United
States


Securities
and Exchange Commission


Washington,
D.C. 20549





Form
10-K





(Mark
One)





[X]
            ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For the fiscal year ended December 31,
2009





[
]           TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES


EXCHANGE ACT OF 1934





For the transition period
from        to





Commission
File Number 000-51765




Bay National
Corporation


(Exact
name of registrant as specified in its charter)





Maryland
            52-2176710(State
      or other jurisdiction of
            (I.R.S.
      Employerincorporation
      or organization)
            Identification
      No.)














2328 West Joppa Road, Lutherville,
      Maryland
            21093(Address
      of principal executive offices)
            (Zip
      Code)











Registrant's telephone
number, including area code: 410-494-2580





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


Title
      of each class
            Name
      of each exchange on which registeredCommon
      stock, par value $0.01 per share
            The
      NASDAQ Stock Market LLC











Securities
registered pursuant to Section 12(g) of the Act:  None





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





Indicate
by checkmark if the registrant is not required to file reports pursuant to
Section 13 or 15(d) of the Act.    Yes 
 __           No   X





Indicate
by checkmark 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  X      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 (§232.405 of this chapter) of
Regulation S-T during the preceding 12 months (or for such shorter period that
the registrant was required to submit and post such
files).       Yes__No __





Indicate
by checkmark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K (§229.405 of this chapter) is not contained herein, and will not
be contained, to the best of 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 checkmark whether the registrant is a large accelerated filer, an accelerated
filer, a non-accelerated filer, or a smaller reporting company.  See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.





Large
      accelerated filer ____
            Accelerated
      filer ____Non-accelerated
      filer ____ (Do not check if a smaller reporting company)
            Smaller
      reporting company  X





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





The aggregate market value of the
common equity held by non-affiliates was $2,041,909 as of June 30, 2009, based
on a sales price of $1.25 per share of Common Stock, which is the sales price at
which shares of Common Stock were last sold on the NASDAQ Stock Market on June
30, 2009.




The
number of shares outstanding of the registrant's Common Stock was 2,154,301 as
of March 24, 2010.





DOCUMENTS
INCORPORATED BY REFERENCE





None.








2








PART
I





Item
1.  Description of Business





BUSINESS
OF BAY NATIONAL CORPORATION AND BAY NATIONAL BANK





General





Bay
National Corporation  was incorporated under the laws of the State of
Maryland on June 3, 1999, primarily to serve as a bank holding company for a
proposed federally chartered commercial bank to be named Bay National
Bank.





Bay
National Bank commenced operations on May 12, 2000 with its main office in
Lutherville, Maryland and a branch office in Salisbury,
Maryland.  Subsequently, it added residential lending offices located
in Salisbury, Maryland and Baltimore, Maryland, in December 2007, a loan
production office in Columbia, Maryland in October 2007 and a residential
mortgage lending office in Cambridge, Maryland in May 2008.   The
Columbia and Cambridge offices were closed in March 2009 and December 2009,
respectively.   Bay National Bank accepts checking and savings
deposits and offers a wide range of commercial and industrial, real estate,
consumer and residential mortgage loans.





In this
report references to “Company,” “we,” “our,” “ours,” “us” and similar references
mean Bay National Corporation and its consolidated subsidiaries and references
to “Bay National Corporation” means Bay National Corporation excluding its
subsidiaries, unless the context otherwise requires.  We sometimes
refer to our subsidiary Bay National Bank as the “Bank.”








Marketing
Focus





Bay
National Bank was formed by a group of individuals active in business,
professional, banking, financial and charitable activities in the Baltimore,
Maryland metropolitan area and the Eastern Shore of Maryland. These individuals
believed that the banking needs of certain segments of these communities were
not being served adequately by existing banks.  Specifically, as a
result of bank mergers in the 1990s, many banks in the Baltimore metropolitan
area and the Eastern Shore of Maryland became local branches of large regional
and national banks.  Although size gave the larger banks some
advantages in competing for business from large corporations, including
economies of scale and higher lending limits, the organizers believed that these
“mega banks” were focused on a mass market approach which de-emphasized personal
contact and service.  The organizers also believed that the
centralization of decision-making power at these large institutions had resulted
in a lack of customer service.  At many of these institutions,
determinations were made at the out-of-state “home office" by individuals who
lacked personal contact with customers as well as an understanding of the
customers' needs and scope of the relationship with the
institution.





Bay
National Bank’s management believes that this trend is ongoing, and continues to
be particularly frustrating to owners of small and mid-sized businesses,
business professionals and high net worth individuals who traditionally have
been accustomed to dealing directly with a bank executive who had an
understanding of their banking needs with the ability to deliver a prompt
response.





Bay
National Bank targets its commercial banking services to small and mid-sized
businesses and targets its retail banking services to the owners of these
businesses and their employees, to business professionals and to high net worth
individuals.








3





Bay
National Bank seeks to distinguish itself by:





·
            Developing
      personal relationships with its
customers;





·
            Customizing
      its products to fit the needs of its customers instead of adopting a "one
      size fits all" mentality;





·
            Streamlining
      the decision-making process; and,





·
            Offering
      its customers additional complementary services, such as insurance and
      investment advice, through relationships with strategic
      partners.





Bay
National Bank’s offices are not organized in the traditional retail branch
structure, which is transaction and "bank teller" oriented.  Instead,
Bay National Bank emphasizes a "sit-down" model where customers can choose to be
greeted by a personal banker and taken to a private desk.  Customers
also have the option to conduct their transactions using a more traditional
teller counter.  Management believes that this approach makes service
more individualized and enhances the banker's understanding of each individual
customer's needs. Furthermore, Bay National Bank’s branch locations do not focus
on capturing every customer within the surrounding area. Instead, they are
strategically located in areas convenient to Bay National Bank’s target customer
base.





Market
Area and Facilities





Bay
National Bank’s headquarters and Baltimore branch office are located at 2328
West Joppa Road, Lutherville, Maryland 21093.  Bay National Bank
serves the Baltimore metropolitan area from that location, with its primary
service area being Towson, Lutherville-Timonium, Cockeysville, Hunt Valley,
Ruxton and Roland Park.  Bay National Bank’s Salisbury, Maryland
branch office is located at 109 Poplar Hill Avenue, Salisbury, Maryland 21801,
from which it serves Maryland’s lower Eastern Shore.  Bay National
Bank also has two residential real estate loan production offices, which
are  located in its Lutherville headquarters and in its Salisbury
branch office.





Products
and Services





Loan
Portfolio





Bay
National Bank offers a full range of loans, including commercial and industrial
loans, real estate loans, consumer loans and residential mortgage and home
equity loans.  Commercial business and commercial real estate loans
for owner-occupied properties are Bay National Bank's primary loan products,
accounting for approximately 77% of the loan portfolio as of December 31,
2009.





Generally,
Bay National Bank is subject to a lending limit to any one borrower of 15% of
Bay National Bank’s unimpaired capital and surplus.  However,
management is able to originate loans and to participate with other lenders with
respect to loans that exceed Bay National Bank's lending limits.





The
following is a description of the types of loans that Bay National Bank has
targeted in building its loan portfolio:





·
            Commercial
      and industrial loans for business purposes including working capital,
      equipment purchases, lines of credit and government contract
      financing.  Asset-based lending and accounts receivable
      financing are also available.  As of December 31, 2009, these
      loans represented approximately 46% of Bay National Bank’s loan portfolio.
      In general, Bay National Bank targets small and mid-sized businesses in
      its market area with credit needs in the range of up to $5
      million.








4





·
            Commercial
      real estate loans, including mortgage loans on non-residential properties,
      and land development and construction loan financing, primarily for
      owner-occupied premises as well as first and second mortgage loans on
      commercially owned residential investment properties.  As of
      December 31, 2009, these loans represented approximately 31% of Bay
      National Bank’s loan portfolio.  We are currently decreasing the
      number of land development and construction loans that we originate and
      decreasing these loans as a percentage of new loans based on current
      market conditions.





·
            Residential
      mortgage loans and construction loans secured by residential property,
      including first and second mortgage loans on owner-occupied and investment
      properties (1 to 4 family and multi-family) owned by individuals, and home
      equity loans secured by single-family owner-occupied residences. As of
      December 31, 2009, these loans represented approximately 21% of Bay
      National Bank’s loan portfolio.  Bay National Bank’s residential
      real estate loans are targeted to business owners and their employees,
      business professionals and high net worth
  individuals.





·
            Consumer
      loans include automobile and personal loans. In addition, Bay National
      Bank offers personal lines of credit. As of December 31, 2009, these loans
      represented approximately 2% of Bay National Bank’s loan portfolio. Like
      its residential mortgage loans, Bay National Bank’s consumer loans are
      targeted to business owners and their employees, business professionals
      and high net worth individuals.





Prior to
2007, Bay National Bank originated some of its Eastern Shore residential
mortgage loans through BNB Mortgage, LLC, a Maryland limited liability company,
which is a joint venture between Bay National Bank and an Ocean City, Maryland
real estate agent.  Bay National Bank was responsible for all of the
operations of BNB Mortgage, LLC. Bay National Bank’s share of net income from
this entity amounted to $2,682 for the year ended December 31, 2006 and no
income was generated from this entity during 2009, 2008, and
2007.  All loans originated by BNB Mortgage, LLC were immediately sold
to Bay National Bank. These loans were then sold to third party investors in the
same fashion as other conventional first and second residential mortgage loans
originated by Bay National Bank.  While recently this joint venture
has not been active due to current market conditions, it is still operational
and could potentially be a source for origination of loans in the future should
real estate market conditions in the area improve.





Bay
National Bank’s conventional first and second residential mortgage loans adhere
to standards developed by Fannie Mae/Freddie Mac.  Bay National Bank
sells most of its first and second residential mortgage loans in the secondary
market. These loans essentially have a lower degree of risk and a lower yield
relative to the other types of loans that Bay National Bank makes. Since these
loans are typically sold, Bay National Bank offers these loans as well as
certain residential construction loans to a broader array of individuals than
its home equity loans and other consumer loan products. As of December 31, 2009,
mortgage loans held for sale totaled approximately $415,000.





Deposits





Bay
National Bank offers a wide range of interest-bearing and non-interest-bearing
accounts, including commercial and retail checking accounts, money market
accounts, individual retirement accounts, interest-bearing statement savings
accounts and Certificates of Deposit (“CDs”) with fixed and variable rates and a
range of maturity date options.





Other Banking and Financial
Services





Bay
National Bank offers cash management services such as sweep accounts, repurchase
agreements, commercial paper investments, account reconciliation, lockbox
services and wire transfers of funds to its








5








commercial
customers.  Additionally, Bay National Bank makes available telephone
banking, ATM/debit cards, safe keeping boxes, after-hours deposit services,
travelers checks, direct deposit of payroll and automatic drafts for various
accounts.  These services are provided either directly by Bay National
Bank or through correspondent banking relationships.  Bay National
Bank does not have its own network of ATM machines.  In most
instances, Bay National Bank waives fees based upon a predetermined number of
ATM transactions per month, thereby allowing its customers to use almost any ATM
machine.





In
addition, Bay National Bank's customers are able to access information about
their accounts and view information about Bay National Bank's services and
products on Bay National Bank's website, which is located at http://www.baynational.com.  Bay
National Bank’s website also permits customers to make transfers of funds among
accounts, pay bills, order checks and send e-mails to Bay National
Bank.





Bay
National Bank offers, through strategic partners, investment advisory, risk
management and employee benefit services. Through these affiliations, banking
clients can receive a full range of financial services, including investment
advice, personal and business insurance products and employee benefit products
such as pension and 401(k) plan administration.  To the extent
permitted by applicable regulations, the strategic partners may share fees and
commissions with Bay National Bank.  As of December 31, 2009, Bay
National Bank had not entered into any such fee arrangements.  When
sufficient volume is developed in any of these lines of business, Bay National
Bank may provide these services if permitted by applicable
regulations.





Competition





In both
the Baltimore metropolitan area and on Maryland's Eastern Shore, Bay National
Bank faces strong competition from large banks headquartered within and outside
of Maryland.  Bay National Bank also competes with other community
banks, savings and loan associations, credit unions, mortgage companies, finance
companies and others providing financial services.  In addition,
insurance companies, securities brokers and other non-bank entities or their
affiliates may provide services, which historically have been considered banking
in nature.





Many of
Bay National Bank’s competitors can finance extensive advertising campaigns,
maintain extensive branch networks and technology investments, and offer
services, which Bay National Bank cannot offer or chooses not to
offer.  Also, larger institutions have substantially higher lending
limits than Bay National Bank. Some of Bay National Bank’s competitors have
other advantages, such as tax exemption in the case of credit unions, and less
stringent regulation in the case of mortgage companies and finance
companies.





Employees





As of
March 24, 2010, Bay National Bank employed 38 individuals including one
part-time employee.  Twenty-eight people operate from Bay National
Bank’s headquarters and banking office in Lutherville, Maryland and ten people
operate from the Salisbury, Maryland office. Bay National Corporation has no
employees.





Recent
Developments





OCC Consent
Order





As we
have previously disclosed, on February 6, 2009, Bay National Bank voluntarily
entered into a Consent Order (the “Consent Order”) with the Office of the
Comptroller of Currency (the “OCC”), our primary banking regulator.







6





Among
other things, the Consent Order requires the Bank and/or its board of directors
(the “Board”) to take certain actions, including developing and submitting
written plans to the OCC, and imposes restrictions on the Bank designed to
improve its financial strength.  In accordance with the Consent Order,
the Bank’s Board has appointed a compliance committee to monitor, coordinate and
report to the Board on the Bank’s compliance with the Consent
Order.





Pursuant
to the Consent Order, the Bank’s Board and its compliance committee have
submitted a written analysis to the OCC in which the Bank details its decision
to remain independent while continually evaluating other options.





We were
not in compliance with the minimum capital requirements set forth in the Consent
Order at April 30, 2009 and our request for an extension for compliance was
denied.  As a result, we are required to develop a contingency plan
for the Bank; we believe, however, that the terms of our previously-disclosed
contemplated public offering of common stock and warrants, if successful, will
satisfy the contingency plan requirement.    We are not in
compliance with this portion of the Consent Order, however, because to date the
OCC has not issued a determination of no supervisory objection to the strategic
plan.





While we
are working to comply with the terms of the Consent Order, we are not currently
in compliance with any of the other requirements of the Consent
Order.





The
Bank’s Board and executive management have adopted a strategic plan that maps
out a strategy for the Bank to restore its higher capitalization, strong
earnings and good asset quality and to also eliminate the concerns raised by the
OCC in the Consent Order.  Pursuant to the strategic plan, the Bank
will return to its original business model, provide stronger risk controls and
provide the management and support items necessary to continue to grow and serve
its customer base.  However, see the discussion under “Capital Status”
below for the impact that our low capital levels is having on our short-term
plans for continuing operations.





For a
more in-depth discussion of the Consent Order, please see “Item 7. Management’s
Discussion and Analysis of Financial Condition and Results of Operations –
Recent Developments.”





Capital
Status





As of the
filing of the Bank’s amended December 31, 2009 Call Report with the OCC on March
12, 2010, the Bank became classified as “significantly undercapitalized” as of
December 31, 2009 under the Prompt Corrective Action provisions discussed under
“Supervision and Regulation” below.  As a result, we are required to
submit a capital restoration plan to the OCC addressing, among other things, the
steps the Bank will take to become adequately capitalized.  We have
submitted a capital restoration plan to the OCC, which is subject to OCC
approval.





Under the
capital restoration plan, the Bank’s Board and executive management will
continue their efforts to raise capital.  However, they will attempt
to preserve the remaining capital and through a decrease in risk weighted
assets, increase its capital ratios.  The plan requires fewer
employees during the stabilization process as no new business will be brought in
and the remaining employees will be dedicated to improving asset quality and
maintaining regulatory compliance while also ensuring safe and sound business
practices are followed.  The Bank’s Board and executive management
realize that successful execution of the plan to reduce assets alone will not
place it in full compliance with the Consent Order.  However,
successful execution will result in rising capital ratios for the Bank and
enable it to reach “adequately capitalized” status by the end of
2010.







7





Federal Reserve Board
Enforcement Action / Written Agreement




On April
28, 2009, pursuant to a formal enforcement action by the Federal Reserve Bank of
Richmond, Bay National Corporation entered into a written agreement with the
Reserve Bank (the “Reserve Bank Agreement”).  Pursuant to the Reserve
Bank Agreement, Bay National Corporation agreed (i) not to take certain actions,
including paying dividends, without approval of the Reserve Bank, (ii) to follow
certain notice provisions with respect to director or executive officer changes,
(iii) to comply with certain restrictions on indemnification and severance
payments, and (iv) to provide quarterly progress reports to the Reserve
Bank.  We are currently in compliance with all of the terms of the
Reserve Bank Agreement.




For a
more in-depth discussion of the Reserve Bank Agreement, please see “Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of
Operations – Recent Developments.”




Appointment of New
Chairman




On
November 17, 2009 the Boards of Directors of Bay National Corporation and Bay
National Bank elected Charles L. Maskell, Jr., CPA as Chairman of the board of
directors of both organizations following Hugh W. Mohler’s resignation as
Chairman.  Mr. Mohler remains as President and Chief Executive Officer
of both Bay National Corporation and the Bank.




Repurchase of Trust
Preferred Securities; Recognition of Deferred Tax Asset




As
wehave disclosed
in our previously filed registration statement, we are attempting to negotiate
with the holders of the trust preferred securities issued through our Delaware
trust subsidiary, Bay National Capital Trust I, to redeem these securities at a
discount to face value.  We have engaged an outside advisor to assist
us in this effort.  There can be no assurance, however, that we will
reach a binding agreement with the holders to redeem the trust preferred
securities.




If we are
successful in redeeming these securities at discount, the amount of the discount
will result in a gain being recognized for Bay National
Corporation.  The amount of the gain, net of applicable income tax
expense, will be an addition to the retained earnings and the total capital of
Bay National Corporation in the period such transaction is
executed.




In
addition, the gain we recognize from the redemption at a discount will be
subject to federal and state income taxes.  Since Bay National
Corporation does not have sufficient net operating loss (“NOL”) carryforwards to
offset the entire gain, we are permitted to utilize a portion of the Bank’s
NOLs  to offset the Federal income tax component in a consolidated
Federal income tax return.  Ordinarily, an entity with a combination
of sufficient past taxable income and/or sufficient probable future taxable
income, can justify reporting a deferred tax asset on its books if the
realization of the tax benefits from the NOL is more
likely-than-not.  However, in the Bank’s case realization of the tax
benefits in question is contingent on both the redemption of the trust preferred
securities (at a discount) as well as subsequent reimbursement from Bay National
Corporation.  Given the uncertainty underlying these two events the
criterion for recognizing a deferred tax asset was not met and a valuation
allowance was established against the entire deferred tax asset on the Bank’s
financial statements as of December 31, 2009.




However,
if we are successful in our efforts to redeem the trust preferred securities and
are also able to raise sufficient capital to reimburse the Bank for the use of
its tax benefits, the Bank would be permitted to reverse that portion of the
valuation allowance which would result in the associated tax benefit to be
reported for both financial statement and regulatory capital calculation
purposes.  There can be no assurance, however, that we will be
successful in this regard.






8







SUPERVISION
AND REGULATION





General





Bay
National Corporation and Bay National Bank are subject to extensive regulation
under state and federal banking laws and regulations. These laws impose specific
requirements and restrictions on virtually all aspects of operations and
generally are primarily intended to protect depositors, not stockholders. The
following discussion is only a summary of certain material regulations, and does
not purport to be a comprehensive summary of all regulations affecting the
operations of Bay National Corporation and Bay National Bank.  Readers
should refer to particular statutory and regulatory provisions for more detailed
information. In addition, management cannot predict the nature or the extent of
the effect on our business and earnings that new federal or state legislation
may have in the future.





Bay
National Corporation





Federal Bank Holding Company
Regulation.Bay National Corporation is a bank holding company
registered under the Bank Holding Company Act of 1956, as amended, and is
subject to supervision by the Board of Governors of the Federal Reserve System
(the “FRB”). As a bank holding company, Bay National Corporation is required to
file with the FRB an annual report and such other additional information as the
FRB may require by statute. The FRB may also examine Bay National Corporation
and each of its subsidiaries.





The FRB
must approve, among other things, the acquisition by a bank holding company of
control of more than 5% of the voting shares, or substantially all the assets,
of any bank or bank holding company or the merger or consolidation by a bank
holding company with another bank holding company. Under the Riegle-Neal
Interstate Banking and Branching Efficiency Act of 1994 (“Riegle-Neal Act”), the
restrictions on interstate acquisitions of banks by bank holding companies were
repealed in September 1995. The effect of the repeal of these restrictions is
that, subject to certain time and deposit base requirements, Bay National
Corporation may acquire a bank located in Maryland or any other state, and a
bank holding company located outside of Maryland can acquire any Maryland-based
bank holding company or bank.





As a bank
holding company, Bay National Corporation is prohibited from acquiring control
of voting shares of any company which is not a bank or bank holding company and
from engaging directly or indirectly in any activity other than banking,
including managing or controlling banks or furnishing services for its
authorized subsidiaries.  There are limited exceptions.  A
bank holding company may, for example, engage in activities which the FRB has
determined by order or regulation to be so closely related to banking and/or
managing or controlling banks as to be "properly incident
thereto."  In making such a determination, the FRB is required to
consider whether the performance of such activities can reasonably be expected
to produce benefits to the public, such as convenience, increased competition or
gains in efficiency, that outweigh possible adverse effects, such as undue
concentration of resources, decreased or unfair competition, conflicts of
interest or unsound banking practices.  The FRB is also empowered to
differentiate between activities commenced de novo and activities commenced by
the acquisition, in whole or in part, of a going concern. Some of the activities
that the FRB has determined by regulation to be closely related to banking
include servicing loans, performing certain data processing services, acting as
a fiduciary, investment or financial advisor, and making investments in
corporations or projects designed primarily to promote community
welfare.




Subsidiary
banks of a bank holding company are subject to certain restrictions imposed by
statute on any extensions of credit to the bank holding company or any of its
subsidiaries, investments in their stock or other securities, and taking such
stock or securities as collateral for loans to any borrower.  Further,
a bank holding company and any subsidiary bank are prohibited from engaging in
certain tie-in arrangements in connection with the extension of credit. The FRB
modified Regulation Y to create exceptions to the Bank








9





Holding
Company Act's anti-tying prohibitions and provide greater flexibility for bank
subsidiaries of holding companies to package products and services with their
affiliates.





In
accordance with FRB policy, Bay National Corporation is expected to act as a
source of financial strength to Bay National Bank and to commit resources to
support Bay National Bank in circumstances in which Bay National Corporation
might not otherwise do so.  The FRB may require a bank holding company
to terminate any activity or relinquish control of a non-bank subsidiary (other
than a non-bank subsidiary of a bank) upon the FRB's determination that such
activity or control constitutes a serious risk to the financial soundness or
stability of any subsidiary depository institution of the bank holding company.
Further, federal bank regulatory authorities have additional discretion to
require a bank holding company to divest itself of any bank or non-bank
subsidiary if the agency determines that divestiture may aid the depository
institution's financial condition.





Bay
National Corporation also is subject to certain risk-based capital guidelines
imposed on bank holding companies by the FRB to ensure the holding company’s
capital adequacy.





The
status of Bay National Corporation as a registered bank holding company under
the Bank Holding Company Act does not exempt it from certain federal and state
laws and regulations applicable to corporations generally, including, without
limitation, certain provisions of the federal securities laws.





State Bank Holding Company
Regulation.  Bay National Corporation is a Maryland corporation
registered as a bank holding company under the Bank Holding Company Act of 1956
(“Holding Company Act”), as amended, and is subject to various restrictions on
its activities as set forth in Maryland law, in addition to those restrictions
set forth in federal law.





Under
Maryland law, a bank holding company that desires to acquire a Maryland
state-chartered bank or trust company, a federally chartered bank with its main
office in Maryland, or a bank holding company that has its principal place of
business in Maryland, must file an application with the Maryland Commissioner of
Financial Regulation (the "Commissioner").  In approving the
application, the Commissioner must consider whether the acquisition may be
detrimental to the safety and soundness of the entity being acquired or whether
the acquisition may result in an undue concentration of resources or a
substantial reduction in competition in Maryland.  The Commissioner
may not approve an acquisition if, upon consummation of the transaction, the
acquiring company, together with all its insured depository institution
affiliates, would control 30% or more of the total amount of deposits of insured
depository institutions in Maryland.  The Commissioner has authority
to adopt, by regulation, a procedure to waive this requirement for good
cause.  In a transaction for which the Commissioner's approval is not
required due to an exemption under Maryland law, or for which federal law
authorizes the transaction without application to the Commissioner, the parties
to the acquisition must provide written notice to the Commissioner at least 15
days before the effective date of the acquisition.





The
status of Bay National Corporation as a registered bank holding company under
the Holding Company Act does not exempt it from certain federal and state
regulations applicable to Maryland corporations, generally, including, without
limitation certain provisions of the federal securities laws.





Bay
National Bank





General.Bay National Bank,
as a national banking association whose accounts are insured by the Deposit
Insurance Fund of the Federal Deposit Insurance Corporation ("FDIC") up to the
maximum legal limits, is subject to regulation, supervision and regular
examinations by the OCC.  Bay National Bank is a member of the Federal
Reserve System and, as such, is subject to certain regulations issued by the
FRB. Bay National Bank also is subject to applicable banking provisions of
Maryland law insofar as they do not conflict with or are not preempted by
federal law.  The regulations of these various agencies govern most
aspects of








10








Bay
National Bank's business, including setting required reserves against deposits,
loans, investments, mergers and acquisitions, borrowing, dividends, and location
and number of branch offices.





A
national bank may expand its activities beyond serving as a depository
institution, provided that any expanded activities must be conducted in a new
entity called a “financial subsidiary” that is a subsidiary of the bank rather
than the bank itself.  A financial subsidiary may engage in any
activities in which a financial holding company or a financial holding company’s
non-bank subsidiaries can engage, except that a financial subsidiary cannot
underwrite most insurance, engage in real estate development or conduct merchant
banking activities.  A financial subsidiary may be established through
acquisition or de
novo.





In order
for a national bank to operate a financial subsidiary, it must be well
capitalized and well managed, have a satisfactory or better rating with respect
to meeting community credit needs and the aggregate assets of all of the bank’s
financial subsidiaries may not exceed 45% of the total assets of the bank,
subject to certain exceptions.  The OCC and the FDIC maintain
authority to review subsidiary activities.





Banking
is a business that depends on interest rate differentials. In general, the
differences between the interest paid by a bank on its deposits and its other
borrowings and the interest received by a bank on loans extended to its
customers and securities held in its investment portfolio constitute the major
portion of a bank's earnings.  Thus, the earnings and growth of Bay
National Bank will be subject to the influence of economic conditions generally,
both domestic and foreign, and also on the monetary and fiscal policies of the
United States and its agencies, particularly the FRB, which regulates the supply
of money.  We cannot predict the nature and timing of changes in such
policies and their impact on Bay National Bank.





Branching and Interstate Banking.The federal banking agencies are authorized to approve interstate bank
merger transactions without regard to whether such a transaction is prohibited
by the law of any state, unless the home state of one of the banks has opted out
of the interstate bank merger provisions of the Riegle-Neal
Act.  Furthermore, under the Riegle-Neal Act, interstate acquisitions
of branches are permitted if the law of the state in which the branch is located
permits such acquisitions.  The Riegle-Neal Act also authorizes the
OCC and FDIC to approve interstate branching, de novo, by national and
non-member banks, respectively, but only in states which specifically allow for
such branching.





The
District of Columbia, Maryland, Delaware and Pennsylvania have all enacted laws
that permit interstate acquisitions of banks and bank branches and permit
out-of-state banks to establish de novo branches.





Gramm-Leach-Bliley
Act.The Gramm-Leach Bliley Act (“GLBA”) substantially altered
the statutory framework for providing banking and other financial services in
the United States of America.  The GLBA, among other things,
eliminated many of the restrictions on affiliations among banks and securities
firms, insurance firms, and other financial service providers.  The
GLBA also provides protections against the transfer and use by financial
institutions of consumers’ nonpublic personal information.  A
financial institution must provide to its customers, at the beginning of the
customer relationship and annually thereafter, the institution’s policies and
procedures regarding the handling of customers’ nonpublic personal financial
information.  The privacy provisions generally prohibit a financial
institution from providing a customer’s personal financial information to
unaffiliated third parties unless the institution discloses to the customer that
the information may be so provided and the customer is given the opportunity to
opt out of such disclosure.




Capital Adequacy
Guidelines.The FRB, the OCC and the FDIC have all adopted
risk-based capital adequacy guidelines by which they assess the adequacy of
capital in examining and supervising banks and bank holding companies and in
analyzing bank regulatory applications.  Risk-based capital
requirements determine the adequacy of capital based on the risk inherent in
various classes of assets and off-balance sheet items.






11





National
banks and bank holding companies are expected to meet a minimum ratio of total
qualifying capital (the sum of core capital (Tier 1) and supplementary capital
(Tier 2)) to risk-weighted assets (a "Total Risk-Based Capital Ratio") of
8%.  At least half of this amount (4%) should be in the form of Tier 1
capital. These requirements apply to Bay National Bank and Bay National
Corporation.





Tier 1
capital generally consists of the sum of common stockholders' equity and
perpetual preferred stock (subject in the case of the latter to limitations on
the kind and amount of such stock which may be included as Tier 1 capital), less
goodwill, without adjustment in accordance with Financial Accounting Standards
Board’s (FASB) guidance on “Accounting for Certain Investments in Debt and
Equity Securities”. Tier 2 capital consists of the following: hybrid capital
instruments, perpetual preferred stock that is not otherwise eligible to be
included as Tier 1 capital, term subordinated debt and intermediate-term
preferred stock, and, subject to limitations, general allowances for credit
losses. Assets are adjusted under the risk-based guidelines to take into account
different risk characteristics, with the categories ranging from 0% (requiring
no risk-based capital) for assets such as cash, to 100% for the bulk of assets
that are typically held by a commercial bank, including certain multi-family
residential and commercial real estate loans, commercial business loans and
consumer loans. Residential first mortgage loans on one-to-four-family
residential real estate and certain seasoned multi-family residential real
estate loans, which are not 90 days or more past-due or non-performing and which
have been made in accordance with prudent underwriting standards, are assigned a
50% level in the risk-weighing system, as are certain privately issued
mortgage-backed securities representing indirect ownership of such
loans.  Off-balance sheet items also are adjusted to take into account
certain risk characteristics.





In
addition to the risk-based capital requirements, the OCC and the FDIC have
established a minimum 3% Leverage Capital Ratio (Tier 1 capital to total
adjusted assets) requirement for the most highly-rated national banks, with an
additional cushion of at least 100 to 200 basis points for all other national
banks, which effectively increases the minimum Leverage Capital Ratio for such
other banks to 4% or 5% or more. Under the applicable regulations, highest-rated
banks and bank holding companies are those that the OCC and the FDIC determine
are not anticipating or experiencing significant growth and have well
diversified risk, including no undue interest rate risk exposure, excellent
asset quality, high liquidity, good earnings and, in general, those which are
considered a strong banking organization.  A national bank or bank
holding company that has less than the minimum Leverage Capital Ratio
requirement must submit, to the applicable regulator for review and approval, a
reasonable plan describing the means and timing by which the bank will achieve
its minimum Leverage Capital Ratio requirement. A national bank or bank holding
company that fails to file such a plan is deemed to be operating in an unsafe
and unsound manner and could be subject to a cease-and-desist
order.





The
OCC  and FDIC regulations also provide that any insured depository
institution with a Leverage Capital Ratio less than 2% is deemed to be operating
in an unsafe or unsound condition.  Operating in an unsafe or unsound
manner could lead the FDIC to terminate deposit insurance. However, such an
institution will not be subject to an enforcement proceeding solely on account
of its capital ratios if it has entered into and is in compliance with a written
agreement with the OCC and FDIC to increase its Leverage Capital Ratio to such
level as the OCC or FDIC deems appropriate and to take such other action as may
be necessary for the institution to be operated in a safe and sound
manner.  The capital regulations also provide, among other things, for
the issuance by the OCC or the FDIC or their respective designee(s) of a capital
directive, which is a final order issued to a bank that fails to maintain
minimum capital or to restore its capital to the minimum capital requirement
within a specified time period.  Such directive is enforceable in the
same manner as a final cease-and-desist order.





On
September 3, 2009, the United States Treasury Department issued a policy
statement (the "Treasury Policy Statement") entitled "Principles for Reforming
the U.S. and International Regulatory Capital Framework for Banking
Firms."  The U.S. Treasury Department (the “Treasury”) developed this
statement in consultation with the U.S. bank regulatory agencies and
contemplates changes to the existing regulatory capital regime that would
involve substantial revisions to the regulatory capital and liquidity








12











regime
for regulated banking organizations and other systemically important
institutions.  The Treasury Policy Statement calls for, among other
things, higher and stronger capital requirements for all banking
firms.  The Treasury Policy Statement suggested that changes to the
regulatory capital framework be phased in over a period of several
years.  The recommended schedule provides for a comprehensive
international agreement by December 31, 2010, with the implementation of reforms
by December 31, 2012, although it does remain possible that U.S. bank regulatory
agencies could officially adopt, or informally implement new capital standards
at an earlier date.




On
December 17, 2009, the Basel Committee on Banking Supervision ("Basel
Committee") issued a set of proposals (the "Capital Proposals") that would
significantly revise the definitions of Tier 1 capital and Tier 2 capital, with
the most significant changes being to Tier 1 capital.  Most notably,
the Capital Proposals would also re-emphasize that common equity is the
predominant component of Tier 1 capital by adding a minimum common equity to
risk-weighted assets ratio and requiring that goodwill, general intangibles and
certain other items that currently must be deducted from Tier 1 capital instead
be deducted from common equity as a component of Tier 1 capital.  The
Capital Proposals also leave open the possibility that the Basel Committee will
recommend changes to the minimum Tier 1 capital and total capital ratios of 4.0%
and 8.0%, respectively.




Concurrently
with the release of the Capital Proposals, the Basel Committee also released a
set of proposals related to liquidity risk exposure (the "Liquidity Proposals",
and together with the Capital Proposals, the "2009 Basel Committee
Proposals").  The Liquidity Proposals have three key elements,
including the implementation of (i) a "liquidity coverage ratio", designed to
ensure that a bank maintains an adequate level of unencumbered, high-quality
assets sufficient to meet the bank's liquidity needs over a 30-day time horizon
under an acute liquidity stress scenario, (ii) a "net stable funding ratio"
designed to promote more medium and long term funding of the assets and
activities of banks over a one year time horizon, and (iii) a set of monitoring
tools that Basel Committee indicates should be considered as the minimum types
of information that banks should report to supervisors and that supervisors
should use in monitoring the liquidity risk profiles of supervised
entities.




Comments
on the 2009 Basel Committee Proposals are due by April 16, 2010, with the
expectation that the Basel Committee will release a comprehensive set of
proposals by December 31, 2010 and that final provisions will be implemented by
December 31, 2012.  The U.S. bank regulators have urged comment on the
2009 Basel Committee Proposals.  Ultimate implementation of such
proposals in the U.S. will be subject to the discretion of the U.S. bank
regulators and the regulations or guidelines adopted by such agencies may differ
from the 2009 Basel Committee Proposals and other proposals that the Basel
Committee may promulgate in the future.





Prompt Corrective
Action.  Each federal banking agency is required to implement a
system of prompt corrective action for institutions which it
regulates.  Under applicable regulations, a bank will be deemed to be:
(i) "well capitalized" if it has a Total Risk-Based Capital Ratio of 10% or
more, a Tier 1 Risk-Based Capital Ratio of 6% or more, a Leverage Capital Ratio
of 5% or more and is not subject to any written capital order or directive; (ii)
"adequately capitalized" if it has a Total Risk-Based Capital Ratio of 8% or
more, a Tier 1 Risk-Based Capital Ratio of 4% or more and a Leverage Capital
Ratio of 4% or more (3% under certain circumstances) and does not meet the
definition of “well capitalized”; (iii) "undercapitalized" if it has a Total
Risk-Based Capital Ratio that is less than 8%, a Tier 1 Risk-Based Capital Ratio
that is less than 4% or a Leverage Capital Ratio that is less than 4% (3.3%
under certain circumstances); (iv) "significantly undercapitalized" if it has a
Total Risk-Based Capital Ratio that is less than 6%, a Tier 1 Risk-Based Capital
Ratio that is less than 3% or a Leverage Capital Ratio that is less than 3%; and
(v) "critically undercapitalized" if it has a ratio of tangible equity to total
assets that is equal to or less than 2%.  Bay National Bank was deemed
"significantly undercapitalized" as of December 31, 2009.




An
institution generally must file a written capital restoration plan that meets
specified requirements with an appropriate federal banking agency within 45 days
of the date the institution receives notice or is








13








deemed to
have notice that it is undercapitalized, significantly undercapitalized or
critically undercapitalized. The federal banking agency must provide the
institution with written notice of approval or disapproval within 60 days after
receiving the capital restoration plan, subject to extensions by the applicable
agency.





An
institution that is required to submit a capital restoration plan must
concurrently submit a performance guaranty by each company that controls the
institution. Such guaranty is limited to the lesser of (i) an amount equal to 5%
of the institution's total assets at the time the institution was notified or
deemed to have notice that it was undercapitalized or (ii) the amount necessary
at such time to restore the relevant capital measures of the institution to the
levels required for the institution to be classified as adequately
capitalized.  Such a guaranty expires after the federal banking agency
notifies the institution that it has remained adequately capitalized for each of
four consecutive calendar quarters.  An institution that fails to
submit a written capital restoration plan within the requisite period, including
any required performance guaranty, or fails in any material respect to implement
a capital restoration plan, is subject to the restrictions in Section 38 of the
Federal Deposit Insurance Act which are applicable to significantly
undercapitalized institutions.





Immediately
upon becoming undercapitalized, an institution becomes subject to the provisions
of Section 38 of the Federal Deposit Insurance Act (FDIA) which: (i) restrict
payment of capital distributions and management fees; (ii) require that the
appropriate federal banking agency monitor the condition of the institution and
its efforts to restore its capital; (iii) require submission of a capital
restoration plan; (iv) restrict the growth of the institution's assets; and (v)
require prior approval of certain expansion proposals.  The
appropriate federal banking agency for an undercapitalized institution also may
take any number of discretionary supervisory actions if the agency determines
that any of these actions is necessary to resolve the problems of the
institution at the least possible long-term cost to the deposit insurance fund,
subject, in certain cases, to specified procedures.  These
discretionary supervisory actions include requiring the institution to raise
additional capital, restricting transactions with affiliates, requiring
divestiture of the institution or the sale of the institution to a willing
purchaser, and any other supervisory action that the agency deems
appropriate.  Significantly undercapitalized and critically
undercapitalized institutions are subject to these and additional mandatory and
permissive supervisory actions.  As of December 31, 2009, Bay National
Bank was subject to such statutory restrictions and limitations.





A
critically undercapitalized institution will be placed in conservatorship or
receivership within 90 days unless the FDIC formally determines that forbearance
from such action would better protect the deposit insurance
fund.  Unless the FDIC or other appropriate federal banking regulatory
agency makes specific further findings and certifies that the institution is
viable and is not expected to fail, an institution that remains critically
undercapitalized on average during the four calendar quarters after the date it
becomes critically undercapitalized must be placed in
receivership.  The general rule is that the FDIC will be appointed as
receiver within 90 days after a bank becomes critically undercapitalized unless
extremely good cause is shown and the federal regulators agree to an
extension.  In general, good cause is defined as capital that has been
raised and is immediately available for infusion into the bank except for
certain technical requirements that may delay the infusion for a period of time
beyond the 90 day time period.





Additionally,
under Section 11(c)(5) of the FDIA, a conservator or receiver may be appointed
for an institution where: (i) an institution’s obligations exceed its assets;
(ii) there is substantial dissipation of the institution’s assets or earnings as
a result of any violation of law or any unsafe or unsound practice; (iii) the
institution is in an unsafe or unsound condition; (iv) there is a willful
violation of a cease-and-desist order; (v) the institution is unable to pay its
obligations in the ordinary course of business; (vi) losses or threatened losses
deplete all or substantially all of an institution’s capital, and there is no
reasonable prospect of becoming “adequately capitalized” without assistance;
(vii) there is any violation of law or unsafe or unsound practice or condition
that is likely to cause insolvency or substantial dissipation of assets or
earnings, weaken the institution’s condition, or otherwise seriously prejudice
the interests of depositors or the insurance fund; (viii) an institution ceases
to be insured; (ix) the institution is undercapitalized and has no reasonable
prospect that it will become adequately capitalized, fails to become adequately
capitalized when required to do so, or








14








fails to
submit or materially implement a capital restoration plan; or (x) the
institution is critically undercapitalized or otherwise has substantially
insufficient capital.





