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EX-31.01 - CEO CERTIFICATION PURSUANT TO RULE 13A-14(A) - Bank of the Carolinas CORPdex3101.htm
EX-32.01 - CEO AND CFO CERTIFICATION PURSUANT TO SECTION 1350 - Bank of the Carolinas CORPdex3201.htm
EX-99.01 - CERTIFICATION PURSUANT TO SECTION 111(B)(4) OF EESA - Bank of the Carolinas CORPdex9901.htm
EX-23.01 - CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM - Bank of the Carolinas CORPdex2301.htm
EX-23.02 - CONSENT OF INDEPENDENT REGISTER PUBLIC ACCOUNTING FIRM - Bank of the Carolinas CORPdex2302.htm
EX-31.02 - CFO CERTIFICATION PURSUANT TO RULE 13A-14(A) - Bank of the Carolinas CORPdex3102.htm
EX-99.02 - CERTIFICATION PURSUANT TO SECTION 111(B)(4) OF EESA - Bank of the Carolinas CORPdex9902.htm
Table of Contents

 

 

 

U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

ANNUAL REPORT UNDER SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2009

 

Commission File No. 000-52195

 

 

 

BANK OF THE CAROLINAS CORPORATION

(Name of small business issuer in its charter)

 

North Carolina   20-4989192

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

135 Boxwood Village Drive

Mocksville, North Carolina 27028

(Address of principal executive offices, including Zip Code)

 

(336) 751-5755

Registrant’s telephone number, including area code

 

 

 

   Securities registered under Section 12(b) of the Act:    Common Stock, $5.00 par value per share
     

(Title of class)

     

NASDAQ Global Market

(Name of exchange on which registered)

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

 

 

 

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨    No x

 

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes ¨    No x

 

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

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of 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. x

 

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “accelerated filer,” “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.)

 

Large accelerated filer ¨            Accelerated filer ¨            Non-accelerated filer ¨            Smaller reporting company x

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨    No x

 

The aggregate market value of the voting and non-voting common equity held by nonaffiliates (computed by reference to the price at which the common equity was sold, or the average bid and asked price of such common equity), as of the last business day of the Registrant’s most recently completed second fiscal quarter was $15.2 million (based on the closing price of such stock as of June 30, 2009).

 

On March 29, 2010, the number of outstanding shares of Registrant’s common stock was 3,897,174.

 

Documents Incorporated by Reference

 

Portions of Registrant’s definitive Proxy Statement as filed with the Securities and Exchange Commission in connection with its 2010 Annual Meeting are incorporated into Part III of this Report.

 

 

 


Table of Contents

BANK OF THE CAROLINAS CORPORATION

 

FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 2009

 

TABLE OF CONTENTS

 

PART I
         Page

Item 1.

 

Business

   2

Item 1A.

 

Risk Factors

   15

Item 1B.

 

Unresolved Staff Comments

   22

Item 2.

 

Properties

   22

Item 3.

 

Legal Proceedings

   22

Item 4.

 

[Removed and Reserved]

   22
PART II

Item 5.

 

Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   23

Item 6.

 

Selected Financial Data

   24

Item 7.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   25

Item 7A.

 

Quantitative and Qualitative Disclosures About Market Risk

   42

Item 8.

 

Consolidated Financial Statements and Supplementary Data

   42

Item 9.

 

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

   70

Item 9A (T).

 

Controls and Procedures

   70

Item 9B.

 

Other Information

   70
PART III

Item 10.

 

Directors, Executive Officers and Corporate Governance

   71

Item 11.

 

Executive Compensation

   71

Item 12.

 

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   71

Item 13.

 

Certain Relationships and Related Transactions, and Director Independence

   72

Item 14.

 

Principal Accountant Fees and Services

   72
PART IV

Item 15.

 

Exhibits and Financial Statement Schedules

   73


Table of Contents

PART I

 

In this Report, the terms “we,” “us,” “our” and similar terms refer to Bank of the Carolinas Corporation separately and, as the context requires, on a consolidated basis with

our banking subsidiary, Bank of the Carolinas. Bank of the Carolinas is

sometimes referred to separately as the “Bank.”

 

Item 1. Description of Business

 

 

GENERAL

 

Bank of the Carolinas Corporation (the “Company”) was formed in 2006 to serve as a holding company for Bank of the Carolinas (the “Bank”). The Company is registered with the Board of Governors of the Federal Reserve System (the “Federal Reserve”) under the Bank Holding Company Act of 1956, as amended (the “BHCA”), and the bank holding company laws of North Carolina. The Company’s office is located at 135 Boxwood Village, Mocksville, North Carolina 27028. The Company’s primary business activity consists of directing the activities of the Bank.

 

The Bank is incorporated under the laws of North Carolina and began operations on December 7, 1998 as a North Carolina chartered commercial bank. The Bank operates under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation (the “FDIC”). As a state chartered non-Federal Reserve member bank, the Bank is subject to examination and regulation by the FDIC and the North Carolina Commissioner of Banks (the “Commissioner”). The Bank is further subject to certain regulations of the Federal Reserve. The business and regulation of the Bank are also subject to legislative changes from time to time. See Item 1. Business—Supervision and Regulation.

 

The Bank’s primary market area is in the Piedmont region of North Carolina where we are engaged in general commercial banking primarily in Davie, Randolph, Rowan, Cabarrus, Davidson, Forsyth and Stokes Counties. The Bank’s main office is located at 135 Boxwood Village in Mocksville, North Carolina. Our main office in Mocksville and our Advance office are located in Davie County. Our other offices are located in Asheboro (Randolph County), Cleveland and Landis (Rowan County), Harrisburg and Concord (Cabarrus County), Lexington (Davidson County), King (Stokes County) and Winston-Salem (Forsyth County).

 

See Item 6. Selected Financial Data, for a summary of operations, selected year-end assets and liabilities, ratios and per share data for December 31, 2005 through 2009 and the years then ended.

 

SERVICES

 

Our operations are primarily retail oriented and directed toward individuals and small- and medium-sized businesses located in our banking market. The majority of our deposits and loans are derived from customers in our banking market, but we also make loans and have deposit relationships in areas surrounding our immediate banking market. We also occasionally solicit and accept wholesale deposits. We offer a variety of commercial and consumer banking services, but our principal activities are the taking of demand and time deposits and the making of consumer and commercial loans. To a lesser extent, we also generate income from other fee-based products and services that we provide.

 

The Bank’s primary source of revenue is interest and fee income from its lending activities. These lending activities consist principally of originating commercial operating and working capital loans, residential mortgage loans, home equity lines of credit, other consumer loans and loans secured by commercial real estate. Interest and dividend income from investment activities generally provide the second largest source of income to the Bank.

 

Deposits are the primary source of the Bank’s funds for lending and other investment purposes. The Bank attracts both short-term and long-term deposits from the general public by offering a variety of accounts and rates. The Bank offers statement savings accounts, negotiable order of withdrawal accounts, money market demand accounts, non-interest-bearing accounts and fixed interest rate certificates with varying maturities. The Bank also utilizes alternative sources of funds such as brokered certificates of deposit and borrowings from the Federal Home Loan Bank (the “FHLB”) of Atlanta, Georgia and other commercial banks.

 

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The Bank’s deposits are obtained primarily from its primary market area. The Bank uses traditional marketing methods to attract new customers and deposits including print media advertising and direct mailings. Deposit flows are greatly influenced by economic conditions, the general level of interest rates, competition and other factors.

 

ORGANIZATION

 

The Bank is the sole banking subsidiary of the Company. A trust (Bank of the Carolinas Trust I) was formed as a subsidiary of the Company to facilitate the issuance of Trust Preferred Securities as a form of non-dilutive equity to supplement our capital.

 

The Bank formed an LLC (East Atlantic Properties, LLC) to manage our income producing assets transferred from our Other Real Estate Owned. The LLC is consolidated into the Bank and is a disregarded entity for tax purposes.

 

LENDING ACTIVITIES

 

General.    We make a variety of types of consumer and commercial loans to individuals and small- and medium-sized businesses for various personal, business and agricultural purposes, including term and installment loans, commercial and equity lines of credit, and overdraft checking credit. For financial reporting purposes, our loan portfolio generally is divided into real estate loans (including home equity lines of credit), commercial loans, and consumer loans. We make credit card services available to our customers through a correspondent relationship. For an analysis of the components of our loan portfolio, see Table I. Analysis of Loan Portfolio in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

Real Estate Secured Loans.    Our real estate loan classifications include loans secured by real estate which are made to purchase, construct or improve residential or commercial real estate, for real estate development purposes, and for various other commercial and consumer purposes (whether or not those purposes are related to our real estate collateral).

 

Commercial real estate and construction loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. In the case of commercial real estate loans, loan repayment may be dependent on the successful operation of income producing properties, a business, or a real estate project and, thus, may, to a greater extent than in the case of other loans, be subject to the risk of adverse conditions in the economy generally or in the real estate market in particular.

 

Construction loans involve special risks due to the fact that loan funds are advanced upon the security of houses or other improvements that are under construction and that are of uncertain value prior to the completion of construction. For that reason, it is more difficult to evaluate accurately the total loan funds required to complete a project and the related loan-to-value ratios. To minimize these risks, generally we limit loan amounts to 80% of the projected appraised value of our collateral upon completion of construction.

 

Many of our real estate loans, while secured by real estate, were made for purposes unrelated to the real estate collateral. That generally is reflective of our efforts to minimize credit risk by taking real estate as primary or additional collateral, whenever possible, without regard to loan purpose. All our real estate loans are secured by first or junior liens on real property, the majority of which is located in or near our banking market. However, we have made loans, and have purchased participations in some loans from other entities, which are secured by real property located outside our banking market.

 

Our real estate loans may be made at fixed or variable interest rates and, generally, with the exception of our long-term residential mortgage loans discussed below, have maturities that do not exceed five years. However, we also make real estate loans that have maturities of more than five years, or which are based on amortization schedules of as much as 30 years, but that generally will include contractual provisions which allow us to call the loan in full, or provide for a “balloon” payment in full, at the end of no more than five to fifteen years.

 

In addition to residential real estate loans made for a variety of purposes, we offer long-term, residential mortgage loans that are funded by and closed in the name of third-party lenders. This arrangement permits us to offer this product

 

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in our banking market and enhance our fee-based income, but, by closing the loans in the names of the ultimate owners of those loans, we avoid the credit and interest rate risk associated with these long-term loans. However, on a limited basis, we also make residential mortgage loans that we retain in our own loan portfolio. Those loans typically are secured by first liens on the related residential property, are made at fixed and variable interest rates, and have maturities that do not exceed 15 years, although we have a small number of residential mortgage loans in our portfolio with 30-year maturities.

 

Our home equity lines of credit include lines of credit that generally are used by borrowers for consumer purposes and are secured by first or junior liens on residential real property. Our commitment on each line is for a term of 15 years, and interest is charged at a variable rate. The terms of these lines of credit provide that borrowers either may pay accrued interest only, with the outstanding principal balances becoming due in full at the maturity of the lines, or they will make payments of principal and interest based on a 15-year amortization schedule.

 

Commercial Loans.    Our commercial loan classification includes loans to individuals and small- and medium-sized businesses for working capital, equipment purchases, and various other business and agricultural purposes, but that classification excludes any such loan that is secured by real estate. These loans generally are secured by inventory, equipment or similar assets, but they also may be made on an unsecured basis. In addition to loans which are classified on our books as commercial loans, as described above, many of our loans included within the real estate loan classification were made for commercial purposes but are classified as real estate loans on our books because they are secured by first or junior liens on real estate. Commercial loans may be made at variable or fixed rates of interest. However, it is our policy that any loan which has a maturity or amortization schedule of longer than five years normally would be made at an interest rate that varies with our prime lending rate or would include contractual provisions which allow us to call the loan in full, or provide for a “balloon” payment in full, at the end of no more than five years.

 

Commercial loans typically are made on the basis of the borrower’s ability to make repayment from business cash flow, and those loans typically are secured by business assets, such as accounts receivable, equipment and inventory. As a result, the ability of borrowers to repay commercial loans may be substantially dependent on the success of their businesses, and the collateral for commercial loans may depreciate over time and their values may not be as determinable relative to the time the loans were originated.

 

Consumer Loans.    Our consumer loans consist primarily of loans for various consumer purposes, as well as the outstanding balances on non-real estate secured consumer revolving credit accounts. A majority of these loans are secured by liens on various personal assets of the borrowers, but they also may be made on an unsecured basis. Additionally, our real estate loans include loans secured by first or junior liens on real estate which were made for consumer purposes unrelated to the real estate collateral. Consumer loans generally are made at fixed interest rates and with maturities or amortization schedules which generally do not exceed five years. However, consumer-purpose loans secured by real estate (and, thus, classified as real estate loans as described above) may be made for terms of up to 30 years, but under terms which allow us to call the loan in full, or provide for a “balloon” payment, at the end of no more than five to fifteen years.

 

Consumer loans generally are secured by personal property and other personal assets of borrowers which often depreciate rapidly or are vulnerable to damage or loss. In cases where damage or depreciation reduces the value of our collateral below the unpaid balance of a defaulted loan, repossession may not result in repayment of the entire outstanding loan balance. The resulting deficiency often does not warrant further substantial collection efforts against the borrower. In connection with consumer lending in general, the success of our loan collection efforts are highly dependent on the continuing financial stability of our borrowers. Our collection capacity on consumer loans may be more likely to be adversely affected by a borrower’s job loss, illness, personal bankruptcy or other change in personal circumstances than is the case with other types of loans.

 

Loan Administration and Underwriting.    Like most community banks, we make loans based to a great extent, on our assessment of borrowers’ income, cash flow, net worth, character and ability to repay the loan. A principal risk associated with each loan category is the creditworthiness of our borrowers. Our loans may be viewed as involving a higher degree of credit risk than is typically the case with some other types of loans, such as long-term residential mortgage loans where greater emphasis is placed on assessed collateral values. To manage risk, we have adopted written loan policies and procedures. Our loan portfolio is administered under a defined process that includes guidelines for loan underwriting standards, risk assessment, procedures for loan approvals, loan risk grading, ongoing identification and management of

 

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credit deterioration, and portfolio reviews to assess loss exposure. These reviews also are used to test our compliance with our credit policies and procedures in an ongoing fashion.

 

The underwriting standards that we employ for loans include an evaluation of various factors, including but not limited to a loan applicant’s income, cash flow, payment history on other debts and an assessment of ability to meet existing obligations including payments on any proposed loan. Though creditworthiness of the applicant is a primary consideration within the loan approval process, we take collateral (particularly real estate) whenever it’s available. This is done without regard to loan purpose. In the case of secured loans, the underwriting process includes an analysis of the value of the proposed collateral. The analysis is conducted in relation to the proposed loan amount. Consideration is given to the value of the collateral, the degree to which the value is ascertainable with any certainty, the marketability of the collateral in the event of default, and the likelihood of depreciation in the collateral value.

 

Our Board of Directors has approved levels of lending authority for lending personnel based on our aggregate credit exposures to borrowers, along with the secured or unsecured status and the risk grade of a proposed loan. A loan that satisfies our loan policies and is within a lending officer’s assigned authority may be approved by that officer. Anything above that amount must be approved before funding by our Credit Administration management, the Loan Committee of the Board of Directors or our Board of Directors.

 

At the time a loan is proposed, the account officer assigns a risk grade to the loan based on various underwriting and other criteria. The grades assigned to loans generally indicate the level of ongoing review and attention that we will give to those loans to protect our position.

 

After funding, all loans are reviewed by our Loan Administration personnel for adequacy of documentation and compliance with regulatory requirements. Most loans (including the largest exposure loans) are reviewed for compliance with our underwriting criteria and to reassess the grades assigned to them by the account officers.

 

During the life of each loan, its grade is reviewed and validated. Modifications can and are made to reflect changes in circumstances and risk. Loans generally are placed in a non-accrual status if they become 90 days past due (unless, based on relevant circumstances, we believe that collateral is sufficient to justify continued accrual and the loan is in process of collection). Non-accrual status is also applied whenever we believe that collection has become doubtful. Loans are charged off when the collection of principal and interest has become doubtful and the loans no longer can be considered a sound collectible asset (or, in the case of unsecured loans, when they become 90 days past due).

 

Allowance for Loan Losses.    Our Board of Directors’ Loan Committee reviews all substandard loans at least monthly, and our management meets regularly to review asset quality trends and to discuss loan policy issues. Based on these reviews and our current judgments about the credit quality of our loan portfolio and other relevant internal and external factors as well as historical charge off rates, we have established an allowance for loan losses. The appropriateness of the allowance is assessed by our management, reviewed by the Loan Committee each month, and reviewed by the Board of Directors quarterly. We make provisions to the allowance based on those assessments which are charged against our earnings.

 

For additional information regarding loss experience, our allowance for loan losses and problem assets, see Table II. Summary of Loss Experience, Table III. Allocation of Allowance for Loan Losses, and Table IV. Problem Assets in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

DEPOSIT ACTIVITIES

 

Our deposit products include business and individual checking accounts, savings accounts, NOW accounts, certificates of deposit and money market checking accounts. We monitor our competition in order to keep the rates paid on our deposits at a competitive level. The majority of our deposits are derived from within our banking market. However, we have historically solicited and accepted wholesale deposits as a way to supplement funding to support loan growth and provide added balance sheet liquidity. During 2008, we engaged in a strategic effort to increase our core deposit accounts while decreasing our reliance on brokered deposits. We initiated a money market special in July 2008 that guaranteed a special money market rate through June 30, 2009. For additional analysis of deposit relationships, see Table VII. Deposit Mix in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

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INVESTMENT PORTFOLIO

 

On December 31, 2009, our investment portfolio consisted of U.S. government agency securities, state and municipal obligations, mortgage-backed securities issued by FNMA, GNMA and FHLMC and corporate obligations. Our securities are classified as both “held to maturity” and “available for sale.” We analyze their performance monthly and carry the available for sale securities on our books at their fair market values while carrying the held to maturity securities at their amortized cost. For additional analysis of investment security balances by type and maturities and average yields by security type, see Table V. Investments and Table VI. Investment Securities in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. For additional information regarding appreciation and depreciation by security type, and information relating to Other Than Temporary Impairment, see Note 2. Investment Securities in our Consolidated Financial Statements under Item 8.

