection with the 2010
Annual Meeting of Stockholders.





Item
      11.
            Executive
      Compensation.





The
information required by this item is incorporated herein by reference to the
Company’s definitive proxy statement to be filed in connection with the 2010
Annual Meeting of Stockholders.


72


Item
      12.
            Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters.





The
information provided in Item 5 of Part II of this report under the heading
“EQUITY COMPENSATION PLAN INFORMATION” is incorporated herein by
reference.  All other information required by this item is
incorporated herein by reference to the Company’s definitive proxy statement to
be filed in connection with the 2010 Annual Meeting of
Stockholders.





Item
      13.
            Certain
      Relationships and Related Transactions, and Director
      Independence.





The
information required by this item is incorporated herein by reference to the
Company’s definitive proxy statement to be filed in connection with the 2010
Annual Meeting of Stockholders.





Item
      14.
            Principal
      Accountant Fees and Services.





The
information required by this item is incorporated herein by reference to the
Company’s definitive proxy statement to be filed in connection with the 2010
Annual Meeting of Stockholders.





PART
IV





Item
      15.
            Exhibits
      and Financial Statement Schedules.




(a)(1),
      (2) and (c) Financial statements and schedules:Report
      of Independent Registered Public Accounting FirmConsolidated
      Balance Sheets at December 31, 2009 and 2008Consolidated
      Statements of Income — Years Ended December 31, 2009, 2008, and
      2007Consolidated
      Statements of Changes in Stockholders’ Equity — Years Ended December 31,
      2009, 2008 and 2007Consolidated
      Statements of Comprehensive Income — Years Ended December 31, 2009, 2008
      and 2007Consolidated
      Statements of Cash Flows — Years Ended December 31, 2009, 2008 and
      2007Notes
      to Consolidated Financial Statements for the years ended December 31,
      2009, 2008 and 2007(a)(3)
      and (b) Exhibits required to be filed by Item 601 of Regulation
      S-K:


The
exhibits filed or furnished with this annual report are shown on the Exhibit
Index that follows the signatures to this annual report, which index is
incorporated herein by reference.





SIGNATURES





Pursuant to the requirements of Section
13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.





Shore
      Bancshares, Inc.Date:     March
      12, 2010
                      By:
                      /s/ W. Moorhead VermilyeW.
      Moorhead VermilyePresident
      and CEO





Pursuant to the requirements of the
Securities Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the Registrant and in the capacities and on the
dates indicated.





/s/ Herbert L. Andrew, III
                        
                        Director
                        
                        March
      12, 2010Herbert
      L. Andrew, III/s/ Blenda W. Armistead
                        
                        Director
                        
                        March
      12, 2010Blenda
      W. Armistead/s/ Lloyd L. Beatty, Jr.
                        
                        Director
                        
                        March
      12, 2010Lloyd
      L. Beatty, Jr.
  73
  /s/ William W. Duncan
                        
                        Director
                        
                        March
      12, 2010William
      W. Duncan/s/ Richard C. Granville
                        
                        Director
                        
                        March
      12, 2010Richard
      C. Granville/s/ James A. Judge
                        
                        Director
                        
                        March
      12, 2010James
      A. Judge/s/ Neil R. LeCompte
                        
                        Director
                        
                        March
      12, 2010Neil
      R. LeCompte/s/ Jerry F. Pierson
                        
                        Director
                        
                        March
      12, 2010Jerry
      F. Pierson/s/ Christopher F. Spurry
                        
                        Director
                        
                        March
      12, 2010Christopher
      F. Spurry/s/ F. Winfield Trice, Jr.
                        
                        Director
                        
                        March
      12, 2010F.
      Winfield Trice, Jr./s/ John H. Wilson
                        
                        Director
                        
                        March
      12, 2010John
      H. Wilson/s/ W. Moorhead Vermilye
                        
                        Director
                        
                        March
      12, 2010W.
      Moorhead Vermilye
                        
                        President/CEO/s/ Susan E. Leaverton
                        
                        Treasurer/
                        
                        March
      12, 2010Susan
      E. Leaverton
                        
                        Principal
      Accounting Officer


74


EXHIBIT
LIST





Exhibit No.
              