Deposit
Insurance.  Bay National Bank is a member of the Deposit
Insurance Fund (“DIF”) maintained by the FDIC.  Substantially all
of Bay National Bank’s deposits are insured by the DIF.  The FDIC has
temporarily raised its coverage amounts through December 31, 2013 from $100,000
to $250,000 per insured depositor (as defined by law and regulation) and up to
$250,000 for deposits held by individual retirement accounts.  On
January 1, 2014, the standard insurance amount will return to $100,000 per
depositor for all account categories except for IRAs and other certain
retirement accounts which will remain at $250,000 per depositor.





Deposit Insurance
Assessments.  Through the DIF, the FDIC insures the deposits of
Bay National Bank up to prescribed limits for each depositor, as indicated in
the preceding paragraph.  To maintain the DIF, member institutions are
assessed deposit insurance premiums based on their current condition and the
nature of their activities, and the revenue needs of the DIF, as determined by
the FDIC.  For institutions that do not have a long-term public debt
rating, the risk assessment is based on certain measurements of its financial
condition and its supervisory ratings.  The FDIC maintains a risk
based assessment system for determining deposit insurance
premiums.  The FDIC has established four risk categories (I-IV), each
subject to different premium rates, based upon an institution's status as well
capitalized, adequately capitalized or under capitalized, and the institution's
supervisory rating.  In December 2008, the FDIC raised the then
current assessment rates uniformly by 7 basis points for the first quarter of
2009 assessment, which resulted in an increase in annualized assessment rates of
ranging 12 to 50 basis points.  In February 2009, the FDIC issued
final rules to amend the DIF restoration plan, change the risk-based assessment
system and set assessment rates for member institutions beginning in the second
quarter of 2009.  As a Risk Category IV institution, Bay National
Bank’s annualized assessment rate is 45 basis points.





In May
2009, the FDIC issued a final rule which levied a special assessment applicable
to all insured depository institutions totaling five basis points of each
institution's assets, minus its Tier 1 Capital, as of June 30, 2009, not to
exceed 10 basis points of the institution’s domestic deposits.  The
special assessment was part of the FDIC's efforts to rebuild the
DIF.




In
November 2009, the FDIC issued a rule that required all insured depository
institutions to prepay their estimated quarterly risk based assessments for the
fourth quarter of 2009 and for all of 2010, 2011 and 2012, unless exempted by
the FDIC.  The FDIC exempted Bay National Bank from the obligation to
prepay its estimated quarterly risk based assessments.  The FDIC also
adopted a uniform three basis point increase in assessment rates effective on
January 1, 2011.  During the year ended December 31, 2009, Bay
National Bank paid $904,000 in FDIC assessment premiums.




The FDIC
may terminate the deposit insurance of any insured depository institution,
including Bay National Bank, if it determines after a hearing that the
institution has engaged or is engaging in unsafe or unsound practices, is in an
unsafe or unsound condition to continue operations, or has violated any
applicable law, regulation, order or any condition imposed by an agreement with
the FDIC.  It also may suspend deposit insurance temporarily during
the hearing process for the permanent termination of insurance, if the
institution has no tangible capital.  If insurance of accounts is
terminated, the accounts at the institution at the time of the termination, less
subsequent withdrawals, shall continue to be insured for a period of six months
to two years, as determined by the FDIC.





Temporary Liquidity Guarantee
Program.  In 2009 Bay National Bank began participating FDIC’s
Temporary Liquidity Guarantee Program (“TAG Program”) and paid a premium of 10
basis points per $100 to fully insure noninterest-bearing transaction
accounts.  Although previously scheduled to expire on December 31,
2009, the TAG Program was extended until June 30, 2010.  The annual
assessment rate applied to institutions participating during this extension
period was increased to either 15 basis points, 20 basis points or 25 basis
points, depending on the risk category assigned to the institution under the
FDIC's








15








risk-based
premium system.  Bay National Bank did not opt out of the TAG Program
and currently pays an annual assessment rate of 25 basis points per $100 for all
accounts balances in excess of the $250,000 FDIC deposit insurance coverage
amount.





Regulatory Enforcement
Authority.  The Financial Institutions Reform, Recovery, and
Enforcement Act of 1989 ("FIRREA") included substantial enhancement to the
enforcement powers available to federal banking regulators.  This
enforcement authority included, among other things, the ability to assess civil
money penalties, to issue cease-and-desist or removal orders and to initiate
injunctive actions against banking organizations and institution-affiliated
parties, as defined in FIRREA.  In general, these enforcement actions
may be initiated for violations of laws and regulations and unsafe or unsound
practices.  Other actions or inactions may provide the basis for
enforcement action, including misleading or untimely reports filed with
regulatory authorities.  FIRREA significantly increased the amount of
and grounds for civil money penalties and requires, except under certain
circumstances, public disclosure of final enforcement actions by the federal
banking agencies.





Transactions with Affiliates and
Insiders.Bay National Bank is subject to the provisions of
Section 23A and 23B of the Federal Reserve Act and Regulation W of the Federal
Reserve Bank, which place limits on the amount of loans or extensions of credit
to affiliates (as defined in the Federal Reserve Act), investments in or certain
other transactions with affiliates and on the amount of advances to third
parties collateralized by the securities or obligations of
affiliates.  The law and regulation limit the aggregate amount of
transactions with any individual affiliate to 10% of the capital and surplus of
Bay National Bank and also limit the aggregate amount of transactions with all
affiliates to 20% of capital and surplus.  Loans and certain other
extensions of credit to affiliates are required to be secured by collateral in
an amount and of a type described in the regulation.





Federal
law and Regulation W, among other things, prohibit an institution from engaging
in certain transactions with certain affiliates (as defined in the Federal
Reserve Act) unless the transactions are on terms substantially the same, or at
least as favorable to such institution and/or its subsidiaries, as those
prevailing at the time for comparable transactions with non-affiliated
entities.  In the absence of comparable transactions, such
transactions may only occur under terms and circumstances, including credit
standards that in good faith would be offered to or would apply to
non-affiliated companies.  In addition, under Regulation
W:





·
            a
      bank and its subsidiaries may not purchase a low-quality asset from an
      affiliate;


·
            covered
      transactions and other specified transactions between a bank or its
      subsidiaries and an affiliate must be on terms and conditions that are
      consistent with safe and sound banking practices;
  and


·
            with
      some exceptions, each loan or extension of credit by a bank to an
      affiliate must be secured by collateral with a market value ranging from
      100% to 130%, depending on the type of collateral, of the amount of the
      loan or extension of credit.





Regulation
W generally excludes all nonbank and nonsavings association subsidiaries of
banks from treatment as affiliates, except to the extent that the FRB decides to
treat these subsidiaries as affiliates.





Bay
National Bank also is subject to the restrictions contained in Section 22(h) of
the Federal Reserve Act and the FRB's Regulation O thereunder on loans to
executive officers, directors and principal stockholders.  Under
Section 22(h), loans to a director, an executive officer or a greater-than-10%
stockholder of a bank as well as certain affiliated interests of any of the
foregoing may not exceed, together with all other outstanding loans to such
person and affiliated interests, the loans-to-one-borrower limit applicable to
national banks (generally 15% of the institution's unimpaired capital and
surplus), and all loans to all such persons in the aggregate may not exceed the
institution's unimpaired capital and unimpaired surplus. Regulation O also
prohibits the making of loans in an amount greater than $25,000 or 5% of capital
and surplus but in any event not over $500,000, to directors, executive officers
and greater-than-10% stockholders of a bank, and their respective affiliates,
unless such loans are approved in advance by a majority of the Board








16





of
Directors of the bank with any "interested" director not participating in the
voting. Further, Regulation O requires that loans to directors, executive
officers and principal stockholders be made on terms substantially the same as
those that are offered in comparable transactions to unrelated third parties
unless the loans are made pursuant to a benefit or compensation program that is
widely available to all employees of the bank and does not give preference to
insiders over other employees.  Regulation O also prohibits a
depository institution from paying overdrafts over $1,000 of any of its
executive officers or directors unless they are paid pursuant to written
pre-authorized extension of credit or transfer of funds plans.





All of
Bay National Bank’s loans to its and Bay National Corporation’s executive
officers, directors and greater-than-10% stockholders, and affiliated interests
of such persons, comply with the requirements of Regulation W and 22(h) of the
Federal Reserve Act and Regulation O.





Loans to One
Borrower.As a national bank, Bay National Bank is subject to
the statutory and regulatory limits on the extension of credit to one
borrower.  Generally, the maximum amount of total outstanding loans
that a national bank may have to any one borrower at any one time is 15% of the
bank's unimpaired capital and surplus.  A national bank may lend an
additional 10% on top of the 15% if the amount that exceeds 15% of the bank's
unimpaired capital and surplus is fully secured by readily marketable
collateral.





Liquidity.Bay National Bank
is subject to the reserve requirements of FRB Regulation D, which applies to all
depository institutions with transaction accounts or non-personal time
deposits.  Specifically, amounts in transaction accounts above $10.3
million and up to $44.4 million must have reserves held against them in the
ratio of 3 percent of the amount.  Amounts above $44.4 million require
reserves of $1.023 million plus 10 percent of the amount in excess of $44.4
million.  Bay National Bank is in compliance with the applicable
liquidity requirements.





Dividends.  The amount
of dividends that may be paid by Bay National Bank to Bay National Corporation
depends on its earnings and capital position and is limited by statute,
regulations and policies.  As a national bank, Bay National Bank may
not pay dividends from its paid-in surplus.  All dividends must be
paid out of undivided profits then on hand, after deducting expenses, including
provisions for credit losses and bad debts.  In addition, a national
bank is prohibited from declaring a dividend on its shares of common stock until
its surplus equals its stated capital, unless there has been transferred to
surplus no less than one-tenth of the bank’s net profits for the preceding two
consecutive half-year periods (in the case of an annual
dividend).  OCC approval is required if the total of all dividends
declared by a national bank in any calendar year exceeds the total of its net
profits for that year combined with its retained net profits for the preceding
two years, less any required transfers to surplus.  Under the terms of
the Consent Order, Bay National Bank may not pay dividends unless it is in
compliance with the capital program required by the Consent Order and applicable
regulatory requirements and receives the OCC’s written
non-objection.





Community Reinvestment
Act.  The Community Reinvestment Act (the "CRA") requires that,
in connection with examinations of financial institutions within their
respective jurisdictions, the FRB, FDIC or OCC shall evaluate the record of the
financial institutions in meeting the credit needs of their local communities,
including low and moderate income neighborhoods, consistent with the safe and
sound operation of those institutions.  The CRA does not establish
specific lending requirements or programs for financial institutions nor does it
limit an institution's discretion to develop the types of products and services
that it believes are best suited to its particular community, consistent with
the CRA.  An institution's CRA activities are considered in, among
other things, evaluating mergers, acquisitions and applications to open a branch
or facility as well as determining whether the institution will be permitted to
exercise certain of the powers allowed by the GLBA.  The CRA also
requires all institutions to make public disclosure of their CRA ratings. Bay
National Bank received a “satisfactory” rating in its latest CRA examination
conducted in October 2008.






17







USA PATRIOT
Act.  Under the Uniting and Strengthening America by Providing
Appropriate Tools Required to Intercept and Obstruct Terrorism Act, commonly
referred to as the “USA Patriot Act” or the “Patriot Act,” financial
institutions are subject to prohibitions against specified financial
transactions and account relationships, as well as enhanced due diligence
standards intended to detect, and prevent, the use of the United States
financial system for money laundering and terrorist financing
activities.  The Patriot Act requires financial institutions,
including banks, to establish anti-money laundering programs, including employee
training and independent audit requirements,  follow minimum standards
for customer identification and maintenance of customer identification records,
and regularly compare customer lists against lists of suspected terrorists,
terrorist organizations and money launderers.





The
Treasury has issued a number of implementing regulations that apply to various
requirements of the USA Patriot Act to financial institutions such as Bay
National Bank.  Those regulations impose new obligations on financial
institutions to maintain appropriate policies, procedures and controls to
detect, prevent and report money laundering and terrorist
financing.





Failure of a financial institution to
comply with the USA Patriot Act’s requirements could have serious legal and
reputational consequences for the institution. Bay National Bank has adopted
appropriate policies, procedures and controls to address compliance with the
requirements of the USA Patriot Act under the existing regulations and will
continue to revise and update its policies, procedures and controls to reflect
changes required by the USA Patriot Act and Treasury’s
regulations.





The costs
or other effects of the compliance burdens imposed by the Patriot Act or future
anti-terrorist, homeland security or anti-money laundering legislation or
regulations cannot be predicted with certainty.





Consumer
Protection Laws.  Bay National Bank is subject to a number of federal
and state laws designed to protect borrowers and promote lending to various
sectors of the economy. These laws include the Equal Credit Opportunity Act, the
Fair Credit Reporting Act, the Fair and Accurate Credit Transactions Act, the
Truth in Lending Act, the Home Mortgage Disclosure Act, and the Real Estate
Settlement Procedures Act, and various state law counterparts.





In
addition, federal law currently contains extensive customer privacy protection
provisions. Under these provisions, a financial institution must provide to its
customers, at the inception of the customer relationship and annually
thereafter, the institution’s policies and procedures regarding the handling of
customers’ nonpublic personal financial information. These provisions also
provide that, except for certain limited exceptions, a financial institution may
not provide such personal information to unaffiliated third parties unless the
institution discloses to the customer that such information may be so provided
and the customer is given the opportunity to opt out of such disclosure. Federal
law makes it a criminal offense, except in limited circumstances, to obtain or
attempt to obtain customer information of a financial nature by fraudulent or
deceptive means.





Effective
July 1, 2010, a new federal banking rule under the Electronic Fund Transfer Act
will prohibit financial institutions from charging consumers fees for paying
overdrafts on automated teller machines (“ATM”) and one-time debit card
transactions, unless a consumer consents, or opts in, to the overdraft service
for those type of transactions. If a consumer does not opt in, any ATM
transaction or debit that overdraws the consumer’s account will be denied.
Overdrafts on the payment of checks and regular electronic bill payments are not
covered by this new rule. Before opting in, the consumer must be provided a
notice that explains the financial institution’s overdraft services, including
the fees associated with the service, and the consumer’s choices. Financial
institutions must provide consumers who do not opt in with the same account
terms, conditions and features (including pricing) that they provide to
consumers who do opt in.








18





Proposed Legislation and Regulatory
Actions.New regulations and statutes are regularly proposed
that contain wide-ranging proposals for altering the structures, regulations,
and competitive relationships of the nation’s financial
institutions.  We cannot predict whether or in what form any proposed
regulation or statute will be adopted or the extent to which our business may be
affected by any new regulation or statute.




Effect Of Governmental Monetary
Policies.Our earnings are affected by domestic economic conditions and
the monetary and fiscal policies of the United States government and its
agencies.  The FRB’s monetary policies have had, and are likely to
continue to have, an important impact on the operating results of commercial
banks through its power to implement national monetary policy in order, among
other things, to curb inflation or combat a recession.  The monetary
policies of the FRB affect the levels of bank loans, investments and deposits
through its control over the issuance of United States government securities,
its regulation of the discount rate applicable to member banks and its influence
over reserve requirements to which member banks are subject.  We
cannot predict the nature or impact of future changes in monetary and fiscal
policies.




FORWARD
      LOOKING STATEMENTS





Some of
the matters discussed in this annual report including under the captions
“Business of Bay National Corporation and Bay National Bank,” and “Management’s
Discussion and Analysis of Financial Condition and Results of Operations”
include forward-looking statements.  These forward-looking statements
include statements regarding, among other things, statements in connection with
our description of our strategic plan and actions to be taken in connection with
the Consent Order, actions to be taken in connection with our capital
restoration plan and the effects thereof including raising capital, increasing
our capital ratios and becoming adequately capitalized by the end of 2010, our
long-term business strategy, our expectations with respect to resolving issues
in our loan portfolio, credit problems in the commercial real estate sector,
loan workouts, future sources of revenue, liquidity including anticipated
sources of liquidity going forward, the allowance for credit losses, interest
rate sensitivity, payment of dividends, market risk,  effects of the
resignation of the loan officer who was managing workouts of the Towson
portfolio, increasing non-interest income, competing for large CDs, assigning
the sublease for the space of our former residential mortgage operation in
Towson to the landlord, investment strategies and expansion, financial and other
goals.  Forward-looking statements often use words such as “believe,”
“expect,” “plan,” “may,” “will,” “should,” “could,” “would,” “project,”
“contemplate,” “anticipate,” “forecast,” “intend”, or other words of similar
meaning.  You can also identify them by the fact that they do not
relate strictly to historical or current facts.When you read a
forward-looking statement, you should keep in mind the risk factors described
below and any other information contained in this annual report which identifies
a risk or uncertainty.  Bay National Corporation’s actual results and
the actual outcome of Bay National Corporation’s expectations and strategies
could be different from that described in this annual report because of these
risks and uncertainties and you should not put undue reliance on any
forward-looking statements.  All forward-looking statements speak only
as of the date of this filing, and Bay National Corporation undertakes no
obligation to make any revisions to the forward-looking statements to reflect
events or circumstances after the date of this filing or the occurrence of
unanticipated events.





Item
1A.  Risk Factors





You
should carefully consider the following risks, along with the other information
contained in this annual report.  The risks and uncertainties
described below are not the only ones that may affect Bay National
Corporation.  Additional risks and uncertainties may also adversely
affect our business and operations including those discussed in Item 7 –
Management’s Discussion and Analysis of Financial Condition and Results of
Operations and risks that we are currently unaware of or that we do not
currently consider material. If any of the following events actually occur, our
business and financial results could be materially adversely
affected.






19





If
we cannot raise adequate capital we may be unable to continue
operations.




As
previously reported we have experienced an unprecedented amount of loan
charge-offs in recent periods as a result of the continuing weakness in the
local and national economy, in particular in the real estate
sector.  These losses have caused us to fall below “well-capitalized”
status, which led to our entry into the Consent Order.  Among other
things, the Consent Order requires us to raise capital, and we are planning to
conduct an offering to raise capital in accordance with such provisions of the
Consent Order.




As a
result of recent loan losses and the significant provisions for the allowance
for credit losses, we require additional capital in order to continue
operations.  While as previously announced we are attempting to raise
the required capital and are hopeful that our efforts will be successful, we
cannot guarantee that this will be the case.  If we cannot raise
sufficient capital before the Bank reaches regulatory capital levels that will
result in a receivership of the Bank, we will attempt a direct sale of the
Company and/or the Bank or of the Bank’s assets.  In any such sale,
stockholders may not receive an amount for their stock that they consider
adequate, and it is possible stockholders will not receive anything at all in
such a transaction, particularly if we engage solely in a sale of
assets.




We
may be required to raise additional capital in the future, but that capital may
not be available when it is needed and could be dilutive to existing
stockholders.




We are
required by our regulators to maintain adequate levels of capital to support our
operations.  We anticipate that our capital resources as a result of
the proceeds raised from our currently contemplated stock and warrant offering
will allow us to regain “well-capitalized” status and meet other applicable
capital regulatory requirements, comply with our strategic plan, and otherwise
satisfy our capital requirements for the foreseeable future.  However,
we may be required or choose to raise additional capital subsequent to the
offering if we do not raise sufficient funds in the contemplated offering or
otherwise for strategic, regulatory or other reasons.




Current
conditions in the capital markets are such that traditional sources of capital
may not be available to us on reasonable terms if we needed to raise additional
capital.  In such case, there is no guarantee that we will be able to
successfully raise additional capital at all or on terms that are favorable or
otherwise not dilutive to existing stockholders.




Difficult
economic and market conditions have adversely affected, and may continue to
adversely affect, us and our industry.




Dramatic
declines in the housing market, with decreasing home prices and increasing
delinquencies and foreclosures, have negatively impacted the credit performance
of mortgage and construction loans and resulted in significant write downs of
assets by many financial institutions, including us.  Because a
significant portion of our loan portfolio is comprised of real estate-related
loans, continued decreases in real estate values could adversely affect the
value of property used as collateral for loans in our
portfolio.  General downward economic trends, reduced availability of
commercial credit and increasing unemployment have negatively impacted the
credit performance of commercial and consumer credit, resulting in additional
write downs.  Concerns over the stability of the financial markets and
the economy have resulted in decreased lending by financial
institutions.  This market turmoil has led to increased commercial and
consumer deficiencies, lack of customer confidence, increased market volatility
and reduction in general business activity.  The resulting economic
pressure on consumers and businesses and the lack of confidence in the financial
markets may continue to adversely affect our business, financial condition,
results of operation and stock price.  We do not expect that the
difficult conditions in the financial markets are likely to improve in the near
future.  A worsening of these conditions would likely exacerbate the
adverse effects of these difficult market conditions on us and others in the
financial institutions industry.






20




Liquidity
risk could impair our ability to fund operations and jeopardize our financial
condition, and we are limited in the amount of interest we can pay on
deposits.




Liquidity
is essential to our business.  An inability to raise funds through
deposits, borrowings, sale of loans and other sources could have a material
adverse effect on our liquidity.  Further, if U.S. markets and
economic conditions continue to deteriorate, our liquidity could be adversely
affected.  For example, even with the proceeds from our anticipated
offering, further declines in the housing market could result in additional
asset write downs, which could reduce our liquidity below required levels and
require us to seek additional capital.  There can be no guarantee,
however, that such capital would be available when we require it or, if
available, on favorable terms, and if we raise capital via the sale of common
stock, the holdings of our current stockholders would be diluted.  Our
access to funding sources in amounts adequate to finance our activities could be
impaired by factors that affect us specifically or the financial services
industry in general.  Factors that could detrimentally impact our
access to liquidity sources include a decrease in the level of our business
activity due to a further market downturn or adverse regulatory action against
us.  Our ability to acquire deposits or borrow could also be impaired
by factors that are not specific to us, such as a severe disruption of the
financial markets or negative views and expectations about the prospects for the
financial services industry.  Further, given that the Bank is unable
to issue brokered CDs without prior approval from the FDIC, the Bank’s inability
to replace maturing brokered deposits with core deposits or cash flows from loan
repayments may require us to generate liquidity through other
means.  If we cannot raise additional capital when needed, our ability
to further expand operations through internal growth and deposit gathering could
be materially impaired.




In
addition, as a result of being less than “well capitalized” we are limited as to
the interest rate we may pay on deposit accounts.  Pursuant to
applicable FDIC regulations, we may not pay more than .75% over the “national
rate” on deposits, which is defined as the average of rates paid by insured
depositary institutions and branches for which data is available.  If
we believe our local market rates are higher than this average, we can seek
approval to charge a higher rate based on the average of local rates, but such
approval is not guaranteed.  In either case we are limited in our
ability to aggressively seek deposits through the use of the interest rate we
pay on deposits, which may limit our ability to obtain and retain
deposits.  Further, if we are required to pay a lower interest rate
than competing institutions, we may be unable to retain some of our deposits,
and these restrictions may also cause us to have difficulty obtaining new
deposits as readily as we have in the past, all of which would also adversely
affect our liquidity position.




Nonperforming
assets take significant time to resolve and adversely affect our results of
operations and financial condition.




At
December 31, 2009, nonperforming loans (nonaccrual loans, loans past due 90 days
or more and still accruing and troubled debt restructures) totaled $20.2
million, or 10.4% of our loan portfolio.  At December 31, 2009, our
nonperforming assets (which include foreclosed real estate) were $22.9 million,
or 7.8% of total assets.  We also had $934,139 in accruing loans that
were 30 to 89 days delinquent, or 0.5% of our loan portfolio, at December 31,
2009.




Our
nonperforming assets adversely affect our net income in various
ways.  Until economic and market conditions improve, we expect to
continue to incur additional losses relating to an increase in nonperforming
loans.  We do not record interest income on nonaccrual loans or other
real estate owned, thereby adversely affecting our income and increasing our
loan administration costs.  When we take collateral in foreclosures
and similar proceedings, we are required to mark the collateral to its then fair
value less expected selling costs, which, when compared to the principal amount
of the loan, may result in a loss.  These nonperforming loans and
other real estate owned also increase our risk profile and the capital our
regulators believe is appropriate in light of such risks.  There can
be no assurance that we will be able to reduce our nonperforming assets in a
timely manner, that we will not experience further increases in nonperforming
loans in the future or that our nonperforming assets will not result in future
losses.






21




Because
we currently serve limited market areas, we could be more adversely affected by
an economic downturn in our market areas than our larger competitors who are
more geographically diverse.




Currently,
our primary market areas are limited to the Baltimore metropolitan area and
Maryland’s Eastern Shore.  Although the economic decline has not
impacted the suburban Maryland and Washington D.C. suburbs as adversely as other
areas of the United States, it has caused an increase in unemployment and
business failures and a significant decline in property values in the
metropolitan areas.  As a result, if any of these areas continues to
suffer an economic downturn, our business and financial condition may be more
severely affected than our larger bank competitors.  Our larger
competitors serve a more geographically diverse market area, parts of which may
not be affected by the same economic conditions that exist in our primary market
areas.  Further, unexpected changes in the national and local economy
may adversely affect our ability to attract deposits and to make
loans.  Such risks are beyond our control and may have a material
adverse effect on our financial condition and results of operations and, in
turn, the value of our securities.




Government
regulation could restrict our growth or cause us to incur higher
costs.




We
operate in a highly regulated environment and are subject to examination,
supervision and comprehensive regulation by several federal and state regulatory
agencies.  Banking regulations, designed primarily for the safety of
depositors, may limit our growth and the return to investors by restricting
activities such as: the payment of dividends; mergers with, or acquisitions by,
other institutions; investments; loans and interest rates; interest rates paid
on deposits; and the creation of branch offices.  Laws and regulations
could change at any time, and such changes could adversely affect our
business.  In addition, the cost of compliance with regulatory
requirements could adversely affect our ability to operate
profitably.




In
addition, the financial sector has recently been the focus of legislative debate
and government intervention, and we anticipate that additional laws and
regulations may be enacted in response to the current financial crises that
could have an impact on our operations.  Any changes in regulation and
oversight, including in the form of changes to statutes, regulations or
regulatory policies or changes in interpretation or implementation of statutes,
regulations or policies, could affect the service and products we offer,
increase our operating expenses and otherwise adversely impact our financial
performance and condition.  In addition, the burden imposed by these
federal and state regulations may place banks in general, and the Bank
specifically, at a competitive disadvantage compared to less regulated
competitors.




Further,
given our current financial condition, we are subject to increased regulatory
scrutiny.  Among other things, we are subject to increased deposit
insurance premiums, restrictions on employment termination payments and
regulatory preapproval of new directors and senior management.  Our
regulators have the ability to take further action against us that could, among
other things, force us to raise capital, remove board members and management,
pay civil money penalties or to take or cease taking certain actions, all of
which would negatively impact our ability to operate.  Depending on
the severity of any regulatory actions, we may not be able to continue
operations.  Depending on the severity of any future loan or other
losses, our regulators could declare the Bank insolvent and in such event, all
stockholder equity would be lost.




We
depend heavily on one key employee, Mr. Hugh W. Mohler, and our business would
suffer if something were to happen to Mr. Mohler.




Mr.
Mohler is the President and Chief Executive Officer of Bay National
Bank.  If he were to leave for any reason, our business would suffer
because he has banking experience and relationships with clients and potential
clients that would not be easy to replace.  In addition, because our
business is relationship-driven, the loss of an employee who has primary contact
with one or more of the Bank’s clients could cause the Bank to lose those
clients’ business, possibly resulting in a decline in revenues.  We
maintain Bank Owned Life Insurance with respect to Mr. Mohler that is
functionally equivalent to a key-man life insurance policy.  The
current benefit to Bay National under such insurance is approximately $1.5
million.  As discussed below under “Management’s Discussion and
Analysis – Recent Developments – Capital Status;











22





Impact on
Operations,” however, we anticipate that we may redeem the bank owned life
insurance during 2010.




If
our allowance for credit losses is not sufficient to cover actual loan losses,
our earnings could decrease.




We make
various assumptions and judgments about the collectability of our loan
portfolio, including the creditworthiness of our borrowers and the value of
collateral for repayment.  In determining the amount of the allowance
for credit losses, we review and evaluate, among other things, our loans and our
loss and delinquency experience and current economic conditions.  If
our assumptions are incorrect, our allowance for credit losses may not be
sufficient to cover losses inherent in our loan portfolio, resulting in
additions to our allowance.




We are
particularly susceptible to this risk at the present time because we have
experienced significant credit quality deterioration in the current recession,
as reflected in recent losses and delinquency statistics.  As the
effects of the recent recession continue, the financial condition of our
borrowers will be further strained, which could lead to higher reserve
requirements.  The depth and duration of the recession have also made
successful outcomes on Towson mortgage workout efforts more difficult to
achieve.  In addition, the continuing effects of the recession could
accelerate any credit deterioration or default which may normally occur as
pre-recession growth in our residential real estate loan portfolio becomes
outstanding for some period of time, a process referred to as
“seasoning.”  If the residential real estate market does not improve,
the level of delinquencies and defaults may exceed historical levels as our
residential real estate loans season.  Were this to occur, we may be
required to further increase our provision for credit losses.




Material
further additions to our allowance, as have occurred in 2008 and 2009, would
materially decrease our net income.  In addition, bank regulators
periodically review our allowance for credit losses and may require us to
increase our provision for loan losses or recognize further loan
charge-offs.  Any increase in our allowance for credit losses or loan
charge-offs may have a material adverse effect on our results of operations and
financial condition.  Systemic and pervasive loan and lease losses can
cause insolvency and failure of a financial institution and, in such an event,
our stockholders could lose their entire investment.




We
may not be successful in implementing our strategic plan.




Our
success in implementing our three-year strategic plan will depend on, among
other things, our ability to obtain any necessary regulatory approvals, our
access to capital, our ability to reduce expenses, our ability to generate
high-quality loans, our ability to increase core deposits and our ability to
improve liquidity.  We cannot guarantee that we will be able to do any
of these things.  In addition, our success will depend in a large part
on market interest rates and the economy in our market area, both of which are
beyond our control.  We may not be successful in implementing our
strategic plan and, even if implemented, the plan may not be
successful.




We
may continue to incur losses.




We are a
single bank holding company and our business is owning all of the outstanding
stock of Bay National Bank.  As a result, our operating results and
financial position depend on the operating results and financial position of the
Bank.  Bay National Corporation incurred net losses of $5,064,643 and
$16,070,308 for the years ended December 31, 2008 and December 31, 2009,
respectively.  While we were profitable for the years ended December
31, 2007, 2006, 2005 and 2004, the downturn in the real estate market
significantly impacted 2008 and 2009 results.  Although our three-year
strategic plan sets forth a plan for achieving and maintaining profitability, we
may not achieve profitability within the time frame anticipated by management,
or ever.  Many factors could adversely affect our short and long term
operating performance, including the failure to fully implement the plan,
unfavorable economic conditions, increased competition, loss of key personnel
and government regulation.






23






Bay
National Bank’s lending strategy involves risks resulting from the choice of
loan portfolio.




Our loan
strategy emphasizes commercial business loans and commercial real estate
loans.  At December 31, 2009, such loans accounted for approximately
67.6% of our loan portfolio.  Commercial business and commercial real
estate loans may carry a higher degree of credit risk than do residential
mortgage loans.  Such loans typically involve larger loan balances to
a single borrower or related borrowers.




Commercial
real estate loans can be affected by adverse conditions in local real estate
markets and the economy, generally because commercial real estate borrowers’
ability to repay their loans depends on successful development of their
properties as well as other factors affecting residential real estate borrowers.
These loans also involve greater risk because they generally are not fully
amortizing over the loan period, but have a balloon payment due at
maturity.  A borrower’s ability to make a balloon payment typically
will depend on being able to either refinance the loan or timely sell the
underlying property.




A
commercial business loan is typically based on the borrower’s ability to repay
the loan from the cash flows of the businesses.  Such loans may
involve risk because the availability of funds to repay each loan depends
substantially on the success of the business itself.  In addition, the
collateral securing the loans may depreciate over time, be difficult to appraise
and liquidate, or fluctuate in value based on the success of the
business.  Because commercial real estate, commercial business and
construction loans are vulnerable to downturns in the business cycle, further
economic weakness could cause more of those loans to become
nonperforming.  The underwriting, review and monitoring performed by
our officers and directors cannot eliminate all of the risks related to these
loans.




While we
are currently decreasing the number of land development and construction loans
we originate based on current market conditions, such loans accounted for
approximately 13.1% of our loan portfolio as of December 31,
2009.  Real estate construction, land acquisition and development
loans are based upon estimates of costs and values associated with the completed
project.  These estimates may be inaccurate, and we may be exposed to
significant losses on loans for these projects.  Such loans involve
additional risks because funds are advanced upon the security of the project,
which is of uncertain value prior to its completion, and costs may exceed
realizable values in declining real estate markets.  Because of the
uncertainties inherent in estimating construction costs and the realizable
market value of the completed project and the effects of governmental regulation
of real property, it is relatively difficult to evaluate accurately the total
funds required to complete a project and the related loan-to-value
ratio.  As a result, construction loans often involve the disbursement
of substantial funds with repayment dependent, in part, on the success of the
ultimate project and the ability of the borrower to sell or lease the property,
rather than the ability of the borrower or guarantor to repay principal and
interest.  If our appraisal of the value of the completed project
proves to be overstated or market values or rental rates decline, we may have
inadequate security for the repayment of the loan upon completion of
construction of the project.  If we are forced to foreclose on a
project prior to or at completion due to a default, there can be no assurance
that we will be able to recover all of the unpaid balance of, and accrued
interest on, the loan as well as related foreclosure and holding
costs.  In addition, we may be required to fund additional amounts to
complete the project and may have to hold the property for an unspecified period
of time while we attempt to dispose of it.




Bay
National Bank’s lending limit may limit our growth.




The Bank
is limited in the amount it can loan to a single borrower by the amount of its
capital.  Specifically, under current law, Bay National Bank may lend
up to 15% of its unimpaired capital and surplus to any one
borrower.  The limit on the dollar amount we can lend, however, is
significantly less than that of many of its competitors and may discourage
potential borrowers who have credit needs in excess of Bay National Bank’s
lending limit from conducting business with us.






24






We
face substantial competition which could adversely affect our ability to attract
depositors and borrowers.




We
operate in a competitive market for financial services and face intense
competition from other institutions both in making loans and in attracting
deposits.  Many of these institutions have been in business for
numerous years, are significantly larger, have established customer bases, have
greater financial resources and lending limits than us, and are able to offer
certain services that we are not able to offer.  If we cannot attract
deposits and make loans at a sufficient level, our operating results will
suffer, as will our opportunities for growth.




Our
ability to compete may suffer if we cannot take advantage of technology to
provide banking services or if our customers fail to embrace that
technology.




Our
business strategy relies less on customers’ access to a large branch network and
more on access to technology and personal relationships.  Further, the
market for financial services is increasingly affected by advances in
technology, including developments in telecommunications, data processing,
computers, automation, Internet-based banking and tele-banking.  Our
ability to compete successfully may depend on the extent to which we can take
advantage of technological changes and the extent to which our customers embrace
technology to complete their banking transactions.




Our
profitability depends on interest rates and changes in monetary policy may
impact us.




Our
results of operations depend to a large extent on our “net interest income,”
which is the difference between the interest expense incurred in connection with
our interest-bearing liabilities, such as interest on deposit accounts, and the
interest income received from our interest-earning assets, such as
loans.  Interest rates are influenced by, among other things,
expectations about future events, including the level of economic activity,
federal monetary and fiscal policy and geo-political stability, and as a result,
are not predictable or controllable.  In addition, competitive factors
heavily influence the interest rates we can earn on our loan and investment
portfolios and the interest rates we pay on our deposits.  Community
banks, in part, are often at a competitive disadvantage in managing their cost
of funds compared to the large regional, super-regional or national banks that
have access to the national and international capital markets.  These
factors influence our ability to maintain a stable interest margin.




The
costs of being a public company are proportionately higher for small companies
like us due to the requirements of the Sarbanes-Oxley Act.




The
Sarbanes-Oxley Act of 2002 and the related rules and regulations promulgated by
the SEC have increased the scope, complexity and cost of corporate governance,
reporting and disclosure practices.  We are required to comply with
these regulations.  We expect to continue to experience increasing
compliance costs, including costs related to internal controls, as a result of
the Sarbanes-Oxley Act, particularly if smaller SEC reporting companies like us
are not exempted from the auditor attestation requirement with respect to
internal control over financial reporting, which requirement is currently
scheduled to apply to us beginning with our 2010 annual report.  These
obligatory costs are proportionately higher for a company of our size and will
affect our profitability more than that of some of our larger
competitors.




Item
1B.  Unresolved Staff Comments





Not
applicable as the Company is not an accelerated filer or large accelerated
filer.







25





Item
2.  Properties





Baltimore





Our
headquarters building is located at 2328 West Joppa Road, Lutherville, Maryland
21093.  Currently, we lease space in the basement (1,429 square feet),
the first floor (4,067 square feet) and the third floor (6,206 square feet) of
this building.  The basement space is currently used for training and
storage purposes.  First floor space of 765 square feet is currently
used by bank operations personnel and 2,355 square feet is used for the
Lutherville branch office; approximately 947 square feet has been sublet since
April 1, 2009.  The third floor space is used for our executive, loan
and administrative offices.  The current lease was renewed on January
6, 2010, and extends the lease for one five-year term to February 28,
2015.





As of
December 31, 2009, we were paying rent of $381,655 per year, or $31,805 per
month for all of the leased space in the building.  For the March 2010
to February 2011 lease year, we will pay annual rent of $381,665, or $31,805 per
month.  The new lease terms increase the yearly base rent by 3%
annually commencing with the third year and then for each lease year
thereafter.  The rent includes our share of taxes and building
operating costs.





The
Landlord, Joppa Green II Limited Partnership, LLLP, is beneficially owned by the
MacKenzie Companies.  Gary T. Gill, who had been a director of Bay
National Corporation and Bay National Bank from January 2003 until May 2008, is
the president and chief executive officer of the MacKenzie
Companies.




Towson





We began
leasing 4,317 square feet of space on the first floor of a building located at
1122 Kenilworth Drive, Towson, Maryland 21204 for our Baltimore residential
mortgage operation on October 1, 2006.  Pursuant to the lease
agreement, we agreed to an initial lease term of five years and two months,
terminating on November 30, 2011.  We were also provided the right to
renew the lease for
one additional five-year term.  As part of this agreement, the
aggregate rent due under the lease is $9,238 monthly from December 2009 through
November 2010.  For each lease year thereafter, including any lease
years during any renewal term, the yearly base rent will increase by
3%.





In
November 2008, the Baltimore residential mortgage operation moved to available
space on the third floor of our headquarters building.  Since December
2008, we have sublet this space as part of our continued emphasis on expense
management.  The aggregate rent due from tenants equals $7,385 monthly
through March 2010 and $6,156 from May 2010 through April
2011.  Effective April 2010, successful negotiations with the landlord
and one of the sub-tenants to lower the amount of space for which we are under
contract and assign the existing sub-lease for that space to the landlord
resulted in a modestly lower future lease expense, net of sub-lease income, over
the remaining term of the lease.





Columbia





On
October 3, 2007, we agreed to lease 3,181 square feet of space on the third
floor of a building located at 8820 Columbia 100 Parkway, Suite 301, Columbia,
Maryland 21045.  This space was previously used for our
Baltimore-Washington corridor loan production office, which was closed effective
March 19, 2009.  Pursuant to the lease agreement, we agreed to an
initial lease term of five years.  We were also provided the right to
renew the lease for two additional five-year terms.  The current rent
under this agreement is $7,129 per month and will increase by 3% for each
subsequent lease year hereafter, including any lease years during any renewal
term.  We have sublet the space previously occupied by this group as
part of our continued emphasis on expense management for $5,169 per month and
the rental payment under the sublease will increase 3% for each subsequent lease
year hereafter through May 2013.






26





Salisbury





Our
Salisbury, Maryland branch office is located at 109 Poplar Hill Avenue,
Salisbury Maryland 21801 in a two-story building containing approximately 2,500
square feet of office space.  The current lease terminated on August
31, 2009, and we have agreed to extend the lease on a rolling month to month
basis including a 12-month notice period for termination.  Under the
current lease term, we are paying monthly rent of approximately $2,604, plus all
real estate taxes and utilities with a 3% annual increase scheduled in August
2010.  Pursuant to this lease, we have a right of first refusal to
purchase the building in the event the landlord receives a bona fide offer to
purchase.  This property is owned by John R. Lerch, who has been a
director of Bay National Corporation and Bay National Bank since their
formation.  See “Item 13 – Certain Relationships and Related
Transactions, and Director Independence.”