 

COMPETITION

 

Commercial banking in North Carolina is highly competitive, due in large part to our state’s early adoption of statewide branching. Over the years, federal and state legislation (including the elimination of restrictions on interstate banking) has heightened the competitive environment in which all financial institutions conduct their business, and the potential for competition among financial institutions of all types has increased significantly. We compete with approximately 30 commercial banks and institutions with offices in our banking market.

 

Interest rates, both on loans and deposits, and prices of fee-based services are significant competitive factors among financial institutions in general. Other important competitive factors include office location, office hours, the quality of customer service, community reputation, continuity of personnel and services, and, in the case of larger commercial customers, relative lending limits and the ability to offer sophisticated cash management and other commercial banking services. Many of our competitors have greater resources, broader geographic markets, more extensive branch networks, and higher lending limits than we do. They also can offer more products and services and can better afford and make more effective use of media advertising, support services and electronic technology than we can. In terms of assets, we are one of the smaller commercial banks in North Carolina, and there is no assurance that we will be or continue to be an effective competitor in our banking market. However, we believe that community banks can compete successfully by providing personalized service and making timely, local decisions, and that further consolidation in the banking industry is likely to create additional opportunities for community banks to capture deposits from affected customers who may become dissatisfied as their financial institutions grow larger. Additionally, we believe that the continued growth of our banking market affords an opportunity to capture new deposits from new residents.

 

Substantially all of our customers are individuals and small- and medium-sized businesses. We try to differentiate ourselves from our larger competitors with our focus on relationship banking, personalized service, direct customer contact, and our ability to make credit and other business decisions locally. We also depend on our reputation as a community bank in our banking market, our involvement in the communities we serve, the experience of our senior management team, and the quality of our associates. We believe that our focus allows us to be more responsive to our customers’ needs and more flexible in approving loans based on our personal knowledge of our customers.

 

EMPLOYEES

 

On December 31, 2009, we had approximately 120 full-time equivalent employees (including our executive officers). We are not party to any collective bargaining agreement with our employees, and we consider our relations with our employees to be good.

 

SUPERVISION AND REGULATION

 

Our business and operations are subject to extensive federal and state governmental regulation and supervision. The following is a summary of some of the basic statutes and regulations that apply to us, but it is not a complete discussion of all the laws that affect our business.

 

Regulation of Bank Holding Companies.    Bank of the Carolinas Corporation is a North Carolina business corporation that operates as a registered bank holding company under the Bank Holding Company Act of 1956, as amended (the “BHCA”). We are subject to supervision and examination by, and the regulations and reporting

 

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requirements of, the Federal Reserve Board (the “FRB”). Under the BHCA, a bank holding company’s activities are limited to banking, managing or controlling banks, or engaging in other activities the FRB determines are closely related and a proper incident to banking or managing or controlling banks.

 

Bank holding companies may elect to be regulated as “financial holding companies” if all their financial institution subsidiaries are and remain well capitalized and well managed as described in the FRB’s regulations and have a satisfactory record of compliance with the Community Reinvestment Act. In addition to the activities that are permissible for bank holding companies, financial holding companies are permitted to engage in additional activities that are determined by the FRB, in consultation with the Secretary of the Treasury, to be financial in nature or incidental to a financial activity, or that are complementary to a financial activity and do not pose a substantial risk to the safety and soundness of depository institutions, or the financial system generally, as determined by the FRB.

 

The BHCA prohibits a bank holding company or financial holding company from acquiring direct or indirect control of more than 5.0% of the outstanding voting stock, or substantially all of the assets, of any financial institution, or merging or consolidating with another bank holding company or savings bank holding company, without the prior approval of or, under specified circumstances, notice to, the FRB. Additionally, the BHCA generally prohibits banks or financial holding companies from acquiring ownership or control of more than 5.0% of the outstanding voting stock of any company that engages in an activity other than one that is permissible for the holding company. In approving an application to engage in a nonbanking activity, the FRB must consider whether that activity can reasonably be expected to produce benefits to the public, such as greater 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 law imposes a number of obligations and restrictions on a bank holding company and its insured bank subsidiaries designed to minimize potential losses to depositors and the FDIC insurance funds. For example, if a bank holding company’s insured bank subsidiary becomes “undercapitalized,” the bank holding company is required to guarantee the bank’s compliance (subject to certain limits) with the terms of any capital restoration plan filed with its federal banking agency. A bank holding company is required to serve as a source of financial strength to its bank subsidiaries and to commit resources to support those banks in circumstances in which, absent that policy, it might not do so. Under the BHCA, the FRB may require a bank holding company to terminate any activity or relinquish control of a nonbank subsidiary if the FRB determines that the activity or control constitutes a serious risk to the financial soundness and stability of a bank subsidiary of a bank holding company.

 

Regulation of the Bank.    The Bank is an insured, North Carolina-chartered bank. Its deposits are insured under the FDIC’s Deposit Insurance Fund (“DIF”), and it is subject to supervision and examination by, and the regulations and reporting requirements of, the FDIC and the North Carolina Commissioner of Banks (the “Commissioner”). The FDIC and the Commissioner are its primary federal and state banking regulators. The Bank is not a member bank of the Federal Reserve System.

 

As an insured bank, the Bank is prohibited from engaging as principal in any activity that is not permitted for national banks unless (1) the FDIC determines that the activity or investment would not pose a significant risk to the DIF, and (2) the Bank is, and continues to be, in compliance with the capital standards that apply to it. The Bank also is prohibited from directly acquiring or retaining any equity investment of a type or in an amount that is not permitted for national banks.

 

The FDIC and the Commissioner regulate all areas of the Bank’s business, including its reserves, mergers, payment of dividends and other aspects of its operations. They conduct regular examinations of the Bank, and the Bank must furnish periodic reports to the FDIC and the Commissioner containing detailed financial and other information about its affairs. The FDIC and the Commissioner have broad powers to enforce laws and regulations that apply to the Bank and to require the Bank to correct conditions that affect its safety and soundness. Among others, these powers include issuing cease and desist orders, imposing civil penalties, and removing officers and directors, and their ability otherwise to intervene in the Bank’s operation if their examinations of the Bank, or the reports it files, reflect a need for them to do so.

 

The Bank’s business also is influenced by prevailing economic conditions and governmental policies, both foreign and domestic, and, though it is not a member bank of the Federal Reserve System, by the monetary and fiscal policies of the

 

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FRB. The FRB’s actions and policy directives determine to a significant degree the cost and availability of funds the Bank obtains from money market sources for lending and investing, and they also influence, directly and indirectly, the rates of interest the Bank pays on time and savings deposits and the rates it charges on commercial bank loans.

 

Powers of the FDIC in Connection with the Insolvency of an Insured Depository Institution.    Under the Federal Deposit Insurance Act (the “FDIA”), if any insured depository institution becomes insolvent and the FDIC is appointed as its conservator or receiver, the FDIC may disaffirm or repudiate any contract or lease to which the institution is a party which it determines to be burdensome, and the disaffirmance or repudiation of which is determined to promote the orderly administration of the institution’s affairs. The disaffirmance or repudiation of any of our obligations would result in a claim of the holder of that obligation against the conservatorship or receivership. The amount paid on that claim would depend upon, among other factors, the amount of conservatorship or receivership assets available for the payment of unsecured claims and the priority of the claim relative to the priority of other unsecured creditors and depositors.

 

In its resolution of the problems of an insured depository institution in default or in danger of default, the FDIC generally is required to satisfy its obligations to insured depositors at the least possible cost to the deposit insurance funds. In addition, the FDIC may not take any action that would have the effect of increasing the losses to the deposit insurance funds by protecting depositors for more than the insured portion of deposits or creditors other than depositors. The FDIA authorizes the FDIC to settle all uninsured and unsecured claims in the insolvency of an insured bank by making a final settlement payment after the declaration of insolvency as full payment and disposition of the FDIC’s obligations to claimants. The rate of the final settlement payments will be a percentage rate determined by the FDIC reflecting an average of the FDIC’s receivership recovery experience.

 

Gramm-Leach-Bliley Act.    The federal Gramm-Leach-Bliley Act enacted in 1999 (the “GLB Act”) dramatically changed various federal laws governing the banking, securities and insurance industries. The GLB Act permitted bank holding companies to become “financial holding companies” and, in general (1) expanded opportunities to affiliate with securities firms and insurance companies; (2) overrode certain state laws that would prohibit certain banking and insurance affiliations; (3) expanded the activities in which banks and bank holding companies may participate; (4) required that banks and bank holding companies engage in some activities only through affiliates owned or managed in accordance with certain requirements; and (5) reorganized responsibility among various federal regulators for oversight of certain securities activities conducted by banks and bank holding companies. The GLB Act expanded opportunities for banks and bank holding companies to provide services and engage in other revenue-generating activities that previously were prohibited to them. However, while this expanded authority permits us to engage in additional activities, it also presents us with challenges as our larger competitors continue to expand their services and products into areas that are not feasible for smaller, community-oriented financial institutions. We have not elected to become a financial holding company.

 

Payment of Dividends.    Under North Carolina law, we are authorized to pay dividends as declared by our Board of Directors, provided that no such distribution results in our insolvency on a going concern or balance sheet basis. However, although we are a legal entity separate and distinct from the Bank, our principal source of funds with which we can pay dividends to our shareholders and pay our own obligations is dividends we receive from the Bank. For that reason, our ability to pay dividends effectively is subject to the same limitations that apply to the Bank. There are statutory and regulatory limitations on the Bank’s payment of dividends to us.

 

Our and the Bank’s Board of Directors have entered into informal agreements with our respective banking regulators which are described in Note 10 to our audited financial statements included in Item 8 of this Report. Among other things, the agreements require that we and the Bank obtain the consent of our regulators before we may pay any cash dividends.

 

Our sale of Series A Preferred Stock to the U.S. Treasury during April 2009 under the TARP Capital Purchase Program resulted in additional restrictions on our ability to pay dividends on our common stock and to repurchase shares of our common stock. Unless all accrued dividends on the Series A Preferred Stock have been paid in full, (1) no dividends may be declared or paid on our common stock, and (2) we may not repurchase any of our outstanding common stock. Additionally, during the first three years following our sale of the Series A Preferred Stock, we are required to obtain the consent of the U.S. Treasury in order to increase the dividend per share paid on our common stock from the last quarterly cash dividend per share declared prior to our sale of the Series A Preferred Stock, or to purchase

 

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outstanding shares of our common stock, unless the Series A Preferred Stock has been redeemed in full or the U.S. Treasury has transferred all of the Series A Preferred Stock to third parties.

 

Under North Carolina law, the Bank may pay dividends only from its undivided profits. However, if the Bank’s surplus is less than 50% of its paid-in capital stock, then the Bank’s directors may not declare any cash dividend until it has transferred from undivided profits to surplus 25% of its undivided profits or any lesser percentage necessary to raise its surplus to an amount equal to 50% of its paid-in capital stock.

 

In addition to the restrictions described above, other state and federal statutory and regulatory restrictions apply to the Bank’s payment of cash dividends. As an insured depository institution, federal law prohibits the Bank from making any capital distributions, including the payment of a cash dividend if it is “undercapitalized” (as that term is defined in the FDIA) or after making the distribution, would become undercapitalized. If the FDIC believes that we are engaged in, or about to engage in, an unsafe or unsound practice, the FDIC may require, after notice and hearing, that we cease and desist from that practice. The FDIC has indicated that paying dividends that deplete a depository institution’s capital base to an inadequate level would be an unsafe and unsound banking practice. The FDIC has issued policy statements that provide that insured banks generally should pay dividends only from their current operating earnings, and, under the FDIA, no dividend may be paid by an insured bank while it is in default on any assessment due the FDIC. The Bank’s payment of dividends also could be affected or limited by other factors, such as events or circumstances which lead the FDIC to require (as further described below) that it maintain capital in excess of regulatory guidelines.

 

In the future, our ability to declare and pay cash dividends will be subject to our Board of Directors’ evaluation of our operating results, capital levels, financial condition, future growth plans, general business and economic conditions, and tax and other relevant considerations.

 

Capital Adequacy.    We and the Bank are required to comply with the FRB’s and FDIC’s capital adequacy standards for bank holding companies and insured banks. The FRB and FDIC has issued risk-based capital and leverage capital guidelines for measuring capital adequacy, and all applicable capital standards must be satisfied for us or the Bank to be considered in compliance with regulatory capital requirements.

 

Under the FDIC’s risk-based capital measure, the minimum ratio (“Total Capital Ratio”) of the Bank’s total capital (“Total Capital”) to its risk-weighted assets (including various off-balance-sheet items, such as standby letters of credit) is 8.0%. At least half of Total Capital must be composed of “Tier 1 Capital.” Tier 1 Capital includes common equity, undivided profits, minority interests in the equity accounts of consolidated subsidiaries, qualifying noncumulative perpetual preferred stock, and a limited amount of cumulative perpetual preferred stock, less goodwill and various other intangible assets. The remainder of Total Capital may consist of “Tier 2 Capital” which includes certain subordinated debt, certain hybrid capital instruments and other qualifying preferred stock, and a limited amount of loan loss reserves. A bank or bank holding company that does not satisfy minimum capital requirements may be required to adopt and implement a plan acceptable to its federal banking regulator to achieve an adequate level of capital.

 

Under the leverage capital measure, the minimum ratio (“Leverage Capital Ratio”) of Tier 1 Capital to average assets, less goodwill and various other intangible assets, generally is 3.0% for entities that meet specified criteria, including having the highest regulatory rating. All other entities generally are required to maintain an additional cushion of 100 to 200 basis points above the stated minimum. The FDIC’s guidelines also provide that banks experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum levels without significant reliance on intangible assets, and a bank’s “Tangible Leverage Ratio” (determined by deducting all intangible assets) and other indicators of a bank’s capital strength also are taken into consideration by banking regulators in evaluating proposals for expansion or new activities.

 

Our and the Bank’s Board of Directors have entered into informal agreements with our respective banking regulators which are described in Note 10 to our audited financial statements included in Item 8 of this Report. Among other things, the agreements require that the Bank maintain capital levels in excess of normal statutory minimums, including a Leverage Capital Ratio of not less than 7.5%, and other ratios at least at “well capitalized” levels.

 

The FRB and FDIC also consider interest rate risk (arising when the interest rate sensitivity of the Bank’s assets does not match the sensitivity of its liabilities or its off-balance-sheet position) in the evaluation of the Bank’s capital adequacy.

 

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Banks with excessive interest rate risk exposure are required to hold additional amounts of capital against their exposure to losses resulting from that risk. The regulators also require banks to incorporate market risk components into their risk-based capital. Under these market risk requirements, capital is allocated to support the amount of market risk related to a bank’s trading activities.

 

Our capital categories are determined solely for the purpose of applying the “prompt corrective action” rules described below and they are not necessarily an accurate representation of our overall financial condition or prospects for other purposes. A failure to meet the capital guidelines could subject us to a variety of enforcement actions under those rules, including the issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on the taking of brokered deposits, and other restrictions on our business. As described below, the FDIC also can impose other substantial restrictions on banks that fail to meet applicable capital requirements.

 

Regulatory Guidance on “CRE” Lending Concentrations.    During 2006, the FDIC and other federal banking regulators issued guidance for sound risk management for financial institutions whose loan portfolios are deemed to have significant concentrations in commercial real estate (“CRE”). In March 2008, the FDIC and other federal banking regulators issued further guidance on applying these principles in the current real estate lending environment, and they noted particular concern about construction and development loans. The banking regulators have indicated that this guidance does not set strict limitations on the amount or percentage of CRE within any given loan portfolio, and that they also will examine risk indicators in banks which have amounts or percentages of CRE below the thresholds. However, if a bank’s CRE exceeds these thresholds or if other risk indicators are present, the FDIC and other federal banking regulators may require additional reporting and analysis to document management’s evaluation of the potential additional risks of such concentration and the impact of any mitigating factors. The March 2008 supplementary guidance stated that banks with significant CRE concentrations should maintain or implement processes to: (1) increase and maintain strong capital levels; (2) ensure that their loan loss allowances are appropriately strong; (3) closely manage their CRE and construction and development loan portfolios; (4) maintain updated financial and analytical information about borrowers and guarantors; and (5) bolster their workout infrastructure for problem loans. It is possible that regulatory constraints associated with this guidance could adversely affect our ability to grow CRE assets, and they also could increase the costs of monitoring and managing this component of our loan portfolio.

 

Prompt Corrective Action.    Federal law establishes a system of prompt corrective action to resolve the problems of undercapitalized banks. Under this system, the FDIC has established five capital categories (“well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized”) and is required to take various mandatory supervisory actions, and is authorized to take other discretionary actions, with respect to banks in the three undercapitalized categories. The severity of any such actions taken will depend upon the capital category in which a bank is placed. Generally, subject to a narrow exception, current federal law requires the FDIC to appoint a receiver or conservator for a bank that is critically undercapitalized.

 

Under the FDIC’s prompt corrective action rules, a bank that (1) has a Total Capital Ratio of 10.0% or greater, a Tier 1 Capital Ratio of 6.0% or greater, and a Leverage Ratio of 5.0% or greater, and (2) is not subject to any written agreement, order, capital directive, or prompt corrective action directive issued by the FDIC, is considered to be “well capitalized.” A bank with a Total Capital Ratio of 8.0% or greater, a Tier 1 Capital Ratio of 4.0% or greater, and a Leverage Ratio of 4.0% or greater, is considered to be “adequately capitalized.” A bank that has a Total Capital Ratio of less than 8.0%, a Tier 1 Capital Ratio of less than 4.0%, or a Leverage Ratio of less than 4.0%, is considered to be “undercapitalized.” A bank that has a Total Capital Ratio of less than 6.0%, a Tier 1 Capital Ratio of less than 3.0%, or a Leverage Ratio of less than 3.0%, is considered to be “significantly undercapitalized,” and a bank that has a tangible equity capital to assets ratio equal to or less than 2.0% is deemed to be “critically undercapitalized.” For purposes of these rules, the term “tangible equity” includes core capital elements counted as Tier 1 Capital for purposes of the risk-based capital standards, plus the amount of outstanding cumulative perpetual preferred stock (including related surplus), minus all intangible assets (with various exceptions). A bank may be considered to be in a capitalization category lower than indicated by its actual capital position if it receives an unsatisfactory examination rating.