              Description3.1(i)
              
              Amended
      and Restated Articles of Incorporation (incorporated by reference to
      Exhibit 3.1 of the Company’s Form 8-K filed on December 14,
      2000)3.1(ii)
              
              Articles
      Supplementary relating to the Fixed Rate Cumulative Perpetual Preferred
      Stock, Series A (incorporated by reference Exhibit 4.1 of the Company’s
      Form 8-K filed on January 13, 2009)3.1(iii)
              
              Articles
      Supplementary relating to the reclassification of Fixed Rate Cumulative
      Perpetual Preferred Stock, Series A, as common stock (incorporated by
      reference Exhibit 3.1(i) of the Company’s Form 8-K filed on June 17,
      2009)3.2(i)
              
              Amended
      and Restated By-Laws (incorporated by reference to Exhibit 3.2(i) of the
      Company’s Annual Report on Form 10-K for the year ended December 31,
      2008)3.2(ii)
              
              First
      Amendment to Amended and Restated By-Laws (incorporated by reference to
      Exhibit 3.2(ii) of the Company’s Annual Report on Form 10-K for the year
      ended December 31, 2008)4.1
              
              Letter
      Agreement, including the related Securities Purchase Agreement – Standard
      Terms, dated January 9, 2009 by and between the Company and the U.S.
      Department of Treasury (incorporated by reference to Exhibit 10.1 of the
      Company’s Form 8-K filed on January 13, 2009)4.2
              
              Letter
      Agreement dated as of April 15, 2009 between the Company and the U.S.
      Department of the Treasury (incorporated by reference to Exhibit 10.1 to
      the Company’s Form 8-K filed on April 16, 2009)4.3
              
              Substitute
      Common Stock Purchase Warrant dated January 9, 2009 issued to the U.S.
      Department of Treasury (incorporated by reference to Exhibit 4.1 of the
      Company’s Form 8-K filed on June 4, 2009)10.1
              
              Form
      of Employment Agreement with W. Moorhead Vermilye (incorporated by
      reference to Appendix XIII of Exhibit 2.1 of the Company’s Form 8-K filed
      on July 31, 2000).10.2
              
              Employment
      Termination Agreement among Centreville National Bank, the Company, and
      Daniel T. Cannon dated December 7, 2006 (incorporated by reference to
      Exhibit 10.1 of the Company’s Form 8-K filed on December 12,
      2006).10.3
              
              Employment
      Agreement with Thomas H. Evans, as amended on November 3, 2005
      (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed
      on November 9, 2005).10.4
              
              Summary
      of Compensation Arrangement for Lloyd L. Beatty, Jr. (incorporated by
      reference to Exhibit 10.1 of the Company’s Form 8-K filed on August 1,
      2006).10.5
              
              Amended
      Summary of Compensation Arrangement for William W. Duncan, Jr.
      (incorporated by reference to Exhibit 10.1 of the Company’s Form 8-K filed
      on February 14, 2007, as amended by Form 8-K/A filed on May 3,
      2007).10.6
              
              Summary
      of Compensation Arrangement between Centreville National Bank and F.
      Winfield Trice, Jr. (incorporated by reference to Exhibit 10.1 of the
      Company’s Form 8-K filed on August 13, 2007).10.7
              
              Employment
      Agreement between The Avon-Dixon Agency, LLC and Mark M. Freestate
      (incorporated by reference to Exhibit 10.6 of the Company’s Annual Report
      on Form 10-K for the year ended December 31, 2006).10.8
              
              Shore
      Bancshares, Inc. Management Incentive Plan (incorporated by reference to
      Exhibit 10.1 of the Company’s Form 8-K filed on April 3,
      2007).10.9
              
              Revised
      Schedule A to the Shore Bancshares, Inc. Management Incentive Plan
      (incorporated by reference to Exhibit 10.2 of the Company’s Form 8-K filed
      on August 13, 2007).