Through
October 2008, our Salisbury, Maryland mortgage division office was located at
318 East Main Street, Salisbury Maryland.  The leased space consisted
of two office suites totaling approximately 420 square feet.  The
original lease for this space expired on December 31, 2004 and we continued to
rent the space on a month-to-month basis at a cost of $700 per
month.  The landlord was responsible for all real estate taxes and
utilities.  We had leased an additional 200 square feet in this
building from January 1, 2005 through November 30, 2005 at an additional cost of
$300 per month.  During October 2008, the Salisbury mortgage division
moved to available space at our Salisbury branch office .





In August
2008, the Company began renting office space in Cambridge, Maryland on a
month-to-month basis at a cost of $350 per month for residential real estate
loan production, which office was later closed.  We elected to
terminate this lease in December 2009.





Item
3.  Legal Proceedings





We are
party to legal actions that are routine and incidental to our
business.  In management’s opinion, the outcome of these matters,
individually or in the aggregate, will not have a material effect on our results
of operations or financial position. There are no proceedings known to us to be
contemplated by any governmental authority.  There are no material
proceedings known to us, pending or contemplated, in which any director, officer
or affiliate or any principal security holder of Bay National Corporation is a
party adverse to Bay National Corporation or Bay National Bank or has a material
interest adverse to Bay National Corporation or Bay National Bank.




Item
4.  (Removed and Reserved)







27





PART
II





Item
5.  Market for Registrant’s Common Equity, Related Stockholder Matters
and Issuer Purchases of Equity Securities





As of
March 24, 2010, the number of holders of record of Bay National Corporation’s
common stock was approximately 324 as reported by our stock transfer agent,
Registrar and Transfer Company. Bay National Corporation’s common stock is
currently traded on The NASDAQ Capital Market under the symbol
"BAYN."





The
following table reflects the high and low sales information as reported on The
NASDAQ Capital Market for the periods presented. Quotations reflect inter-dealer
prices, without retail mark-up, mark-down, or commission and may not represent
actual transactions.





2009
              Sales
      Price Range
            
            
            2008
              Sales
      Price RangeQuarter
            
            Low
            
            
            High
            
            
            Low
            
            
            High1st
            
            $
            .52
            
            
            $
            2.63
            
            
            $
            8.12
            
            
            $
            11.702nd
            
            
            1.10
            
            
            
            1.65
            
            
            
            7.80
            
            
            
            10.203rd
            
            
            .96
            
            
            
            3.70
            
            
            
            4.26
            
            
            
            8.034th
            
            
            1.09
            
            
            
            2.45
            
            
            
            1.50
            
            
            
            5.96




We have
not paid any cash dividends during 2008 and 2009.  Management
anticipates that we  will retain all earnings, if any, in order to
provide more funds to operate and expand our business; therefore, we have no
plans to pay any cash dividends at least until our profitability exceeds the
level necessary to support capital growth in excess of regulatory capital
needs.  If we decide to pay dividends in the future, our ability to do
so will depend on the ability of Bay National Bank to pay dividends to Bay
National Corporation.  In addition, management would consider a number
of other factors before deciding to pay dividends, including our earnings
prospects, financial condition and cash needs.  In addition, in
February 2009, we received notice from the Federal Reserve Bank of Richmond that
Bay National Corporation is expected to immediately terminate future dividend
payments.  This order will remain in effect until we receive written
approval from the Reserve Bank to resume such payments.





The
amount of dividends that Bay National Bank may pay to Bay National Corporation
depends on the Bank's earnings and capital position and is limited by statute,
regulations and regulatory policies.  As a national bank, Bay National
Bank may not pay dividends from its permanent capital.  All cash
dividends must be paid out of undivided profits then on hand, after deducting
expenses, including provisions for credit losses and bad debts.  In
addition, a national bank is prohibited from declaring a cash dividend on its
shares of common stock until its surplus equals its stated capital, unless there
has been transferred to surplus no less than one-tenth of the bank's net profits
for the preceding two consecutive half-year periods (in the case of an annual
dividend).  OCC approval is required if the total of all cash
dividends declared by a national bank in any calendar year exceeds the total of
its net profits for that year combined with its retained net profits for the
preceding two years, less any required transfers to surplus.  In
addition, Bay National Bank may not pay a dividend if, after paying the
dividend, it would be “undercapitalized” as defined in the applicable
regulations.  Furthermore, under the terms of the February 6, 2009
Consent Order, the Bank may not pay dividends unless it is in compliance with
the capital program required by the Consent Order and applicable regulatory
requirements and receives the OCC’s written non-objection.








28











Item
6.  Selected Financial Data





SELECTED
FINANCIAL DATA


AS OF
DECEMBER 31, 2009, 2008, 2007, 2006 and 2005


(dollars
in thousands, except per share data)





2009
            
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005Total
      assets
            
            $
            290,343
            
            
            $
            270,588
            
            
            $
            256,536
            
            
            $
            254,805
            
            
            $
            209,966Cash
      and due from banks
            
            
            71,153
            
            
            
            7,263
            
            
            
            2,314
            
            
            
            2,348
            
            
            
            1,461Federal
      funds sold and other overnight investments
            
            
            943
            
            
            
            2,023
            
            
            
            4,859
            
            
            
            31,550
            
            
            
            6,033Investment
      securities available for sale
            
            
            21,129
            
            
            
            -
            
            
            
            400
            
            
            
            698
            
            
            
            1,540Federal
      Reserve Bank stock
            
            
            663
            
            
            
            704
            
            
            
            607
            
            
            
            607
            
            
            
            452Federal
      Home Loan Bank stock
            
            
            488
            
            
            
            535
            
            
            
            1,108
            
            
            
            510
            
            
            
            342Loans,
      net
            
            
            184,913
            
            
            
            242,676
            
            
            
            235,956
            
            
            
            214,841
            
            
            
            196,590Deposits
            
            
            281,503
            
            
            
            244,628
            
            
            
            201,981
            
            
            
            224,149
            
            
            
            182,573Short-term
      borrowings
            
            
            -
            
            
            
            1,864
            
            
            
            25,372
            
            
            
            1,545
            
            
            
            1,444Note
      payable
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Subordinated
      debt
            
            
            8,000
            
            
            
            8,000
            
            
            
            8,000
            
            
            
            8,000
            
            
            
            8,000Stockholders’
      (deficit) equity
            
            
            (992
            )
            
            
            15,022
            
            
            
            19,921
            
            
            
            18,842
            
            
            
            16,214Common
      shares outstanding*
            
            
            2,154,301
            
            
            
            2,153,101
            
            
            
            2,137,633
            
            
            
            2,128,867
            
            
            
            2,116,841Book
      value per share
            
            $
            (.46
            )
            
            $
            6.98
            
            
            $
            9.32
            
            
            $
            8.85
            
            
            $
            7.66Ratio
      of interest earning assets to interest bearing liabilities
            
            
            121.18
            %
            
            
            123.85
            %
            
            
            121.35
            %
            
            
            126.40
            %
            
            
            126.38
            %Stockholders’
      (deficit) equity as a percentage of assets
            
            
            (.34
            )%
            
            
            5.55
            %
            
            
            7.77
            %
            
            
            7.39
            %
            
            
            7.72
            %





SELECTED
FINANCIAL RATIOS


FOR THE
YEARS ENDED DECEMBER 31, 2009, 2008, 2007, 2006 and 2005





Weighted
      average yield/rate on:
            
            2009
            
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005Loans
      and loans held for sale
            
            
            5.13
            %
            
            
            6.15
            %
            
            
            8.79
            %
            
            
            9.12
            %
            
            
            7.46
            %Investments
      and interest bearing cash balances
            
            
            .88
            %
            
            
            1.47
            %
            
            
            3.90
            %
            
            
            3.79
            %
            
            
            2.27
            %Deposits
      and borrowings
            
            
            2.74
            %
            
            
            3.20
            %
            
            
            4.45
            %
            
            
            4.31
            %
            
            
            2.96
            %Net
      interest spread
            
            
            1.56
            %
            
            
            2.71
            %
            
            
            3.95
            %
            
            
            4.40
            %
            
            
            4.12
            %Net
      interest margin
            
            
            2.06
            %
            
            
            3.30
            %
            
            
            4.82
            %
            
            
            5.27
            %
            
            
            4.74
            %





SELECTED
OPERATIONAL DATA


FOR THE
YEARS ENDED DECEMBER 31, 2009, 2008, 2007, 2006 and 2005


(dollars
in thousands, except per share data)





2009
            
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005Interest
      income
            
            $
            12,043
            
            
            $
            15,325
            
            
            $
            20,588
            
            
            $
            19,781
            
            
            $
            12,983Interest
      expense
            
            
            6,266
            
            
            
            6,763
            
            
            
            8,765
            
            
            
            7,823
            
            
            
            4,294Net
      interest income
            
            
            5,777
            
            
            
            8,562
            
            
            
            11,823
            
            
            
            11,958
            
            
            
            8,689Provision
      for credit losses
            
            
            10,966
            
            
            
            6,478
            
            
            
            2,126
            
            
            
            203
            
            
            
            1,179Net
      interest (loss) income after provision for credit losses
            
            
            (5,189
            )
            
            
            2,084
            
            
            
            9,697
            
            
            
            11,755
            
            
            
            7,510Non-interest
      income
            
            
            869
            
            
            
            763
            
            
            
            725
            
            
            
            777
            
            
            
            750Non-interest
      expenses
            
            
            9,893
            
            
            
            11,106
            
            
            
            8,993
            
            
            
            8,424
            
            
            
            6,171(Loss)
      Income before income taxes
            
            
            (14,212
            )
            
            
            (8,259
            )
            
            
            1,429
            
            
            
            4,108
            
            
            
            2,089Income
      tax expense (benefit)
            
            
            1,857
            
            
            
            (3,194
            )
            
            
            492
            
            
            
            1,678
            
            
            
            (655
            )Net
      (loss) income
            
            $
            (16,070
            )
            
            $
            (5,065
            )
            
            $
            937
            
            
            $
            2,430
            
            
            $
            2,744PER
      COMMON SHAREBasic
      net (loss) income per share*
            
            $
            (7.46
            )
            
            $
            (2.37
            )
            
            $
            .44
            
            
            $
            1.14
            
            
            $
            1.30Diluted
      net (loss) income per share*
            
            $
            (7.46
            )
            
            $
            (2.37
            )
            
            $
            .42
            
            
            $
            1.09
            
            
            $
            1.24Average
      shares outstanding (Basic)*
            
            
            2,153,910
            
            
            
            2,140,793
            
            
            
            2,133,174
            
            
            
            2,131,882
            
            
            
            2,114,809Average
      shares outstanding (Diluted)*
            
            
            2,153,910
            
            
            
            2,140,793
            
            
            
            2,210,151
            
            
            
            2,219,989
            
            
            
            2,202,417


*All periods have been adjusted to
reflect a 1.1 to 1 stock split in the form of a 10% dividend recorded on June
29, 2007.






29






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




The
following discussion of our financial condition and results of operations should
be read in conjunction with our consolidated financial statements, the notes
thereto and the other information included in this annual report.





This
discussion and analysis provides an overview of our financial condition and
results of operations as of December 31, 2009 and 2008 and for the years ended
December 31, 2009 and 2008.





Certain
reclassifications have been made to amounts previously reported to conform to
the classifications made in 2009.  These reclassifications had no
effect on previously reported results of operations or retained
earnings.




General





Bay
National Corporation was incorporated on June 3, 1999 under the laws of the
State of Maryland to operate as a bank holding company of the
Bank.  The Bank commenced operations on May 12, 2000.





Our
principal business is to make loans and other investments and to accept time and
demand deposits. Our primary market areas are the Baltimore Metropolitan area,
Baltimore-Washington corridor and Maryland’s Eastern Shore, although our
business development efforts generate business outside of these
areas.  We offer a broad range of banking products, including a full
line of business and personal savings and checking accounts, money market demand
accounts, CDs, and other banking services.  We fund a variety of loan
types including commercial and residential real estate loans, commercial term
loans and lines of credit, consumer loans, and letters of credit with an
emphasis on meeting the borrowing needs of small businesses. Our target
customers are small and mid-sized businesses, business owners, professionals,
nonprofit institutions and high net worth individuals.





Overview





During
2009, we decided to restrict loan growth, and operating results declined due to
continued deterioration of the economic environment and industry-wide problems
in residential real estate lending. As such, management continues to emphasize
prudent asset/liability management and has significantly tightened our
underwriting standards for residential real estate loans.  Key
measurements for the year ended December 31, 2009 include the
following:





·
            Total
      assets at December 31, 2009 increased by 7.3% to $290.3 million as
      compared to $270.6 million as of December 31,
  2008.





·
            Net
      loans outstanding decreased by 23.8% from $242.7 million as of December
      31, 2008 to    $184.9 million as of December 31,
      2009.





·
            There
      was approximately $20.2 million in non-accrual loans as of December 31,
      2009.  In addition, we foreclosed on or accepted a deed-in-lieu
      of foreclosure on ten residential real estate properties related to
      investor-owned residential real estate during the year ending December 31,
      2009. These properties were placed into other real estate owned (“OREO”)
      at an aggregate estimated net realizable value of approximately $2.1
      million.  As of December 31, 2009, 12 properties remained in
      OREO with an aggregate net realizable value of $2.7
      million.  Also, we had troubled debt restructurings totaling
      $5.4 million. We continue to maintain appropriate reserves for credit
      losses.








30











·
            Twelve
      properties held in real estate acquired through foreclosure, were sold
      during 2009. In aggregate, losses on nine properties totaled $244,000
      while a gain of $4,000 was realized on three properties.  We
      also recovered $69,000 for a loan originally transferred into OREO during
      2008.





·
            Deposits
      at December 31, 2009 were $281.5 million, an increase of $36.9 million or
      15.1% from December 31, 2008.





·
            The
      Company realized a net loss of $16.1 million for the year ended December
      31, 2009 as compared to a net loss of $5.1 million for year ended December
      31, 2008.  Included in the results for  the year ended
      December 31, 2009 was a provision for credit losses of $11.0 million and
      an increase in the valuation allowance for deferred tax assets of $7.5
      million.  The increase in valuation allowance more than offset
      the income tax benefit from the current year’s pre-tax loss and resulted
      in an income tax expense of $1.9 million  compared to a $3.2
      million income tax benefit recorded in
2008.





·
            Net
      interest income, our main source of income, was $5.8 million for the year
      ended December 31, 2009 compared to $8.6 million for the year ended
      December 31, 2008.  This represents a decrease of 32.5% from
      2008.





·
            We
      increased the allowance for credit losses by $4.1 million, or 72.0%, from
      $5.7 million at December 31, 2008, to $9.8 million at December 31,
      2009.  Over this 12-month period, the allowance for credit
      losses was increased by a provision of $10.7 million, net of the component
      providing for unfunded commitments, in order to reserve for credit losses
      inherent in the loan portfolio, and was reduced by net charge-offs
      totaling $6.6 million.  The substantially higher reserve
      requirement at December 31, 2009 versus the prior year-end reflects the
      continuing adverse effects of the recession, which include declining
      property values, discounting the value of collateral for a forced “bank
      sale” situation and considering  the age of the underlying
      appraisal to better reflect economic conditions.  With regard to
      loan losses, commercial and commercial real estate net charge-offs rose
      during the 12 months ended December 31, 2009, from negligible amounts in
      2008, to $1.9 million and $1.2 million, respectively, in
    2009.





·
            Non-interest
      income for the year ended December 31, 2009 increased by $105,800, or
      13.9%, as compared to the year ended December 31,
  2008.





·
            Non-interest
      expense decreased by $1.2 million, or 10.9% for the year ended December
      31, 2009, as compared to the year ended December 31,
  2008.





·
            The
      market price of our common stock ended the year at $1.20, down 50.0% from
      the closing price of $2.40 on December 31,
2008.





A
detailed discussion of the factors leading to these changes can be found in the
discussion below.





Recent
Developments





OCC Consent
Order





As we
have previously disclosed, on February 6, 2009, pursuant to a Stipulation and
Consent to the Issuance of a Consent Order, the Bank consented to the issuance
of a Consent Order by the OCC, the Bank’s primary regulator.






31







Among
other things, the order requires the Bank and/or its Board to take certain
actions, including developing and submitting certain written plans to the OCC,
and imposes certain restrictions on the Bank designed to improve its financial
strength, including the following:




·
            within
      30 days provide a written analysis of the Board’s decision whether to
      sell, merge or liquidate the Bank or remain
  independent;


·
            if
      the Board decides the Bank should remain independent and the OCC does not
      object to the written analysis, within 60 days of the Order implement a
      three-year strategic plan for the Bank with respect to certain financial
      objectives;


·
            by
      April 30, 2009 maintain a 12% total risk-based ratio, an 11% Tier 1
      risk-based ratio and a 9% leverage
ratio;


·
            develop
      a three-year capital program that, among other things, assesses current
      and expected funding needs and ensures that sufficient funds or access to
      funds exists to meet those needs;


·
            ensure
      that the Bank has competent management in its credit risk and asset
      liability risk management
functions;


·
            conduct
      management reviews and adopt a written education program for officers as
      necessary;


·
            immediately
      take action to protect the Bank’s interest in assets criticized by the OCC
      and adopt a written program designed to eliminate the basis of such
      criticism;


·
            increase
      liquidity;


·
            establish
      an effective, independent and on-going loan review system within 60 days
      of the Consent Order; and


·
            develop
      written plans to address liquidity improvement, loan portfolio management,
      asset diversification, the Bank’s allowance for loan and lease losses,
      monitoring and review of problem loans and leases, charged-off loans and
      related issues, and monitoring of  portfolio
    trends.





In
accordance with the Consent Order, the Board has appointed a compliance
committee to monitor, coordinate and report to the Board on the Bank’s
compliance with the Consent Order.  In addition, under the Consent
Order the Bank may not pay dividends unless it is in compliance with the capital
program required by the Consent Order and applicable regulatory requirements and
receives the OCC’s written non-objection.





The
Bank’s Board and its compliance committee have submitted a written analysis to
the OCC in which the Bank details its decision to remain independent while
continually evaluating other options.





We were
not in compliance with the minimum capital requirements at April 30, 2009 and
our request for an extension for compliance was denied.  As a result,
we are required to develop a contingency plan for the Bank; we believe, however,
that the terms of our previously-disclosed contemplated public offering of
common stock and warrants, if successful, will satisfy the contingency plan
requirement.  We are not in compliance with this portion of the
Consent Order, however, since the OCC has not issued a determination of no
supervisory objection to the strategic plan.





While we
are working to comply with the terms of the Consent Order, we are not currently
in compliance with any of the other requirements of the Consent Order (other
than the requirement to determine whether to sell, merge or liquidate the Bank
or remain independent).





The
foregoing description is only a summary of the material terms of the Order and
is qualified in its entirety by reference to the Order, which was filed as
Exhibit 10.19 to our Form 10-K for the year ended December 31,
2008.








32





Summary
of Key Items contained in the Board’s written response to the Consent
Order:





The
Bank’s Board of Directors and executive management have adopted a strategic plan
that maps out our strategy for the Bank to restore its higher capitalization,
strong earnings and good asset quality and to also eliminate the concerns raised
by the OCC in the Consent Order.  Pursuant to the strategic plan the
Bank will return to its original business model, provide stronger risk controls
and provide the management and support items necessary to continue to grow and
serve its customer base.  We envision all the key elements of the plan
being in place by September 30, 2010.





There can
be no assurance that the OCC will accept our strategic plan to remain
independent and they could strictly enforce the terms of the
Order.  In such a situation there can be no assurance that the Company
will be able to raise the required amount of capital within the time frame
required in the Order and further regulatory actions could follow.





In order
to make the plan work, the Bank will focus on six goals that are the keys to its
success.  These are:





•           A return to the original
mission: The Bank’s original mission was to serve local businesses and
professionals through internally-generated loans.  The Bank has
returned to that mission.





•           Improve asset
quality:  Asset quality must be raised to acceptable levels and
thereafter maintained as part of a high quality loan portfolio.  This
loan portfolio will consist of primarily internally-generated small business
loans that are fully within the Bank’s expertise and provide adequate yields
with manageable risk.





•           Increase
capitalization:  Capital must be raised to levels above the
minimum capital needed to meet regulatory requirements.  This higher
level of capital can be achieved by either shrinking the size of the balance
sheet, raising additional contributions from present and new stockholders or by
a combination of these two approaches.  In this regard we held a
special meeting of stockholders on February 25, 2010, at which our stockholders
authorized an additional 75 million shares of our common stock to be available
for issuance.  Significantly increasing the Bank’s level of capital
will ensure that the Bank not only remains viable through the present economic
downturn, but will have the ability to grow its earning assets and regain its
former earnings profile.





•          Improve
liquidity:   Overall liquidity and the number of liquidity
options must be increased to a level consistent with the risk level of the Bank
and be sufficient to allow the Bank room to grow assets.  This
requires that the Bank develop multiple sources of liquidity that it can access
as necessary and at normal prices.  This means, among other things,
establishing, increasing or maintaining lines of credit with the other banks,
the ability to obtain advances from the Federal Home Loan Bank, borrowing from
the Federal Reserve discount window, the use of national market CDs, the ability
to fully utilize the certificate of deposits registry service (“CDARS”) and
identifying collateral that may be pledged.  It also means developing
an investment portfolio of securities.





•        
Return to
Profitability:  Profitability must be restored as soon as
possible and beyond that point earnings must show consistent and steady
growth.  In the context of improving profitability and preserving
capital, the Bank has already made the following internal changes that have
helped to minimize losses.





•   Significant
staff reductions that reduced the bank’s full-time equivalent employees from 75
as of March 31, 2008 to 46 as of March 31, 2009 and to


38
on March 24, 2010 .


•   Across
the board salary reductions in January of 2009 of 10% for all remaining officers
except for the president and chief executive officer who


took
a 20% reduction.


•   Cancellation
of 2008 and 2009 year-end bonuses.


•   Board
of Directors has declined to be paid their fees for 2008, 2009 and
2010.


•   Closing
of loan production offices in Towson and Howard County.






33







•           Develop management
depth:


·
            The
      Board is currently negotiating with a top-flight executive to add to the
      present management team.  We believe that the addition of an
      experienced, talented and proven executive will enhance the executive
      management team and management succession plan’s depth, experience and
      talent, allowing us to maintain the confidence of the public, clients,
      directors, stockholders and regulators.  The Board will continue
      to evaluate management on a regular
basis.





Federal Reserve Board
Enforcement Action / Written Agreement




On April
28, 2009, pursuant to a formal enforcement action by the Federal Reserve Bank of
Richmond, Bay National Corporation entered into a written agreement with the
Reserve Bank (the “Reserve Bank Agreement”).  Pursuant to the Reserve
Bank Agreement, Bay National Corporation agreed to the following:




•    We
may not declare or pay any dividends without the prior written approval of the
Reserve Bank and the Director of the Division of Banking Supervision and
Regulation of the Board of Governors of the Federal Reserve (the
“Director”).




•    We
may not directly or indirectly take dividends or any other form of payment
representing a reduction in capital from the Bank without the Reserve Bank’s
prior written approval.




•    We
(including our nonbank subsidiaries) may not make any distributions of interest,
principal or other sums on subordinated debentures or trust preferred securities
without the prior written approval of the Reserve Bank and the
Director.




•    We
(including our nonbank subsidiaries) may not, directly or indirectly, incur,
increase or guarantee any debt without the Reserve Bank’s prior written
approval.




•    We
(including our nonbank subsidiaries) may not, directly or indirectly, purchase
or redeem any shares of our stock without the Reserve Bank’s prior written
approval.




•    In
appointing any new director or senior executive officer, or changing the
responsibilities of any senior executive officer so that the officer would
assume a different senior executive officer position, we will comply with
certain notice provisions set forth in the Federal Deposit Insurance Act and
Board of Governors’ Regulations.




•    We
will comply with certain restrictions on indemnification and severance payments
pursuant to the Federal Deposit Insurance Act and FDIC regulations.




•    We
will provide quarterly progress reports to the Reserve Bank.




We are
currently in compliance with all of the terms of the Reserve Bank
Agreement.




Appointment
of New Chairman




On
November 17, 2009 the Boards of Directors of Bay National Corporation and Bay
National Bank elected Charles L. Maskell, Jr., CPA as Chairman of the board of
directors of both organizations following Hugh W. Mohler’s resignation as
Chairman.  Mr. Mohler remains as President and Chief Executive Officer
of both Bay National Corporation and the Bank.






34






Repurchase of Trust
Preferred Securities; Recognition of Deferred Tax Asset




As
wehave disclosed
in our previously filed registration statement, we are attempting to negotiate
with the holders of the trust preferred securities issued through our Delaware
trust subsidiary, Bay National Capital Trust I, to redeem these securities at a
discount to face value.  We have engaged an outside advisor to assist
us in this effort.  There can be no assurance, however, that we will
reach a binding agreement with the holders to redeem the trust preferred
securities.




If we are
successful in redeeming these securities at discount, the amount of the discount
will result in a gain being recognized for Bay National
Corporation.  The amount of the gain, net of applicable income tax
expense, will be an addition to the retained earnings and the total capital of
Bay National Corporation in the period such transaction is
executed.




In
addition, the gain we recognize from the redemption at a discount will be
subject to federal and state income taxes.  Since Bay National
Corporation does not have sufficient net operating loss (“NOL”) carryforwards to
offset the entire gain, we are permitted to utilize a portion of the Bank’s
NOLs  to offset the Federal income tax component in a consolidated
Federal income tax return.  Ordinarily, an entity with a combination
of sufficient past taxable income and/or sufficient probable future taxable
income can justify reporting a deferred tax asset on its books if the
realization of the tax benefits from the NOL is more
likely-than-not.  However, in the Bank’s case realization of the tax
benefits in question is contingent on both the redemption of the trust preferred
securities (at a discount) as well as subsequent reimbursement from Bay National
Corporation.  Given the uncertainty underlying these two events the
criterion for recognizing a deferred tax asset was not met and a valuation
allowance was established against the entire deferred tax asset on the Bank’s
financial statements as of December 31, 2009.




However,
if we are successful in our efforts to redeem the trust preferred securities and
are also able to raise sufficient capital to reimburse the Bank for the use of
its tax benefits, the Bank would be permitted to reverse that portion of the
valuation allowance which would result in the associated tax benefit to be
reported for both financial statement and regulatory capital calculation
purposes.  There can be no assurance, however, that we will be
successful in this regard.




Capital Status; Impact on
Operations




Subsequent
to the submission of our written response to the Consent Order, we found it
necessary to continue to significantly increase the allowance for credit losses
during 2009, which lead to further declines in our total stockholders’
equity.  As of the filing of the Bank’s amended December 31, 2009 Call
Report with the OCC on March 12, 2010, the Bank became classified as
“significantly undercapitalized” as of December 31, 2009 under the Prompt
Corrective Action provisions discussed under “Item 1. Business - Supervision and
Regulation” above.  As a result, we are required to submit a capital
restoration plan to the OCC addressing, among other things, the steps the Bank
will take to become adequately capitalized.  We have submitted a
capital restoration plan to the OCC, which is subject to OCC
approval.





Under the
capital restoration plan, if approved, the Bank’s Board and executive management
will continue their efforts to raise capital and to follow its strategic plan as
discussed above.  Under the capital restoration plan we anticipate
that we would significantly downsize the Bank and decrease assets including
through efforts to decrease the amount of loans held in our loan portfolio and
redeeming our bank owned life insurance.  We will also attempt to
reduce our expenses.  Going forward in the short- and medium-term we
would focus on attempting to resolve the issues in our loan portfolio, preserve
the remaining capital and, through a decrease in risk-weighted assets, increase
our capital ratios.  The plan requires fewer employees, and more
stringent cost control measures during the stabilization process as no new
business will be brought in and the remaining employees will be dedicated to
improving asset quality and maintaining regulatory compliance while also
ensuring that safe and sound business practices are followed.  These
actions would impact our operating results and financial condition through at
least 2010 and 2011 by reducing our interest revenues and net interest income,
as well as reducing certain categories of expenses.






35





The
Bank’s Board and executive management realize that successful execution of the
plan to reduce assets alone will not place it in full compliance with the
Consent Order.  However, successful execution will result in rising
capital ratios and decreasing losses for the Bank and enable it to reach
“adequately capitalized” status by the end of 2010.  There can be no
assurance, however, that we will be successful in this regard








Results
of Operations





OVERVIEW





We
recorded a net loss of $16.1 million for the year ended December 31, 2009. This
compares to a net loss of $5.1 million reported for the year ended December 31,
2008, an increase in loss of $11.0 million.  The increase in losses in
year-over-year results is primarily due to an increased provision for credit
losses of $4.5 million in 2009 and a $7.5 million write-down in the carrying
value of our deferred tax assets.  We are not able to reflect the full
income tax benefit for the current year’s losses due to the uncertainty that
these future tax benefits will be realized.  Due to this uncertainty,
the Bank established a valuation allowance for 100% of the deferred tax assets
which resulted in an income tax expense during 2009.  A reduction in
net interest income and higher FDIC insurance and outsourcing costs also
contributed to the net loss for the period ending December 31,
2009.





Bay
National Bank’s mortgage origination operations, located in Lutherville and
Salisbury, Maryland, originate conventional first and second lien residential
mortgage loans and construction and rehabilitation loans. The Bank sells most of
its first and second lien residential mortgage loans in the secondary market and
typically recognizes a gain on the sale of these loans after the payment of
commissions to the loan origination officer.  Since its inception in
February 2001, the Salisbury mortgage division has been a significant
contributor to operating results.  The Towson mortgage operation was
initiated in February 2005 and began to contribute to the Company’s overall
profitability during the second half of 2006.  For the years ended
December 31, 2009 and 2008, gains on the sale of mortgage loans totaled $538,592
and $281,029.  Gains on the sale of mortgage loans increased for the
year ended December 31, 2009 as compared to the same period in 2008 due to a
general increase in refinance activity in our market areas.





In
2004, we introduced a loan program for conventional first lien and second lien
residential mortgage loans.  Under this program, we purchased a 100%
participation in mortgage loans originated by a mortgage company in the
Baltimore metropolitan area.  These participations are for loans which
a secondary market investor has committed to purchase.  The
participations are typically held for a period of three to four weeks before
being sold to the secondary market investor.  This holding period
represents the amount of time taken by the secondary market investor to review
the loan files for completeness and accuracy.  During this holding
period, we earn interest on these loans at a rate indexed to the prime
rate.





The
primary risk to us from this program is that the secondary market investor may
decline to purchase the loans due to documentary deficiencies or errors. We
attempt to manage this risk by conducting a thorough review of the documentation
prior to purchasing the participation. If the secondary market investor declines
to purchase the loan, we could attempt to sell the loan to other investors or
hold the loan in our loan portfolio.  As of December 31, 2009, we had
no such loans outstanding under this program, which are classified as held for
sale. We earned $97,264 of interest on this program during 2008. We terminated
the program in 2008 due to deterioration in the national mortgage
markets.





Management
expects 2010 to continue to be challenging for earnings as we limit loan growth
and continue to face a weakened economy.  Future results will be
subject to, among other things, the volatility of the provision for credit
losses, which is related to loan quality, loan growth and the fluctuation of
mortgage







36








loan
production, all of which is sensitive to economic and interest rate instability
and other competitive pressures that arise in a recessionary
economy.








NET
INTEREST INCOME / MARGINS





Net
interest income is the difference between income on earning assets and the cost
of funds supporting those assets. Earning assets are composed primarily of
loans, investments, and federal funds sold. Interest-bearing deposits and other
borrowings make up the cost of funds. Non-interest bearing deposits and capital
are also funding sources. Changes in the volume and mix of earning assets and
funding sources along with changes in associated interest rates determine
changes in net interest income.





Net
interest income was $5.8 million for the year ended December 31, 2009 as
compared to $8.6 million for the same period in 2008. This represents a decrease
of 32.5% for the year ended December 31, 2009 as compared to the year ended
December 31, 2008.





Interest
income from loans and investments for the year ended December 31, 2009 was $12.0
million    compared to $15.3 million for the year ended
December 31, 2008. The 21.6% decrease from 2008 was primarily related to changes
in average yields caused by a low interest rate environment in 2009, as well as
the impact of lost interest on an increased average balance of non-accrual loans
and the decline in average total loans outstanding.  With respect to
interest rates, the average target federal funds rate decreased from 2.33% for
the year ended December 31, 2008 to a range of 0 to .25% for the year ended
December 31, 2009.    As a result, due to the substantial
number of variable rate loans in our portfolio, which re-price based on the
federal funds target rate as well as the increase in non-accrual loans, the
yields on interest-earning assets decreased from 5.91%  for the year
ended December 31, 2008 to 4.30% for the year ended December 31,
2009.





Interest
and dividends on investment securities increased $310,310 to $375,048 during the
year ended December 31, 2009 as compared to $64,738 during the year ended
December 31, 2008, despite the decreased interest rate environment, as a result
of a large increase in investment securities during 2009.  At December
31, 2009, we held approximately $21 million in investment securities; we held no
investment securities at December 31, 2008 and a negligible amount during the
year ended December 31, 2008.





The
percentage of average interest-earning assets represented by loans was 80.5% and
94.8% for the year ended December 31, 2009 and 2008, respectively. For the year
ended December 31, 2009, the average yield on the loan portfolio decreased to
5.13% from 6.15% for the year ended December 31, 2008, primarily as a result of
the decrease in the federal funds rate and the high percentage of variable-rate
loans in our loan portfolio noted above.





The
average yield on the investment portfolio and other earning assets, such as
federal funds sold, was .88% for the year ended December 31, 2009 as compared to
1.47% for the same period in 2008. This decline in the average yield was a
direct result of a decrease in federal funds rate for the 2009
period.  The percentage of average interest-earning assets represented
by investment securities, federal funds sold and interest bearing cash balances
was 19.5% and 5.2% for the year ended December 31, 2009 and 2008,
respectively.   As of December 31, 2009, the weighted average
yield for the available for sale investment portfolio was approximately
2.91%.





Interest
expense for deposits and borrowings for the year ended December 31, 2009 was
$6.3 million compared to $6.8 million for the same period in
2008.  The decrease for the 12-month period is the result of the
previously discussed reduction in the target federal funds rate partially offset
by an increase in the percentage of deposits held in the form of
CDs.  CDs are the Bank’s most expensive form of deposits. As of
December 31, 2009, CDs comprised 79.4% of average interest-bearing liabilities
compared to 56.8% of average interest-bearing liabilities as of December 31,
2008, due to management’s decision to maintain a





37








higher
level of liquidity in 2009 since we have no available back up lines of
credit.  The average rate paid on all interest-bearing liabilities
decreased from 3.20% for the year ended December 31, 2008 to 2.74% for the
period ended December 31, 2009.





As a
result of the factors discussed above, the net interest margin decreased to
2.06% for the year ended December 31, 2009 from 3.30% for the same period in
2008.  Although management has been able to decrease deposit rates,
the yield on loans and investments decreased to a greater extent than the cost
of funds. Management has observed ongoing pressure to offer lower rates on loans
as the market for loans remains competitive since demand remains
low.  In addition, the market is very competitive for deposits, which
has limited management’s ability to maintain margins through reductions in the
interest rates on deposit accounts generally and CD rates in
particular.





The
following tables set forth, for the periods indicated, information regarding the
average balances of interest-earning assets and interest-bearing liabilities,
the amount of interest income and interest expense, and the resulting yields on
average interest-earning assets and rates paid on average interest-bearing
liabilities. Average balances are also provided for non-interest-earning assets
and non-interest-bearing liabilities.





No tax
equivalent adjustments were made and no interest income was exempt from federal
income taxes.  All average balances are daily average
balances.  The average balances of non-accrual loans are included in
the average loan balances for the periods indicated.  The amortization
of loan fees is included in computing interest income; however, such fees are
not material.








38


Year
      Ended December 31, 2009Average
              Balance
            
            
            Interest
      and fees
            
            
            Yield/
              RateASSETSLoans
      and loans held for sale
            
            $
            225,265,094
            
            
            $
            11,563,783
            
            
            
            5.13
            %Investment
      securities (1)
            
            
            12,065,505
            
            
            
            375,048
            
            
            
            3.11Federal
      funds sold and interest bearing cash balances
            
            
            42,482,749
            
            
            
            104,165
            
            
            
            .25Total
      earning assets
            
            
            279,813,348
            
            
            
            12,042,996
            
            
            
            4.30
            %Less:
      Allowance for credit losses
            
            
            (5,991,457
            )Cash
      and due from banks
            
            
            5,236,397Other
      real estate owned
            
            
            3,561,798Premises
      and equipment, net
            
            
            965,285Investment
      in bank owned life insurance
            
            
            5,374,399Income
      tax receivable
            
            
            2,389,701Deferred
      taxes receivable
            
            
            3,312,719Accrued
      interest receivable and other assets
            
            
            1,388,022Total
      assets
            
            $
            296,050,212LIABILITIES
      AND STOCKHOLDERS’ EQUITYInterest-bearing
      demand deposits
            
            $
            37,470,681
            
            
            
            109,270
            
            
            
            .29
            %Regular
      savings deposits
            
            
            1,070,371
            
            
            
            -
            
            
            
            .00Time
      deposits
            
            
            181,278,467
            
            
            
            5,532,341
            
            
            
            3.05Short-term
      borrowings
            
            
            463,745
            
            
            
            2,191
            
            
            
            .47Subordinated
      debt (2)
            
            
            8,000,000
            
            
            
            622,284
            
            
            
            7.78Total
      interest-bearing liabilities
            
            
            228,283,264
            
            
            
            6,266,086
            
            
            
            2.74
            %Net
      interest income and spread
            
            
            
            
            
            $
            5,776,909
            
            
            
            1.56
            %Non-interest-bearing
      demand deposits
            
            
            53,885,047Accrued
      expenses and other liabilities
            
            
            1,100,537Stockholders’
      equity
            
            
            12,781,364Total
      liabilities and stockholders’ equity
            
            $
            296,050,212Interest
      and fee income/average earning assets
            
            
            4.30
            %Interest
      expense/average earning assets
            
            
            2.24Net
      interest margin
            
            
            2.06
            %Return
      on Average Assets (Annualized)
            
            
            (5.43
            )
      %Return
      on Average Equity (Annualized)
            
            
            (125.73
            )
      %Average
      Equity to Average Assets
            
            
            4.32
            %








(1)
            Investment
      securities include AFS securities, FRB and FHLB
  stock.


(2)
            Deferred
      Subordinated debt interest payments are compounded to principal when
      calculating interest expense.






39







Year
      Ended December 31, 2008Average
              Balance
            
            
            Interestand fees
            
            
            Yield/
              RateASSETSLoans
      and loans held for sale
            
            $
            245,877,726
            
            
            $
            15,127,186
            
            
            
            6.15
            %Investment
      securities (1)
            
            
            1,311,027
            
            
            
            64,738
            
            
            
            4.94Federal
      funds sold and other overnight investments
            
            
            12,218,004
            
            
            
            133,615
            
            
            
            1.09Total
      Earning Assets
            
            
            259,406,757
            
            
            
            15,325,539
            
            
            
            5.91
            %Less:
      Allowance for credit losses
            
            
            (6,307,556
            )Cash
      and due from banks
            
            
            1,005,917Real
      estate acquired through foreclosure, net
            
            
            2,917,588Premises
      and equipment, net
            
            
            1,274,501Investment
      in bank owned life insurance
            
            
            5,146,932Income
      Tax Receivable
            
            
            784,161Deferred
      Tax Receivable
            
            
            2,956,746Accrued
      interest receivable and other assets
            
            
            1,488,679Total
      Assets
            
            $
            268,673,725LIABILITIES
      AND STOCKHOLDERS’ EQUITYInterest-bearing
      demand deposits
            
            $
            69,476,831
            
            
            
            1,137,624
            
            
            
            1.64
            %Regular
      savings deposits
            
            
            1,495,578
            
            
            
            3,924
            
            
            
            .26Time
      deposits
            
            
            120,100,747
            
            
            
            4,792,979
            
            
            
            3.99Short-term
      borrowings
            
            
            12,438,238
            
            
            
            225,985
            
            
            
            1.82Subordinated
      debt
            
            
            8,000,000
            
            
            
            603,039
            
            
            
            7.54Total
      interest-bearing liabilities
            
            
            211,511,394
            
            
            
            6,763,551
            
            
            
            3.20
            %Net
      interest income and spread
            
            
            
            
            
            $
            8,561,988
            
            
            
            2.71
            %Non-interest-bearing
      demand deposits
            
            
            38,573,550Accrued
      expenses and other liabilities
            
            
            1,028,966Stockholders’
      equity
            
            
            17,559,815Total
      Liabilities and Stockholders’ Equity
            
            $
            268,673,725Interest
      and fee income/earning assets
            
            
            5.91
            %Interest
      expense/earning assets
            
            
            2.61Net
      interest margin
            
            
            3.30
            %Return
      on Average Assets
            
            
            (1.89
            )
      %Return
      on Average Equity
            
            
            (28.84
            )
      %Average
      Equity to Average Assets
            
            
            6.54
            %





(1)
Investment securities include AFS securities, FRB and FHLB stock.