 

A bank that becomes “undercapitalized,” “significantly undercapitalized,” or “critically undercapitalized,” is required to submit an acceptable capital restoration plan to the FDIC. An “undercapitalized” bank also is generally prohibited from increasing its average total assets, making acquisitions, establishing new branches, or engaging in any new line of business, except in accordance with an accepted capital restoration plan or with the approval of the FDIC. Also, the FDIC may

 

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treat an “undercapitalized” bank as being “significantly undercapitalized” if it determines that those actions are necessary to carry out the purpose of the law.

 

The following table lists our and the Bank’s capital ratios at December 31, 2009.

 

     Minimum
required ratios
    Required ratios
to be considered
“Well capitalized”
    The Company’s
capital ratios
    The Bank’s
capital ratios
 

Leverage Capital Ratio (Tier 1 Capital to fourth quarter average assets)

   4.0   5.0   7.27   7.38

Tier 1 Capital Ratio (Tier 1 Capital to risk-weighted assets)

   4.0   6.0   9.86   10.01

Total Capital Ratio (Total Capital to risk-weighted assets)

   8.0   10.0   11.67   11.25

 

U.S. Treasury’s Troubled Asset Relief Program (TARP) Capital Purchase Program.    On April 17, 2009, we issued Series A Preferred Stock in the amount of $ 13.179 million and a warrant to purchase 475,024 shares of our common stock to the U.S. Treasury as a participant in the TARP Capital Purchase Program. The Series A Preferred Stock qualifies as Tier 1 capital for purposes of regulatory capital requirements and will pay cumulative dividends at a rate of 5% per annum for the first five years and 9% per annum thereafter. Unless all accrued dividends on the Series A Preferred Stock have been paid in full, (1) no dividends may be declared or paid on our common stock, and (2) we may not repurchase any of our outstanding common stock. Additionally, during the first three years following our sale of the Series A Preferred Stock, we are required to obtain the consent of the U.S. Treasury in order to increase the dividend per share paid on our common stock from the last quarterly cash dividend per share declared prior to our sale of the Series A Preferred Stock, or to purchase outstanding shares of our common stock, unless we have redeemed all of this preferred stock or the U.S. Treasury has transferred all of this preferred stock to a third party. In addition, until the U.S. Treasury ceases to own our securities sold under the TARP Capital Purchase Program, the compensation arrangements for our senior executive officers must comply in all respects with the U.S. Emergency Economic Stabilization Act of 2008, as amended by the American Recovery and Reinvestment Act of 2009, and the rules and regulations there under.

 

Reserve Requirements.    Under the FRB’s regulations, all FDIC-insured depository institutions must maintain average daily reserves against their transaction accounts. No reserves are required to be maintained on the first $10.7 million of transaction accounts, but reserves equal to 3.0% must be maintained on the aggregate balances of those accounts between $10.7 million and $55.2 million, and reserves equal to 10.0% must be maintained on aggregate balances in excess of $55.2 million. The FRB may adjust these percentages from time to time. Because the Bank’s reserves are required to be maintained in the form of vault cash or in an account at a Federal Reserve Bank or with a qualified correspondent bank, one effect of the reserve requirement is to reduce the amount of our assets that are available for lending and other investment activities.

 

Federal Deposit Insurance Reform.    The Bank’s deposits are insured by the FDIC to the full extent provided in the Federal Deposit Insurance Act, and the Bank pays assessments to the FDIC for that insurance coverage. Under the Act, the FDIC may terminate the Bank’s deposit insurance if it finds that the Bank has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated applicable laws, regulations, rules or orders.

 

The Federal Deposit Insurance Reform Act of 2005 (“FDIRA”), as implemented through rules adopted by the FDIC, has changed the federal deposit insurance system by, among other things:

 

   

merging the Bank Insurance Fund and Savings Association Insurance Fund into a new Deposit Insurance Fund (the “DIF”);

 

   

raising the level of Federal deposit insurance coverage for retirement accounts to $250,000;

 

   

establishing a range of 1.15% to 1.50% within which the FDIC must set and maintain the required reserve ratio for the DIF;

 

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requiring that, if the DIF reserve ratio falls, or within six months is expected to fall, below the statutorily required minimum of 1.15%, the FDIC must adopt a restoration plan that provides for the DIF to be restored; and

 

   

eliminating restrictions on premium rates based on the DIF reserve ratio, and giving the FDIC discretion to price deposit insurance according to the risk posed to the DIF by each insured institution, regardless of the DIF reserve ratio.

 

The Emergency Economic Stabilization Act of 2008 temporarily raised the basic limit on federal deposit insurance coverage for all accounts from $100,000 to $250,000 per depositor. The Act provided that the basic deposit insurance limit would return to $100,000 on December 31, 2009. However, during May 2009, that increased coverage was extended until December 31, 2013, at which time it will return to $100,000 for all accounts other than retirement accounts for which FDIRA permanently increased the basic coverage to $250,000.

 

FDIC Temporary Liquidity Guarantee Program.    During 2008, the FDIC implemented its Temporary Liquidity Guarantee Program (the “TLGP”) which applies to all US depository institutions insured by the FDIC and all US bank holding companies, unless they have “opted out” of the TLGP or the FDIC has terminated their participation.

 

Under the TLGP, the FDIC guarantees certain senior unsecured debt and/or non-interest bearing transaction account deposits, and in return for those guarantees the FDIC is paid a fee based on the amount of the deposit or the money and maturity of the debt. Under the debt guarantee component of the TLGP, the FDIC will pay the unpaid principal and interest on an FDIC guaranteed debt instrument upon the uncured failure of the participating entity to make a timely payment of principal or interest in accordance with the terms of the instrument. Under the original terms of the transaction account guarantee component of the TLGP, all non-interest bearing transaction accounts would be insured in full by the FDIC until December 31, 2009, regardless of the standard maximum deposit insurance amount. During August 2009, the FDIC extended the transaction account guarantee component of the TLGP through June 30, 2010. The Bank has elected to participate in the non-interest bearing transaction account guarantee program, but not the debt guarantee program. In return for the expanded insurance coverage, the Bank is paying an additional annual assessment surcharge equal to 10 basis points that applies to the balances of non-interest bearing transaction accounts in excess of the current standard deposit insurance coverage of $250,000.

 

FDIC Insurance Assessments.    Under FDIRA, the FDIC uses a revised risk-based assessment system to determine the amount of the Bank’s deposit insurance assessment based on an evaluation of the probability that the Deposit Insurance Fund will incur a loss with respect to the Bank. That evaluation takes into consideration risks attributable to different categories and concentrations of the Bank’s assets and liabilities and any other factors the FDIC considers to be relevant, including information obtained from the Commissioner. A higher assessment rate results in an increase in the assessments paid by the Bank to the FDIC for deposit insurance.

 

The FDIC is responsible for maintaining the adequacy of the DIF, and the amount the Bank pays for deposit insurance is influenced not only by the assessment of the risk it poses to the DIF, but also by the adequacy of the insurance fund at any time to cover the risk posed by all insured institutions. FDIC insurance assessments could be increased substantially in the future if the FDIC finds such an increase to be necessary in order to adequately maintain the insurance fund.

 

During 2008, and because the DIF reserve ratio had fallen below the minimum of 1.15% mandated by FDIRA, the Board of Directors of the FDIC adopted a restoration plan to return the reserve ratio to that minimum level as required by FDIRA within five years. During February 2009, the Board amended its restoration plan to provide for the minimum DIF reserve ratio to be restored within seven years and voted to impose a special assessment on insured institutions of 20 basis points, and to increase regular assessment rates for 2009.

 

However, during May 2009, the special assessment was reduced to 5 basis points on each insured institution’s assets minus its Tier 1 capital as of June 30, 2009, but not more than 10 basis points of the institution’s assessment base for the second quarter of 2009. The special assessment was payable on September 30, 2009.

 

During October 2009, the FDIC again amended its restoration plan to provide for the minimum DIF reserve ratio to be restored within eight years, and adopted a uniform 3 basis point increase in regular assessment rates effective

 

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January 1, 2011. During November 2009, the FDIC amended its regulations to require that insured institutions prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012 on December 30, 2009.

 

Community Reinvestment.    Under the Community Reinvestment Act (the “CRA”), an insured institution has a continuing and affirmative obligation, consistent with its safe and sound operation, to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for banks, nor does it limit a bank’s discretion to develop, consistent with the CRA, the types of products and services that it believes are best suited to its particular community. The CRA requires the federal banking regulators, in connection with their examinations of insured banks, to assess the banks’ records of meeting the credit needs of their communities, using the ratings of “outstanding,” “satisfactory,” “needs to improve,” or “substantial noncompliance,” and to take that record into account in its evaluation of various applications by those banks. All banks are required to publicly disclose their CRA performance ratings. The Bank received a “Satisfactory” rating in its last CRA examination during July 2009.

 

Interstate Banking and Branching.    The BHCA, as amended by the interstate banking provisions of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Interstate Banking Law”), permits adequately capitalized and managed bank holding companies to acquire control of the assets of banks in any state. Acquisitions are subject to antitrust provisions that cap at 10.0% the portion of the total deposits of insured depository institutions in the United States that a single bank holding company may control, and generally cap at 30.0% the portion of the total deposits of insured depository institutions in a state that a single bank holding company may control. Under certain circumstances, states have the authority to increase or decrease the 30.0% cap, and states may set minimum age requirements of up to five years on target banks within their borders.

 

Subject to certain conditions, the Interstate Banking Law also permits interstate branching by allowing a bank in one state to merge with a bank located in a different state. Each state was allowed to “opt out” and thereby prohibit interstate branching by merger by enacting legislation to that effect. The Interstate Banking Law also permits banks to establish branches in other states by opening new branches or acquiring existing branches of other banks, provided the laws of those other states specifically permit that form of interstate branching. North Carolina has adopted statutes which, subject to conditions, authorize out-of-state bank holding companies and banks to acquire or merge with North Carolina banks and to establish or acquire branches in North Carolina.

 

Restrictions on Transactions with Affiliates.    The Bank is subject to the provisions of Section 23A and 23B of the Federal Reserve Act which restrict a bank’s ability to enter into certain types of transactions with its “affiliates,” including its parent holding company or any subsidiaries of its parent company. Section 23A places limits on the amount of:

 

   

a bank’s loans or extensions of credit to, or investment in, its affiliates;

 

   

assets a bank may purchase from affiliates, except for real and personal property exempted by the FRB;

 

   

the amount of loans or extensions of credit by a bank to third parties which are collateralized by the securities or obligations of the bank’s affiliates; and

 

   

a bank’s guarantee, acceptance or letter of credit issued on behalf of one of its affiliates.

 

Transactions of the type described above are limited in amount, as to any one affiliate, to 10% of a bank’s capital and surplus and, as to all affiliates combined, to 20% of a bank’s capital and surplus. In addition to the limitation on the amount of these transactions, each of the above transactions must also meet specified collateral requirements. The Bank also must comply with other provisions designed to avoid the taking of low-quality assets from an affiliate.

 

Among other things, Section 23B prohibits a bank or its subsidiaries generally from engaging in transactions with its affiliates unless the transactions are on terms substantially the same, or at least as favorable to the bank or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.

 

Federal law also places restrictions on our ability to extend credit to our executive officers, directors, principal shareholders and their related interests. These extensions of credit (1) must be made on substantially the same terms,

 

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including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated third parties, and (2) must not involve more than the normal risk of repayment or present other unfavorable features.

 

USA Patriot Act of 2001.    The USA Patriot Act of 2001 is intended to strengthen the ability of U.S. law enforcement and the intelligence community to work cohesively to combat terrorism on a variety of fronts. The impact of the Act on financial institutions of all kinds is significant and wide ranging. The Act contains sweeping anti-money laundering and financial transparency laws and requires various regulations, including standards for verifying customer identification when accounts are opened, and rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.

 

Sarbanes-Oxley Act of 2002.    The Sarbanes-Oxley Act of 2002 is sweeping federal legislation that addressed accounting, corporate governance and disclosure issues. The Act applies to all public companies and imposed significant new requirements for public company governance and disclosure requirements. Some of the provisions of the Act became effective immediately while others are still in the process of being implemented.

 

In general, the Sarbanes-Oxley Act mandated important new corporate governance and financial reporting requirements intended to enhance the accuracy and transparency of public companies’ reported financial results. It established new responsibilities for corporate chief executive officers, chief financial officers and audit committees in the financial reporting process, and it created a new regulatory body to oversee auditors of public companies. It backed these requirements with new SEC enforcement tools, increased criminal penalties for federal mail, wire and securities fraud, and created new criminal penalties for document and record destruction in connection with federal investigations. It also increased the opportunity for more private litigation by lengthening the statute of limitations for securities fraud claims and providing new federal corporate whistleblower protection.

 

The Act also required that the various securities exchanges, including The Nasdaq Stock Market, prohibit the listing of the stock of an issuer unless that issuer complies with various requirements relating to their audit committees and the independence of their directors that serve on those committees. In response to the Act, the exchanges themselves have imposed additional corporate governance requirements as conditions to the continued listing of an issuer’s stock, including the requirement that various corporate matters (including executive compensation and board nominations) be approved, or recommended for approval by the issuer’s full board of directors, by directors of the issuer who are “independent” as defined by the exchanges’ rules or by committees made up of “independent” directors. We are subject to the requirements of the Act and, because our common stock is listed on The Nasdaq Global Market, we are subject to the corporate governance requirements of The Nasdaq Stock Market.

 

The economic and operational effects of the Sarbanes-Oxley Act on public companies, including us, have been and will continue to be significant in terms of the time, resources and costs associated with compliance. Because the Act, for the most part, applies equally to larger and smaller public companies, we have been and will continue to be presented with additional challenges as a smaller, community-oriented financial institution seeking to compete with larger financial institutions in our market.

 

AVAILABLE INFORMATION

 

Copies of reports we file electronically with the Securities and Exchange Commission, including copies of our Annual Reports on Form 10-K, Quarterly Reports on form 10-Q, Current Reports on Form 8-K, and amendments to those reports, are available free of charge through the Bank’s Internet website as soon as reasonably practicable after they are filed. The Bank’s website address is www.bankofthecarolinas.com.

 

STATISTICAL DATA

 

Certain statistical data regarding our loans, deposits, investment securities and business is included in the information provided in Part II of this Report under the caption Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

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Item 1A. Risk Factors.

 

The following paragraphs describe material risks that could affect our business. Other risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations. If any of the following risks actually occur, our business, results of operations and financial condition could suffer. The risks discussed below also include forward-looking statements, and our actual results may differ materially from those discussed in these forward-looking statements.

 

Risks Relating to our Business

 

The current economic environment poses significant challenges for our business and could adversely affect our financial condition and results of operations.

 

There has been significant disruption and volatility in the financial and capital markets since 2007. The financial services industry in particular has suffered unprecedented disruption, causing a number of institutions to fail or require government intervention to avoid failure. These conditions were largely the result of the erosion of the U.S. and global credit markets, including a significant and rapid deterioration in the mortgage lending and related real estate markets. Dramatic declines in the housing markets over the past three years, with falling home prices and increasing foreclosures and unemployment, have resulted in significant write-downs of asset values by financial institutions. Continued declines in real estate values, home sales volumes, and financial stress on borrowers as a result of the uncertain economic environment could have an adverse effect on the our borrowers or their customers, which could adversely affect our financial condition and results of operations. A worsening of these conditions would likely exacerbate the adverse effects on us and others in the financial institutions industry. There can be no assurance that the economic conditions that have adversely affected the financial services industry, and the capital, credit and real estate markets generally, will improve significantly in the near term, in which case we could continue to experience losses, write-downs of assets, further impairment charges of investment securities and capital and liquidity constraints or other business challenges. A further deterioration in local economic conditions, particularly within our geographic regions and markets, could drive losses beyond that which is provided for in our allowance for loan losses. We may face the following risks in connection with these events:

 

   

Economic conditions that negatively affect housing prices and the job market have resulted, and may continue to result, in deterioration in credit quality of our loan portfolios, and such deterioration in credit quality has had, and could continue to have, a negative impact on our business.

 

   

Market developments may affect consumer confidence levels and may cause adverse changes in payment patterns, causing increases in delinquencies and default rates on loans and other credit facilities.

 

   

The processes we use to estimate allowance for loan losses and reserves may no longer be reliable because they rely on complex judgments, including forecasts of economic conditions, which may no longer be capable of accurate estimation.

 

   

Our ability to assess the creditworthiness of our customers may be impaired if the models and approaches we use to select, manage, and underwrite our customers become less predictive of future charge-offs.

 

   

We expect to face increased regulation of our industry, and compliance with such regulation may increase our costs, limit our ability to pursue business opportunities, and increase compliance challenges.

 

As the above conditions or similar ones continue to exist or worsen, we could experience continuing or increased adverse effects on our financial condition and results of operations.

 

We are subject to extensive regulation which could adversely affect our business and recent legislative and regulatory initiatives to address difficult market and economic conditions may not stabilize the U.S. banking system.

 

Our operations are subject to extensive regulation and supervision by federal and state governmental authorities and are subject to various laws and judicial and administrative decisions imposing requirements and restrictions on part or all of our operations. Banking regulations governing our operations are primarily intended to protect depositors’ funds, federal deposit insurance funds and the banking system as a whole, not security holders. Congress and federal regulatory

 

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agencies continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect us in substantial and unpredictable ways. Such changes could subject us to additional costs, limit the types of financial services and products we may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Also, failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on our business, financial condition and results of operations. While we have policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur. These laws, rules and regulations, or any other laws, rules or regulations, that may be adopted in the future, could make compliance more difficult or expensive, restrict our ability to originate, broker or sell loans, further limit or restrict the amount of commissions, interest or other charges earned on loans originated or sold by the Bank and otherwise adversely affect our business, financial condition or prospects.

 

On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was signed into law. EESA authorizes Treasury to purchase from financial institutions and their holding companies up to $700 billion in mortgage loans, mortgage-related securities and certain other financial instruments, including debt and equity securities issued by financial institutions and their holding companies, under a troubled asset relief program, or “TARP.” The purpose of TARP is to restore confidence and stability to the U.S. banking system and to encourage financial institutions to increase their lending to customers and to each other. The Treasury has allocated $250 billion towards the TARP Capital Purchase Program. Under that program, Treasury is purchasing equity securities from participating institutions.