75





10.10
              
              Shore
      Bancshares, Inc. Amended and Restated Executive Deferred Compensation Plan
      (incorporated by reference to Exhibit 10.2 of the Company’s Form 8-K filed
      on February 14, 2007)10.11
              
              Deferral
      Election, Investment Designation, and Beneficiary Designation Forms under
      the Shore Bancshares, Inc. Amended and Restated Executive Deferred
      Compensation Plan (incorporated herein by reference to Exhibit 10.1 to the
      Company’s Form 8-K filed on October 2, 2006).10.12
              
              Form
      of Centreville National Bank of Maryland Director Indexed Fee Continuation
      Plan Agreement with Messrs. Cannon, Freestate and Pierson (incorporated by
      reference to Exhibit 10.2 to the Company’s Form 8-K filed on December 12,
      2006).10.13
              
              Form
      of Amended and Restated Director Indexed Fee Continuation Plan Agreement
      between Centreville National Bank and Messrs. Cannon, Freestate and
      Pierson (incorporated by reference to Exhibit 10.2 of the Company’s
      Current Report on Form 8-K filed on January 7, 2009).10.14
              
              Form
      of Centreville National Bank Life Insurance Endorsement Split Dollar Plan
      Agreement with Messrs. Cannon, Freestate and Pierson (incorporated by
      reference to Exhibit 10.3 to the Company’s Form 8-K filed on December 12,
      2006).10.15
              
              Form
      of Executive Supplemental Retirement Plan Agreement between The
      Centreville National Bank of Maryland and Daniel T. Cannon (incorporated
      by reference to Exhibit 10.4 of the Company’s Quarterly Report on Form
      10-Q for the period ended September 30, 2003).10.16
              
              Form
      of Life Insurance Endorsement Method Split Dollar Plan Agreement between
      The Centreville National Bank of Maryland and Daniel T. Cannon
      (incorporated by reference to Exhibit 10.5 of the Company's Quarterly
      Report on Form 10-Q for the period ended September 30,
    2003).10.17
              
              Talbot
      Bank of Easton, Maryland Supplemental Deferred Compensation Plan
      (incorporated by reference to Exhibit 10.7 of the Company’s Quarterly
      Report on Form 10-Q for the period ended September 30,
    2005).10.18
              
              First
      Amendment to The Talbot Bank of Easton, Maryland Supplemental Deferred
      Compensation Plan for the benefit of W. Moorhead Vermilye (incorporated by
      reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K
      filed on January 7, 2009).10.19
              
              Talbot
      Bank of Easton, Maryland Supplemental Deferred Compensation Plan Trust
      Agreement (incorporated by reference to Exhibit 10.7 of the Company’s
      Quarterly Report on Form 10-Q for the period ended September 30,
      2005).10.20
              
              1998
      Employee Stock Purchase Plan, as amended (incorporated by reference to
      Appendix A of the Company’s definitive Proxy Statement on Schedule 14A for
      the 2003 Annual Meeting of Stockholders filed on March 31,
      2003).10.21
              
              1998
      Stock Option Plan (incorporated by reference to Exhibit 10 of the
      Company’s Registration Statement on Form S-8 filed with the SEC on
      September 25, 1998 (Registration No. 333-64319)).10.22
              
              Talbot
      Bancshares, Inc. Employee Stock Option Plan (incorporated by reference to
      Exhibit 10 of the Company’s Registration Statement on Form S-8 filed May
      4, 2001 (Registration No. 333-60214)).10.23
              
              Shore
      Bancshares, Inc. 2006 Stock and Incentive Compensation Plan (incorporated
      by reference to Appendix A of the Company’s 2006 definitive proxy
      statement filed on March 24, 2006).10.24
              
              Form
      of Restricted Stock Award Agreement under the 2006 Stock and Incentive
      Compensation Plan (incorporated by reference to Exhibit 10.1 to the
      Company’s Form 8-K filed on April 11, 2007).10.25
              
              Changes
      to Director Compensation Arrangements (incorporated by reference to
      Exhibit 10.1 of the Company’s Form 8-K filed on February 6,
      2006).


76





21
              
              Subsidiaries
      of the Company (included in the “BUSINESS—General” section of Item 1 of
      Part I of this Annual Report on Form 10-K).23
              
              Consent
      of Stegman & Company (filed herewith).31.1
              
              Certifications
      of the CEO pursuant to Section 302 of the Sarbanes-Oxley Act (filed
      herewith).31.2
              
              Certifications
      of the PAO pursuant to Section 302 of the Sarbanes-Oxley Act (filed
      herewith).32
              
              Certification
      pursuant to Section 906 of the Sarbanes-Oxley Act (furnished
      herewith).


77