40







RATE/VOLUME
ANALYSIS





A
rate/volume analysis, which demonstrates changes in taxable-equivalent interest
income and expense for significant assets and liabilities, appears
below.  The calculation of rate, volume and rate/volume variances is
based on a procedure established for bank holding companies by the Securities
and Exchange Commission.  Rate, volume and rate/volume variances
presented for each component may not total to the variances presented on totals
of interest income and interest expense because of shifts from year to year in
the relative mix of interest-earning assets and interest-bearing
liabilities.





Year
      ended December 31,2009
      vs. 2008
              Due
      to variances inTotal
            
            
            Rates
            
            
            Volumes
            
            
            Rate/
      VolumeInterest
      income on:Loans
      and loans held for sale
            
            $
            (3,563,403
            )
            
            
            (2,505,272
            )
            
            
            (1,268,155
            )
            
            
            210,024Investment
      securities
            
            
            310,310
            
            
            
            (23,986
            )
            
            
            531,052
            
            
            
            (196,756
            )Federal
      funds sold and other overnight investments
            
            
            (29,450
            )
            
            
            (103,657
            )
            
            
            330,973
            
            
            
            (256,765
            )Total
      interest income
            
            
            (3,282,543
            )
            
            
            (2,632,915
            )
            
            
            (406,130
            )
            
            
            (243,497
            )Interest
      expense on:Interest-bearing
      demand deposits
            
            
            (1,028,354
            )
            
            
            (935,019
            )
            
            
            (524,073
            )
            
            
            430,739Regular
      savings deposits
            
            
            (3,924
            )
            
            
            (3,924
            )
            
            
            (1,116
            )
            
            
            1,116Time
      deposits
            
            
            739,363
            
            
            
            (1,127,687
            )
            
            
            2,441,390
            
            
            
            (574,340
            )Short-term
      borrowings
            
            
            (223,794
            )
            
            
            (167,220
            )
            
            
            (217,559
            )
            
            
            160,985Subordinated
      debt
            
            
            19,245
            
            
            
            19,245
            
            
            
            -
            
            
            
            -Total
      interest expense
            
            
            (497,464
            )
            
            
            (2,214,605
            )
            
            
            1,698,641
            
            
            
            18,500Net
      interest income
            
            $
            (2,785,079
            )
            
            
            (418,310
            )
            
            
            (2,104,772
            )
            
            
            (261,997
            )








PROVISION
FOR CREDIT LOSSES





The
provision for credit losses (“provision”) was $11.0 million for the year ended
December 31, 2009, as compared to $6.5 million for the year ended December 31,
2008.  During 2009, the provision had two components, one for loan
losses in the amount of $10.7 million which increased the allowance for credit
losses and the other for losses determined to be inherent unfunded commitments
for approximately $270,994 that is included in other liabilities.  The size
of the provision for credit losses is reflective of the ongoing economic
difficulties that many businesses and households are
experiencing.  The economy continues to suffer the effects of further
declines in the values of real estate, which represents a substantial portion of
the collateral for non-performing loans.  Most of the increase in the
provision during 2009 was due to declines in the value of collateral securing
non-performing loans.   For additional information on
nonperforming loans, see the Management Discussion and Analysis section entitled
“Nonperforming Loans and Other Delinquent Assets.”





For
additional information regarding the methodology used to determine the provision
for credit losses see the Management Discussion and Analysis section entitled
“Allowance for Credit Losses and Credit Risk Management.”








41







NON-INTEREST
INCOME





The
components of non-interest income were as follows:





Years Ended December
    31,2009
            
            
            2008Service
      charges on deposit accounts
            
            $
            318,155
            
            
            $
            266,064Gain
      on sale of mortgage loans
            
            
            538,592
            
            
            
            281,029Increase
      in cash surrender value of bank owned life insurance
            
            
            224,503
            
            
            
            226,867Loss
      on sale of real estate acquired through foreclosure
            
            
            (239,932
            )
            
            
            (59,688
            )Loss
      on disposal of furniture & equipment
            
            
            (19,181
            )
            
            
            (18,603
            )Other
      income
            
            
            47,014
            
            
            
            67,666Total
      non-interest income
            
            $
            869,151
            
            
            $
            763,335





Non-interest
income consists primarily of gains on the sale of mortgage loans, deposit
account service charges and increases in the cash surrender value of bank owned
life insurance offset by losses on sale of real estate acquired through
foreclosure. For the year ended December 31, 2009, we realized non-interest
income in the amount of $869,151, as compared to $763,335 for the year ended
December 31, 2008.





Service
charges on deposit accounts totaled $318,155 for the year ended December 31,
2009, as compared to $266,064 for the year ended December 31,
2008.  This represents an increase of 19.6% over 2008.  The
increase over the prior year was attributable to an increase in analysis fees as
a result of the previously-discussed FRB actions, which reduced the rates used
to calculate credits available to customers to offset any analysis fees they
incurred.





Gains on
the sale of mortgage loans of $538,592 represented 62% of non-interest income
for the year ended December 31, 2009.  This compares to gains on the
sale of mortgage loans of $281,029 or 36.8% of total non-interest income for the
year ended December 31, 2008.  Although the average balance of
individual loans originated and sold during 2009 has decreased from the year
ended December 31, 2008, mainly as a result of continuing falling housing
prices, the number of loans sold has increased as the number of home sale
transactions have increased, primarily, we believe, as a result of the
government’s $8,000 tax credit for first-time home buyers.  The Bank
is originating and selling loans with lower average dollar balances but which
have higher margins than jumbo loans.





Losses on
the sale of OREO properties totaled $239,932 for the year ended December 31,
2009 as compared to a loss of $59,688 for the year ended December 31,
2008.  Increased foreclosure activity and deteriorating economic
conditions within our markets beginning early in 2008 and continuing during 2009
has caused housing prices to decrease, which is the reason for the increased
loss during the 2009 period.  During 2008, there were 17 OREO
properties sold compared to 12 properties that were sold during
2009.





We
recognized increases in the cash surrender value of bank owned life insurance
(“BOLI”) of $224,503 for the year ended December 31, 2009 compared to $226,867
in the prior year.  We purchased this investment during the fourth
quarter of 2007 and the initial investment totaled $5.0 million.





Losses on
the sales of fixed assets totaled $19,181 and $18,603 for the year ended
December 31, 2009 and 2008, respectively.  The loss for the year is
associated with the closing of our loan production office in Columbia, Maryland
in March 2009 and the relocation of our former mortgage loan origination office
from Towson, Maryland to our headquarters building in Lutherville, Maryland in
November 2008.





Other
income totaled $47,014 for the year ended December 31, 2009 as compared to
$67,666 for year ended December 31, 2008.  This represents a decrease
of 30.5% over 2008.  Other income primarily consists of cash
management fees and the decrease from the prior period was attributed to a
decline in business activity.






42







We will
continue to seek ways to expand our sources of non-interest
income.  In the future, we may enter into fee arrangements with
strategic partners that offer investment advisory, risk management and employee
benefit services.   We have not entered into any such fee
arrangements, although the Bank does offer such services to customers through
referral relationships for which it is not compensated. No assurance can be
given that any such fee arrangements will be obtained or
maintained.








NON-INTEREST
EXPENSE





The components of non-interest expense
were as follows:





Years Ended December 31,2009
            
            
            2008Salaries
      and employee benefits
            
            $
            3,511,712
            
            
            $
            6,018,002Occupancy
      expenses
            
            
            644,287
            
            
            
            763,336Furniture
      and equipment expenses
            
            
            434,167
            
            
            
            426,190Legal
      and professional fees
            
            
            761,931
            
            
            
            821,347Data
      processing and other outside services
            
            
            821,083
            
            
            
            798,922Outsourcing
      costs
            
            
            873,242
            
            
            
            194,726Advertising
      and marketing related expenses
            
            
            158,697
            
            
            
            509,939Provision
      for losses on real estate acquired through foreclosure
            
            
            734,395
            
            
            
            569,350FDIC
            
            
            1,129,469
            
            
            
            200,850Loan
      Collection Costs
            
            
            325,259
            
            
            
            200,612Other
      expenses
            
            
            498,359
            
            
            
            603,132Total
      non-interest expenses
            
            $
            9,892,601
            
            
            $
            11,106,406








Non-interest
expense for the year ended December 31, 2009 totaled $9.9 million compared to
$11.1 million for the year ended December 31, 2008. The decrease of $1.2
million, or 11%, was primarily due to reductions in salary and employee
benefits, occupancy expenses, and advertising and marketing related expenses
which were partially offset by increases in provisions for losses on real estate
acquired through foreclosure, outsourcing costs and FDIC insurance
premiums.





Salaries
and employee benefit expenses represented 35.5% and 54.2% of non-interest
expenses for the years ended December 31, 2009 and 2008,
respectively.  Salaries and benefits decreased by $2.5 million, or
41.7%, over the prior year.  The decrease in salaries and benefits for
the 2009 period related to three separate reductions in personnel since March
31, 2008, including the closing of the loan production office in Columbia,
Maryland during the first quarter of 2009.  As of December 31, 2009,
we had 41 active employees as opposed to 54 at December 31, 2008.





Occupancy
expenses decreased by $119,049 for the year ended December 31, 2009. During the
second quarter of 2009, we successfully negotiated sub-leases of our former
Towson, Maryland mortgage origination office and for space that became available
in our Lutherville, Maryland headquarters building.  In addition, we
negotiated with a sub-tenant for the space in the former loan production office
in Columbia, Maryland, who began sub-leasing the space in June
2009.  As a result, net occupancy expenses have decreased from 2008
levels.





Legal and
professional fees decreased by $59,416, or 7.2%, during 2009. A significant
portion of the decrease in 2009 was attributable to a higher level of workout
activity during 2008 compared to 2009.  During 2008, we foreclosed or
accepted deeds-in-lieu on 28 pieces of residential real estate compared to
foreclosures or deeds-in-lieu on ten pieces of residential real estate during
2009.






43







Data
processing costs increased by $22,161 or 2.8% for the year ended December 31,
2009 as compared to the same period in 2008.  The increased data
processing costs in 2009 were primarily attributable to additional expenses for
the upgrade of a commercial loan software package, and these increased costs
will continue through the third quarter 2010.





Outsourcing
costs increased by $678,516, or 348%, for the year ended December 31, 2009 as
compared to the same period in 2008.  Most of the increase is due to
the cost of outside professional services firms providing additional personnel
to assist the Company with streamlining process flows, bridging gaps in the
workforce caused by the departure of several employees and with preparing
materials required by the OCC Consent Order.





Advertising
and marketing-related expenses decreased $351,242, or 68.9%, for the year ended
December 31, 2009 as compared to the same period in 2008.  The
decrease is a result of the combination of higher expenses incurred in 2008 as
we expanded the business development staff pursuant to the opening of our
Columbia, Maryland office in December 2007, as well as subsequent efforts to
reduce overall costs for 2009.  With a focus on minimizing costs, we
deemed advertising a discretionary expenditure and curtailed such expenditures
beginning in January 2009.





There was
an increase of $165,045, or 29%, in the provision for losses on other real
estate owned for the year ended December 31, 2009 compared to the same period in
2008.  The increase is due to further markdowns to the value of the
real estate based on the relative age of the appraisal and the increase in
number of days that real estate has been held for sale.  There were
further declines in the values of OREO during 2009 that are evidenced by the
increase in losses on the sales of OREO that were discussed previously under the
heading “Non-interest Income.”





FDIC
insurance premiums increased by $928,619, or 462.4%, for the year ended December
31, 2009 over the same period in 2008.  The FDIC insurance premium
increase is the direct result of the Company’s rating downgrade and also
reflects a special assessment of $149,724 payable on September 30, 2009, as well
as a general increase in premium rates. The FDIC insurance rate will remain at
an elevated level until the Bank’s rating improves, which could only happen
after a capital infusion and several consecutive quarters of net
earnings.





Loan
collection costs increased $124,647, or 62%, as compared to
2008.  Higher loan collection costs are attributable to greater
amounts of tax, legal and maintenance expenses associated with maintaining and
recovering troubled assets.





Other
expenses for the year ended December 31, 2009 totaled $498,359. This compares to
other expense for the comparable period in 2008 of $603,132.  The
decrease of $104,773, or 17.4%, is largely attributable to lower membership
dues, telephone and printing expenses as a result of cost control measures but
partially offset by higher OCC assessments during 2009.





The
banking industry utilizes an “efficiency ratio” as a key measure of expense
management and overall operating efficiency. This ratio is computed by dividing
non-interest expense by the sum of net interest income and non-interest income.
Our efficiency ratio was 148.9% for the year ended December 31, 2009 compared to
119.1% for the year ending December 31, 2008.  The increase in the
efficiency ratio from the prior year was primarily a result of the previously
discussed decline in interest revenues.





Approximately
5% of the occupancy costs in 2009 were paid to directors of Bay National
Corporation or entities controlled by directors of Bay National
Corporation.  Management believes that the terms of these leases are
at least as favorable as could be obtained from independent third
parties.  However, management has not conducted a recent market
analysis to confirm this.  For a discussion of the terms of the leases
with these persons, see “Item 13 – Certain Relationships and Related
Transactions, and Director Independence.”









44





INCOME
TAXES





For the
year ended December 31, 2009, we recorded an income tax expense of $1.9 million
as compared to an income tax benefit of $3.2 million for the year ended December
31, 2008.  The decrease is due to the need for a $7.5 million
valuation allowance against the carrying value of deferred tax assets due to the
uncertainty that these future tax benefits will be realized.





If we are
not able to raise sufficient capital in a timely manner, there is serious doubt
as to the ability of the Company to remain in business and to generate
sufficient taxable income against which the deferred tax assets may be used as
an offset.





At
December 31, 2009, we had approximately $7,796,000 of net deferred tax
receivables before a required valuation allowance of $7,796,000 brought the
amount reported in the balance sheet to $0.  The valuation allowance
is $7,548,000 higher at December 31, 2009 than the $248,000 reported at December
31, 2008.  If we are successful in our capital raising efforts, there
could be a change of ownership for tax purposes that could cause a portion, or
all, of the write-down of our deferred tax assets to be
permanent.  The authority for the applicable tax calculations is found
in Section 382 of the Internal Revenue Code.











Financial
Condition





COMPOSITION
OF THE BALANCE SHEET





Our total
assets were $290.3 million as of December 31, 2009, compared to total assets of
$270.6 million as of December 31, 2008.  This represents growth of
approximately $19.8 million, or 7.3%, since December 31, 2008.  The
change in total assets includes increases of $63.9 million in cash and due from
banks, $21.1 million in investment securities, $224,503 in bank owned life
insurance and $60,941 in other assets. These increases were partially offset by
decreases of $54.7 million in loans net of the allowance for credit losses, $5.1
million in current and deferred taxes, $1.1 million in federal funds sold and
other overnight investments, $1.1 million in other real estate owned and
$371,238 in premises and equipment.   Deposits at December 31,
2009 were $281.5 million as compared to deposits of $244.6 million at December
31, 2008.  The increase in deposits was primarily attributed to an
increase of $52.8 million in CDs and was partially offset by a $19.1 million
decrease in other interest-bearing deposits.





As of
December 31, 2009, loans net of unearned fees and excluding loans held for sale,
totaled $194.3 million.  This represents a decrease of $52.9 million,
or 21.4%, from a balance of $247.2 million as of December 31, 2008.





The
composition of the loan portfolio as of December 31, 2009 was approximately
$89.9 million of commercial loans (excluding real estate loans), $3.1 million of
consumer loans and $101.2 of real estate loans excluding $415,091 of mortgage
loans held for sale. The composition of the loan portfolio as of December 31,
2008 was approximately $125.3 million of commercial loans (excluding real estate
loans), $3.8 million of consumer loans and $118.1 million of real estate loans
excluding $1.2 million of mortgage loans held for sale.  The decrease
in the loan portfolio is due to management’s efforts to restrict loan growth in
order to increase capital levels, liquidity and the Bank’s regulatory capital
ratios.





Out of
$194.7 million in total loans outstanding, the Company carried on its books
$20.3 million, or approximately 10.4% of the total, in its Towson loan portfolio
at December 31, 2009.  Prominent among loan types in the Towson
portfolio are those to investors for residential construction and reconstruction
projects which continue to exhibit especially high levels of credit
risk.  During 2009, we recorded net charge-offs








45








from this
portfolio totaling $3.5 million, or 52.5% of total net charge-offs for the year,
in addition to $5.5 million, or 94.6% of total net charge-offs, during
2008.  In both years, all of the Towson portfolio charge-offs occurred
in the construction and real estate categories, predominantly consumer and
commercial construction loans.  At December 31, 2009, 69.7%, or $14.1
million, of the Towson portfolio loans were on the Company’s watch list of
carefully managed credits.  Of these watch list loans, there were
$10.5 million that were impaired at December 31, 2009, including $4.5 million of
troubled debt restructures.  At December 31, 2009, specific reserves
associated with Towson portfolio credits totaled $2.9 million, and comprised
66.2% of total specific reserves.  We are no longer originating loans
to investors for consumer and commercial construction, except for owner-occupied
projects.  Management has devoted significant time and resources to
resolving problems in the Towson portfolio.  These efforts have
included working with borrowers on restructuring where appropriate and where
possible, trying to secure the pledge of additional collateral, and seeking
potential investors to facilitate property sales.  Since the economic
climate and housing market are making it difficult for borrowers to sell or
refinance their projects, management cannot assure that its actions will be
successful in resolving credit risk issues in the Towson
portfolio.  In October 2009 the loan officer who was managing the
workout of troubled Towson mortgage loans resigned his position with the
Bank.  His duties are currently being performed by existing staff, and
management does not anticipate significant adverse effects on its credit
administration over this portfolio as a result of this resignation.





Our
credit quality issues are no longer contained predominantly within the Towson
loan portfolio, however.  As unemployment has remained high, the
effects of the recession continue, characterized by the depressed real estate
environment and lower property values.  These conditions have
negatively affected an increasing number of our borrowers.  During
2009, net charge-offs of commercial loans that were not from the Towson mortgage
portfolio totaled $1.9 million, compared to $105,795 thousand in
2008.  Commercial loans on our watch list of credits continuously and
individually evaluated reached $13.3 million, out of a total watch list of $36.7
million, at December 31, 2009.  Essentially all of these commercial
watch list credits came from outside the Towson portfolio.  Our
commercial loans represent core business loans to clients for the operation of
their small to middle-market enterprises, or to professional service
firms.  While commercial loans which involved owner occupied
properties, a relatively safe type of commercial credit, totaled approximately
$22 million, or nearly 25% of the $90 million portfolio of commercial loans,
another approximately $34 million, or 38% of total commercial loans, were
secured by inventory and receivables, and other like business assets, and
approximately $13 million, or 15% of total commercial loans, were
unsecured.  The latter two categories of commercial loans are
considered likely to harbor greater inherent risk than other
categories.  Commercial loans continued to be our largest loan
category at December 31, 2009, comprising 46.2% of total loans.  This
commercial concentration, coupled with our increasing risk profile, as reflected
in 2009 charge-offs, the substantial presence of commercial credits on the watch
list at year-end and the composition of commercial loans, resulted in reserves
for this loan category of $3.0 million, or 31.2% of total reserves, at December
31, 2009.





During
the third quarter of 2009, management analyzed its large home equity lines of
credit (“HELOC”) portfolio, identifying a number of borrowers for
downgrade.  HELOC borrowers with weak credit scores will also be more
carefully monitored.  Delinquency reports and charge-offs did not
indicate notable credit deterioration in this portfolio at December 31,
2009.  However, given economic conditions and the repeated appearance
of some HELOC customers on reports of loans past-due less than 30 days,
management is allocating more time, effort and reserves to this portfolio,
especially in light of experience that HELOC credits can move quickly from
performing to loss status, without normal migration over time through
successively riskier watch list grades.





Published
reports of loan risk trends seem to indicate that the next wave of credit
problems may occur in commercial real estate.  This prediction by
industry experts seems to support the contention that inherent loss may be
present in this portfolio to a greater degree than has yet become evident in
delinquency trends.  However, year-over-year charge-off analysis for
2009 versus 2008, does reveal a sharp rise in commercial real estate
charge-offs, occurring almost equally in the Towson portfolio and in the other
Bank portfolios, to $1.2 million for 2009, from $14,105 in
2008.  Therefore, management has evidence of possible








46








credit
deterioration in the commercial real estate portfolio, as in the commercial and
HELOC portfolios (discussed above), and is applying sound and improved credit
and workout methods to address issues timely and thoroughly.





Troubled
debt restructures amounted to $5.4 million at December 31, 2009, comprised
exclusively of real estate secured credits, principally from the commercial real
estate portfolio, compared to $952,372 of troubled debt restructures at December
31, 2008.





During
2009, we either foreclosed or accepted deeds-in-lieu of foreclosure on ten
pieces of residential real estate related to investor-owned residential real
estate.  These properties were placed into other real estate owned at
estimated net realizable value of approximately $2.1 million.  The
difference between the related loan balances and the net realizable value, $2.6
million, was charged off to the allowance for credit losses during the
period.  The foreclosures combined with additional property sales,
certain capitalized expenditures for improvements, and allowance adjustments
resulted in a net decrease in other real estate owned of $1.1 million between
the December 31, 2008 net carrying value of $3.9 million and the December 31,
2009 net carrying value of $2.7 million.





Management
is aggressively addressing the credit risk issues in its various loan
portfolios; however, resolving these problems will take time as the residential
real estate market works through its downturn and housing inventories return to
normal levels.  As such, there can be no assurance that management’s
actions will result in decreases in the levels of non-accrual and past-due
loans.





At
December 31, 2009, we had cash and due from banks of $71.2 million as compared
to $7.3 million as of December 31, 2008.  This increase is a result of
management’s increased focus on liquidity during 2009.  See the Liquidity section later in
this Management’s Discussion and Analysis for further information.





Funds not
extended in loans are invested in cash and due from banks and various
investments including federal funds sold and other overnight investments and
investment securities.   Excluding cash and due from banks,
federal funds sold and other overnight investments totaled $942,784 as of
December 31, 2009 compared to approximately $2.0 million as of December 31,
2008. The decrease is a result of management’s increased focus on capital
ratios.





Since we
had previously pursued a path of loan growth, the amount we invested in
securities had declined to zero by the end of 2008 through reinvestment of the
proceeds from maturing securities into new loans.  In March 2009, the
Board of Directors approved a new investment policy and reinstituted
management’s authority to invest in a traditional securities portfolio in order
to provide ongoing liquidity, income and a ready source of collateral that can
be pledged in order to access other sources of funds.  The investment
securities available for sale balances of $21.1 million as of December 31, 2009
are investment securities such as agency-backed bonds and mortgage-backed
securities.  We held Federal Reserve Bank stock and FHLB of Atlanta
stock of $663,450 and $487,700 as of December 31, 2009 and $704,200 and $535,400
as of December 31, 2008, respectively.





Included
in other assets at December 31, 2009 is approximately $202,787 of deferred stock
issuance costs.  These are costs incurred predominately for services
rendered by legal counsel and investment advisors for the specific purpose of
raising capital via the issuance of stock.  If we are successful in
our capital raising efforts, these costs will be charged to the additional paid
in capital account thereby partially offsetting the increase to
capital.  If we are not able to raise additional capital, the costs
must be eliminated from the asset category by a charge to expense in the period
that such efforts to raise capital are abandoned.





As of
December 31, 2008, we had short term borrowings totaling $1.9 million in Federal
Funds Purchased.   There were no outstanding short term
borrowings as of December 31, 2009.






47







Total stockholder’s (deficit) equity at
December 31, 2009 was ($992,323) as compared to $15.0 million at December 31,
2008. The decrease in stockholder’s equity is a result of the negative operating
results for the year ended December 31, 2009 and elimination of the deferred tax
assets through the establishment of a valuation allowance.








COMPOSITION
OF LOAN PORTFOLIO





Because
yields on loans typically exceed the yields on investments, our long-term
business strategy is to continue to increase the overall level of loans, as well
as maintain a relatively high percentage of loans to total earning
assets.  Increasing loans and loans as a percentage of total earning
assets will maximize the net interest margin.  However, in order to
enhance liquidity, we are willing to accept a slightly lower margin by creating
an investment portfolio that could result in a decrease in the percentage of
loans to total earning assets. As of December 31, 2009 and 2008, loans
represented 68.2% and 98.7% of total earning assets, respectively.





The
following table sets forth the composition of the principal balances of our loan
portfolio as of December 31, 2009, 2008, 2007, 2006, and 2005, respectively.








2009
            
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005Commercial
            
            $
            89,920,589
            
            
            $
            125,331,210
            
            
            $
            102,728,342
            
            
            $
            88,491,722
            
            
            $
            75,626,825Real
      Estate – Mortgage
            
            
            47,930,243
            
            
            
            50,611,464
            
            
            
            36,210,905
            
            
            
            27,903,399
            
            
            
            34,542,931Real
      Estate – Construction
            
            
            24,937,789
            
            
            
            44,061,253
            
            
            
            67,775,883
            
            
            
            76,889,997
            
            
            
            47,933,768Real
      Estate – Home Equity Line of Credit
            
            
            28,336,500
            
            
            
            23,377,524
            
            
            
            18,585,641
            
            
            
            19,963,116
            
            
            
            21,067,964Loans
      Held for Sale
            
            
            415,091
            
            
            
            1,187,954
            
            
            
            11,601,070
            
            
            
            1,444,303
            
            
            
            17,509,064Consumer
            
            
            3,132,375
            
            
            
            3,781,316
            
            
            
            4,054,400
            
            
            
            3,323,141
            
            
            
            2,909,409Total
      Loans
            
            $
            194,672,587
            
            
            $
            248,350,721
            
            
            $
            240,956,241
            
            
            $
            218,015,678
            
            
            $
            199,589,961








The
following table sets forth the percentages of loans in each category for our
loan portfolio as of December 31, 2009, 2008, 2007, 2006 and 2005,
respectively.





2009
            
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005Commercial
            
            
            46.19
            %
            
            
            50.47
            %
            
            
            42.63
            %
            
            
            40.59
            %
            
            
            37.89
            %Real
      Estate – Mortgage
            
            
            24.62
            
            
            
            20.38
            
            
            
            15.03
            
            
            
            12.80
            
            
            
            17.31Real
      Estate – Construction
            
            
            12.81
            
            
            
            17.74
            
            
            
            28.13
            
            
            
            35.27
            
            
            
            24.02Real
      Estate – Home Equity Line of Credit
            
            
            14.56
            
            
            
            9.41
            
            
            
            7.71
            
            
            
            9.16
            
            
            
            10.55Loans
      Held for Sale
            
            
            .21
            
            
            
            0.48
            
            
            
            4.82
            
            
            
            0.66
            
            
            
            8.77Consumer
            
            
            1.61
            
            
            
            1.52
            
            
            
            1.68
            
            
            
            1.52
            
            
            
            1.46Total
      Loans
            
            
            100.00
            %
            
            
            100.00
            %
            
            
            100.00
            %
            
            
            100.00
            %
            
            
            100.00
            %








48










The
following table sets forth the maturity distribution for our loan portfolio at
December 31, 2009. Some of the loans may be renewed or repaid prior to
maturity.  Therefore, the following table should not be used as a
forecast of future cash flows.








Within
      one year
            
            
            One
      to
              three years
            
            
            Three
      to
              five years
            
            
            Over
      five years
            
            
            TotalCommercial
            
            $
            57,702,280
            
            
            
            15,413,175
            
            
            
            13,057,713
            
            
            
            3,747,421
            
            
            
            89,920,589Real
      Estate – Mortgage
            
            
            18,614,424
            
            
            
            17,503,297
            
            
            
            8,975,110
            
            
            
            2,837,412
            
            
            
            47,930,243Real
      Estate – Construction
            
            
            22,013,964
            
            
            
            1,256,668
            
            
            
            123,664
            
            
            
            1,543,493
            
            
            
            24,937,789Real
      Estate – Home Equity Line of Credit
            
            
            28,336,500
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            28,336,500Loans
      Held for Sale
            
            
            415,091
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            415,091Consumer
            
            
            2,840,763
            
            
            
            265,686
            
            
            
            25,926
            
            
            
            -
            
            
            
            3,132,375Total
            
            $
            129,923,022
            
            
            
            34,438,826
            
            
            
            22,182,413
            
            
            
            8,128,326
            
            
            
            194,672,587Fixed
      interest rate
            
            $
            22,555,158
            
            
            
            34,438,826
            
            
            
            22,182,413
            
            
            
            8,128,326
            
            
            
            87,304,723Variable
      interest rate
            
            
            106,952,773
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            106,952,773Loans
      Held for Sale
            
            
            415,091
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            415,091Total
            
            $
            129,923,022
            
            
            
            34,438,826
            
            
            
            22,182,413
            
            
            
            8,128,326
            
            
            
            194,672,587





The
scheduled repayments as shown above are reported in the maturity category in
which the payment is due, except for the adjustable (variable) rate loans, which
are reported in the period of repricing.





Our loan
portfolio composition as of December 31, 2009 reflects a 55.0% concentration in
variable rate loans. Loans held for sale represented 0.2% of the loan portfolio.
Fixed rate loans totaled $87.3 million, or 44.8%, of the loan portfolio.
Interest rates on variable rate loans adjust to the current interest rate
environment, whereas fixed rates do not allow this flexibility. Loans held for
sale are expected to be sold in three months or less and as a result are not
materially impacted by interest rate fluctuations. If interest rates were to
increase in the future, the interest earned on the variable rate loans would
improve, and, if rates were to fall, the interest earned would
decline.  See “Liquidity and Interest Rate Sensitivity.”





Our
officers and directors, including their related companies, had outstanding loans
from the Bank of $8.8 million at December 31, 2009 and $11.8 million at December
31, 2008. All loans made to officers and directors, including their related
companies, are made on substantially the same terms, including interest rates
and collateral, as those prevailing at the time for comparable transactions with
unaffiliated third parties and do not involve more than the normal risk of
repayment or present other unfavorable features.





ALLOWANCE
FOR CREDIT LOSSES AND CREDIT RISK MANAGEMENT





Originating
loans involves a degree of risk that credit losses will occur in varying amounts
according to, among other factors, the type of loans being made, the
credit-worthiness of the borrowers over the term of the loans, and the quality
of the collateral for the loan, if any, as well as general economic
conditions.  We charge the provision for credit losses, which affects
earnings, in order to maintain the allowance for credit losses (“allowance”) at
a level considered by management to represent its best estimate of the losses
known and inherent in the portfolio that are both probable and reasonable to
estimate.  Such estimation is based upon, among other factors, prior
loss experience, volume and type of lending conducted, estimated value of any
underlying collateral, economic conditions (particularly as such conditions
relate to our market area), regulatory guidance, peer statistics, management’s
judgment, past due loans in the loan portfolio and concentrations of risk (if
any).  We charge losses on loans against the allowance when we believe
that collection of loan principal is unlikely.  Recoveries on loans
previously charged off are added back to the allowance.






49







Determining
an appropriate level for the allowance involves a high degree of
judgment.  The  allowance provides for probable losses,
based upon evaluations of inherent risks in the loan portfolio.  The
allowance is maintained at a level considered by management to be adequate to
absorb losses inherent in the loan portfolio as of the date of the financial
statements.  We have developed appropriate policies and procedures for
assessing the adequacy of the allowance that reflect management’s careful
evaluation of credit risk considering available
information.  Management uses historical, quantitative information to
assess the adequacy of the allowance, as well as qualitative information about
the prevailing economic and business environment, among other
considerations.  In developing this assessment, management must rely
on estimates and exercise judgment in assigning credit
risk.  Depending on changing circumstances, future assessments of
credit risk may yield materially different results from the estimates, which may
require an increase or decrease in the allowance.  Determination of
the allowance involves careful and continuous monitoring of developments and
changes in the loan portfolios, and in the factors that influence their
collectability, through a methodology revised in 2009 to reflect external
general economic factors, which includes (1) the specific allowance used to
provide reserves for impaired credits on an individual basis, and (2) formula
allowances reflecting historical losses, as adjusted, on pools of homogeneous
unimpaired credits defined either by loan category or by risk
rating.





The
specific allowance is generally computed as the shortfall, if any, between the
fair value of collateral and the outstanding loan balance on individually
evaluated impaired loans.  The Bank’s formula allowances apply the
historical loss experience of each loan category or risk grade, depending on how
the portfolio is managed, to their respective loan balances.  For
loans managed by category, historical losses consist of net charge-offs,
averaged over the trailing four quarters; whereas, for unimpaired loans
evaluated by risk grade, charge-off rates are determined by migration analysis
over a one-year time horizon.  Resulting historical loss percentages
are then adjusted by factors which address various risk characteristics in the
loan portfolio including (1) the quality of our lending policies and procedures,
(2) the experience, ability, and depth of management and other lending staff,
(3) the quality of loan review systems, (4) changes in the nature and volume of
the loan portfolio, (6) changes in trends, volume and severity of past dues,
non-accruals, charge-offs and recoveries, and (7) national and local economic
trends and business conditions.





A test of
the adequacy of the allowance, using the methodology outlined above, is
performed by management and reported to the Board of Directors on at least a
quarterly basis.  The complex evaluations involved in such testing
require significant estimates.  These estimates include, among others,
the grading of credits according to risk, collateral valuations, and estimated
losses on pools of homogeneous loans, any of which may be susceptible to
significant change.  Estimated losses are based upon historical
experience, adjusted for consideration of current economic trends and other
qualitative factors listed above.  Management uses available data to
establish the allowance at a prudent level, recognizing that the determination
is inherently subjective, and that future adjustments may be necessary,
depending upon many items including a change in economic conditions affecting
specific borrowers, or in general economic conditions, and new information that
becomes available.  However, there are no assurances that the
allowance will be sufficient to absorb losses on nonperforming loans, or that
the allowance will be sufficient to cover losses on nonperforming loans in the
future.





The
allowance was $9.8 million at December 31, 2009, compared to $5.7 million at
December 31, 2008.  These amounts represented 5.01% of total loans
(including loans held for sale) at December 31, 2009, compared to 2.29% at
December 31, 2008.  Excluding loans held for sale, the allowance was
5.02% of total loans at December 31, 2009, versus 2.30% at December 31,
2008.  This increase in allowance level resulted from the offsetting
effects of a $10.7 million 2009 provision for credit losses, net of the
component providing for unfunded commitments, coupled with net charge-offs of
$6.6 million.  Most significantly, commercial and commercial real
estate net charge-offs rose substantially during the 12 months ended December
31, 2009, to $1.9 million and $1.2 million, respectively, from negligible
amounts in 2008.  The higher reserve requirement at December 31, 2009,
versus the prior year-end, reflects the continuing adverse effects of the recent
recession on the financial condition of our borrowers, declining property
values, and deeper








50








discounting
of the value of collateral by adjustments discussed below.  When a
specific impaired loan has a collateral shortfall, management acts to further
secure the loan with additional collateral, allocates reserves for the
difference between the loan principal balance and the fair value of the
collateral and, if necessary, timely pursues foreclosure actions and charges off
any losses.  The fair value of the collateral reflects adjustment by a
factor that considers a discount for a “bank sale” situation, along with the age
of the last appraisal, both of these enhancements to the allowance methodology
plus a factor for selling and collection costs were introduced during 2009 to
better reflect current recessionary conditions.  We have no exposure
to foreign countries or foreign borrowers.  For a further explanation
of activity in the allowance, please refer to the discussion about “loan
composition” above in the section entitled “Composition of the Balance
Sheet.”  The systematic allowance methodology is further described in
“Note 1 – Summary of Significant Accounting Policies – Loans and Allowance for
Credit Losses.”





Management
believes that the allowance is adequate.  However, its determination
requires significant judgment, and estimates of probable losses in the loan
portfolio can vary significantly from the amounts actually
observed.  While management uses available information to recognize
probable losses, future additions to the allowance may be necessary based on
changes in the credits comprising the portfolio and changes in the financial
condition of borrowers, such as may result from changes in economic
conditions.  In addition, federal and state regulatory agencies,
especially the OCC, as an integral part of their examination process, and
independent consultants engaged by the Bank, periodically review the loan and
lease portfolio and the allowance, including the effectiveness and quality of
credit administration.  Such reviews have in the past, and may in
future periods, result in adjustments to the provision based upon their
judgments of information available at the time of each examination.





As of
December 31, 2009, we had non-accrual loans totaling $20.2 million, all of which
were impaired and included on the watch list.  Non-accrual loans are
divided in approximately equal amounts between Towson mortgage portfolio
credits, comprised significantly of loans for investor residential real estate,
and loans from other portfolios, consisting primarily of more traditional
commercial lending to small and middle-market businesses and professional
service firms.  The Towson mortgage portfolio was adversely affected
by the slowdown in the real estate market that reduced the ability of its
borrowers to refinance or sell properties as quickly as
anticipated.  On the commercial lending side, the length, severity and
continuing impact of the recent recession, coupled with unusually high levels of
unemployment, resulted in the deterioration in credit quality.  Any
losses on non-accrual loans will be charged off as soon as the amount of the
loss is determinable.  At December 31, 2009, nonperforming loans,
which were then comprised only of non-accrual loans (and their subset of
troubled debt restructures), since there were no loans past due 90 or more days
and still accruing, represented 10.4% of total loans, including loans held for
sale, in comparison to 6.6% reported as of December 31, 2008.





Gross
interest income that would have been recorded in 2009 if non-accrual loans had
been current and in accordance with their original terms was $1.7 million, while
interest actually recorded on such loans was approximately
$697,461.  During 2008, the respective amounts were $1.3 million that
would have been recognized, and $422,714 that was actually recognized,
respectively.  Please see Note 1 – Summary of Significant Accounting
Policies for a description of our policy for placing loans on non-accrual
status.





Performing
loans considered potential problem loans, as defined and identified by
management, amounted to $16.5 million at December 31, 2009.  Potential
problem loans are contained in the unimpaired watch list of carefully and
individually monitored credits.  Although these are loans where known
information about the borrowers’ possible credit problems causes management to
have concerns as to the borrowers’ ability to comply with the loan repayment
terms, they are not believed to present significant risk of
loss.  Loans classified as “other loans especially mentioned”, as well
as “substandard” loans which are still accruing interest, comprise the potential
problem loans.  There are no loans classified for regulatory purposes
not included in either non-performing or potential problem loans








51





We define
a credit concentration as 25% of the loan portfolio in any customer, product
type, geographic area, industry, or other identified category, which is
consistent with the definition provided in the OCC Comptroller’s Handbook,
“Concentration of Credits.”  Using this threshold, we have a
concentration in commercial lending at December 31, 2009, which is consistent
with the Bank’s mission and greatest expertise.





Management
instituted quarterly reporting of its loan portfolio by geographic concentration
during 2009, by borrower and by collateral.  The reports further show
the individual loan makeup, branch makeup, and city location detail of the
portfolio’s geographic concentration.  The December 31, 2009 reports
indicate a borrower concentration in Maryland of approximately
89.5%.  This Maryland concentration means that much of the Bank’s loan
portfolio may be similarly affected by economic conditions in a single
state.  The adverse effects of this type of concentration are somewhat
offset by the location of most of the loan portfolio in geographic areas where
management has the best understanding of economic conditions and
trends.





We
recorded net charge-offs amounting to $6.6 million, or 2.94% of average total
loans, during 2009, as compared to $5.8 million, or 2.36% of average total
loans, during 2008.