 

In February, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was enacted containing additional provisions designed to support the national economy and aid in economic recovery. The provisions of EESA and ARRA are in addition to numerous other actions by the Federal Reserve, Treasury, the FDIC, the SEC and others to address the current decline in the national economy and liquidity and credit crisis that commenced in 2007. These measures include homeowner relief that encourages loan restructuring and modification; the establishment of significant liquidity and credit facilities for financial institutions and investment banks; the lowering of the federal funds rate; emergency action against short selling practices; a temporary guaranty program for money market funds; the establishment of a commercial paper funding facility to provide back-stop liquidity to commercial paper issuers; and coordinated international efforts to address illiquidity and other weaknesses in the banking sector.

 

The purpose of EESA, ARRA and other recent legislative and regulatory actions is to support the national economy, stabilize the U.S. banking system, and aid in economic recovery. However, there is no assurance that EESA, ARRA and the other regulatory initiatives described above will be fully effective or have their desired effects. If the volatility in the markets continues and economic conditions fail to improve or worsen, our business, financial condition and results of operations could be materially and adversely affected.

 

Current levels of market volatility are unprecedented.

 

The capital and credit markets have experienced volatility and disruption for more than two years. As the volatility and disruption has continued, the markets have produced downward pressure on stock prices and credit availability for many issuers without regard to their underlying financial strength. This has been particularly the case with respect to financial institutions, and the market prices of the stock of financial services companies in general, including ours, are at their lowest levels in recent history. If current levels of market disruption and volatility continue or worsen, there can be no assurance that we will not experience an adverse effect, which may be material, on our ability to access capital and on our business, financial condition and results of operations.

 

Our allowance for loan losses may prove to be insufficient to absorb probable losses in our loan portfolio.

 

Lending money is a substantial part of our business. Every loan carries a degree of risk that it will not be repaid in accordance with its terms or that any underlying collateral will not be sufficient to assure repayment. This risk is affected by, among other things:

 

   

cash flow of the borrower and/or a business activity being financed;

 

   

in the case of a collateralized loan, changes in and uncertainties regarding future values of collateral;

 

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the credit history of a particular borrower;

 

   

changes in economic and industry conditions; and

 

   

the duration of the loan.

 

We use underwriting procedures and criteria that we believe minimize the risk of loan delinquencies and losses, but banks routinely incur losses in their loan portfolios. Regardless of the underwriting criteria we use, we will experience loan losses from time to time in the ordinary course of our business, and some of those losses will result from factors beyond our control.

 

Like all financial institutions, we maintain an allowance for loan losses to provide for probable losses. However, we cannot be certain that our allowance for loan losses will be adequate to cover actual loan losses we incur, and future provisions for loan losses could materially and adversely affect our operating results. The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Our allowance for loan losses is determined by analyzing historical loan losses, current trends in delinquencies and charge-offs, plans for problem loan resolution, changes in the size and composition of the loan portfolio, and industry information. Also included in management’s estimates for loan losses are considerations with respect to the impact of economic events, the outcome of which are uncertain. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates that may be beyond our control, and these losses may exceed current estimates. Federal and North Carolina regulatory agencies, as an integral part of their examination process, review our loans and allowance for loan losses. Although we believe that our allowance for loan losses is adequate to provide for probable losses, there are no assurances that future increases in the allowance for loan losses will not be needed or that regulators will not require us to increase its allowance. Either of these occurrences could materially and adversely affect our earnings and profitability.

 

We have experienced increases in the levels of non-performing assets and loan charge-offs in recent periods. For additional information regarding loss experience, our allowance for loan losses and problem assets, see Table II. Summary of Loss Experience, Table III. Allocation of Allowance for Loan Losses and Table IV. Problem Assets in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. Additional increases in our non-performing assets or loan charge-offs may require it to increase its allowance for loan losses, which would have an adverse effect upon our future results of operations.

 

A large percentage of our loans are secured by real estate. Adverse conditions in the real estate market in our banking markets might adversely affect on our loan portfolio.

 

While we do not have a sub-prime lending program, a relatively large percentage of our loans are secured by real estate. Our management believes that, in the case of many of those loans, the real estate collateral is not being relied upon as the primary source of repayment, and the level of our real estate loans reflects, at least in part, our policy to take real estate whenever possible as primary or additional collateral rather than other types of collateral. However, adverse conditions in the real estate market and the economy in general have decreased real estate values in our banking markets. If the value of our collateral for a loan falls below the outstanding balance of that loan, our ability to collect the balance of the loan by selling the underlying real estate in the event of a default will be diminished, and we would be more likely to suffer a loss on the loan. An increase in our loan losses could have a material adverse effect on our operating results and financial condition.

 

The FDIC recently adopted rules aimed at placing additional monitoring and management controls on financial institutions whose loan portfolios are deemed to have concentrations in commercial real estate (“CRE”). At December 31, 2009, our loan portfolio was less than the two thresholds established by the FDIC for CRE concentrations and for additional regulatory scrutiny. Indications from regulators are that strict limitations on the amount or percentage of CRE within any given portfolio are not expected, but, rather, that additional reporting and analysis will be required to document management’s evaluation of the potential additional risks of such concentrations and the impact of any mitigating factors. However, it is possible that regulatory constraints associated with these rules could adversely affect our ability to grow loan assets and thereby limit our overall growth. These rules also could increase the costs of monitoring and managing this component of our loan portfolio. Either of these eventualities could have an adverse impact on our operating results and financial condition.

 

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Liquidity risk could impair our ability to fund operations and jeopardize our financial condition.

 

Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale of loans and other sources could have a substantial negative effect on our liquidity. Our access to funding sources in amounts adequate to finance our activities, or on terms which are acceptable to us, could be impaired by factors that affect us specifically or the financial services industry or economy in general. Factors that could detrimentally affect our access to liquidity sources include a decrease in the level of our business activity as a result of a downturn in the markets in which our loans are concentrated or adverse regulatory action against us. Our ability to borrow could also be impaired by factors that are not specific to us, such as a disruption in the financial markets or negative views and expectations about the prospects for the financial services industry in light of the recent turmoil faced by banking organizations and the continued deterioration in credit markets.

 

Among other sources of funds, we rely heavily on deposits for funds to make loans and provide for our other liquidity needs. However, our loan demand has historically exceeded the rate at which we have been able to build core deposits, so we have relied heavily on interest-sensitive deposits, including wholesale deposits, as sources of funds. Those deposits may not be as stable as other types of deposits and, in the future, depositors may not renew those deposits when they mature, or we may have to pay a higher rate of interest to attract or retain them or to replace them with other deposits or with funds from other sources. Not being able to attract those deposits, or to retain or replace them as they mature, would adversely affect our liquidity. Paying higher deposit rates to attract, retain or replace those deposits could have a negative effect on our interest margin and operating results.

 

We may need to raise additional capital in the future in order to continue to grow, but that capital may not be available when it is needed.

 

Federal and state banking regulators require us to maintain adequate levels of capital to support our operations. In addition, in the future we may need to raise additional capital to support our business or to finance acquisitions, if any, or we may otherwise elect or be required to raise additional capital. In that regard, a number of financial institutions recently have sought to raise considerable amounts of capital in response to deterioration in their results of operations and financial condition arising from the turmoil in the mortgage loan market, deteriorating economic conditions, declines in real estate values and other factors. On December 31, 2009, our three capital ratios were above “well capitalized” levels under bank regulatory guidelines. However, as described in Note 10 to our audited financial statements included in Item 8 of this Report, our and the Bank’s Boards of Directors have entered into informal agreements with our respective banking regulators which, among other things, require that the Bank maintain capital levels in excess of the normal statutory minimums, including a Leverage Capital Ratio of not less than 7.5%, and other ratios at least at “well capitalized” levels. If those agreed-upon minimums are not met at the end of any quarter, the Bank’s Board of Directors is required to submit a plan to its banking regulators within 30 days detailing how such minimums are to be met. At December 31, 2009, the Bank’s Leverage Capital Ratio was 7.38%, slightly below the minimum. The Tier 1 Leverage Capital Ratio is calculated based on the fourth quarter average of total assets, so the full effect of our strategy to reduce the size of the Bank’s balance sheet was not recognized for this purpose at year-end. If period-end assets had been used to calculate the Bank’s Tier 1 Leverage Ratio at December 31, 2009 rather than fourth quarter average, the ratio would have been 7.76%, higher than the level agreed to and above the ratio at which institutions are normally considered well-capitalized. Based on average assets through March 29, 2010, we are confident that the Tier 1 Leverage Ratio will remain above 7.50% for the first quarter of 2010. Future growth in our earning assets resulting from internal expansion and new branch offices, at rates in excess of the rate at which our capital is increased through retained earnings, will reduce our capital ratios unless we continue to increase our capital. Also, future unexpected losses, whether resulting from loan losses or other causes, would reduce our capital.

 

Should we need, or be required by regulatory authorities, to raise additional capital in the future to support our operations and growth, or if we seek to raise additional capital in order to redeem the preferred stock we have sold to the U.S. Treasury under the TARP Capital Purchase Program, we may seek to do so through the issuance of, among other things, our common stock or preferred stock. However, our ability to raise that additional capital will depend on conditions at that time in the capital markets, economic conditions, our financial performance and condition, and other factors, many of which are outside our control. There is no assurance that, if needed, we will be able to raise additional capital on terms favorable to us or at all. Our inability to raise additional capital, if needed, on terms acceptable to us, may have a material adverse effect on our ability to expand our operations, and on our financial condition, results of operations and future prospects.

 

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If we are unable to redeem the preferred stock we sold to the U.S. Treasury under the TARP Capital Purchase Program after five years, the cost of this capital to us will increase substantially.

 

The dividend rate on the preferred stock we sold under the TARP Capital Purchase Program will increase from 5.0% per annum to 9.0% per annum after five years. Depending on our financial condition at the time, this increase in the annual dividend rate could have a material negative effect on our liquidity and on our net income available to holders of our common stock.

 

Higher FDIC deposit insurance premiums and assessments could adversely affect the Company’s financial condition.

 

The Bank’s FDIC insurance premiums increased substantially in 2009, and the Company expects to pay significantly higher premiums in the future. A large number of depository institution failures have significantly depleted the DIF and reduced the ratio of reserves to insured deposits. In order to restore the DIF to its statutorily mandated minimum of 1.15% over a period of several years, the FDIC increased deposit insurance premium rates at the beginning of 2009 and imposed a special assessment on June 30, 2009. The FDIC may impose additional special assessments in the future.

 

Our profitability is subject to interest rate risk. Changes in interest rates could have an adverse effect on our operating results.

 

Our profitability depends, to a large extent, on our net interest income, which is the difference between our income on interest-earning assets and our expense on interest-bearing deposits and other liabilities. In other words, to be profitable, we have to earn more interest on our loans and investments than we pay on our deposits and borrowings. Like most financial institutions, we are affected by changes in general interest rate levels and by other economic factors beyond our control. Interest rate risk arises in part from the mismatch (i.e., the interest sensitivity “gap”) between the dollar amounts of repricing or maturing interest-earning assets and interest-bearing liabilities, and is measured in terms of the ratio of the interest rate sensitivity gap to total assets. When more interest-earning assets than interest-bearing liabilities will reprice or mature over a given time period, a bank is considered asset-sensitive and has a positive gap. When more liabilities than assets will reprice or mature over a given time period, a bank is considered liability-sensitive and has a negative gap. A liability-sensitive position (i.e., a negative gap) may generally enhance net interest income in a falling interest rate environment and reduce net interest income in a rising interest rate environment. An asset-sensitive position (i.e., a positive gap) may generally enhance net interest income in a rising interest rate environment and reduce net interest income in a falling interest rate environment. Our ability to manage our gap position determines to a great extent our ability to operate profitably. However, fluctuations in interest rates are not predictable or controllable, nor do specific asset and liability groups reprice at the same time or in the same magnitude as general changes in interest rates. Therefore, we cannot assure you we will be able to manage net interest income in a manner that will allow us to become or remain profitable.

 

On December 31, 2009, we had a negative one-year cumulative interest sensitivity gap, which means that, during a one-year period, our interest-bearing liabilities generally would be expected to reprice at a faster rate than our interest-earning assets.

 

Our business depends on the condition of the local and regional economies where we operate.

 

We currently have offices only in one region of North Carolina. Consistent with our community banking philosophy, a majority of our customers are located in and do business in that region, and we lend a substantial portion of our capital and deposits to commercial and consumer borrowers in our local banking markets. Therefore, our local and regional economy has a direct impact on our ability to generate deposits to support loan growth, the demand for loans, the ability of borrowers to repay loans, the value of collateral securing our loans (particularly loans secured by real estate), and our ability to collect, liquidate and restructure problem loans. If our local communities are adversely affected by current conditions in the national economy or by other specific events or trends, there could be a direct adverse effect on our operating results. Adverse economic conditions in our banking markets could reduce our growth rate, affect the ability of our customers to repay their loans to us, and generally affect our financial condition and operating results. We are less able than larger institutions to spread risks of unfavorable local economic conditions across a large number of diversified economies.

 

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New or changes in existing tax, accounting, and regulatory rules and interpretations could have an adverse effect on our strategic initiatives, results of operations, cash flows, and financial condition.

 

We operate in a highly regulated industry and are subject to examination, supervision and comprehensive regulation by various federal and state agencies. Federal and state banking regulations are designed primarily to protect the deposit insurance funds and consumers, not to benefit a financial company’s shareholders. These regulations may sometimes impose significant limitations on our operations, and our compliance with regulations is costly and restricts certain of our activities, including payment of dividends, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits, and locations of offices.

 

The significant federal and state banking regulations that affect us are described under Item 1. Business—Supervision and Regulation. These regulations, along with the currently existing tax, accounting, securities, insurance, and monetary laws, regulations, rules, standards, policies, and interpretations, control the methods by which financial institutions conduct business, implement strategic initiatives and tax compliance, and govern financial reporting and disclosures. The laws, regulations, rules, standards, policies, and interpretations are constantly evolving and may change significantly over time. As a result of recent turmoil in the financial services industry, it is likely that there will be an increase in the regulation of all financial institutions. We cannot predict the effects of future changes on our business and profitability.

 

Significant legal actions could subject us to substantial liabilities.

 

We are from time to time subject to claims related to our operations. These claims and legal actions, including supervisory actions by our regulators, could involve large monetary claims and significant defense costs. As a result, we may be exposed to substantial liabilities, which could adversely affect our results of operations and financial condition.

 

Among the laws that apply to us, the USA Patriot and Bank Secrecy Acts require financial institutions to develop programs to prevent financial institutions from being used for money laundering and terrorist activities. If such activities are detected, financial institutions are obligated to file suspicious activity reports with the Treasury’s Office of Financial Crimes Enforcement Network. These rules require financial institutions to establish procedures for identifying and verifying the identity of customers seeking to open new financial accounts. Failure to comply with these regulations could result in fines or sanctions. Several banking institutions have recently received large fines for non-compliance with these laws and regulations. Although we have developed policies and procedures designed to assist in compliance with these laws and regulations, no assurance can be given that these policies and procedures will be effective in preventing violations of these laws and regulations.

 

Competition from financial institutions and other financial service providers may adversely affect our profitability.

 

Our future growth and success will depend on, among other things, our ability to compete effectively with other financial services providers in our banking markets. To date, we have grown our business by focusing on our lines of business and emphasizing the high level of service and responsiveness desired by our customers. However, commercial banking in our banking markets and in North Carolina as a whole is extremely competitive. We compete against commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds, as well as other local and community, super-regional, national and international financial institutions that operate offices in our market areas and elsewhere. We compete with these institutions in attracting deposits and in making loans, and we have to attract our customer base from other existing financial institutions and from new residents. Our larger competitors have greater resources, broader geographic markets and name recognition, and higher lending limits than we do, and they can offer more products and services and better afford and more effectively use media advertising, support services and electronic technology than we can. Also, larger competitors may be able to price loans and deposits more aggressively than we do. While we believe we compete effectively with other financial institutions, we may face a competitive disadvantage as a result of our size, lack of geographic diversification and inability to spread marketing costs across a broader market. Although we compete by concentrating our marketing efforts in our primary markets with local advertisements, personal contacts and greater flexibility and responsiveness in working with local customers, we cannot assure you that we will continue to be an effective competitor in our banking markets.

 

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We rely on dividends from the Bank for substantially all of our revenue.

 

We receive substantially all of our revenue as dividends from the Bank. As described under the caption Item 1. Business—Supervision and Regulation, federal and state regulations limit the amount of dividends that the Bank may pay to us, and our and the Bank’s Boards of Directors have entered into informal agreements with our respective banking regulators which require that we and the Bank obtain the consent of our regulators before we may pay any cash dividends. If the Bank becomes unable to pay dividends to us, then we may not be able to service our debt, pay our other obligations or pay dividends on our common stock and on the preferred stock we sold to the U.S. Treasury under the TARP Capital Purchase Program. Accordingly, our inability to receive dividends from the Bank could also have a material adverse effect on our business, financial condition and results of operations and the value of your investment in our common stock.

 

We depend on the services of our current management team.

 

Our operating results and ability to adequately manage our growth and minimize loan losses are highly dependent on the services, managerial abilities and performance of our executive officers. Smaller banks, like us, sometimes find it more difficult to attract and retain experienced management personnel than larger banks. We currently have an experienced management team that our Board of Directors believes is capable of managing and growing the Bank. However, changes in key personnel and their responsibilities may disrupt our business and could have a material adverse effect on our business, operating results and financial condition.

 

Risks Relating to Our Common Stock

 

The price of our common stock may fluctuate significantly, and this may make it difficult for you to resell our common stock when you want or at prices you find attractive.

 

We cannot predict how or at what prices our common stock will trade in the future. The market value of our common stock will likely continue to fluctuate in response to a number of factors including the following, most of which are beyond our control, as well as the other factors described in this “Risk Factors” section:

 

   

actual or anticipated quarterly fluctuations in our operating and financial results;

 

   

changes in financial estimates and recommendations by financial analysts;

 

   

actions of our current shareholders, including sales of common stock by existing shareholders and our directors and executive officers;

 

   

fluctuations in the stock price and operating results of our competitors;

 

   

regulatory developments; and

 

   

developments related to the financial services industry.

 

The market value of and trading in our common stock also is affected by conditions (including price and trading fluctuations) affecting the financial markets in general, and in the market for the stocks of financial services companies in particular. These conditions may result in volatility in the market prices of stocks generally and, in turn, our common stock. Also, market conditions may result in sales of substantial amounts of our common stock in the market. In each case, market conditions could affect the market price of our stock in a way that is unrelated or disproportionate to changes in our operating performance.

 

The trading volume in our common stock has been low, and the sale of a substantial number of shares in the public market could depress the price of our stock and make it difficult for you to sell your shares.

 

Our common stock is listed on the NASDAQ Global Market, but it has a relatively low average daily trading volume relative to many other stocks. Thinly traded stock can be more volatile than stock trading in an active public market, which can lead to significant price swings even when a relatively small number of shares are being traded and limit an investor’s ability to quickly sell blocks of stock. We cannot predict what effect future sales of our common stock in the market, or the availability of shares of our common stock for sale in the market, will have on the market price of our common stock.

 

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Our management beneficially owns a substantial percentage of our common stock, so our directors and executive officers can significantly affect voting results on matters voted on by our shareholders.

 

Our current directors and executive officers, as a group, beneficially own a significant percentage of our outstanding common stock. Because of their voting rights, in matters put to a vote of our shareholders it could be difficult for any group of our other shareholders to defeat a proposal favored by our management (including the election of one or more of our directors) or to approve a proposal opposed by management.

 

We participate in the TARP Capital Purchase Program and there are restrictions on our ability to pay dividends on and repurchase our common stock.

 

The securities purchase agreement entered into with the U.S. Treasury generally provides that, for a period of three years, we may not, without the consent of Treasury:

 

   

increase the cash dividend on our common stock; or

 

   

subject to limited exceptions, redeem, repurchase or otherwise acquire shares of our common stock or preferred stock (other than the preferred stock we sell to Treasury) or trust preferred securities.

 

In addition, we are unable to pay any dividends on our common stock unless we are current in our dividend payments on the preferred stock we sold to the U.S. Treasury. These restrictions, together with the potentially dilutive impact of the warrant described in the next risk factor, could have a negative effect on the value of our common stock. Moreover, holders of our common stock are entitled to receive dividends only when, as and if declared by our Board of Directors. We did not declare any dividends on our common stock in 2009 and we are not required to do so. Our Board of Directors likely will not restore our common stock dividend in the foreseeable future.

 

The preferred stock we sold to the U.S. Treasury affects net income available to our common shareholders and our earnings per common share, and the warrant we issued to Treasury is dilutive to holders of our common stock.

 

The dividends we pay on the preferred stock sold to the U.S. Treasury reduces the net income available to our common shareholders and our earnings per common share. The preferred stock also would receive preferential treatment in the event of liquidation, dissolution or winding up of our company. Additionally, the ownership interest of the existing holders of our common stock will be diluted to the extent the warrant we issued to Treasury in conjunction with the sale of preferred stock is exercised. Although Treasury has agreed not to vote any of the shares of our common stock it receives upon exercise of the warrant, a transferee of any portion of the warrant or of any shares of common stock acquired upon exercise of the warrant would not be bound by that restriction.

 

Item 1B. Unresolved Staff Comments.

 

Not applicable

 

Item 2. Properties.

 

We own the facilities housing six of our banking offices, and we lease the facilities housing our remaining four offices. In addition, we own an operations center which houses the deposit operations, information technology and loan administration departments of the Bank. Each of our banking offices is in good condition and fully equipped for our purposes. On December 31, 2009, our investment in premises and equipment (cost less accumulated depreciation) was approximately $14.0 million.

 

Item 3. Legal Proceedings.

 

From time to time we may become involved in legal proceedings occurring in the ordinary course of our business. We believe there currently are no pending or threatened proceedings that are likely to result in a material adverse change in our financial condition or operations, subject to the uncertainties inherent in any litigation.

 

Item 4. [Removed and Reserved]

 

 

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PART II

 

Item 5. Market for Common Equity, Related Stockholder Matters and Purchases of Equity Securities

 

 

Market for Registrant’s Common Stock; Dividends. Our common stock is listed for trading on The Nasdaq Global Market under the trading symbol “BCAR”. The following table lists high and low published prices of our common stock, and cash dividends declared on our common stock, for each calendar quarter during 2008 and 2009.

 

     Sales Price Range    Cash
Dividends
Declared

Quarter

       High            Low       

2009 Fourth

   $ 8.70    $ 3.00    $

Third

     5.00      3.25     

Second

     5.85      4.01     

First

     5.95      3.17     

2008 Fourth

     6.51      3.35      0.05

Third

     8.39      5.50      0.05

Second

     9.52      6.02      0.05

First

     11.00      9.00      0.05

 

On December 31, 2009, there were approximately 1,947 total beneficial holders of our common stock, including 1,083 shareholders of record and approximately 864 holders whose shares were in street name.

 

Under North Carolina law, subject to certain restrictions, we are authorized to pay dividends as declared by our Board of Directors. However, although we are a legal entity separate and distinct from the Bank, our principal source of funds with which we can pay dividends to our shareholders and pay our own obligations is dividends we received from the Bank. For that reason, our ability to pay dividends effectively is subject to the same limitations that apply to the Bank. Information regarding restrictions on our and the Bank’s ability to pay dividends is contained in Item 1 of this Report under the caption “Payment of Dividends.”

 

In the future, any declaration and payment of cash dividends will be subject to the Board of Directors’ evaluation of our operating results, financial condition, future growth plans, general business and economic conditions, and tax and other relevant considerations. Also, the payment of cash dividends in the future will be subject to ongoing review by our banking regulators and to certain other legal and regulatory limitations including the requirement that our capital be maintained at certain minimum levels. In that regard, our and the Bank’s Boards of Directors have entered into informal agreements with our respective bank regulators (described in Note 10 to our audited financial statements included in Item 8 of this Report) which require that we and the Bank obtain the consent of our regulators before we may pay any cash dividends.

 

Our sale of Series A Preferred Stock to the U.S. Treasury during April 2009 under the TARP Capital Purchase Program resulted in additional restrictions on our ability to pay dividends on our common stock and to repurchase shares of our common stock. Unless all accrued dividends on the Series A Preferred Stock have been paid in full, (1) no dividends may be declared or paid on our common stock, and (2) we may not repurchase any of our outstanding common stock. Additionally, during the first three years following our sale of the Series A Preferred Stock, we are required to obtain the consent of the U.S. Treasury in order to increase the dividend per share paid on our common stock from the last quarterly cash dividend per share declared prior to our sale of the Series A Preferred Stock, or to purchase outstanding shares of our common stock, unless the Series A Preferred Stock has been redeemed in full or the U.S. Treasury has transferred all of the Series A Preferred Stock to third parties.

 

There is no assurance that, in the future, we will have funds available to pay cash dividends, or, even if funds are available, that we will pay or the Bank will be permitted to pay dividends in any particular amount or at any particular times, or that we will pay dividends at all.

 

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Item 6. Selected Financial Data

 

 

     As of and for the years ended December 31,  
     2009     2008     2007     2006     2005  
     (In thousands, except per share data and financial ratios)  

Summary of Operations

          

Net interest income

   $ 14,666      $ 12,691      $ 14,605      $ 14,663      $ 12,151   

Provision for loan losses

     5,547        6,291        1,470        1,157        1,120   

Noninterest income

     3,297        2,434        1,935        3,374        1,341   

Noninterest expense

     17,514        15,092        12,398        11,512        8,832   
                                        

Income before income tax provision

     (5,098     (6,258     2,672        5,368        3,540   

Income tax provision

     (1,968     (2,634     714        1,894        1,207   
                                        

Net income (loss)

     (3,130     (3,624     1,958        3,474        2,333   

Preferred dividends and accretion

     (637                            
                                        

Net income (loss) available to common shareholders

   $ (3,767   $ (3,624   $ 1,958      $ 3,474      $ 2,333   
                                        

Selected year-end assets and liabilities

          

Assets

   $ 610,387      $ 562,007      $ 505,998      $ 454,578      $ 390,187   

Loans

     391,265        405,402        395,052        354,555        299,927   

Allowance for loan losses

     8,167        6,308        4,245        3,732        3,315   

Deposits

     493,917        444,540        421,928        382,721        326,640   

Borrowed funds

     69,537        79,412        41,657        31,000        27,400   

Preferred Shareholders’ Equity

     13,179                               

Total Shareholders’ equity

   $ 44,992      $ 36,591      $ 40,240      $ 37,714      $ 34,651   

Ratios

          

Return (loss) on average total assets

     (0.50 )%      (0.68 )%      0.42     0.84     0.69

Return (loss) on average common equity

     (10.57     (9.59     5.10        9.57        6.86   

Dividend Payout

     n/a        n/a        39.22        21.98        27.87   

Average equity to average assets

     7.20        7.32        8.39        8.73        10.01   

Per common share

          

Earnings (loss)

          

Basic

   $ (0.97   $ (0.92   $ 0.51      $ 0.91      $ 0.61   

Diluted

     (0.97     (0.92     0.50        0.88        0.59   

Cash dividends declared

     n/a        0.20        0.20        0.20        0.17   

Tangible Book Value

   $ 8.16      $ 9.40      $ 10.11      $ 9.70      $ 8.90   

 

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

 

The following presents management’s discussion and analysis of our financial condition and results of operations. The discussion is intended to assist in understanding our consolidated financial condition and results of operations, and it should be read in conjunction with the consolidated financial statements and related notes included elsewhere in this annual report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ significantly from those anticipated in these forward-looking statements as a result of various factors. All share and per share data have been adjusted to give retroactive effect to stock splits and stock dividends.

 

Bank of the Carolinas Corporation (the Company) is a North Carolina-chartered bank holding company that was incorporated on May 30, 2006, for the sole purpose of serving as the parent bank holding company for the Bank. The Bank is an insured, North Carolina-chartered bank that began operations on December 7, 1998.

 

Because the Company has no operations and conducts no business on its own other than owning Bank of the Carolinas (the “Bank”), the discussion contained in these footnotes concerns primarily the business of the Bank. However, for ease of reading and because the financial statements are presented on a consolidated basis, the Company and its subsidiary are collectively referred to herein as the Company unless otherwise noted.

 

CRITICAL ACCOUNTING POLICIES

 

Our financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The notes to our audited financial statements for the years ended December 31, 2009, 2008 and 2007 contain a summary of our significant accounting policies. We believe our policies with respect to methodology for the determination of our allowance for loan losses, and our asset impairment judgments, such as the recoverability of other real estate values, involve a higher degree of complexity and require us to make difficult and subjective judgments that often require assumptions or estimates about highly uncertain matters. Accordingly, we consider the policies related to those areas critical.

 

The allowance for loan losses represents our best estimate of probable losses that are inherent in the loan portfolio at the balance sheet date. The allowance is based on generally accepted accounting principles, which require that losses be accrued when they are probable of occurring and estimatable and require that losses be accrued based on the differences between the value of collateral, the present value of future cash flows or values that are observable in the secondary market, and the loan balance.

 

The allowance for loan losses is created by direct charges to income. Losses on loans are charged against the allowance in the period in which those loans, in our opinion, become uncollectible. Recoveries during the period are credited to the allowance. The factors that influence our judgment in determining the amount charged against operating income include analyzing historical loan and lease losses, current trends in delinquencies and charge-offs, current assessment of problem loan administration, the results of regulatory examinations, and changes in the size, composition and risk assessment of the loan and lease portfolio. Also included in our estimates for loan losses are considerations with respect to the impact of current economic events, the outcomes of which are uncertain. These events may include, but are not limited to, fluctuations in overall interest rates, political conditions, legislation that may directly or indirectly affect the banking industry and economic conditions affecting specific geographical areas and industries in which we conduct business.

 

The factors that are enumerated above form the basis for a model which we utilize in calculating the appropriate level of our allowance for loan losses at the balance sheet date. This model has three main components. First, losses are estimated on loans we have individually identified and determined to be “impaired”. A loan is considered to be impaired when, based on current information and events, it is probable we will be unable to collect all amounts due according to the contractual terms of the loan agreement. The loss allowance applicable to impaired loans is the difference, if any, between the loan balances outstanding and the value of the impaired loans as determined by either 1) an estimate of the cash flows that we expect to receive from those borrowers discounted at the loan’s effective rate, or 2) in the case of collateral-dependent loans, the fair value of the collateral securing those loans.

 

Second, for all other loans, we divide the loan portfolio into groups or pools based on similarity of risk characteristics. Historical loss rates, which are weighted toward current experience, are then applied to determine an appropriate allowance for each pool or group.

 

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Finally, an adjustment is applied, if appropriate, to give effect to qualitative or environmental factors that could cause estimated credit losses within the existing loan portfolio to differ from the historical loss experience.

 

We review our allowance on a quarterly basis and believe that it is adequate to cover inherent loan losses on the loans outstanding as of each reporting date. However, the appropriateness of the allowance using our procedures and methods is dependent upon the accuracy of various judgments and assumptions about economic conditions and other factors affecting loans. No assurance can be given that we will not, in any particular period, sustain loan losses that are significantly different from the amounts reserved for those loans, or that subsequent evaluations of the loan portfolio and our allowance, in light of conditions and factors then prevailing, will not require material changes in the allowance for loan losses or future charges to earnings. In addition, various regulatory agencies, as an integral part of their routine examination process, periodically review our allowance. Those agencies may require that we make additions to the allowance based on their judgments about information available to them at the time of their examinations.

 

Accounting for intangible assets is as prescribed by generally accepted accounting principles. We account for recognized intangible assets based on their estimated useful lives. Intangible assets with finite useful lives are amortized, while intangible assets with an indefinite useful life are not amortized. Goodwill is not amortized, but is subject to fair value impairment tests on at least an annual basis. If based upon our evaluation impairment has occurred, the impairment charge is recognized at that time. During the 2008 evaluation of our goodwill, the determination was made that our goodwill was impaired and the entire remaining balance of $591,000 was charged off our balance sheet.

 

OVERVIEW

 

The past two years have been difficult ones for the financial services industry in general. Bank failures have been numerous, particularly among community banks in some southeastern states, primarily brought about by the severe downturn in real estate markets. Our operating results over the past two years have been adversely affected by the weakness in the economy in general and real estate in particular. Our net loss available to common shareholders was $3.8 million for 2009 and $3.6 million for 2008. The losses in both years were driven by substantial increases in loan loss provisions due to deterioration in our loan portfolio, significant losses and net operating expenses associated with foreclosed real estate, as well as, lost interest revenue caused by elevated levels of nonperforming assets.

 

In addition to the effect on our operating results noted above, the economic environment of the past two years led to a decline of $14.1 million in our loan portfolio during 2009. Given the prominence of real estate loans in our lending activities, it has been and continues to be a challenge to generate quality credit in sufficient volume to outpace payments.

 

We strive to serve the financial needs of small to medium-sized businesses and individuals in our market area, offering an array of financial products emphasizing superior customer service.

 

Real estate secured loans, including construction loans and loans secured by existing commercial and residential properties, made up almost 80% of our loan portfolio at December 31, 2009, with the remainder of our loans consisting of commercial and industrial loans and loans to individuals. We also offer certain loan products through associations with various mortgage lending companies. Through these associations, we originate 1-4 family residential mortgages, at both fixed and variable rates. We earn fees for originating these loans and transferring the loan package to the mortgage lending companies.

 

The deposit services we offer include small business and personal checking accounts, savings accounts, money market checking accounts and certificates of deposit. The Company concentrates on providing customer service to build its customer deposit base and competes aggressively in the area of transaction accounts.

 

Additional funding includes certificates of deposit acquired through deposit brokers, advances from the Federal Home Loan Bank, term repurchase agreements from two money center financial institutions and federal funds lines of credit from correspondent banks.

 

Over 80% of our revenue (net interest income plus noninterest income) was comprised of net interest income, which is the difference between the interest earned on loans and securities and the interest paid on deposits and borrowings. Therefore, the levels of interest rates and our ability to effectively manage the effect that changes in interest rates have on net interest income can have a significant impact on revenue and results of operations. Results of operations may also be

 

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materially affected by our provision for loan losses, which has been much higher during the past two years than our long-term trend. Service charges and fee income generated from customer services represented less than 10% of revenue in each of the past two years and represents an area of potential revenue growth. Noninterest expense is the third major driver of operating results along with net interest income and the provision for loan losses. Total noninterest expenses absorbed over 95% of our revenue in each of the past two years. Noninterest expenses include compensation and employee benefits, occupancy and equipment expenses, FDIC insurance premiums, expenses related to foreclosed real estate, professional services, expenditures for data processing services and various other costs of doing business.

 

FINANCIAL CONDITION AT DECEMBER 31, 2009 AND DECEMBER 31, 2008

 

Total assets at December 31, 2009, increased by $48.4 million or 8.6% to $610.4 million compared to $562.0 million at December 31, 2008. We had earning assets of $565.1 million at December 31, 2009 consisting of $391.3 million in loans, $140.0 million in investment securities and $33.8 million in temporary investments. Stockholders’ equity was $45.0 million at December 31, 2009 compared to $36.6 million at December 31, 2008.

 

Loans.    Total loans declined by $14.1 million or 3.5% during the twelve months of 2009, from $405.4 million on December 31, 2008 to $391.3 million at December 31, 2009. On December 31, 2009, real estate loans made up 79.5% of total loans while commercial non-real estate loans comprised another 19.4% of the portfolio. Total loans represented 64.1% and 72.1% of our total assets on December 31, 2009 and 2008, respectively.

 

Interest rates charged on loans vary with the degree of risk, maturity and amount of the loan. Competitive pressures, money market rates, availability of funds, and government regulation also influence interest rates. On average, our loan portfolio yielded 5.9% for the year ending December 31, 2009 as compared to an average yield of 6.5% during 2008.

 

We intend to continue to pursue growth of high quality loans to the extent permitted by our capital.

 

The following table contains selected data relating to the composition of our loan portfolio by type of loan on the dates indicated.

 

TABLE I.