The
following table represents an analysis of the activity in the allowance for
credit losses for the periods presented:





2009
            
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005Balance
      at beginning of year
            
            $
            5,675,035
            
            
            $
            5,000,000
            
            
            $
            3,175,000
            
            
            $
            3,000,000
            
            
            $
            1,810,000Provision
      for credit losses *
            
            
            10,695,432
            
            
            
            6,478,200
            
            
            
            2,125,680
            
            
            
            202,931
            
            
            
            1,178,866Loan
      charge-offsCommercial
            
            
            (1,919,409
            )
            
            
            (107,495
            )
            
            
            (1,733
            )
            
            
            (37,931
            )
            
            
            -Real
      Estate – Mortgage
            
            
            (1,422,123
            )
            
            
            (454,739
            )
            
            
            -
            
            
            
            -
            
            
            
            -Real
      Estate – Construction
            
            
            (2,967,029
            )
            
            
            (5,286,406
            )
            
            
            (342,186
            )
            
            
            -
            
            
            
            -Real
      Estate – Home Equity Line of Credit
            
            
            (231,556
            )
            
            
            (36,572
            )
            
            
            -
            
            
            
            -
            
            
            
            -Consumer
            
            
            (160,300
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Loan
      recoveriesCommercial
            
            
            47,779
            
            
            
            1,700
            
            
            
            27,931
            
            
            
            10,000
            
            
            
            11,134Real
      Estate – Mortgage
            
            
            9,425
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Real
      Estate – Construction
            
            
            31,573
            
            
            
            80,347
            
            
            
            15,308
            
            
            
            -
            
            
            
            -Real
      Estate – Home Equity Line ofCredit
            
            
            1,173
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Net
      (charge-offs) recoveries
            
            
            (6,610,467
            )
            
            
            (5,803,165
            )
            
            
            (300,680
            )
            
            
            (27,931
            )
            
            
            11,134Balance
      at end of year
            
            $
            9,760,000
            
            
            $
            5,675,035
            
            
            $
            5,000,000
            
            
            $
            3,175,000
            
            
            $
            3,000,000





*        The
provision for 2009 is net of the $270,994 component providing inherent losses
arising from unfunded commitments.








The
following table presents the allocation of the allowance for credit losses,
reflecting use of the methodology presented above for the periods
presented:





Amount2009
            
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005Commercial
            
            $
            3,100,638
            
            
            $
            1,978,854
            
            
            $
            1,206,946
            
            
            $
            1,281,491
            
            
            $
            2,046,219Real
      Estate – Mortgage
            
            
            4,170,298
            
            
            
            1,072,779
            
            
            
            186,545
            
            
            
            177,116
            
            
            
            214,601Real
      Estate – Construction
            
            
            1,452,520
            
            
            
            2,235,729
            
            
            
            3,435,204
            
            
            
            1,482,349
            
            
            
            469,580Real
      Estate – Home Equity Line of Credit
            
            
            732,871
            
            
            
            358,890
            
            
            
            92,935
            
            
            
            100,811
            
            
            
            106,986Loans
      Held for Sale
            
            
            2,010
            
            
            
            5,940
            
            
            
            58,005
            
            
            
            7,222
            
            
            
            87,545Consumer
            
            
            301,664
            
            
            
            22,843
            
            
            
            19,562
            
            
            
            16,693
            
            
            
            10,275Unallocated
            
            
            -
            
            
            
            -
            
            
            
            803
            
            
            
            109,318
            
            
            
            64,794Total
      Allowance
            
            $
            9,760,000
            
            
            $
            5,675,035
            
            
            $
            5,000,000
            
            
            $
            3,175,000
            
            
            $
            3,000,000









52





During
2009, management made enhancements to its allowance methodology in an effort,
during the current recession, to better estimate inherent losses in the loan
portfolio.  Other enhancements have included: more segmentation of the
loan portfolio by loan category, as well as risk-rating; inclusion of historical
loss experience factors over a trailing four-quarter time horizon to compute
general reserves; development of migration analysis used to determine historical
loss factors for risk grades; implementation of the practice of discounting the
value of collateral for a “bank sale” situation along with the age of the
underlying appraisal to better reflect current economic conditions; and improved
qualitative factor analysis.  In addition, management took steps to
improve the loan review process, resulting in: appraisals that are more current;
improved communication between loan officers, credit administration and senior
executives about problem credits; more effective identification of credits to
monitor and evaluate continuously due to risk; and, enhanced determination of
internal risk rating changes, charge-offs and allocations of specific reserves
for non-performing loans.





The
following table sets forth the percentages of loans in each category for the
loan portfolio as of December 31, 2009, 2008, 2007, 2006, and 2005,
respectively.





2009
            
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005Commercial
            
            
            46.19
            %
            
            
            50.47
            %
            
            
            42.63
            %
            
            
            40.59
            %
            
            
            37.89
            %Real
      Estate – Mortgage
            
            
            24.62
            
            
            
            20.38
            
            
            
            15.03
            
            
            
            12.80
            
            
            
            17.31Real
      Estate – Construction
            
            
            12.81
            
            
            
            17.74
            
            
            
            28.13
            
            
            
            35.27
            
            
            
            24.02Real
      Estate – Home Equity Line of Credit
            
            
            14.56
            
            
            
            9.41
            
            
            
            7.71
            
            
            
            9.16
            
            
            
            10.55Loans
      Held for Sale
            
            
            0.21
            
            
            
            0.48
            
            
            
            4.82
            
            
            
            0.66
            
            
            
            8.77Consumer
            
            
            1.61
            
            
            
            1.52
            
            
            
            1.68
            
            
            
            1.52
            
            
            
            1.46Total
      Loans
            
            
            100.00
            %
            
            
            100.00
            %
            
            
            100.00
            %
            
            
            100.00
            %
            
            
            100.00
            %








NONPERFORMING
LOANS AND OTHER DELINQUENT ASSETS





Nonperforming
assets are comprised of non-accrual loans, including troubled debt restructures,
loans past due 90 days or more and still accruing (of which there were none at
December 31, 2009), and real estate acquired through
foreclosure.  Management will generally classify loans as non-accrual
when collection of full principal and interest under the original terms of the
loan is not expected or payment of principal or interest has become 90 days past
due. When a loan is classified as non-accrual, interest will no longer be
accrued, and any interest previously accrued, but not collected, will be
reversed.  A non-accrual loan may be restored to accrual status when
delinquent principal and interest payments are brought current (and, generally,
have been kept current for a period of six months) and collection of future
monthly principal and interest payments is expected. As of December 31, 2009, we
had $20.2 million of non-accrual loans, compared to $13.5 million as of December
31, 2008.





Any
property we acquired as a result of foreclosure on a mortgage loan is classified
as real estate acquired through foreclosure and recorded at the lower of the
unpaid principal balance or fair value at the date of acquisition and,
subsequently, carried at the lower of cost or net realizable value. Any required
write-down of the loan to its net realizable value will be charged against the
allowance for credit losses.  Upon foreclosure, we generally will
require an appraisal of the property and, thereafter, appraisals of the property
on at least an annual basis with external inspections on at least a quarterly
basis. As of December 31, 2009, we held $2.7 million of real estate acquired as
a result of foreclosure, which was net of an allowance of $806,774 for estimated
losses in market value.  This compares to $3.9 million held at
December 31, 2008, which was net of an allowance of $645,322 for estimated
losses in market value.





Troubled
debt restructures (“TDRs”), which are loans that have been restructured due to
the borrower’s inability to maintain a current status on the loan, totaled $5.4
million as of December 31, 2009, comprised of commercial real estate credits
from the Towson portfolio ($4.5 million of principle and $1.6








53





million
in specific reserves) and residential real estate credits from our other
portfolios ($957,172 of principle and $607,328 in specific
reserves).  By comparison, as of December 31, 2008, troubled debt
restructures amounted to $952,372 of residential real estate construction loans,
with associated specific reserves of  $39,551.





Considering
loan impairment, we apply FASB’s guidance for the "Accounting by Creditors for
Impairment of a Loan," and "Accounting by Creditors for Impairment of a
Loan-Income Recognition and Disclosure."  Loans are considered
impaired (and non-accrual) when, based on current data, it is improbable that we
will collect all principal and interest payments according to contractual
terms.  Impaired loans are measured based on the present value of
expected future cash flows discounted at the loan’s effective interest
rate.  However, as a practical expedient, we may measure impairment
based upon a loan’s observable market price or the fair value of the collateral
if repayment of the loan is collateral dependent.  Generally, we
measure impairment on such loans by reference to the fair value of the
collateral.  If the measure of the impaired loan is less than the
recorded investment in the loan, impairment is recognized for the shortfall and
recorded in a valuation allowance through a provision for credit
losses.  Impaired loans do not include large groups of smaller balance
homogeneous credits such as residential real estate and consumer installment
loans, which are evaluated collectively for impairment.  Impaired
loans are written off when management determines that a permanent decline in
value has occurred.





As of
December 31, 2009, we had impaired loans totaling $20.2 million, or 5.01% of
total outstanding loans, including loans held for sale.   These
impaired loans, all of which were also non-accrual, included TDRs amounting to
$5.4 million.  However, impaired loans at year-end 2009 did not
include any loans 90 days or more past due and still accruing
interest.  The composition of impaired loans as of December 31, 2009,
was: commercial real estate - $7.9 million (including TDRs of $4.5 million);
commercial construction - $4.7 million; commercial loans - $3.1 million;
residential real estate - $2.0 million (including TDRs of $0.9 million);
consumer construction - $1.8 million; home equity lines of credit - $345,686;
and, consumer - $232,000. Because essentially all of these loans were at least
partially collateralized by real estate and considered to be collateral
dependent, management computed specific reserves for each credit as the
collateral shortfall, if any, compared to the outstanding principal
balance.  Total specific reserves provided for impaired credits, which
continue to be carefully monitored, amounted to $4.4 million at December 31,
2009.  By comparison, impaired loans at December 31, 2008 amounted to
$16.4 million, including non-accrual loans of $13.5 million and TDRs of
$952,372, and carried specific reserves of approximately $2.9
million.  Average impaired loans were approximately $26.9 million and
approximately $13.7 million for the years ended December 31, 2009 and 2008,
respectively.








INVESTMENT
PORTFOLIO





In March
2009, the Board of Directors approved a new investment policy and authorized
management to invest in a traditional securities portfolio in order to provide
ongoing liquidity, income and a ready source of collateral that can be pledged
in order to access other sources of funds.  The investment securities
available for sale balances of $21.1 million as of December 31, 2009 are
investment securities such as agency-backed bonds and mortgage-backed
securities.  The Company held Federal Reserve Bank stock and FHLB of
Atlanta stock of $663,450 and $487,700 as of December 31, 2009 and $704,200 and
$535,400 as of December 31, 2008, respectively.  In 2008, we chose to
invest available funds primarily in federal funds sold and other overnight
investments. As a result, there were no investment securities as of December 31,
2008.





We had no
investments that were obligations of the issuer, or payable from or secured by a
source of revenue or taxing authority of the issuer, whose aggregate book value
exceeded 10% of stockholders' equity at December 31, 2009.







54





The
following table sets forth information in the scheduled maturities, amortized
cost, market value and average yields for the Bank’s investment portfolio as of
December 31, 2009:





US
      Government Securities
            
            
            Mortgage-backed
      Securities
            
            
            Total
      Investment SecuritiesAmortized
      Cost
            
            
            Market
      Value
            
            
            Average
      Yield
            
            
            Amortized
      Cost
            
            
            Market
      Value
            
            
            Average
      Yield
            
            
            Amortized
      Cost
            
            
            Market
      Value
            
            
            Average
      YieldYears
      to Maturity:One
      Year or less
            
            
            
            
            
            
            
            
            
            
            $
            2,243,709
            
            
            
            2,248,256
            
            
            
            1.04
            %
            
            $
            2,243,709
            
            
            
            2,248,256
            
            
            
            1.04
            %One
      to Five Years
            
            
            5,499,731
            
            
            
            5,518,410
            
            
            
            1.95
            %
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            5,499,731
            
            
            
            5,518,410
            
            
            
            1.95
            %Five
      to Ten Years
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            4,914,210
            
            
            
            4,915,833
            
            
            
            3.20
            %
            
            
            4,914,210
            
            
            
            4,915,833
            
            
            
            3.20
            %More
      than Ten Years
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            8,373,005
            
            
            
            8,446,375
            
            
            
            3.87
            %
            
            
            8,373,005
            
            
            
            8,446,375
            
            
            
            3.87
            %Total
      Investment Portfolio
            
            $
            5,499,731
            
            
            
            5,518,410
            
            
            
            1.95
            %
            
            $
            15,530,924
            
            
            
            15,610,464
            
            
            
            3.25
            %
            
            $
            21,030,655
            
            
            
            21,128,874
            
            
            
            2.91
            %




The
maturities for the investment securities shown above are based upon contractual
maturities; floating rate instruments are sorted by their next repricing
date.




Management
has made the decision to maintain its available funds in highly-liquid assets
because it wants to ensure that funds are readily available to fund loan
commitments and maturing time deposits. Management believes that this strategy
is necessary in order to maintain appropriate levels of liquidity and
acknowledge that it prevents us from maximizing margins.





SOURCES
OF FUNDS





General





Deposits,
short-term borrowings in the form of repurchase agreements, short-term
borrowings under secured and unsecured lines of credit, borrowings under the
subordinated debt, scheduled amortization and unscheduled prepayment of loans,
funds provided by operations and capital are the  sources of funds we
utilizefor lending
and investment activities, and other general business purposes.





Deposits





We offer
a variety of deposit products having a range of interest rates and terms. Our
deposits consist of checking accounts, savings accounts, money market accounts
and CDs.





The
following table sets forth the composition of our deposits as of December 31,
2009 and December 31, 2008:




2009
            
            
            2008Demand
      Deposits
            
            $
            68,623,282
            
            
            
            24.38
            %
            
            $
            76,115,803
            
            
            
            31.12
            %Savings
            
            
            895,694
            
            
            
            .32
            
            
            
            1,047,533
            
            
            
            0.43Money
      Market and sweep
            
            
            15,445,289
            
            
            
            5.49
            
            
            
            23,763,974
            
            
            
            9.71CDs
            
            
            196,539,188
            
            
            
            69.81
            
            
            
            143,700,722
            
            
            
            58.74Total
      deposits
            
            $
            281,503,453
            
            
            
            100.00
            %
            
            $
            244,628,032
            
            
            
            100.00
            %





The mix
of deposits shifted to a higher concentration of CDs and a decreased
concentration in demand deposits, savings and money market and sweep accounts in
2009 compared to 2008. The increased concentration in certificate of demand
accounts was primarily a function of management’s decision to aggressively
compete for national market deposits during 2009 for liquidity
management.






55







Of the
total deposits at December 31, 2009, $7.1 million, or 2.52%, was related to one
customer as compared to $5.3 million, or 2.17%, at December 31, 2008 for this
same customer.  The deposits for this large customer tend to fluctuate
significantly; as a result, management monitors these deposits on a daily basis
to ensure that liquidity levels are adequate to compensate for these
fluctuations.





The
following table sets forth the maturity distribution for the Company's deposits
at December 31, 2009. Some of the deposits may be renewed or withdrawn prior to
maturity. Therefore, the following table should not be used as a forecast of
future cash flows.





Within
      one year
            
            
            One
      to three years
            
            
            Three
      to
              five years
            
            
            Over
      five years
            
            
            TotalDemand
      deposits
            
            $
            68,623,282
            
            
            
            
            
            
            
            
            
            
            
            
            68,623,282Savings
            
            
            895,694
            
            
            
            
            
            
            
            
            
            
            
            
            895,694Money
      Market and sweep
            
            
            15,445,289
            
            
            
            
            
            
            
            
            
            
            
            
            15,445,289CDs
            
            
            165,744,538
            
            
            
            28,940,846
            
            
            
            1,805,213
            
            
            
            48,591
            
            
            
            196,539,188Total
            
            $
            250,708,803
            
            
            
            28,940,846
            
            
            
            1,805,213
            
            
            
            48,591
            
            
            
            281,503,453








CDs in
amounts of $100,000 or more, and their remaining maturities at December 31,
2009, are as follows:





Three
      months or less
            
            $
            40,858,760Over
      three months through six months
            
            
            44,471,609Over
      six months through twelve months
            
            
            41,802,576Over
      twelve months
            
            
            16,597,639Total
            
            $
            143,730,584





The
market in which we operate is very competitive and the rates of interest paid on
deposits are affected by rates paid by other depository
institutions.  Management closely monitors rates offered by other
institutions and seeks to be competitive within the market.  The
Company has chosen to selectively compete for large CDs. As of December 31,
2009, we had outstanding CDs of approximately $165.5 million that were either
obtained through the listing of CD rates on two Internet-based listing services
(such deposits are sometimes referred to herein as national market certificates
of deposit) or to a lesser extent, acquired through Promontory Financial
Network’s certificate of deposit account registry service (“CDARS”) program. The
national market certificates of deposits were issued with an average yield of
2.17% and an average term of 6.6 months. Included in the $165.5 million are
national market certificates of deposit totaling $8.6 million that have been
classified as “Brokered Deposits” for bank regulatory purposes. These “Brokered
Deposits” were issued with an average yield of 3.88% and an average term of
7.1months.  As of December 31, 2008, the total CDs obtained through
the listing of CDs rates on the Internet-based listing services were
approximately $94.9 million, and included $80.5 million of “Brokered
Deposits.”  We have never paid broker fees for deposits.





In 2006,
we began using brokered CDs through the Promontory Financial
Network.  Through this deposit matching network and its CDARS program,
we have the ability to offer our customers access to FDIC-insured deposit
products in aggregate amounts exceeding current insurance limits. When the
Company placed funds through CDARS on behalf of a customer, it was eligible to
receive matching deposits through the network. We also had the ability to raise
deposits directly through the network.  These deposits received
through the CDARS program are considered “Brokered Deposits” for bank regulatory
purposes. At








56








December
31, 2008, we had approximately $3.1 million of CDARS deposits all of which was
placed on behalf of customers.  As a result of falling below the
“well-capitalized” status for regulatory reporting purposes, we may still place
customer deposits with CDARS but we are no longer permitted to accept brokered
deposits including the match portion through the CDARS program.  As of
December 31, 2009 there were no reciprocal CDARS deposits on the Bank’s
books.





Effective
with the filing of our September 30, 2008 Call Report, we are unable to accept
additional brokered deposits without prior FDIC approval.  This is a
standard restriction for banks once they are deemed to be less than
“well-capitalized.”   As of December 31, 2009, $4.5 million of
the $8.6 million of remaining brokered CDs will mature during the first quarter
of 2010.




Below is
a reconciliation of total deposits to core deposits as of December 31, 2009 and
2008, respectively:





December
      31,
              2009
            
            
            December
      31, 2008Total
      deposits
            
            $
            281,503,453
            
            
            $
            244,628,032National
      market CDs
            
            
            (165,518,431
            )
            
            
            (94,919,991
            )Variable
      balance accounts (1 customer in 2009 and 2008)
            
            
            (7,070,688
            )
            
            
            (5,311,720
            )Portion
      of variable balance accounts considered to be core
            
            
            3,000,000
            
            
            
            3,000,000Core
      deposits
            
            $
            111,914,334
            
            
            $
            147,396,321





Core
deposits, which management categorizes as commercial paper sweep balances and
all deposits other than national market CDs, CDARS deposits and $4.1 million of
the $7.1 million deposits from the large customer described above, stood at
$111.9 million as of December 31, 2009, down 24.0% from $147.4 million as of
December 31, 2008.  Overall, we did not aggressively compete for new
local deposits during 2009, which essentially accounts for the decrease in core
deposits from 2008.  Management closely monitors core deposits because
they consider such deposits not only a relatively stable source of funding but
also reflective of the growth of commercial and consumer depository
relationships.




Borrowings





Short-term
borrowings as of December 31, 2008 consist primarily of $1.9 million borrowed
under Federal Funds lines of credit. These borrowings are unsecured and are
subordinated to all deposits.  There were no short-term borrowings as
of December 31, 2009.





Subordinated
debt consists of $8 million of fixed interest rate trust preferred securities
(the “Trust Preferred Securities”), issued on December 12, 2005 through a
Delaware trust subsidiary, Bay National Capital Trust I (the “Trust”). The Trust
was formed for the purpose of issuing the Trust Preferred Securities and all of
its common securities are owned by the Company.  The Company purchased
the common securities from the Trust for $248,000. In accordance with provisions
of FASB’s guidance for “Consolidation of Variable Interest Entities”, the financial position and
results of operations are not included in the Company’s consolidated financial
position and results of operations.





The Trust
used the proceeds of the sale of the Trust Preferred Securities and common
securities to purchase from the Company the aggregate principal amount of
$8,248,000 of the Company’s Fixed Rate Junior Subordinated Debt Securities Due
2036 (the “Debt Securities”). Like the Trust Preferred Securities, the Debt
Securities bear interest at the fixed annual rate of 7.20% until
maturity.  The interest expense on Trust Preferred Securities, which
include amortization of issuance costs, was $622,284 and $603,039 in 2009 and
2008, respectively.  The Debt Securities mature on February 23, 2036,
but may be redeemed at the








57





Company’s
option at any time on any February 23, May 23, August 23 or November 23 on or
after February 23, 2011, or at any time upon certain events, such as a change in
the regulatory capital treatment of Debt Securities, the Trust being deemed to
be an “investment company” under the Investment Company Act of 1940, as amended,
or the occurrence of certain adverse tax events.  Except upon the
occurrence of the events described above, which require a redemption premium for
redemptions prior to February 23, 2011, the Company may redeem the Debt
Securities at their aggregate principal amount, plus accrued interest, if
any.





Bay
National Corporation was required to retain $1,000,000 of the proceeds from the
Debt Securities for general corporate purposes (which may include making
interest payments on the Debt Securities) until the earlier of (i) the date on
which the retained funds are reduced to zero, or (ii) the date on which the Bank
(or any successor) meets the statutory requirements to pay dividends of at least
$148,464 for each of two consecutive quarters with positive retained earnings
remaining after any such dividend payment.





The Debt
Securities are subordinated to the prior payment of other indebtedness of the
Company that, by its terms, is not similarly subordinated.  Although
the Debt Securities are recorded as a liability on the Company’s balance sheet,
the trust preferred securities qualify as Tier 1 capital, subject to regulatory
guidelines that limit the amount included to an aggregate of 25% of Tier 1
capital.





On
January 6, 2009, we provided notice under the indenture for the Debt Securities
dated December 12, 2005 (the “Indenture”) of our election to defer the interest
payment due on February 23, 2009.    In February 2009, the
Company received formal notice from the FRB instructing it to suspend its trust
preferred interest payments.





During
the period in which interest payments are being deferred, we may not, subject to
certain exceptions, (i) declare or pay any dividends or distributions on, or
redeem, purchase, acquire, or make a liquidation payment with respect to, any of
our capital stock, (ii) make any payments on, repay, repurchase or redeem any
debt securities other than those that rank senior to the Debt Securities, or
(iii) make any payment under any guarantees, other than those that rank senior
to our guarantee on the capital securities issued by the
Trust.  Interest on the Debt Securities continues to accrue during the
deferral period and interest on the deferred interest also accrues, both of
which must be paid at the end of the deferral period.  Prior to the
expiration of the deferral period, we have the right to further defer interest
payments, provided that no deferral period, together with all prior deferrals,
exceed 20 consecutive quarters and that no event of default (as defined in the
Indenture) has occurred and is continuing at the time of the deferral. We were
not in default with respect to the Indenture at the time the payments were
deferred and such deferrals did not cause an event of default under the
Indenture.





As of
December 31, 2008, we had unused commitments for a total of $2.1 million of
borrowing availability under an unsecured Federal Funds line of credit with
another institution.  This facility was terminated on January 15, 2009
primarily based on the Company’s negative earnings trend.





We had
approximately $21.5 million of borrowing capacity with the FHLB of Atlanta as of
December 31, 2008.  This facility was rescinded on February 13,
2009.  We took steps to restore this line of credit and it was
restored to $6.5 million on March 27, 2009.  Subsequently, on April 9,
2009 the available line capacity was reduced to $5.0 million.  On May
14, 2009, the Company received notification that due to the weak operating
results of the Bank for the first quarter of 2009, the line had again been
rescinded.  We will continue to take appropriate steps to identify and
arrange for lines of credit from other sources.  To date, we have not
been successful in obtaining a line of credit from other sources and there can
be no assurance that we will be successful in this regard.




For
additional information with respect to borrowings, please see Note 6 to the
Company’s audited financial statements, “Borrowings.”







58





INTEREST
RATE SENSITIVITY





The
primary objective of asset/liability management is to minimize interest rate
risk as net interest income can fluctuate with significant interest rate
movements.  To minimize the risk associated with these rate swings,
management attempts to structure the Company’s balance sheet so that the ability
exists to adjust pricing on interest-earning assets and interest-bearing
liabilities in roughly equivalent amounts at approximately the same time
intervals.  Imbalances in these repricing opportunities at any point
in time constitute interest rate sensitivity.





The
measurement of the Company’s interest rate sensitivity, or "gap," is one of the
principal techniques used in asset/liability management.  The interest
sensitive gap is the dollar difference between assets and liabilities which are
subject to interest rate pricing within a given time period, including both
floating rate or adjustable rate instruments, and instruments which are
approaching maturity.





The
following table sets forth the amount of the Company's interest-earning assets
and interest-bearing liabilities as of December 31, 2009, which are expected to
mature or reprice in each of the time periods shown:




Maturity
      or repricing withinAmount
                
                
                Percent
      of Total
                
                
                0
      to 3Months
                
                
                4
      to 12Months
                
                
                1
      to 5Years
                
                
                Over
      5YearsInterest-earning
      assetsFederal
      funds sold and other overnight investments
                
                $
                69,636,017
                
                
                
                24.31
                %
                
                $
                69,636,017
                
                
                $
                -
                
                
                $
                -
                
                
                $
                -Loans
      held for sale
                
                
                415,091
                
                
                
                .14
                
                
                
                415,091
                
                
                
                -
                
                
                
                -
                
                
                
                -Loans
      – Variable rate
                
                
                106,952,773
                
                
                
                37.33
                
                
                
                106,952,773
                
                
                
                -
                
                
                
                -
                
                
                
                -Loans
      – Fixed rate
                
                
                87,304,723
                
                
                
                30.47
                
                
                
                8,813,248
                
                
                
                13,741,910
                
                
                
                56,621,239
                
                
                
                8,128,326Investment
      Securities, FRB and FHLB Stock
                
                
                22,181,805
                
                
                
                7.74
                
                
                
                -
                
                
                
                2,243,709
                
                
                
                5,499,731
                
                
                
                14,438,365Total
      interest-earning assets
                
                $
                286,490,410
                
                
                
                100.00
                %
                
                $
                185,817,130
                
                
                $
                15,985,619
                
                
                $
                62,120,970
                
                
                $
                22,566,691Interest-bearing
      liabilitiesDeposits
      – Variable rate
                
                $
                31,930,393
                
                
                
                13.50
                %
                
                $
                31,930,393
                
                
                $
                -
                
                
                $
                -
                
                
                $
                -Deposits
      – Fixed rate
                
                
                196,539,188
                
                
                
                83.12
                
                
                
                66,533,069
                
                
                
                99,211,469
                
                
                
                30,746,059
                
                
                
                48,591Short-term
      borrowings – variable rate
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                -Subordinated
      debt
                
                
                8,000,000
                
                
                
                3.38
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                8,000,000Total
      interest-bearing liabilities
                
                $
                236,469,581
                
                
                
                100.00
                %
                
                $
                98,463,462
                
                
                $
                99,211,469
                
                
                $
                30,746,059
                
                
                $
                8,048,591Periodic
      repricing differencesPeriodic
      gap
                
                
                
                
                
                
                
                
                
                $
                87,353,668
                
                
                $
                (83,225,850
                )
                
                $
                31,374,911
                
                
                $
                14,518,100Cumulative
      gap
                
                
                
                
                
                
                
                
                
                $
                87,353,668
                
                
                $
                4,127,818
                
                
                $
                35,502,729
                
                
                $
                50,020,829Ratio
      of rate sensitive assets to rate sensitive liabilities
                
                
                
                
                
                
                
                
                
                
                188.72
                %
                
                
                16.11
                %
                
                
                202.05
                %
                
                
                280.38
                %








We have
61.78% of our interest-earning assets and 13.50% of our interest-bearing
liabilities in variable rate balances. The excess of interest-earning assets
over interest-bearing liabilities of $50 million in the categories of items
maturing or repricing within five years comprises the majority of the overall
gap.  This gap is generally reflective of our emphasis on investing in
short-term investments and originating








59








variable
rate loans and the demand in the market for higher yielding fixed rate
deposits.  This analysis indicates that we generally will benefit from
rising market rates of interest but will generally be adversely affected by
declining market rates of interest.  Since all interest rates and
yields do not adjust at the same pace, however, the gap is only a general
indicator of interest rate sensitivity.  The analysis of our
interest-earning assets and interest-bearing liabilities presents only a static
view of the timing of maturities and repricing opportunities, without taking
into consideration the fact that changes in interest rates do not affect all
assets and liabilities equally. Net interest income may be affected by other
significant factors in a given interest rate environment, including changes in
the volume and mix of interest-earning assets and interest-bearing
liabilities.





Management
constantly monitors and manages the structure of the Company's balance sheet,
seeks to control interest rate exposure and evaluate pricing strategies while
maximizing earnings and net worth.  Strategies and policies to manage
the balance sheet are predicated upon the examination of how interest rate risk
affects overall business risk, capital risk, liquidity risk, and credit
risk.  The proper strategy will depend on the current level of risk,
the time frame,  the current and expected interest rate environment
and the consequences of such strategy on our liquidity needs.  We will
attempt to extend fixed-rate liabilities to longer maturities while purchasing
variable rate assets to widen the net interest margin if we determine that
interest rates will more than likely increase and if such actions will help
ensure that our liquidity needs can be met.  If we perceive that
interest rates will decline, we will attempt to shorten fixed rate liabilities
while securing longer term fixed rate assets if the impact of such strategy is
consistent with our liquidity needs.





In
theory, maintaining a nominal level of interest rate sensitivity can diminish
interest rate risk.  In practice, this is made difficult by a number
of factors, including cyclical variation in loan demand, different impacts on
interest sensitive assets and liabilities when interest rates change and the
availability of funding sources. Management generally attempts to maintain a
balance between rate-sensitive assets and liabilities as the exposure period is
lengthened to minimize the overall interest rate risk to the
Company.





LIQUIDITY





Our
overall asset/liability management strategy takes into account the need to
maintain adequate liquidity to fund existing loan commitments, deposit runoff
and ongoing operations.  Management monitors the liquidity position
daily.





Our
primary sources of funds are deposits, scheduled amortization and prepayment of
loans, funds provided by operations and capital.  We also have access to
national markets for CDs.  While scheduled principal repayments on
loans are a relatively predictable source of funds, deposit flows and loan
prepayments are greatly influenced by market interest rates, economic
conditions, and rates offered by our competition.





Our most
liquid assets are cash and assets that can be readily converted into cash,
including federal funds sold, other overnight investments and investment
securities. As of December 31, 2009, we had $71.2 million in cash and due from
banks, $942,784 in federal funds sold and other overnight investments,
$21.1million in investment securities and $415,091 in loans expected to be sold
within 60 days. As of December 31, 2008, we had $7.3 million in cash and due
from banks, $2.0 million in federal funds sold and other overnight investments
and $1.2 million in loans expected to be sold within 60 days.





The
increase in the overall level of liquid assets, other than loans expected to be
sold within 60 days, is the result of management’s decision to increase
liquidity and, when appropriate, to allow non-core time deposits to
mature.





As an
additional source of liquidity, management has also identified specific loans to
sell and has contacted several correspondent banks as potential purchasers of
such loans.  Since undertaking transactions








60





of this
nature could have an adverse impact on our profitability (i.e., loss in interest
income on the participated loans), we are considering the sale of these assets
only as a contingent source of liquidity.





To
further aid in managing liquidity, the Board has approved and an Investment
Committee was formed to review and discuss recommendations for the use of
available cash and to establish an investment portfolio.  By limiting
the maturity of securities and maintaining a conservative investment posture,
management can rely on the investment portfolio to help meet any short-term
funding needs.





Based on
the actions noted above, we believe that we have adequate cash on hand and
available through liquidation of investment securities to meet a liquidity
shortfall. Although we believe sufficient liquidity exists, if economic
conditions continue to deteriorate and consumer confidence is not restored, this
excess liquidity could be depleted, which would then materially affect our
ability to meet our operating needs and to raise additional
capital.





As
previously discussed, we intend to raise funds via an offering of our common
stock and warrants to purchase common stock.  We need to raise these
funds and recapitalize the Bank in order for the Bank to continue
operations.  If we cannot raise sufficient capital before the Bank
reaches regulatory capital levels that will result in a receivership of the
Bank, we will attempt a direct sale of the Company and/or Bank or of the Bank’s
assets.  While we continue our efforts to raise capital, we will also
implement our capital restoration plan and reduce our total risk-weighted
assets.  A by-product of successful efforts to shrink the balance
sheet in this regard will be increased liquidity for the Bank.








CONTRACTUAL
OBLIGATIONS, COMMITMENTS, CONTINGENT LIABILITIES, AND OFF-BALANCE SHEET
ARRANGEMENTS





We are a
party to financial instruments with off-balance sheet risk in the normal course
of our business.  These financial instruments primarily include
commitments to extend credit, lines of credit and standby letters of
credit.  We use these financial instruments to meet the financing
needs of our customers.  These financial instruments involve, to
varying degrees, elements of credit, interest rate and liquidity
risk.  In addition, we also have operating lease obligations and
purchase commitments.





Outstanding
loan commitments and lines and letters of credit at December 31, 2009 and 2008
are as follows:


2009
            
            
            2008Loan
      commitments
            
            $
            9,445,011
            
            
            $
            14,981,584Unused
      lines of credit
            
            
            48,046,982
            
            
            
            84,495,398Letters
      of credit
            
            
            1,431,747
            
            
            
            2,924,671




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.  Commitments
generally have interest rates fixed at current market amounts, fixed expiration
dates or other termination clauses, which may require payment of a
fee.  Unused lines of credit represent the unused portion of lines of
credit previously extended and available to the customer as long as there is no
violation of any contractual condition. These lines generally have variable
interest rates. Since many of the commitments are expected to expire without
being drawn upon, and since it is unlikely that customers will draw upon their
line of credit in full at any time, the total commitment amount or line of
credit amount does not necessarily represent future cash
requirements.  We are not aware of any loss we would incur by funding
our commitments or lines of credit.





Standby
letters of credit are conditional commitments issued to guarantee the
performance of a customer to a third party.  Our exposure to credit
loss in the event of nonperformance by the customer is the contract amount of
the commitment.






61







In
general, loan commitments, lines of credit and letters of credit are made on the
same terms, including with respect to collateral, as outstanding
loans.  Each customer’s credit-worthiness and the collateral required
are evaluated on a case-by-case basis.





The
decline in the overall level of loan commitments and unused lines of credit as
of December 31, 2009 as compared to December 31, 2008, is reflective of
management’s decision to strictly manage loan growth and is also reflective of
the current global economic downturn.





We have
various financial obligations, including contractual obligations and commitments
that may require future cash payments.





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








Within
      one year
            
            
            One
      to three years
            
            
            Three
      to
              five years
            
            
            Over
      five years
            
            
            TotalDeposits
      without a
              stated
      maturity(a)
            
            $
            84,964,343
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            84,964,343CDs(a)
            
            
            165,744,538
            
            
            
            28,940,846
            
            
            
            1,805,213
            
            
            
            48,591
            
            
            
            196,539,188Other
      borrowings(a)
            
            
            -
            
            
            
            -
            
            
            
            655,583
            
            
            
            8,000,000
            
            
            
            8,655,583Operating
      leases
            
            
            424,530
            
            
            
            829,378
            
            
            
            809,613
            
            
            
            67,483
            
            
            
            2,131,004Purchase
      obligations
            
            
            360,013
            
            
            
            720,025
            
            
            
            720,025
            
            
            
            240,008
            
            
            
            2,040,071Total
            
            $
            251,493,424
            
            
            $
            30,490,249
            
            
            $
            3,990,434
            
            
            $
            8,356,082
            
            
            $
            294,330,189





(a)
            Includes
      accrued interest payable.





Our
operating lease obligations represent short and long-term lease and rental
payments for facilities. Purchase obligations represent estimated obligations
under agreements to purchase goods or services that are enforceable and legally
binding on us. The purchase obligation amounts presented above primarily relate
to estimated obligations under data and item processing contracts and accounts
payable for goods and services received through December 31, 2009.





CAPITAL
RESOURCES





The
Company had stockholders’ (deficit) equity at December 31, 2009 of $(992,323) as
compared to $15.0 million at December 31, 2008. The decrease in capital is the
result of an increased provision for credit losses, negative operating results
and the establishment of a valuation allowance against the deferred tax assets.
We have not declared any cash dividends since inception.  Management
is extremely focused on improving our capital as required by the terms of the
OCC’s Consent Order.





Banking
regulatory authorities have implemented strict capital guidelines that directly
relate to the credit risk associated with an institution’s
assets.  Banks and bank holding companies are required to maintain
capital levels based on their "risk adjusted” assets so that categories of
assets with higher "defined” credit risks will require more capital support than
assets with lower risks. The Bank’s capital level has fallen to the category
of  “significantly undercapitalized” at December 31, 2009 and
management  is presently evaluating alternative courses of action to
improve its capital position and to meet the higher risk-based capital ratios
imposed by the OCC in its Consent Order.





Banking
regulations also limit the amount of dividends that may be paid without prior
approval of the Bank's regulatory agencies.  Regulatory approval is
required to pay dividends that exceed the Bank’s net profits for the current
year plus its retained net profits for the preceding two years.  The
Bank could not have








62





paid
dividends to the Company without approval from bank regulatory agencies at
December 31, 2009 and no such payments are currently
planned.  Furthermore, under the terms of the Consent Order, the Bank
may not pay dividends unless it is in compliance with the capital program
required by the Order and applicable regulatory requirements and receives the
OCC’s written non-objection.





In
addition, in February 2009, Bay National Corporation received notice from the
Federal Reserve Bank of Richmond that the Company is expected to immediately
terminate future dividend payments, including payments on trust preferred
securities.  This order will remain in effect until we receive written
approval from the Reserve Bank to resume such payments.





The
tables below present the Bank's capital position relative to its various minimum
regulatory capital requirements as of December 31, 2009 and 2008.  For
a discussion of these capital requirements, see "Item 1. Description of Business
- Supervision and Regulation - Bay National Bank - Capital Adequacy
Guidelines."





December
      31, 2009Actual
            
            
            For
      Capital
              Adequacy
      Purpose
            
            
            To
      Be Well
              Capitalized
      Under
              Prompt
      Corrective
              Action
      ProvisionsAmount
            
            Ratio
            
            
            Amount
            
            Ratio
            
            
            Amount
            
            RatioTotal
      Capital (to Risk Weighted Assets)*:
            $
            10,064,000
            
            4.90
            %
            $
            16,420,000
            
            8.00
            %
            $
            20,525,000
            
            10.00
            %Tier
      I Capital (to Risk Weighted Assets)*:
            
            7,406,000
            
            3.61
            %
            
            8,210,000
            
            4.00
            %
            
            12,315,000
            
            6.00
            %Tier
      I Capital (to Average Assets)*:
            
            7,406,000
            
            2.47
            %
            
            9,013,000
            
            3.00
            %
            
            15,021,000
            
            5.00
            %*In
      order to be in compliance with the terms of the Consent Order, the Bank
      must meet minimum Total Capital, Tier 1 Capital  (to Risk
      Weighted Assets) and Tier 1 Capital (to Average Assets) ratios of 12.00%,
      11.00% and 9.00%, respectively.








December
      31, 2008Actual
            
            
            For
      Capital
              Adequacy
      Purpose
            
            
            To
      Be Well
              Capitalized
      Under
              Prompt
      Corrective
              Action
      ProvisionsAmount
            
            Ratio
            
            
            Amount
            
            Ratio
            
            
            Amount
            
            RatioTotal
      Capital (to Risk Weighted Assets):
            $
            26,322,000
            
            9.57
            %
            $
            22,001,000
            
            8.00
            %
            $
            27,501,000
            
            10.00
            %Tier
      I Capital (to Risk Weighted Assets):
            
            22,857,000
            
            8.31
            %
            
            11,000,00
            
            4.00
            %
            
            16,501,000
            
            6.00
            %Tier
      I Capital (to Average Assets):
            
            22,857,000
            
            8.31
            %
            
            8,255,000
            
            3.00
            %
            
            13,758,000
            
            5.00
            %





Impact
of Inflation and Changing Prices





The
consolidated financial statements and notes thereto presented herein have been
prepared in accordance with accounting principles generally accepted in the
United States of America, which require the measurement of financial position
and operating results in terms of historical dollars without considering the
change in the relative purchasing power of money over time and due to inflation.
The impact of inflation is reflected in the increased cost of our
operations.  Unlike most industrial companies, nearly all our assets
are monetary in nature.  As a result, interest rates have a greater
impact on our performance than do the effects of general levels of inflation.
Interest rates do not necessarily move in the same direction or to the same
extent as the price of goods and services.





Application
of 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








63











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 must 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 we follow 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 financial review,
provide information on how significant assets and liabilities are valued in the
financial statements and how those values are determined.





Loans





Loans are
stated at the principal amount outstanding net of any deferred fees and
costs.  Interest income on loans is accrued at the contractual rate on
the principal amount outstanding.  It is the Company’s policy to
discontinue the accrual of interest when circumstances indicate that collection
is doubtful.  Loans are returned to accrual status when all principal
and interest amounts contractually due are brought current and future payments
are reasonably assured.  Fees charged and costs capitalized for
originating certain loans are amortized by the interest method over the term of
the loan.





Loans are
considered impaired when, based on current information, it is improbable that we
will collect all principal and interest payments according to contractual terms.
The Bank’s non-accrual and impaired loans comprise the same loans at December
31, 2009.  Generally, loans are placed on non-accrual status once they
are determined to be impaired or when principal or interest payments are 90 or
more days past due.  Management also considers the financial condition
of the borrower, cash flows of the loan and the value of the related collateral
in determining whether to classify a loan as impaired.  Impaired loans
do not include large groups of smaller balance homogeneous credits such as
residential real estate and consumer installment loans, which we evaluate
collectively for impairment.  During periods of “minimal delay” in
payment (usually ninety days or less), loans specifically reviewed for
impairment are not considered impaired or non-accrual unless eventual collection
of all amounts due is not expected.  Impaired loans are measured based
on the present value of expected future cash flows discounted at the loan’s
effective interest rate.  However, as a practical expedient, we may
measure impairment based on a loan’s observable market price or the fair value
of the collateral if repayment of the loan is
collateral-dependent.  Generally, we measure impairment on such loans
by reference to the fair value of the collateral.  The Company
recognizes cash-basis interest income on its impaired loans if the borrower
demonstrates the ability to make payments, and where payments are past due 90
days or more, collateral is sufficient.  Other impaired loans are
accounted for by the cost-recovery method.  We also provide for
inherent losses arising from unfunded commitments as a separate component of the
provision for credit losses used to fund an allowance included on the balance
sheet in other liabilities.  Such provision relies upon the adjusted
historical loss experience for each loan category, coupled with the likelihood
of draw on the available credit amounts.





Allowance
for credit losses





Based on
the valuation techniques used and the sensitivity of financial statement amounts
to the methods, assumptions and estimates underlying those amounts, management
has identified the determination








64








of the
allowance for credit losses as a critical accounting policy that requires the
most subjective or complex judgments, and, as such, could be most subject to
revision as new information becomes available.





The
allowance for credit losses represents management's best estimate of losses
known and inherent in the loan portfolio that are both probable and reasonable
to estimate, based upon, among other factors: our prior loss experience; current
economic conditions; review of the ongoing financial conditions of borrowers;
and the views of our regulators and consultants who conduct reviews of the
allowance methodology and credit administration.  Determining the
amount of the allowance is considered a critical accounting estimate because it
requires significant estimates, assumptions and judgments.  The loan
portfolio also represents the largest asset type on the consolidated balance
sheets.





The
allowance is established at a prudent level through complex, subjective
evaluations of the collectability of loans.  These evaluations require
significant estimates including the grading of credits according to risk,
collateral valuations, and estimated losses on pools of homogeneous loans based
upon historical loss experience and consideration of current economic trends and
other qualitative factors outlined below, which may be susceptible to
significant change.  Determination of the allowance involves careful
and continuous monitoring of developments and changes in its loan portfolios,
and in the factors that influence their collectability, through a methodology
which includes: (1) the specific allowance for risk-rated credits on an
individual basis; and (2) formula allowances reflecting historical losses, as
adjusted, on pools of homogeneous credits defined either by loan category or by
risk rating.





Management
has significant discretion in making the judgments inherent in the determination
of the provision and allowance for credit losses, including the valuation of
collateral and the assessment of the financial condition of the borrower, and in
establishing allowance percentages and risk ratings.  The
establishment of allowance factors is a continuing exercise and allowance
factors may change over time, resulting in an increase or decrease in the amount
of the provision or allowance based upon the same volume and classification of
loans.





Changes
in allowance factors or in management’s interpretation of those factors will
have a direct impact on the amount of the provision and a corresponding effect
on income and assets.  Also, errors in management’s perception and
assessment of the allowance factors could result in the allowance not being
adequate to cover losses in the portfolio and may result in additional
provisions or charge-offs, which would adversely affect income and
capital.  For additional information regarding the allowance for loan
and lease losses, see the “Allowance for Credit Losses and Credit Risk
Management” section of this financial review.





Investments
available for sale and other equity securities





Marketable
equity securities and debt securities, not classified as held-to-maturity or
trading, are classified as available-for-sale.  Securities
available-for-sale are acquired as part of our asset/liability management
strategy and we may sell such securities in response to changes in interest
rates, loan demand, deposit maturities and/or withdrawals, changes in prepayment
risk and other factors.  Securities available-for-sale are carried at
fair value, with unrealized gains or losses based on the difference between
amortized cost and fair value reported as accumulated other comprehensive
income, a separate component of stockholders' equity, net of deferred
tax.  Realized gains and losses, using the specific identification
method, are included as a separate component of non-interest income. Related
interest and dividends are included in interest income.  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.  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 the fact that management would not have the intent
and ability to hold a security for a period of time sufficient to allow for any
anticipated recovery in fair value or whether we would be required to sell the
securities before anticipated recovery.






65







Income
taxes





We apply
the liability method of accounting for income taxes.  Under the
liability method,


deferred-tax
assets and liabilities are determined based on differences between the financial
statement carrying amounts and the tax bases of existing assets and liabilities
(i.e., temporary differences) and are measured at the enacted rates in effect
when these differences reverse.  Deferred tax assets are subject to
management’s judgment based upon available evidence that future realization is
more likely than not.





Real
estate acquired through foreclosure





We record
foreclosed real estate assets at the lower of cost or estimated fair value, less
selling costs, on their acquisition dates and at the lower of such initial
amount or estimated fair value less selling costs
thereafter.  Estimated fair value is based on many subjective factors,
including location and condition of the property and current economic
conditions, among other things.  Because the calculation of fair value
relies on estimates and judgments relating to inherently uncertain events,
results may differ from our estimates.





Write-downs
at time of acquisition are made through the allowance for credit
losses.  Write-downs subsequent to acquisition are included in our
noninterest expenses, along with operating income, net of related expenses of
such properties.  Gains or losses realized upon disposition are
included in non-interest income.





Recent
Accounting Pronouncements And Developments





Note 1 to
the consolidated financial statements discusses new accounting policies we
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, we discuss the impact of these
changes in the applicable section(s) of this financial review and notes to the
consolidated financial statements.





Risk
Management





The Board
of Directors is the foundation for effective corporate governance and risk
management. The Board demands accountability of management, keeps stockholders'
and other constituencies' interests in focus and fosters a strong internal
control environment. Through its Executive, Asset/Liability and Audit
Committees, the Board actively reviews critical risk positions, including
market, credit, 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
management actively manages risk at the line of business level, supplemented
with corporate-level oversight through the Asset/Liability Committee, the
internal audit process and quality control functions and other risk management
groups within the Company.  This risk management structure is designed
to uncover risk issues through a systematic process, enabling timely and
appropriate action to avoid and mitigate risk. The risk management process
establishes risk limits, and other measurement systems, with a focus on risk
reduction strategies and capital allocation practices.








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





Not
applicable





Item
8.  Financial Statements and Supplementary Data





The
following consolidated financial statements are filed with this
report:






66







Management’s
Report On Internal Control Over Financial Reporting





Report of
Independent Registered Public Accounting Firm





Consolidated
Balance Sheets – December 31, 2009 and 2008





Consolidated
Statements of Operations – For the years ended December 31, 2009 and
2008





Consolidated
Statements of Changes in Stockholders’ Equity – For the years ended December 31,
2009 and 2008





Consolidated
Statements of Cash Flows – For the years ended December 31, 2009 and
2008





Notes to
Consolidated Financial Statements







67





Management’s
Report On Internal Control Over Financial Reporting





The
management of Bay National Corporation (“the Company”) is responsible for
establishing and maintaining adequate internal control over financial reporting.
The internal control over financial reporting has been designed under our
supervision to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of the Company’s consolidated financial
statements for external reporting purposes in accordance with accounting
principles generally accepted in the United States of America.




Management
has conducted an assessment of the effectiveness of the Company’s internal
control over financial reporting as of December 31, 2009, utilizing the
framework established in Internal Control-Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission.  Based on this assessment, management has
determined that the Company’s internal control over financial reporting as of
December 31, 2009 is effective.




Our
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.




Any
internal control system, no matter how well designed, will have inherent
limitations. Therefore, even those systems determined to be effective can
provide only reasonable assurance with respect to financial statement
preparation and presentation. 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.




This
annual report does not include an attestation report of the Company’s registered
public accounting firm regarding internal control over financial
reporting.  Management’s report was not subject to attestation by the
Company’s registered public accounting firm pursuant to temporary rules of the
Securities and Exchange Commission that permit the Company to provide only
management’s report in this annual report.






68




Report
of Independent Registered Public Accounting Firm








Board of
Directors and Stockholders


Bay
National Corporation





We have audited the accompanying
consolidated balance sheets of Bay National Corporation and subsidiary (the
“Company”) as of December 31, 2009 and 2008, and the related consolidated
statements of operations, changes in stockholders’ (deficit) equity, and cash
flows for each of the two years in the period ended December 31,
2009.  The Company’s management is responsible for these consolidated
financial statements.  Our responsibility is to express an opinion on
these financial statements 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 audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement.  The Company is not required to have, nor
were we engaged to perform, an audit of its internal control over financial
reporting.  Our audits included consideration of internal control over
financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company’s internal control over financial
reporting.  Accordingly, we express no such opinion.  An
audit also includes 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, as well as evaluating the
overall financial statement presentation.  We believe that our audits
provide a reasonable basis for our opinion.





In our opinion, the consolidated
financial statements referred to above present fairly, in all material respects,
the financial position of Bay National Corporation and subsidiary as of December
31, 2009 and 2008, and the results of their operations and cash flows for each
of the two years in the period ended December 31, 2009, in conformity with
accounting principles generally accepted in the United States of
America.





The
accompanying consolidated financial statements have been prepared assuming the
Company will continue as a going concern. The Company has experienced recurring
losses from operations.  As discussed in Note 1 to the consolidated
financial statements, the bank subsidiary (the "Bank") is operating under a
Consent Order issued by the Office of Comptroller of the Currency ("OCC"), which
requires management to take a number of actions, including, among other things,
restoring and maintaining its capital levels at amounts that are in excess of
the Company’s current capital levels. Without a waiver by the OCC or amendment
or modification of the Consent Order, the Bank could be subject to further
regulatory enforcement action. These matters raise substantial doubt as to the
Company's ability to continue as a going concern. Management's plan in regard to
these matters is also described in Note 1. The consolidated financial statements
do not include any adjustments that might result from the outcome of these
uncertainties.








/s/
Stegman & Company


Baltimore,
Maryland


March 31,
2010








69




BAY NATIONAL CORPORATION


CONSOLIDATED BALANCE
SHEETS


December
31, 2009 and 2008





2009
            
            
            2008ASSETSCash and due from
      banks
            
            $
            71,152,942
            
            
            $
            7,263,034Federal funds sold and other
      overnight investments
            
            
            942,784
            
            
            
            2,023,478Investment securities available
      for sale (AFS) - at fair value
            
            
            21,128,874
            
            
            
            -Federal Reserve and Federal
      Home Loan Bank Stock
            
            
            1,151,150
            
            
            
            1,239,600Loans held for
    sale
            
            
            415,091
            
            
            
            1,187,954Loans, net of unearned
      fees
            
            
            194,257,496
            
            
            
            247,162,767Total
      Loans
            
            
            194,672,587
            
            
            
            248,350,721Less: Allowance for credit
      losses
            
            
            (9,760,000
            )
            
            
            (5,675,035
            )Loans, net
            
            
            184,912,587
            
            
            
            242,675,686Other real estate owned,
      net
            
            
            2,730,572
            
            
            
            3,873,405Premises and equipment,
      net
            
            
            780,008
            
            
            
            1,151,246Investment in bank owned life
      insurance
            
            
            5,493,032
            
            
            
            5,268,529Income taxes
      receivable
            
            
            643,106
            
            
            
            3,276,739Deferred tax
    asset
            
            
            -
            
            
            
            2,469,000Accrued interest receivable and
      other assets
            
            
            1,408,212
            
            
            
            1,347,271Total Assets
            
            $
            290,343,267
            
            
            $
            270,587,988LIABILITIESNon-interest-bearing
      deposits
            
            $
            53,033,872
            
            
            $
            49,945,354Interest-bearing
      deposits
            
            
            228,469,581
            
            
            
            194,682,678Total deposits
            
            
            281,503,453
            
            
            
            244,628,032Short-term
      borrowings
            
            
            -
            
            
            
            1,864,056Subordinated
      debt
            
            
            8,000,000
            
            
            
            8,000,000Accrued expenses and other
      liabilities
            
            
            1,832,137
            
            
            
            1,073,899Total
    Liabilities
            
            
            291,335,590
            
            
            
            255,565,987STOCKHOLDERS'
      (DEFICIT) EQUITYCommon stock - $.01 par value,
      authorized:20,000,000 shares authorized,
      2,154,301and 2,153,101 issued and outstanding as of December 31, 2009 and
      2008, respectively:
            
            
            21,543
            
            
            
            21,531Additional paid in
      capital
            
            
            17,951,811
            
            
            
            17,954,770Accumulated
    deficit
            
            
            (19,024,608
            )
            
            
            (2,954,300
            )Accumulated other comprehensive
      gain
            
            
            58,931
            
            
            
            -Total Stockholders' (Deficit)
      Equity
            
            
            (992,323
            )
            
            
            15,022,001Total Liabilities and
      Stockholders' (Deficit) Equity
            
            $
            290,343,267
            
            
            $
            270,587,988





See
accompanying notes to consolidated financial statements.






70




BAY NATIONAL CORPORATION


CONSOLIDATED STATEMENTS OF
OPERATIONS


For the
years ended December 31, 2009 and 2008





2009
            
            
            2008INTEREST
      INCOME:Interest and fees on
      loans
            
            $
            11,563,783
            
            
            $
            15,127,186Interest on federal funds sold
      and other overnight investments
            
            
            104,165
            
            
            
            133,615Taxable interest and dividends
      on investment securities
            
            
            375,048
            
            
            
            64,738Total interest
    income
            
            
            12,042,996
            
            
            
            15,325,539INTEREST
      EXPENSE:Interest
      on deposits
            
            
            5,641,612
            
            
            
            5,934,527Interest
      on short-term borrowings
            
            
            2,191
            
            
            
            225,985Interest
      on subordinated debt
            
            
            622,284
            
            
            
            603,039Total
      interest expense
            
            
            6,266,087
            
            
            
            6,763,551Net
      interest income
            
            
            5,776,909
            
            
            
            8,561,988Provision
      for credit losses
            
            
            10,966,430
            
            
            
            6,478,200Net
      interest (loss) income after provision for credit losses
            
            
            (5,189,521
            )
            
            
            2,083,788NON-INTEREST
      INCOME:Service charges on deposit
      accounts
            
            
            318,155
            
            
            
            266,064Gain
      on sale of mortgage loans
            
            
            538,592
            
            
            
            281,029Increase in cash surrender value
      of bank owned life insurance
            
            
            224,503
            
            
            
            226,867Loss on sale of OREO
      properties
            
            
            (239,932
            )
            
            
            (59,688
            )Loss on disposal of furniture
      & equipment
            
            
            (19,181
            )
            
            
            (18,603
            )Other income
            
            
            47,014
            
            
            
            67,666Total non-interest
      income
            
            
            869,151
            
            
            
            763,335NON-INTEREST
      EXPENSE:Salaries and employee
      benefits
            
            
            3,511,712
            
            
            
            6,018,002Occupancy
    expenses
            
            
            644,287
            
            
            
            763,336Furniture and equipment
      expenses
            
            
            434,167
            
            
            
            426,190Legal and professional
      fees
            
            
            761,931
            
            
            
            821,347Data processing and items
      processing
            
            
            821,083
            
            
            
            798,922Outsourcing
      costs
            
            
            873,242
            
            
            
            194,726Advertising
      and marketing related expenses
            
            
            158,697
            
            
            
            509,939Provision for losses on real
      estate acquired through foreclosure
            
            
            734,395
            
            
            
            569,350FDIC insurance
    costs
            
            
            1,129,469
            
            
            
            200,850Loan Collection
      Costs
            
            
            325,259
            
            
            
            200,612Other expenses
            
            
            498,359
            
            
            
            603,132Total non-interest
      expenses
            
            
            9,892,601
            
            
            
            11,106,406Loss
      before income taxes
            
            
            (14,212,971
            )
            
            
            (8,259,283
            )Income
      tax expense (benefit)
            
            
            1,857,337
            
            
            
            (3,194,640
            )Net
      Loss
            
            $
            (16,070,308
            )
            
            $
            (5,064,643
            )Per
      Share Data:Net Loss (Basic)
            
            $
            (7.46
            )
            
            $
            (2.37
            )Net
      Loss (Diluted)
            
            $
            (7.46
            )
            
            $
            (2.37
            )Average
      Shares Outstanding (Basic)
            
            
            2,153,910
            
            
            
            2,140,793Effect
      of dilution – Stock options and warrants
            
            
            -
            
            
            
            -Average
      Shares Outstanding (Diluted)
            
            
            2,153,910
            
            
            
            2,140,793





See
accompanying notes to consolidated financial statements.






71




BAY NATIONAL
CORPORATION


CONSOLIDATED STATEMENTS OF
CHANGES IN STOCKHOLDERS’ (DEFICIT) EQUITY


For the
years ended December 31, 2009 and 2008








Common
      Stock
            
            
            Additional
      Paid in Capital
            
            
            (Accumulated
              Deficit)
      Retained Earnings
            
            
            Accumulated
              Other
      Comprehensive Income
            
            
            TotalBalances
      at January 1, 2008
            
            $
            21,376
            
            
            $
            17,788,833
            
            
            $
            2,110,343
            
            
            $
            -
            
            
            $
            19,920,552Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            (5,064,643
            )
            
            
            -
            
            
            
            (5,064,643
            )Stock-based
      compensation expense
            
            
            -
            
            
            
            75,517
            
            
            
            -
            
            
            
            -
            
            
            
            75,517Issuance
      of common stock
            
            
            66
            
            
            
            67,769
            
            
            
            -
            
            
            
            -
            
            
            
            67,835Issuance
      of stock awards
            
            
            56
            
            
            
            (56
            )
            
            
            -
            
            
            
            -
            
            
            
            -Stock
      options exercised
            
            
            33
            
            
            
            22,707
            
            
            
            -
            
            
            
            -
            
            
            
            22,740Balances
      at December 31, 2008
            
            
            21,531
            
            
            
            17,954,770
            
            
            
            (2,954,300
            )
            
            
            -
            
            
            
            15,022,001Comprehensive
      IncomeNet
      loss
            
            
            -
            
            
            
            -
            
            
            
            (16,070,308
            )
            
            
            -
            
            
            
            (16,070,308
            )Unrealized
      Gain on securities available for sale (net of taxes)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            58,931
            
            
            
            58,931Total
      Comprehensive Income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (16,011,377
            )Net
      Stock-based compensation recovery
            
            
            -
            
            
            
            (2,947
            )
            
            
            -
            
            
            
            -
            
            
            
            (2,947
            )Issuance
      of stock awards
            
            
            12
            
            
            
            (12
            )
            
            
            -
            
            
            
            -
            
            
            
            -Balances
      at December 31, 2009
            
            $
            21,543
            
            
            $
            17,951,811
            
            
            $
            (19,024,608
            )
            
            $
            58,931
            
            
            $
            (992,323
            )








See
accompanying notes to consolidated financial statements.






72




BAY NATIONAL
CORPORATION


CONSOLIDATED STATEMENTS OF
CASH FLOWS


For the
years ended December 31, 2009 and 2008





2009
            
            
            2008Cash
      Flows From Operating Activities:Net
      Loss
            
            $
            (16,070,308
            )
            
            $
            (5,064,643
            )Adjustments to reconcile net
      income to net cash provided by operating activities:Depreciation
            
            
            332,992
            
            
            
            337,368Loss
      on disposal of equipment
            
            
            19,181
            
            
            
            18,603Accretion
      of investment discounts
            
            
            (256
            )
            
            
            (471
            )Amortization of investment
      premiums
            
            
            65,607
            
            
            
            -Provision for credit
      losses
            
            
            10,966,430
            
            
            
            6,478,200Provision
      for losses on real estate acquired through foreclosure
            
            
            734,395
            
            
            
            569,350Loss
      on sale of real estate acquired through foreclosure
            
            
            239,932
            
            
            
            59,688Net
      (decrease) increase stock-based compensation
            
            
            (2,947
            )
            
            
            75,517Increase
      in cash surrender of  bank owned life insurance
            
            
            (224,503
            )
            
            
            (226,867
            )Decrease
      (increase) deferred income taxes
            
            
            2,469,000
            
            
            
            (527,000
            )Decrease (increase) income
      taxes receivable
            
            
            2,633,633
            
            
            
            (2,856,039
            )Gain on sale of loans held for
      sale
            
            
            (538,592
            )
            
            
            (281,029
            )Origination of loans held for
      sale
            
            
            (62,716,223
            )
            
            
            (76,205,941
            )Proceeds from sale of
      loans
            
            
            64,027,679
            
            
            
            86,900,086Net
      (increase) decrease in accrued interest receivable and other
      assets
            
            
            (60,942
            )
            
            
            382,567Net increase (decrease) in
      accrued expenses and other liabilities
            
            
            718,950
            
            
            
            (188,434
            )Net
      cash provided by operating activities
            
            
            2,594,028
            
            
            
            9,470,955Cash
      Flows From Investing Activities:Purchases of investment
      securities available for sale
            
            
            (22,978,411
            )
            
            
            -Redemptions and maturities of
      investment securities available for sale
            
            
            1,882,405
            
            
            
            400,000Redemption
      (purchase) of Federal Reserve Bank stock
            
            
            40,750
            
            
            
            (96,900
            )Redemption
      of Federal Home Loan Bank of Atlanta stock
            
            
            47,700
            
            
            
            572,300Loan
      reduction (increase) in excess of principal payments
            
            
            43,914,409
            
            
            
            (32,178,466
            )Proceeds
      from sale of real estate acquired through foreclosure
            
            
            2,592,246
            
            
            
            5,056,545Expenditures
      for real estate acquired through foreclosure
            
            
            (314,343
            )
            
            
            (44,852
            )Proceeds
      (expenditures) for premises and equipment
            
            
            19,065
            
            
            
            (296,431
            )Net cash provided (used) by
      investing activities
            
            
            25,203,821
            
            
            
            (26,587,804
            )Cash
      Flows From Financing Activities:Net increase in
      deposits
            
            
            36,875,421
            
            
            
            42,646,567Net
      decrease in short-term borrowings
            
            
            (1,864,056
            )
            
            
            (23,507,452
            )Net proceeds from issuance of
      common stock
            
            
            -
            
            
            
            90,575Net cash provided by financing
      activities
            
            
            35,011,365
            
            
            
            19,229,690Net
      increase in cash and cash equivalents
            
            
            62,809,214
            
            
            
            2,112,841Cash
      and cash equivalents at beginning of year
            
            
            9,286,512
            
            
            
            7,173,671Cash
      and cash equivalents at end of year
            
            $
            72,095,726
            
            
            $
            9,286,512





Supplemental
      information:Interest
      paid
            
            $
            5,937,951
            
            
            $
            6,652,564Income
      taxes paid
            
            $
            -
            
            
            $
            353,894Accrued
      director fees paid in common stock
            
            $
            -
            
            
            $
            67,835Amount
      transferred from loans to other real estate owned
            
            $
            2,109,398
            
            
            $
            8,575,010





See
accompanying notes to consolidated financial statements.





73




BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





1.
            SUMMARY
      OF SIGNIFICANT ACCOUNTING POLICIES





The
consolidated financial statements include the accounts of Bay National
Corporation and its subsidiary, Bay National Bank (the “Bank”), collectively
(the “Company”). All significant intercompany balances and transactions have
been eliminated in consolidation. The investment in subsidiary is recorded on
Bay National Corporation’s books on the basis of its equity in the net
assets.  The accounting and reporting policies of the Company conform
to accounting principles generally accepted in the United States of America and
to general practices in the banking industry.





Nature of
Business





Bay
National Corporation is incorporated under the laws of the State of Maryland to
operate as a bank holding company of a national bank with the name Bay National
Bank.  The Company owns all the shares of common stock issued by the
Bank. The Bank is chartered by the Office of the Comptroller of the Currency
(the "OCC") to operate as a national bank. The Bank’s deposit accounts are
eligible to be insured by the Federal Deposit Insurance
Corporation.





The
principal business of the Company is to make loans and other investments and to
accept time and demand deposits.  The Company’s primary market areas
are Baltimore, the Baltimore-Washington corridor and Salisbury, Maryland,
although the Company’s business development efforts generate business outside of
these areas.  The Company offers a broad range of banking products,
including a full line of business and personal savings and checking accounts,
money market demand accounts, CDs and other banking services. The Company funds
a variety of loan types including commercial and residential real estate loans,
commercial term loans and lines of credit, consumer loans and letters of credit.
The Company’s customers are primarily individuals and small
businesses.





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.





OCC Consent
Order





As we
have previously disclosed, on February 6, 2009, pursuant to a Stipulation and
Consent to the Issuance of a Consent Order, the Bank consented to the issuance
of a Consent Order by the OCC, the Bank’s primary regulator.





Among
other things, the order requires the Bank and/or its Board to take certain
actions, including developing and submitting certain written plans to the OCC,
and imposes certain restrictions on the Bank designed to improve its financial
strength, including the following:




·
            within
      30 days provide a written analysis of the Board’s decision whether to
      sell, merge or liquidate the Bank or remain
  independent;


·
            if
      the Board decides the Bank should remain independent and the OCC does not
      object to the written analysis, within 60 days of the Order implement a
      three-year strategic plan for the Bank with respect to certain financial
      objectives;






74




BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008




·
            by
      April 30, 2009 maintain a 12% total risk-based ratio, an 11% Tier 1
      risk-based ratio and a 9% leverage
ratio;


·
            develop
      a three-year capital program that, among other things, assesses current
      and expected funding needs and ensures that sufficient funds or access to
      funds exists to meet those needs;


·
            ensure
      that the Bank has competent management in its credit risk and asset
      liability risk management
functions;


·
            conduct
      management reviews and adopt a written education program for officers as
      necessary;


·
            immediately
      take action to protect the Bank’s interest in assets criticized by the OCC
      and adopt a written program designed to eliminate the basis of such
      criticism;


·
            increase
      liquidity;


·
            establish
      an effective, independent and on-going loan review system within 60 days
      of the Consent Order; and


·
            develop
      written plans to address liquidity improvement, loan portfolio management,
      asset diversification, the Bank’s allowance for loan and lease losses,
      monitoring and review of problem loans and leases, charged-off loans and
      related issues, and monitoring of portfolio
  trends.





In
accordance with the Consent Order, the Board has appointed a compliance
committee to monitor, coordinate and report to the Board on the Bank’s
compliance with the Consent Order.  In addition, under the Consent
Order the Bank may not pay dividends unless it is in compliance with the capital
program required by the Consent Order and applicable regulatory requirements and
receives the OCC’s written non-objection.





The
Bank’s Board and its compliance committee have submitted a written analysis to
the OCC in which the Bank details its decision to remain independent while
continually evaluating other options.





We were
not in compliance with the minimum capital requirements at April 30, 2009 and
our request for an extension for compliance was denied.  As a result,
we are required to develop a contingency plan for the Bank; we believe, however,
that the terms of our previously-disclosed contemplated public offering of
common stock and warrants, if successful, will satisfy the contingency plan
requirement.  We are not in compliance with this portion of the
Consent Order, however, because the OCC has not issued a determination of
no supervisory objection to the strategic plan.





While we
are working to comply with the terms of the Consent Order, we are not currently
in compliance with any of the other requirements of the Consent Order (other
than the requirement to determine whether to sell, merge or liquidate the Bank
or remain independent).









75








BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008




Federal Reserve Board
Enforcement Action / Written Agreement




On April
28, 2009, pursuant to a formal enforcement action by the Federal Reserve Bank of
Richmond, Bay National Corporation entered into a written agreement with the
Reserve Bank (the “Reserve Bank Agreement”).  Pursuant to the Reserve
Bank Agreement, Bay National Corporation agreed to the following:




•    We
may not declare or pay any dividends without the prior written approval of the
Reserve Bank and the Director of the Division of Banking Supervision and
Regulation of the Board of Governors of the Federal Reserve (the
“Director”).




•    We
may not directly or indirectly take dividends or any other form of payment
representing a reduction in capital from the Bank without the Reserve Bank’s
prior written approval.




•    We
(including our nonbank subsidiaries) may not make any distributions of interest,
principal or other sums on subordinated debentures or trust preferred securities
without the prior written approval of the Reserve Bank and the
Director.




•    We
(including our nonbank subsidiaries) may not, directly or indirectly, incur,
increase or guarantee any debt without the Reserve Bank’s prior written
approval.




•    We
(including our nonbank subsidiaries) may not, directly or indirectly, purchase
or redeem any shares of our stock without the Reserve Bank’s prior written
approval.




•    In
appointing any new director or senior executive officer, or changing the
responsibilities of any senior executive officer so that the officer would
assume a different senior executive











76





BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008








officer
position, we will comply with certain notice provisions set forth in the Federal
Deposit Insurance Act and Board of Governors’ Regulations.




•    We
will comply with certain restrictions on indemnification and severance payments
pursuant to the Federal Deposit Insurance Act and FDIC regulations.




•    We
will provide quarterly progress reports to the Reserve Bank.




We are
currently in compliance with all of the terms of the Reserve Bank
Agreement.




Capital Status; Impact on
Operations




As
of December 31, 2009, the Bank became classified as “significantly
undercapitalized” under the Prompt Corrective Action provisions.  As a
result, we are required to submit a capital restoration plan to the OCC
addressing, among other things, the steps the Bank will take to become
adequately capitalized.  We have submitted a capital restoration plan
to the OCC, which is subject to OCC approval.





Under the
capital restoration plan, if approved, the Bank’s Board and executive management
will continue their efforts to raise capital and to follow its strategic plan as
discussed above.  Under the capital restoration plan we anticipate
that we would significantly downsize the Bank and decrease assets including
through efforts to decrease the amount of loans held in our loan portfolio and
redeeming our bank owned life insurance.  We will also attempt to
reduce our expenses.  Going forward in the short- and medium-term we
would focus on attempting to resolve the issues in our loan portfolio, preserve
the remaining capital and, through a decrease in risk-weighted assets, increase
our capital ratios.  The plan requires fewer employees, and more
stringent cost control measures during the stabilization process as no new
business will be brought in and the remaining employees will be dedicated to
improving asset quality and maintaining regulatory compliance while also
ensuring that safe and sound business practices are followed.  These
actions would impact our operating results and financial condition through at
least 2010 and 2011 by reducing our interest revenues and net interest income,
as well as reducing certain categories of expenses.





Notwithstanding
the circumstances described above relating to the Consent Order, the Company
continues actively to market itself, seeking either to be acquired or to obtain
a capital infusion in order to meet the conditions of the Consent
Order.  There can be no assurance that these efforts will be
successful and, as a result of the circumstances described here, there is
substantial doubt concerning the ability of the Company and the Bank to continue
as going concerns for a reasonable period of time.  Without a waiver
by the OCC or amendment or modification of the Consent Order, the Bank would be
subject to further regulatory enforcement action, including, without limitation,
the issuance of additional Consent Orders (which may, among other things,
further restrict the Bank’s business activities), or the placing of the Bank in
conservatorship or receivership, any of which would mitigate against the Bank
and the Company continuing as going concerns.





Cash and Cash
Equivalents





The
Company has included cash and due from banks, and federal funds sold and other
overnight investments as cash and cash equivalents for the purpose of reporting
cash flows.






77




BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





Investments
Available-for-Sale and Other Equity Securities





Marketable
equity securities and debt securities, not classified as held-to-maturity or
trading, are classified as available-for-sale.  Securities
available-for-sale are acquired as part of the Company's asset/liability
management strategy and may be sold in response to changes in interest rates,
loan demand, deposit maturities and/or withdrawals, changes in prepayment risk
and other factors.  Securities available-for-sale are carried at fair
value, with unrealized gains or losses based on the difference between amortized
cost and fair value reported as accumulated other comprehensive income, a
separate component of stockholders' equity, net of deferred
tax.  Realized gains and losses, using the specific identification
method, are included as a separate component of non-interest income. Related
interest and dividends are included in interest income.  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.  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 the fact that management would not have the intent
and ability to hold a security for a period of time sufficient to allow for any
anticipated recovery in fair value or whether we would be required to sell the
securities before anticipated recovery .





Restricted
Stock Investments– The Bank, as member of the Federal Reserve and
Federal Home Loan Bank System, is required to maintain an investment in capital
stock of the Federal Reserve Bank (“FRB”) and Federal Home Loan Bank of Atlanta
(“FHLB”) in varying amounts based on balances of outstanding home loans and on
amounts borrowed from the FHLB.  Because no ready market exists for
this stock and it has no quoted market value, the Bank’s investment in this
stock is carried at cost.





At
December 31, the Company’s investment in restricted stock investments consisted
of:


2009
            
            
            2008Federal
      Reserve Bank stock
            
            $
            663,450
            
            
            $
            704,200Federal
      Home Loan Bank stock
            
            
            487,700
            
            
            
            535,400Total
      investments in other equity securities
            
            $
            1,151,150
            
            
            $
            1,239,600





Loans Held for
Sale





The
Company engages in sales of residential mortgage loans originated by the Bank
and at times, by a third party.  Loans held for sale are carried at
the lower of aggregate cost or fair value. Fair value is derived from secondary
market quotations for similar instruments. Gains and losses on the sale of loans
originated by the Bank are recorded as a component of non-interest income in the
accompanying consolidated statements of operations. No gains or losses are
realized on the sale of loans originated by third parties. The Company's current
practice is to sell loans on a servicing released basis, and, therefore, it has
no intangible asset recorded for the value of such servicing at either December
31, 2009 or December 31, 2008. The Company earns interest on the outstanding
balances of all loans that are held for sale.






78




BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008








Loans





Loans are
stated at the principal amount outstanding net of any deferred fees and
costs.  Interest income on loans is accrued at the contractual rate on
the principal amount outstanding.  It is the Company’s policy to
discontinue the accrual of interest when circumstances indicate that collection
is doubtful.  Loans are returned to accrual status when all principal
and interest amounts contractually due are brought current and future payments
are reasonably assured.  Fees charged and costs capitalized for
originating certain loans are amortized by the interest method over the term of
the loan.





Loans are
considered impaired when, based on current information, it is improbable that we
will collect all principal and interest payments according to contractual terms.
The Bank’s non-accrual and impaired loans comprise the same loans at December
31, 2009.  Generally, loans are placed on non-accrual status once they
are determined to be impaired or when principal or interest payments are 90 or
more days past due.   Management also considers the financial
condition of the borrower, cash flows of the loan and the value of the related
collateral in determining whether to classify a loan as
impaired.  Impaired loans do not include large groups of smaller
balance homogeneous credits such as residential real estate and consumer
installment loans, which we evaluate collectively for
impairment.  During periods of “minimal delay” in payment (usually
ninety days or less), loans specifically reviewed for impairment are not
considered impaired or non-accrual unless eventual collection of all amounts due
is not expected.  Impaired loans are measured based on the present
value of expected future cash flows discounted at the loan’s effective interest
rate.  However, as a practical expedient, we may measure impairment
based on a loan’s observable market price or the fair value of the collateral if
repayment of the loan is collateral-dependent.  Generally, we measure
impairment on such loans by reference to the fair value of the
collateral.  The Company recognizes cash-basis interest income on its
impaired loans if the borrower demonstrates the ability to make payments, and
where payments are past due 90 days or more, collateral is
sufficient.  Other impaired loans are accounted for by the
cost-recovery method.  We also provide for inherent losses arising
from unfunded commitments as a separate component of the provision for credit
losses used to fund an allowance included on the balance sheet in other
liabilities.  Such provision relies upon the adjusted historical loss
experience for each loan category, coupled with the likelihood of draw on the
available credit amounts.





Allowance for Credit
Losses





The
allowance for credit losses (“allowance”) represents an amount which, in
management’s judgment, is adequate to absorb estimated losses on outstanding
loans and leases.  The allowance represents an estimation made
pursuant to Accounting Standards Codification (“ASC”) Topic 450
“Contingencies”.  Loans deemed uncollectible are charged against the
allowance, while recoveries are credited to the allowance.  The
allowance is adjusted through the provision for credit losses, which is recorded
as a current period operating expense.   The allowance is
established at a prudent level through complex, subjective evaluations of the
collectability of loans.  These evaluations require significant
estimates including the grading of credits according to risk, collateral
valuations, and estimated losses on pools of homogeneous loans based upon
historical loss experience and consideration of current economic trends and
other qualitative factors outlined below, which may be susceptible to
significant change.  Determination of the Company’s allowance involves
careful and continuous monitoring of developments and changes in its loan
portfolios, and in the factors that influence their collectability, through a
methodology that includes:  (1) the specific allowance for risk-rated
credits on an individual basis, and (2) formula allowances reflecting historical
losses,








79





BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





as
adjusted, on pools of homogeneous credits defined either by loan category or by
risk rating.





The
specific allowance is used to allocate an allowance for impaired loans as
defined in ASC Topic 310 “Receivables”.  Analysis resulting in
specific allowances on loans identified for evaluation of impairment includes
consideration of the borrower’s overall financial condition, resources and
payment record, support available from financial guarantors, and the sufficiency
of collateral.





The
formula allowances, based upon adjusted historical loss experience, are
established for pools of similar, unimpaired loans that have been segmented by
major loan category or by risk-weighting grade.  The first type of
formula allowance, the Company’s general reserves, is determined by application
of historical loss factors for each loan segment, averaged over the trailing
four quarters, to the respective loan balances.  The second formula
allowance involves loan pools by risk grade of (1) individually evaluated
(classified and special mention) credits not deemed impaired, and (2) pass
credits (those which present no inherent loss) from the Towson loan portfolio,
which has been segregated from the Company’s other portfolios due to perceived
risk warranting careful and continuous evaluation.  The methodology
for this formula allowance utilizes migration analysis to determine the
charge-off percentage applicable to credits in each risk grade over a one-year
time horizon.  Historical loss experience for both formula allowances
is adjusted by factors which address various risk characteristics in the
Company’s loan portfolio including (1) the quality of the Company’s lending
policies and procedures, (2) the experience, ability, and depth of management
and other lending staff, (3) the quality of loan review systems, (4) changes in
the nature and volume of the loan portfolio, (6) changes in trends, volume and
severity of past dues, non-accruals, charge-offs and recoveries, and (7)
national and local economic trends and business conditions.





While
management believes it has established the allowance for credit losses in
accordance with generally accepted accounting principles and has taken into
account the views of its regulators and the current economic environment, there
can be no assurance that in the future the Company’s regulators or the economic
environment will not require further increases in the allowance.





Real Estate Acquired Through
Foreclosure





The
Company records foreclosed real estate assets at the lower of cost or estimated
fair value on their acquisition dates and at the lower of such initial amount or
estimated fair value less selling costs thereafter.  Estimated fair
value is based upon many subjective factors, including location and condition of
the property and current economic conditions, among other
things.   Because the calculation of fair value relies on
estimates and judgments relating to inherently uncertain events, results may
differ from our estimates.





Write-downs
at time of acquisition are made through the allowance for credit
losses.  Subsequent write-downs are included in our noninterest
expenses, along with operating income, net of related expenses of such
properties.  Gains or losses realized upon disposition are included in
non-interest income.





Rate Lock
Commitments





The
Company enters into commitments to originate residential mortgage loans with
interest rates determined prior to funding.  Such rate lock
commitments on mortgage loans to be sold in the secondary market are considered
to be derivatives.  The period of time between issuance of a loan
commitment and








80





BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008








closing
and sale of the loan generally range from 15 to 90 days.  The Company
protects itself from changes in interest rates through the use of best efforts
forward delivery commitments, whereby the Company commits to sell a loan at the
time the borrower commits to an interest rate with the intent that the buyer has
assumed interest rate risk on the loan.  As a result, the Company is
not exposed to losses nor will it realize gains related to its rate lock
commitments due to changes in interest rates.