ANALYSIS OF LOAN PORTFOLIO

 

    At December 31,  
    2009     2008     2007     2006     2005  
    Amount     Percent     Amount     Percent     Amount     Percent     Amount     Percent     Amount     Percent  
    (dollars in thousands)  

Real estate loans:

                   

Residential 1-4 family

  $ 76,767      19.62   $ 68,876      16.99   $ 63,023      15.95   $ 63,221      17.83   $ 60,817      20.28

Commercial real estate

    161,904      41.38        154,463      38.10        119,473      30.24        108,907      30.72        95,301      31.77   

Construction and development

    41,580      10.63        60,476      14.92        59,522      15.07        59,693      16.84        36,806      12.27   

Home equity

    30,775      7.87        29,656      7.32        26,575      6.73        21,640      6.10        24,942      8.32   
                                                                     

Total real estate loans

    311,026      79.50        313,471      77.33        268,593      67.99        253,461      71.49        217,866      72.64   

Commercial business loans

    75,762      19.36        84,282      20.79        116,105      29.39        92,479      26.08        72,798      24.27   

Consumer loans:

                   

Installment

    3,303      0.84        5,989      1.48        6,933      1.75        6,614      1.87        5,088      1.70   

Other

    1,174      0.30        1,660      0.40        3,421      0.87        2,001      0.56        4,175      1.39   
                                                                     

Total loans

    391,265      100.00     405,402      100.00     395,052      100.00     354,555      100.00     299,927      100.00
                                       

Allowance for loan losses

    (8,167       (6,308       (4,245       (3,732       (3,315  
                                                 

Total loans, net

  $ 383,098        $ 399,094        $ 390,807        $ 350,823        $ 296,612     
                                                 

 

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The following table reflects the scheduled maturities of commercial real estate loans, construction and development loans, and commercial business loans (dollars in thousands):

 

     December 31, 2009
     1 year or
less
   After 1 year
but within
5 years
   After
5 years
   Total

Commercial real estate loans

   $ 44,791    $ 100,918    $ 16,195    $ 161,904

Constructions and development loans

     22,252      18,464      864      41,580

Commercial business loans

     46,494      27,375      1,893      75,762
                           

Total

   $ 113,537    $ 146,757    $ 18,952    $ 279,246
                           

 

The following table reflects the scheduled maturities of all fixed and variable interest rate loans (dollars in thousands):

 

     December 31, 2009
     1 year or
less
   After 1 year
but within
5 years
   After
5 years
   Total

Loans with fixed interest rates

   $ 51,592    $ 147,190    $ 32,335    $ 231,117

Loans with variable interest rates

     83,585      42,261      34,302      160,148
                           

Total

   $ 135,177    $ 189,451    $ 66,637    $ 391,265
                           

 

Allowance for Loan Losses.    On December 31, 2009, our allowance totaled approximately $8.2 million and amounted to 2.09% of total loans and 88.5% of our nonperforming loans. This compares to an allowance of $6.3 million, or 1.56% of loans and 93.9% of nonperforming loans at December 31, 2008 and $4.2 million, or 1.07% of loans and 58.9% of nonperforming loans as of December 31, 2007.

 

The following table contains an analysis of our allowance for loan losses for the time periods indicated.

 

Table II.

SUMMARY OF LOAN LOSS EXPERIENCE

 

     Year ended December 31,  
     2009     2008     2007     2006     2005  
     (dollars in thousands)  

Balance at beginning of period

   $ 6,308      $ 4,245      $ 3,732      $ 3,315      $ 2,500   

Provision for loan losses

     5,547        6,291        1,470        1,157        1,120   

Charge-offs:

          

Residential mortgage

     (256     (645     (108     (358     (99

Commercial real estate

     (141     (300     (738     (58     (48

Construction and development

     (1,381     (640     (49              

Commercial business

     (1,912     (2,919     (1     (210     (15

Installment

     (218     (169     (143     (132     (155
                                        

Total charge-offs

     (3,908     (4,673     (1,039     (758     (317
                                        

Recoveries:

          

Residential mortgage

     4        45        2                 

Commercial real estate

     50        192        1        4          

Construction and development

     9        50                        

Commercial business

     128        124        2                 

Installment

     29        34        77        14        12   
                                        

Total recoveries

     220        445        82        18        12   
                                        

Net charge-offs

     (3,688     (4,228     (957     (740     (305
                                        

Balance at end of period

   $ 8,167      $ 6,308      $ 4,245      $ 3,732      $ 3,315   
                                        

Ratio of net charge-offs during period to average loans outstanding

     0.92     1.04     0.26     0.23     0.11

Ratio of allowance for loan losses to non-performing loans

     88.5     93.9     58.9     80.1     164.4

Ratio of allowances for loan losses to total loans

     2.09     1.56     1.07     1.05     1.11

 

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During 2009, we incurred net loan charge-offs of $3.7 million, compared to $4.2 million in 2008 and $957,000 in 2007. These levels of net charge-offs produced net loss ratios of .92% for 2009, 1.04% for 2008, and .26% for 2007. The loss ratios for 2009 and 2008 were substantially higher that our longer-term trend which contributed to increased loan loss provisions in both years. The deterioration in our loan portfolio, as evidenced by rising loss ratios and nonperforming loans, resulted in the increases in our allowance for loan losses in both 2009 and 2008.

 

An analysis of the allowance for loan losses for the years ended December 31, 2009, 2008, 2007, 2006, and 2005 is contained in the following table:

 

Table III.

ALLOCATION OF ALLOWANCE FOR LOAN LOSSES

 

     At December 31,  
     2009     2008     2007     2006     2005  
     Amount   Percent     Amount   Percent     Amount   Percent     Amount   Percent     Amount   Percent  
     (dollars in thousands)  

Real estate loans:

                    

Residential, 1-4 family

   $ 721   8.83   $ 1,072   16.99   $ 659   15.52   $ 657   17.62   $ 639   19.28

Commercial real estate

     4,072   49.86        2,403   38.09        1,249   29.41        1,133   30.34        1,002   30.23   

Construction and development

     1,007   12.33        941   14.92        747   17.60        669   17.93        549   16.55   

Home equity

     93   1.14        462   7.32        278   6.54        225   6.03        262   7.91   
                                                            

Total real estate loans

     5,893   72.16        4,878   77.32        2,933   69.07        2,684   71.92        2,452   73.97   

Commercial business loans

     2,165   26.51        1,311   20.78        1,213   28.59        962   25.77        765   23.08   

Consumer loans:

                    

Installment

     104   1.27        93   1.47        72   1.71        69   1.84        53   1.61   

Other

     5   0.06        26   0.43        27   0.63        17   0.47        45   1.34   
                                                            

Total Loans

   $ 8,167   100.00   $ 6,308   100.00   $ 4,245   100.00   $ 3,732   100.00   $ 3,315   100.00
                                                            

 

The allowance has been allocated on an approximate basis. The entire amount of the allowance is available to absorb losses occuring in any category. The allocation is not necessarily indicative of future losses.

 

Asset Quality.    Credit risks are inherent in making loans. We assess these risks and attempt to manage them effectively by adhering to internal credit underwriting policies and procedures. These policies and procedures include officer and customer limits, periodic loan documentation review and follow up on exceptions to credit policies. A loan is placed in non-accrual status when, in our judgment, the collection of interest appears doubtful. Nonperforming assets are defined as nonaccrual loans, loans contractually past due for more than 90 days but still accruing interest, and foreclosed or idled properties. At December 31, 2009, the Company’s non-performing assets totaled $17.4 million, or 4.37% of loan-related assets, compared to $12.3 million, or 3.00% of loan-related assets at December 31, 2008.

 

On December 31, 2009, we had no loans that were delinquent over 90 days and still accruing interest, and $9.2 million that were in non-accrual status. Interest accrued, but not recognized as income on non-accrual loans, was approximately $254,000 during 2009.

 

Other real estate owned at December 31, 2009, amounted to $8.2 million compared to $5.6 million as of December 31, 2008. Other real estate is carried at the lower of cost or estimated net realizable value.

 

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The following table summarizes information regarding our nonperforming assets on December 31, 2009, 2008, 2007, 2006, and 2005.

 

Table IV.

NONPERFORMING ASSETS

     At December 31,  
     2009     2008     2007     2006     2005  
     (dollars in thousands)  

Loans accounted for on a nonaccrual basis:

          

Real estate loans:

          

Mortgage

   $ 2,971      $ 195      $      $ 102      $ 1,150   

Commercial

     1,606        5,466        300        2,596        474   

Construction and development

     1,488        285                        
                                        

Total real estate loans

     6,065        5,946        300        2,698        1,624   

Commercial business customers

     3,151        771        248        82        65   

Installment

     8                               
                                        

Total nonaccrual loans

     9,224        6,717        548        2,780        1,689   

Accruing loans which are contractually past due 90 days or more

                   6,661        1,882        328   
                                        

Total nonperforming loans

     9,224        6,717        7,209        4,662        2,017   

Other real estate owned

     8,233        5,622        2,528        1,000        2,182   
                                        

Total nonperforming assets

   $ 17,457      $ 12,339      $ 9,737      $ 5,662      $ 4,199   
                                        

Total nonperforming loans as a percentage of loans

     2.36     1.66     1.82     1.31     0.67

Total nonperforming assets as a percentage of loans and other
real estate owned

     4.37     3.00     2.45     1.59     1.39

Total nonperforming assets as a percentage of total assets

     2.86     2.20     1.92     1.25     1.08

 

Investment Securities.    Our investment securities totaled $140.0 million at December 31, 2009, and $113.1 million at December 31, 2008. Our investment portfolio includes U.S. Government Agency bonds, mortgage backed securities, state and municipals and corporate subordinated debt of other financial institutions, all of which are classified as held to maturity or available-for-sale. Held to maturity securities are carried at amortized cost value and available for sale securities are carried at fair value.

 

We use our investment portfolio to employ liquid funds and as a tool in the management of interest rate risk, while at the same time providing interest income. Practically all of our securities are classified as available for sale and, as such, may be sold from time to time to increase liquidity or re-balance the interest rate sensitivity profile of our balance sheet. However, we do have the available liquidity to hold our securities to maturity should we have the need to. In fact, we have classified some of our more illiquid securities as held to maturity because we fully intend to hold them until their maturity date. All securities classified as held to maturity were purchased in 2008 and consist of subordinated debt and trust preferred securities issued or guaranteed by other financial institutions. In December 2009, we recorded an impairment charge of $498,000 on a $1 million investment in a trust preferred security as a result of the guarantor exercising its right to defer interest payments to the issuing trust. In addition to the impairment charge, we have discontinued recognizing interest income on this investment until such time as the guarantor resumes interest payments to the trust.

 

The following table summarizes the carrying value of our investment securities on the dates indicated.

 

Table V.

INVESTMENT SECURITIES

     December 31,
     2009    2008    2007
     (dollars in thousands)

U.S. Government agency bonds

   $ 98,312    $ 32,479    $ 42,083

State and municipal bonds

     6,105      11,335      8,883

Mortgage-backed securities

     29,833      61,889      7,662

Corporate securities

     5,754      7,436      2,089
                    

Total

   $ 140,004    $ 113,139    $ 60,717
                    

 

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The following tables summarize information regarding the scheduled maturities, amortized cost, and weighted average yields on a tax equivalent basis for our investment securities portfolio on December 31, 2009 and 2008.

 

Table VI.

INVESTMENT SECURITIES

 

At December 31, 2009:

 

     1 year or
less
    Over 1 to 5
years
    Over 5 to 10
years
    Over 10
years
    Total
Securities
 
    Amortized
Cost
  Average
Yield
    Amortized
Cost
  Average
Yield
    Amortized
Cost
  Average
Yield
    Amortized
Cost
  Average
Yield
    Amortized
Cost
  Average
Yield
 
    (dollars in thousands)  

U.S. Government agency bonds

  $ 26,997   1.56   $ 55,391   2.30   $ 13,179   3.34   $ 3,050   4.35   $ 98,617   2.30

State and municipal bonds

    1,053   4.31        4,233   5.15        554   4.81                 5,840   4.97   

Mortgage-backed securities

    133   2.51        525   3.72        3,587   3.99        25,002   4.25        29,247   4.20   

Corporate securities

    997   8.23        2,392   8.21        1,000   3.75        1,463   7.04        5,852   7.16   
                                       

Total investment securities

  $ 29,180   1.89   $ 62,541   2.73   $ 18,320   3.53   $ 29,515   4.40   $ 139,556   3.01
                                       

 

At December 31, 2008:

 

    1 year or
less
    Over 1 to 5
years
    Over 5 to 10
years
    Over 10
years
    Total
Securities
 
    Amortized
Cost
  Average
Yield
    Amortized
Cost
  Average
Yield
    Amortized
Cost
  Average
Yield
    Amortized
Cost
  Average
Yield
    Amortized
Cost
  Average
Yield
 
    (dollars in thousands)  

U.S. Government agency bonds

  $     $ 23,985   5.05   $ 7,559   5.82   $     $ 31,544   5.13

State and municipal bonds

    661   4.61        6,466   5.15        1,898   4.89        2,092   6.44        11,117   5.32   

Mortgage-backed securities

             1,108   3.90        2,176   4.79        57,531   5.52        60,815   5.46   

Corporate securities

             3,460   8.35        1,000   7.26        2,998   7.73        7,458   8.00   
                                       

Total investment securities

  $ 661   4.61   $ 35,019   5.35   $ 12,633   5.62   $ 62,621   5.66   $ 110,934   5.52
                                       

 

Deposits.    Our deposit service offerings include business and individual checking accounts, savings accounts, NOW accounts, certificates of deposit and money market checking accounts. On December 31, 2009, total deposits were $493.9 million compared with $444.5 million on December 31, 2008, an increase of $49.4 million or 11.1%. This change was primarily the function of growth of $14.5 million in our money market deposits during 2009 as well as an increase of $38.7 million in brokered deposits.

 

The growth in money market deposits began in July 2008 when we offered a special money market rate that was guaranteed through June 30, 2009. Between June 30, 2008 and June 30, 2009, which approximates the time period of the rate guarantee, our money market deposits grew by $236 million. During this same time period we had a decrease of $118 million in savings and other customer time deposits. This leads us to conclude that approximately $118 million of the increase in money market deposits during the special promotion represented new deposits. Since the rate promotion expired we began to reduce the rates paid on money market deposits to levels more in-line with the markets we serve and at December 31, 2009 money market deposits totaled $224.5 million. The year-end 2009 combined balances in savings deposits, money market deposits and customer time deposits increased $66 million, or 23%, over the levels of June 30, 2008, shortly before the special promotion began.

 

Brokered deposits have increased from $32.3 million at December 31, 2008 to $71.0 million at December 31, 2009, an increase of $38.7 million. On December 31, 2009, approximately 14.4% our total deposits were made up of brokered

 

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deposits as compared to 7.3% at December 31, 2008 and 23.0% as of December 31, 2007. On December 31, 2009, total time deposits issued in denominations of $100,000 or more made up approximately 23.5% of our total deposits as compared to 17.4% as of December 31, 2008 and 41.3% at December 31, 2007.

 

Retail deposits gathered through our branch network continue to be our principal source of funding. It is our intent to focus our efforts and marketing resources on the growth of our deposit base as we believe this to be the most effective long term strategy for profitable growth.

 

The following table summarizes our average deposits for the years ended December 31, 2009, 2008, and 2007.

 

Table VII.

DEPOSIT MIX

 

     For the Years ended December 31,  
     2009     2008     2007  
     Average
Balance
   Average
Cost
    Average
Balance
   Average
Cost
    Average
Balance
   Average
Cost
 
     (dollars in thousands)  

Interest-bearing deposits:

               

Interest-checking deposits

   $ 32,172    1.13   $ 25,801    1.11   $ 27,385    1.43

Money market and savings deposits

     266,108    2.62        113,220    3.26        51,410    3.64   

Time deposits

     169,825    2.67        267,649    4.35        292,437    5.13   
                           

Total interest-bearing deposits

     468,105    2.54        406,670    3.84        371,232    4.65   

Noninterest-bearing demand deposits

     33,609        31,855        28,980   
                           

Total deposits

   $ 501,714    2.37   $ 438,525    3.56   $ 400,212    4.31
                           

 

The following table contains an analysis of our time deposits of $100,000 or more December 31, 2009, 2008, and 2007.

 

     At December 31,
     2009    2008    2007
     (dollars in thousands)

Remaining maturity of three months or less

   $ 28,663    $ 34,604    $ 62,478

Remaining maturity of over three to twelve months

     37,640      38,356      105,639

Remaining maturity of over twelve months

     49,609      4,453      6,065
                    

Total time deposits of $100,000 or more

   $ 115,912    $ 77,413    $ 174,182
                    

 

Borrowed Funds.    The following table summarizes our borrowings at December 31, 2009, 2008 and 2007.

 

Table VIII.

BORROWED FUNDS

 

     At December 31,  
     2009     2008     2007  
     Outstanding
Balance
   Average
Rate
    Outstanding
Balance
   Average
Rate
    Outstanding
Balance
   Average
Rate
 
     (dollars in thousands)  

Federal funds purchased and securities sold under overnight repurchase agreements

   $ 1,682    0.53   $ 1,557    2.07   $ 7,657    3.02

Securities sold under term repurchase agreements

     45,000    4.38        45,000    4.38             

Federal Home Loan Bank advances

     15,000    3.15        25,000    3.80        34,000    4.65   

Trust preferred securities

     5,155    3.16        5,155    4.91             

Subordinated debt

     2,700    4.00        2,700    4.00             
                           

Total borrowed funds

   $ 69,537    3.92   $ 79,412    4.17   $ 41,657    4.35
                           

 

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The following table presents our average balances as well as the average cost associated with those balances for the specified periods.

 

     For the years ended December 31,  
     2009     2008     2007  
     Average
    Balance    
   Average
Cost
    Average
    Balance    
   Average
Cost
    Average
    Balance    
   Average
Cost
 
     (dollars in thousands)  

Federal funds purchased and securities sold under overnight repurchase agreements

   $ 1,790    0.67   $ 2,672    2.10   $ 1,330    4.89

Securities sold under term repurchase agreements

     45,000    4.40        19,413    4.39             

Federal Home Loan Bank advances

     21,433    3.65        28,223    3.83        24,017    4.88   

Trust preferred securities

     5,155    3.94        3,968    5.57             

Subordinated debt

     2,700    4.00        1,028    5.16             
                           

Total borrowed funds

   $ 76,078    4.06   $ 55,304    4.10   $ 25,347    4.88
                           

 

During 2008, we entered into term repurchase agreements with two money center financial institutions. These two borrowing arrangements total $45.0 million in the aggregate and currently bear interest at an effective annual blended rate of 4.38%. These borrowings were secured by marketable securities totaling approximately $53.6 million at December 31, 2009. The agreements have final maturity dates in July 2015 and August 2018 but may be terminated by the lenders beginning July 2013 and August 2011, respectively.