Premises and
Equipment





Premises
and equipment are stated at cost less accumulated depreciation and amortization
computed using the straight-line method.  Premises and equipment are
depreciated over the useful lives of the assets, except for leasehold
improvements which are amortized over the terms of the respective leases or the
estimated useful lives of the improvements, whichever is
shorter.  Useful lives range from: five to ten years for furniture,
fixtures and equipment; and three to five years for software, hardware and data
handling equipment.  Leasehold improvements are amortized over the
term of the respective lease plus the first optional renewal period, if
applicable.  Maintenance and repairs are charged to expense as
incurred, while improvements, which extend the useful life, are capitalized and
depreciated over the estimated remaining life of the asset.





Long-lived
depreciable 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 based on a quoted market price, if applicable,
or a discounted cash flow analysis.





Bank Owned Life
Insurance





Bank
owned life insurance is carried at the aggregate cash surrender value of life
insurance policies owned where the Company or its subsidiaries are named
beneficiaries.  Increases in cash surrender value derived from
crediting rates for underlying insurance policies are credited to noninterest
income.





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.





Stock-Based
Compensation





Effective
January 1, 2006, the Company adopted FABS’s guidance on “Share-Based Payment,”
for its equity awards vesting after the effective date.  This guidance
was also adopted for shares available for issuance under the Bay National
Corporation 2007 Stock Incentive Plan (the “Incentive Plan”), which was
presented to and approved by the Company’s stockholders and is described in more
detail under Note 7.  This guidance requires an entity to recognize
compensation expense based on an estimate of the number of awards expected








81





BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





to
actually vest, exclusive of awards expected to be forfeited.





Advertising
Costs





Advertising
costs are generally expensed as incurred.





Income
Taxes





The
Company uses the liability method of accounting for income
taxes.  Under the liability method, deferred-tax assets and
liabilities are determined based on differences between the financial statement
carrying amounts and the tax bases of existing assets and liabilities (i.e.,
temporary differences) and are measured at the enacted rates in effect when
these differences reverse.  Deferred tax assets are subject to
management’s judgment based upon available evidence that future realization is
more likely than not.





The
Company adopted FASB guidance on “Accounting for Uncertainty in Income Taxes” as
of January 1, 2007.  A tax position is recognized as a benefit only if
it is “more likely than not” that the tax position would be sustained in a tax
examination presuming that a tax examination will occur.  The amount
recognized is the largest amount of tax benefit that is greater than 50% likely
to be realized on examination.  For tax positions not meeting the
“more likely than not” test, no tax benefit is recorded.  The adoption
had no effect on the Company’s financial statements.  The Company
recognizes interest and /or penalties related to income tax matters in income
tax expense.





Earnings Per
Share





Basic
earnings per common share are computed by dividing net income by the weighted
average number of common shares outstanding during the
period.  Diluted net income per common share is computed by dividing
net income by the weighted average number of common shares outstanding during
the period, including any potential dilutive common shares outstanding such as
options and warrants.





Reclassifications





Certain
reclassifications have been made to amounts previously reported to conform to
the current presentation.  These reclassifications had no effect on
previously reported results of operations or retained earnings.





Recent Accounting
Pronouncements and Developments





Adoption
of New Accounting Standards:





In June
2009, the FASB issued guidance on “The FASB Accounting Standards Codification
and Hierarchy of Generally Accepted Accounting Principles” and established the
FASB Accounting Standards Codification as the source of authoritative accounting
principles in the preparation of financial statements in conformity with
generally accepted accounting principles (“GAAP”).  This guidance also
explicitly recognized rules and interpretive releases of the Securities and
Exchange Commission (“SEC”) under federal securities laws as authoritative GAAP
for SEC registrants.  This guidance was effective for financial





82





BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008








statements
issued for periods ending after September 15, 2009.  The adoption of
this guidance did not have an impact on our consolidated financial
statements.





In May
2009, the FASB issued guidance on “Subsequent Events.” This guidance established
general standards of accounting for and disclosure of events that occur after
the balance sheet date but before financial statements are issued or available
to be issued. This guidance defines (i) the period after the balance sheet date
during which a reporting entity’s management should evaluate events or
transactions that may occur for potential recognition or disclosure in the
financial statements, (ii) the circumstances under which an entity should
recognize events or transactions occurring after the balance sheet date in its
financial statements, and (iii) the disclosures an entity should make about
events or transactions that occurred after the balance sheet
date.  This guidance was effective for the Company’s financial
statements for periods ending after June 15, 2009 and did not have a significant
impact on the Company’s financial statements.





In April
2009, FASB issued guidance on the “Recognition and Presentation of
Other-Than-Temporary Impairments.”  This guidance (i) changes existing
guidance for determining whether an impairment to debt securities is other than
temporary and (ii) replaces the existing requirement that the entity’s
management assert it has both the intent and ability to hold an impaired
security until recovery with a requirement that management assert: (a) it does
not have the intent to sell the security; and (b) it is more likely than not it
will not have to sell the security before recovery of its cost
basis.  Under the Recognition and Presentation of Other
-Than-Temporary Impairments guidance, declines in the fair value of
held-to-maturity and available-for-sale securities below their cost that are
deemed to be other than temporary are reflected in earnings as realized losses
to the extent the impairment is related to credit losses.  The amount
of the impairment related to other factors is recognized in other comprehensive
income.  The Company adopted the provision of the Recognition and
Presentation of Other-Than-Temporary Impairments during the second quarter of
2009 and adoption did not significantly impact the Company’s financial
statements.





In April
2009, the FASB issued guidance on “Determining Fair Value When the Volume and
Level of Activity for Asset or Liability Have Significantly Decreased and
Identifying Transactions That Are Not Orderly.”  This guidance affirms
that the objective of fair value when the market for an asset is not active is
the price that would be received to sell the asset in an orderly transaction,
and clarifies and includes additional factors for determining whether there has
been a significant decrease in market activity for an asset when the market for
that asset is not active.  This guidance requires an entity to base
its conclusion about whether a transaction was not orderly on the weight of the
evidence.  This guidance was effective for periods after June 15, 2009
and did not significantly impact the Company’s financial
statements.





In
December 2008, the FASB issued guidance on the “Disclosures by Public Entities
(Enterprises) about Transfers of Financial Assets and Interests in Variable
Interest Entities.”  This guidance increases disclosure requirements
for public companies and are effective for reporting periods (interim and
annual) that end after December 15, 2008.  The purpose of this
guidance is to promptly improve disclosures by public entities and enterprises
until the pending amendments to FASB guidance on “Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities and
Consolidation of Variable Interest Entities” is finalized by the
Board.  This guidance amends “Statement Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities” to require
public entities to provide additional disclosures about transferors’ continuing
involvement with transferred financial assets.  This guidance also
amends the “Consolidation of Variable Interest Entities” guidance to require
public enterprises,








83





BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





including
sponsors that have a variable interest in a variable interest entity, to provide
additional disclosures about their involvement with variable interest
entities.  This guidance is related to disclosures only and does not
have an impact on our consolidated financial statements.





In August
2008, the FASB issued guidance on “Determining Whether Instruments Granted in
Share-Based Payment Transactions are Participating Securities.”  This
new guidance accounts for unvested share-based payment awards that contain
non-forfeitable rights to dividends or dividend equivalents (whether paid or
unpaid) that are participating securities and shall be included in the
computation of earnings per share pursuant to the two-class
method.  This guidance is effective for financial statements issued
for fiscal years beginning after December 15, 2008.  The Company has
not granted any share-based payment awards with non-forfeitable rights to
dividends or dividend equivalents and therefore, the adoption of this new
standard does not have a material impact on its consolidated financial
statements.





Accounting
pronouncements issued but not yet effective.





All
pending but not yet effective Accounting Standards Updates (“ASU”) were
evaluated and only those listed below could have material impact on the
Company’s financial condition or results of operation.





In June
2009, the FASB issued guidance on “Accounting for Transfers of Financial Assets”
that requires enhanced disclosures about transfer of financial assets and a
company’s continuing involvement in transferred assets.  This guidance
is effective for financial statements issued for fiscal years beginning after
November 15, 2009.  We do not expect the adoption of this guidance to
have any impact on the Company’s disclosure, since we do not engage in transfer
of financial assets.





In June
2009, the FASB issued guidance which 1) replaces the quantitative-based risks
and rewards calculations for determining whether an enterprise is the primary
beneficiary in a variable interest entity with an approach that is primarily
qualitative, 2) requires ongoing assessments of whether an enterprise is the
primary beneficiary of a variable interest entity, and 3) requires additional
disclosure about an enterprise’s involvement in variable interest
entities.  This guidance is effective for financial statements issued
for fiscal years beginning after November 15, 2009.  We do not expect
the adoption of this guidance to have a material impact, if any, on the
Company’s consolidated financial condition or results of operation.





In
January 2010, the FASB issued updated guidance on Fair Value Measurements and
Disclosures (Topic 820).  The update provides amendments to
Subtopic 820-10 that requires new disclosures for transfers in and out of Levels
1 and 2 investment fair value measurement classifications and activity in Level
3 fair value measurements.  In addition, the update amends Subtopic
820-10 to clarify existing disclosure about  both the level of
disaggregation and disclosures about inputs and valuation techniques and inputs
used to measure fair value for Levels 2 and 3 recurring and non-recurring fair
value measurements.  The new disclosures and clarifications of
existing disclosure are effective for interim and annual reporting periods
beginning after December 15, 2009.  The Company does not expect that
the adoption of this guidance will have a material impact on its financial
position, results of operation or cash flows.








84




BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





2.             INVESTMENT SECURITIES AVAILABLE FOR
SALE





Amortized cost and estimated fair
value of securities available for sale as of December 31, 2009 are summarized as
follows:





Amortized
      Cost
            
            
            Gross
      Unrealized Gains
            
            
            Gross
      Unrealized Losses
            
            
            Estimated
      Fair ValueUS
      Government Agency Securities
            
            $
            5,499,732
            
            
            $
            18,678
            
            
            $
            -
            
            
            $
            5,518,410Mortgage-backed
      Securities
            
            
            15,530,924
            
            
            
            92,916
            
            
            
            13,376
            
            
            
            15,610,464Total
      Investment Securities
            
            $
            21,030,656
            
            
            $
            111,594
            
            
            $
            13,376
            
            
            $
            21,128,874








As of
December 31, 2008, there were no investment securities available for
sale.  There were no sales of investments available-for-sale during
2009 and 2008.





Gross
unrealized losses and fair value by length of time that the individual available
securities have been in a continuous unrealized loss position are as
follows:








Less
      than 12 months
            
            
            12
      Months or Greater
            
            
            TotalFair
      Value
            
            
            Unrealized
      Losses
            
            
            Fair
      Value
            
            
            Unrealized
      Losses
            
            
            Fair
      Value
            
            
            UnrealizedLossesMortgage-backed
      Securities
            
            $
            3,133,410
            
            
            $
            13,376
            
            
            $
            -
            
            
            $
            -
            
            
            $
            3,133,410
            
            
            $
            13,376Total
      Investment Securities
            
            $
            3,133,410
            
            
            $
            13,376
            
            
            $
            -
            
            
            $
            -
            
            
            $
            3,133,410
            
            
            $
            13,376








Gross
unrealized losses that exist are the result of changes in market interest rates
since original purchases.   Because the Company does not intend
to sell the investments nor is it more likely than not that the Company will be
required to sell the investments before recovery of their amortized cost basis,
the Company does not consider these investments to be other-than-temporarily
impaired at December 31, 2009. The amounts in the above table are representative
of three securities with gross unrealized loses at December 31,
2009.





Contractual
maturities of debt securities at December 31, 2009 are shown
below.  Actual maturities may differ from contractual maturities
because borrowers have the right to call or prepay obligations with or without
call or prepayment penalties.








85






BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





Amortized
      Cost
            
            
            Estimated
      Fair ValueAvailable
      for Sale:
              Due
      in one year or less
            
            $
            -
            
            
            $
            -Due
      after one year through five years
            
            
            5,499,732
            
            
            
            5,518,410Due
      after five years through ten years
            
            
            -
            
            
            
            -Due
      after ten years
            
            
            -
            
            
            
            -Mortgage-backed
      securities
            
            
            15,530,924
            
            
            
            15,610,464Total
      Investment Securities
            
            $
            21,030,656
            
            
            $
            21,128,874








At
December 31, 2009, investments available-for-sale with a carrying value of
$1,000,000 are pledged as collateral at the Federal Reserve Bank to satisfy
daylight overdrafts requirements.  No investments were pledged as
collateral as of December 31, 2008.






86




BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008




3.     LOANS
AND ALLOWANCE FOR CREDIT LOSSES





Major
loan categories at December 31 are presented below:





2009
            
            
            2008Commercial
            
            $
            89,920,589
            
            
            $
            125,331,210Real
      Estate – Mortgage
            
            
            47,930,244
            
            
            
            50,611,464Real
      Estate – Construction
            
            
            24,937,789
            
            
            
            44,061,253Real
      Estate – Home Equity Line of Credit
            
            
            28,336,499
            
            
            
            23,377,524Loans
      Held for Sale
            
            
            415,091
            
            
            
            1,187,954Consumer
            
            
            3,132,375
            
            
            
            3,781,316Total
      Loans
            
            
            194,672,587
            
            
            
            248,350,721Less:
      Allowance for credit losses
            
            
            (9,760,000
            )
            
            
            (5,675,035
            )Net
      Loans
            
            $
            184,912,587
            
            
            $
            242,675,686








Activity
in the allowance for credit losses for the years ended December 31, 2009 and
2008 is shown below:





2009
            
            
            2008Balance
      at beginning of year
            
            $
            5,675,035
            
            
            $
            5,000,000Provision
      for credit losses
            
            
            10,695,432
            
            
            
            6,478,200Loan
      charge-offsCommercial
            
            
            (1,919,409
            )
            
            
            (107,495
            )Real
      Estate – Mortgage
            
            
            (1,422,123
            )
            
            
            (454,739
            )Real
      Estate - Construction
            
            
            (2,967,029
            )
            
            
            (5,286,406
            )Real
      Estate – Home Equity LineOf
      Credit
            
            
            (231,556
            )
            
            
            (36,572
            )Consumer
            
            
            (160,300
            )
            
            
            -Loan
      recoveriesCommercial
            
            
            47,779
            
            
            
            1,700Real
      Estate - Mortgage
            
            
            9,425
            
            
            
            -Real
      Estate - Construction
            
            
            31,573
            
            
            
            80,347Real
      Estate-Home Equity Line of Credit
            
            
            1,173
            
            
            
            -Net
      charge-offs
            
            
            (6,610,467
            )
            
            
            (5,803,165
            )Balance
      at end of year
            
            $
            9,760,000
            
            
            $
            5,675,035





The
provision for credit losses shown above for 2009 is net of a component providing
$270,994 to cover inherent losses arising from unfunded
commitments.  The resulting allowance for unfunded commitments of the
same amount is included on the balance sheet in other liabilities at December
31, 2009.  There was no provision regarding unfunded commitments
during 2008, and no related allowance on the balance sheet at December 31,
2008.





As of
December 31, 2009, the Company had impaired loans totaling $20.2 million, of
which all were classified as non-accrual loans, none were 90 days or more past
due and still accruing, and $5.4 million








87





BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008








represented
troubled debt restructures.  As of December 31, 2008, the Company had
impaired loans totaling $16.4 million, of which $13.5 million were classified as
non-accrual loans, $2.0 million were 90 days or more past due and still accruing
and $952 thousand represented troubled debt restructures.  Interest
income is being recognized on a cash basis for $7.0 million of loans that are
reported as non-accrual as of December 31, 2009.




Interest
income that would have been recorded under the original terms of non-accrual
loans and the interest actually recognized for the years ended December 31,
are summarized below:




2009
            
            
            2008Interest
      income that would have been recognized
            
            $
            1,677,094
            
            
            $
            1,337,207Interest
      income recognized
            
            
            697,461
            
            
            
            422,714Interest
      income not recognized
            
            $
            979,633
            
            
            $
            916,493




The
following table sets forth information with respect to impaired loans and the
related valuation allowance as of December 31:





2009
            
            
            2008Impaired
      loans with a valuation allowance
            
            $
            11,369,701
            
            
            $
            16,423,327Impaired
      loans with no valuation allowance
            
            
            8,791,091
            
            
            
            -Total
      impaired loans
            
            $
            20,160,792
            
            
            $
            16,423,037Allowance
      for loans related to impaired loans
            
            $
            4,313,265
            
            
            $
            2,903,561Allowance
      for loans related to other than impaired loans
            
            
            5,446,735
            
            
            
            2,771,474Total
      allowance
            
            $
            9,760,000
            
            
            $
            5,675,035Interest
      income on impaired loans on a cash basis
            
            $
            498,866
            
            
            $
            198,249Average
      recorded investment in impaired loans
            
            $
            26,852,239
            
            
            $
            13,672,271




Other
real estate owned totaled $2.7 million at December 31, 2009, and $3.9 million at
December 31, 2008.






88




BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





4.      PREMISES
AND EQUIPMENT





Premises
and equipment at December 31 include the following:





2009
            
            
            2008Furniture
      and equipment
            
            $
            862,300
            
            
            $
            900,263Computer
      hardware and software
            
            
            887,530
            
            
            
            903,076Leasehold
      improvements
            
            
            775,487
            
            
            
            772,7372,525,317
            
            
            
            2,576,076Less
      accumulated depreciation
            
            
            (1,745,309
            )
            
            
            (1,424,830
            )Net
      premises and equipment
            
            $
            780,008
            
            
            $
            1,151,246





The
Company rents office space in four locations under three non-cancelable lease
arrangements.  The initial lease periods are five years and provide
for one or more five-year renewal options.  The lease for the
Salisbury location provides for percentage rent escalations upon
renewal.  The leases for the remaining locations provide for
percentage annual rent escalations.  The lease for the Towson and
Salisbury locations require that the lessee pay certain operating expenses
applicable to the leased space.  Effective December 2009, the
Cambridge monthly rental agreement accounted for as an operating lease has been
terminated.





Rent
expense applicable to operating leases, for the periods ended December 31, was
as follows:





2009
            
            
            2008Minimum
      rentals
            
            $
            618,114
            
            
            $
            607,716Less:
      Sublease rentals
            
            
            (119,345
            )
            
            
            (5,654
            )Net
      rent expense
            
            $
            498,769
            
            
            $
            602,062





At December 31, 2009, future minimum
lease payments under non-cancelable operating leases having an initial term in
excess of one year are as follows:





Years
      ending December 31:2010
            
            $
            424,5302011
            
            
            418,6292012
            
            
            410,7492013
            
            
            404,7162014
      and beyond
            
            
            472,380Total
      minimum lease payments
            
            $
            2,131,004






89




BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





5.       DEPOSITS





The
following table sets forth the composition of the Company's deposits as of
December 31, 2009 and December 31, 2008:





2009
            
            
            2008Demand
      deposits
            
            $
            68,623,282
            
            
            
            24.38
            %
            
            $
            76,115,803
            
            
            
            31.12
            %Savings
            
            
            895,694
            
            
            
            .32
            
            
            
            1,047,533
            
            
            
            0.43Money
      market and sweep
            
            
            15,445,289
            
            
            
            5.49
            
            
            
            23,763,974
            
            
            
            9.71CDs
            
            
            196,539,188
            
            
            
            69.81
            
            
            
            143,700,722
            
            
            
            58.74Total
      deposits
            
            $
            281,503,453
            
            
            
            100.00
            %
            
            $
            244,628,032
            
            
            
            100.00
            %





The
following table sets forth the maturity distribution for the Company's deposits
at December 31, 2009. Some of the deposits may be renewed or withdrawn prior to
maturity. Therefore, the following table should not be used as a forecast of
future cash flows.





Within
      one year
            
            
            One
      to
              three years
            
            
            Three
      to
              five years
            
            
            Over
      five years
            
            
            TotalDemand
      deposits
            
            $
            68,623,282
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            68,623,282Savings
            
            
            895,694
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            895,694Money
      market and sweep
            
            
            15,445,289
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            15,445,289CDs
            
            
            165,744,538
            
            
            
            28,940,846
            
            
            
            1,805,213
            
            
            
            48,591
            
            
            
            196,539,188Total
            
            $
            250,708,803
            
            
            $
            28,940,846
            
            
            $
            1,805,213
            
            
            $
            48,591
            
            
            $
            281,503,453





CDs in
amounts of $100,000 or more and their remaining maturities at December 31 are as
follows:





2009
            
            
            2008Three
      months or less
            
            $
            40,858,760
            
            
            $
            28,115,659Over
      three months through six months
            
            
            44,471,609
            
            
            
            12,962,733Over
      six months through twelve months
            
            
            41,802,576
            
            
            
            32,559,811Over
      twelve months
            
            
            16,597,639
            
            
            
            13,951,518Total
            
            $
            143,730,584
            
            
            $
            87,589,721





Interest
expense on deposits, for the years ended December 31, is as
follows:





2009
            
            
            2008Interest-bearing
      transaction
            
            $
            41,598
            
            
            $
            374,434Savings
      and money market
            
            
            67,673
            
            
            
            767,115Time,
      $100,000 or more
            
            
            3,233,400
            
            
            
            2,724,645Other
      time
            
            
            2,298,941
            
            
            
            2,068,157Total
      interest on deposits
            
            $
            5,641,612
            
            
            $
            5,934,351






90




BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





6.       BORROWINGS





Information relating to short-term
borrowings, as of December 31, 2009 and 2008, is as follows:





Federal
      funds purchased2009
            
            
            2008Amount
            
            
            Rate
            
            
            Amount
            
            
            RateAs
      of year-end
            $
            -
            
            
            -
            %
            $
            1,864,000
            
            
            0.25
            %Average
      for the year
            $
            36,865
            
            
            0.05
            %
            $
            293,981
            
            
            3.32
            %Maximum
      month-end balance
            $
            0
            
            
            
            
            $
            1,938,000





Commercial
      paper2009
            
            
            2008Amount
            
            
            Rate
            
            
            Amount
            
            
            RateAs
      of year-end
            $
            0
            
            
            -
            %
            $
            56
            
            
            -
            %Average
      for the year
            $
            30
            
            
            0.05
            %
            $
            9,122,030
            
            
            1.27
            %Maximum
      month-end balance
            $
            58
            
            
            
            
            $
            14,798,374








Federal
      Home Loan Bank Borrowings2009
            
            
            2008Amount
            
            
            Rate
            
            
            Amount
            
            
            RateAs
      of year-end
            $
            -
            
            
            -
            %
            $
            -
            
            
            -
            %Average
      for the year
            $
            426,849
            
            
            0.52
            %
            $
            3,022,227
            
            
            3.33
            %Maximum
      month-end balance
            $
            0
            
            
            
            
            $
            8,150,000








The
Company had approximately $21.5 million of borrowing capacity with the FHLB of
Atlanta as of December 31, 2008.  This facility was rescinded on
February 13, 2009.  The Company took steps to restore this line of
credit and it was restored to $6.5 million on March 27, 2009. Subsequently, on
April 9, 2009 the available line capacity was reduced to $5.0
million.  On May 14, 2009, the Company received notification that due
to the weak operating results of the Bank for the first quarter of 2009, the
line has again been rescinded.  The Company will continue to take
appropriate steps to identify and arrange for lines of credit from other
sources.





91





BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





Information
relating to subordinated debt as of December 31, 2009 and 2008 is as
follows:





2009
            
            
            2008Amount
            
            
            Rate
            
            
            Amount
            
            
            RateAs
      of year-end
            $
            8,000,000
            
            
            7.20
            %
            $
            8,000,000
            
            
            7.20
            %Average
      for the year
            $
            8,000,000
            
            
            7.78
            %
            $
            8,000,000
            
            
            7.54
            %Maximum
      month-end balance
            $
            8,000,000
            
            
            
            
            $
            8,000,000





On
December 12, 2005, the Company participated in a private placement of $8 million
of fixed interest rate trust preferred securities (the “Trust Preferred
Securities”), through a newly formed Delaware trust subsidiary, Bay National
Capital Trust I (the “Trust”). The Trust was formed for the purpose of issuing
the Trust Preferred Securities and all of its common securities are owned by the
Company.  The Company purchased the common securities from the Trust
for $248,000. In accordance with provisions of FASB’s guidance on “Consolidation
of Variable Interest Entities”, the financial position and results of operations
are not included in the Company’s consolidated financial position and results of
operations.





The Trust
used the proceeds of the sale of the Trust Preferred Securities and common
securities to purchase from the Company the aggregate principal amount of
$8,248,000 of the Company’s Fixed Rate Junior Subordinated Debt Securities Due
2036 (the “Debt Securities”). Like the Trust Preferred Securities, the Debt
Securities bear interest at the fixed annual rate of 7.20% until maturity. The
interest expense on Trust Preferred Securities was $622,283 and $603,039 in 2009
and 2008, respectively.  The Debt Securities mature on February 23,
2036, but may be redeemed at the Company’s option at any time on any February
23, May 23, August 23 or November 23 on or after February 23, 2011, or at any
time upon certain events, such as a change in the regulatory capital treatment
of Debt Securities, the Trust being deemed to be an “investment company” under
the Investment Company Act of 1940, as amended, or the occurrence of certain
adverse tax events.  Except upon the occurrence of the events
described above, which require a redemption premium for redemptions prior to
February 23, 2011, the Company may redeem the Debt Securities at their aggregate
principal amount, plus accrued interest, if any.





Bay
National Corporation was required to retain $1,000,000 of the proceeds from the
Debt Securities for general corporate purposes (which may include making
interest payments on the Debt Securities) until the earlier of (i) the date on
which the retained funds are reduced to zero, or (ii) the date on which Bay
National Bank (or any successor) meets the statutory requirements to pay
dividends of at least $148,464 for each of two consecutive quarters with
positive retained earnings remaining after any such dividend payment. As of
December 31, 2009 and 2008, the Bank could not have paid dividends to Bay
National Corporation without approval from bank regulatory
agencies.





The Debt
Securities are subordinated to the prior payment of other indebtedness of the
Company that, by its terms, is not similarly subordinated.  Although
the Debt Securities are recorded as a liability on the Company’s balance sheet,
for regulatory purposes, the Debt Securities are being treated as Tier 1 or Tier
2 capital under regulatory capital guidelines issued by the FRB.






92




BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008


On
January 6, 2009, the Company provided notice under the indenture for the Debt
Securities dated December 12, 2005 (the “Indenture”) of its election to defer
the interest payment due on February 23, 2009.  In February 2009, the
Company received formal notice from the FRB instructing it to suspend its trust
preferred interest payments.





Under the
terms of the Indenture Company has the right to defer payments of interest on
the Debt Securities for up to 20 consecutive quarterly periods, provided that no
event of default (as defined in the Indenture) has occurred and is continuing at
the time of the deferral.  The Company was not in default with respect
to the Indenture at the time the payments were deferred and such deferral did
not cause an event of default under the Indenture.





During the period in which interest
payments are being deferred, the Company may not, subject to certain exceptions,
(i) declare or pay any dividends or distributions on, or redeem, purchase,
acquire, or make a liquidation payment with respect to, any of its capital
stock, (ii) make any payments on, repay, repurchase or redeem any debt
securities other than those that rank senior to the Debt Securities, or (iii)
make any payment under any guarantees of the Company, other than those that rank
senior to the Company’s guarantee on the capital securities issued by the
Trust.  Interest on the Debt Securities continues to accrue during the
deferral period and interest on the deferred interest also accrues, both of
which must be paid at the end of the deferral period.  Prior to the
expiration of the deferral period, the Company has the right to further defer
interest payments, provided that no deferral period, together with all prior
deferrals, exceed 20 consecutive quarters.





7.      STOCK-BASED
COMPENSATION PLANS





Stock
Options





The Bay
National Corporation 2007 Stock Incentive Plan (the “Incentive Plan”) was
established effective May 22, 2007 and provides for the granting of incentive
stock options intended to comply with the requirements of Section 422 of the
Internal Revenue Code (“incentive stock options”), non-qualified stock options,
stock appreciation rights (“SARs”), restricted or unrestricted stock awards,
awards of phantom stock, performance awards, other stock-based awards, or any
combination of the foregoing (collectively “Awards”).  Awards will be
available for grant to officers, employees and directors of the Company and its
affiliates, including the Bank, except that non-employee directors will not be
eligible to receive awards of incentive stock options.




The
Incentive Plan authorizes the issuance of up to 200,000 shares of common stock
plus any shares that were available under the Company’s 2001 Stock Option Plan
(“Option Plan”) that terminated as of May 22, 2007 and shares subject to options
granted under the Option Plan that expire or terminate without having been fully
exercised.  The Incentive Plan has a term of ten years, and is
administered by the Compensation Committee of the Board of Directors. The
Compensation Committee consists of at least three non-employee directors
appointed by the Board of Directors. In general, the options have an exercise
price equal to 100% of the fair market value of the common stock on the date of
the grant.  As of December 31, 2009, ten Awards granted under the
Incentive Plan remain outstanding.  Nine of these Awards are stock
option grants issued in 2002 representing 88,548 shares and average exercise
price of $7.04, and will expire by December 31, 2010.  The remaining
one Award represent restricted stock awards and is discussed in more detail
below in the section entitled “Restricted Stock Units.”






93




BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008


Effective
January 1, 2006 the Company adopted FASB’s guidance for the “Accounting for
Stock-Based Compensation” and has included the stock-based employee compensation
cost in its income statements for the years ended December 31, 2009 and
2008.  Amounts recognized in the financial statements with respect to
stock-based compensation are as follows:





2009
            
            
            2008Amounts
      (recovered from) charged against expense, before tax
    benefit
            
            $
            (2,947
            )
            
            $
            75,517Amount
      of related income tax benefit recognized in income
            
            $
            0
            
            
            $
            13,812


The
following is a summary of changes in shares under options for the years ended
December 31, 2009 and 2008:





Number
      of Shares
            
            
            Weighted
      Average
              Exercise
      PriceBalance,
      January 1, 2008
            
            
            138,741
            
            
            $
            6.99Granted
            
            
            -
            
            
            
            -Cancelled
            
            
            -
            
            
            
            -Exercised
            
            
            (3,300
            )
            
            $
            6.89Balance,
      January 1, 2009
            
            
            135,441
            
            
            $
            6.99Granted
            
            
            -
            
            
            
            -Cancelled
            
            
            (46,893
            )
            
            
            6.89Exercised
            
            
            -
            
            
            
            -Balance,
      December 31, 2009
            
            
            88,548
            
            
            $
            7.04Weighted
      average fair value of options granted during 2002
            
            $
            2.77






94




BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





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





Options
      Outstanding
            
            
            Options
      ExercisableRange
      of Exercise Price
            
            Number
            
            Weighted
      Average Remaining Contractual Life
              (in
      years)
            
            Weighted
      Average Exercise Price
            
            
            Number
            
            Weighted
      Average Exercise Price$6.89
            
            70,052
            
            1
            
            $6.89
            
            
            70,052
            
            $6.89$7.61
            
            18,496
            
            1
            
            $7.61
            
            
            18,496
            
            $7.6188,548
            
            
            
            $7.04
            
            
            88,548
            
            $7.04





Based
upon a closing stock price of $1.20 per share as of December 31, 2009, there was
no aggregate intrinsic value in options outstanding and
exercisable.





All
options were fully vested as of December 31, 2008 and 2009.








Restricted Stock
Units





Based on the 2007 grants, 7,200 shares
of the Company’s common stock awarded to three employees remained unvested as of
December 31, 2008. Three of these awards vest 20% on each anniversary of the
employee’s hiring date over 5 years and the remaining grant vests 25% on each
anniversary of the employee’s hiring date over 4 years.  During 2009,
these recipients were no longer employed with the Company and their unvested
grants, totaling 7,200 shares, were forfeited during the first quarter of
2009.





At
December 31, 2008, a total of 6,000 shares of the 2008 grants of the Company’s
common stock had been awarded to two employees remained
unvested.  These awards vest 20% on each anniversary of the employee’s
hiring date over 5 years.  One recipient of the awards granted during
2008 is no longer employed with the Company.  As such, their unvested
grants, totaling 2,400 shares, were forfeited during the first quarter of
2009.    The remaining 2,400 shares awarded to one employee
remained unvested as of December 31, 2009.





The
Company incurred compensation net (recovery)/expense of ($2,947) and $70,891
associated with restricted stock for the years ended December 31, 2009 and 2008,
respectively.  The unrecognized compensation cost related to
restricted stock was $18,306 at December 31, 2009 based upon a weighted average
fair value of $10.17 and will be recognized ratably through April
2013  based on the vesting schedule of the awards.





The 2009
recovery of stock-based compensation was associated with the forfeiture of
restricted stock units.  The Company assumed a zero percent forfeiture
rate on the grant date.












95




BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008


Number
      of Shares
            
            
            Weighted
      Average Fair Value
              at
      Grant DateUnvested
      grants at January 1, 2009
            
            
            13,200
            
            
            $
            13.24Granted
            
            
            -
            
            
            
            -Vested
            
            
            (1,200
            )
            
            
            10.21Cancelled
            
            
            (9,600
            )
            
            
            14.38Unvested
      grants at December 31, 2009
            
            
            2,400
            
            
            $
            10.17





8.       RETIREMENT
PLAN





The
Company has a 401(k) profit sharing plan covering substantially all full-time
employees. During 2009, the Company continued to match 25% of employee
contributions of up to 3% of compensation as defined under the plan for the
year.  The Company has also elected to make a safe harbor contribution
to the plan on behalf of all eligible employees, as defined under the plan for
the year 2009.  The safe harbor contribution is equal to 3% of
compensation as defined under the plan. The plan permits additional
contributions at the discretion of management.  Expenses under this plan
totaled $117,890 and $187,334 for the years ended December 31, 2009 and
2008, respectively.  Beginning January 1, 2010, the trustees have elected
to suspend the matching contributions of the Company’s 401(k) profit sharing
plan and defer the decision to make the 3% non elective safe harbor contribution
until December 1, 2010.





9.      INCOME
TAXES





For the
year ended December 31, 2009, the Company recorded an income tax expense of
$1,857,337 compared to income tax benefit of $3,194,640 for the year ended
December 31, 2008.  The increase in expense is due to a write-down in
the carrying value of deferred tax assets of $7,548,000 due to the uncertainty
that these future tax benefits will be realized.





At
December 31, 2009, the Company has approximately $3.3 million of cumulative
Maryland pre-tax net operating loss carryforward, which represents a possible
net tax receivable of $273,000 for the unconsolidated state tax return for Bay
National Corporation.  There is a valuation allowance against 100% of
the receivable since it cannot be determined that this will be
realized.  Unless Bay National Corporation generates income from its
own operations (i.e., unrelated to Bay National Bank), these net operating loss
carryforwards will begin to expire in 2019.





At
December 31, 2009, the Company has approximately $9.2 million of cumulative
pre-tax net operating loss carryforward, which represents a possible net tax
receivable of $2.7 million for the consolidated Federal tax
return.  At December 31, 2009, the Company has $10.0 million of
cumulative pre-tax net operating loss carryforward and $939,000 tax receivable
for the state tax return of Bay National Bank.  There is a valuation
allowance against 100% of the entire federal and state deferred tax asset
balance since it








96





BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





cannot be
determined that this will be realized.  Unless Bay National
Corporation generates consolidated income, these net operating loss
carryforwards will begin to expire in 2019.





Also at
December 31, 2009, the Company has a combined federal and state tax receivable
of $643,106 which can be recovered immediately upon the filing of amended prior
year income tax returns that reflect the carryback of the 2009 net operating
loss.





Federal
and state income tax (benefit) expense consists of the following for the periods
ended December 31:





2009
            
            
            2008Current
      federal income tax
            
            $
            (502,552
            )
            
            $
            (2,184,547
            )Current
      state income tax
            
            
            (140,554
            )
            
            
            (483,093
            )Deferred
      federal income tax (benefit) expense
            
            
            2,019,844
            
            
            
            (453,000
            )Deferred
      state income tax (benefit) expense
            
            
            480,599
            
            
            
            (74,000
            )Total
      income tax (benefit) expense
            
            $
            1,857,337
            
            
            $
            (3,194,640
            )





The
following table is a summary of the tax effect of temporary differences that
give rise to a significant portion of deferred tax assets:





Deferred
      tax assets:
            
            2009
            
            
            2008Net
      operating loss carryforwards
            
            $
            3,640,000
            
            
            $
            248,000Alternative
      Minimum Tax credit carryforward
            
            
            147,000
            
            
            
            147,000Interest on nonaccrual loans
            
            
            474,000
            
            
            
            325,000Contributions
            
            
            -
            
            
            
            1,000Stock
      based compensation
            
            
            37,000
            
            
            
            39,000Allowance
      for real estate acquired through foreclosure
            
            
            318,000
            
            
            
            255,000Allowance
      for credit losses
              Reserve
      for unfunded commitments
              Depreciation
      and amortization
            
            
            3,099,000
              107,000
              20,000
            
            
            
            1,747,000
              -
              -Other
            
            
            -
            
            
            
            24,000Total
      deferred tax assets
            
            
            7,842,000
            
            
            
            2,786,000Less
      valuation allowance
            
            
            (7,796,000
            )
            
            
            (248,000
            )Deferred
      tax assets, net of valuation allowance
            
            
            46,000
            
            
            
            2,538,000Deferred
      tax liabilities:Depreciation
      and amortization
            
            
            -
            
            
            
            (1,000
            )Deferred
      loan fees and costs, net
            
            
            (46,000
            )
            
            
            (68,000
            )Net
      deferred tax assets
            
            $
            -
            
            
            $
            2,469,000





For the
year ended December 31, 2008, the Company recorded a current income tax benefit
of $2,667,640. The 2008 benefit was increased by the recognition of a deferred
tax benefit of $527,000, resulting in total tax benefit of $3,194,640 for the
year ended December 31, 2008.





Reported
income tax (benefit) expense differed from the amounts computed by applying the
U.S. federal statutory income tax rate of 34% to income before income taxes as
follows:






97




BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





2009
            
            
            2008Amount
            
            Percentage
      of Pretax Income
            
            
            Amount
            
            Percentage
      of Pretax IncomeFederal
      income tax expense computed at the statutory rate
            $
            (4,832,410
            )
            (34.00
            )%
            $
            (2,808,156
            )
            (34.00
            )%State
      income tax benefit, net
            
            (785,507
            )
            (5.53
            )
            
            (422,538
            )
            (5.12
            )Nondeductible
      expenses
            
            3,832
            
            0.03
            
            
            16,188
            
            0.20Non-taxable
      income
            
            (76,331
            )
            (0.54
            )
            
            (77,135
            )
            (0.93
            )Other
            
            -
            
            -
            
            
            41,031
            
            0.50Adjustment
      to valuation allowance
            
            7,547,753
            
            53.10
            
            
            55,970
            
            0.68Income
      tax (benefit) expense, as reported
            $
            1,857,337
            
            13.06
            %
            $
            (3,194,640
            )
            (38.67
            )%








10.         RELATED
PARTY TRANSACTIONS





Certain
directors and executive officers have loan transactions with the Company. Such
loans were made in the ordinary course of business on substantially the same
terms, including interest rates and collateral, as those prevailing at the time
for comparable transactions with outsiders. The following schedule summarizes
changes in amounts of loans outstanding, both direct and indirect, to these
persons during 2009 and 2008.





2009
            
            
            2008Balance
      at beginning of period
            
            $
            11,809,372
            
            
            $
            13,520,043Additions
            
            
            12,802,441
            
            
            
            31,430,692Repayments
            
            
            (15,837,183
            )
            
            
            (33,141,363
            )Balance
      at December 31
            
            $
            8,774,631
            
            
            $
            11,809,372





An
individual, who was a director of the Company from 2003 until May 2008, is an
executive officer of the company which owns an office building in which the
Company had leased space under two separate operating leases.  The
leases were effectively combined during 2004 and extended to February 28,
2010.  Bay National Corporation has extended the leases for one
additional five-year term, to February 28, 2015. Rent expense under this lease
was $379,802 and $368,740 for the periods ended December 31, 2009 and 2008. The
Company has another lease agreement with another director for the Salisbury
facility and is operating under a month to month arrangement with a 12-month
notice period for termination.  The rent expense under this lease was
$29,063 and $27,500 for periods ending December 31, 2009 and 2008,
respectively.  Management believes that the terms of the foregoing
leases are no more and no less favorable to Bay National Bank than those which
could have been received from unaffiliated parties.





11.       
FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK





The
Company is a party to financial instruments with off-balance sheet risk in the
normal course of business.  These financial instruments may include
commitments to extend credit, standby letters of credit and purchase
commitments.  The Company uses these financial instruments to meet the
financing needs of its customers.  Financial instruments involve, to
varying degrees, elements of credit, interest rate and liquidity








98





BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





risk.  These
do not represent unusual risks and management does not anticipate any losses
which would have a material effect on the accompanying financial
statements.





Outstanding
loan commitments and lines and letters of credit at December 31 are as
follows:





2009
            
            2008Loan
      commitments
            $
            9,445,010
            $
            14,981,584Unused
      lines of credit
            
            48,046,982
            
            84,495,398Standby
      letters of credit
            
            1,431,747
            
            2,924,671





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.  The Company
generally requires collateral to support financial instruments with credit risk
on the same basis as it does for on-balance sheet instruments.  The
collateral is based on management's credit evaluation of the counter
party.  Commitments generally have fixed expiration dates or other
termination clauses and may require payment of a fee.  Since many of
the commitments are expected to expire without being drawn upon, the total
commitment amount does not necessarily represent future cash
requirements.  Each customer's credit-worthiness is evaluated on a
case-by-case basis.





Standby
letters of credit are conditional commitments issued to guarantee the
performance of a customer to a third party.  The credit risk involved
in issuing letters of credit is essentially the same as that involved in
extending loan facilities to customers.








12.  REGULATORY
MATTERS





As of
December 31, 2009, the Company was required to maintain a weekly average of
$25,000 of non-interest-bearing deposits with the Federal Reserve Bank
“(FRB”).  As of December 31, 2008, the Company was required to
maintain a weekly average of $25,000 of non-interest-bearing deposits with the
FRB.  The average weekly balance maintained with the FRB for the
weekly period ending December 31, 2009 was $58.4 million.  The average
weekly balance maintained with the FRB for the weekly period ending December 31,
2008 was $3.4 million. The actual balances maintained with the FRB at December
31, 2009 and December 31, 2008 was $70.8 million and $6.8 million,
respectively.  Since the Bank uses its operating account with the FRB
for its daily clearing activities, during 2009 the FRB instituted a requirement
that we pledge collateral with a value of $6.2 million to cover possible
daylight overdrafts.  At December 31, 2009, the Bank has pledged $1.0
million of investment securities and a pool of loans receivable from customers
with an aggregate value of not less than $5.5 million as
collateral.








The
Company and the Bank are subject to various regulatory capital requirements
administered by 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 and the Bank's financial
statements.  Under capital adequacy guidelines and the regulatory
framework for prompt corrective action, the Bank must meet specific capital
guidelines that involve quantitative measures of the Bank's assets, liabilities
and certain off-balance sheet items as calculated under regulatory accounting
practices.  The Bank's capital amounts and classification are also
subject to qualitative








99





BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008








judgments
by the regulators about components, risk weightings and other
factors.





Quantitative
measures established by regulation to ensure capital adequacy require the Bank
to maintain amounts and ratios (set forth in the table below) of total and Tier
I capital (as defined in the regulations) to risk-weighted assets (as defined)
and Tier I capital (as defined) to average assets (as defined).





As of
December 31, 2009, the Bank has been categorized as “significantly
undercapitalized” by the OCC under the regulatory framework for prompt
corrective action. To be categorized as adequately capitalized, the Bank must
increase its total risk-based, Tier I risk-based and Tier I leverage ratios
accordingly. Without an increase in capital, management believes that if there
is another significant operating loss in the first quarter of 2010, it is
possible that with the filing of the next call report on April 30, 2010, the
Bank could fall to the “critically undercapitalized”category.





The
Bank’s actual capital amounts and ratios as of December 31, 2009 and 2008 are
presented in the following tables:





December
      31, 2009Actual
            
            
            For
      Capital
              Adequacy
      Purpose
            
            
            To
      Be Well
              Capitalized
      Under
              Prompt
      Corrective
              Action
      ProvisionsAmount
            
            Ratio
            
            
            Amount
            
            Ratio
            
            
            Amount
            
            RatioTotal
      Capital (to Risk Weighted Assets)*:
            $
            10,064,000
            
            4.90
            %
            $
            16,420,000
            
            8.00
            %
            $
            20,525,000
            
            10.00
            %Tier
      I Capital (to Risk Weighted Assets)*:
            
            7,406,000
            
            3.61
            %
            
            8,210,000
            
            4.00
            %
            
            12,315,000
            
            6.00
            %Tier
      I Capital (to Average Assets)*:
            
            7,406,000
            
            2.47
            %
            
            9,013,000
            
            3.00
            %
            
            15,021,000
            
            5.00
            %*In
      order to be in compliance with the terms of the Consent Order, the Bank
      must meet minimum Total Capital, Tier 1 Capital  (to Risk
      Weighted Assets) and Tier 1 Capital (to Average Assets) ratios of 12.00%,
      11.00% and 9.00%, respectively.





December
      31, 2008Actual
            
            
            For
      Capital
              Adequacy
      Purpose
            
            
            To
      Be Well
              Capitalized
      Under
              Prompt
      Corrective
              Action
      ProvisionsAmount
            
            Ratio
            
            
            Amount
            
            Ratio
            
            
            Amount
            
            RatioTotal
      Capital (to Risk Weighted Assets):
            $
            26,322,000
            
            9.57
            %
            $
            22,001,000
            
            8.00
            %
            $
            27,501,000
            
            10.00
            %Tier
      I Capital (to Risk Weighted Assets):
            
            22,857,000
            
            8.31
            %
            
            11,000,000
            
            4.00
            %
            
            16,501,000
            
            6.00
            %Tier
      I Capital (to Average Assets):
            
            22,857,000
            
            8.31
            %
            
            8,255,000
            
            3.00
            %
            
            13,758,000
            
            5.00
            %





Banking
regulations also limit the amount of dividends that may be paid without prior
approval of the Bank's regulatory agencies.  Regulatory approval is
required to pay dividends that exceed the Bank’s net profits for the current
year, plus its retained net profits for the preceding two
years.  Under the terms of the February 6, 2009 Consent Order, the
Bank may not pay dividends unless it is in compliance with the capital program
required by the Order and applicable regulatory requirements and receives the
OCC’s written non-objection.






100




BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008


In
addition, in February 2009, Bay National Corporation received notice from the
Federal Reserve Bank of Richmond that it is expected to immediately terminate
future dividend payments, including payments on trust preferred
securities.  This order will remain in effect until Bay National
Corporation receives written approval from the Reserve Bank to resume such
payments.








13.       FAIR
VALUE OF FINANCIAL INSTRUMENTS





Effective
January 1, 2008, the Company adopted the FASB’s guidance on the accounting for
fair value measurements which defines fair value, establishes a framework for
measuring fair value in generally accepted accounting principles and expands
disclosures about fair value measurements.  In accordance with the
FASB’s literature, the Company must apply this guidance whenever other standards
require (or permit) assets or liabilities to be measured at fair value but it
does not expand the use of fair value in any new circumstances.  In
this standard, the FASB clarifies the principle that fair value should be based
on the assumptions that market participants would use when pricing the asset or
liability.  In support of this principle, the FASB’s guidance
establishes a fair value hierarchy that prioritizes the information used to
develop those assumptions. The fair value hierarchy is as follows:





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 and 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.





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
applicable.  If quoted prices are not available, fair value is
measured using independent pricing models or other model-based valuation
techniques such as present value of future cash flows, adjusted for the
security’s credit rating, prepayment assumptions and other factors such as
credit loss assumption.  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







101




BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





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, if appropriate, a specific
allowance for credit loss is established.  Loans for which it is
probable that payment of interest and principal will not be made in accordance
with the contractual terms of the loan are considered impaired.  Once
a loan is identified as individually impaired, management measures impairment in
accordance with FASB’s guidance for accounting by creditors for the impairment
of a loan.  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.  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.  At December 31, 2009, essentially all of the impaired
loans were evaluated based upon the fair value of the collateral.  In
accordance with FASB’s guidance, impaired loans where an allowance is
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 measures
and 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 measures and records the loan as nonrecurring Level
3.





Assets
and Liabilities Recorded at Fair Value on a Recurring Basis





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





(in
      thousands)
            
            Carrying
      Value
              (Fair
      Value)
            
            
            Quoted
      Prices
              (Level
      1)
            
            
            Significant
      Other Observable Inputs
              (Level
      2)
            
            
            Significant
      Other Unobservable Inputs
              (Level
      3)Investment
      securities available for sale
            
            $
            21,129
            
            
            $
            -
            
            
            $
            21,129
            
            
            $
            -Total
      assets measured on a recurring basis at fair value
            
            $
            21,219
            
            
            $
            -
            
            
            $
            21,129
            
            
            $
            -




The value
of other real estate owned (“OREO”) property is determined at the time of
foreclosure and generally is based upon the lower of cost or net realizable
value (as determined by third party real estate appraisals) less the estimated
cost of disposal.  Also at the time of foreclosure, the excess (if
any) of the carrying value of the underlying loan receivable over the net
realizable value is charged-off before transferring the remaining balance from
loan receivable into OREO.





On a
nonrecurring basis, the Company may be required to measure certain assets at
fair value in accordance with generally accepted accounting
principles.  These adjustments usually result from application of
lower-of-cost-or-market accounting or write-downs of specific
assets.






102




BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008


The
following table includes the assets measured at fair value on a nonrecurring
basis as of December 31, 2009:


(in
      thousands)
            
            Carrying
      Value (Fair Value)
            
            
            Quoted
      Prices (Level 1)
            
            
            Significant
      Other Observable Inputs (Level 2)
            
            
            Significant
      Other Unobservable inputs (Level 3)Impaired
      Loans
            
            $
            15,848
            
            
            $
            -
            
            
            $
            -
            
            
            $
            15,848Real
      estate acquired through foreclosure
            
            
            2,730
            
            
            
            -
            
            
            
            2,730
            
            
            
            -Total
      assets measured on a non-recurring basis at fair value
            
            $
            18,578
            
            
            $
            -
            
            
            $
            2,730
            
            
            $
            15,848








In
accordance with FASB’s guidance for the “Accounting by Creditors for Impairment
of a Loan” impaired loans totaling $20.2 million were written down to their fair
value of $15.8 million resulting in an impairment charge of $4.4 million that
was included in the allowance for credit losses.





Impaired
loans are evaluated and valued at the time the loan is identified as impaired,
at the lower of cost or market value.  Market value is measured based
upon the value of the collateral securing these loans and is classified at a
level 3 in the fair value hierarchy.  Collateral may be real estate
and/or business assets including equipment, inventory and/or accounts
receivable.  The value of real estate collateral is determined based
on appraisals by qualified licensed appraisers hired by the
Company.  The value of business equipment, inventory and accounts
receivable collateral is based on the net book value on the business’ financial
statements and, if necessary, is discounted based on management’s review and
analysis.  Appraised values are discounted for a “bank-sale” situation
along with the age of the underlying appraisal to better reflect current
economic conditions, and for selling and collection costs.  Impaired
loans are reviewed and evaluated on at least a quarterly basis for additional
impairment and adjusted accordingly, based on the same factors identified
above.





The
Company discloses fair value information about financial instruments, for which
it is practicable to estimate the value, whether or not such financial
instruments are recognized on the balance sheet.  Financial
instruments have been defined broadly to encompass 99.2% of the Company's assets
and 100% of its liabilities.  Fair value is the amount at which a
financial instrument could be exchanged in a current transaction between willing
parties, other than in a forced sale or liquidation, and is best evidenced by a
quoted market price, if one exists.





Quoted
market prices, where available, are shown as estimates of fair market
values.  Because no quoted market prices are available for a
significant part of the Company's financial instruments, the fair values of such
instruments have been derived based on the amount and timing of future cash
flows and estimated discount rates.





Present
value techniques used in estimating the fair value of many of the Company's
financial instruments are significantly affected by the assumptions
used.  In that regard, the derived fair value estimates cannot be
substantiated by comparison to independent markets and, in many cases, could not
be realized in





103





BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





immediate
cash settlement of the instrument.  Additionally, the accompanying
estimates of fair values are only representative of the fair values of the
individual financial assets and liabilities and should not be considered an
indication of the fair value of the Company.





The
following disclosure of estimated fair values of the Company's financial
instruments at December 31 are made in accordance with the requirements of
FASB’s guidance Fair Value Measurements and Disclosure and are as
follows:





2009
            
            2008Estimated
            
            
            
            
            
            EstimatedCarrying
            
            
            Fair
            
            
            Carrying
            
            
            FairAmount
            
            Value
            
            Amount
            
            ValueFinancial
      AssetsCash
      and temporary investments (1)
            
            $
            72,095,726
            
            
            $
            72,095,726
            
            
            $
            9,286,512
            
            
            $
            9,286,512Investments
      available-for-sale
            
            
            21,128,874
            
            
            
            21,128,874
            
            
            
            -
            
            
            
            -FRB
      and FHLB Stock
            
            
            1,151,150
            
            
            
            1,151,150
            
            
            
            1,239,600
            
            
            
            1,239,600Bank
      owned life insurance
            
            
            5,493,032
            
            
            
            5,493,032
            
            
            
            5,268,529
            
            
            
            5,268,529Loans,
      net of allowances (2)
            
            
            184,912,587
            
            
            
            186,009,737
            
            
            
            242,675,686
            
            
            
            244,909,172Accrued
      interest receivable and other assets (3)
            
            
            2,051,318
            
            
            
            2,051,318
            
            
            
            7,093,010
            
            
            
            7,093,010Financial
      LiabilitiesDeposits
            
            $
            281,503,453
            
            
            $
            282,083,701
            
            
            $
            244,628,032
            
            
            $
            245,085,887Short-term
      borrowings
            
            
            -
            
            
            
            -
            
            
            
            1,864,056
            
            
            
            1,864,056Subordinated
      debt
            
            
            8,000,000
            
            
            
            6,453,000
            
            
            
            8,000,000
            
            
            
            5,796,000Accrued
      interest payable and other liabilities (3)
            
            
            1,832,137
            
            
            
            1,832,137
            
            
            
            1,073,899
            
            
            
            1,073,899





(1)
            Temporary
      investments include federal funds sold and overnight
      investments.


(2)
            Loans,
      net of allowances, include loans held for
sale.


(3)
            Only
      financial instruments as defined in FASB guidance on the “Disclosure about
      Fair Value of Financial Instruments,” are included in other assets and
      other liabilities.





The
following methods and assumptions were used to estimate the fair value of each
category of financial instruments for which it is practicable to estimate that
value:





Cash and due from banks, federal
funds sold and overnight investments.  The carrying amount
approximated the fair value.





Investment Securities.The
fair value for U.S. Government Agency and Mortgage-backed securities was based
upon quoted market bids.





Other equity securities.The
fair values of Federal Reserve Bank and Federal Home Loan Bank (“FHLB”) of
Atlanta stock are not readily determinable since these stocks are restricted as
to marketability.




104




BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





Loans.  The fair
value was estimated by computing the discounted value of estimated cash flows,
adjusted for potential credit losses, for pools of loans having similar
characteristics. The discount rate was based upon the current loan origination
rate for a similar loan. Non-performing loans have an assumed interest rate of
0%.  The carrying amount for residential mortgage loans held for sale
approximated the fair value due to the fact, historically; the loans held for
sale have been sold within 60 days of the origination date.





Bank owned life
insurance.The carrying amount approximated the fair value due
to the variable interest rate.





Accrued interest receivable.The carrying amount approximated the fair value of accrued interest,
considering the short-term nature of the receivable and its expected
collection.





Other assets. The carrying
amount approximated the fair value.





Deposit
liabilities.  The fair value of demand, money market savings
and regular savings deposits, which have no stated maturity, were considered
equal to their carrying amount, representing the amount payable on
demand.  These estimated fair values do not include the intangible
value of core deposit relationships, which comprise a significant portion of the
Bank’s deposit base.  Management believes that the Bank’s core deposit
relationships provide a relatively stable, low-cost funding source that has a
substantial intangible value separate from the value of the deposit
balances.





The fair
value of time deposits was based upon the discounted value of contractual cash
flows at current rates for deposits of similar remaining maturity.





Short-term borrowings.The
carrying amount approximated the fair value due to their variable interest
rates.





Subordinated Debt.Fair values
were calculated by discounting the carrying values using a scheduled cash flows
approach based on market interest rates as of December 31, 2009 and
December 31, 2008.   The calculated fair values do not
consider the credit risk rating of the Company or that the Company is not
currently permitted by its regulators to pay interest.





Other
liabilities.  The carrying amount approximated the fair value
of accrued interest payable, accrued dividends and premiums payable, considering
their short-term nature and expected payment.





Off-balance sheet
instruments.  The Company charges fees for commitments to
extend credit. Interest rates on loans, for which these commitments are
extended, are normally committed for periods of less than one month. Fees
charged on standby letters of credit and other financial guarantees are deemed
to be immaterial andthese guarantees are
expected to be settled at face amount or expire unused. It is impractical to
assign any fair value to these commitments.








105





BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





14.       PARENT
COMPANY FINANCIAL INFORMATION





Condensed
financial information for Bay National Corporation (Parent Only) is as
follows:





CONDENSED BALANCE
SHEETS


December
31, 2009 and 2008





2009
            
            
            2008ASSETSCash and cash
      equivalents
            
            $
            -
            
            
            $
            5,843Due
      from subsidiary
            
            
            168,102
            
            
            
            162,244Investment in
      subsidiary
            
            
            7,712,895
            
            
            
            23,104,949Other
      assets
            
            
            30,263
            
            
            
            56,533Total Assets
            
            $
            7,911,260
            
            
            $
            23,329,569LIABILITIESAccrued expenses and other
      liabilities
            
            $
            655,583
            
            
            $
            59,568Subordinated
      debt
            
            
            8,248,000
            
            
            
            8,248,000Total
    Liabilities
            
            
            8,903,583
            
            
            
            8,307,568STOCKHOLDERS'
      (DEFICIT) EQUITYCommon stock - $.01 par value,
      authorized:20,000,000 shares authorized,
      2,154,301 and 2,153,101 issued and outstanding as of December 31, 2009 and
      2008, respectively:
            
            
            21,543
            
            
            
            21,531Additional paid in
      capital
            
            
            17,951,811
            
            
            
            17,954,770(Accumulated deficit) retained
      earnings
            
            
            (19,024,608
            )
            
            
            (2,954,300
            )Accumulated other comprehensive
      gain
            
            
            58,931Total Stockholders' (Deficit)
      Equity
            
            
            (992,323
            )
            
            
            15,022,001Total Liabilities and
      Stockholders' Equity
            
            $
            7,911,260
            
            
            $
            23,329,569







106




BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





CONDENSED STATEMENTS OF
OPERATIONS


For the
years ended December 31, 2009 and 2008





2009
            
            
            2008Interest
      and dividends on investment securities
            
            $
            14
            
            
            $
            129Interest
      expense
            
            
            622,284
            
            
            
            603,039Net
      interest expense
            
            
            (622,270
            )
            
            
            (602,910
            )Non-interest
      expense
            
            
            (2,947
            )
            
            
            75,517Loss
      before income taxes and equity in undistributed losses of
      subsidiary
            
            
            (619,323
            )
            
            
            (678,427
            )Income
      tax benefit
            
            
            -
            
            
            
            (230,665
            )Loss
      before equity in undistributed losses of subsidiary
            
            
            (619,323
            )
            
            
            (447,762
            )Equity
      in undistributed loss of subsidiary
            
            
            (15,450,985
            )
            
            
            (4,616,881
            )Net
      Loss
            
            $
            (16,070,308
            )
            
            $
            (5,064,643
            )





CONDENSED STATEMENTS OF CASH
FLOWS


For the
years ended December 31, 2009 and 2008





2009
            
            
            2008Cash
      Flows From Operating ActivitiesNet Loss
            
            $
            (16,070,308
            )
            
            $
            (5,064,643
            )Adjustments to reconcile net
      loss to net cashprovided by operating
      activities:Equity in undistributed loss of
      subsidiary
            
            
            15,450,985
            
            
            
            4,616,881Stock based compensation
      (recovery) expense
            
            
            (2,947
            )
            
            
            75,517Net decrease in other
      assets
            
            
            20,412
            
            
            
            3,671,679Net increase in other
      liabilities
            
            
            596,015
            
            
            
            784Net cash (used) provided by
      operating activities
            
            
            (5,843
            )
            
            
            3,300,218Cash
      Flows From Investing ActivitiesInvestment in
      subsidiary
            
            
            -
            
            
            
            (3,390,664
            )Net cash used in investing
      activities
            
            
            -
            
            
            
            (3,390,664
            )Cash
      Flows From Financing ActivitiesNet proceeds from issuance of
      common stock
            
            
            -
            
            
            
            90,575Cash dividends paid in lieu of
      fractional shares
            
            
            -
            
            
            
            -Net cash provided by financing
      activities
            
            
            -
            
            
            
            90,575Net
      (decrease) increase in cash and cash equivalents
            
            
            (5,843
            )
            
            
            129Cash
      and cash equivalents at beginning of year
            
            
            5,843
            
            
            
            5,714Cash
      and cash equivalents at end of year
            
            $
            -
            
            
            $
            5,843








107





BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





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





There has
been no occurrence requiring a response to this Item.





Item
9A.  Controls and Procedures





As of the
end of the period covered by this annual report on Form 10-K, Bay National
Corporation’s Chief Executive Officer and Chief Financial Officer evaluated the
effectiveness of Bay National Corporation’s disclosure controls and
procedures.  Based upon that evaluation, Bay National Corporation’s
Chief Executive Officer and Chief Financial Officer concluded that Bay National
Corporation’s disclosure controls and procedures are effective as of December
31, 2009.  Disclosure controls and procedures are controls and other
procedures that are designed to ensure that information required to be disclosed
by Bay National Corporation in the reports that it files or submits under the
Exchange Act is recorded, processed, summarized and reported within the time
periods specified in the Securities and Exchange Commission’s rules and
forms.





In
addition, there were no changes in Bay National Corporation’s internal control
over financial reporting (as defined in Rule 13a-15 under the Exchange Act)
during the quarter ended December 31, 2009, that have materially affected, or
are reasonably likely to materially affect, Bay National Corporation’s internal
control over financial reporting.





This
annual report does not include an attestation report of the Company’s registered
public accounting firm regarding internal control over financial
reporting.  Management’s report was not subject to attestation by the
Company’s registered public accounting firm pursuant to temporary rules of the
Securities and Exchange Commission that permit the Company to provide only
management’s report in this annual report.






108




BAY
NATIONAL CORPORATION
 Notes to
Consolidated Financial Statements
 For the
years ended December 31, 2009 and 2008





Item
9B.  Other Information







None.






109





PART
III





Item
10.  Directors, Executive Officers and Corporate
Governance





Code
of Ethics





Bay
National Corporation’s Board of Directors has adopted a code of conduct that
applies to all of its directors, officers and employees, including it principal
executive officer, principal financial officer, principal accounting officer or
controller and persons performing similar functions. That Code of Conduct is
posted on Bay National Bank’s internet website at www.baynational.com.





The
remaining information required by this Item 10 is incorporated by reference
to the information appearing under the captions “Proposal 1. Election of
Directors,” “Board Meetings and Committees,” “Board Leadership Structure and
Oversight of Risk” and “Section 16(a) Beneficial Ownership Reporting Compliance”
in the Proxy Statement for the 2010 Annual Meeting of Stockholders of Bay
National Corporation.





Item
11.  Executive Compensation





The
information required by this Item 11 is incorporated by reference to the
information appearing under the captions “Director Compensation” and “Executive
Compensation” in the Proxy Statement for the 2010 Annual Meeting of Stockholders
of Bay National Corporation.






110







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





Securities
Authorized For Issuance Under Equity Compensation Plans





The
following table sets forth certain information as of December 31, 2009,
with respect to compensation plans under which equity securities of Bay National
Corporation are authorized for issuance.





Equity
      Compensation Plan InformationPlan
      category
            
            Number
      of securities to be issued(1)
              (a)
            
            
            Weighted-average
      exercise price of outstanding options and warrants(2)
              (b)
            
            
            Number
      of securities remaining available for future issuance under equity
      compensation plans (excluding securities reflected in column
      (a))
              (c)Equity
      compensation plans approved by security holders
            
            90,948
            
            
            $7.04
            
            
            293,568Equity
      compensation plans not approved by security holders
            
            -
            
            
            -
            
            
            -Total
            
            90,948
            
            
            $7.04
            
            
            293,568


(1)
            Includes
      unvested restricted stock units


(2)
            Excludes
      unvested restricted stock units





The
remaining information required by this Item 12 is incorporated by reference
to the information appearing under the caption “Security Ownership of Management
and Certain Security holders” in the Proxy Statement for the 2010 Annual Meeting
of Stockholders of Bay National Corporation.





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





The
information required by this Item 13 is incorporated by reference to the
information appearing under the captions “Proposal 1.  Election of
Directors” and “Certain Relationships and Related Transactions” in the Proxy
Statement for the 2010 Annual Meeting of Stockholders of Bay National
Corporation.





Item
14.  Principal Accountant Fees and Services.





The
information required by this Item 14 is incorporated by reference to the
information appearing under the captions “Audit Committee Report – Audit and
Non-Audit Fees” and “Audit Committee Report – Policy on Audit Committee
Pre-Approval of Audit and Non-Audit Services of Independent Registered Public
Accounting Firm” in the Proxy Statement for the 2010 Annual Meeting of
Stockholders of Bay National Corporation.






111






Part
IV





Item
15.  Exhibits





The
following exhibits are filed with or incorporated by reference into this
report.





No.
            Description of Exhibit3.1*
            Articles
      of Incorporation of Bay National Corporation3.1.1&&
            Articles
      of Amendment to Articles of Incorporation3.1.2
            Articles
      of Amendment to Articles of Incorporation3.2%
            Amended
      and Restated Bylaws of Bay National Corporation4.1*
            Rights
      of Holders of Common Stock (as contained in Exhibit
3.1)4.2*
            Form
      of Common Stock Certificate4.3@
            Indenture
      dated as of December 12, 2005 between Bay National Corporation and
      Wilmington Trust Company, as Trustee.4.4@
            Amended
      and Restated Declaration of Trust dated as of December 12, 2005 between
      Wilmington Trust Company, as the Trustees of Bay National Capital Trust I,
      Bay National Corporation, as Sponsor, and Hugh W. Mohler, Mark A. Semanie
      and Warren F. Boutilier, as the Administrators.4.5@
            Guarantee
      Agreement dated as of December 12, 2005 between Bay National Corporation
      and Wilmington Trust Company.10.1+
            Amended
      and Restated Employment Agreement, dated as of June 1, 2006, between Bay
      National Bank and Hugh W. Mohler.10.2%%
            Terms
      of January 2009 Amendment to Employment Agreement between Bay National
      Bank and Hugh W. Mohler.10.3&&
            Terms
      of Employment Arrangement between Bay National Bank and David E.
      Borowy10.4
            Terms of Employment Arrangement between Bay National
      Bank and Jill Moraniec10.5**
            Bay
      National Corporation Stock Option Plan10.6.1**
            Form
      of Incentive Stock Option Agreement for Stock Option
  Plan10.6.2%%
            Form
      of Non-Qualified Stock Option Agreement for Stock Option
    Plan10.7#
            Bay
      National Corporation and Bay National Bank Director Compensation
      Policy10.8*
            Office
      Lease Agreement dated July 16, 1999 between Bay National Corporation and
      Joppa Green II Limited Partnership10.9*
            Office
      Lease Agreement dated July 16, 1999 between Bay National Corporation and
      Joppa Green II Limited Partnership10.10##
            Amendment
      to Lease Agreement dated February 12, 2004 between Bay National
      Corporation and Joppa Green II Limited Partnership10.11##
            Amendment
      to Lease Agreement dated October 5, 2004 between Bay National Corporation
      and Joppa Green II Limited Partnership10.12##
            Amendment
      to Lease Agreement dated January 3, 2005 between Bay National Corporation
      and Joppa Green II Limited Partnership10.13##
            Amendment
      to Lease Agreement dated March 7, 2005 between Bay National Corporation
      and Joppa Green II Limited Partnership10.14*
            Lease
      Agreement dated September 16, 1999 between Bay National Corporation and
      John R. Lerch and Thomas C. Thompson   112
   10.15@@
            Lease
      Agreement dated July 19, 2006 between Bay National Bank and Riderwood
      Limited Partnership10.16^
            Lease
      Agreement dated October 3, 2007 between Bay National Corporation and
      Columbia 100, LLC10.17++
            Bay
      National Corporation 2007 Stock Incentive Plan and Forms of
      Agreement10.18%%
            Stipulation
      and Consent to the Issuance of a Consent Order by the Office of the
      Comptroller of the Currency10.19%%
            Consent
      Order issued by the Office of the Comptroller of the
    Currency10.20&
            Written
      Agreement by and between Bay National Corporation and the Federal Reserve
      Bank of Richmond dated April 28, 200921.1%%
            Subsidiaries
      of Bay National Corporation23.1
            Consent of Stegman & Company31.1
            Rule 13a-14(a) Certification of Chief Executive
      Officer31.2
            Rule 13a-14(a) Certification of Chief Financial
      Officer32
            Section 1350 Certification of Chief Executive Officer and
      Chief Financial Officer





The
exhibits which are denominated with an asterisk (*) were previously filed by Bay
National Corporation as a part of, and are hereby incorporated by reference
from, Bay National Corporation’s Registration Statement on Form SB-2, as
amended, under the Securities Act of 1933, Registration Number
333-87781.





The
exhibits which are denominated by two ampersands (&&) were previously
filed by Bay National Corporation as a part of, and are incorporated by
reference from, Bay National Corporation’s Registration Statement on Form S-1,
File No. 333-163493.





The
exhibit which is denominated with a percentage sign (%) was previously filed by
Bay National Corporation as a part of, and is hereby incorporated by reference
from, Bay National Corporation’s Current Report on Form 8-K filed on September
26, 2007.





The
exhibits which are denominated with an @ sign were previously filed by Bay
National Corporation as part of, and are hereby incorporated by reference from,
Bay National Corporation’s Annual Report on Form 10-K for the year ended
December 31, 2005, filed with the Commission on March 30, 2006.





The
exhibits which are denominated by the plus sign (+) were previously filed by Bay
National Corporation as a part of, and are hereby incorporated by reference
from, Bay National Corporation’s Current Report on Form 8-K filed on June 6,
2006.





The
exhibits which are denominated with an two percentage signs (%%) were previously
filed by Bay National Corporation as part of, and are hereby incorporated by
reference from, Bay National Corporation’s Annual Report on Form 10-K for the
year ended December 31, 2008, filed with the Commission on March 31,
2009.





The
exhibits which are denominated by two asterisks (**) were previously filed by
Bay National Corporation as a part of, and are hereby incorporated by reference
from, Bay National Corporation’s Registration Statement on Form S-8, as amended,
under the Securities Act of 1933, Registration Number 333-69428.






113







The
exhibit which is denominated by the number sign (#) was previously filed by Bay
National Corporation as a part of, and is hereby incorporated by reference from,
Bay National Corporation’s Current Report on Form 8-K filed on January 26,
2005.





The
exhibits which are denominated by two number signs (##) were previously filed by
Bay National Corporation as a part of, and are hereby incorporated by reference
from, Bay National Corporation’s Current Report on Form 8-K filed on March 11,
2005.





The
exhibit which is denominated by two @ signs (@@) was previously filed by Bay
National Corporation as a part of, and is hereby incorporated by reference from,
Bay National Corporation’s Quarterly Report on Form 10-Q for the quarter ended
June 30, 2006, filed on August 14, 2006.





The
exhibit which is denominated by a carrot sign (^) was previously filed by Bay
National Corporation as a part of, and is hereby incorporated by reference from,
Bay National Corporation’s Current Report on Form 8-K filed on October 9,
2007.





The
exhibit which is denominated by two plus signs (++) was previously filed by Bay
National Corporation as a part of, and is hereby incorporated by reference from,
Bay National Corporation’s Registration Statement on Form S-8 under the
Securities Act of 1933, Registration Number 333-143544.





The
exhibit which is denominated by an ampersand (&) was previously filed by Bay
National Corporation as a part of, and is hereby incorporated by reference from,
Bay National Corporation’s Current Report on Form 8-K dated April 28, 2009,
filed on May 1, 2009.





Note:
Exhibits 10.1 through 10.7 and 10.17 relate to management contracts or
compensatory plans or arrangements.






114







SIGNATURES





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





BAY
      NATIONAL CORPORATIONDate:  March
      31, 2010
            By:/s/ Hugh
      W. Mohler
            Hugh
      W. Mohler,   President





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.











Name
            Position
            Date/s/ Charles L. Maskell, Jr.,
      CPA
              Charles
      L. Maskell, Jr., CPA
            Director
      and Chairman (Principal Executive Officer)
            March
      31, 2010/s/ Hugh W. Mohler
              Hugh
      W. Mohler
            Director
      and President (Principal Executive Officer)
            March
      31, 2010/s/ David E. Borowy
              David
      E. Borowy
            Senior
      Vice President and CFO
              (Principal
      Accounting and Financial Officer)
            March
      31, 2010/s/ R. Michael Gill
              R.
      Michael Gill
            Director
            March
      31, 2010/s/ Harold C. Green
              Harold
      C. Green
            Director
            March
      31, 2010/s/ Donald G. McClure, Jr.
              Donald
      G. McClure, Jr.
            Director
            March
      31, 2010/s/ Robert L. Moore
              Robert
      L. Moore
            Director
            March
      31, 2010/s/ James P. O’Conor
              James
      P. O’Conor
            Director
            March
      31, 2010/s/ H. Victor Rieger, Jr.
              H.
      Victor Rieger, Jr.
            Director
            March
      31, 2010/s/ William B. Rinnier
              William
      B. Rinnier
            Director
            March
      31, 2010   115
   /s/ Edwin A. Rommel
              Edwin
      A. Rommel, III
            Director
            March
      31, 2010/s/Henry H. Stansbury
              Henry
      H. Stansbury
            Director
            March
      31, 2010/s/ Eugene M. Waldron, Jr.
              Eugene
      M. Waldron, Jr.
            Director
            March
      31, 2010/s/ Carl A. J. Wright
              Carl
      A.J. Wright
            Director
            March
      31, 2010








116





EXHIBIT
INDEX








No.
            Description of Exhibit3.1*
            Articles
      of Incorporation of Bay National Corporation3.1.1&&
            Articles
      of Amendment to Articles of Incorporation3.1.2
            Articles
      of Amendment to Articles of Incorporation3.2%
            Amended
      and Restated Bylaws of Bay National Corporation4.1*
            Rights
      of Holders of Common Stock (as contained in Exhibit
3.1)4.2*
            Form
      of Common Stock Certificate4.3@
            Indenture
      dated as of December 12, 2005 between Bay National Corporation and
      Wilmington Trust Company, as Trustee.4.4@
            Amended
      and Restated Declaration of Trust dated as of December 12, 2005 between
      Wilmington Trust Company, as the Trustees of Bay National Capital Trust I,
      Bay National Corporation, as Sponsor, and Hugh W. Mohler, Mark A. Semanie
      and Warren F. Boutilier, as the Administrators.4.5@
            Guarantee
      Agreement dated as of December 12, 2005 between Bay National Corporation
      and Wilmington Trust Company.10.1+
            Amended
      and Restated Employment Agreement, dated as of June 1, 2006, between Bay
      National Bank and Hugh W. Mohler.10.2%%
            Terms
      of January 2009 Amendment to Employment Agreement between Bay National
      Bank and Hugh W. Mohler.10.3&&
            Terms
      of Employment Arrangement between Bay National Bank and David E.
      Borowy10.4
            Terms of Employment Arrangement between Bay National
      Bank and Jill Moraniec10.5**
            Bay
      National Corporation Stock Option Plan10.6.1**
            Form
      of Incentive Stock Option Agreement for Stock Option
  Plan10.6.2%%
            Form
      of Non-Qualified Stock Option Agreement for Stock Option
    Plan10.7#
            Bay
      National Corporation and Bay National Bank Director Compensation
      Policy10.8*
            Office
      Lease Agreement dated July 16, 1999 between Bay National Corporation and
      Joppa Green II Limited Partnership10.9*
            Office
      Lease Agreement dated July 16, 1999 between Bay National Corporation and
      Joppa Green II Limited Partnership10.10##
            Amendment
      to Lease Agreement dated February 12, 2004 between Bay National
      Corporation and Joppa Green II Limited Partnership10.11##
            Amendment
      to Lease Agreement dated October 5, 2004 between Bay National Corporation
      and Joppa Green II Limited Partnership10.12##
            Amendment
      to Lease Agreement dated January 3, 2005 between Bay National Corporation
      and Joppa Green II Limited Partnership10.13##
            Amendment
      to Lease Agreement dated March 7, 2005 between Bay National Corporation
      and Joppa Green II Limited Partnership10.14*
            Lease
      Agreement dated September 16, 1999 between Bay National Corporation and
      John R. Lerch and Thomas C. Thompson10.15@@
            Lease
      Agreement dated July 19, 2006 between Bay National Bank and Riderwood
      Limited Partnership10.16^
            Lease
      Agreement dated October 3, 2007 between Bay National Corporation and
      Columbia 100, LLC10.17++
            Bay
      National Corporation 2007 Stock Incentive Plan and Forms of
      Agreement10.18%%
            Stipulation
      and Consent to the Issuance of a Consent Order by the Office of the
      Comptroller of the Currency10.19%%
            Consent
      Order issued by the Office of the Comptroller of the
    Currency   117
    21.1
            Subsidiaries
      of Bay National Corporation23.1
            Consent of Stegman & Company31.1
            Rule 13a-14(a) Certification of Chief Executive
      Officer31.2
            Rule 13a-14(a) Certification of Chief Financial
      Officer32
            Section 1350 Certification of Chief Executive Officer and
      Chief Financial Officer





The
exhibits which are denominated with an asterisk (*) were previously filed by Bay
National Corporation as a part of, and are hereby incorporated by reference
from, Bay National Corporation’s Registration Statement on Form SB-2, as
amended, under the Securities Act of 1933, Registration Number
333-87781.





The
exhibits which are denominated by two ampersands (&&) were previously
filed by Bay National Corporation as a part of, and are incorporated by
reference from, Bay National Corporation’s Registration Statement on Form S-1,
File No. 333-163493.





The
exhibit which is denominated with a percentage sign (%) was previously filed by
Bay National Corporation as a part of, and is hereby incorporated by reference
from, Bay National Corporation’s Current Report on Form 8-K filed on September
26, 2007.





The
exhibits which are denominated with an @ sign were previously filed by Bay
National Corporation as part of, and are hereby incorporated by reference from,
Bay National Corporation’s Annual Report on Form 10-K for the year ended
December 31, 2005, filed with the Commission on March 30, 2006.





The
exhibits which are denominated by the plus sign (+) were previously filed by Bay
National Corporation as a part of, and are hereby incorporated by reference
from, Bay National Corporation’s Current Report on Form 8-K filed on June 6,
2006.





The
exhibits which are denominated with an two percentage signs (%%) were previously
filed by Bay National Corporation as part of, and are hereby incorporated by
reference from, Bay National Corporation’s Annual Report on Form 10-K for the
year ended December 31, 2008, filed with the Commission on March 31,
2009.





The
exhibits which are denominated by two asterisks (**) were previously filed by
Bay National Corporation as a part of, and are hereby incorporated by reference
from, Bay National Corporation’s Registration Statement on Form S-8, as amended,
under the Securities Act of 1933, Registration Number 333-69428.





The
exhibit which is denominated by the number sign (#) was previously filed by Bay
National Corporation as a part of, and is hereby incorporated by reference from,
Bay National Corporation’s Current Report on Form 8-K filed on January 26,
2005.





The
exhibits which are denominated by two number signs (##) were previously filed by
Bay National Corporation as a part of, and are hereby incorporated by reference
from, Bay National Corporation’s Current Report on Form 8-K filed on March 11,
2005.





The
exhibit which is denominated by two @ signs (@@) was previously filed by Bay
National Corporation as a part of, and is hereby incorporated by reference from,
Bay National Corporation’s Quarterly Report on Form 10-Q for the quarter ended
June 30, 2006, filed on August 14, 2006.






118







The
exhibit which is denominated by a carrot sign (^) was previously filed by Bay
National Corporation as a part of, and is hereby incorporated by reference from,
Bay National Corporation’s Current Report on Form 8-K filed on October 9,
2007.





The
exhibit which is denominated by two plus signs (++) was previously filed by Bay
National Corporation as a part of, and is hereby incorporated by reference from,
Bay National Corporation’s Registration Statement on Form S-8 under the
Securities Act of 1933, Registration Number 333-143544.





The
exhibit which is denominated by an ampersand (&) was previously filed by Bay
National Corporation as a part of, and is hereby incorporated by reference from,
Bay National Corporation’s Current Report on Form 8-K dated April 28, 2009,
filed on May 1, 2009.





Note:
Exhibits 10.1 through 10.7 and 10.17 relate to management contracts or
compensatory plans or arrangements.









119