 

On December 31, 2009, we had advances from the Federal Home Loan Bank (“FHLB”) totaling $15.0 million. These advances bear interest at the combined annual rate of 3.15% and are secured by eligible one-to-four family mortgages, commercial real estate loans and home equity loans with aggregate outstanding principal balances of approximately $33.0 million.

 

During 2008, the Company issued $5.2 million of junior subordinated debentures to its wholly owned capital trust, Bank of the Carolinas Trust I (the “Trust”), which, in turn, issued $5.0 million in trust preferred securities having a like liquidation amount and $155,000 in common securities (all of which is owned by the Company). The Company has fully and unconditionally guaranteed the Trust’s obligations related to the trust preferred securities. The Trust has the right to redeem the trust preferred securities in whole or in part, on or after March 26, 2013 at a redemption price equal to 100% of the principal amount plus accrued and unpaid interest. In addition, the Trust may redeem the trust preferred securities in whole (but not in part) at any time within 90 days following the occurrence of a tax event, an investment company event or a capital treatment event at a special redemption price (as defined in the debenture). The trust preferred securities bear interest at the annual rate of 90-day LIBOR plus 300 basis points adjusted quarterly.

 

The Company also has issued $2.7 million of subordinated debt in a private transaction with another banking institution. This subordinated note has a floating interest rate equal to 75 basis points over the Prime Rate published by Wall Street Journal and a maturity date of August 13, 2018. The Company makes monthly interest payments on the outstanding debt to the holder of the note. This debt can be repaid in full at any time with no penalty.

 

Capital Resources.    Total stockholders’ equity increased by $8.4 million to $45.0 million on December 31, 2009, compared to $36.6 million on December 31, 2008. The increase was the substantially the net result of the current year’s net loss, net unrealized losses on securities available for sale, the issuance of preferred shares to the United States Treasury (the “UST”) and the accrual of dividends on the preferred shares.

 

On April 17, 2009, the Company became a participant in the UST Capital Purchase Program by selling shares of Series A preferred stock to the UST having a liquidation value of $13.2 million. The preferred shares have a cumulative dividend rate of 5% per annum for the first five years and 9% per annum thereafter. As a part of the transaction, the Company also issued the UST warrants to purchase 475,204 shares of the Company’s common stock at $4.16 per share for a term of ten years.

 

Off-Balance Sheet Transactions.    Certain financial transactions are entered into by the Company in the ordinary course of performing traditional banking services that result in off-balance sheet transactions. The off-balance sheet

 

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transactions as of December 31, 2009 and 2008 were commitments to extend credit and financial letters of credit. Except as disclosed in this report, the Company does not have any ownership interest in any off-balance sheet subsidiaries or special purpose entities.

 

     December 31,
     2009    2008
     (In Thousands)

Loan commitments

   $ 24,176    $ 57,717

Financial standby letters of credit

     2,477      2,139
             

Total unused commitments

   $ 26,653    $ 59,856
             

 

Commitments to extend credit to customers represent legally binding agreements with fixed expiration dates. Since many of these commitments expire without being funded, the commitment amounts do not necessarily represent liquidity requirements.

 

Contractual Obligations.    The following disclosure shows the contractual obligations that the Company had outstanding at December 31, 2009.

 

     Total payments due by period
     Total    Less than
1 Year
   1-3
Years
   3-5
Years
   More than
5 Years
     (in thousands)

Time deposits

   $ 187,344    $ 119,438    $ 66,698    $ 1,208    $

Securities sold under term repurchase agreements(1)

     45,000                     45,000

Federal Home Loan Bank advances

     15,000      5,000      10,000          

Trust preferred securities

     5,155                     5,155

Subordinated debt

     2,700                     2,700

Leases

     1,311      280      661      370     
                                  

Total

   $ 256,510    $ 124,718    $ 77,359    $ 1,578    $ 52,855
                                  

 

(1)   Obligations in this category are classified as to maturity dates. One repurchase agreement, with a principal balance of $20 million, may be called by the holder on a quarterly basis beginning August 20, 2011. The other repurchase agreement included above, which has a principal balance of $25 million, may be called by the holder on a quarterly basis beginning July 8, 2013.

 

COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2009, 2008, AND 2007

 

Net Income (Loss).    We had a net loss available to common shareholders of $3.8 million or $0.97 per share for the year ended December 31, 2009, compared to net loss of $3.6 million or $0.92 per share for the year ended December 31, 2008 and net income for the year ended December 31, 2007 of $2.0 million, or $.50 per diluted common share. As noted earlier, the principal reason for the losses incurred during the past two years has been related to deterioration in our loan portfolio which has resulted in materially higher loan loss provisions and increased expenses related to the ownership and disposal of foreclosed real estate.

 

Net Interest Income.    Our primary source of revenue is net interest income, which is the difference between interest income generated by our interest-earning assets (primarily loans and investment securities) and interest expense on interest-bearing liabilities (primarily deposits and borrowed funds). Net interest income increased $2.0 million to $14.7 million in 2009 from 2008 after declining $1.9 million from 2007. Our net interest margin remained stable in 2009 compared to 2008 at 2.56% after declining from a margin of 3.36% in 2007. Our net interest spread improved to 2.42% in 2009 from 2.29% in 2008 which represented a substantial decline from the 2007 spread of 2.96%. The volatility in our net interest margin and net interest spread and resulting net interest income over the past two years has been primarily due to the declines in short-term rates brought about by very aggressive Federal Reserve policies, slowing loan growth, increased levels of nonperforming assets and the effects of the special money market promotion discussed earlier. While our 2009 net interest margin was identical with 2008 performance, net interest income, as noted above, increased $2.0 million, or 15.6%, in 2009 compared to 2008. Also, the net interest margin in the third and fourth quarters of 2009 showed better

 

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relative improvement from the 2008 quarters than the full year results largely as the result of reducing rates on the money market deposits that were placed with us during our special promotion.

 

Table IX summarizes the average balances of our various categories of assets and liabilities and their associated yields or costs for the years ended on December 31, 2009, 2008, and 2007.

 

Table IX.

SUMMARY OF NET INTEREST INCOME AND AVERAGE BALANCES

 

    December 31, 2009     December 31, 2008     December 31, 2007  
    Average
Balance
  Interest
Income/
Expense
  Yield/
Cost
    Average
Balance
  Interest
Income/
Expense
  Yield/
Cost
    Average
Balance
  Interest
Income/
Expense
  Yield/
Cost
 
    (dollars in thousands)  

Interest-earning assets:

                 

Loans

  $ 401,512   $ 23,685   5.90   $ 405,951   $ 26,276   6.47   $ 365,866   $ 29,874   8.17

Investment securities

    149,061     5,860   3.93        80,916     4,091   5.06        60,370     2,808   4.65   

Other interest-earning assets

    22,445     76   0.34        9,441     208   2.20        8,161     423   5.18   
                                         

Total interest-earning assets

    573,018     29,621   5.17     496,308     30,575   6.16     434,397     33,105   7.62
                             

Other assets, net

    51,490         38,197     `        32,248    
                             

Total assets

  $ 624,508       $ 534,505       $ 466,645    
                             

Interest bearing liabilities:

                 

Interest-checking deposits

  $ 32,172     365   1.13   $ 25,801     287   1.11   $ 27,385     392   1.43

Money Market and Savings deposits

    266,108     6,973   2.62        113,220     3,687   3.26        51,410     1,870   3.64   

Time deposits

    169,825     4,530   2.67        267,649     11,645   4.35        292,437     15,001   5.13   
                                         

Total interest-bearing deposits

    468,105     11,868   2.54        406,670     15,619   3.84        371,232     17,263   4.65   

Borrowed funds

    76,078     3,087   4.06        55,304     2,265   4.10        25,347     1,237   4.88   
                                         

Total Interest-bearing liabilities

    544,183     14,955   2.75        461,974     17,884   3.87        396,579     18,500   4.66   
                             

Noninterest-bearing demand deposits

    33,609         31,855         28,980    

Other liabilities

    1,739         1,535         2,699    

Stockholders’ Equity

    44,977         39,141         38,387    
                             

Total liabilities and stockholders’ equity

  $ 624,508       $ 534,505       $ 466,645    
                             

Net interest income and interest rate spread

    $ 14,666   2.42     $ 12,691   2.29     $ 14,605   2.96
                                         

Net yield on average interest-earning assets

      2.56       2.56       3.36
                             

Ratio of average interest-earning assets to average interest-bearing liabilities

      105.30       107.43       109.54
                             

 

Non accrual loans are included in the table for the years ended December 31, 2009, 2008, and 2007.

 

Loan fees and late charges of $224, $899, and $1,054 for 2009, 2008, and 2007, respectively, are included in interest income.

 

Table X summarizes the dollar amount of changes in interest income and interest expense for the major components of our interest-earning assets and interest-bearing liabilities during the twelve months ended December 31, 2009 and 2008. The table shows changes in interest income and expense attributable to volume changes and interest rate changes. The changes attributable to both rate and volume changes have been allocated between the two components on a relative basis. As the table indicates, the increase in net interest income realized during 2009 in comparison to 2008 was overwhelmingly the result of interest rate changes, as volume changes actually had a negative effect on the current year

 

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results. The table also indicates that rates reduced the cost of interest-bearing liabilities significantly more than they reduced the income from interest-earning assets, which is reflective of the effect of reducing the rates on our money market deposits.

 

Table X.

VOLUME / RATE VARIANCE ANALYSIS

 

    Year Ended December 31, 2009 vs. 2008
Increase (Decrease) Due to
    Year Ended December 31, 2008 vs. 2007
Increase (Decrease) Due to
 
    Volume     Rate     Total     Volume    Rate     Total  
    (dollars in thousands)  

Interest-earning assets:

            

Loans

  $ (288   $ (2,303   $ (2,591   $ 3,199    $ (6,797   $ (3,598

Investment securities

    2,800        (1,031     1,769        984      299        1,283   

Other interest-earning assets

    (47     (85     (132     60      (275     (215
                                              

Total interest income

    2,465        (3,419     (954     4,243      (6,773     (2,530
                                              

Interest-bearing liabilities:

            

Deposits

    2,238        (5,989     (3,751     1,621      (3,265     (1,644

Borrowed funds

    848        (26     822        1,184      (156     1,028   
                                              

Total interest expense

    3,086        (6,015     (2,929     2,805      (3,421     (616
                                              

Net interest income

  $ (621   $ 2,596      $ 1,975      $ 1,438    $ (3,352   $ (1,914
                                              

 

Provision for Loan Losses.    Provisions for loan losses are charged to income in order to maintain the allowance for loan losses at a level we deem appropriate under circumstances known to exist at the balance sheet date. In evaluating the allowance for loan losses, we consider factors that include portfolio size, composition and industry diversification of the portfolio, historical loan loss experience, current levels of impaired and delinquent loans, adverse situations that may affect a borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions and other relevant factors. The allowance for loan losses expressed as a percentage of total loans was 2.09%, 1.56%, and 1.07% at December 31, 2009, 2008, and 2007, respectively. The allowance includes $4.0 million at December 31, 2009 and $1.4 million at December 31, 2008 allocated to specific loans with principal balances totaling approximately $11.3 million and $4.2 million, respectively. See “Critical Accounting Policies”.

 

The provision for loan losses decreased 11.8% to $5.5 million in 2009 from $6.3 million in 2008. The 2008 provision was 4.3 times the $1.5 million provision recorded in 2007 and reflected the beginning of the current credit cycle, which has been particularly difficult for lenders with large concentrations of real estate loans. The sizable provisions recorded in both 2009 and 2008 were the result of net charge-offs and nonperforming asset levels that were significantly above long-term historic trends on a relative basis.

 

Net loan charge-offs for 2009 totaled $3.7 million which equates to 0.92% of average loans for the year and a 12.8% decline from 2008 net charge-offs of $4.2 million which represented 1.04% of average loans outstanding for that year. For the five years prior to the current credit cycle (2003 – 2007), our net charge-offs averaged .21% of average loans on an annual basis.

 

Total nonperforming assets amounted to $17.4 at December 31, 2009, an increase of 41.4% from the year-end 2008 total of $12.3 million. Total nonperforming assets as a percent of loan-related assets (loans plus foreclosed real estate) amounted to 4.37% at December 31, 2009 compared to 3.00% as of year-end 2008. For the five year-ends preceding the current credit cycle, nonperforming assets averaged 1.35% of loan-related assets. Nonperforming assets as a percent of total assets was 2.86% of total assets at the end of 2009 compared to 2.20% at December 31, 2008. On a historic basis, nonperforming assets as a percent of total assets averaged 1.06% for the 2003 – 2007 year-ends.

 

Noninterest Income.    In addition to net interest income, we derive revenues from providing a variety of financial services to our customers. Fees from providing these services totaled $1.3 million in 2009, $1.4 million in 2008 and $1.5 million in 2007. The largest component of customer service fees is revenues from deposit services which totaled $826,000

 

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in 2009, $889,000 in 2008 and $849,000 in 2007. While this is a mature and very competitive part of our business, we believe this is an area of opportunity. The fastest growing area of fee revenue is from debit card services. While this is not a new service, it is still a relatively new part of the U.S. payment system. Our revenues in this area almost doubled from $151,000 to $290,000 over the past two years. Fees from loan services, which primarily includes fees related to real estate loan production, declined 27.2% in 2009 as real estate lending slowed. A significant factor affecting our growth in overall customer service fees is our decision to exit the investment services business. In 2007, we collected $229,000 in revenue from facilitating the sale of packaged financial products to our customer base while only $3,000 in revenue was recorded in 2009.

 

Other significant components of noninterest income are gains and losses on investment securities and increase in the cash value of life insurance policies we hold on our officer level employees. In 2009, we realized $1.5 million in net gains on investment securities. This includes an other than temporary impairment charge of $498,000 on a $1 million investment in the trust preferred securities as a result of the guarantor exercising its right to defer interest payments to the issuing trust.

 

The following is a tabular presentation of our non-interest income for the years ended December 31, 2009, 2008, and 2007.

 

Table XI.

NONINTEREST INCOME

 

     2009    2008    2007  
     (dollars in thousands)  

Deposit services fees

   $ 826    $ 889    $ 849   

Card services fees

     290      237      151   

Loan services fees

     147      202      200   

Investment services revenue

     3      19      229   

Other customer services fees

     78      74      64   
                      

Total customer services fees

     1,344      1,421      1,493   

Net gain (loss) on investment securities

     1,530      615      (42

Increase in cash value of bank owned life insurance

     364      362      346   

All other income

     59      36      138   
                      

Total noninterest income

   $ 3,297    $ 2,434    $ 1,935   
                      

 

Non-interest Expense.    Non-interest expense totaled $17.5 million for the year ended December 31, 2009, an increase of $2.4 million, or 16.0% over the $15.1 million reported for the year ended December 31, 2008, which was a $2.7 million increase, or 21.7%, from the 2007 amount. The major factors contributing to the increase in noninterest expenses in 2009 compared to 2008 were (1) an increase of $1.2 million, or 358.8%, in FDIC insurance cost, as the result of the increased assessment rate, (2) an increase of $782,000, or 70.0%, in net operating costs and net losses on foreclosed real estate, reflecting higher levels of foreclosure activity, (3) an increase of $729,000, or 156.8%, in professional service expenditures, primarily the result of outsourcing certain credit administration functions and increased legal fees, (4) an increase of $201,000, or 10.0%, in occupancy and equipment expenses due primarily to new asset purchases and property taxes, and (5) an increase of $199,000, or 23.6%, in data processing costs as a result of a systems conversion. These increases were partially offset by a reduction in goodwill impairment charges of $591,000 due to the Company’s action to completely write-off its unamortized goodwill in 2008.

 

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The following table summarizes the major components of our non-interest expense for the years ended December 31, 2009, 2008, and 2007.

 

Table XII.

NONINTEREST EXPENSES

 

     2009    2008    2007
     (dollars in thousands)

Salaries and benefits

   $ 7,040    $ 7,054    $ 5,977

Occupancy and equipment expenses

     2,221      2,020      1,731

FDIC insurance assessments

     1,505      328      252

Data processing

     1,042      843      758

Professional services

     1,194      465      1,016

Telephone and data communications

     341      338      202

Advertising and promotional

     316      443      474

Postage and courier

     264      206      210

Printing and supplies

     241      211      230

Valuation allowances and net operating costs associated with foreclosed real estate

     1,899      1,117      45

Goodwill impairment

          591     

All other expenses

     1,451      1,476      1,503
                    

Total noninterest expenses

   $ 17,514    $ 15,092    $ 12,398
                    

 

Income Taxes.    We recorded income tax benefits of $2.0 million in 2009 and $2.6 million in 2008 and income tax expense of $714,000 in 2007. The 2009 income tax benefit amounted to 38.6% of our pretax loss as compared to 42.1% of pre-tax loss for 2008 and the income tax expense amounted to 26.7% of pre-tax income for 2007.

 

CAPITAL ADEQUACY

 

We are required to comply with the capital adequacy standards established by the Federal Deposit Insurance Corporation (FDIC). The FDIC has issued risk-based capital and leverage capital guidelines for measuring the adequacy of a bank’s capital, and all applicable capital standards must be satisfied for us to be considered in compliance with the FDIC’s requirements. On December 31, 2009, our Total Capital Ratio and Tier 1 Capital Ratio were 11.67% and 9.86%, respectively, both well above the minimum levels required by the FDIC’s guidelines. On December 31, 2009 our Tier 1 Leverage Capital Ratio was 7.27%, which was also well above the minimum level required by the FDIC’s guidelines. However, the Company and the Bank’s Board of Directors have entered into informal agreements with our respective banking regulators which are described in Note 10 to our audited financial statements included in Item 8 of this Report.

 

Among other things, the agreements require that the Bank maintain capital levels in excess of normal statutory minimums, including a Tier 1 Leverage Capital Ratio of not less than 7.50%, and other ratios at least at “well capitalized” levels. At December 31, 2009, the Bank’s Tier1 Leverage Capital Ratio was 7.38%, slightly below the agreed to minimum. During the latter part of 2009 the Bank implemented a deposit pricing strategy designed to improve net interest income and at the same time reduce the size of our balance sheet. This strategy has been effective as total period-end assets at December 31, 2009 declined $53.7 million from September 30, 2009. The decline in assets was the principally the result of a $51.3 million reduction in deposits, driven by declines in money market and brokered deposits. The outflow in deposits was funded through reductions in liquid assets. The Tier 1 Leverage Capital Ratio is calculated based on the fourth quarter average of total assets, so the full effect of our balance sheet strategy was not recognized for this purpose at year-end. If period-end assets had been used to calculate the Bank’s Tier 1 Leverage Ratio at December 31, 2009 rather than fourth quarter average, the ratio would have been 7.76%, higher than the level agreed to and above the ratio at which institutions are normally considered well-capitalized. Based on average assets through March 29, 2010, we are confident that the Tier 1 Leverage Ratio will remain above 7.50% for the first quarter of 2010.

 

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LIQUIDITY AND INTEREST RATE SENSITIVITY

 

Liquidity.    Liquidity management is the process of managing assets and liabilities as well as their maturities to ensure adequate funding for loan and deposit activity as well as continued growth of the Company. Sources of liquidity come from both balance sheet and off-balance sheet sources. We define balance sheet liquidity as the relationship that net liquid assets have to unsecured liabilities. Net liquid assets is the sum of cash and cash items, less required reserves on demand and NOW deposits, plus demand deposits due from banks, plus temporary investments, including federal funds sold, plus the fair value of investment securities, less collateral requirements related to public funds on deposit and repurchase agreements. Unsecured liabilities is equal to total liabilities less required cash reserves on noninterest-bearing demand deposits and interest-checking deposits and less the outstanding balances of all secured liabilities, whether secured by liquid assets or not. We consider off-balance sheet liquidity to include unsecured federal funds lines from other banks and loan collateral which may be used for additional advances from the Federal Home Loan Bank. As of December 31, 2009 our balance sheet liquidity ratio (net liquid assets as a percent of unsecured liabilities) amounted to 23.8% and our total liquidity ratio (balance sheet plus off-balance sheet liquidity) was 26.0%.

 

In addition, we have the ability to borrow $10.0 million from the Discount Window of the Federal Reserve, as well as $10.0 million from a correspondent bank, subject to our pledge of marketable securities, which could be used for temporary funding needs. We also have the ability to borrow from the Federal Home Loan Bank on similar terms. While we consider these arrangements sources of back-up funding, we do not consider them as liquidity sources because they require our pledge of liquid assets as collateral. We regularly borrow from the Federal Home Loan Bank as a normal part of our business. These advances, which totaled $15.0 million at December 31, 2009, are secured by various types of real estate-secured loans. The Company closely monitors and evaluates its overall liquidity position. The Company believes its liquidity position at December 31, 2009 is adequate to meet its operating needs.

 

Interest Rate Sensitivity.    Our goal is to maintain a neutral interest rate sensitivity position whereby little or no change in interest income would occur as interest rates change. On December 31, 2009, we were cumulatively liability sensitive for the next twelve months, which means that our interest-bearing liabilities would reprice more quickly than our interest bearing assets. Theoretically, our net interest margin will decrease if market interest rates rise or increase if market interest rates fall. However, the repricing characteristic of assets is different from the repricing characteristics of funding sources. Therefore, net interest income can be impacted by changes in interest rates even if the repricing opportunities of assets and liabilities are perfectly matched.

 

The following table shows the interest rate sensitivity of our balance sheet on December 31, 2009, but is not necessarily indicative of our position on other dates. Each category of assets and liabilities is shown with projected repricing and maturity dates. Except as stated below, the amounts of assets and liabilities shown which reprice or mature within a particular period were determined in accordance with the contractual terms of the assets or liabilities. Loans with adjustable rates are shown as being due at the end of the next upcoming adjustment period. NOW accounts, savings accounts, and money market accounts are assumed to be subject to immediate repricing and depositor availability. Prepayment assumptions on mortgage loans and decay rates on deposit accounts have not been included in this analysis. Also, the table does not reflect scheduled principal repayments that will be received on loans. The interest rate sensitivity of our assets and liabilities may vary substantially if different assumptions are used or if our actual experience differs from that indicated by the assumptions.

 

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Table XIII.

INTEREST SENSITIVITY

 

     December 31, 2009  
     1-3
months
    Over 3 to
12 months
    Over 12 to
60 months
    Over
60 months
    Total  
     (dollars in thousands)  

Interest-earning assets:

          

Loans

   $ 206,700      $ 34,719      $ 124,044      $ 25,802      $ 391,265   

Investment securities

     7,746        8,165        86,998        37,095        140,004   

Other interest-earning assets

     29,835        4,000                      33,835   
                                        

Total interest-earning assets

   $ 244,281      $ 46,884      $ 211,042      $ 62,897      $ 565,104   
                                        

Interest-bearing liabilities:

          

Interest-checking deposits

   $ 34,614      $      $      $      $ 34,614   

Money market and savings deposits

     235,541                             235,541   

Time deposits

     45,212        74,225        67,907               187,344   

Borrowed funds

     9,537        5,000        35,000        20,000        69,537   
                                        

Total interest-bearing liabilities

   $ 324,904      $ 79,225      $ 102,907      $ 20,000      $ 527,036   
                                        

Interest-sensitivity gap

   $ (80,623   $ (32,341   $ 108,135      $ 42,897      $ 38,068   
                                        

Cumulative sensitivity gap

   $ (80,623   $ (112,964   $ (4,829   $ 38,068      $ 38,068   
                                        

Cumulative gap as a % of total interest-earning assets

     (14.27 )%      (19.99 )%      (0.85 )%      6.74     6.74
                                        

Cumulative ratio of sensitive assets to sensitive liabilities

     75.19     59.18     205.08     314.49     107.22
                                        

 

Quarterly financial data for 2009 and 2008 is summarized in the table below.

 

Table XIV.

QUARTERLY FINANCIAL DATA

 

     2009     2008  
     4th Qtr     3rd Qtr.     2nd Qtr.     1st Qtr.     4th Qtr     3rd Qtr.     2nd Qtr.     1st Qtr.  
     (dollars in thousands except per share amounts)  

Interest income

   $ 7,122      $ 7,529      $ 7,433      $ 7,537      $ 7,794      $ 7,531      $ 7,353      $ 7,897   

Interest expense

     2,748        3,433        4,421        4,353        4,508        4,521        4,196        4,659   
                                                                

Net interest income

     4,374        4,096        3,012        3,184        3,286        3,010        3,157        3,238   

Provision for loan losses

     3,081        1,046        720        700        2,046        3,150        781        314   
                                                                

Net interest income (loss) after provision for loan losses

     1,293        3,050        2,292        2,484        1,240        (140     2,376        2,924   

Noninterest income

     634        1,715        610        338        994        470        518        452   

Noninterest expense

     4,697        3,846        5,179        3,792        4,280        4,140        3,291        3,381   
                                                                

Income (loss) before income taxes

     (2,770     919        (2,277     (970     (2,046     (3,810     (397     (5

Income taxes (benefit)

     (992     137        (798     (315     (1,406     (1,090     (138       
                                                                

Net income (loss)

     (1,778     782        (1,479     (655     (640     (2,720     (259     (5

Dividends and accretion on preferred stock

     (226     (312     (99                                   
                                                                

Net income (loss) available to common shareholders

   $ (2,004   $ 470      $ (1,578   $ (655   $ (640   $ (2,720   $ (259   $ (5
                                                                

Earnings (loss) per common share:

                

Basic

   $ (0.51   $ 0.12      $ (0.41   $ (0.17   $ (0.16   $ (0.69   $ (0.07   $   

Diluted

   $ (0.51   $ 0.12      $ (0.41   $ (0.17   $ (0.16   $ (0.69   $ (0.07   $   

 

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EFFECTS OF INFLATION AND CHANGING PRICES

 

A commercial bank has an asset and liability structure that is distinctly different from that of a company with substantial investments in plant and inventory because the major portion of its assets is monetary in nature. As a result, a bank’s performance may be significantly influenced by changes in interest rates. Although the banking industry is more affected by changes in interest rates than by inflation in the price of goods and services, inflation also is a factor that may influence interest rates. Yet, the frequency and magnitude of interest rate fluctuations do not necessarily coincide with changes in the general inflation rate. Inflation does affect our operating expense in that personnel expense and the cost of supplies and outside services tend to increase more during periods of high inflation.

 

DISCLOSURES ABOUT FORWARD LOOKING STATEMENTS

 

This Report and its exhibits may contain statements relating to our financial condition, results of operations, plans, strategies, trends, projections of results of specific activities or investments, expectations or beliefs about future events or results, and other statements that are not descriptions of historical facts. Those statements may be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may be identified by terms such as “may,” “will,” “should,” “could,” “expects,” “plans,” “intends,” “anticipates,” “believes,” “estimates,” “predicts,” “forecasts,” “potential” or “continue,” or similar terms or the negative of these terms, or other statements concerning opinions or judgments of the Company’s management about future events. Forward-looking information is inherently subject to risks and uncertainties, and actual results could differ materially from those currently anticipated due to a number of factors, which include, but are not limited to, risk factors discussed in the Company’s Annual Report on Form 10-K and in other documents the Company files with the Securities and Exchange Commission from time to time. Copies of those reports are available directly through the Commission’s website at www.sec.gov. Other factors that could influence the accuracy of forward-looking statements include, but are not limited to, (a) pressures on the earnings, capital and liquidity of financial institutions resulting from current and future adverse conditions in the credit and equity markets and the banking industry in general; (b) changes in competitive pressures among depository and other financial institutions or in the Company’s ability to compete successfully against the larger financial institutions in its banking markets; (c) the financial success or changing strategies of the Company’s customers; (d) actions of government regulators, or changes in laws, regulations or accounting standards, that adversely affect the Company’s business; (e) changes in the interest rate environment and the level of market interest rates that reduce the Company’s net interest margins and/or the volumes and values of loans it makes and securities it holds; (f) changes in general economic or business conditions and real estate values in the Company’s banking markets (particularly changes that affect the Company’s loan portfolio, the abilities of its borrowers to repay their loans, and the values of loan collateral); and (g) other unexpected developments or changes in the Company’s business. Although the Company believes that the expectations reflected in the forward-looking statements are reasonable, it cannot guarantee future results, levels of activity, performance or achievements. All forward-looking statements attributable to the Company are expressly qualified in their entirety by the cautionary statements in this paragraph. The Company has no obligation, and does not intend, to update these forward-looking statements.

 

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

 

Not applicable

 

Item 8. Financial Statements and Supplementary Data.

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Bank of the Carolinas

 

To the Board of Directors and

Stockholders of Bank of the Carolinas Corporation

 

We have audited the accompanying consolidated balance sheet of Bank of the Carolinas Corporation and Subsidiary (hereinafter referred to as the “Company”) as of December 31, 2009, and the related consolidated statements of operations, changes in stockholders’ equity and cash flows for the year ended December 31, 2009. Bank of the Carolinas Corporation and Subsidiary’s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. The consolidated financial statements of Bank of the Carolinas Corporation and Subsidiary for the years ended December 31, 2008 and 2007 were audited by other auditors whose report dated April 15, 2009 expressed an unqualified opinion on those statements.

 

We conducted our audit 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 from 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 audit 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 audit provides a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Bank of the Carolinas Corporation and Subsidiary as of December 31, 2009, and the results of its operations and cash flows for the year ended December 31, 2009 in conformity with accounting principles generally accepted in the United States of America.

 

/s/ Turlington and Company, LLP

Lexington, North Carolina

March 29, 2010

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Bank of the Carolinas

 

To the Board of Directors and Stockholders

Bank of the Carolinas Corporation

Mocksville, North Carolina

 

We have audited the accompanying consolidated balance sheet of Bank of the Carolinas Corporation and subsidiary (hereinafter referred to as the “Company”) as of December 31, 2008, and the related consolidated statements of operations, changes in stockholders’ equity and cash flows for each of the years in the two year period ended December 31, 2008. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated 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. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audit 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 includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes 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 Bank of the Carolinas Corporation and subsidiary as of December 31, 2008, and the results of their operations and their cash flows for each of the years in the two year period ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America.

 

/s/ Dixon Hughes, PLLC

Asheville, North Carolina

April 15, 2009

 

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CONSOLIDATED BALANCE SHEETS

 

Bank of the Carolinas Corporation

December 31, 2009 and 2008

 

     2009     2008  
     (In thousands except share
and per share data)
 

Assets:

    

Cash and due from banks, noninterest-bearing

   $ 3,524      $ 8,271   

Interest-bearing deposits in banks

     9,020        2,220   
                

Cash and cash equivalents

     12,544        10,491   

Federal funds sold

     24,815          

Investment securities

     140,004        113,139   

Loans receivable

     391,265        405,402   

Less: Allowance for loan losses

     (8,167     (6,308
                

Total loans, net

     383,098        399,094   

Premises and equipment, net

     14,010        15,324   

Other real estate owned

     8,233        5,622   

Bank owned life insurance

     10,010        9,645   

Deferred tax assets

     3,429        1,326   

Prepaid FDIC insurance assessment

     4,569          

Accrued interest receivable

     2,397        3,039   

Other assets

     7,278        4,327   
                

Total Assets

   $ 610,387      $ 562,007   
                

Liabilities:

    

Deposits:

    

Noninterest-bearing demand deposits

   $ 36,418      $ 27,507   

Interest-checking deposits

     34,614        28,172   

Money market and savings deposits

     235,541        232,282   

Time deposits

     187,344        156,579   
                

Total deposits

     493,917        444,540   

Securities sold under repurchase agreements

     46,682        46,557   

Federal home loan bank advances

     15,000        25,000   

Subordinated debt

     7,855        7,855   

Other liabilities

     1,941        1,464   
                

Total Liabilities

     565,395        525,416   
                

Commitments and contingencies (Notes 4, 12, and 13)

              

Stockholders’ Equity:

    

Preferred stock, no par value

     13,179          

Discount on preferred stock

     (1,245       

Common stock, $5 par value per share

     19,486        19,456   

Additional paid in capital

     12,978        11,625   

Retained earnings

     300        4,067   

Accumulated other comprehensive income

     294        1,443   
                

Total Stockholders’ Equity

     44,992        36,591   
                

Total Liabilities and Stockholders’ Equity

   $ 610,387      $ 562,007   
                

Preferred shares authorized

     3,000,000        3,000,000   

Preferred shares issued and outstanding

     13,179          

Common shares authorized

     15,000,000        15,000,000   

Common shares issued and outstanding

     3,897,174        3,891,174   

 

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

 

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CONSOLIDATED STATEMENTS OF OPERATIONS

 

Bank of the Carolinas Corporation

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

 

     2009     2008     2007  
     (In thousands except
per share data)
 

Interest and dividend income:

      

Loans, including fees

   $ 23,685      $ 26,276      $ 29,874   

Investment securities

     5,860        4,091        2,808   

Other

     76        208        423   
                        

Total interest income

     29,621        30,575        33,105   
                        

Interest expense:

      

Deposits

     11,868        15,619        17,263   

Other borrowings

     3,087        2,265        1,237   
                        

Total interest expense

     14,955        17,884        18,500   
                        

Net interest income

     14,666        12,691        14,605   

Provision for loan losses

     5,547        6,291        1,470   
                        

Net interest income after provision for loan losses

     9,119        6,400        13,135   
                        

Non-interest income:

      

Customer service fees

     1,344        1,421        1,493   

Increase in bank owned life insurance

     364        362        346   

Gain (loss) on investment securities

     1,530        615        (42

Other

     59        36        138   
                        

Total non-interest income

     3,297        2,434        1,935   
                        

Noninterest expense:

      

Salaries and employee benefits

     7,040        7,054        5,977   

Net occupancy expense

     2,221        2,020        1,731   

FDIC insurance assessments

     1,505        328        252   

Data processing

     1,042        843        758   

Professional services

     1,194        465        1,016   

Advertising

     316        443        474   

Goodwill impairment

            591          

Valuation allowances and net operating costs associated with foreclosed real estate

     1,899        1,117        45   

Other

     2,297        2,231        2,145   
                        

Total non-interest expense

     17,514        15,092        12,398   
                        

Income (loss) before income taxes

     (5,098     (6,258     2,672   

Income tax expense (benefit)

     (1,968     (2,634     714   
                        

Net income (loss)

     (3,130     (3,624     1,958   

Preferred stock dividends and accretion

     (637              
                        

Net income (loss) available to common stockholders

   $ (3,767   $ (3,624   $ 1,958   
                        

Net income (loss) per common share

      

Basic

   $ (0.97   $ (0.92   $ 0.51   
                        

Diluted

   $ (0.97   $ (0.92   $ 0.50   
                        

 

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

 

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CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

 

Bank of the Carolinas Corporation

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

 

    Preferred Stock     Common Stock     Additional
Paid-In

Capital
    Retained
Earnings
    Accumulated
Other
Comprehensive

Income (Loss)
    Total
Stockholders’

Equity
 
    Shares   Amount   Discount     Shares     Amount          
    (In thousands except share and per share data)  

Balance, December 31, 2006

    $   $      3,826,792      $ 19,134      $ 11,444      $ 7,293      $ (157   $ 37,714   

Stock options exercised

               93,960        470        129                      599   

Current income tax benefit on options exercised

                             121                      121   

Stock based compensation expense

                             22                      22   

Cash dividends declared ($.20 per share)

                                    (775            (775

Comprehensive income:

                 

Net income

                                    1,958               1,958   

Other comprehensive income

                                           601        601   
                       

Total comprehensive income

                    2,559   
                                                               

Balance, December 31, 2007

               3,920,752        19,604        11,716        8,476        444        40,240   

Stock options exercised

               66,622        333        91                      424   

Stock repurchase

               (96,200     (481     (241                   (722

Current income tax benefit on options exercised</